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Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at the Morningstar Sustainable Investing Summit 2023, Amsterdam, 12 October 2023. | Steven Maijoor: Managing climate and environmental related risk stepping up the pace Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at the Morningstar Sustainable Investing Summit 2023, Amsterdam, 12 October 2023. *** I was with my family in Greece for the summer holidays. One evening we walked through a street in Athens with restaurants lined up along the street, and there was a man trying to lure tourists into his restaurant. When he approached us I told him we had other plans, but somehow I wanted to know how he was doing. So I asked him. And what I did not expect was that he started ranting, a complete stranger, about how the summers had become unbearably hot, and that the number of tourists was already declining as a result. He was very depressed about the whole situation and he confided in me that he was seriously considering moving to Norway. I was shocked and sad because I saw he really meant it. And the hard truth hit home again that the climate crisis is here and now, and it is affecting the lives of real people. And on top of that, it is affecting our economies. And when it affects our economies, it affects our financial sector as well. Financial institutions are exposed to climate and environmental risk. Think for instance about the risk of a flood in the western part of the Netherlands. Don't forget we are below sea level here. Serious flooding could increase a bank's credit risk following damage to collateral such as houses and other buildings. And this would then require a bank to draw on its capital reserves. That's what we call physical risk. And then there is transition risk as well. Transitioning to a net-zero society will likely lead to adjusted or new government policies. It could also lead to technological advances, or changes in market sentiment and market preferences. The transition to a net-zero economy creates risk for financial institutions that are highly exposed to sectors of the economy that are unprepared. Governments, for example, could impose higher taxes on greenhouse gas emissions. As a result, the revenue of an energy-intensive company could decline. And this could impact the company's creditworthiness and its ability to repay outstanding debts to banks. Physical and transition risks are not only related to climate change. Financial institutions are also exposed to risk stemming from the degradation of nature, and actions aimed at preserving and restoring it. Nature provides services that are essential to our economies and, basically, life itself. Think of pollination, which is crucial for farmers, and for our food supply in general. To give you an idea of the magnitude of the exposures, let me give you some numbers. More than 500 billion euro in investments by Dutch financial institutions are highly dependent on one or more of the services we find in our natural environment. Also, the global carbon footprint financed by Dutch financial institutions is at least 82 Megatonnes. This is equivalent to the emissions caused if all the inhabitants of New York City would fly to London and back. Ten times. This carbon footprint can lead to increased credit and market risk, among other things, as a result of the transition to a carbon-neutral economy. 1/4 BIS - Central bankers' speeches This is exposure, not risk. But still, these exposures could develop into a substantial amount of risk. Because business models that are reliant on sectors and markets which are particularly vulnerable to climate- and nature-related risks may not be future-proof anymore. Simply because transition risks may impact the current-day business models. For example, the Dutch agricultural industry will likely need to shrink in order to meet long term bio-diversity requirements. Hence, banks that are heavily involved in financing the agricultural industry today, must prepare for a changing demand for credit from this sector, in the future. In addition to physical risk and transition risk, financial institutions also face potential reputational and legal risk. These risks follow from an increased awareness in society of the effects of climate change and nature degradation. For instance, if a bank promises to be more green and to reduce its investments in fossil fuel sectors, but does not live up to its commitment, its reputation could be harmed. People will react and activist measures or changes in consumption patterns could follow. Their goal being, ultimately, to drive banks towards a more environmentally friendly business model. It is clear that people have become more and more aware of the importance of climate change and environmental degradation and their consequences for daily life. People are prepared to take action. And they are prepared to take legal steps as well. Therefore, banks may also be exposed to increasing litigation risk. If a bank, as a signatory to a climate commitment, does not live up to what it promises, not only could its reputation be harmed, it could also be subject to litigation, for example by NGOs. Actions against greenwashing are a good example. Environmental organisations, policymakers and supervisors are all sensitive to attempts at greenwashing. The legal risks associated with greenwashing are significant. And so not living up to a climate commitment may lead to litigation risk that could have significant financial consequences. To illustrate the significance of this risk, the total number of climate change-related court cases worldwide has more than doubled since 2017 and is growing. So the climate- and nature-related risk to which financial firms like yours are exposed may be considerable. The recent good news is that the Dutch Environmental Agency for the first time has indicated that the Netherlands seems to be on track to reach its target of a 55 percent decrease in CO2 emissions by 2030 – as compared to 1990. If we work really hard. And we won't be done with the Netherlands delivering on its climate ambition only. The transition to a carbon-neutral society, in harmony with nature, is, simply put, the world's biggest challenge and should be a top priority around the globe. Governments are in the lead here, through regulation, adequate pricing of carbon emissions, and encouraging the financing of innovative, sustainable investment. As a central bank we have supported this transition with research, advice and by bringing key players together to facilitate sustainable finance where we can. As a supervisory authority we also have a responsibility. A responsibility to make sure that financial institutions manage climate- and nature-related risk. Because ignoring these risks is no longer compatible with sound risk management. That's where my focus lies today. Over the past years we have been active in bringing these risks to your attention. Initially by sharing with you what we consider to be good practices and other suggestions for dealing with climate and environmental risks. Think of the ECB and DNB guides on climate-related and environmental risks. Think of the Basel Committee principles for the effective management and supervision of climate-related financial 2/4 BIS - Central bankers' speeches risks. And the ECB has urged banks to analyse climate and environmental risks and integrate them into their business models, governance, risk management and disclosures. But despite all efforts I must say I am concerned about the pace and the amount of action in the financial sector. Yes, financial institutions have made meaningful progress in accounting for climate and environmental risks. Some banks have shown they acknowledge the materiality of climate risks in their portfolios. The same holds for pension funds. And they have made progress in including these risks in their risk management frameworks and processes. Also, around 50 banks, insurers, pension funds and asset managers in the Netherlands have signed the Climate Commitment. As signatories to this Commitment they agree to actively contribute to the implementation of the climate goals set out in the Paris Agreement. Institutions that have signed this commitment have 18 months to do a number of things. They need to identify operational and attributable greenhouse gas emissions in their lending and investment portfolios. And then they need to set specific targets, for both 2030 and 2050, so that they can align themselves with the trajectories towards net-zero by 2050 or earlier. So there has been progress. No doubt about that. But at the same time we are still a long way from where we need to be. We are not converging fast enough. For example, and as I mentioned, most significant banks acknowledge the materiality of the climaterelated risks in their portfolios. But there is less progress on environmental risks. 40% of the European banks have not yet properly assessed their exposure. Assessments by the ECB show that significant gaps still remain in banks' disclosures, as well as in the substance of these disclosures. About three out of four significant Eurozone banks do not disclose whether climate-related and environmental risks are material to them. This shows that these institutions are either unaware of the potential impact of these risks on their balance sheets – or are aware of their impact, but do not disclose it. And a recent report from Autonomous shows that the worldwide banking sector has shown slow progress with regard to their Paris Readiness Index over the last 12 months. The Paris Readiness Index measures the implementation of climate-related financial disclosures, the promotion of green finance and the management of the physical and transition risks of climate change and environmental degradation. On top of getting your risk management in order, you need to do more in the area of disclosure. With the introduction of various European disclosure requirements, such as the Corporate Sustainability Reporting Directive and the EBA's Pillar 3 ESG reporting, little time remains for banks to close the disclosure gaps. And even more standards are currently being developed, such as those from the International Sustainability Standards Board and the Basel Committee on Banking Supervision. Therefore, supervisors are intensifying their focus on climate and environmental related risks. At DNB we continue to integrate sustainability risk in our regular supervisory activities. We recently announced this in our revised sustainable finance strategy. This year we will update and expand the good practices that we have identified. Furthermore, we are embedding ESG factors in the supervisory assessment framework that we use. And we are going to monitor the ambitions that financial institutions have signed on to in the Climate Commitment. If they fail to make sufficient progress, we will consider all tools in our toolbox, including, ultimately, enforcement measures. And we are not the only one stepping up the attention. The ECB has communicated deadlines 3/4 BIS - Central bankers' speeches for banks to meet all supervisory expectations. By the end of 2023, significant banks are expected to include climate and environmental risks in their governance, strategy and risk management. The ECB has communicated that it will perform targeted deep dives and onsite inspections. The Basel Committee will give more consideration to whether regulatory measures are needed to address climate risks in the prudential framework. The European Banking Authority is exploring how ESG risks could be incorporated in the European prudential framework. As financial institutions, you play a crucial role in our societies. You play an important role in creating sustainable prosperity. So we need you to act urgently. The world needs your help in funding the transition to a carbon-neutral society that is in harmony with nature. And as a financial supervisor I say: we need you to manage your climate- and nature-related financial risks. They are often two sides of the same coin. Because that's what the story of a desperate restaurant owner in Greece is telling us. That's what the millions of people whose lives and livelihoods are at stake are telling us. That we have to fight climate change and environmental degradation. That we have to fight the risks they entail for our financial system, our economy and sustainable prosperity. And that, in that fight, we all have to do our part. For us as supervisor, this means keeping the risks in check, and thus safeguard the stability of the financial system. But ultimately, we will only succeed if we join forces – supervisors, governments, private parties and financial institutions. So let's check in today, and take up the task that lies before us – together. Thank you. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,023 | 11 |
Speech (virtual) by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at Afore Consulting's 7th Annual FinTech and Regulation Conference, 8 February 2023. | Steven Maijoor: Managing climate and environmental related risk stepping up the pace Speech (virtual) by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at Afore Consulting's 7th Annual FinTech and Regulation Conference, 8 February 2023. *** Hello everyone. Almost ten years ago, in 2014, an article on 'the secret life of passwords' was published in the New York Times.1 The author of the article, Ian Urbina, was fascinated by what people use as passwords. And after collecting stories about passwords for some time, he heard about scholarly research on a gigantic password hack. A few years earlier, in 2009, a database of 32 million passwords had been published on the internet. And this triggered a group of academic researchers from the University of Ontario Institute of Technology to start analysing the database. Not only with a security focus, but also with a linguistic, psychological and anthropological focus. And they found that for every ten passwords, one turned out to be a name, or a name plus a year. For every 1000 passwords, two turned out to be the word- "password". And the most commonly used verb turned out to be to "love" – tellingly, more often in combination with a man's name than with a woman's. None of these popular passwords are safe options, of course. So it is no wonder that the overall conclusion one of the researchers drew, was not overly optimistic. He was worried about the fate of our privacy. To him, "the database made clear that humans really are the weak link when it comes to data security." This was almost ten years ago. A lot has happened since then. Today, when you log in on your device, you often still use a password, but probably in combination with facial recognition, fingerprints, or a piece of unique hardware. Unfortunately, however, humans remain the weak link in data security. Last year's Global Risks Report from the World Economic Forum2 says that 95 percent of cybersecurity issues can be traced back to human errors. The report also says that, in 2020, there was an increase of 435 percent in ransomware compared to 2019. Many of you are probably familiar with the ransomware attack on a big American insurer a few years ago. This insurer ultimately had to pay 40 million dollars to retrieve its data and regain control of its systems. The report also says that, worldwide, we will need three million additional cyber professionals to adequately protect our data – professionals for cyber leadership, to test and secure systems, and to train people in digital hygiene. 1/5 BIS - Central bankers' speeches From my perspective, as a supervisor with De Nederlandsche Bank, I can only underscore the urgency to act that speaks from this report. My aim is to safeguard trust in the financial system. And cybercrime, be it a data leak or ransomware or any other form, poses a significant threat to that trust. What happened to the Central Bank of Bangladesh in 2016 was a loud and clear reminder. But it is, of course, no wonder that cyber threats are on the rise. Over the years, financial institutions have been morphing more and more into IT companies with a banking licence. More and more of what financial institutions do, happens digitally. As a consequence, the IT infrastructure has become more and more essential to the functioning of the financial institution as a whole. In the past, it was the vault with cash and coins that needed protection – today, it's the digital infrastructure. Three other evolutions further complicate effective protection of data and operational continuity. First, there is the increasing interconnectedness between financial institutions. They rely on each other for many services, including handling transactions, balances, clearing and settlement. A disruption at one financial institution could have consequences for another. Second, the increasing digital dependency on specialised third parties – for instance for cloud solutions, payment systems, or security operation centres. Often, this makes sense – if only for the economies of scale that come with outsourcing. But by now, we have reached a point where a significant number of financial institutions are highly dependent on third party services for some of their vital processes. And this creates a potential security threat. If an external party were to fall victim to cybercrime, this could permeate through the entire financial system with severe results. The third evolution is that only a few specialised and increasingly dominant providers handle the majority of outsourced services and processes. And some of them are definitely very well equipped to counter cyberattacks. Nevertheless, with this evolution comes a concentration risk. If one of those service providers were to encounter operational difficulties or get hacked, a lot of its financial clients might experience difficulties. Across the board, it is safe to say that as the digitalisation of financial services increases, and the subsequent interconnectedness, dependency and concentration along with it, the more difficult it becomes for a financial institution to estimate if, how and when it runs the risk of a cyberattack. Let me now turn to the Netherlands. In its studies from 2021 and 2022, De Nederlandsche Bank found that, on average, five percent of financial institutions in the Netherlands had to deal with the repercussions of a successful cyberattack at some point. "Successful" in this case does not necessarily mean that corporate operations were in danger or that data was stolen, but it does mean that there was a security breach. 2/5 BIS - Central bankers' speeches But overall, it remains hard to pinpoint exactly how many cyberattacks occur in the Netherlands, and what the success rate is. So that begs the question: how well-prepared for cyberattacks is the Dutch financial sector? The TIBER-NL program, developed and coordinated by De Nederlandsche Bank, gives us an idea. TIBER is short for threat intelligence-based ethical red teaming. Financial institutions participate voluntarily in staged test attacks, using them to gauge their cyber resilience. The aim is to gain insight into strengths and weaknesses, and to identify areas for improvement. Afterwards, they share experiences and improvement plans with other institutions. Over the past five years, De Nederlandsche Bank has coordinated over 40 TIBER tests on vital Dutch institutions. And in many of the cases, ethical hackers successfully accessed critical parts of the financial institutions' systems. The results of the TIBER tests have led financial institutions to take measures to increase their cyber resilience. But the results also tell us that we need to remain vigilant at all times. I am pleased that our TIBER program has inspired the European Central Bank to draw up the TIBER-EU Framework. This is important. Because increasing cyber resilience will, at least partly, need to happen on a European level. Simply because cyberattacks know no borders. That is why I am also very pleased with the finalisation of the Digital Operational Resilience Act – DORA. From 2025 onwards, financial institutions will have to comply with this European regulation aimed at increasing cyber resilience. This means, among other things, that third parties will have to comply with certain cyber security criteria. Hence, they will become part of the supervisor's scope. With TIBER, we already have an instrument that supervisors could use to broaden their scope from financial institutions to third parties. But even with such an instrument at hand, successful supervision will always require a degree of adaptability – it will always require the capacity to identify and understand new risks and threats, and adapt accordingly. To successfully do this, consistent and constructive collaboration between financial institutions, third parties, and supervisors, will remain at the heart of cyber resilience. Another part of DORA is that a financial institution's leadership will need to be highly involved in cyber security. This is fully in line with what De Nederlandsche Bank has been working on for some time now – increasing the boardroom's cyber knowledge and expertise. Whenever corporate digital strategy is discussed, somebody who knows the ins and outs of cyber security should have a seat at the table. So, I am very pleased with the regulatory advancements. But, compliance alone is not a financial institution's recipe for success. However important, it is a mere ingredient. 3/5 BIS - Central bankers' speeches Financial institutions themselves are responsible for the entire recipe. And just as a professional kitchen can't operate without basic ingredients like salt and pepper, a financial institution must have its basic cyber security ingredients in place. Without the salt and pepper of cyber security, a financial institution is a sitting duck for cyberattacks. You could think, for instance, about drafting and implementing a security policy – a policy that explicitly describes who gets access to your offices, how people should protect their hardware and software, and how new employees should be screened. Or how digital vulnerabilities, like necessary software updates, are managed. Or whether a cyber security crisis plan and team are set up. And most importantly, the basic ingredients of cyber security should not just be put in writing. They should not just be items on people's to-do list. Everyone, from staff to top management, in-house or third party, everyone must understand why this is important. The article on the 'secret life of passwords' I talked about a few minutes ago, reveals how important the why is for people. The author of the article spoke to dozens of people about their passwords, and he found that a lot of passwords have rich background stories. A lot of passwords are a motivational mantra. A lot of them are a daily reminder of something important, someone important. Of course, this is exactly what makes passwords potentially unsafe. This is exactly what hackers aim for. This is exactly why, more and more often, additional safety features are used – like facial recognition or fingerprints. But the answer to diminishing the weak link in cyber security – which is us, humans – might not be to take away meaning, but, on the contrary, to build on it. Today, the complexity people have to deal with is increasing sharply, just like the complexity of the financial landscape; the number of third parties is increasing, just like the interconnectedness and the dependency; the complexity of cyber threats is increasing, just like the measures to prevent them; and it is hard to predict when or where the next cyberattack will hit, but chances are that it will have to do with a human error. And so, it is all the more important that people, in all layers of an organisation, know the why of it all. Why they need to follow certain processes and procedures. Why they should preferably use meaningless passwords. Why they need to protect themselves – and with that, their colleagues, their institutions, and the whole financial system. Here lies a great responsibility for financial institutions – the responsibility of giving meaning. But one thing seems clear – cyber resilience should definitely not lead a secret life. It should very much lead a human life. 4/5 BIS - Central bankers' speeches Thank you. 1 Ian Urbina 2014, The Secret Life of Passwords, The New York Times, accessed on 24 January 2023, < The Secret Life of Passwords - The New York Times (nytimes.com) >. 2 World Economic Forum 2022, The Global Risks Report 2022 (p.45-56), World Economic, accessed 24 January 2023, 5/5 BIS - Central bankers' speeches | netherlands bank | 2,023 | 11 |
Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the APG Global Investors Day, Amsterdam, 16 November 2023. | Olaf Sleijpen: Investing in the future Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the APG Global Investors Day, Amsterdam, 16 November 2023. *** Even for the international participants at this event, it can hardly have escaped your attention that we have national elections next week. We will elect our new House of Representatives, and there are 26 (!) political parties clamouring for our attention. Always an interesting time, because elections are about choices. And choices can be made based on many different considerations. I think that in this time of transition, in this time of aging and migration, in this time of climate change and energy transition, disruptive new technologies and devastating loss of biodiversity, the most important consideration is the choice between today's wishes and tomorrow's needs. The choice between instant gratification and sustainable development. And that proves to be a difficult one. Not only for votersBecause it proves difficult to look further than your own backyard, further than one election, one period of government. And that is not only true in politicsIn the financial sector we also know how difficult it is to look beyond risk and return, to take broader environmental and societal impact into consideration, and to look at the impact on the future instead of the proof of the past. Like in politics, that attitude, that ingrained short-sightedness, has to change. Because as APG says on its website: " What is the use of a good pension, if the world around you has become unliveable? " The question I want to address today is: how can we, how can the financial ecosystem play its part in the transition towards a sustainable future, towards sustainable prosperity? Because it's undeniable that policymakers, regulators and the financial sector all have their part to play, and they all depend on each other. It's undeniable that the transition needs to be funded, and that it is the financial sector that can allocate resources, that can fuel the transition towards a carbon-neutral society in harmony with nature. Towards a world where environmental, social and governance criteria are in balance. This impact-driven mindset has to be the basis of our decision-making, especially because it is squarely within all of our mandates and responsibilities. As Frank Elderson, ECB board member, said earlier this year: "Destroy nature and you destroy the economy. This is not some kind of a flower power, tree hugging exercise. This is core economics. Even if I couldn't care less about the planet, I would say exactly the same thing." In other words: financial institutions need to speed up their own transition to a tri-dimensional decision framework for investment and lending decisions. A framework that is not defined by the traditional risks and returns, but by risk, return and impact. 1/4 BIS - Central bankers' speeches What does that entail? The World Bank defines impact investing as an approach that aims to contribute to achieving measurable positive social and environmental impacts. An approach that looks to the future instead of to the past. Impact investing and lending creates a significant opportunity to mobilise capital into investments that target measurable positive social, economic, or environmental impact alongside financial returns. I consider it important that financial institutions start making conscious decisions to invest in, or lend to, counterparties that have the capacity to generate measurable positive impact, in whatever form. I know, adopting this impact framework can be scary: financial institutions have a tendency towards herd behaviour and feel a substantial 'first-mover disadvantage'. But if we move towards this framework, this mindset, together, the impact will not only be bigger, but we will also find safety in numbers. And let's be honest: it is not only our own decision to make. It is what investors, clients and partners demand. Maybe we tend to see them as the pawns, whereas profit is king in the financial sector. However, as Anatoly Karpov said: "Pawns not only create the sketch for the whole painting, they are also the soil, the foundation of any position." So, if we base our position on the ESG mindset, if we incorporate impact investments and loans into our portfolios, we will not only create proper and prudent risk management, but we will also paint a sustainable future. How can financial institutions make this work? By making choices. First choice: Tailoring the operational primary processes – like investment processes and customer acceptance, credit judgement and revision – towards impact investments. That means that impact needs to be part of the parameters for decisions about investments, next to risk and return. That can be scary; it means daring to move away from the broad market benchmark and choosing a smaller portfolio of impact-oriented companies. And we have to make clear what the implications of these choices may be for the diversification of our portfolios. Second choice: Finding the right people and creating the right processes to make this work. That means recruiting the appropriate capacity and competences and reorganising our organisations. That means defining new or additional KPIs to also reward decisions that contribute to impact goals and put less emphasis on classical views, like the Markowitz modern portfolio theory. Third choice: Being more transparent about what you do and the results you are aiming for. That means: moving away from the short-term focus that keeps you locked in the past and present, towards a sustainable, long-term future. 2/4 BIS - Central bankers' speeches However, it's not only the financial sector that has to make choices. Like I said: it's undeniable that policymakers, regulators and the financial sector are mutually dependent. These upcoming national elections are therefore important. Because to make the transition to a sustainable future a success, or even a possibility, we need a government with a clear long-term vision of sustainability. Not only at the national level, of course, but also at the international level, where global standards and a unified approach to the big issues are sorely lacking. A global setting investors can have confidence in and build on. Policy stability and a clear destination are key conditions for financial institutions to embark on the road towards sustainability And of course, central banks and supervisors have their role to play, their responsibility to take, their choices to make. We may not sit in the driving seat; we are definitely part of the team: as a supervisor and regulator and as a watchdog over monetary and financial stability interests. The latter will clearly be threatened by a disorderly transition. Today I want to elaborate on these roles in a more holistic and integrated way. In our role as supervisors and regulators we make sure that financial institutions identify, recognise and mitigate climate and nature-related risks, and – should risks materialise – prevent them from having serious consequences. Risks that – we must acknowledge this – not only involve the mitigation of climate change and nature degradation or risks stemming from sudden transition policies, but that also require us to adapt to risks and realities that can no longer be avoided. Risks our planet is already facing every day, like extreme heat and drought that cause wildfires, or torrential rains that cause floods. Risks that have financial consequences for our food supply, health and housing; for insurance and investments. Risks that we must take into account. But it doesn't end there. As a guardian of monetary and financial stability it is also our responsibility to contribute to a smooth transition. This cannot take place without the involvement of the financial sector. In that role, we encourage embracing impact investing as a means to accelerate the sustainability transition and reduce systemic risks. In my view, this also means that we need to ensure that we are not a barrier to your transition to impact investing, while at the same time managing your risks effectively. That means that we have to change too, that we have to make choices too. For instance, when we assess financial risks for investments, we have to consider whether or not they are future-proof. Or when applying the prudent person principle, one could argue that we should be concerned not only with the financial returns that participants will receive from fund investments, but also with whether there will still be a liveable world where participants can enjoy those returns. However, it is important to note that impact investing is often associated with illiquid and more complex products, such as venture capital and private equity. Here again, our different roles come together. Indeed, such investments require a sufficient level of knowledge and expertise to manage these products responsibly. 3/4 BIS - Central bankers' speeches To further tailor the way we supervise and help funds like yours, we have developed a good practice guide for sustainable risk management. We will update this guide next year and we also intend to include FAQs for clear expectations. I hope these tools, and of course close cooperation, will encourage you to use forward looking indicators. To apply scenario analyses rather than focus on historical track records. And motivate you to implement a concrete transition plan and more long-term, sustainability-focused KPIs. Yes, there is work to be done, there are choices to be made. This transition will take time and energy. And it will take teamwork. Between government and the financial sector, but also between the funds you represent and the central bank I represent. But as Edmund Burke once said: "Nobody made a greater mistake than he who did nothing because he could do only a little." I am convinced that all our 'littles' will add up to one liveable planet, where your participants can really enjoy their pension-. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,023 | 11 |
Keynote speech (virtual) by Mr Klaas Knot, President of the Netherlands Bank, at the 7th Annual Conference of the European Systemic Risk Board "Financial stability challenges ahead: emerging risks and regulation", 16 November 2023. | Klaas Knot: The recent financial tumult - lessons and responses Keynote speech (virtual) by Mr Klaas Knot, President of the Netherlands Bank, at the 7th Annual Conference of the European Systemic Risk Board "Financial stability challenges ahead: emerging risks and regulation", 16 November 2023. *** Good afternoon everyone. As many of you know, I am a General Board member of the European Systemic Risk Board (ESRB). In that capacity, I contribute to, and follow the work of the ESRB closely. But today, I will be speaking as chair of the Financial Stability Board. And so, I wanted to begin by highlighting a few similarities between these two important international bodies. Both the ESRB and the FSB were created after the 2008 global financial crisis (GFC). The former under the EU, the latter under the G20. Those of you who have been involved in one of our committees such as the ESRB's ATC 1 or the FSB's SRC 2 will know that we share a love for acronyms. But, of course, we have something far more fundamental in common. We both monitor vulnerabilities in the financial system. We make policy recommendations to address them and we look at how these recommendations are implemented. Ultimately, we have the same goal. Increasing the resilience of the financial system. Either with a European focus, in the case of the ESRB; or with a global focus – in the case of the FSB. International cooperation is in our DNA. So what has the FSB been doing? Since our inception in 2009, we have overseen a range of financial sector reforms. These include: increases in the quality and quantity of capital and liquidity in the banking system; frameworks to resolve failing financial institutions; and enhancements to the resilience of non-bank financial intermediation, among others. I think it's fair to say that these post-crisis reforms have made the financial system better equipped to withstand unexpected shocks. Of course, our focus is on the financial system at large. Therefore, individual financial institutions may fail even as the broader system continues to function. We saw this happening in the banking sector earlier this year. But, however unexpected shocks like these may have been, in hindsight, they can be explained. And so, it is up to us, regulators, but also the industry, to look for that explanation and draw lessons from it. 1/4 BIS - Central bankers' speeches As we do so, and look ahead to possible future systemic threats, it is important to start with the broader macro-financial backdrop. Because shocks never happen in a vacuum. For much of the past 15 years, financial conditions have been highly accommodative. This spurred risk taking. At the ESRB we sometimes called it the 'hunt for yield'. A hunt in which some financial institutions relied on business models based on the presumption of low and stable interest rates. An old banker's adage states: 'it's not the speed that kills, but the sudden stop'3. So, with those accommodative financial conditions coming to a swift end, the vulnerabilities that developed during the 'hunt for yield' could be crystalised. Financial markets and indeed regulators did not fully anticipate the 'sudden stop'. But, both the ESRB and the FSB had been warning about the developing vulnerabilities for some time. There was bound to be transition risk for financial institutions and the system at large when coming from such a long period of low interest rates. Today, we find ourselves in that transition phase. At the same time, there is limited fiscal space in many countries. This is the consequence of elevated public debt, alongside a higher interest rate environment. And, of course, until inflation is returned to target, monetary policy space is similarly constrained. Thus, the scope to lean against an economic downturn is more limited than in the past. For this reason, financial policy makers need to be especially vigilant. With this backdrop in mind, let me now turn to the recent disruptions affecting the global financial sector, across both banks and non-banks. As I said, in the aftermath of such events, it is important to draw the right lessons and to respond. The FSB is working hard on both. Earlier this year, the banking sector saw the most significant system-wide stress since the GFC, in terms of both scale and scope. A global systemically important bank in Switzerland had to be rescued, and several medium-sized US-based banks failed. These events highlighted a number of issues for financial stability: First and foremost, the importance of banks' own risk management and governance practices was again brought to the fore. Second, we witnessed an unprecedented speed of bank runs. This underscores the growing impact of technology and social media on depositor behaviour. Third, the recent failures provided a number of important lessons for regulators. On this last point, the Basel Committee on Banking Supervision (BCBS) recently issued a report in which it outlines its initial learnings for bank regulation and supervision 4 . Among other things, the bank failures raise important questions about: the calibration and usability of bank liquidity buffers, 2/4 BIS - Central bankers' speeches the regulatory treatment of held to maturity assets and interest rate risk in the banking book, and the application of the Basel framework to smaller regional banks that may be systemic upon failure. The BCBS is taking this work forward and will assess the need to explore policy options in due course. The FSB has published its own lessons learnt report. In our case, regarding the international bank resolution framework 5. Our findings uphold the appropriateness and feasibility of the framework. But we find that there is still work to do – regarding how key parts of the framework are implemented and operationalised. For instance, we are looking at whether resolution planning and loss-absorbing capacity requirements should apply to a broader range of banks. The regional US banks that failed earlier this year were not subject to the full range of these requirements. Indeed, they did not have in place long term debt, designed to absorb losses in the event of the bank failing. This meant that uninsured depositors were at a greater risk of taking losses. That, in turn, created a strong incentive for these depositors to run when signs of trouble emerged. And there are various other topics that the FSB is addressing, like the choice and flexibility of resolution strategies, temporary public sector liquidity backstops, and ways to address legal challenges to executing bail-in across borders. Making progress on these issues is essential to ensure that we can effectively resolve systemic banks without undue harm to either the economy, or the taxpayers' pocketbook. In our pursuit of financial stability, we must also look beyond banks. Unfortunately, severe liquidity stress and even institution failures have also recently occurred in the non-bank financial intermediation sector. In the past few years alone, we witnessed: widespread pressure on core funding markets when the pandemic hit, the demise of Archegos, extreme pressure on commodity markets and traders following Russia's invasion of Ukraine, and turmoil among liability driven investment funds and pension funds in the UK. These events each reflected a combination of two vulnerabilities: excessive leverage and insufficient liquidity risk management on the part of the affected non-banks. On various occasions in recent years, large market movements or redemption pressures have placed non-banks under strain. 3/4 BIS - Central bankers' speeches These disruptions aren't just an existential threat to the players involved. They spill over onto other institutions – and in some cases, they affect the functioning of the underlying markets. So, following the March 2020 market turmoil, the FSB embarked upon a wide-ranging effort to bolster NBFI resilience. In our work so far, we have focused on both entity types and activities which may contribute to systemic risk. We have made good progress, including by issuing policy recommendations for money market funds in 2021. Looking ahead, we will soon issue policy recommendations to address liquidity mismatches in open ended funds. And next year we will advance our work to address excessive leverage in NBFI, and to enhance liquidity preparedness for margin calls. Let me conclude. The failures of various banks this year were an important reminder of the speed with which vulnerabilities can be triggered in the current environment. We are learning lessons from this. At the same time, contagion from these individual bank failures was limited. This is thanks to the swift and concerted actions of authorities on both sides of the Atlantic, and amid confidence in the resilience of the broader financial system. That confidence is underpinned by the financial reforms that regulators collectively introduced following the GFC. I don't know what the future will bring. There will certainly be more challenges to come. But as long as we continue to learn from the past. As long as we advance the implementation of the reforms already agreed upon. And as long as we work together across jurisdictions to address emerging vulnerabilities - we can maintain a level playing field, set on a solid foundation. And, we can safeguard a future in which the financial system remains a source of growth and prosperity for our economies. Thank you. 1 ATC stands for Advisory Technical Committee 2 SRC stands for Standing Committee on Supervisory and Regulatory Cooperation 3 Quoted in: Doornbusch, R. Goldfajn, I and Valdes, R. (1995). Currency Crises and Collapses. Brookings Papers on Economic Activity, 2, pp 219-293. 4 Report on the 2023 banking turmoil (bis.org)(Refers to an external site) 5 2023 Bank Failures: Preliminary lessons learnt for resolution - Financial Stability Board (fsb.org) 4/4 BIS - Central bankers' speeches | netherlands bank | 2,023 | 11 |
Speech (online) by Mr Klaas Knot, President of the Netherlands Bank and chair of Financial Stability Board, at the ASEAN+3 Economic Cooperation and Financial Stability Forum, Kanazawa, 5 December 2023. | Klaas Knot: High debt and financial stress - implications for Asian financial stability Speech (online) by Mr Klaas Knot, President of the Netherlands Bank and chair of Financial Stability Board, at the ASEAN+3 Economic Cooperation and Financial Stability Forum, Kanazawa, 5 December 2023. *** Thank you for inviting me to speak today. I am sorry that I cannot be there in person with you, as I was unable to travel from the COP28 proceedings , where I am today, to Kanazawa in time. Nevertheless, I am grateful to be able to share a few words with you on a theme that aligns so closely with the mandate of the FSB: Safeguarding Growth and Stability in a Complex World. A resilient and stable financial system is indispensable to sustaining economic growth, particularly in the current environment. This is at the core of the FSB's mandate. As the global financial stability watchdog, the FSB is responsible for assessing vulnerabilities affecting the global financial system. In addition, the FSB identifies and reviews the regulatory and supervisory actions needed to address these vulnerabilities. So how do we go about that? To start with, our surveillance framework aims to proactively identify vulnerabilities and provides a global, cross-border, and crosssectoral perspective on existing vulnerabilities. This framework draws on the collective perspective of the broader FSB membership. But that perspective can only take us so far in understanding and responding to global vulnerabilities. Indeed, the global issues of today require coordinated responses, but this does not necessarily mean one size fits all. Regional perspectives matter. To gain a truly global perspective, it is important for us to incorporate the experience and intelligence of emerging market economies (EMEs) and also look beyond our G20 membership. Our Regional Consultative Groups are one way we do this. They provide us with a richer and more detailed regional perspective. One which we appreciate ever more during times like the present when financial and macroeconomic uncertainty are elevated. Last week our Regional Consultative Group for Asia met in Hong Kong. Members discussed global and regional financial market developments and their impact on Asian economies. A key theme was rising government indebtedness and financial stability risks linked to the sovereign-bank nexus. I note that AMRO's Financial Stability Report raises many of the themes discussed by our regional group, including elevated private and public nonfinancial debt and the expanded role of NBFIs in the region. Let me talk about these vulnerabilities from an FSB perspective, with a focus on EMEs and the Asian region. 1/3 BIS - Central bankers' speeches The global financial system is transitioning to a higher interest rate environment. Financial institutions and market participants have not experienced sharply rising interest rates for a long time, making this adjustment to a world of higher rates challenging. Earlier this year, amid shifting financial conditions, we witnessed the first failure of a global systemically important bank since the 2008 global financial crisis. In addition, a few medium-sized bank failures also rang alarm bells. Contagion from these individual bank failures was limited, thanks to the swift and coordinated actions of authorities across the globe and to the confidence in the resilience of the broader financial system. This resilience is underpinned by the G20 reforms introduced following the global financial crisis. Still, further strains in financial markets cannot be ruled out, as the dynamics associated with the transition to higher interest rates play out over time. Market conditions for the larger EMEs have been fairly stable. But, the recent slowdown in economic growth – and rising interest rates in some jurisdictions – could make it more challenging for some economies to service high debt levels. At the same time, increasing government debt and the withdrawals of foreign investors in the wake of the pandemic have strengthened the "sovereign-bank nexus". This may lead to speedier transmission of shocks between sovereigns and banks and threaten bank macrofinancial stability. One particular issue that could arise relates to the interaction of US dollar funding and external vulnerabilities in EMEs. For most of the decade prior to the COVID-19 pandemic, capital flows to EMEs were supported by abundant global liquidity and a hunt for yield among investors to boost their returns. These inflows provided EMEs with the benefits of greater access to international capital markets, but also contributed to the build-up of vulnerabilities. Non-bank financial intermediaries (NBFIs) have played an increasing role in funding EME external debt. While this development added to the diversity of EME funding sources, it also created new challenges. As the global financial system continues to digest higher interest rates, there is the possibility that this could affect capital flows to EMEs. In a more extreme scenario, NBFIs and others might withdraw their investments in certain economies. This has been an important area of work for the FSB. In 2022, we published a report looking at trends in the structure of EMEs' external borrowing, focusing on the shift towards non-bank financing. The report examined how these developments contributed to the build-up of vulnerabilities in EMEs and to the March 2020 turmoil. It discussed policy issues that could be considered when thinking about measures to limit these vulnerabilities. This included measures to tackle the build-up of foreign exchange mismatches; enhance crisis management tools; and address data gaps to facilitate risk monitoring and the timely adoption of policies. The FSB also stressed the importance of ongoing work to address vulnerabilities from liquidity mismatches in open-ended funds, which would also help bolster the resilience of EMEs' financial systems. I am therefore happy to report that the FSB is finalising its policy recommendations to address structural vulnerabilities from liquidity mismatch in open-ended funds, working in close coordination with IOSCO. 2/3 BIS - Central bankers' speeches Enhancing the resilience of the NBFI remains a key priority for the FSB in 2024. The FSB will also continue to build on the lessons from the March 2023 turmoil and to monitor macro-financial vulnerabilities in a higher interest rate environment. Let me conclude. Vulnerabilities in the global financial system remain elevated. Tightening financial conditions and high levels of debt create challenges for both bank and non-bank lenders. In tackling the challenges ahead, formulating policy responses and building resilience, it is essential that there is global coordination and that we pay attention to potential cross-border spill-overs. Gatherings like today's forum are an important way of exchanging views and identifying the different ways in which governments and international organisations can work to enhance the resilience of our global financial system. As I mentioned earlier, regional perspectives matter a great deal, and AMRO's financial stability report is therefore a welcome contribution to the global dialogue on vulnerabilities. For our part, the FSB will remain focused on building resilience, so that the financial system can continue to play its part in building strong, sustainable, inclusive, and balanced growth. Thank you. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,023 | 12 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at a lunch of the Curaçao Business Association on the importance of sustainable green finance, Curaçao, 15 February 2024. | Klaas Knot: Step by step towards a sustainable future Speech by Mr Klaas Knot, President of the Netherlands Bank, at a lunch of the Curaçao Business Association on the importance of sustainable green finance, Curaçao, 15 February 2024. *** "Fall in love with the pearly white sandy beaches, breathtaking diving locations and the colorful street scene of Curaçao. Choose a holiday in Curaçao and do what the residents have been doing for generations: relax!" That is the text on the website of a large travel organization. It could almost make you think that life on this island is all about relaxing. But you know better than anyone that nothing could be further from the truth. Because entrepreneurs like you work hard every day. To keep Curaçao's economy running and its residents at work. To ensure that the people here are secure in their livelihoods. To ensure that all those tourists get the holiday they dream of. All that would not be possible without entrepreneurs. Without entrepreneurs who are not afraid to think out of the box, who dare to be innovative and decide to be sustainable. Entrepreneurs who don't believe in standing still but in moving forward, towards a sustainable economy and a sustainable future. A future in which we choose the long term instead of the short term, in which we choose prosperity and well-being, economic development and quality of life. That will not happen without choices and challenges, opportunities and threats, risks and investments. As your chairman Zeno Circkens said last year in his speech about the future of business in Curaçao: "We stand at a crossroads." I can assure you: you are not standing there alone. Working on a sustainable future, on sustainable economic growth, is first and foremost a question of teamwork. The driving force behind that team is the government. A government that takes responsibility for creating the right preconditions to enable, encourage and support sustainable choices. A government that is a reliable partner for citizens and businesses in the transition to sustainable economic growth. A government that ensures a reliable financial system. Of course, a reliable financial system cannot exist without financial stability. And that is where that other team members enter: the central banks. Because financial stability is their – our – responsibility. But we can only fulfill that role with a clear and unambiguous mandate. Independent of political whims. In all confidence. It is only when we have the trust of our governments and are independent from politics that we can do what we have to do: ensure financial stability and confidence in the financial system. 1/4 BIS - Central bankers' speeches To play our part in building and managing a reliable financial system that ensures a stable and responsible provision of credit to the real economy, that ensures that citizens and companies can build their future, in the knowledge and confidence that their money is safe. In the knowledge, in the confidence, that they can pay their bills without any problems and that they can get credit to buy a house or start a business. That is our role in the team. To play that role best, it is important that we work together with the other team members. Not only with the government, but also with other central banks, the financial sector and with the business community. I am therefore happy to be here now to further strengthen our ties with the Central Bank of Curaçao and St. Maarten and with your business communities. I am also happy to be your guest today, because I know that you can and want to play an important role in the transition to a sustainable economy here on Curaçao. Your actions make that clear. For instance, in the financial sector. I start there, because it is the sector I know best. But also because the financial sector is the hub for bringing savings and investments together. The hub that ensures that entrepreneurs can do business. The financial sector can only be a sustainable sector if it it focuses on more than just large companies. It is a sustainable sector if and when it also finances small and medium-sized enterprises. The CBCS is working hard to make this possible. Why is this important? Because this is how the financial sector can become more diverse and more inclusive, and therefore more sustainable. Another way to make this happen is by providing basic payment accounts to people who currently do not have access to banking services. And by empowering those who are less experienced with financial matters to understand how the system works.. And, if necessary, by promoting digital skills. The CBCS is involved in all of this. A sustainable financial sector is also a sector that combats money laundering. It is very promising that a National Risk Assessment has been carried out in Curaçao. And that Sint Maarten is working hard to make this happen too. This assessment makes clear what the remaining vulnerabilities are. I hope and expect that these will be sufficiently addressed before the next review by the Caribbean Financial Action Task Force later this year. A sustainable financial sector is also a sector that can withstand setbacks. For instance by making sure that savings are protected in the event of a bank failure. We learned from the global financial crisis how important that is for ensuring and safeguarding trust in the financial system. We learned that without trust there is no 2/4 BIS - Central bankers' speeches financial system. So it is good news that your Deposit Guarantee System is almost in place. But to make real progress towards a sustainable economy, towards a sustainable future, we have to look at what entrepreneurs can do. "Soñ'e, dese'e, logr'e (Dream it, wish it, achieve it)" I am impressed by how quickly the tourism industry in Sint Maarten and Curaçao has recovered after the pandemic. For Sint Maarten this came in the wake of hurricanes Irma and Maria in 2017. The speed of the recovery from this devastation has exceeded expectations. The tourists are back in force. That is good news, but the success of the tourism sector also leads to new challenges, of course. Challenges for the environment, because tourists not only use energy and produce waste, they can also be a threat to biodiversity. And naturally you want those beaches to stay pearly white and your flora and fauna breathtaking. Not only because they are a source of revenue, but because they are your heritage and your home, and because they are too beautiful to neglect. A good reason to look for diversification. To look for other business opportunities outside the tourism sector. Another reason, of course, is that diversification makes your economy less vulnerable. A vulnerability you experienced during the pandemic. And diversification can be found in investments in the energy transition, a double step towards a sustainable future. Curaçao is currently heavily dependent on fossil fuels, which produce high levels of greenhouse gas emissions. To reduce these emissions, it is necessary to switch to renewable energy sources such as solar and wind energy, and energy storage technologies. This transition takes time, money and manpower. It requires investments and efforts, it requires entrepreneurs with vision and courage. And the willingness to work together. Because a lightly populated island like Curaçao cannot make this transition on its own. You need to attract foreign investments and engage in international collaboration. And that is what you are doing. A good example of such a collaboration is the memorandum of understanding for the development of a wind farm in Curaçao that our Climate Minister Rob Jetten signed here last May. May much more collaboration follow! Because the path towards a sustainable future goes 'Paso pa paso, dia pa dia' (step by step, day by day), as you say here. Central banks can help you take these steps. We can help to shape the transition to sustainable economic development. We can help ensure that sustainable choices are not only made, but also successfully encouraged and implemented. As supervisors, for example, we help the financial sector to identify sustainability risks and encourage institutions to take action where necessary. We are committed to making payment transactions more sustainable, including when it comes to the paper and printing 3/4 BIS - Central bankers' speeches process for the money we issue. And we have an important role and position as an advisor to politicians and the government, for instance in the debate about a sustainable economy and the energy transition. In short: we are part of the team that will bring about a sustainable future. As are you. Let's take this opportunity to share thoughts and ideas about the way forward. I know you have a proverb that would be a nice motto for our team: 'Soñ'e, dese'e, logr'e' (Dream it, wish it, achieve it) 4/4 BIS - Central bankers' speeches | netherlands bank | 2,024 | 2 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Eurofi High Level Seminar, Ghent, 23 February 2024. | Klaas Knot: Free trade and financial stability, containing the effects of geopolitical fragmentation Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Eurofi High Level Seminar, Ghent, 23 February 2024. *** Chart to the speech Thank you. It's always a pleasure to be at Eurofi, a great meeting place to exchange views on finance and the economy. And could there be a more fitting place for this than the city of Ghent? When you are in the city centre, and you walk from the magnificent Belfry tower, past the St Nicolas church, to the St Michiels bridge and the Korenlei, you cannot escape the impression that this is a city that not only has a rich history, but also a history of richness. And indeed, in the 13th and 14th centuries Ghent was the Silicon Valley of Europe. It was the first real industrialised city, where wool was transformed into very fine cloth, 'laken' in Dutch, which was in high demand in the rest of Europe. This industry was so highly developed that wool was imported from Scotland and England. Thanks to innovation and trade, Ghent was one of the biggest and most prosperous cities in Europe. Free trade, economic growth, prosperity: they often go together. And that is a fitting illustration of why we should be concerned also today about the growing geopolitical tensions and geo-economic fragmentation, and their impact on cross border trade and investment. Let's have a look at the history of trade. As the chart shows, free trade has experienced periods of rise and fall throughout history. During much of the 19th century we saw an increase in trade, as measured by the global-trade-to-GDP ratio. This golden age of industrialisation and international trade came to an abrupt end with the outbreak of World War I. During the first half of the 20th century, world trade collapsed as a result of the Great Depression, nationalism and war. In the post-war decades, there was a prolonged period of growing world trade. Of course, it was the period of the Cold War, and trade between the eastern and western blocs was very limited. Nonetheless, world trade increased, driven by the post-war recovery and policies of trade liberalisation. After the fall of the Iron Curtain, trade between east and west expanded rapidly. This coincided with a period of hyper-globalisation in the 1990s and 2000s. The ITrevolution, multilateral trade liberalisation and an easing of global politics all worked together to boost global economic and financial integration to levels never seen before. A historic moment was when China joined the WTO in 2001. Closer to home, the introduction of the euro was a huge milestone. Not surprisingly, this was also a period marked by high economic growth. However, the pace of globalisation has stagnated since 2008, with trade-to-GDP stabilising. Over the past five years, the threats to free trade and investment have increased. Scepticism about globalisation has grown. International cooperation is in retreat. Brexit, ongoing tensions between the US and China, the Russian invasion of Ukraine and the conflict in the Middle East have put further pressure on globalisation. In 1/4 BIS - Central bankers' speeches response to geopolitical developments, countries and blocs more often apply a policy of strategic autonomy. According to the IMF, around 3,000 trade restricting measures were imposed last yearnearly triple the number imposed in 2019. And many firms around the world are reorganising their supply chains and are considering re-shoring, near-shoring or friendshoring. So while global trade is still resilient, we are already seeing more and more cracks appearing under the surface. Of course, these policies don't come out of nowhere. Strengthening national security and curbing strategic economic risks are logical policies in a world that has become a more dangerous place. But, if not properly managed, the economic costs of these policies could be very high. Coming from the Netherlands, I know the benefits of free trade for a small and highly open economy. Our share of imports and exports is almost 180% of GDP, one of the highest in the world. That makes us vulnerable to disruptions in global value chains. While the Netherlands may be a rather strong case of economic openness, the essence also holds for the EU as a whole. The numbers show that even as a bloc, the EU economy is more open than, for example, China and the US. EU trade with other countries is more than 40 percent of EU GDP. Europe has prospered as an open economic region, but is also more heavily exposed to the effects of geo-economic fragmentation. And let's not forget that today's economies are much more connected than only a few decades ago. Global trade-to-GDP is now 60 percent compared to 24 percent during the Cold War. That tells us that this time the potential costs of fragmentation are much higher. Let's have a look at the channels through which fragmentation impacts the real economy and financial stability. From an economic viewpoint, an increase in geo-economic fragmentation can be seen as a negative supply shock. Such a shock has a downward effect on economic growth and an upward effect on inflation through increasing trade costs. Fragmentation in the form of increasing trade restrictions leads to higher import prices, market segmentation and reduced access to technology and knowledge. Cost estimates of trade restrictions vary widely. But we do know that they are particularly high in the case of barriers to technology diffusion and disruptions in global value chains. The IMF estimates that trade fragmentation could reduce global GDP volume by up to 7% over time. And as we know, countries that rely more on international trade are particularly susceptible to trade fragmentation. Another transmission channel of fragmentation is inflation. International political tensions make inflation dynamics less predictable. An example is the current situation in the Middle East. An escalation of the conflict could trigger a spike in commodity prices that could impact price stability. A quite prominent case is the attacks by Houthis on cargo ships in the Red Sea. Some shipowners have decided to send their ships on the much longer route around the Cape of Good Hope. Obviously, this disrupts global value chains and raises transportation costs. These are the types of events that inflation 2/4 BIS - Central bankers' speeches models do not take into account. This makes inflation less predictable and it makes the job more difficult for central bankers. Fragmentation does not only impact the real economy and inflation. It also impacts financial stability. First of all, weaker growth and higher inflation make it more likely that banks and other financial institutions will incur credit and market losses. Restrictions on the flow of capital and investments limit the ability of financial institutions to diversify their portfolios. Fragmentation is also associated with a more challenging cyberthreat landscape. State actors have become more active in this area, and geopolitical conflicts have become more hybrid. Perhaps the most important way in which fragmentation impacts financial stability is when we cannot find each other any more in important cross-border challenges. And there are many such challenges. During the Global Financial Crisis, policymakers around the world were able to respond swiftly and effectively. This was possible thanks to good relations among public-sector financial decision makers and solid institutional structures that had developed over the years. After the crisis, countries around the world, assembled in the G20, took the lead in hammering out a firm package of financial reforms. In a fragmented world, such a swift response is becoming more complicated. This could prove costly. That's because the most important challenges to financial stability that we currently face are precisely the cross-border issues that we can only solve if we work together. The clearest example is the energy transition. This is an area where geo-economic fragmentation could be particularly damaging. Access to commodities, raw materials and products for energy generation is essential for the energy transition. There is a high concentration of suppliers of these goods. For many countries in Europe, China is the main supplier of energy transition goods, such as solar panels and lithium batteries. The same holds for the supply of critical and strategic raw materials. These are mainly sourced from non-EU countries. Think of Russian nickel, copper and cobalt. Hence, a global approach and multilateral cooperation remain key as we move forward with the energy transition. We also continue to need a global approach to financial regulation. For example the regulation of non-banks, the so-called NBFIs. This sector has shown tremendous growth and now represents more than 50% of the global financial sector. Its significant cross-border interconnectedness requires that regulators worldwide work together on this issue. Another example is the regulation of crypto assets. A number of incidents over the past years have highlighted the vulnerabilities in the crypto-asset ecosystem. These vulnerabilities also require a consistent international regulatory approach based on the principle of 'same activity, same risk, same regulation'. If we do not work together, we risk a race-to-the-bottom dynamic where crypto dealers are located in the least regulated regions, but spark problems elsewhere. So a global approach is key in many of the challenges we face. But at the same time, we need to be realistic: geo-economic fragmentation is already underway. Policymakers face difficult trade-offs between dealing with geopolitical security concerns and minimising the costs of fragmentation. What we need are pragmatic approaches that preserve the benefits of free trade to the greatest extent 3/4 BIS - Central bankers' speeches possible while also safeguarding international cooperation aimed at solving global challenges. What does that mean for EU policies? First of all, a strong Europe is more important than ever. Our internal market can at least partly protect us from adverse developments elsewhere in the world. While Europe is relatively heavily exposed to fragmentation, on the positive side, we also have unique opportunities to deal with it as we are still far from having exhausted the full potential of our internal integration. Therefore, as an economic antidote to global fragmentation, we should strive to further deepen the European Single Market. By removing the remaining internal barriers, for example, we would boost the mobility of labour and capital, and make it easier to transition to new technologies. Second, by completing the Capital Markets Union, we would help to mobilise much-needed funding for the EU's enormous climate and digital investment needs. To this extent, together with the Dutch Authority for Financial Markets we recently joined an increasingly impatient chorus of authorities having published a position paper containing concrete priorities and recommendations. Finally, by completing the banking union, we would stimulate pan-European banking competition and allow bank capital to be used more efficiently. We do not only need to strengthen the internal market. We also need to find a balance between autonomy in strategic areas such as defence, healthcare and energy, and we must maintain a multilateral mindset. It is common sense that Europe should protect its strategic interests and cut down on dependencies it doesn't want. But while doing this, policymakers should strive to protect free trade and not undermine the internal market. We should therefore be selective in our policies to increase strategic autonomy. And the EU should make a strong stand for maintaining and supporting the multilateral rulebased system that has brought us stability and growth. The people of Ghent knew the perils of geopolitics. During the Hundred Years' War between England and France, trade with England suffered greatly. We too live in a time where war has come close to our borders, and geo-economic fragmentation is increasingly a reality. Yet, even in this new geopolitical reality, policymakers can seek pragmatic solutions that minimise the economic costs of fragmentation. We should do our utmost to find these solutions. Because just as we need to protect ourselves, we also have to protect the free flow of goods, services, investment and knowledge. Things that are fundamental to economic growth and the prosperity of billions. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,024 | 2 |
Speech (virtually) by Mr Klaas Knot, President of the Netherlands Bank and Chair of the Financial Stability Board, at the Asia Securities Industry & Financial Markets Association (ASIFMA) Annual Conference, Hong Kong, 29 February 2024. | Klaas Knot: The need for regulating crypto-assets - a global effort Speech (virtually) by Mr Klaas Knot, President of the Netherlands Bank and Chair of the Financial Stability Board, at the Asia Securities Industry & Financial Markets Association (ASIFMA) Annual Conference, Hong Kong, 29 February 2024. *** Thank you for inviting me to speak today. I am sorry that I cannot be there with you in person. But nevertheless, I am grateful for the chance to speak about a topic that is not for the faint-hearted: crypto-assets. As some of you who've invested in Bitcoin know, the price curve has gone through some steep inclines and quick descents the past couple of years. And it is not just the price of Bitcoin that resembles a rollercoaster. The crypto-ecosystem itself also continues to evolve rapidly and in different directions. It is not just some retail investors that are 'dipping their toes' into crypto – large institutional parties continue to show serious interest in crypto-assets and its underlying technologies. In its role as 'guardian' of global financial stability, the FSB has been closely monitoring crypto-asset markets since 2018. While we have been working hard to address crypto's potentially systemic implications, we do recognize the possible benefits of this innovation. In our opinion, effective regulation should create the right conditions for innovation to unfold in a responsible manner. Being technology neutral forms a guiding principle of the FSB's recommendations. In recent years we have for example seen the potential benefits of distributed ledger technology. We have also seen that these benefits will not be realized without the comprehensive regulation of financial activities built on top of this technology. For the FSB, supporting effective regulation of crypto-assets has so far meant addressing the risks related to it. Since 2018 we have repeatedly expressed concern about the risks associated with crypto's fast evolving nature and its growing interconnectedness with traditional finance. As an example, some of crypto's inherent financial vulnerabilities became painfully apparent during the crypto-winter of 2022 and 2023. Think only of the spectacular rise and fall of FTX. The authorities represented at the FSB have taken important steps to effectively regulate crypto-related activities – either through the introduction of new rules or through the enhanced enforcement of existing rules & regulations. In recent years we have also seen that those national initiatives were not always fully aligned with each other. Therefore, the FSB published a Global Regulatory Framework last year, aimed at supporting the consistency and comprehensiveness of regulatory approaches to crypto-asset activities. But the job is not done yet. 'Crypto' is at a crossroads, and if society wants to stay on the path towards responsible innovation, we cannot be complacent. Let me highlight two interesting market developments. 1/3 BIS - Central bankers' speeches First of all, the emergence of so-called 'multifunction crypto-asset intermediaries', or MCIs, has shown that crypto may not be as decentralized as some claim it to be. These entities combine economic functions in a manner that is not commonly seen in traditional finance. We also find that most MCIs lack proper governance. As a result, the functioning of MCIs may actually amplify financial vulnerabilities. MCIs can also form nodes that link the crypto-ecosystem with the broader economy and investors. This means that, at a certain scale, their failure could have serious implications for the wider financial system. A key policy lesson we thus learned is that, if needed, these entities should be able to be wound down in an orderly manner: memento mori, or in this case, remember that you may fail. Next to MCIs, we have seen revived interest in the stablecoin market, following earlier crypto-market turmoil. Some of this interest has come from BigTechs and traditional financial institutions. These institutions could leverage large existing customer bases and rapidly issue a more widely used stablecoin. The potentially significant systemic implications of such a stablecoin means they require careful regulation and oversight. After all, these coins have proved to not always be that 'stable'. It is thus essential that we keep opting for fitting regulation. At the same time, let me be clear: opting for regulation is not a stamp of approval. Investing in crypto remains a risky and volatile business, illustrating that our work is not done yet. In the meantime, I'd like to therefore also stress: memento perdere – remember that you may lose. The FSB's regulatory framework forms a global baseline. However, on top of this baseline, individual jurisdictions can implement additional measures should national circumstances require them to do so. For example, we observed that the financial stability risks presented by crypto-assets may already be heightened in some EMDEs. These jurisdictions often have weaker domestic currencies or large underbanked populations. I do recognize that not all EMDEs are the same. As we can see right here in Asia, there can be a wide variety of EMDEs in a single region, and advanced economies could also be in the mix. There is however one common risk for EMDEs: residents might come to primarily rely on off-shore providers of crypto-services. This dynamic may require us to place greater emphasis on effective cross-border regulatory cooperation. Without such coordination and cooperation, crypto service-providers may find it easier to evade local requirements. In this context, the FSB is doing further work to practically address the cross-border regulatory challenges of stablecoins for EMDEs. Also central in our framework is the principle of 'same activity, same risk, same regulation'. This principle means that effective regulation should fit the financial stability risks that crypto-activities pose. Flashy marketing terms might muddy the waters for regulators. This makes it all the more important to find the actual underlying economic functions and risks. 2/3 BIS - Central bankers' speeches Publishing a framework is only part of the job. The most important next step is making sure that our recommendations are consistently implemented across the globe. Because, without globally consistent implementation, certain crypto-service providers may continue to evade regulation. The FSB aims to deliver effective and consistent implementation of its regulatory framework by working closely with other standard-setting bodies, such as IOSCO, the IMF, and FATF. Because crypto-asset activities are inherently cross-border, specific attention will go to promoting implementation beyond the FSB's membership. We will do this through our own channels, including our regional consultative groups. But we will also closely work on this with the IMF – given it's near global membership. As implementation is ongoing, we are committed to learning new lessons and to keep responding to new developments in the crypto-ecosystem. The sector is moving fast, so there is no room for complacency. Before moving to a conclusion, I would like to touch upon one of these developments: tokenization. Creating a digital representation of an asset and placing it on a distributed ledger could bring benefits to the financial system. This includes efficiency gains and potentially increased liquidity of certain assets. Of course, there may also be risks for financial stability. For example, tokenization could increase the linkages between the crypto-ecosystem and traditional finance. The FSB is assessing the financial stability implications of tokenization, although our work is still in the early stages. And we are not the only standard setter considering this topic. To conclude, the crypto ecosystem is at a major cross-roads. We cannot presume that this innovation, and potentially more decentralization, will bring significant benefits to the global financial system. What I do know is that the full benefits of digital innovation stemming from crypto-assets can only be realised if there is durable trust in the sector. For this, we need to keep working on a strong and consistent regulatory system, to safeguard financial stability. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 2 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Bank for International Settlements High Level Roundtable on Financial Inclusion, Basel, 12 March 2024. | Klaas Knot: Open finance regimes – experiences in some countries Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Bank for International Settlements High Level Roundtable on Financial Inclusion, Basel, 12 March 2024. *** Your Majesty, dear colleagues, Let me start by saying a few words on the regulatory approach towards open finance in the Netherlands – and Europe more broadly – in my capacity as DNB President. I will come back to the work of the Financial Stability Board during the next item on the agenda that touches on international work and the role of standard setting bodies. [Echoing the words of Her Majesty Queen Máxima], central banks and international standard setting bodies play an important role in promoting financial inclusion. While progress is being made, we must continue our efforts to make financial inclusion a reality for all. In Europe, financial services that are considered commonplace for many people are not as inclusive as one might think: around 13 million European citizens still experience financial exclusion in one way or another according to the Global Findex Database. Our shared objective of financial inclusion is of particular relevance when responding to digital innovation in financial services. Importantly, digital and financial inclusion go hand in hand. Open finance regimes can have a positive effect on financial inclusion by fostering innovation, stimulating competition and by empowering consumers – in turn improving their financial health. At the same time, fewer physical touchpoints in the high street and increased reliance on digital services may also create tensions with consumers who are not digitally native. So we must make sure that we strike the right balance between promoting digital innovation and ensuring equitable access. The European regulatory approach to open finance is evolving at pace. In June last year the European Commission proposed its framework for Financial Information Data Access – or FIDA in short. The Payments Services Directive – known as PSD2 – already required banks to create digital portals that other companies could use to access basic client data. With FIDA, this digital portal requirement is extended to the rest of the financial sector. With the explicit permission of consumers, firms should be able to access a broad spectrum of personal financial information related to personal savings, loans, insurances and pensions. With this data, financial service providers will be able to offer highly personalized financial services. For example, a bundling of separate insurance products into one package with a lower premiums or better conditions. Data access initiatives touch on the mandate of multiple authorities. For this reason, DNB published a position paper with the Dutch Authority for Financial Markets that sets out a joint policy vision. Our main message is that policymakers should prioritize actions that enable trusted, innovation-enabling and equitable data access. Let me briefly elaborate on these three elements: 1/2 BIS - Central bankers' speeches To ensure trust, it is vital that data can only be accessed with the consent of the data owner, and that safeguards ensure that data use results in outcomes that are in the interest of data owners. Enhancing the potential for innovation requires that sufficient volumes and varieties of data – both financial and nonfinancial – can be shared and accessed. And ensuring equitable data access means subjecting different types of financial entities to similar rights, rules and requirements with respect to accessing data, while having the possibility to impose access restriction on entities if this would cause harmful data concentration. While FIDA will help us reaping the benefits of data access, we also need to make sure that we mitigate potential drawbacks. In particular, there is a risk that open finance contributes to price differentiation due to personalized pricing, and the exclusion of those perceived to be high-risk. For example, people who don't give access to their data, either because they don't want to or are not able to, might face higher prices. Or, if your payments data show an unusually high number of car repairs, insurance companies may not want to offer you car insurance. In addition, citizens who have not shared their data can be affected by others who have shared their data. When they are automatically included in the dataset being on the other side of a financial transaction, for example, or when data of a small sample of consumers is used to derive behavioral assumptions for a certain sub-group of society. Since the negotiations on the FIDA-proposal are still on their way, regulatory opportunities to mitigate these risks should not be left unused. For legislators this means that they should not only focus their attention on data access in the context of financial services, but also look closely at the interaction with other horizontal pieces of legislation such as the General Data Protection Regulation and the AI act. But even then, a complementary focus is needed to ensure that the outcomes of financial data use are ethical and in the interest of data owners and society overall. In this context, I would like to highlight the importance of requiring data ethics frameworks, which explain what data is used for what processes and what impacts on price differentiation and exclusion are acceptable. To sum up, open finance frameworks offer tangible opportunities for people who have difficulty in accessing financial services, but we need to calibrate them carefully to make sure that open finance will be a force for good. Thank you. 2/2 BIS - Central bankers' speeches | netherlands bank | 2,024 | 3 |
Opening remarks by Mr Klaas Knot, President of the Netherlands Bank, to the European House-Ambrosetti's panel on "Central Bank Digital Currencies (CBDCs): The Future of Money", Cernobbio, 5 April 2024. | SPEECH Public money: keeping up with the times ‘Why do we need a central bank digital currency? To keep up with society. To pursue strategic autonomy. And to maintain access to public money in a digital world.’ With these words, Klaas Knot concluded his opening remarks to The European HouseAmbrosetti’s panel on ‘Central Bank Digital Currencies (CBDCs): The Future of Money’, on 5 April 2024. Published: 05 April 2024 Hello everyone. It is a pleasure to be back in Italy. Back at the Lago di Como. Back at the Villa d’Este. Lake Como has been drawing people to its shores ever since Roman times. So, it is no wonder it does so too, today – and not only physically, like us, but also in the digital world. Apparently, somewhere on the digital shores of Lake Como, the first so-called Metaverse Mansion was built. So, also in cyberspace these shores are a desirable place to spend time. Everywhere you look, the world around us is digitalising rapidly. And so, you might ask: isn’t it high time for the coins and banknotes in our wallets to do the same? Isn’t it high time for our central bank currencies to go digital? And the answer is, of course, yes. Let me elaborate on three reasons why central banks around the world are investigating CBDCs. First, our banknotes have stood the test of time, but central banks are making sure that they also keep up with the times. As the world is digitalizing, so are central banks. © DNB & Shutterstock Let me start by taking you back to what you can see on the left side of this slide. On this picture, we are back in 1988, where we find ourselves in a Dutch supermarket. And what we are witnessing here, is the very first time someone, somewhere in Amsterdam, used a card instead of cash to make a payment. In the meantime, the world of digital payments has evolved rapidly – we went from card, to contactless, to mobile phone and, today, even a ring. And the cash in my wallet…? Well, on my next slide, you can see the evolution of a banknote. From 1988 till now. © DNB & Shutterstock Don’t get me wrong, banknotes have definitely undergone a lot of innovations. While banknotes date back to seventh century China, today’s security features and materials are very much up to date. Banknotes have stood the test of time – and they continue to do so. But, however much that may be the case, the leap into the digital realm has not been made. Not yet. With such a leap into the digital realm, we would extend the public’s trust in physical banknotes to the digital world. To do so successfully, a banknote’s digital twin must have the same features as physical banknotes have today. No one needs to know what you pay for with digital euros – just like with cash. The balance, though, between privacy and other public policy objectives, like countering money laundering and illicit activities, is ultimately for the European co-legislators to decide. Everyone must be able to use the digital euro, including the less digitally savvy. Just like cash. Everywhere in Europe, at every point of sale, to every other person, you should be able to pay with the digital euro, just like cash. Digital euro holdings will not be remunerated, in line with the non-remuneration of cash. Indeed, the digital euro will have all the good things of cash. Most notably the offline functionality, which is to be offered from the outset, will be instrumental. Offline is the embodiment of a digital version of cash, bringing true and unique added value to consumers and retailers, not just in my home country. A digital euro must provide for both online and offline use cases to fulfill the promise of being able to pay with public money anywhere in Europe at any time. © DNB & Shutterstock A second reason why we are investigating the digital euro is that it will provide a public answer that – together with private solutions – will lay the puzzle for a more integrated European retail payments market. Digitization has brought innovative solutions to the European payments market, but two characteristics stand out: One – our European retail payments market is heavily fragmented along national lines; And two – our European digital payments market is, essentially, dependent on non-European technologies or non-European parties. To cut to the chase: currently, we do not have a pan-European digital retail payment solution of European origin. And though this doesn’t have to be a problem in normal times, it does raise questions about European strategic autonomy in adverse times. Because no matter how you look at it, payments – whether cash or digital – are like water, electricity and gas for our economy. They keep our economy going. And so, to increase the resilience of the European payment system, for whatever the future holds, we will likely need the digital euro – as a digital pan-European means of payment, supporting Europe’s strategic autonomy in payments. This being said, a digital public currency will not crowd-out private initiatives. On the contrary, it will rather support ‘crowding-in’ – as it will pave the way for, and co-exist with, private solutions of European origin. And so, it is encouraging that private parties are now also stepping up their game in developing pan-European retail payments solutions. Third, the digital euro meets society's demand for public money. Today, there is a clear downward trend in the use of cash to make payments – as you can see on the next slide. © DNB & Shutterstock In the Netherlands, only one in every five transactions at a point of sale is made in cash. There is an overall decline in paying with cash. And this means that the role of public money in our economy is declining. To a certain degree, this is worrisome. And although there is no reason to think cash will fully disappear in the foreseeable future; although the European Commission, on the same day it proposed the draft digital euro legislation, also proposed a legislation on the legal tender status of euro cash; the diminishing use of public money could pose a problem, because public money serves an important goal. It safeguards trust in our currency, alongside cash. It safeguards accessibility – all over the euro area, alongside cash. It safeguards inclusivity – for everyone, alongside cash. And let’s not forget that there is still a demand for cash – from the less digitally savvy consumers, to people who use it for budgeting purposes, to the elderly, and young people too. After the ‘why?’ comes the question of ‘how?’. And, as with many major innovations, there are challenges. Let me share two with you. © DNB & Shutterstock For starters, there are concerns about the impact of CBDCs on financial stability and on the banking system. Let me assure you that a digital euro would not upend the healthy equilibrium that has existed for decades between bank deposits and central bank money, between private money and public money. How do we ensure financial stability? The digital euro would be designed as a means of payment – and not as a store of value. As such: Digital euro holdings will not be remunerated, in line with the non-remuneration of cash. There will be a holding limit on digital euro holdings – without constraining users’ ability to pay with the digital euro. Users can link their private bank account to their digital euro account through a (reverse) waterfall functionality. Merchants and businesses would have a zero holding limit. Because of these mitigating design features, the digital euro will not fully mirror cash as a store of value. Nevertheless, the store of value function of cash is already diminished by the fact that it is unremunerated and that you could lose it. © DNB & Shutterstock Next to concerns about their potential impact on financial stability, some parts of the population question our motives for developing CBDCs. In an era in which public institutions in general are under pressure, central banks are also grappling with mistrust. We take these concerns seriously. So let me also assure you in this regard, that there is no hidden agenda. What we are doing regarding the digital euro is taking place in all openness. Which is also why I am here. Which is also why we are speaking with all relevant stakeholders, including, but not limited to, retailers, consumers and banks. Ready to answer any questions and gather feedback. Ultimately, the introduction of the digital euro is a political decision – not one made by technocrats. As such, it is a decision backed by the whole of society. In Europe, it is currently up to the co-legislators to give the green light to the digital euro. They will need to establish the legal framework for the ECB to issue the digital euro. This is, of course, not an easy task – because it will lay the foundation for the euro in the digital age. And so, thorough discussions are taking place in both politics and society. Privacy is one of the topics of discussion. It is clear that different jurisdictions working on CBDCs have different social and political systems, and with that, different understandings of privacy. From my a-political stance, I can only assure, once more, that privacy is a central pillar of the digital euro design. Let there be no misunderstanding: the Eurosystem would not be able to identify users through the transaction information we get. Moreover, being discussed in the political union with the strongest privacy and security laws in the world, the digital euro will, of course, comply with all EU rules on data protection. This is essential for the necessary political and societal support. Let me wrap up. I started my presentation with a question. ‘Why do we need a central bank digital currency?’ After what I have just told you, the answer could be summarised as follows: to keep up with society. To pursue strategic autonomy. And to maintain access to public money in a digital world. Banknotes belong to all of us. They have stood the test of time, and – if you ask me – will continue to do so. And as we prepare them for what lies ahead, we will keep an eye on financial stability risks and leave it to politics to decide. We will not venture into a vacuum. The digital euro will not exist in isolation, but will take its place in an integrated European payments landscape. © DNB & Shutterstock And with this conclusion, I find myself paying tribute to our host’s – The European HouseAmbrosetti’s – tagline. This tagline says: ‘Proud of our past. Propelled towards the future.’ Well, let that be exactly how I feel about our European currency. Thank you. | netherlands bank | 2,024 | 4 |
Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the DNB-Risk Management workshop on "Central bank capital in turbulent times", Amsterdam, 11 April 2024. | Olaf Sleijpen: On the pivotal role of central bank capital Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the DNB-Risk Management workshop on "Central bank capital in turbulent times", Amsterdam, 11 April 2024. *** Good morning, esteemed participants. This workshop convenes at a pivotal moment for central banks, and the chosen title reflects this significance. Over the past decade, the post Great Financial Crisis monetary policies followed by a global surge in inflation and subsequent monetary tightening resulted in significant losses for central banks across the globe. Amidst widespread central bank losses, the significance of central bank capital has surged. Central bank capital plays a pivotal role as a buffer to absorb risks stemming from monetary policy operations. Also DNB, the Dutch central bank, is experiencing a large loss due to the Eurosystem's monetary policy, estimated at 9 billion euros during the period 2023 until 2028 (a bit short of 1% of GDP). In the recent revision of the capital policy, both DNB and the Ministry of Finance – representing the Bank's sole shareholder - reaffirmed the pivotal role of central bank capital. They emphasized the urgent need to reestablish robust buffers, especially during periods of profitability for central banks. Indeed, if you want to achieve an effective capital policy you need to engage in a thorough and transparent dialogue with the central bank's shareholder, typically the government. Throughout the revision of DNB's capital policy, we meticulously outlined to the shareholder the sources of financial risks and the rationale behind their materialization into losses. Then we delineated how central bank capital serves to mitigate impending losses and elucidated on how future profits will contribute to rebuilding our capital position. DNB and its shareholder have reached a consensus on a strategy to gradually rebuild buffers through the retention of future profits, rather than opting for recapitalization. This decision underscores the mutual commitment to preserving central bank independence. Furthermore, it signifies the robustness of DNB's capital position, reassuring stakeholders that the central bank policies remain effective despite the erosion of capital over the coming years. In essence, DNB regards capital as paramount, because it ensures the central bank's ability to fulfill its mandate even amidst challenging economic conditions. This commitment to maintaining a strong capital base underscores our dedication to safeguarding price stability and preserving its capacity to navigate through uncertain economic landscapes. 1/2 BIS - Central bankers' speeches The program of this workshop builds pretty much on this view. In the first session, we start by discussing the importance of central bank capital. Then, in the second session, we will discuss how future changes in monetary policy will impact central bank capital. Finally, tomorrow in the third session, we broaden the scope to the external environment. We will examine how central banks negotiate with their shareholders, and how risks outside monetary policy, such as financial stability risks and climate risk, affect central bank capital. You all contribute to intellectual capital by sharing your diverse expertise and insights. Your contributions help central banks make informed decisions, refine capital policy frameworks, and adapt to evolving financial landscapes, ultimately strengthening the role of central banks in society. Thank you. 2/2 BIS - Central bankers' speeches | netherlands bank | 2,024 | 4 |
Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at the Advanced red teaming (ART) launch event, Amsterdam, 10 April 2024. | Steven Maijoor: State of the ART - DNB launches a new cyber security test framework Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at the Advanced red teaming (ART) launch event, Amsterdam, 10 April 2024. *** Hello everyone, and welcome. Today, we have good reason to celebrate. Because we are launching a brand new framework to test our society's resilience against cyberattacks. We're launching: ART – which stands for 'Advanced Red Teaming'. Usually, when you have something to celebrate, there's cake. Maybe even candles. And definitely a card with some nice words. Today, there's none of that – but we do have bitterballen. And, we have you – CISOs from the financial sector, the healthcare sector, the telecom sector and our government. And we have my colleagues from De Nederlandsche Bank who put their hearts and souls into developing ART. And if we combine this, we've got something far better than candles, cards or cake. We've got a cause. A cause to protect our society against cyber threats, cyberattacks and cyber criminals. Unfortunately, that is necessary. You know this. And we know this. All of us here, today, know that all over the world, across all different sectors, cyberattacks have become a standard instrument in both criminal and military toolkits. Or, for that matter, in any type of threat-actor's toolkit, regardless of their motivation. The ongoing war in Ukraine, for instance, will not only be won in the trenches, with boots on the ground, regaining terrain, step by step. It will also need to be fought online, with hands on the keyboard, defending liberty – bit by bit, byte by byte. Like we witnessed recently – when the Ukrainian telecom provider Kyivstar was attacked. Not by bombs. Not by missiles. But through cyberspace. This attack hit a vital infrastructure of Ukrainian society – and left 24 million people struggling to communicate. The attack also caused significant second tier damage. Because the attack on Kyivstar also hit ATMs that used the company's SIM cards. Leaving people struggling to get cash. Closer to home, our military intelligence warned about Chinese hackers trying to infiltrate critical Dutch infrastructure, planting threats that would lay dormant till activated – and then cause havoc from half a world away. 1/4 BIS - Central bankers' speeches Like I said, all of us are aware of these threats. In fact, a part of DNB's cyber strategy is monitoring and reporting on the cyber threats for the financial sector. Even more, we also organise and coordinate cyber crisis and red teaming exercises. But the fact remains as simple as uncomfortable: cyber threats will not go away. And the increasing scale and scope of cyber threats are not news to you. Neither are the costs and calamities that result from actual attacks. But what is new, is the framework we are launching today: ART. Because one fact, as simple as it is comforting, is that you and I share a common cause – we will not stop fighting cyber threats. So, let me tell you a bit more about what ART is and why we built it. With ART, you voluntarily sign up to get your core IT infrastructure hacked – not to steal your assets, but to seal your weak spots. Doing an ART test means that a real cyberattack is simulated as closely as possible. To do so, the attack plays out a plausible, threat-intelligence based scenario. So, it is based on the actual capabilities and motivations of existing malicious actors – be they state or non-state, geopolitical or criminal. During the test, only a handful of people – from both within and outside your organisation – know about the actual attack. As such, ART helps to identify your weak spots – it helps you to see how much damage a malicious actor could cause, how long it takes you to discover the foul play, and how much time you need to get back on your feet and mitigate the damage. I can hear many of you think: don't we already have such a framework? Yes, indeed – ART builds on our earlier, successful framework, TIBER, which stands for Threat-Intelligence Based Ethical Red-teaming. TIBER is an ethical hacking framework, developed in 2016, to test the cyber security of our core financial infrastructure, such as large banks and payment institutions. With TIBER, an institution's people, processes and pivotal IT infrastructure could be targeted. The development of ART benefited tremendously from eight years of TIBER experience – both in terms of quality standards as in successful deployment. So, with ART, we definitely don't have to start from scratch – in a sense, we can stand on the shoulders of a giant. Which, I think, is fair to say, especially since TIBER has been embraced by 17 central banks all over Europe. And even by the European colegislators, given that starting January 2025, TIBER will be included in European law and will then be called TLPT: Threat-Led Penetration Testing. 2/4 BIS - Central bankers' speeches Still, there was a clear need for something more, something alongside TIBER or TLPT. A need that could be summarised as a need for a voluntary test framework, one that is more modular, so that it can be tailored more easily to the specific testing needs of an organisation. Of your organisation. And ART is our answer to this need – ready for you to use. Whether you are a small or a large organisation – the former is no less important, sometimes the opposite is in fact the case. Whether you have an advanced cyber security policy, or one that is more limited in terms of scale and scope. Or whether you operate in the financial sector, or elsewhere – like the healthcare or the telecom sector, or the government. Later today, you will get a more detailed presentation on ART. This will give you the opportunity to ask all your questions – about ART, TIBER or TLPT. But really – with this new framework, with ART, there is no reason not to test your cyber security. Whether it is a very specific real-life scenario you want to test, or whether you want to use it as a stepping stone to TIBER, or even to set it up as a test that goes beyond TIBER. The modular set-up of ART will make testing more accessible and hence increase our overall cyber resilience. And that is necessary. It is an unpleasant realisation, but actual lives are at stake in what is essentially a numbers game. A game of ones and zeros. A game of investing time and money into protecting those ones and zeros, and hence yourself and the people who rely on you – whether it's for your financial expertise, your medical care, your communication infrastructure or as their political representatives. You and I know that testing your cyber security and subsequently improving it – if and where needed – is an effective way to keep hackers out. You and I know, that it takes time and money to do so. But we also all know that your time and money are not unlimited. That is why we are launching ART. A new framework we strongly believe in. A voluntary, modular framework that was built in response to the needs of the financial sector and beyond; one that has proven its value in pilot tests; and one that, in the meantime, has received encouraging reactions from the ECB. I therefore want to call upon everyone here today to start using ART – in whatever form suits you. To start using this state of the art framework to learn about the state of your cybersecurity, and hence, to take an improved stance in our joint fight against cyber threats. And don't shy away from spreading the word – the ART we are talking about today, is not one for the few, it is one for the many. 3/4 BIS - Central bankers' speeches Dear CISOs, it is heart-warming to see so many of you here, today – from the financial sector, the healthcare sector, the telecom sector, and the Dutch government. Each one of you plays a vital role in our society – a role that becomes even more vital, the more connected we become, whether you share software, service providers, or cyber risks. Maybe we'll reconvene in the future, and then there will be cake. And candles. And cards. And hopefully we will be celebrating the success of ART, the success of a common cause: our fight against cyberthreats. We're not there yet, but I am confident we will get there – stronger and more resilient than ever. Together, we'll protect our organisations, our people and our society. And today marks another step forward. And that alone is very much reason to celebrate. So let's celebrate! Thank you. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,024 | 4 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the DNB-Risk Management Workshop on "Central bank capital in turbulent times", Amsterdam, 12 April 2024. | Klaas Knot: Central bank capital - of capital importance? Speech by Mr Klaas Knot, President of the Netherlands Bank, at the DNB-Risk Management Workshop on "Central bank capital in turbulent times", Amsterdam, 12 April 2024. *** Good morning everyone. Welcome to the second day of this workshop on 'central bank capital in turbulent times'. And this title really does sum it all up. Central banks around the world are going through some pretty turbulent times these days. With huge losses. And the Dutch central bank is no exception. The last time the Dutch central bank faced a similar turbulent situation was roughly a century ago, in 1931 to be exact. The turbulent times that caused significant losses back then, had to do with the gold standard. After the First World War, the Netherlands and the United Kingdom agreed that, for the Dutch gold held in the UK, the Dutch central bank would accept pounds sterling. As a result, the Dutch central bank had a vast amount of British pounds on its balance sheet. But by the 1930s, the British economy was in stormy weather – with high unemployment and an overvalued currency hindering export. And even though the Dutch central bank got guarantees from the Bank of England that they would not leave the gold standard – they did so overnight, and effectively devalued the pound. As a consequence of this devaluation, the Dutch central bank was left with huge losses. Losses that were one and a half times the size of its capital. Today, almost a hundred years later, in a world that looks a lot different, we find ourselves again in a situation with huge central bank losses. The Dutch central bank had to report a loss of 2.3 billion euros for 2023 – and our projected cumulative losses over 2023 until 2028 are 9 billion euros. Our neighbours at the Bundesbank reported a loss of 21.6 billion euros in 2023. And across the Atlantic, the US Federal Reserve published a loss of 114.3 billion dollars last year. We know how we got here. And we know we have lessons to learn. So, let me begin by taking a step back. Up until a few years ago, and especially since the 2008 Global Financial Crisis, inflation was persistently low. In response, and with the aim of countering deflation risks, stabilising our economies and safeguarding monetary policy transmission, central banks around the world expanded their toolkits to include a range of new and 1/5 BIS - Central bankers' speeches unconventional measures – like large-scale asset purchases and targeted lending programmes. These new measures provided central banks with policy options to pursue their price stability objective, at a time when interest rates were at their lower bound. But these new tools – as has become apparent – have a flipside. They come with a price tag in terms of increased risks that may lead to substantial losses. While quantitative easing did help to stave off deflation risk, it also reshaped central bank balance sheets. Because, essentially, QE locked in low returns on a significant portion of central banks' assets – the so-called 'buy high' strategy. In the final phase of QE in particular, we bought vast quantities of bonds at relatively high prices, with very low and often negative yields. As rates on our liabilities could eventually go up, this strategy would then generate some losses. What materialised, though, was the worst case scenario. Namely, a sudden and massive spike in inflation leading to an increase in policy rates. Leading to the current huge losses. And so, as the profitability of these new, riskier, and by now conventional monetary policy tools has proved to be lower than the profitability of traditional instruments, central banks should critically asses their capital levels. They should be forward-looking and build up their capital accordingly. In short, more risk means more capital. Especially since central banks are not expected to return to their lean balance sheets of the pre-QE era any time soon – which means that they will face heightened financial risks for quite some time to come. So, as we shift from a decade dominated by unconventional monetary policy to a phase of normalisation, it is imperative to consider a few key factors that influence central bank capital. First, with its recent review of the operational framework, the Eurosystem aims to maintain structural liquidity in the financial system. Besides weekly refinancing operations, part of this liquidity provisioning will be established through long term refinancing operations as well as a structural portfolio of securities. In implementing these operations, it is crucial for the Eurosystem to consider its capital position in relation to these structural operations. Second, in its Strategy Review, the ECB categorised QE as a monetary policy instrument near the effective lower bound. This necessitates proactive risk assessment for potential future use of QE (note 1). But, obviously, concerns about central bank profitability must not result in a less effective monetary policy. Third, in currency unions like the European Monetary Union, risk and income-sharing mechanisms can help achieve a fair re-distribution among national central banks. These mechanisms are essential for promoting stability and cohesion within the monetary union, as they ensure that the costs and benefits of membership are distributed equitably among all participating central banks. 2/5 BIS - Central bankers' speeches In transitioning to a phase with a normalised monetary policy, these considerations will also help to normalise central bank capital adequacy. And the importance of sufficient capital goes beyond the mere accountancy aspect. If we were a commercial bank, large losses that erode capital would lead to bankruptcy. But central banks cannot go bankrupt. One reason for this is that a central bank can create money. Thus, it cannot default on liabilities denominated in its own currency. A second reason is that, implicitly, central banks have the support of their respective governments as systemically vital national authorities. Under extreme circumstances, a capital injection by the government may be considered. But as long as there is a realistic expectation that the net present value of future revenues – mainly from seigniorage – will be large enough to compensate for the current and projected central bank losses, financial support from a government seems unlikely to me. Hence, central bank independence – independence from our respective governments to do what needs to be done to safeguard price stability – is not in jeopardy. From a trust perspective, it is important to be transparent about this. We have a saying in Dutch that, in English, goes something like this: 'Trust arrives on foot and leaves on horseback'. Well, we don't want the current turbulent times, with the current losses, to make the public's trust in our independence take off on horseback. Because it would take much longer to regain it. I think the Netherlands offers an interesting case study in central bank transparency. For instance, on losses. Given the current central bank losses, you would expect critical press coverage. But in the Netherlands, coverage has been relatively sparse and mild. Most of the news outlets covered DNB's losses in a balanced way. And I think this is partly, maybe even mainly, due to our transparency on this matter. We very deliberately took the time to announce the possibility of losses. We explained the source of the losses when they occurred. And we were transparent about how we expected them to evolve. Transparency should be a guiding principle for central banks. They should be prepared to discuss their monetary policy decisions and clearly explain how their decisions safeguard price stability, and also not shy away from considering any link with public finances and the real economy. Equally, they should not refrain from being transparent about the potential impact of their decisions on their balance sheets and, as such, emphasise their crucial role in absorbing losses in times of crises. Looking at the future – if QE would ever be needed again – and I think that next time around the ECB will be much more cautious – but if it were to happen, I think central 3/5 BIS - Central bankers' speeches banks should pursue transparency. They should clearly communicate the benefits of QE for price stability, for liquidity in the financial system, and for the economic welfare of society – and they should also proactively communicate about the impact these purchases might have on their balance sheets. To do so, to be able to proactively communicate, central banks, of course, need to have an idea of the potential risks, of the potential impact of monetary policy operations on their balance sheets. And so, they should conduct comprehensive, forward-looking risk assessments. Assessments that take into account scenario analyses from their risk management departments. Assessments that may result in higher provisioning ex-ante. Looking at QE again – from a scenario analysis point of view – QE aimed at boosting inflation may result in losses, because assets are purchased at high prices. Conversely, when asset purchases are deployed to stabilise markets, they tend to be more profitable. Because in that case, assets are not necessarily acquired at peak prices. But the actual financial results of QE will depend on the actual timing and extent of the purchases, together with the actual interest rate evolution. Indeed, there is a lot of uncertainty and in the end only one scenario will play out. And although my colleagues from the risk management department ran through some extreme but plausible interest rate scenarios, we did not foresee the impact a pandemic could have nor did we factor in a Russian invasion of Ukraine. As such we did not anticipate the recent inflationary shock and the speed and intensity of policy rate increases. And so, we did not foresee the extent of the current losses. Had there been no such shock, and had policy rates risen gradually and to a lesser extent, QE losses would probably have been contained, and profits would even have been attainable. But let me stress again, as much as we can't predict the future, we do need to imagine several extreme but possible scenarios. And this scenario analysis can guide us in maintaining sufficient buffers in terms of capital and provisions, and hence mitigate the impact on our balance sheets, and strengthen our resilience in case of a future crisis. Now then, so far I have referred to central banks in general. As if there were only one type. But of course, central banks come in all sorts and sizes. And faced with the same challenges that come with huge losses, our differences could become an asset. Central banks could benefit from collaborating – for instance by sharing best practices or by establishing common principles. Principles, for example, on accounting standards, capital adequacy and risk management. Principles that could ensure regular evaluations and adjustments of capital levels, including provisions – all of this to maintain resilience, to absorb unexpected losses, to adapt to evolving risks, and to effectively fulfil our mandates, even in challenging economic conditions. Principles that should, of course, take jurisdiction-specific circumstances into account, as central banks have diverse mandates, operations, sizes and ownership structures. 4/5 BIS - Central bankers' speeches So, going forward, central banks should establish robust risk management policies to address potentially large losses. For instance, by safeguarding structural profitability, or by establishing additional buffers, or by adopting a higher tolerance for periods with reduced or negative capital. And they should do so in a continuous and transparent dialogue with their stakeholders and the general public. Let me wrap up. Crises that have been overcome, like the Global Financial Crisis and the Covid-19 pandemic, and crises that are ongoing, like geopolitical tensions and global warming, pose a challenge to central banks – they test them to their limits. They test their ability to safeguard price stability, their resilience, and the public's trust in them. At the same time, these very tests reaffirm the pivotal role an independent central bank plays in stabilising financial markets – in preventing or tackling deflationary or inflationary pressures – in safeguarding our economic welfare. Nearly a century ago, my predecessor faced unexpected and huge losses. Losses that exceeded the central bank's capital. And that cost him his job as head of the Dutch central bank. I have the pleasure of still being in office, which gives me the opportunity to speak to you today, and to wish you an interesting second day of this workshop – a workshop with, recalling the past, an aptly-chosen topic. I would almost say, a topic of capital importance. Thank you. Note 1: Announcement on the strategy review: The ECB's monetary policy strategy statement (europa.eu) 5/5 BIS - Central bankers' speeches | netherlands bank | 2,024 | 4 |
Speech by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the Central Bank of Ireland's Macroprudential Policy for Investment Funds Conference, Dublin, 20 May 2024. | Klaas Knot: A solid foundation for a resilient structure Speech by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the Central Bank of Ireland's Macroprudential Policy for Investment Funds Conference, Dublin, 20 May 2024. *** Good afternoon. It is great to be back in Dublin in this impressive building of the Central Bank of Ireland. The Dutch central bank will be moving into its renovated headquarters in December, so I can't help paying attention to my architectural environment. But that's not the only reason. The way architects look at the foundation and resilience of their buildings resembles the way the Financial Stability Board (FSB) looks at the financial system. A structure, after all, is only as strong as its weakest point. 15 years ago, the global financial system was on the verge of collapse. There were, in fact, many weak points. But, we know that non-banks, including investment funds, played a role in that global financial crisis1. More recently, there was the March 2020 turmoil2, and indeed other incidents, such as the failure of Archegos and the LDI turmoil. These events have been further reminders of one simple fact: there remain key vulnerabilities within NBFI. The basic regulatory structure is not strong enough. In recent years, the FSB and the international standard-setting bodies have been working hard to address these NBFI vulnerabilities. We have made progress, but there is still more to do. Just like this fantastic building, we are aiming to construct something that can stand the test of time. Something that functions well through hot spells and big storms. For a resilient structure we need a solid regulatory foundation. Then, macroprudential measures could be added to the design to further support the structure, where needed. Measures that may change over time and could differ from one jurisdiction to the next. Measures that are complements to, but not substitutes for, the baseline set of regulations. Therefore, to me, a successful macroprudential approach depends on the completion and proper implementation of the international regulations the FSB has been developing. In the remainder of this speech, I will discuss in more detail the FSB's recent work in the area of investment funds and NBFI more broadly. I will then offer some thoughts on the next steps at the international level towards a macroprudential approach. 1/4 BIS - Central bankers' speeches The NBFI sector has grown substantially since 2008, to almost half of global financial assets. It has also become more diverse. As a result, NBFI is increasingly important for the financing of the real economy. More diverse financing channels are beneficial to the real economy. But the flipside is that vulnerabilities within the NBFI sector can increasingly threaten financial stability. To address these vulnerabilities, the FSB has been looking at imbalances between liquidity demand and supply. Let me highlight a few important factors. First of all, liquidity mismatches reduce the ability of certain non-bank entities to handle shifts in liquidity demand. Consider an investment fund that offers its investors the possibility of daily redemptions, with no notice period. If the fund has invested for a large part in illiquid or less liquid assets, it may struggle to sell assets to meet redemptions, especially in challenging market conditions. In turn, redemptions may increase if investors are worried that the fund cannot facilitate them. On the liquidity supply side, we are also seeing challenges. For example, bank dealers may be unable to absorb large selling pressures during times of stress, as their balance sheets have generally not kept pace with the increase in the size of debt markets. Having analysed both liquidity supply and demand, the FSB is working on policies to prevent the mismatch from becoming excessive. Last year, the FSB revised its policy recommendations on addressing vulnerabilities from liquidity mismatch in open-ended funds. The FSB also published policy proposals to enhance the resilience of money market funds in 2021. The ultimate objective in both cases is to improve liquidity risk management by fund managers. The FSB has also been working on margin and collateral calls. Unexpectedly large calls contribute to shifts in liquidity demand and can create stress if market participants are insufficiently prepared for them. Last month, the FSB launched a consultation for its policy work in this area. The recommendations aim to reduce excessive procyclical behaviour in response to margin and collateral calls. This work will be finalised by year end. Further, the FSB is currently exploring policies to address financial stability risks from leverage in NBFI. We know that leverage has the potential to amplify losses through position liquidations or counterparty defaults. Leverage can also worsen liquidity stress, for example via margin calls on collateralised leveraged positions. We aim to enhance the monitoring of leverage in NBFI and address related vulnerabilities. The FSB is also soon going to publish an examination of the structural issues in some key short-term funding markets that prevent liquidity supply from matching demand during periods of turmoil. It is important to keep in mind that the NBFI ecosystem is highly connected across entities, and with the banking sector. This creates the risk that local stress will be transmitted to other parts of the financial system and across borders. For this reason, global financial stability is increasingly dependent upon a resilient NBFI ecosystem. 2/4 BIS - Central bankers' speeches We expect to see this resilience increase as national and regional authorities implement the FSB policy recommendations. But, of course, that is not the end of this story. As we monitor implementation, we will also pay close attention to assessing the effectiveness of these new policies. I should mention that our starting point for this work was to acknowledge that the existing policy toolkit for NBFI is extensive. But, these tools were primarily investor protection focussed. Hence, to date, FSB policy proposals have largely repurposed existing policy tools rather than creating new ones. Clearly that means that the realworld experience with using these tools for systemic risk mitigation is limited. So, it will be important to assess whether the repurposing of existing tools is sufficient to address systemic risks in NBFI – or whether new tools are needed. What I have described so far takes care of the foundational part of the structure. But what about the additional features? What about a macroprudential approach? Well, the FSB plans to begin this phase by discussing members' experiences, and the lessons learnt in the design and use of their own macroprudential tools. These lessons may then inform best practices at the international level. That's why I applaud the Central Bank of Ireland (CBI) for arranging this conference. The CBI's own experiences, including with the recent actions it's taken to enhance the resilience of its non-bank sector are of great interest to us. The same is true for macroprudential actions for nonbanks taken by other authorities. One might say that, in developing our policy measures, we should look at the tried and tested approach for banks. And indeed, as we have seen in banking, a macroprudential approach may be useful to lean against the build-up of cyclical vulnerabilities or to address concentration risk. But we mustn't lose sight of how complex and diverse the NBFI ecosystem is. And the difference in how systemic risk propagates. In the NBFI sector this is likely driven more by activities and collective actions, and less by the size of specific entities, as it is in banking. And so, macroprudential policy for NBFI might differ in important ways from the approach used in banking. A further consideration for macroprudential policy is the need to enhance our capabilities in the area of data and analytical tools. The data landscape for NBFI is not as well developed as for banks. To improve this, the FSB is exploring ways to enhance the availability, quality and usability of data. We are also working on the development of additional metrics and new analytical tools to monitor NBFI vulnerabilities on an ongoing basis. For example, stress testing of funds is an important topic for which the FSB will organise a workshop in July, jointly with IOSCO. Lastly, we know that macroprudential policy has important cross border implications, including in terms of reciprocity and home-host considerations. These call for international cooperation. The FSB is well placed to support efforts to achieve this, working alongside key standard setters, like IOSCO. 3/4 BIS - Central bankers' speeches Let me wrap up. We have seen several market incidents recently. Incidents that were due to vulnerabilities in the NBFI sector. And though the incidents were overcome, in some cases relying on extraordinary central bank interventions, the underlying vulnerabilities and the amplifiers of stress are still largely in place. This means, for example, that investment funds remain vulnerable to further liquidity strains. And so, it is critical to finalise and implement international reforms to enhance NBFI resilience. Thereafter, we will be well placed to assess whether any regulatory gaps remain and to move forward toward a macroprudential approach. Today's conference provides an important opportunity to discuss what that could look like. This fantastic building we are gathered in, is set on a solid foundation. With a resilient – 'Irishweatherproof' – structure. And it is actually two buildings – unified around an atrium that draws in the light. Very much in this building's spirit, the FSB will continue to unify countries, sectors and market activities around strong regulation. It will continue to shed light on shared vulnerabilities. And it will continue to foster a resilient financial system for all seasons. Thank you. 1 See, for example, the findings of the U.S. Financial Crisis Inquiry Commission: http://fcic-static.law.stanford.edu/cdn_media/fcic-reports /fcic_final_report_full.pdf 2 See the FSB's Holistic Review into the March 2020 Turmoil. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,024 | 5 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 3rd annual Barclays-Centre for Economic Policy Research (CEPR) International Monetary Policy Forum, London, 28 May 2024. | SPEECH Learn from the past and plan for the future: a perspective on monetary policy Read aloud ‘As the disinflationary path in the euro area continues and the medium-term inflation outlook further improves, we become increasingly confident that inflation will return to target in a timely manner. Consequently, it can soon be appropriate to ease the currently restrictive monetary policy stance, and gradually take our foot off the brake.’, said Klaas Knot in his speech at the Barclays-CEPR Monetary Policy Forum today. Knot spoke about the economy, inflation and the outlook for monetary policy. Published: 28 May 2024 © DNB Good afternoon everyone, Thank you very much for inviting me to join this distinguished panel here at the BarclaysCEPR Monetary Policy Forum. It’s a pleasure to be here. I feel particularly inspired knowing that we are assembled here just a few blocks away from Gordon Square, where John Maynard Keynes – one of the greatest economic minds of modern times – lived. Preparing for this event, I learned that this beautiful venue is sometimes also called the ‘Titanic hotel’. The main reason being that the restaurant is said to be almost identical to the Titanic's dining room. Both were designed by Charles Fitzroy Doll, the hotel’s architect, and also the man who was commissioned to do the first-class parts of the ocean liner. Let me say that although I feel the weight of the historical context of this beautiful place, thankfully I do not see a connection between the euro area economy and the doomed ship. In fact, the economy has sailed a steady course lately despite high global waves and tight monetary policy. © DNB Starting with inflation, I am confident to say that the inflation peak lies behind us. Chart 1 on the left-hand side shows the evolution of euro area headline inflation, decomposed into its main components since 2019. We see a clear disinflation since late 2022 when inflation stood at more than 10%. This largely reflects the unwinding of earlier energy and food prices spikes, as well as the easing of supply-side bottlenecks. The reduction in goods inflation from 6.8% to 0.9% has been very strong, too. Only services inflation still stands at an elevated 3.7%. The next phase of disinflation is likely to be more volatile, because the large swings in energy prices last year together with the staggered reversal of fiscal support measures have an impact on this year’s inflation readings via base effects. Chart 2 provides a more structural decomposition of inflation, based on recent DNB research. Among the set of models we use at DNB, this one focuses particularly on capturing supply-side constraints. While the model supports the notion that supply-side shocks were dominant drivers of the rise in euro area inflation, it still attributes more than one third of the inflation dynamics to demand shocks. For the disinflation period, the decline in demand is particularly important. The contribution of demand has narrowed to less than one fifth relative to the peak. Monetary policy – which is captured here largely as affecting demand – has thus supported the disinflationary process. But the reaction of monetary policy has also been important in the face of these supplyside shocks. Even though monetary policy has less effects on supply bottlenecks or on food and energy prices, the public is particularly sensitive to these salient aspects. As a result, an extended period of above-target inflation and possible second round effects create the risk that high inflation will become entrenched and, at some point, that inflation expectations will drift away from the target. A timely return of inflation to target is therefore crucial. That’s why it is important for monetary policy to react forcefully to underline our commitment to price stability. © DNB Taking a step back, many have argued that the ECB was too late in hiking rates. While I, with the benefit of hindsight, understand where that interpretation is coming from, I would like to make three points in defence of the Governing Council’s response. First, it is important not to reduce the monetary stance to the policy rates alone. The Governing Council adjusted its forward guidance long before and tapered its bond purchases under the APP as early as December 2021. Second, it is important to note that the energy shocks were a direct consequence of the unjustified Russian invasion of Ukraine. As such, these shocks were not only unprecedented, but with a war at the European borders, the uncertainty went beyond energy prices. In this situation, my colleagues and I on the Governing Council were wary to choke off the economy in light of possible contractionary effects of the war. Finally, even if we had initially fallen somewhat behind the curve, the eventual response has been very forceful and united, thus underlining the Governing Council’s commitment to its 2% inflation target over the medium term. This interpretation is also supported by a simple – so-called thick – modelling approach of policy rate paths implied by a large set of Taylor rules shown here in Chart 3. Clearly, the ECB’s policy rate implied by these simple reaction functions lifts off later but catches up quite soon. © DNB In my view, one key element of the success of monetary policy over the last few years has been in ensuring that the large inflationary shocks did not cause a de-anchoring of expectations. One way to assess the risk of de-anchoring of expectations is this modelbased analysis shown here on Slide 4. In this euro area application, DNB staff assess the path of inflation that is consistent with anchoring long-run inflation expectations going forward. As you can see on the left-hand side, at the September 2023 Governing Council meeting, the projected path of inflation depicted by the green dots was slightly above the anchoring-compatible path of inflation, the blue-dashed line. Therefore, further policy tightening was justified as this clearly posed an upward risk to inflation. The right-hand side of Chart 4 shows the same analysis conducted at the March 2024 Governing Council meeting. As you can see, the latest projected path of inflation is consistent with anchoring long-run inflation expectations. So, our policy of running a tight ship seems to have paid off. Over recent years, policy decisions have been made in an environment of high uncertainty and large shocks. We knew that icebergs were looming in the dark, but it was hard to predict where. This uncertainty not only included the inflation outlook and the balance of risks, but was also related to the transmission of the extraordinary tightening of monetary policy. The Governing Council has therefore opted to take a data-dependent approach. Underlying this approach are three criteria. First, the inflation outlook in light of the incoming data. Second, the dynamics of underlying inflation, based on indicators which remove some of the high-frequency movements in inflation. And third, evidence on the strength of monetary policy transmission. The focus on incoming data was particularly important, because making projections in an environment of high uncertainty is inherently difficult. Not surprisingly then, the forecast errors of the Eurosystem staff as well as those of other institutions have been sizeable. You can see this in Chart 5, which shows the inflation forecast errors from the Eurosystem staff projections since 2021. Yet, what’s more important than the forecast errors themselves is understanding the underlying cause of these errors. And as you can see in Chart 5, the largest part of these forecast errors can be explained by assumptions about energy prices and their direct and indirect effects on inflation, indicated by the yellow and red bars. This is not surprising given the large shocks to energy prices we observed in this sample. Other non-energy related errors also play an important role in the latter part of the sample. I’m convinced that this multi-pillar approach with a stronger focus on actual data realisations has served us well recently and that we need to continue to be data-dependent going forward. At the same time, as the decline in forecast errors in Chart 5 shows, there are also reasons to regain some confidence in our projections. This, together with the fact that a lot of the relevant and comprehensive data such as that on wages, productivity and profit margins are only published on a quarterly basis, suggests to me that projection round meetings of the Governing Council will be the key meetings for our interest rate decisions. Currently, the monetary stance remains historically tight. This is not only the case for the level of policy rates themselves, but also when comparing real interest rates relative to the natural rate of interest, r-star. Chart 6 shows this gap between the ex-ante real interest rate and r-star for the euro area and the US, based on DNB research. Of course, these estimates always have to be taken with a grain of salt given the sizeable model and estimation uncertainty as highlighted by the huge confidence bands. But the picture looks similar across a wide array of Eurosystem models. According to this model, the degree of monetary tightness is comparable across the two regions. However, as the disinflationary path in the euro area continues and the medium-term inflation outlook further improves, we become increasingly confident that inflation will return to target in a timely manner. Consequently, it can soon be appropriate to ease the currently restrictive monetary policy stance, and gradually take our foot off the brake. As a result, policy rates will slowly but gradually move to less restrictive levels. The precise timing, speed and scale of easing will also follow a data-dependent approach, with our projections being a key ingredient. To give you a perspective on the path of policy normalisation based on the March Eurosystem staff projections, Chart 7 shows optimal policy scenarios. Optimal here means that monetary policy tries to minimise the deviations of inflation from target and output from its potential*. The range, in turn, is based on both a set of models and varying weights that the central bank attaches to inflation relative to growth. The upper end of that range thus corresponds to stricter inflation targeting. This means achieving a faster return of inflation to target, albeit at higher costs in terms of output. According to the chart, the optimal rate path would prescribe a reduction in the policy rate over the next quarters. Looking at the horizon until the end of the year, based on the March projections, optimal policy would have been broadly in line with 3-4 rate cuts, similar to the market pricing that was incorporated into these projections. It’s important to note that these optimal rate paths rely on the inflation projections from March that include a quite rapid fall of inflation and slightly below-target inflation from the second half of 2025 onwards. This reflects, amongst others, a moderation of wage growth, a recovery of productivity growth and firms’ profit margins that absorb the higher wages. While the incoming data on new wage agreements does indicate some moderation since late 2023, wage growth has remained elevated and – according to forward-looking indicators – the path for 2024 is still expected to be quite bumpy. Productivity growth has remained low and is yet to pick up. Hence, we will have to await our next projections in June that will provide an updated assessment of the inflation outlook and the accompanying balance of risks. I am aware I have been throwing a lot of technical stuff at you for the last few minutes, and I hope you are still with me. In any case, the important takeaway is that, although these interest rate scenarios can provide useful guidance, given the current environment we still have to avoid any commitments on a specific future rate path. Waters may still be rough in the time ahead, so it’s too early to declare that we have made a safe crossing. Our datadependent approach allows us to assess the incoming data and inflation outlook moving from one meeting to the next and adjust our policy stance accordingly. Let me stop here. I am looking forward to an insightful discussion. Thank you for your attention! | netherlands bank | 2,024 | 5 |
Introductory statement by Mr Klaas Knot, President of the Netherlands Bank, prior to the session with the Standing Parliamentary Committee for Finance, The Hague, 18 June 2024. | Klaas Knot: Main risks to the financial system Introductory statement by Mr Klaas Knot, President of the Netherlands Bank, prior to the session with the Standing Parliamentary Committee for Finance, The Hague, 18 June 2024. *** I would like to thank the Chair and the members of the House of Representatives for their invitation. Together with my colleagues from CPB and the AFM, I would like to discuss with you the main risks to the financial system. I will do so on the basis of the DNB's Financial Stability Report, which has been sent to you. I will start by outlining the overall macroeconomic picture before specifically addressing the risks of geopolitical tensions and the formation of blocs around the world (geoeconomic fragmentation), as well as the resilience of Dutch financial institutions. On both subjects I will highlight a number of recommendations for areas where national governments and parliamentarians, such as yourselves, have scope to further improve the financial system. Before moving on to these risks and recommendations, I will first look back briefly at the past year, because it has been an eventful year for the global financial system. In the spring of 2023, the rapid transition from low to higher interest rates – in response rising inflation – exposed vulnerabilities in the financial sector. In the midst of this transition, a number of US regional banks and the systemic Swiss bank Credit Suisse encountered severe difficulties for different, unrelated reasons, leading to resolution, merger or acquisition. On my previous visit, I therefore drew a number of lessons from the failure of these banks. Fortunately, a year on, the situation seems to have improved. Inflation has fallen substantially in both the Netherlands and the euro area. Dutch inflation, for example, fell to 2.7% in May 2024. This substantial fall in inflation and the improved inflation outlook in the euro area prompted the ECB to cut interest rates for the first time in early June. At the same time, Dutch economic growth is expected to pick up in the year ahead, spurring confidence in a "soft landing" for our economy. The Dutch financial sector has also proved resilient, partly due to the reforms following the financial crisis. Confidence in a soft landing for the economy is reflected among other things in historically high share prices and less tight financial conditions. As a result, the soft landing is initially good news for financial stability. Looking ahead, however, there are risks to the economy and our financial system, with uncertainty being a central concern. First, inflation might start rising again, for example due to continued strong wage growth. It is therefore important to base further monetary decisions on incoming data rather than pre-empting future developments. At the same time, various factors, such as rising geopolitical tensions, are generating greater uncertainty, which could lead to financial market corrections and higher risks for financial institutions. High share prices make financial markets vulnerable to corrections and a downturn in sentiment. For instance, political uncertainty in France last week caused a correction in French government bonds, which also spread to bank shares in France. These corrections are taking place against the backdrop of geopolitical 1/3 BIS - Central bankers' speeches tensions and geo-economic fragmentation. Price falls prompted by geopolitical tensions have so far been short-lived, but I do wonder whether investors are fully pricing in the risks of geopolitical tensions. This is one of the reasons why I would like to focus particular attention on the risks of heightened tensions and geo-economic fragmentation. Geo-economic fragmentation is not new but is part of a gradual global shift. The fragmentation of the global economy into blocs has increased in recent years, leading to more trade restrictions and sanctions. At the same time, geopolitical tensions have increased. At first sight, Dutch financial institutions appear to have only limited sensitivity to geopolitical tensions given their small corporate loan and investment portfolios exposed to countries that are geopolitically remote from the Netherlands. Geo-economic fragmentation may nevertheless have an indirect impact on these portfolios, because Dutch firms also use imported goods in their production processes and trade restrictions disrupt these value chains. Geopolitical tensions also increase cyber risks worldwide and reduce the effectiveness of multilateral fora. For example, blocking and tensions hampers effective crisis response as during the COVID-19 pandemic, but also effectively tackling global challenges such as the energy transition. As well as the need for greater awareness and analysis of these risks by financial institutions and policymakers, I also see scope for action by national governments. At a time when there is high external pressure from other regions of the world, a wellfunctioning European single market reduces Dutch dependence on other regions. As an open economy, the Netherlands has benefited from this more than other countries. After all, the European internal market acts as a cushion for shocks originating from outside Europe, thus providing economic security. In my view, this requires a European market that is as open as possible to market forces and competition. Further development both of the internal market and of the capital markets union and the banking union is necessary to achieve this. The European market offers scope for further integration, especially in the services sector. National governments have a vital role to play in driving progress and can draw on lessons from European banking supervision. Given the heightened uncertainty, which is partly due to fragmentation, it is important that Dutch financial institutions remain resilient. Dutch banks, pension funds and insurers are in a good position, partly thanks to reforms following the financial crisis. In all sectors, the transition to higher interest rates has had a positive effect and prudential ratios are above the required levels. Although the transition to higher interest rates enabled banks to generate high profits in 2023, the higher rates may also negatively impact the quality of outstanding loans and investments. Higher interest rates and lower economic activity increase the probability of default among firms and households. So far, we have not seen this affecting banks, although the first signs of deterioration are visible. The credit quality of corporate loans secured on commercial real estate has deteriorated, partly because this market is under pressure. One solution to this is for banks to use part of their high earnings to set aside additional provisions. Insurers and pension funds are also now investing more in firms. Specifically, there has been growth in private equity investments and loans to high-risk firms, in other words private credit. Private credit broadens the range of credit available to firms and reduces their dependence on banks, which may contribute positively to the stability of the system. Private credit is attractive to investors because of the higher returns. But higher returns 2/3 BIS - Central bankers' speeches are accompanied by risks, and the same applies to this shift in lending. Specifically in the case of private credit firms, risks additionally ensue from their inherently low transparency, given that they typically lack external credit ratings. Financial institutions must therefore maintain sound risk management and monitor potential interdependencies. Given the heightened uncertainty, it is important to have an appropriate macroprudential toolkit for financial institutions in Europe. During the COVID-19 pandemic, we saw the value of banks having releasable capital buffers. At DNB, we have now introduced these additional capital buffers, but these lessons could be even more firmly embedded in the European toolkit, as recommended in the Ministry's study on the resilience of banks. More consistent use of instruments is also desirable for a more level playing field among European banks. In the case of non-banks, this macroprudential toolkit is still in its infancy, but pension funds, insurers and investment funds are now playing a greater role in the financial system. Improvements to the framework are therefore desirable, particularly for investment funds. This concludes my introduction. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 6 |
Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the Indonesia-Netherlands Trade, Tourism, and Investment Forum, Amsterdam, 28 May 2024. | Olaf Sleijpen: The rise to economic leadership - Indonesia's development from the perspective of the Dutch central bank Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the Indonesia-Netherlands Trade, Tourism, and Investment Forum, Amsterdam, 28 May 2024. *** Your Excellencies, ladies and gentlemen, It is a great honour to speak at the Indonesia-Netherlands Trade, Tourism, and Investment Forum. Indonesia is a very important and close partner of the Netherlands, so it feels good to meet with you here. Terima Kasih [thank you]. Nearly 700 years ago, before modern-style banks existed, people stored their money at home. Rather than metal containers, they used common kitchen jars made from a cheap orange-colour clay called 'pygg'. Whenever families had money left over, they would save their coins in these clay jars, known as 'pygg pots.' The first true piggy banks originated in Java as far back as the 13th century. They were made of terracotta and shaped like pigs, with a slot on top for depositing coins. Few of these piggy banks, known as "cèlèngan" in Javanese, survived as they had to be demolished to retrieve the saved coins inside. While the piggy bank represents a simple but ingenious system for individual savings and informal storage, central banks can be thought of as the piggy banks of the entire monetary system. So as the representative of the Dutch piggy bank, let me give you my view on the macroeconomic development of Indonesia, and its role in the world. I am not the only speaker this morning to mention that Indonesia and the Netherlands are important trading partners: according to the International Trade Centre, in 2023 we exported 0.8 billion euros worth of goods to Indonesia, while we imported 5.1 billion euros worth of goods in that same year. This makes the Netherlands the 12th largest import partner of Indonesia, and the largest within the EU. We enjoy a strong economic partnership, and the Netherlands is keen to further develop economic opportunities for our countries' businesses. Besides being key trade partners, Indonesia and the Netherlands work closely together in other domains as well. During the G20 Bali summit two years ago, for example, we co-hosted a conference on payment systems with the Bank Indonesia Institute, as part of a long-lasting cooperation between our central banks. A follow-up event is planned for later this year, focusing on recent developments in the international payment system. It is a great opportunity for DNB to keep track of Indonesia's highly innovative payment system, and DNB is proud to have such a close and fruitful relationship with Bank Indonesia regarding such an important topic. Indonesia is one of the largest and fastest growing countries in the most densely populated region in the world: Southeast Asia. With a population of approximately 280 1/4 BIS - Central bankers' speeches million people, it is the fourth most populous country in the world. If you take the map of Indonesia and you lay it on top of that of Europe, it reaches all the way from Ireland to Kazakhstan. For the Dutch participants of this conference: let that sink in for a moment. With a real GDP of around 3.4 trillion US dollars, it is currently the world's 7th economy. Over the last decade, the Indonesian economy has expanded at a rapid and robust pace. During this period, real GDP has increased by at least 5 percent annually – except in the COVID years of 2020 and 2021. In that same period, inflation has been kept under control: averaging around 3.7% per year. This is a testament to the readiness of Indonesia's central bank, which raised its benchmark interest rate last month in an effort to support the rupiah. This was a strong policy response, as a strong dollar took a toll on Asian currencies amidst market uncertainty around the US Federal Reserve's rate outlook and escalating global economic uncertainties. Indonesia's economy continues to perform strongly, with inflationary pressures moderating, macroeconomic policies returning to their pre-pandemic settings and a stable, profitable financial sector serving businesses and the public. This highlights the maturity of the country's institutions and macroeconomic frameworks as it has navigated a highly challenging global environment. But there are also clouds on the horizon. Over the past years, the threats to free trade and investment have increased globally. Scepticism about globalisation has grown. International cooperation is in retreat. Brexit, ongoing tensions between the US and China, the Russian invasion of Ukraine and the conflict in the Middle East have put further pressure on globalisation. In response to geopolitical developments, countries and blocs are now often likely to pursue strategic autonomy. According to the IMF, around 3,000 trade restricting measures were imposed last yearnearly triple the number imposed in 2019. And many firms around the world are reorganising their supply chains and are considering re-shoring, near-shoring or friendshoring. So while global trade is still resilient, we are already seeing more and more cracks appearing under the surface. In today's interconnected world, the prospect of geoeconomic fragmentation looms large over nations like Indonesia and the Netherlands. Indeed, our economies thrive on international trade, with each other and with the rest of the world. The cost of geo-economic fragmentation comes in different shapes. Further geo-economic fragmentation and trade restrictions reduces the efficiency in the allocation of resources and hinders the diffusion of innovations. This will add to global price pressures and lower productivity growth. Recent IMF estimates state that trade fragmentation could reduce global GDP volume by between 0.2% and 7%, with countries that rely more heavily on international trade being more susceptible. As a central bank, we are also concerned about geo-economic fragmentation affecting financial stability, particularly through its impact on financial institutions. For example, disruptions in value chains and their impact on economic growth and inflation can lead 2/4 BIS - Central bankers' speeches to an increase in banks' market and credit losses. Moreover, a tightening of financial conditions because of geo-economic fragmentation may increase vulnerabilities in the banking sector as risk premia rise. Perhaps the most important way in which fragmentation impacts financial stability is when we cannot find each other anymore when facing important cross-border challenges. And there are many such challenges. During the Global Financial Crisis of 2008, policymakers around the world were able to respond swiftly and effectively. This was possible thanks to good relations among public-sector financial decision makers and solid institutional structures that had developed over the years. After the crisis, countries around the world, assembled in the G20, took the lead in hammering out a firm package of financial reforms. In a fragmented world, such a swift response is becoming more complicated. This could prove costly. That's because the most important challenges to financial stability that we currently face are precisely the crossborder issues that we can only solve if we work together. Think of climate change, for example. To overcome these challenges, we need to foster collaboration between countries and emphasise the importance of an international rule-based order. A fragmented world demands stronger international collaboration to prevent the costs from outweighing the benefits. What we need today in this fragile and fragmented world, is countries that speak out in favour of cooperation, in the international financial system and beyond. A fitting example of this was Indonesia's G20 Presidency in 2022, during which President Widodo emphasised that inclusiveness is the priority of Indonesia's leadership in the G20, and to "leave no one behind." Indonesia took over the G20 presidency in a tumultuous time, when the world was facing economic, public health, and geopolitical uncertainties. Under the banner of 'Recover Together, Recover Stronger' and strong leadership by Indonesian authorities, this was a great success. Indonesia's G20 presidency rose to the occasion to shape global priorities amid challenges and promote a more resilient, equitable world. And as chair, Indonesia invited the Netherlands to the meetings, even though we are not an offical G20 member. For that, we are grateful. Also, Indonesia and the Netherlands are partners the Network for Greening the Financial System. In this network, central banks collaborate globally to address climaterelated risks. This collective effort ensures coordinated action and knowledge sharing. Also, Indonesia and the Netherlands are co-chairing the Coalition of Finance Ministers for Climate Action. This important organisation brings together key fiscal policymakers from over 90 countries for a unified response to combat climate change. Today, Indonesia is one of the leading economies in the world. It is good and fitting that Indonesia's position as an economic powerhouse is reflected in a stronger role on the international financial stage. The world needs your leadership. The Netherlands supports you in that role. I started my remarks with a reflection on the humble origins of piggy banks in Indonesia. Today's world is so much more interconnected. The world economy and global finance rely on cooperation and shared rules to thrive. In the face of geoeconomic fragmentation, we must recognise that the benefits of a rule-based order and free trade 3/4 BIS - Central bankers' speeches extend beyond national borders. These benefits include increased prosperity, reduced poverty, and enhanced stability. By adhering to the international rules-based order, we can safeguard the gains globalisation has brought us. So, let us continue to nurture the spirit of cooperation. By doing so, we can build a more resilient and prosperous world, reinforcing our shared destiny. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,024 | 6 |
Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the jointly hosted Erasmus/Netspar Symposium "What's cooking in sustainable investing?", Utrecht, 16 May 2024. | Olaf Sleijpen: Sustainable investment - the perspective of the Dutch central bank Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the jointly hosted Erasmus/Netspar Symposium "What's cooking in sustainable investing?", Utrecht, 16 May 2024. *** One month ago, on April 11th, it was European Green Energy Day. On that day the European Union had used up all its available green energy for the current year. For the rest of the year, the EU is still dependent on fossil energy. For the Netherlands, Green Energy Day fell even earlier, on the 8th of March, although the good news is that we are catching up. As the energy transition progresses, Green Energy Day shifts in the right direction by a few days each year. But the shift is going too slow. In order to achieve the Paris goal of being fully carbon neutral by 2050, we have to double our speed. The energy transition is as urgent as ever. Shaping that transition, and accelerating it, is a responsibility we all share. Each in our different roles. Governments are in the driving seat. They have the democratic mandate and the position to lay down a long-term vision and strategy, to set goals, and to design and implement policies. They also have the economically most effective and efficient tools at their disposal. Here I think of setting standards and imposing regulation, adequate pricing of externalities, and encouraging innovative, sustainable investment, for instance through subsidies. Striking the balance between the medium to longer term gains of the energy transition and short-term transition costs may be the most complicated task for a government whose mandate is in most cases not longer than four or five years. At De Nederlandsche Bank, we may not be in the driving seat, but we are definitely part of the team. A part of the team in three different ways, in three different roles. As a supervisor and regulator, as a central bank and as a leader by example. As a supervisor and regulator we have a responsibility to make sure that financial institutions manage their climate- and nature-related risks. Those risks have a bearing on the financial soundness of financial institutions, which is something we are watching over. And ignoring these risks is not compatible with sound risk management. As a central bank, our objective is to maintain price stability and to safeguard financial stability. Climate change definitely has an impact on both and, hence, squarely falls within our mandate. And as a public institution at the heart of the financial sector we want to lead by example and, albeit in a small way, contribute to international sustainability goals. International goals regarding climate change and legislation also applies to us, evidently. This is why we are committed to integrating sustainability considerations in all our core tasks by the end of next year. 1/5 BIS - Central bankers' speeches Two things stand out. First of all, no matter how you look at climate change, it will have an impact, one way or the other. Ignoring mitigation of climate change, will increase the costs of adaptation and will pose serious risks for the economy as we know it. But effective climate risk mitigation also comes at a cost in the short term, that may impact the economy, financial institutions and financial stability. However, the cost of dealing with the consequences of climate change far outweighs the cost of a timely transition. Whatever the route will be, central banks and financial supervisors will, given their mandate, always prefer a predictable and orderly transition path. Secondly, green policies need to be coordinated at an international level to make them more effective and to create a level playing field for economic actors. But that doesn't mean waiting for the others. If we don't take the lead as the developed world, with our technological and financial might, countries like India and China will be even less inclined to speed up their energy transitions. Let me now focus on the role of financial institutions, in particular sustainable investments, which is at the heart of this seminar. So in our role vis-à-vis financial institutions, what do we – as supervisor and regulator find important? We do not tell financial firms how they should run their business. Our primary concern is that they have their management of climate- and nature-related risks in order. To give you an example. Engagement is a hot topic at the moment, in other words trying to change the course of a company as a financier, versus divesting, stopping with financing. Given our role, we have always remained relatively agnostic in this debate. As a financier, you can influence a company's decisions. A company that is currently a polluter can make a substantial contribution to the transition if it has a credible transition plan in place. You can also argue about how the world will be helped if you sell your shares or stop financing a company out of sustainability concerns, which may only open the door to other financiers with less green interests who are eager to take advantage of this 'opportunity'. For us, it's important that a financial institution can explain how it manages the risks resulting from a financing decision. And I think it's obvious that companies without a credible transition plan or ones that structurally fail to deliver on their promises will become uninvestable over time. That means the risks for a financial institution that remains invested in such companies will continue rising. What else do we find important? Well, a significant portion of the Dutch financial sector has signed the climate commitment, pledging to support the Dutch government's climate objectives and taking initial steps towards impact investing. DNB welcomes this initiative and has recently analysed the action plans the institutions have published in this regard. Financial institutions have created an important reference point by setting a long-term climate target. And they have taken a significant step in the right direction by establishing a monitoring framework for their action plans. At the same time we see that financial institutions are facing challenges in implementing their action plans, that require them to take not only financial considerations into account, but also non-financial considerations. While investing in a prudent manner remains at all times essential, it's important that the commitments the institutions have made result in concrete actions. Otherwise, they may face legal or reputational risks. Greenwashing is increasingly a source of legal action, with the number of climate- 2/5 BIS - Central bankers' speeches related court cases worldwide more than doubling since 2017. That's why DNB is both supportive and vigilant. We applaud the financial sector's dedication to the climate transition. At the same time, we expect the sector to meet its commitments, to mitigate the risks of reputational damage and litigation. In general, financial supervisors are intensifying their focus on climate- and environment-related risks. The ECB has put climate- and nature-related risk high on the agenda. Banks under its supervision must comply with the supervisory expectations for good risk management by the end of this year. At DNB, we are on the same track for the banks, insurers and pension funds under our supervision. While there has been progress, we are still not where we need to be. As supervisors, we are doing what we can to nudge the sector in the right direction, for example with good practices. But if these efforts prove insufficient, enforcement will come into view as a viable option. As I said, more and more financial institutions have indicated they want to go beyond managing climate-related risk. They want to actively contribute to the green transition. And that brings me to the topic of impact investing. The World Bank defines impact investing as an approach that aims to contribute to achieving measurable positive social and environmental impacts. An approach that looks to the future instead of to the past. Impact investing and lending creates a significant opportunity to mobilise capital into investments that target measurable positive social, economic or environmental impact alongside financial returns. So what exactly is the difference between impact investing and traditional investing? Traditional investing aims for financial value, seeking an outcome on the risk-return curve known as the efficient frontier. ESG risks could be taken into account as a first step, meaning that companies assess the potential financial consequences of physical or transition risk events when looking at the risk-return curve. This is what DNB expects from the financial institutions we supervise, and this is generally known as taking 'single materiality' into account. To truly move towards impact investing, this two-dimensional framework changes to a three-dimensional one, as ecological and societal impacts are included in an investment decision. The sum of financial, ecological and societal value forms the target variable for optimisation. Or, in a slightly 'lighter' form, some minimum requirements for the ecological and societal impacts are formulated when optimising for the financial value. Determining an impact value is not always an easy process, but increasingly quantitative methods are being proposed, for instance by Dirk Schoenmaker and Willem Schramade in a corporate finance book they published last year. In essence, they propose to find a monetary value and a quantity for the impact a financing decision has (or the harm it does). Think of the cost of a tonne of CO2 emitted, or the shadow price of a life year saved by a certain new medical technology. The resulting annual value streams can be discounted with a similar discounted cash flow model that is used for financial flows, although the discount rate may be different. The three-dimensional approach makes it possible to arrive at an integrated value, where financial value and impact value are taken together. But let me stop here with the technical elaboration and recommend that you read Willem and Dirk's book if you want to know more. 3/5 BIS - Central bankers' speeches Putting this into practice is complicated. For one thing, a lot of the shadow prices, quantities and ways to discount are unknown or strongly debated. I know it may also be scary: financial institutions have a tendency towards herd behaviour and feel a substantial 'first-mover disadvantage'. And let's be honest: it is not only our own decision to make. It is what investors, customers and partners demand. So, if we base our position on this ESG mindset, if we incorporate impact investments and loans into our portfolios, we will not only apply proper and prudent risk management, but we will also contribute to a sustainable future. How can financial institutions make this work? Well, there are three elements to this. First of all, tailoring the operational processes towards impact investments. Here I think of investment processes and customer acceptance, credit judgement and revision. That means impact needs to be part of the parameters for decisions about investments, alongside risk and return. That means daring to move away from the broad market benchmark and choosing a smaller portfolio of impact-oriented companies. And you have to make it clear to your stakeholders what the implications may be for the diversification of your portfolios. Secondly, finding the right people and creating the right processes to make this work. That means recruiting the appropriate capacity and competences and reorganising organisations. That means defining new or additional KPIs that reward decisions that contribute to impact goals and place less emphasis on classical views, like beating the benchmark. And the third element is being more transparent about what you do and the results you are aiming for. That means: moving away from the short-term focus towards a sustainable, long-term future. As a guardian of financial stability, we encourage you to embrace impact investing as a means to accelerate the green transition and thereby reduce systemic risks. In my view, this also means that we as a regulator need to ensure that we are not a barrier to your transition to impact investing. That means that we have to change too. For instance, when we assess financial risks for investments, we have to consider whether or not they are future-proof. Or when applying the prudent person principle, one could argue that we should be concerned not only with the financial returns that participants will receive from fund investments in the short run, but also whether these returns are sustainable in a longer term perspective. It is important to note that impact investing is often associated with illiquid and more complex products, such as venture capital and private equity. We have to take account of that in our supervision. Of course, such investments require a sufficient level of knowledge and expertise to manage these products responsibly. To further tailor the way we supervise, we have developed a good practice guide for sustainable risk management. We will update the guide this year and we also intend to include Frequently Asked Questions to provide clear explanations and expectations. I hope these tools will encourage the financial sector to use forward-looking indicators. To apply scenario analyses rather than focus on historical track records. And motivate 4/5 BIS - Central bankers' speeches the sector to implement a concrete transition plan and more long-term, sustainabilityfocused KPIs. I will now come to a conclusion. Financial institutions play a crucial role in our societies. They play an important role in creating sustainable prosperity. So we need the financial sector to act urgently. We need to speed up the transition to become climate neutral by 2050, in line with international goals. We have to shift that Green Energy Day on the calendar as fast as we can. There is no time to lose. The world needs the financial sector's help in financing the transition to a carbon-neutral society that is in harmony with nature. And we need the sector to manage its climate- and nature-related financial risks. They are often two sides of the same coin. We will only succeed if we join forces – supervisors, governments, financial institutions and other private parties. So let's check in today, and take up the task that lies before us – together. 5/5 BIS - Central bankers' speeches | netherlands bank | 2,024 | 6 |
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Speech (virtually) by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the CPMI (Committee on Payments and Market Infrastructures) conference on the "Progress and priorities on the G20 cross-border payments roadmap", Florence, 11 July 2024. | Klaas Knot: Acta, non verba - interlinking fast payment systems to enhance cross-border payments Speech (virtually) by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the CPMI (Committee on Payments and Market Infrastructures) conference on the "Progress and priorities on the G20 cross-border payments roadmap", Florence, 11 July 2024. *** Thank you for inviting me to speak today. I am sorry that I cannot be there with you in person. Just as Rome wasn't built in a day, the splendour of Florence didn't arise overnight. Both cities are testaments to the power of time, artistry, and persistent dedication. At the FSB, we don't build anything alike – but we are ambitious in a similar way. And we take on projects that reach the same level of complexity. The G20 Roadmap to enhance cross-border payments are not immediate and easy tasks. The Roadmap is ambitious in its goal to improve the cost, speed, availability and transparency of crossborder payments globally. The complexity of this undertaking cannot be overstated. The cross-border payments ecosystem is made up of countless individuals, businesses, and governments, relying on a network of national and regional payment services providers and infrastructures. And these themselves are subject to the laws and regulations of every jurisdiction in which they operate. As most of you will likely recall, the FSB and our partners, including the CPMI, began this journey in 2020. We spent the first two years exploring a wide range of possibilities to address the frictions that cross-border payments face. This included practical arrangements, operating practices, technological solutions and regulatory changes. The work involved stocktakes and in-depth analyses. And it produced best practices, and recommendations for how to improve existing arrangements and to develop potential new arrangements. In 2021, we published quantitative targets to define the ambition of the Roadmap and establish a shared, concrete vision of the goals to be achieved. We then identified the actions we would need to take to achieve the targets by end-2027. Based on this, we transitioned, in February 2023, to a practical implementation phase, consisting currently of 15 priority actions. These priority actions are designed around three interconnected themes. The first theme focuses on improving payment system interoperability and extending RTGS operating hours and access policies. The aim of this is to shorten transaction chains and reduce related frictions. The CPMI leads the work in this area. And we just heard about the work underway on interlinking fast payment systems, including technological innovations in this area. I just want to underscore the value of this work. 1/3 BIS - Central bankers' speeches The second theme is to promote consistency in legal, regulatory and supervisory frameworks for cross-border payments. Because the opposite can be a significant source of frictions in cross-border payments. And unnecessarily increase the complexity and, consequently, the cost of cross-border payments. This is not to suggest that laws, regulations or supervisory practices should necessarily be relaxed or constrained. They serve important public-policy goals. However, where unnecessary frictions are created, we should seek to reduce or alleviate them. For our part in the FSB, next week, we will publish a report for public consultation on this topic. It consists of recommendations to strengthen consistency of the application of regulation and supervision to banks and non-banks providing cross-border payment services. We want to promote common minimum standards on a basis of "same activity, same risk, same regulation". In doing so, we aim to create an environment of trust for consumers, banking intermediaries and infrastructure providers, including fast payment systems. Actions under the Roadmap also include work by the Financial Action Task Force, or FATF, to strengthen their guidance on anti-money laundering and combatting the financing of terrorism: AML/CFT. In February, FATF completed its guidance on beneficial ownership. Currently, it is assessing the responses to its public consultation on updating its rules on wire transfers. This way, it will take account of recent and upcoming developments in the architecture of payments systems. Later this year, the FSB expects to announce that yet another international organisation will be joining the Roadmap ambition. The third theme focuses on facilitating cross-border data exchange and increasing the use of standardised messaging formats for cross-border payments. The global transition to the ISO 20022 standard is underway. However, inconsistent use of the standard could limit its benefits in enhancing straight-through processing and the interlinking of payment systems. Data lies at the heart of payments. But data standards, frameworks and formats vary significantly across jurisdictions, infrastructures and message networks. The efficient transfer of data supports cheaper, faster, and more transparent payments. And it also supports our shared interest in combatting financial crime, such as fraud and money laundering, and terrorist financing. Here, the FSB has explored the interaction between data frameworks and cross-border payments. This way, we want to contribute to greater alignment and interoperability of cross-border payments services. Data frameworks and regulations aim to preserve the security of transactions, limit AML /CFT, and protect the privacy of citizens. However, the fragmentation in data frameworks across jurisdictions is a major barrier to automating cross-border payments and preventing fraud. Using our convening power to reach beyond financial authorities and engage with data privacy and data protection regulators, the FSB has developed a set of recommendations. With these, we want to: 2/3 BIS - Central bankers' speeches promote standardisation and uniform implementation of payment-related data requirements. address conflicting requirements, such as those related to data privacy and to AML /CFT. create trusted avenues for the cross-border flow of data while supporting data privacy. And encourage progress on promising innovations to reduce frictions in crossborder payments. Next week, these recommendations will be issued for public consultation and I encourage you to provide feedback. Much still needs to be done by both the public and private sectors. To support jurisdictions' enhancement of payment systems, the IMF and World Bank have launched technical assistance for cross-border payments, and encourage jurisdictions to engage with them. But no action can be conceived without global coordination and without purposeful and proactive engagement with the private sector. This event is an excellent example of engagement of public and private sector stakeholders on one of the priority actions. In addition, the FSB and CPMI have each established a taskforce comprised of the public and private sectors. Their purpose is to facilitate the sharing of views and support a shared commitment. At the beginning of my contribution, I talked about the targets we want to achieve by end 2027. What we need to keep on progressing towards these targets, is threefold. First, we need continuous commitment from the regulatory community to finalise the work that is in progress. The FSB is committed to making sure that this happens. Second, we also need a shared commitment to improving cross-border payments, both from the public and the private sector. The onus to turn some of the completed priority actions into reality rests with the private sector, with the support of the public sector. Third and finally, we need specific attention to those regions and market segments that find themselves furthest from the targets. This is the case, because we may need a more in-depth understanding of the market practices and a dedicated action plan for those regions in order to see substantial progress at a global level. Indeed, Rome wasn't built in a day. Nor did the splendour of Florence arise overnight. They required time and dedication. Conferences like this create the necessary time – to reflect, make connections, and share insights. And above all, they provide the inspiration to stay dedicated to our ambitions – and make our goals a reality. So let me wish you all good discussions and a lot of food for thought to inspire action once you go back home. Thank you. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 7 |
Speech by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the International Monetary Fund-World Bank Constituency meeting, Moldova, 11 July 2024. | Klaas Knot: The AI adventure - how artificial intelligence may shape the economy and the financial system Speech by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the International Monetary Fund-World Bank Constituency meeting, Moldova, 11 July 2024. *** Innovation is everywhere. Take the wine industry here in Moldova, for example. An industry that goes back thousands of years. When I was preparing for this meeting, it was pointed out to me that recent innovations in agriculture have greatly improved wine production in your country. I was particularly amazed to hear about the use of drones to monitor the health of vineyards. And about the optimisation of grape production through automated irrigation systems and data analytics. If you want to get a literal taste of what innovation can bring, look no further than Moldova. Since the early days of economics, we've known that technological innovation is an important driver of economic output per worker, and therefore of wealth and prosperity. That's why generative artificial intelligence is so exciting: with the emergence of incredibly capable generative models and dramatic advances in computing power, we might very well be on the verge of a new technological revolution. Studies suggest that AI can greatly increase total factor productivity across several industries, including the financial sector, healthcare, manufacturing, energy, transport and logistics. Research also shows that the use of AI can significantly improve productivity within individual companies. This may contribute to economic growth in a meaningful way. This would be great news. At the recent IMF Spring Meetings, the talk of the town was lagging productivity growth. In large parts of the world, productivity growth has been sluggish for many years now, so a boost from AI would be very welcome. Obviously, it's difficult to predict the impact AI will have on the economy and productivity at this juncture. We're already amazed at what ChatGPT and other generative AI models can do. But when we look back five years from now, today might very well seem like the Stone Age. I will certainly not claim to have all the answers. But we can make some intelligent guesses about the impact of AI, based on recent developments and sound economic thinking. For one thing, AI will likely shake up labour markets. Although the jury is still out on the net effects, we know that the current wave of generative AI presents new dynamics. It can both replace and complement human labour. So like any other new technology, AI can create and destroy jobs. What's new about AI, however, is that it's especially the high-skilled, high-paying jobs that are vulnerable. The ultimate impact is likely to be sector specific, and will partly depend on companies' creativity, and their ability to adopt AI in a way that complements, rather than replaces, human labour. Policies and regulations can also help steer these developments. It's especially important to have social safety nets in place to support workers who have lost their jobs, as well as labour market policies to help workers stay employed. Tax policies should also be carefully assessed to ensure that tax systems don't favour indiscriminate labour replacement. 1/3 BIS - Central bankers' speeches IMF research shows that several countries have tax systems in place that implicitly favour automation over facilitation. So we need to make sure that our regulatory and fiscal policies do not work against our needs. Differences in economic structures and education levels mean that AI may have different impacts across different countries. According to the IMF, almost 40 percent of global employment is exposed to AI. Advanced economies are at greater risk, but are also better positioned to reap the benefits of AI compared to emerging market and developing economies. In advanced economies, about 60 percent of jobs are exposed to AI, due to the prevalence of jobs that revolve around cognitive tasks. Of these 60 percent, about half may be negatively affected by AI, while the rest could benefit from enhanced productivity through AI integration. In emerging market economies, overall exposure is 40 percent, and in low-income countries it is 26 percent. This means that many emerging market and developing economies may experience less immediate AIrelated disruption. On the other hand, they're also less ready to take advantage of AI's capabilities. This could have a negative impact on the digital divide and income inequalities between countries. That's why emerging market and developing economies should give priority to the development of digital infrastructures and digital skills. There are many open questions concerning AI. Instead of pretending to know the answers, my message would be this: artificial intelligence is neither the great villain nor the great saviour of our time. It's a technology that we can use to our benefit, but only if we implement the right policies and regulations. As regulators and policymakers, we should therefore maintain a healthy balance between harnessing the benefits of innovation while mitigating the risks. When it comes to innovation, the Americans have traditionally been focused on the opportunities, with a regulatory environment that's more flexible and conducive to business innovation. Europeans tend to focus on the risks and call for regulation. But falling behind in adopting new innovations is a significant risk too, as all parts of the world should benefit from the productivity potential of AI. So I would call for a slightly more American attitude to things, and warn against stifling AI-driven innovation. That said, welcoming and fostering innovation doesn't relieve us of the obligation to monitor the risks that come with it. And that is my focus as chair of the FSB. This year, we are updating an FSB paper on the financial stability implications of artificial intelligence, originally published in 2017. While it's too early to say with certainty what our conclusions will be, the emerging consensus is that the risks identified in the earlier report are still there. The most important ones are concentration risk, third-party risks, possible increases in herding behaviour, and model risk, including challenges with regard to explainability. Many of the potential risks of AI may seem new, but when you look beneath the surface, they are strikingly similar to traditional financial risks. Risks that we are familiar with. We already have frameworks to assess concentration risk, third party dependence and interconnectedness. This is good news. But potential new forms of interconnectedness in the financial system may emerge. For example, autonomous trading agents may interact to create new dynamics in financial markets. Some studies have found that AI-powered algorithms consistently learn to charge higher prices 2/3 BIS - Central bankers' speeches through collusive strategies, even if there's no direct communication between them. Such interdependencies may be especially pronounced if the market for data and model providers is highly concentrated, which appears to be the case for generative AI models in particular. Although there are lots of applications out there, in practice they all seem to be based on only a handful of models, perhaps just three or four. At this stage, the FSB's work is purely analytical. We are not currently developing policy options or coordinating across standard setting bodies or international organisations. But the FSB is ready to do what is needed to monitor these risks and implement effective regulatory frameworks. Regulating a fast-changing, almost ubiquitous technology may sound daunting, but we have many good tools at our disposal. AI is not a new discipline – various use cases have been around for quite some time now. And as I pointed out earlier, many of the risks involved are risks we're already familiar with. They're just wearing new disguises. Although this is no reason for complacency, we can take comfort in the fact that we're not starting from scratch. In short, I see the glass as half full. Innovation has brought us many good things throughout history, from the printing press to drones that can help improve wine production. The possibilities of AI may be endless, but humans are inventive. So I'm confident that we'll be able to put AI to good use while keeping its darker sides in check. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 7 |
Introductory remarks by Mr Klaas Knot, President of the Netherlands Bank, at the European Central Bank policy panel at the annual congress of the European Economic Association, Rotterdam, 27 August 2024. | Klaas Knot: Monetary-fiscal policy mix in the euro area - lessons learnt and the way forward Introductory remarks by Mr Klaas Knot, President of the Netherlands Bank, at the European Central Bank policy panel at the annual congress of the European Economic Association, Rotterdam, 27 August 2024. *** Thank you very much for inviting me. This panel touches upon a topic that I believe will always lie at the forefront of policy discussions, especially in the light of our experiences from the recent past. I will start my remarks by recalling the policy responses to the global financial crisis and the Covid pandemic. Because I think these events have taught us important lessons not only about the appropriate monetary/fiscal policy mix, but also about the fiscal policy design both at the national and at the union level. When the euro was introduced, the common belief was that national fiscal policy should focus on stabilising national business cycles and that monetary policy was the appropriate instrument for stabilisation at the euro area level. This thinking changed when interest rates fell for an extended period and were approaching their effective lower bound, thereby limiting the effectiveness of monetary policy. This increased the importance of fiscal coordination among member states. This came to the fore for the first time during the global financial crisis. During the global financial crisis and the subsequent debt crisis in the euro area. The monetary/fiscal policy mix was suboptimal, both at the national and the European level. Monetary policy was quite accommodative throughout that period, there is little doubt about that. Its intended stimulus could have been reinforced by a countercyclical fiscal stance. That would potentially have allowed a faster economic recovery without having to rely so excessively on loose monetary policy. However, this is not what happened. Throughout most of the debt crisis, most governments pursued tight fiscal policies. This reflected choices that are understandable at the national level, as some countries had little choice but to undergo fiscal consolidation, but it was not conducive to economic recovery at the European level. Had monetary and fiscal policy moved in tandem, the recovery could have been quicker. But this would only have been possible if public finances had been on a sound footing throughout the euro area. Unsustainable debt levels and fiscal deficits spinning out of control make it difficult to implement the right monetary/fiscal policy mix. The monetary/fiscal policy mix was more effective during the pandemic. Again, the ECB conducted a very accommodative monetary policy. But this time, it was accompanied by an expansionary fiscal stance. The general escape clause in the Stability and Growth Pact was activated for that specific purpose. Monetary expansion created the necessary fiscal space for governments to increase public expenditures in order to prevent a collapse in economy activity. Of course, a key difference with the global financial crisis was that the pandemic hit all member states simultaneously. This made 1/3 BIS - Central bankers' speeches it easier to align national fiscal responses. Also, many of the member states that were previously fiscally burdened were in a somewhat healthier fiscal position at the onset of the pandemic. Lately, however, monetary and fiscal policy have gotten mixed up again, although with both policies now having traded places. The recent energy crisis and its impact on inflation led to a monetary tightening, while fiscal policy continued to be very loose. This monetary/fiscal policy mix is equally undesirable. Interest rate hikes put upward pressure on debt servicing costs which should have been compensated by higher primary fiscal balances. Also, most of the burden of bringing inflation down was placed on the ECB. Here too we see that an inappropriate fiscal stance can hamper the efficacy of monetary policy. In this case, a more restrictive fiscal policy would have been desirable. In the past, economists have been critical of the EU fiscal framework. A major weakness was the lack of flexibility. The existing rules were inspired by the need to reduce fiscal deficits in the early years of the monetary union. However, they were not suitable for dealing with the kind of crises we have seen since 2008. This is mainly because the rules were not flexible enough to allow automatic fiscal stabilisation to do its work in an economic downturn. Had this been the case, and had fiscal consolidation been allowed to proceed more gradually, the monetary/fiscal policy mix would probably have been less damaging to economic growth. The good news is that the new European fiscal framework has been in place since the 1 st of May. The new rules provide more room for automatic stabilisation and decrease the risk of fiscal tightening in bad economic times. Also, the new rules are more countryspecific and offer incentives for long-term investment and reform. This increases the long-term growth potential of member states, especially those with substantial levels of debt. But flexibility has its limits, also under the new framework. That's because the room for countercyclical fiscal policy is limited by the need for national fiscal discipline. If markets perceive that national debt is on an unsustainable path, spreads will widen and financial stability in the union will be threatened. So the increased flexibility under the new rules to allow for expansionary fiscal policy in economic downturns is definitely an improvement. But it will only work if national governments reduce their debt during upturns. Whether this happens will largely depend on compliance and enforcement of the rules. In this regard, the new EU fiscal framework will immediately have to prove itself. In view of national fiscal constraints, some form of supranational fiscal spending could be helpful in dealing with a large euro area wide shock. A good example of this is the Next Generation EU recovery fund, which was introduced during the Covid pandemic. The introduction of Next Generation EU had a calming effect on financial markets and prevented the spreads from widening. And the conditionality attached provides an incentive for economic reform. Having said this, more spending at the central level should not lead one-for-one to more public debt or higher taxes in the euro area. After all, the national and European taxpayer is ultimately one and the same person. More fiscal space at the European level should therefore go hand in hand with less fiscal space at the national level. 2/3 BIS - Central bankers' speeches And on that rather sobering note, I give the floor back to you, Leonardo. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 8 |
Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at a Bloomberg event, Amsterdam, 16 September 2024. | Steven Maijoor: Painting like Rembrandt - managing risks in the age of AI Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at a Bloomberg event, Amsterdam, 16 September 2024. *** Thank you, Peter, for your kind introduction and for the invitation. I understand that the organisation of this event was looking for some entertainment. So they asked the regulator to speak. I mean, what can go wrong? So here I stand, very conscious of my role, in the most beautiful museum of the country. In a few minutes you will enter the Gallery of Honour, the beating heart of the Rijksmuseum, showing masterpieces by the greatest painters of the 17th century. With one absolute focal point: the Night Watch. As you may know, the Night Watch used to be bigger than it is now. Two hundred years ago, they cut off pieces from the painting to make it fit in a particular room. These pieces have never been found. A couple of years ago the museum's experts were able to reconstruct the missing pieces on the basis of a 17th century copy. They did so with the help of artificial intelligence. By comparing thousands of tiny pieces of the two versions of the painting, the computers basically learned to paint like Rembrandt. You should ask one of the experts here about it during your tour, it's an amazing story. Digital innovation is literally everywhere. It has become part of everyday life, but its possibilities are still far from exhausted. The financial industry is one of the sectors in the economy that has embraced digitalisation to the full, especially here in the Netherlands. Digitalisation has produced more efficient business processes, greater transparency for consumers, and many new financial services, in particular in the area of payments. For example, in the Netherlands, only two in ten purchases are still made with cash. The other eight are done with digital means of payment. At De Nederlandsche Bank, we welcome digitalisation in the financial sector. But we obviously also consider the risks. Take for example the outsourcing of digital services to large technology companies. What if these companies are no longer able or willing to fulfil their obligations? Are financial institutions fully aware of what these companies are doing with the data they entrust to them? Another aspect is that many of these tech companies are not located in Europe. With geopolitical tensions rising, there is a desire, particularly among some European politicians, to develop certain critical technologies on European soil. Tremendous effort has been put into developing European regulations to manage these and other digitalisation-related risks. So that European citizens and businesses can take full advantage of new technologies, safe in the knowledge that the risks are well managed. 1/2 BIS - Central bankers' speeches Large digital service providers, such as cloud providers, are set to become subject to European oversight, for example. And supervision of crypto service providers is being expanded. However, developments are happening rapidly, and the challenge is to be able to reap the benefits of innovation while keeping out the bad stuff. Of all innovations, generative artificial intelligence is undoubtedly the most exciting: with the emergence of incredibly capable generative models and dramatic advances in computing power, we might very well be on the verge of a new technological revolution. Who knows soon we can all paint like Rembrandt. Also here, we must make sure to maintain a healthy balance between harnessing the benefits of innovation while mitigating the risks. When it comes to innovation, some regions, like the US, have traditionally focused more on the opportunities side, with a regulatory environment that's conducive to business innovation. We Europeans tend to focus on the risks and call for regulation. But falling behind in adopting new innovations is a significant risk too. So I would call for a balanced approach, and warn against constraining AI-driven innovation too much But that doesn't relieve us of the obligation to monitor the risks that come with it. Many of the potential risks of AI may seem new, but if you look beneath the surface, they are strikingly similar to traditional financial risks. Risks that we are familiar with. We already have frameworks to assess concentration risk, third party dependence and interconnectedness. This is good news. Of course, it's not a simple copy-paste exercise. We may see new forms of interconnectedness in the financial system. For example, autonomous trading agents may interact to create new dynamics in financial markets. And technology that can be used to paint like Rembrandt also offers possibilities for creative fraud, from phishing to identity theft. So the nature of the risks may not be different, but the crooks are getting better. That means we are entering a new phase of the never-ending race between risk and risk management. But we are entering this race from a relatively good starting point. AI is not a new discipline – various use cases have been around for quite some time now. And as I pointed out, many of the risks involved are risks we're already familiar with. They're just wearing new disguises. So although this is no reason for complacency, we can take comfort in the fact that we're not starting from scratch. In short, to use a fitting metaphor, I see the glass as half full. And I'm confident that we'll be able to put digital innovation to good use while keeping its darker sides in check. On that rather cheerful note, let me stop here and wish you a pleasant evening and a wonderful tour of the paintings. 2/2 BIS - Central bankers' speeches | netherlands bank | 2,024 | 9 |
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Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at the kick-off event of the impact centre "AI4 Fintech", Amsterdam, 4 October 2024. | Steven Maijoor: 2024 - an AI odyssey Speech by Mr Steven Maijoor, Executive Director of Supervision of the Netherlands Bank, at the kick-off event of the impact centre "AI4 Fintech", Amsterdam, 4 October 2024. *** 'I'm sorry, Dave, I'm afraid I can't do that.' This heartfelt excuse is a line from a movie. A movie that came out in 1968, a year before the first human set foot on the moon. Nevertheless, the movie is largely set in space. I am talking about '2001: A Space Odyssey'. And that line, that excuse I just uttered, is spoken by a computer. A computer called HAL-9000. A computer that talks, that shows emotions, that says 'no'. In other words: artificial intelligence. AI. In 1968. We are now well beyond 1968. Even well beyond 2001. But we are still on an odyssey. An AI odyssey. Not in space. But here, on this very planet, where AI is increasingly becoming a part of our everyday lives – be it professional, be it personal. As in any odyssey, we are searching for something that brings us good fortune, but probably won't come easy. Something we long for, but might take a while to find. When I look at the current, broad applications of AI, I am impressed by its potential. Coming from rule-based AI, and subsequently machine learning, it is clear that we have now moved to a new era – an era in which AI still counts as a great predictive force, but is now also capable of generating content, be it texts, images or videos. And soon enough, a combination of them, in multimodal AI. Nevertheless. AI may indeed have become ubiquitous, we are still far from using its full potential. Whether in its different forms, from machine learning to generative AI – or in its breadth of use, from society as a whole to the financial sector in particular. As supervisors, for instance, we see that financial institutions are indeed experimenting with AI – quite a lot, actually – but at the same time, we also see that those experiments are mainly happening around the fringes of their professional activities. For instance, in customer service. And that's quite far from the core financial processes. Quite far from the places that have a real regulatory impact. And remarkably, if AI is indeed used in core processes – in areas that are of high regulatory importance – we notice that it is used in parallel to already existing models. In the sense that both the old and the new run next to each other. This shows that, currently, there is not yet enough confidence in the new technology to replace the older technology – the risk of regulatory mistakes is still deemed too high. The financial sector as a whole is, indeed, on an AI odyssey – a long and eventful journey towards its destination. A journey with setbacks and progress. A journey with an unclear and uncertain path forward. But also, I hope, a journey that is fuelled by the very idea of becoming a financial sector that has embraced AI to its fullest potential – 1/4 BIS - Central bankers' speeches and that does so with respect for the values that underly our society, like fairness, freedom and security. Rules and regulations reflect these values. They are instrumental in protecting them. And as our society changes and certain values come under pressure, rules and regulations need to change accordingly. DNB is currently supervising AI within its prudential and AML/CFT mandate. With this mandate, we ensure the stability of the financial system, and the solidity and integrity of financial institutions. The European AI Act, which came into effect earlier this year, broadens our mandate. In our AI supervision, we will now also take account of fundamental rights, like privacy and non-discrimination. These changes also affect the financial sector, of course. They create uncertainty. At De Nederlandsche Bank, however, we are committed to creating regulatory certainty around AI supervision in the financial sector, for instance in our contributions to the European Supervisory Authorities, and the Bank of International Settlements. We won't stop encouraging financial institutions to explore and experiment. At the same time, we want them to be confident in discussing their progress with us. Because we believe this is part and parcel of a successful odyssey. As a supervisor, we are fully aware that AI is here to stay. Already in our 2022 report 'From Recovery to Balance', we called for the use of machine learning in transaction monitoring and KYC risk profiling. We did this because we are convinced that it will help build better predictive models – models that will benefit financial institutions, because they can conduct more targeted and efficient due diligence. Models that also benefit society as a whole. Precisely because AI is capable of raising more targeted red flags, customers of financial institutions will experience less hassle when, let's say, opening a bank account. Our supportive stance does come with a concern, though. A concern that can be brought back to the difference between support and guidance. Between: 'I encourage you to go and experiment with AI', and 'Look, here's the technology you should use and a manual on how you should use it.' But sometimes, that's precisely what financial institutions seem to expect from us. Alas, however supportive we may be, as supervisors we are not guiding the way when it comes to AI innovation. What's more, it is inevitable that we are running behind in our knowledge and understanding of AI. If a financial institution wishes to use AI, our primary task is to evaluate whether it does so with due observance of existing rules, regulations and fundamental rights. Any real innovation must happen within and between financial institutions, and together with AI experts. AI supervision only provides boundaries to the responsible deployment of AI models. And we believe there is sufficient room within these legal boundaries to experiment and innovate with AI. 2/4 BIS - Central bankers' speeches Now, even with many data science PhDs working at financial institutions, it is not a given that their knowledge will translate into cutting-edge models. So, this is when I look at you. At impact centres like this one: AI4 Fintech. At centres that combine advanced research with a focus on actual industry impact. At making sure that research contributes to resolving challenges. At the bright academic minds who will do the hard work – and devote a few years of their lives to a PhD. As I said, DNB is not leading the way in AI innovation. This does not mean, however, that we are not on an odyssey of our own. As supervisors, we are on a journey to adapt our supervisory role to this next era of AI. For our supervision to benefit society as a whole alongside financial institutions, our supervisors must be able to have in-depth conversations about responsible AI. As such, we want our people to be as up-to-date as possible with all innovations in this area – to have a deep understanding of AI in the financial sector. This will allow them to set this against the existing regulatory framework and to address fundamental rights issues, like algorithmic fairness, transparency and explainability, and privacy considerations. DNB is working hard on this. We are currently in the process of identifying our supervisors' level of AI knowledge. This will give us a clear picture of any knowledge gaps so that we can develop specific training programmes. One great way to identify any knowledge gaps is, of course, the good old conversation. I understand that financial institutions may be hesitant to engage in this type of conversation with their supervisor. To fully disclose what they are working on. What they are experimenting with. Where they have encountered setbacks and hiccups. And where they question compatibility with existing supervisory rules and regulations. Nevertheless. I encourage the financial sector to engage with us. To open up the conversation. To include us in their deliberations on the responsible use of AI. Not only on the fringes of their work, but also in their core processes. Ultimately, these conversations will benefit everyone. In '2001: A Space Odyssey', the HAL-9000 computer puts it this way: 'The 9000 series is the most reliable computer ever made. No 9000 computer has ever made a mistake or distorted information. We are all, by any practical definition of the words, foolproof and incapable of error.' By the end of the movie, however, HAL is shut down. Dave, the main human character in the movie, had started to feel threatened by HAL. After being shut down, the computer restarts. But any memory of what happened has been erased. Contrary to the HAL-9000 computer, I don't think any of us would say that AI is foolproof and incapable of error. Even now, well beyond 1968. Well beyond 2001. On our odyssey, we will definitely come across issues with AI. But let's not feel threatened. Let's not feel the need to unplug everything and start over. Let's keep going. 3/4 BIS - Central bankers' speeches Eventually, we'll reach the destination of our odyssey. A financial sector that has embraced AI to its fullest potential, and that does so in compliance with supervisory rules and regulations. Thank you. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,024 | 10 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, before the International Institute for Banking Research (IIEB), a group of European bankers, Amsterdam, 11 October 2024. | Klaas Knot: Want a strong financial system? Implement Basel III Speech by Mr Klaas Knot, President of the Netherlands Bank, before the International Institute for Banking Research (IIEB), a group of European bankers, Amsterdam, 11 October 2024. *** Thank you Ralph, and thank you for the invitation to speak here before this distinguished audience. You are all leaders of big organisations. So you are familiar with the question of strategic change: how do you navigate your bank through the waves of financial market sentiment, changing consumer preferences and technological innovation? A sound strategy starts with a lot of thinking, for sure. Strategic thinking. Board room discussions. A couple of consultants perhaps. Finally there is a strategy. A Strategy with a capital S. You know where you want to go and how. But now you enter a crucial phase: implementation. How do you get all corners of your bank from A to B? Because all the strategic thinking in the world will come to nothing if your bank does not follow suit. Implementation is key. So how would you feel if, after 13 years, your plans are still stuck in the implementation phase? I ask because that's the situation we are in with Basel III. When I became governor back in 2011, we were discussing the implementation of Basel III. And now, towards the end of my second term, we are still discussing the implementation of Basel III. By now, some of you might think: 'ok, so this morning we got war for breakfast, and now for lunch we get a central banker who wants to talk about the rules. What's next? We've heard this scratchy old broken record dozens of times before!' But, as you know, these are often the best records. So let me take a step back here. Where are we coming from? In 2010, the Basel Committee on Banking Supervision introduced the first set of Basel III standards. A set of international rules designed to fortify the global banking system after the worst financial crisis since the Great Depression. These reforms were not just a patch-up job. They were a complete overhaul of banking regulation to improve bank resilience, transparency, and risk management. Basel III focused on increasing capital adequacy, introducing the leverage ratio, and creating more stringent liquidity requirements. With the memory of the crisis still fresh, national implementation of this first part of Basel III went relatively quickly. This first set of standards was then complemented in 2017 by the final Basel III standards. They focused on enhancing the risk-weighting framework, introducing more robust capital floors, and limiting the variation in banks' internal risk models. These standards, by now famously known as the Basel endgame, have not yet been implemented by jurisdictions around the world. The EU, in its implementation, deviated on important points, making banking regulation weaker than agreed in the new standards. In the US and the UK, initial legislation proposals have also been weakened, 1/4 BIS - Central bankers' speeches with some elements not fully aligned with the Basel III agreement. Legislators also point at each other when making these adjustments. US banks spent tens of millions of dollars on a lobbying campaign that included ads in the middle of American football games. I don't think it's ethical to interrupt football games for any kind of message, let alone on Basel III. But on a serious note: our failure to implement fully what had already been agreed upon back in 2017 should be worrying. Not only to me, as a regulator, but also to you, as bankers. To explain why, let me give you my version of a pro-Basel lobbying commercial. Implementation of Basel III will increase the credibility of capital ratios and strengthen the banking sector. Think of it as a safety net, your safety net. It will ensure that when the next economic shock comes-and it will come-you will be better prepared to withstand it. The capital buffers required by Basel III are not a burden; they are a shield, allowing you to absorb losses while maintaining operations, protecting your customers and preserving your reputation in times of stress. Many in the banking sector view regulation as a constraint, something that limits profitability and imposes undue costs. But it's just the other way around. Basel III is not an obstacle to growth, it is an enabler of sustainable, long-term growth. Banks with strong capital positions and sound liquidity management are better positioned to extend and rollover credit, invest in new technologies and fund large-scale projects. They are better able to maintain lending during an economic downturn. And stronger banks can secure more favourable funding conditions, attract long-term customers and build partnerships that increase shareholder value. Basel III works best when it works everywhere. When Basel III is implemented unevenly across jurisdictions, it creates a patchwork of regulations that opens the door to regulatory arbitrage. Banks may be tempted to shift operations to regions with looser standards. Consistency across borders is not just in regulators' interests-it's in yours as well. An uneven playing field undermines confidence in the global banking system, disrupts competition, and ultimately increases systemic risk. It puts banks at risk of operating in jurisdictions where regulatory frameworks are not equipped to deal with crises, leaving you exposed when things go wrong. By contrast, global implementation of Basel III creates a level playing field, ensuring that all banks-no matter where they operate-adhere to the same high standards. This uniformity strengthens global financial stability and, in turn, enhances the confidence of your shareholders, customers, and counterparties. The opposition to Basel III reflects a kind of short-term thinking, that, frankly, I find hard to understand. Weakening of Basel III may give you a few basis points in capital relief, but it exposes you to long-term vulnerabilities. As the memory of the global financial crisis fades, we risk entering a race to the bottom. A race that would be very dangerous for financial stability. Or, as Daniel Davis said in his much-quoted Financial Times article, 'while the road to hell is paved with good intentions, the road to the next banking crisis is paved with good exemptions.' 2/4 BIS - Central bankers' speeches So in short, it is essential to implement the Basel III standards in all jurisdictions. Not least because, as you know, financial markets are not waiting for us to learn the lessons of 13 years ago. New risks are always emerging, as the events in March last year showed. The demise of Silicon Valley Bank and Credit Suisse not only brought lessons for banks and supervisors. They also highlighted that we may need some targeted changes in banking regulation beyond Basel III. I want to mention three areas here: liquidity, interest risk and AT1 instruments. First on liquidity. Partly as a result of social media and digitalisation, the outflow of deposits at SVB was much faster than in previous cases, and much faster than LCR calculations take into account. This raises the question of whether the LCR should be calibrated differently for certain types of deposits. The aim would be to increase banks' resilience and provide incentives to attract longer and more diversified funding. Another avenue which should be explored in the light of the SVB case is whether unrealised losses should be better reflected in the capitalisation of banks. Here I'm referring to the difference between market and book value for bonds which are held to maturity. And we should look at how to address the issue that, in times of stress, banks may be hesitant to use instruments in the liquidity buffer that are not marked to market daily for accounting purposes. The turmoil last year also showed how important it is that banks are operationally prepared for liquidity stress. Banks need credible and tested contingency funding plans and they must be operationally ready to access central bank liquidity facilities in times of stress. While this may be more of an issue in the US, we should also look at how this can be improved in the EU. Then interest rate risk. When banks fail to cover this risk sufficiently, changes in market interest rates can lead to substantial losses and, in extreme cases, even to bank failure. The recent developments at regional banks in the US offer a vivid illustration of this. The events last year underline the importance of regulation for interest rate risk management and the need for prudent assumptions about customer behaviour. Capital is also necessary to absorb the uncertainty of customer behaviour. In order to promote global harmonisation, we should explore the inclusion of interest rate risk in the Pillar 1 requirements. And last but not least, we need to think about AT1. Rather than acting to stabilise a bank as a going concern in stress, international experience has shown that AT1 absorbs losses only at a very late stage of a bank failure. We saw this in the case of Credit Suisse in 2023, with the Swiss National Bank noting that 'the AT1 features designed for early loss absorption in a going concern were not effective'. In this instance, AT1 only absorbed losses when the point of non-viability was imminent and failed to stabilise the entity at an earlier stage of stress. This should encourage regulators to reflect on the role and functioning of AT1 instruments in determining the capital position of banks. These are all important things that we have to look into. But first and foremost we have to implement Basel III. And while I know this is primarily a message to regulators and 3/4 BIS - Central bankers' speeches lawmakers, it is also a message to you. Because what a strong signal it would be if you as a group would say: don't water down Basel III. Don't give us weak rules, give us strong rules. Strong rules that apply to all banks wherever they are and whatever their size. It would not only be a strong signal to us, regulators and lawmakers, it would also be the rational thing to do. Because strong rules are in your interest. Because a strong financial system based on a level playing field is in your interest. Because regulation is not a constraint on the financial industry, it is a license to operate. 4/4 BIS - Central bankers' speeches | netherlands bank | 2,024 | 10 |
Speech by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the Bloomberg Global Regulatory Forum, New York City, 22 October 2024. | Klaas Knot: Strengthening financial resilience - lessons from Pittsburgh Speech by Mr Klaas Knot, Chair of the Financial Stability Board and President of the Netherlands Bank, at the Bloomberg Global Regulatory Forum, New York City, 22 October 2024. *** Good morning everyone. It could have been right here in New York City. That would have been fitting, as this city was, and still is, the center of gravity for global finance. But, as it happened, the US administration made a last-minute decision to pick Pittsburgh as the venue for the G20 summit. We are back in the fall of 2009. Less than a year earlier, when G20 leaders first met in Washington DC, the world economy had been facing its greatest crisis in generations. At the Pittsburgh Summit, the memory of the crisis was still fresh. The fall of Lehman. The rescue of AIG. The race against the clock to prevent a total meltdown of the financial system. Leaders from the 20 largest nations in the world had all gone through those fateful crisis days. They shared a conviction that this should not happen again. Ever. They decided on a massive strengthening of regulation to address the weaknesses in the global financial system and to curb excessive risk taking. And they endorsed the mandate of the newly established Financial Stability Board to coordinate and monitor progress. Pittsburgh turned the tide. The rest is history. But it is an unfinished history. For sure, the reforms that were agreed in Pittsburgh did substantially strengthen the global financial system. In recent years, markets have experienced several episodes of turmoil, and we have seen potentially destabilising failures of banks and non-banks. But the core of the system has held up relatively well. So, one interpretation is that the financial system has proved to be resilient. But that is not entirely true. Take March 2020 for example. This turmoil was contained both through improved resilience and unprecedented policy actions. Without the combined force of these policy actions, the reforms implemented since 2009 may have not been sufficient to stave off another financial crisis. And it's not only in 2020 that unprecedented policy actions were needed. In 2023 the fire brigade had to turn out again. So, we've made progress, but there is much left to do if we want a truly resilient financial system. One that can finance the economy through thick and thin without recourse to extraordinary support. Furthermore, the financial system is evolving, and so must our regulations. Can we keep up the pace? Allow me to share some concerns about that. First of all, our work to make the banking sector more resilient is not yet complete. For one thing, the final Basel III standards still need to be implemented in many 1/3 BIS - Central bankers' speeches jurisdictions. In the meantime, the banking turmoil in March last year was a reminder that bank runs are not a thing of the past. The demise of Silicon Valley Bank and Credit Suisse not only brought lessons for banks and supervisors. They also highlighted that 13 years after the FSB issued its Key Attributes for Effective Resolution Regimes, authorities still face challenges in dealing with failing banks. Next to the unfinished agenda in banking, the non-bank financial sector continues to face serious vulnerabilities. Partly as a response to strengthening banking regulation, non-bank financial institutions are playing a larger role in financing the real economy, now accounting for nearly half of total global financial assets. And as we have seen over the past few years, structural vulnerabilities in the sector have the potential to cause systemic risk. These include liquidity mismatches, leverage, and inadequate margin preparedness. The FSB, working with other standard setters, has done a great deal of work on this issue. We have issued policy recommendations in several key areas. Drawing up these policy recommendations, however, is not enough to stem systemic risk in NBFI. For that to happen, we must implement them. That means authorities must not only put them into national laws and regulations, they must also have the capacity to operationalize them. Third, technological innovation continues to shape the way the financial sector functions, and it adds another layer of complexity. Technology can create new interdependencies, for example when many financial institutions rely on the same service providers. It can also increase the speed at which a crisis unfolds. And technology raises important questions about the regulatory perimeter. Above all technology related risks can exacerbate pre-existing vulnerabilities in the financial system and may create new ones. Take crypto-assets. This fast-growing market has seen more than its fair share of bankruptcies, liquidity crises and outright fraud, even as its links with traditional finance continue to grow. The FSB has issued recommendations to regulate the market for crypto-assets. The G20 has endorsed these recommendations and, again, they now need to be implemented globally. As you might notice, I'm talking a lot about implementation, because that's where my concern lies. It seems that, 16 years after Lehman, implementation fatigue has started to set in. Political commitment for maintaining financial stability is usually the highest when the collective memory of the last crisis is still fresh. When this memory starts to fade, there is the risk that financial stability is taken for granted. Something that can be left to the bureaucrats, to the technicians. Not least because there are so many other policy priorities to deal with for governments. But that would be a mistake. We do need the involvement of politicians, of lawmakers, because without them, it becomes even harder to implement necessary regulations. After all, financial stability is the foundation for almost all public policy. If financial stability is gone, as a government you can forget about the other policy priorities. You will spend most of your time drawing up rescue plans for an economy in free fall. So we should not wait for the next crisis. We also need commitment in good times, when the work to develop and implement policy needs to get done. This commitment is even more important in a world that is getting more fragmented, both politically and economically. I am concerned about our capacity to work together on cross-border challenges in such a world. During the Global Financial Crisis, policymakers around the globe were able to respond swiftly and 2/3 BIS - Central bankers' speeches effectively. In a fragmented world, such a swift response could become more complicated. This could prove costly because the most important challenges to financial stability are precisely the cross-border issues that we can only solve if we work together. And to the financial industry I would say: rules that strengthen the resilience of the financial system are in your best interest too. Some in the industry view regulation as a constraint, something that limits profitability and imposes undue costs. But it's just the other way around. Financial regulation is not an obstacle, it is an enabler of sustainable, long-term growth. Globally implemented regulation strengthens international financial stability, levels the playing field, and, in turn, enhances the confidence of your shareholders, clients, and counterparties. Strong regulation is not a constraint on the financial industry, it is an asset. 15 years after Pittsburgh, strengthening the financial system is an unfinished history. Partly that comes with the job. The financial system is always evolving, so our policy also needs to evolve. But, that's not the only reason. It is also important that authorities finish implementing the measures we've all agreed are needed to address existing vulnerabilities. Vulnerabilities that could lead to the next crisis, if they are allowed to persist. This calls for maintaining our ambition as policy makers, and for law makers to take the agreed policies all the way through to implementation. I wish for us to have the determination and collaborative spirit that the leaders in Pittsburgh collectively felt. Let's work together to finish what we started. Let's stay sharp, focused and committed to preserving financial stability. And where better to express that commitment than in the city that never sleeps. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 10 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Group of Thirty's 39th Annual International Banking Seminar, Washington DC, 26 October 2024. | null | netherlands bank | 2,024 | 10 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Netherlands Bank Ethics and Compliance Conference, Amsterdam, 7 November 2024. | Klaas Knot: Beyond the rules - promoting an ethical culture in central banks and supervisory authorities Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Netherlands Bank Ethics and Compliance Conference, Amsterdam, 7 November 2024. *** At the Eurovision Song Contest of 1980 – that was long before the time when artists were disqualified for alleged misconduct - the Dutch singer Maggie MacNeal came in fifth with the lyrics 'Amsterdam, Amsterdam, de stad waar alles kan'. In English, this means: 'Amsterdam, Amsterdam, the city where anything goes'. Now, especially for compliance officers this may sound like a particularly alarming statement. You may wonder: is this an appropriate venue for a conference on ethics and compliance? But I can reassure you, things have changed, and even in this city some degree of law and order has returned. So when I became governor of the Dutch central bank 13 years ago, I could not have imagined that one day I would be confronted with the issue of a stolen coat. It was a white coat, a woman's coat that was stolen at our coffee bar sometime last year. With bicycle keys and all. Not very material in terms of value lost, but a serious breach of trust among colleagues. So our compliance officers investigated. Unfortunately, the coat was never recovered. What this story is telling me, and why I am telling it to you, is that the people working in our institutions are just a cross-section of society. At the same time, we work for organisations that perform a very special public task. Keeping the financial system safe and sound. People trust us. If we breach that trust, it not only damages our organisation, it affects the entire financial system. What's more, as a supervisory authority we impose all kinds of standards on the financial sector, including ethical ones. If we do not live up to the standards we impose on others, we lose all authority. This means that we have to set the bar on ethics and compliance in our own organisations very high. At DNB we set up a professional department and integrity framework in 2008. The framework includes controlling the risk of fraud and corruption, insider trading, lobbying, and conflicts of interest. We also placed additional emphasis on inappropriate behaviour and its prevention. Similarly, at the ECB I have witnessed the development of one of the most stringent ethical standards in the world. The ECB was among the first to establish an Ethics Committee for our high-level officials, in 2014. Since then, the Ethics Committee has turned into a truly independent advisory body. While in its first years it was comprised exclusively of former members of the Governing Council, today the Committee only has one former Governing Council member. The two other members have no previous roles at all at the ECB or in the Eurosystem. This outside perspective lends additional credibility to the Committee's work and bolsters trust in the Committee as an independent body. 1/3 BIS - Central bankers' speeches Pretty much in the same vein, the ECB has a solid rules framework for its high-level officials. This rules framework – the Single Code of Conduct – not only establishes state-of-the-art conduct and integrity rules, but also comprises demanding governance standards and related transparency requirements, which ultimately ensure proper accountability. And developments are still ongoing. For example at EU level where an EU Ethics Body is currently being set up, with the primary mandate to further refine the ethics standards for high-level EU officials. The ECB's ethics framework served as an example for the new Body. So we have come a long way on building ethical organisations. As ethics and compliance officers, you perform an indispensable role in safeguarding an ethical culture. But of course, you cannot do it all by yourself. Maintaining an ethical culture is not only the job of the compliance officers, it is a task for the whole organisation. It is a task for the whole organisation because ethics and compliance is more than setting up a rule book and monitoring whether everybody is following the rules. Because the rules cannot cover every single situation. First of all, the world in which we operate is constantly changing. Our organisations are constantly changing. Which means that our perceptions of what is OK and what is not OK are also changing. Take for example activist behaviour and posts on social media. Everyone has the right to voice their political opinion. Thank goodness we live in a democracy. But do we want our colleagues, identifying themselves as central bank employees, voicing controversial opinions online that are far removed from our mandates and official standpoints? Clearly, this could harm our reputation. Similarly, demonstrating against government policies is a democratic right. But we had colleagues who were involved in Extinction Rebellion activities and who were actively encouraging breaking the law. How should you deal with that? Where do you draw the line? Although this a very delicate matter, we decided to draw up guidelines, but we are aware that these are issues that require constant evaluation and dialogue. Not only is the world around us changing, it is not black and white either. There are grey areas. Dilemmas. Ethical standards may clash with doing your job effectively. Let me give you an example from my own experience. As governor and as FSB Chair I regularly engage with people from the financial industry. It's a way for me to keep up with what's going on in the outside world. Inevitably, there is often a degree of lobbying involved in these conversations. So what to do? The only way of not exposing myself to lobbying would be to cut all contacts with industry leaders. But then I would miss out on an information flow that in my view is necessary to do my job effectively. So I take a well-considered middle road. I am transparent about who I meet, I am as nondiscriminatory as my agenda allows, and I try to avoid situations in which there's too much one-way traffic. In a world that is changing and where many shades of grey exist, adapting the rules is not the only solution. You need to have an ethical culture within your organisation. I believe that an ethical culture is one where people have a properly developed ethical compass. People who understand that, especially for our types of organisations, the ethical bar is set high. You need people who are able and willing to think for themselves, based on our organisational values. Moreover, in an ethical culture we 2/3 BIS - Central bankers' speeches need people to speak up when they see or hear a colleague doing something that is not OK. That can be difficult for many, because we often wish to avoid conflict or feel awkward taking the moral high ground. So that's why we as a board decided to offer training on what to do as a bystander who observes undesirable behaviour. The training was mandatory for managers. Part of you will be taking this active bystander training this afternoon. In general, periodic training for all staff is important, not just to rehash what's right and what's wrong, but to boost awareness, to encourage people to ask the question: how would I deal with this situation? It is also important to know the views within your organisation on ethical issues. At DNB we recently conducted a survey on the perception of integrity among our staff. This biennial measurement gives us a good insight into our ethical culture. And last but certainly not least, we can only build an ethical culture if we as a board lead by example. That not only means being compliant at all times, it also means stimulating discussion, and being transparent about your mistakes. For example, some months ago we published an article on how homeowners can finance climate-friendly home improvements, which triggered a lot of public criticism. While the article provided a useful contribution on the highly contested affordability issue, its rather explicit policy conclusion was an error of judgement, and I took full responsibility for that. It's important to set a good example like this and show your staff that it's OK to report mistakes without fear of having their heads chopped off. To sum up: if we are to live up to the high standards we set for ourselves, we need rules, but first and foremost we need an ethical culture. That requires effort from all of us, but your work as compliance officers is especially indispensable. You work hard every day to promote compliance in your organisations. It is not always easy being the voice of compliance in the room. So we need to support each other where we can, and conferences like these are an excellent opportunity to do so. And don't be afraid of Amsterdam. But nonetheless, watch your coat. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 11 |
Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the IIF International Accounting and Reporting Forum, Amsterdam, 12 November 2024. | 012345 1678 988ÿÿ445ÿ85ÿ4ÿ4ÿ QRSSTU ÿÿ!"!#"$ÿ"%$&ÿ!ÿ"''(!ÿ)*)+ u st klmnÿmpqrn j ,-./01ÿ340ÿ5678.15ÿ9:;06ÿ6.<=<>ÿ80ÿ?@<3ÿ9713.1@0ÿ7@6ÿ876=ÿ37ÿ60A@90ÿ340ÿB67;C;.D.3: 7Eÿ9:;06C33C9=<ÿ84.D0ÿ<.?@D3C107@<D:ÿ;77<3.15ÿ7@6ÿ60<.D.0190ÿC5C.1<3ÿ340.6ÿB73013.CD .?BC93FG>ÿ<C.AÿHDCEÿID0.JB01ÿC3ÿ340ÿKKLÿK13061C3.71CDÿ[email protected]ÿC1AÿN0B763.15ÿL76@?F O0ÿ3CD=0AÿC;7@3ÿ340ÿ6.<=<ÿ37ÿP1C19.CDÿ<3C;.D.3:ÿ9C@<0Aÿ;:ÿ340ÿ6.<0ÿ.1ÿ507B7D.3.9CD 301<.71<ÿC1Aÿ50709717?.9ÿE6C5?013C3.71F VWXYZ[\]^_ÿabÿcde]fX]gÿbhbi 0112ÿ456789119ÿ492ÿ649 ÿ1 ÿ518ÿ67ÿ964619ÿÿ472ÿ74ÿ916ÿ61ÿ47ÿ61ÿ64ÿ41 6 41 969ÿ79ÿ646ÿÿ4ÿ916ÿ49ÿ7786ÿ9ÿ6ÿ186496ÿ72ÿ 6ÿ4ÿ4ÿ51878ÿ778ÿ15 67ÿ47ÿ16677ÿÿ91ÿ791 ÿ41 6ÿ6ÿ61ÿ92786492ÿ646ÿ87 4619ÿ492ÿ41 969 487ÿ84ÿ61ÿ779ÿ67ÿ49 9ÿ92 68ÿ457ÿ492ÿ1 92 46ÿÿÿ21ÿÿ64 7ÿ1 ÿ681 ÿ67ÿ16ÿ186496ÿ8ÿ61ÿ9494ÿ646ÿ646ÿ7 88796ÿ77ÿ4ÿ4ÿ79684ÿ49 ÿ74 7ÿÿ69 ÿ6ÿÿ78ÿ877496ÿ61ÿ1 8ÿ72ÿ15ÿ18ÿ4 1ÿ67ÿ59ÿ41 6ÿ4949ÿ9494ÿ646ÿ8ÿÿ646ÿ6787!ÿ9778ÿ4ÿ2 ÿ1796ÿ"4 7 46ÿ77 ÿ518ÿ747ÿÿ49916ÿ4 ÿÿ64 72ÿÿ19ÿ77619ÿ9 6ÿ 6ÿ11 ÿ67ÿ1 617 15ÿ67ÿ#$ÿ8727964ÿ77619ÿÿ49ÿ186496ÿ54618ÿ518ÿ9494ÿ646ÿ%92ÿ916ÿ19ÿ6 87482ÿ61ÿ67ÿ97ÿ429684619!ÿ7191ÿ1ÿ 6ÿ784ÿ779ÿ187ÿ6ÿ51879ÿ1 9ÿ4ÿ182ÿ 787ÿ71164ÿ67919ÿ47ÿ879ÿ48 92772ÿ6ÿ87ÿ9ÿ71164ÿ67919ÿ4ÿ5772ÿ71&7191ÿ5847964619ÿ1 9687 487ÿ6789ÿ617678ÿ9ÿ7191ÿ492ÿ164ÿ1ÿ67ÿ487ÿ68796799ÿ946194 7 86ÿ492ÿ 89ÿ68467ÿ7191ÿ8ÿ492ÿ7ÿ487ÿ779ÿ187ÿ492ÿ187ÿ68427 8768619ÿ9ÿ87197ÿ8ÿ481 92ÿ67ÿ182ÿ487ÿ8769 9ÿ678ÿÿ 49ÿ492ÿ487 192789ÿ87&189ÿ9748&189ÿ18ÿ58792&189 %ÿ1 ÿ49ÿ77ÿ9ÿ6ÿ 486ÿ67ÿ27144619ÿ68792ÿ4ÿ779ÿ19&19ÿ778ÿ97ÿ67ÿ14 9494ÿ8ÿ%ÿ49ÿ179ÿ7191 ÿ6ÿ4ÿ487ÿ9494ÿ7618ÿ67ÿ7678492ÿ 486 48ÿ7967ÿ61ÿ71&7191ÿ5847964619ÿ 6ÿ61ÿ17ÿ76796ÿ6ÿ41ÿ12ÿ518 67ÿ'#ÿ4ÿ4ÿ 17ÿ" 7ÿ9 78ÿ1ÿ646ÿ779ÿ4ÿ4ÿ1ÿ67ÿ'#ÿ7191 ÿÿ187ÿ179ÿ649 012ÿ4567894ÿ 6ÿ6ÿ4ÿÿÿ264ÿ ÿ142ÿ124ÿÿ7124ÿ6ÿÿ8424ÿ10ÿ ÿ2184ÿ6ÿ8218424ÿ6ÿ6ÿ184ÿ4117 ÿ241ÿÿÿ691ÿ7124ÿ46 9!ÿ45814ÿ1 4ÿ4"4ÿ10ÿ41#4117 ÿ0267461 $1ÿ4181969ÿ41ÿ6ÿ41#4117 ÿ0267461ÿ6ÿ6"4ÿ%669ÿ69!ÿ6 14ÿ4"4ÿ6ÿ01991ÿ"424ÿ 649ÿ&12ÿ64ÿ4181969ÿ41ÿ624ÿ6164 ÿ6ÿ 42ÿ742ÿ10ÿ!4266'ÿ129 4ÿ(91ÿ%669ÿ1ÿ624ÿ6"44ÿ! 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Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the Green Finance Symposium at Tilburg University, Tilburg, 21 November 2024. | Olaf Sleijpen: When economists agree - the role of central banks in the green transition Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the Green Finance Symposium at Tilburg University, Tilburg, 21 November 2024. *** Thank you. And congratulations, Asli, on your honorary doctorate. Given your impressive track record of academic and policy contributions, I think this is very well deserved. And I feel honoured to speak here today at this symposium. If I had to pick one thing from your work, and there is many to pick from, it would be that strong, stable and inclusive institutions are a precondition for financial and economic development. Strong institutions are also a precondition for the green transition. And central banks are one such institution. Let me put this into context. Climate change and nature degradation pose risks to monetary and financial stability. We all know the examples. We may see asset and collateral depreciation because of flooding, or investments in polluting industries becoming stranded assets. We may see an increase in the price of agricultural commodities due to more frequent droughts. And we have all seen that the impact of the energy mix and energy policies on the general price level can be extremely strong. Whether the transition will be orderly or not, central banks and financial supervisors have a role to play. Because climate change and nature degradation will have an impact, one way or the other. If we do not succeed in putting a stop to it, it will increase the cost of adaptation and will pose serious risks to the economy. But policies that mitigate climate risk also come at a cost in the short term. A cost that may impact the economy, financial institutions and financial stability. Having said that, the long-term cost of dealing with the consequences of climate change, if we do nothing or too little, far outweighs the short-term cost of an orderly and timely transition. Central banks and financial supervisors, having a long-term view, will therefore always prefer a predictable and orderly transition path. Shaping that transition, and accelerating it, is a responsibility we all share. Each in our different roles. Governments for instance have the democratic mandate and the position to lay down a long-term vision and strategy, to set goals, and to design and implement policies. They also have the economically most effective and efficient tools at their disposal. Here I think of setting standards and imposing regulation, adequate pricing of externalities, and encouraging innovative, sustainable investment, for instance through subsidies. At the same time, governments have to manage social and economic transaction costs, as we all tend to be myopic. The lessons from behavioural economics also apply to the energy transition. Indeed, striking the balance between the medium- to longer-term gains of the energy transition and short-term transition costs may be the most complicated task for governments, whose mandates are in most cases no longer than four or five years. 1/3 BIS - Central bankers' speeches But also the private sector and households have a role to play. It is not appropriate to only rely on the government. The difficult message is that all economic actors bear a responsibility and their actions are not substitutes; that is, if we want an orderly transition to be successful. At De Nederlandsche Bank, we definitely also play a role. As a supervisor and regulator, as a central bank and as a leader by example. As a supervisor and regulator, we have a responsibility to make sure that financial institutions manage their climate- and nature-related risks. These risks have an impact on the soundness of financial institutions, which is something we watch over. And ignoring these risks is not compatible with sound risk management. In general, financial supervisors are intensifying their focus on climate- and environment-related risks. The ECB has put climate- and nature-related risk high on the agenda. Banks under its supervision must comply with the supervisory expectations for good risk management by the end of this year. At DNB, we are on the same track for the banks, insurers and pension funds under our supervision. While there has been progress, we are still not where we need to be. As supervisors, we are doing what we can to nudge the sector in the right direction. For example, by publishing good practices, like the Guides on managing climate and environmental risks from the ECB and DNB. But if these efforts prove insufficient, enforcement will come into view as a viable option. As a central bank, our objective is to maintain price stability and to safeguard financial stability. Climate change and nature degradation have an impact on both and, hence, fall squarely within our mandate. Also, as a central bank, we are an adviser to the government, as economic and financial policies impact monetary and financial stability. In that role we aim to contribute to stable long-term climate and environmental policies by providing economic analysis and research. Showing decision makers what the economic consequences are of the various policy options they may choose. A good example is the research we did together with the Netherlands Environmental Assessment Agency on the economic and financial impact of nature degradation. It revealed that more than 500 billion of investments by Dutch financial institutions is highly dependent on services provided by nature. Services that may come at risk due to biodiversity loss. In our role as adviser, we are part of a broader community to which Tilburg University also belongs, and of which you, Asli, are a prominent member. Without the work of this broader research and policy-advise community, climate policies would be a shot in the dark. As a public institution at the heart of the financial sector we want to lead by example and contribute to international sustainability goals ourselves. This is why we are committed to integrating sustainability considerations in all our core tasks by the end of next year. For example, we are in the process of making our investment policies more sustainable. In our internal operations, too, we are working to be as sustainable as possible in the choices we make, for instance in the renovation of our headquarters building. 2/3 BIS - Central bankers' speeches We also use our position on the crossroads of research, policy and finance to bring various parties together. On the national scale, we work together with the financial industry, academics, and ministries in the Platform for Sustainable Finance. Internationally, we are a member of the Network on Greening the Financial System, an organisation of over 140 central banks and regulators. The NGFS focuses on topics that are core to central banks and supervisors around the world, providing expertise, capacity building support and training. So that's how we see our role in the green transition. This role is legitimised by the fact that climate change and nature degradation directly affect the economy and financial stability. But this also indicates the limits of our involvement. As I said, we all have a responsibility in shaping the transition, each in our different roles. The central bank cannot take up the responsibility of other parties, because as a non-elected body we do not have the mandate or policy instruments to do so. We cannot tell financial firms where to invest their money. Similarly, the primary objective of monetary policy is to maintain price stability. It is in the end up to society to choose the transition path it deems most fit and appropriate. In case society is not willing to pay the short-term price of an orderly and timely transition, then, our task is to research the effects of alternative scenarios. But even then, we must continue to explain that a timely and orderly transition is the first-best policy. As George Bernard Shaw famously said: if all the economists were laid end to end, they'd never reach a conclusion. So if two economists can agree on the economic sense of a green transition, just imagine the impression a whole room full of them can make. It is not always easy to be the voice of economic reason in the room. But nobody is served with fact-free policies. So we should continue to research the effects of alternative policies, present the facts, speak truth to power. That's our role, that's how Asli does it, and that's what we should deliver. Thank you. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 11 |
Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the annual conference of the European Payment Institutions Federation (EPIF), Brussels, 20 November 2024. | Olaf Sleijpen: From ding dong to bleep bleep - promoting innovative retail payments markets in a fragmented world Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial Stability of the Netherlands Bank, at the annual conference of the European Payment Institutions Federation (EPIF), Brussels, 20 November 2024. *** Thank you. Some 35 years ago, when I was a student traveling through Europe on my summer holidays, I took traveler cheques with me. Everybody in the room knows what a cheque is? Although you had to purchase them for a fee, they were safer than taking lots of foreign currency with you hidden in your money belt. But the drawback was you could not pay with those cheques in shops or restaurants. You had to go to a local bank branch to exchange them for cash. So one of the first things you did when you arrived in a new country was to queue up in a crowded local bank. At the sound of a 'ding dong', it was finally your turn, and you could only hope that the grumpy bank employee would be willing to hand over some precious local currency in exchange for your cheque. For a considerable fee of course. And provided it wasn't weekend. Or some local holiday. Or lunch-time. Today, when I want to get something to drink in a café in a little town somewhere in Spain or Estonia, I just take my mobile phone or card, hold it near some wireless little box, wait for the 'bleep bleep', and I have paid. It's magic! I can hardly think of a single activity that we do so often, and that has become so much easier, safer and quicker, than paying. It has become so easy, it's almost fun to pay! What has made this payment revolution possible is a combination of new technologies, regulation that opened up payments markets, and increased competition. Fifteen years ago, the Payment Services Directives kicked in. It allowed non-banks to access the European market by obtaining a license in one Member State and "passport" their payment services to other EU member states. Later on, PSD2 granted non-banks access to payment accounts, with the consent of the payment account holder. As a result of these developments, a whole new group of innovative non-bank payment service providers entered the European market with smart, convenient and high-quality services. Many of these companies are represented here today. Millions of European citizens use your payment services daily. You are quick to adopt new technologies and offer modern payment solutions like mobile wallets, online peer-to-peer payments, smart and relatively cheap currency conversion and instant transfers. Also as a result of your competitive strength, banks too improved the quality and efficiency of their online payment services to customers. Of course, markets can only be truly fair and competitive if there is a level playing field. That's why we at the Dutch central bank strive towards applying the well-known principle of "same activity, same risk, same rule" across the payment sector. As the 1/3 BIS - Central bankers' speeches most recent step in creating a level playing field in the EU's payment market, the Eurosystem will allow regulated non-banks to access central bank operated payment systems such as T2 and TIPS. In short, at the Dutch central bank we appreciate the important role of EPIF members in the payments market. And we appreciate the active role EPIF plays in European payment forums like the Euro Retail Payment Board. But things can also get too flashy and innovative, so it was a wise decision by EPIF to invite someone from a central bank to balance things out. And being the dinosaur in the room, maybe I'm the right guy to address the elephant in the room. Because there is an elephant here, and it's called strategic autonomy. Over the past years, the world has changed dramatically. Rivalry between the big economic blocs has increased. And there is a major war raging on the European continent that has heightened international political tensions. Geopolitical tensions that translate into economic fragmentation and protectionism. Of all the major economies, Europe is the most exposed to these shifts. Remember our dependence on Russian gas at the outbreak of the war in Ukraine. Likewise, we import over 80% of our digital technology. Personally I find navigation an impressive example. All the navigation equipment in Europe uses GPS infrastructure which is run by the US army. Without GPS, Google Maps or the navigation in your car is completely useless. There are many more examples where Europe is heavily dependent on the policies of other countries for the provision of strategic goods and services. In the current political climate, it is understandable that European governments see this dependence as a strategic vulnerability that needs addressing. That's why strategic autonomy is a priority for the European Commission. It also featured prominently in the speech by Mario Draghi when he presented his report on the future of European competitiveness. Europe is serious about this. Strategic vulnerability is also an issue in the European retail payments market. Like gas, electricity, and for that matter navigation, the payments infrastructure is a critical infrastructure that is considered a backbone of the economy. At the same time we see that the payments infrastructure is heavily dependent on products and services of globally active payment services providers that are not governed within the EU. Your membership list confirms this. Although these companies are regulated by EU frameworks, the policies of foreign governments can still result in control over what, how, and to whom European citizens and businesses can pay. A well-known example is Wikileaks. Presumably after a phone call from the White House, Mastercard and Visa announced that they would stop all payments to Wikileaks. Whatever your opinion of Wikileaks is, the issue here is that in Europe we want to decide for ourselves whether payments to merchants and organisations should be allowed or not. And we do not want our payment system to be dependent on the policies of foreign governments. So we have a challenge here. We value how much you contribute to a competitive and innovative market in Europe. But at the same time we have to find ways to decrease the strategic exposure to policies of non-EU governments. 2/3 BIS - Central bankers' speeches Strategic autonomy is not the same as protectionism. We are committed to maintaining the open markets that have brought us so many benefits. Strategic autonomy in retail payments means there also needs to be a European option, where Europe can independently manage its payments ecosystem. This involves creating a secure payment infrastructure, using home-grown pan-EU payments solutions, and developing regulations to ensure system safety and efficiency. This approach is reflected in the Eurosystem's policies. First of all, we are developing a digital euro. I am happy to see you will be discussing this in more detail later this morning. We envisage that the distribution and acquisition of this European payment instrument will be open to private payment service providers. Second, we aim to reduce major dependencies on non-EU parties by supporting pan-European initiatives such as the European Payments Initiative. And third, the EU's geopolitical trading power will be enhanced by linking TIPS with various regional payment systems, such as those of the Nordics. Let me now briefly touch upon another issue that is of relevance to you, and that has become more prominent as a result of the geopolitical tensions, and that is cyber risk. Cyber threats are increasing, including to the European economy and European payments. Some countries are carrying out sophisticated cyber-attacks. Today, a quarter of cyber-attacks worldwide affect the financial sector. These can be direct attacks on financial institutions - including payment service providers - or indirect threats via external parties that financial institutions depend on. For example, an attack on a third party - such as a telecom provider or a cloud provider - could disrupt the services of one or more payment service providers, affecting the payment system. In addition, a large-scale disruption of payment services can damage confidence in the payments system as a whole. To make sure we are ready for a crisis, payments service providers should create and maintain comprehensive business continuity plans that outline procedures for maintaining operations during and after a crisis. Regular testing and drills are essential to ensure all employees are familiar with the contingency measures and can execute them effectively. Ongoing training and awareness programmes help employees understand the importance of security and stay updated on the latest threats and best practices. And investing in resilient technology and infrastructure is crucial for withstanding attacks and disruptions. Please prepare your organisations for such scenarios, be aware of your important role in the European payments system and, where possible, actively participate in European crisis management structures. Ending with the strategic autonomy issue, I think finding solutions for it is a two-way street. European policy makers should continue to cherish innovation and competition, the forces that so impressively lifted our payments market out of the stone age. That means recognising the indispensable role played by non-bank payment service providers like you, either EU or non-EU. At the same time, the non-EU parties among you should start discussing with your headquarters and governments on how to avoid extra-territorial effects of government policies. Because we don't want to go back in time. We don't want the 'ding dong' of the local bank queuing system. We want the 'bleep bleep' of easy, cheap, and always available payments. That's the future of an ever more innovative European payments market. We should not want it otherwise. 3/3 BIS - Central bankers' speeches | netherlands bank | 2,024 | 11 |
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Text of the first Klaas Knot Lecture, by Mr Klaas Knot, President of De Nederlandsche Bank, initiated by the University of Groningen, Groningen, 31 January 2025. | null | netherlands bank | 2,025 | 2 |
Speech by Mr Steven Maijoor, Executive Director of Supervision of De Nederlandsche Bank, at the Annual FinTech and Regulation Conference, Brussels, 4 February 2025. | Steven Maijoor: Cyber resilience in an age of geopolitical tensions Speech by Mr Steven Maijoor, Executive Director of Supervision of De Nederlandsche Bank, at the Annual FinTech and Regulation Conference, Brussels, 4 February 2025. *** On December 12th 2023, Kyivstar, Ukraine's largest telecom provider, suffered a cyberattack that disrupted services for millions of users. The attack, attributed to the Russian state-sponsored group Sandworm, was one of the biggest cyber incidents in Ukraine since the onset of the Russian invasion. The hackers had infiltrated Kyivstar's infrastructure months earlier. They deployed malware that erased thousands of virtual servers and personal computers, crippling the company's network for managing communication services. The attack had several immediate effects. First of all, approximately half of Kyivstar's network was disabled, leaving millions without mobile and internet connection. But the damage wasn't limited to the telecom sector. The attack also disrupted banking operations, payment processing, and online banking services. Some ATMs and point-ofsale terminals didn't work. Financial transactions were in disarray across the country. Amazingly, the Ukrainians were quickly able to restore services. Over the past three years they have become quite proficient in dealing with large-scale disruption. Many critical processes in Ukraine are equipped with redundancy measures. Many people even have two sim cards in their phones. That enabled the other Ukrainian telecom providers to circumvent the outage. Services at Kyivstar were gradually reinstated, with almost full restoration achieved eight days after the attack. This episode raises some inconvenient questions. What if this would happen to us? What if a large scale Russian or Chinese cyberattack is launched on the telecoms sector of an EU member state? Would it be possible? How much damage could such an attack cause? Would it affect financial services? And would we be able to recover as quickly as the Ukrainians did? A few years ago, most people would have found these questions to be rather hypothetical, but today, unfortunately, they have become quite urgent. Geopolitical tensions have been rising for more than a decade, but over the past few years they have accelerated. Countries are re-arming, they are protecting their strategic economic infrastructures, they are imposing trade restrictions and sanctions on each other, and they are weaponising access to international financial infrastructures and services. Needless to say this is bad news for the world economy and the financial sector. But perhaps in no area is the geopolitical threat so real and acute as in the digital domain. Apart from the Kyivstar case, there are many other examples to back this up. In late 2023, a Russian hacker breached Microsoft's corporate network by exploiting a legacy account. As a result, the security and confidentiality of the email accounts of many organisations around the world were potentially compromised. Last year, the FBI discovered a dormant network of Chinese hackers in the United States that had compromised hundreds of routers and that was on standby to launch an attack if called on. And recently, Russian and Chinese vessels were suspected of damaging subsea 1/4 BIS - Central bankers' speeches data cables. Since state-sponsored cyberattacks are often very well concealed, we do not have reliable numbers on how often they occur. But anecdotal information from intelligence agencies, like the Dutch General Intelligence and Security Service, suggest their number is increasing. Traditionally, the financial sector has been an attractive target for cyber criminals with financial motives. But with the changing geopolitical climate, nation-state cyberattacks have become a very real possibility. Their main aim is to cause disruption and to steal sensitive information. Nation-state actors possess more resources, sophistication, and endurance than other hackers. And many sectors of the economy have become more vulnerable to large-scale disruption due to increased complexity and digitalisation. This is certainly true of financial services, with their long outsourcing chains and interconnectedness. And many financial firms depend on the same third-party service providers, so if one of these suppliers is attacked, large chunks of the financial sector may experience the knock-on effects. As we showed in our latest Financial Stability overview, a quarter of all reported global cyberattacks can potentially affect the financial sector through a vital process run by a third party on which the financial system depends. So, to answer the questions I posed at the start: yes, I think a major state-sponsored cyberattack on the financial sector or one of its supporting sectors could happen. And frankly, I hope we would be able to recover as quickly as the Ukrainians did. That is not because financial institutions haven't prepared. Many financial institutions have taken big steps in recent years to boost their cyber resilience. I think it is fair to say the financial industry is one of the better digitally defended sectors in the economy. As it should be. But given the size and urgency of the threat, we need to do even more to keep financial services safe. This is why cyber resilience will absolutely be a key focus area in our supervision of the financial industry in the coming years. This goes both for De Nederlandsche Bank, and for the European Central Bank. Our aim is to make financial services safer against cyber threats. Not only by increasing the resilience of the financial sector itself, but also by stepping up the robustness of the entire chain of ICT service providers. DORA, the European Digital Operational Resilience Act, that came into effect at the beginning of this year, gives us additional tools to accomplish this aim. To start with, under DORA, threat-led penetration tests are mandatory for the largest financial institutions in Europe. In the Netherlands we have been conducting these kinds of tests voluntarily for over eight years with good results, and we are very pleased that it is now becoming the norm at the European level. But DORA also imposes stricter requirements for managing cyber risks in outsourcing chains. For example, financial firms face stricter rules for conducting due diligence on potential ICT providers. As a result, Fintechs may also experience more stringent due diligence from financial sector customers. And very importantly, under DORA, European supervisors can conduct inspections of critical third-party ICT service providers in tandem with national supervisory authorities. We expect bigtechs like Google and Microsoft to be placed under EU-wide supervision. And, just as with the banks, we are going to test their readiness to detect and withstand cyberattacks. 2/4 BIS - Central bankers' speeches Despite all efforts, there is no such thing as perfect cyber security. It is therefore vital that financial institutions take measures to recover quickly after cyber incidents. This is crucial to ensure that services can continue and people don't lose trust in financial firms or the financial sector as a whole. The results of the ECB's 2024 cyber stress test show that there is room for improvement on the recovery front. So it's a very good thing that DORA also imposes new requirements on institutions' continuity plans and backup policies. They need to develop a culture where cyber incidents are quickly detected and reported, they need to have their playbooks in place and they need to have clearly defined management roles and responsibilities. These are key ingredients for an effective response after a cyberattack. An important principle of our supervision has always been that financial institutions are responsible for putting their own house in order. And that is also the case with cybersecurity. But if we only focus on individual institutions, we miss something. As I mentioned, on a digital level the financial sector is so interconnected, and connected to other vital sectors of the economy as well, that some degree of overall coordination and cooperation is necessary to arrive at an optimal level of resilience. Notably, recent assessments, derived from nationwide contingency exercises in the Netherlands, reveal various weaknesses. These weaknesses relate to the exchange of information between critical infrastructure providers, the distribution of roles and responsibilities, and the mobilisation of scarce cyber security knowledge and expertise in the event of major cyber incidents. So the message here is: we need to work together. Governments should take the lead to improve cross-sectoral cooperation and coordination. They must continue to conduct large-scale cyber-drills and practice activating crisis plans. The insights gained should be used to enhance resilience. But there is also a role for financial supervisors like DNB. Under the new legislation, we do not only need to check whether financial firms are compliant, but we also have an obligation ourselves to look over the fence and cooperate closely with other sectors. DNB is putting this into practice by working with vital sectors that are most critical to the financial sector, such as energy and telecommunications. Within our mandate, we support these sectors with information, cooperation and ethical hacking experience. To sum up, the threat of major disruptions to our financial system from nation-state cyberattacks has become more urgent. Financial firms, and the entire outsourcing chain on which they depend, therefore need to do whatever they can to further boost their cyber resilience. Both in terms of detection and recovery. Cyber resilience is a top priority for European financial supervisors and there are new European laws in place. And we are going to use these laws to make sure that financial institutions under our supervision are as secure and well defended as possible. Enhancing resilience also means we need to work together. Governments, financial firms, supervisors, telecom, energy and other vital players in the outsourcing chain. Because in cyberspace, we are all linked together. And after all, a chain is only as strong as its weakest link. Thank you. 3/4 BIS - Central bankers' speeches 4/4 BIS - Central bankers' speeches | netherlands bank | 2,025 | 2 |
Opening speech by Mr Adriano Maleiane, Governor of the Bank of Mozambique (Banco de Moçambique), at the SWIFT African Regional Meeting, Maputo, 22 May 2006. | Adriano Maleiane: Financial services efficiency in Mozambique Opening speech by Mr Adriano Maleiane, Governor of the Bank of Mozambique (Banco de Moçambique), at the SWIFT African Regional Meeting, Maputo, 22 May 2006. * * * Dear Mr. Arthur Cousins, SWIFT Board member, Dear Mr. David Pryce, Regional Director for Africa Dear guests Ladies and Gentlemen I accepted with satisfaction the invitation to chair the opening ceremony of the SWIFT African Regional Conference to be held under the slogan “Transforming the future: optimizing the local, regional and global markets”. I would like to welcome all delegates present in this conference room, especially the African countries’ representatives. As hosts of the SWIFT African Regional Conference, we are greatly honoured to welcome you in Maputo and wish you a pleasant stay. The great interest and participation in this Conference proves the commitment of our governments and financial institutions to information technology current matters that we currently use in order to better prepare our countries to face up the challenges of the globalization and regional and continental integration. Nowadays, information technologies are a paramount platform for the activity of various economy sectors, including the financial sector as well as the payment systems. The SWIFT is an integral part of the technological infrastructure that our institutions use for settlement and clearing of bills, in the perspective of better serving the clients, prevent risks associated with our activity and, in general, to contribute for business environment improvement, an important factor to attract investments that we need to accomplish our economic and social development plans. In the globalized world we live, the information technology platforms are ever more harmonised, the reason why it is urgent to improve them in order to reduce the transaction costs and allow an adequate risk management, both in the domestic plan, as well as within the regional and international scope. Ladies and Gentlemen, Our economies continue to be too small in the context of production and world trade. Our countries are, in general, very sensible to exogenous shocks, either those resulting from adverse natural factors as well as those induced by situational changes and yet those resulting from changes in the international trade rules. Our positioning in the world economy continues to be, in overall terms, that of commodity producers, whose access to international markets still faces various barriers and unequal treatment. This characteristic makes our countries highly dependent on the international community financial support, mainly in the form of grants. Mozambique started with deep reforms in 1987, whose results within the financial sector are already visible, as can be evaluated through the number of operators as well as the financial products available in the market. In effect, owing to substantial changes that we have been undertaking, today we have a number of diversified credit institutions and financial corporations which offer competitive products and services within the domestic and international markets. In the domain of the information technology, we have evolved to a financial system in which greater part of the transactions that take place are made in real time, whereas by the beginning of 90’s, such transactions were made resorting to a telex and other primitive data transmission mechanisms. The nostro accounts management improved after our adherence to SWIFT by 1995. At that time, only 3 (three) banks were operating within the SWIFT system, but about 10 (ten) years later, we can gladly confirm that all Credit Institutions operating in the country perform their foreign exchange transactions through that system, resulting in an improved management of the country’s foreign exchange operations. The entry of new operators in our banking system, with strong establishments abroad, brought an added value to the national financial system, to the extent that Maputo and other capital province trading markets have thereafter been connected to the main international financial markets. The financial system evolvement put forward to the Banco de Moçambique, as Central Bank entity, the challenge to introduce foreign exchange and monetary policy management instruments more adequate to the dynamics and transformations of the markets. We continue to modernize our payment systems, especially on clearing and settlement of bills, besides having strengthened the banking supervision to comply with the dimension of our financial market. Ladies and Gentlemen, The improvement of financial services’ efficiency is an important encouraging factor for the attraction of more foreign investments and other financial inflows to our countries. Today, a strong and sound infrastructure is an important factor in the creation of new opportunities for our countries to find alternative sources of financing. In this context, the SWIFT system is considered to be an important element of such infrastructure, which should therefore be prepared to participate in the definition of markets development strategies that are being undertaken in many countries and within several African sub-regions. Other challenges that today are put forward to SWIFT system and other banking management computer solutions, is the assurance of adequate integration among front, middle and back office operation systems to allow an efficient management as well as access of information on nostro accounts, in real time. Within the SADC (Southern African Development Community) region, some countries have already implemented or are set in an advanced stage of implementation of the RTGS (Real Time Gross Settlement) payment systems. SWIFT should be assumed as an important partner for the improvement of the payments’ systems efficiency and mainly for risk mitigation. Recognising the importance of having good infrastructures in Africa, it is our responsibility, as Africans, to develop common and/or harmonised projects in this field. Within the Southern African Development Community region, pre-conditions harmonisation process of some financial infrastructures have already been created. for the In effect, various projects on procedures harmonization with the Central Banks are at the implementation stage, of which it is worth referring to the payment, settlement and clearing systems, communication and information technologies and banking supervision projects. Let me finish by expressing my conviction that this conference will produce the expected results and the strengthening of cooperation among our institutions in the domain of interbanking telecommunications, in order to develop a modern and liable financial platform and compatible with those used in the main international markets. The matters to be addressed and the expertise of the lecturers ensure that the discussions will be frank and everyone will come out of the meeting with enriched knowledge. Once again, I wish you good stay in Maputo and in this way, I officially declare the SWIFT African Regional Conference open. Thank you very much. | bank of mozambique | 2,006 | 9 |
Speech by Mr Adriano Maleiane, Governor of the Bank of Mozambique (Banco de Moçambique), during the announcement of notes and coins of the Metical of the New Family, Maputo, 16 June 2006. | Adriano Maleiane: Notes and coins in Mozambique Speech by Mr Adriano Maleiane, Governor of the Bank of Mozambique (Banco de Moçambique), during the announcement of notes and coins of the Metical of the New Family, Maputo, 16 June 2006. * * * Dear Guests, Ladies and Gentlemen, I would like to thank you, on behalf of the Board of Directors of the Banco de Moçambique and personally, for your presence in this ceremony for the announcement of the notes and coins of the Metical of the New Family, the day in which our currency completes 26 years of existence. This event results from the process that began with the approval by the Parliament, of the Law Nº 7/2005, of December 20th, which creates and sets the value of the Metical conversion rate and empowers the Governor of the Banco de Moçambique to define the register designation of the Metical of the New Family. The Metical of the New Family will facilitate our financial and commercial transactions and it will offer greater security and commodity as a result of the reduction of digits and the incorporation of more modern security features in the notes and coins. The success of the process of introduction of the Metical of the New Family will continue to depend on an ample and participative advertising campaign, which reaches the country as a whole. In this context, we count on information dissemination channels, such as the radio, television, newspapers and the internet website. With regard to radio, our message is already being broadcast through the Radio Moçambique and the community radios, in a total of 25 (twenty-five) national languages. It is also worth referring to the distribution throughout the country of posters, brochures and leaflets. The Banco de Moçambique technical staff visited all districts of the country for public clarification of all aspects pertaining to this process, having had the collaboration of Government institutions, religious congregations, municipal authorities, community leaders and socio-professional organizations. We have also been undertaking clarification lectures addressed to Mozambican community abroad, with particular focus to countries which host the majority of our compatriots. Today, we feel that the message about the Metical of the New Family has reached greater majority of the Mozambican population, including that of the rural zones which, at the beginning of the process, represented our major priority. Ladies and Gentlemen, The notes and coins of the Metical of the New Family enter into circulation as from July 1st, 2006. Today, we are announcing the publication of the features and the facial value of the notes and coins of the Metical of the New Family. The purpose of this ceremony is to announce the beginning of the process aiming at familiarizing the public with the new notes and coins, particularly in relation to minimum security features in order to facilitate the transactions as from July 1st, 2006. As we have been informing, the entry into circulation of the notes and coins of the Metical of the New Family will not imply immediate withdrawal of notes and coins currently in circulation. The simultaneous circulation of notes and coins currently in circulation and the notes and coins of the Metical of the New Family starts on July 1st, 2006, and will last for six months. During the period of simultaneous circulation, there will be a process of gradual introduction of the Metical of the New Family. Therefore, there will not be any exchange posts. The notes and coins of the Metical of the New Family will be obtained normally in the course of commercial and banking transactions. July 1st, 2006 only marks the beginning of the circulation of the Metical of the New Family and the beginning of conversion operations. Therefore, our behaviour should be equal to that we have shown when an introduction of new facial values of our currency takes place. Payments using either notes and coins of the Metical currently in circulation as well as those of the Metical of the New Family can be made until December 31st, 2006, and the change received either in one Family of the Metical or in the other. As from January 1st, 2007, the notes and coins of the Metical currently in circulation, which could still be held by the public, may be changed to notes and coins of the Metical of the New Family at the banking institutions until December 31st, 2007, and at the Banco de Moçambique until December 31st, 2012. The effective conversion will occur on July 1st, 2006. This means that all banking accounts and the prices of goods and services expressed in Meticais will be converted to the Metical of the New Family. For this purpose, I would like to stress the following aspects established under Decree nº 55/2005, of December 27th: • In order to adjust the accounting procedures to the conversion process, within the 2006 financial year, we will have two accounting reports: the first (reported to June 30th, 2006) should be in the Metical currently in circulation and the second (reported to December 31st, 2006) should be in the Metical of the New Family; • The conversion of the Metical in circulation to that of the New Family does not affect the existence, validity and effectiveness of contracts and other legal acts signed before July 1st, 2006. • The double indication of prices will continue to be mandatory until December 31st, 2006. The price of goods and services in the markets, shops and company service providers, the bank account balances, the foreign exchange rate tables, for example, should continue to be stated simultaneously in the Metical of the New Family as well as in the Metical currently in circulation. Dear guests, Ladies and Gentlemen, The characteristics of notes and coins of the Metical of the New Family, namely the colours, dimensions, motives and other features, are such that they cannot be mistaken with those of the Metical currently in circulation. In the definition of the characteristics of notes and coins of the Metical of the New Family we integrated features about education, economy, history, culture and wildlife of our Country. The notes and coins of the Metical of the New Family benefited of the technological advances in respect of note printing and currency minting. Therefore, they integrate elements that facilitate the identification of various denominations through a touch, which constitutes an innovation, and they are of good quality, endowed with modern security features. Despite that, it is our responsibility to dignify and ensure the good conservation of the national currency, the Metical. For this purpose, allow me to quote the preamble of the Law Nº 2/80, of June 16th, the Law of the Metical, which states “The fight for currency stability is an integral part of the fight for economic development. The currency stability requires ever increased growth of production and productivity, as well as efforts aiming at preventing all acts and attempts to use our currency incorrectly.” (End of quotation). To end, I would like to call your attention for the presentation, by the Banco de Moçambique technical staff, of the notes and coins of the Metical of the New Family. Thank you very much. | bank of mozambique | 2,006 | 9 |
Speech by Mr Ernesto Gouveia Gove, Governor of the Bank of Mozambique, on the occasion of the XXXI Consultative Council, Nampula, 26 January 2007. | Ernesto Gouveia Gove: The challenges in extending financial services throughout Mozambique Speech by Mr Ernesto Gouveia Gove, Governor of the Bank of Mozambique, on the occasion of the XXXI Consultative Council, Nampula, 26 January 2007. * * * Honourable Governor of Nampula Province Excellency Honourable President of Nampula City Council Excellency Distinct Former Governors of the Banco de Moçambique, Dr. SérgioVieira, Dr. Prakash Ratilal, Dr. Eneas Comiche and Dr. Adriano Maleiane Dear President of the National Institute of Statistics Dear Representatives of Niassa Provincial Government Dear members of the Board of Directors of the BM Dear representatives of the Financial Institutions Dear Guests Ladies and Gentlemen First of all, I would like to express, on behalf of the Board of Directors and the employees of the Banco de Moçambique and personally, our satisfaction and gratitude for having accepted the invitation for a joint reflection on a current topic of our economy. Your presence in this conference room is of indubitable meaning, since it shows the sympathy and commitment towards the common problems we face in our country and particularly in the financial system, whose solution overcomes the simple will of each of us. Allow me to refer in a special way to the presence of the Former Governors of the Banco de Moçambique, personalities whose leadership and competence marked, at its time, the nearly three decades of the history of our institution. I would also like to take this opportunity also to express the profound regard of the Banco de Moçambique to all the banking institutions that operate in our market, the private and public financial institutions, the public in general and to all the international community, for all the support they have provided to elevate the financial system, contributing to the development of the economy and reduction of absolute poverty in the country. This is the second day of our XXXI Consultative Council. In yesterday’s session, besides the analysis of the implementation of the Recommendations of the XXX Consultative Council, we analysed the execution of our Strategic Plan, the report on human resources, titled “Balanço Social do Banco” and yet we discussed other important domestic matters, and stressed the relevant role of the colleagues who retired last year. Ladies and Gentlemen The recent history regarding the evolution of our financial system shows notable development and growth in terms of the number of institutions, diversification and modernization of products, thanks to the market opening to private financial institutions in the sequence of financial and economic reforms began in the 80’s, and which witnessed great move as from 1990. In effect, of a total of three banks and one insurance company that the country had in 1987, currently the number has moved to a total of (12) twelve banks, 11 (eleven) credit cooperatives, 56 (fifty-six) micro-finance institutions, besides 4 (four) insurance and leasing companies and others, as well as a notable implementation of electronic systems of international standards. However, this development is characterized by a tendency towards the concentration of institutions and financial services in the main cities of the country, situation that became worse with the closing of some branches in the rural areas, creating within the authorities and in the society in general, a great concern, given that it is in these areas where the majority of our population is concentrated. In fact, the numbers show that the 228 (two hundred and twenty-eight) bank branches existing in the country only cover 28 (twenty-eight) districts, which means that the remainder 100 (one hundred) districts, which comprise about 79% of the national territory, do not possess any banking representation, in other words, a vast group of people are deprived of financial services. The disproportions are still more evident if we consider that the three main cities of the country, Maputo, Beira and Nampula, have altogether 132 (one hundred and thirty-two) branches, that is, 58% of the total branches, of which Maputo city, alone, absorbs about 45%. In Maputo City, for example, each branch serves 11,592 inhabitants, while in Milange and Angoche, the coverage is of 411,267 and 258,594 inhabitants, respectively. Analysing the prevailing situation in another perspective, it is concluded that in Maputo city there is a branch in each 2.85 square kilometres against 15,871 square kilometres in Montepuez and 14,150 square kilometres in Mueda, which shows the long way still to be pursued. With regard to other kinds of services and financial products, namely ATM’s (Automated Teller Machines) and POS (Point of Sale) devices, it is concluded that there are differences provided that they are also concentrated in Maputo (Province and City), as they represent 69% of the total national coverage. In order to invert the situation, the authorities have devised a number of legal and regulating measures aimed at promoting micro finance, on one side and, on the other side, the establishment of banks through to the areas of the country with minor financial services. Similarly, it is worth referring that the Government, in the context of its Five-Year Term Program, has been undertaking efforts in order to create conditions in terms of infrastructures, namely, roads, bridges, telecommunications and electric power network. We are conscious that, even though, there are constraints that should be cleared, but this is the real country we have and under which we should work, being necessary to continue seeking innovative ideas in order to face the current and future challenges. The view that the authorities have about the expansion of financial intermediation is that it cannot only be confined to the physical presence of bank branches in rural areas. It should be done in a broad and integrated way, making use of the advantages offered by the information technology systems. We need to find an adequate combination between the traditional and electronic banking, maximizing the use of products such as ATM’s, POS, Internet banking and mobile banking. In this engineering, the mailing services can and should be asked to play an important role as bank correspondents, making savings on their behalf and responsibility and rendering other kind of financial services. The principal idea is that the financial sector must also associate itself clearly to the efforts of the Government and other economic agents, as well as the society in general, towards the accomplishment of the major objective of creating wealth in order to eradicate poverty in the country. Ladies and Gentlemen The objective of expanding banking institutions and financial services through to the rural areas is in line with the Government strategy, which defines district as the pole of planning and development of our economy. We are certain that these two factors will interact contributing towards the same purpose, taking into account that, for the growth of districts, it will be necessary to continue to endow them with financial and human resources as well as infrastructures, similarly important for the financial sector to flourish. At the micro-finance level, we should stress the valuable contribution given by the authorities through the Micro-finance Support Program, which aims specifically at expanding micro-finance activities through to the rural areas. There are experiences of countries with characteristics like ours, which confirm to be possible for the financial system to serve as the encouraging factor for development of economic and financially poor regions. Countries like Ghana, Kenya and Nigeria, for instance, can serve, at the level of our continent, as the source of inspiration in the process of promotion and development of micro-finance institutions. Although the cases of relative failure observed since the 70s until the present days are not at all to be neglected, in the micro-finance domain, however, we have to note that Asia is a continent replete with successful experiences. With respect to cases of success, three institutions deserve relevance for their contribution in the fight against poverty in their respective countries: The Bank for Agriculture and Agricultural Cooperatives, (BAAC), of Thailand founded in 1966, the “BRI Unit Desa” System of the Bank Rakyat of Indonesia (BRI-UD), founded in 1984 and the Grameen Bank (GB) of Bangladesh created in 1983, which today hold a portfolio of savers to the tune of 4.4, 14.5 and 2.1 million, respectively. The history of Grameen Bank is very simple, but very rich in terms of learning aspects. Its founder, Mr Mohammad Yunus, began his activity as money lender, granting loans to 42 poor people who needed an individual amount equivalent to USD 27. That was in this way that everything started for the case, which today is the world reference in the field. The success obtained in terms of the fight against poverty and the increased potential of business in the areas where he operated, encouraged him to create a rural bank. Besides the information I referred to, recent data pointed out that today the bank employs 18,796 workers, and holds a portfolio of 6.61 million loan beneficiary clients, of which 97% are women and, a network of 2,226 branches. Mohammad Yunus and the Grammen Bank were awarded the 2006 Peace Nobel Prize, thanks to their devotion to the cause of the more needed population of their country. It is not possible to ensure social and political stability with high poverty indices the reason why the fight against it is a priority that cannot be postponed. Besides, recognising this fact, the Norwegian Committee of Nobel Prize supported its decision to award the prize in the following terms: “The long lasting Peace cannot be achieved without opening a way so that a large number of people is poverty free” end of quotation. It was considering all the potential financial intermediation for economic growth that, in the present year, we chose for debate in our XXXI Consultative Council the topic: Bancarização da Economia – Extensão dos Serviços Financeiros para as zonas Rurais, (Banking the Economy – Expanding Financial Services to the Rural Areas), believing it to be a current matter of national interest and importance for our reality where the district was assumed as the pole of development. Ladies and Gentlemen The hosting of our Consultative Council here in Nampula is a sign especially addressed to financial institutions and operators, to show that we should expand our activities beyond the Capital city. And for that reason we are grateful for the presence in this session of the Governor of Nampula Province and other representatives of the north region provinces. We are conscious that the attainment of the will for greater expansion of financial services throughout the national territory requires the intervention, with appropriate measures, by several interested parts: the Government, the private sector, and ourselves – Banco de Moçambique! Our strategy of reinforcing the level of expansion of banking institutions throughout the country, facilitating and encouraging the enlargement of financial services, had an important landmark with the process already underway, which consists of opening five branches of the Banco de Moçambique in similar number of Provinces. Until now branches have been inaugurated in Quelimane and Maxixe cities, with plans to open Pemba branch next week. This process will come to the end with the inauguration of branches in Lichinga and Tete by the end of the first semester of 2007. The Banco de Moçambique territorial expansion is within the performance of its role as central bank, namely, as the authority of the national payment systems, supervisor of institutions, issuing bank, and manager of money circulation. Therefore, we are conscious that the branches will facilitate our mission and will contribute to the (i) reduction of storing costs and transport of banknotes and coins by commercial banks, (ii) intermediation of Government financial operations (iii) deposits and withdrawal of banknotes and coins of the Metical by the banking system, (iv) licensing of foreign exchange operations and (v) support and supervision of micro-finance institutions. The urgency in expanding banking institutions throughout the country becomes similarly relevant in the context of regional economic integration programs underway within the SADC, as well as in the African continent. The creation of a single SADC central bank, and later an African central bank, will require a sound, modern financial system, with territorial coverage, otherwise institutions of other member countries of the region will reach this segment of the market rapidly, which is presently ignored by the domestic financial service network. Ladies and Gentlemen We are certain that in the current conditions, the enlargement of financial services to less favoured areas of the country, requires the provision of a number of non banking external factors as well as fiscal and non fiscal incentives. Therefore, bringing into debate a package of measures aimed at encouraging the enlargement of financial services throughout the country, we intend to get contributions from representatives of various transversal areas herein represented so that we can improve further the referred project with the purpose of ensuring the adoption of more effective actions that stimulate investments for the expansion and extension of financial services in Mozambique as quickly as possible, increasing the financial intermediation. We are not eluded in relation to the challenges we have forward, including in the macroeconomic plan, provided that stability is an essential element for investments in the context of more banking institutions throughout the country to take place effectively. We ended 2006 with a considerable reduction of inflation and the data we have been monitoring in 2007 suggest the continuous reduction and control of inflation. In the same way, with respect to the trend of the Metical exchange rate in relation to the USD, available data pointed out to a greater stability in 2007, in an environment of greater convergence between the USD rates in different segments of our foreign exchange market. These data show a scenario that encourages us to review some of the monetary policy instruments managed by the Banco de Moçambique. In this context, during February, we will reduce the Mandatory Reserve rate that the banking institutions should constitute at the Banco de Moçambique, and we will accommodate its regime of constitution in line with our objectives of a major deepening of money market operations and a major financial intermediation in the country. Ladies and Gentlemen Before I finish, I would like to express my gratitude to all those who, in a devoted and patriotic way, involved themselves in the process of introduction of the Metical of the New Family, integrating various working committees, or travelling throughout this country from Maputo to Rovuma and from Indico to Zumbo, visiting villages, towns, districts and Provinces, carrying out the heroic mission of informing our population of the importance and objectives behind this process. The mission is not yet finished, but it is not fairly a lack of modesty if we assert that the process was successful, taking into account similar experiences we have heard of. In this final stage of the process, I would like to urge, particularly, the economic agents involved in the commercialization campagins, in rural shops and all the institutions whose activity runs in the countryside, to serve as catalyst agents of the exchange process, using banknotes and coins of the Metical of the New Family in all transactions held with the public in order for about 6% to 7% of the remainder former families of the Metical to be changed in short time and within a peaceful environment. To end, I would like to invite everyone to participate in the debate, in a frank and open way, expressing your opinions and experiences on the challenges of expanding banking institutions and extending financial services through to the rural areas. Thank you very much. | bank of mozambique | 2,007 | 3 |
Speech by Mr Ernesto Gouveia Gove, Governor of the Bank of Mozambique, on the occasion of the 2006 Financial Year Closing Ceremony, Maputo, 20 December 2006. | Ernesto Gouveia Gove: Central Bank of Mozambique’s review of 2006 and prospects for 2007 Speech by Mr Ernesto Gouveia Gove, Governor of the Bank of Mozambique, on the occasion of the 2006 Financial Year Closing Ceremony, Maputo, 20 December 2006. * * * Distinct Members of the Board of Directors of the Banco de Moçambique Distinct Presidents and Representatives of Commercial Banks and Financial Institutions Dear Guests Ladies and Gentlemen, First of all, I would like to thank you, on behalf of the Board of Directors of the Banco de Moçambique and personally, for your presence in this traditional meeting of the end of the year in which we make the first analysis of the financial year ending and present our perspectives for the 2007 financial and economic year. Introduction The year 2006 was marked by important events for the country and our institution. The agreement on the reversion of Cahora Bassa Hydroelectric (HCB) plant to the Mozambican Government was indeed an event with an historic and economic dimension. Under this agreement, the Mozambican Government became the holder of 85% of the shares of that important undertaking, which empowers the government greater autonomy to make use of the HCB immense potential for social and economic development of the country as well as the whole SADC region. We congratulate our Government for this important victory and hope that Cahora Bassa becomes, more and more, a strong instrument of promotion of national interests and implementation of the national strategy of internal development and in the context of Southern African region. In 2006, the IMF Board, World Bank and African Development Bank, decided to include Mozambique in the list of poor countries, which benefited of debt relief, in the context of Multilateral Debt Relief Initiative, widely known as MDRI. For our country, this decision meant a write-off of about USD 2 billion in the stock of external debt, being USD 1.3 billion from the World Bank, 540 million from the African Development Bank and 154 million from the IMF. This gesture encourages us and confirms the commitment of the international community in relation to the performance of the Government in the implementation of PARPA (Plan of Action for the Reduction of Absolute Poverty) and macroeconomic stability and development programs. With this forgiveness, the ratios of Mozambique external position become greatly improved, allowing the Government to resort to external financing, on the basis of a criteria based management indebtedness, to pursue the multiple purposes of its development program and fight against absolute poverty. The international recognition of the Government positive performance was once more expressed by the International Monetary Fund (IMF) when on December 18th, 2006, approved the PRGF program (Poverty Reduction and Growth Facility) that Mozambique has with that multilateral financial institution, a fact that offers good perspectives for the consolidation of international cooperation. It is worth referring to the changes that took place at the top management level of our institution during the present year. On this occasion, I would like, once again, to express our tribute to Dr. Adriano Maleiane who until mid of the present year was the Governor of the Banco de Moçambique. This recognition is extended to the colleagues of the Board of Directors who have also retired. They left a legacy of unselfish work in favour of our institution and the Mozambican financial system that we are all invited to preserve and to deepen. We would also like to praise the Associação Moçambicana de Bancos (Mozambican Association of Banks) for, most recently, having achieved a consensus in relation to a code of conduct for all its members. Main goals for 2006 At the end of the last year, when we met in this same venue, we announced that our performance in 2006 aimed at contributing to the success of the Government’s agenda, established in the Economic and Social Plan and Government Budget, documents that pointed out to 7.9% economic growth, 9.5% average inflation and an external position measured by gross international reserves equivalent to four months of imports of goods and non-factorial services. Our intermediary objectives pointed out to 14.5% money supply and a growth of the credit to the economy in line with the GDP nominal growth. At that moment, we explained that our agenda for 2006 would basically comprise multi-faced actions aimed at implementing the Law nº 7/2005, which defines the Conversion Rate of the Metical of the New Family. Performance of the monetary and foreign exchange policy Ladies and Gentlemen We began the year 2006 in an adverse international environment, due to the oil price volatility, which in the present year reached a new historic record of about USD 78/barrel. Fortunately, the signs reported this part towards the end of the year give us a certain optimism. Preliminary information, based on data of the first semester of 2006, pointed out that the Mozambican economy may experiment a real growth around 7.9%. Moreover, differently from the last years, GDP growth was influenced by the construction, mining, transports and communication, and cattle-raising activity sectors, which revealed themselves to be more dynamic and with greater relative contribution than the major projects. That is really positive for our growth sustainability, as it results from the activity of small and medium enterprises, which greatly absorb resources and local labour force and, which has greater impact on the process of the fight against absolute poverty and reflect the diversification of the productive activity in the country. As we know, the main mission of our institution is to ensure price stability. The evaluation we make is that inflation recorded a stable behaviour in 2006, compared with the year 2005, even taking into account that it was characterized by three different moments. Until April, we observed a rising trend of prices, period in which the annual variation rate peaked to 17%. Between May and August inflation slowed down, having the monthly variations been successively negative, prompting the annual rate to decline to 10%, the lowest level observed in the whole year. Seasonally, at the end of the year, inflation tends to rise. However, the Consumer Price Index (CPI) monthly variation in November differs from that of the similar period of 2005, which makes it possible to record one-digit cumulative inflation at the end of 2006, even if in terms of average rate, we stand slightly above the projections of the beginning of the year. The main instrument of monetary policy we use to restrain and maintain inflation under control were the Interbank Money Market operations supported by a strong vigilance over the requirement of compulsory reserve, which stand at 11.51% and by the rise of our intervention interest rate announced at the end of the first semester. The oil price rise in the international market had a considerable impact on fuel and related products domestic prices. This factor influenced the inflation, but the combination of policies by different macroeconomic management institutions and the performance of real sector of the economy have allowed to soften this shock. In 2006, the National Institute of Statistics (INE) introduced a new CPI basket, changing the year-base for 2004 and adjusting the weighing factors of several products comprising the basket. We congratulate the INE for this effort that reinforces the comparability of our statistics with those of other SADC countries, thus contributing to a greater integration of our economies. After a year of clear disturbances, in 2006, the Metical revealed to be well more stable against the main currencies traded in various segments of the foreign exchange market. The exceptional measures announced late 2005 revealed to be important to abate the market and endow it with greater discipline and professionalism. We would like to praise the results obtained with the adjustments undertaken in the whole chain of the complex process of fuel imports, in order to stabilize the exchange rate. The Metical depreciation in relation to the USD in 2006 was less than 10%, against 27% recorded in 2005; in relation to the Rand, our currency inverted the loss of 11% recorded last year, as it appreciated by about 3.3%. The Banco de Moçambique continued to be the main supporter of the Interbank Foreign Exchange Market (IFEM), in terms of foreign currency sales, having to date allocated a total of USD 435 million net, in auctions and bilateral sales, against 393 million recorded in 2005. The foreign exchange market witnessed an increased confidence among its operators and this is proved by the increased volume and frequency of foreign exchange transactions among commercial banks, which peaked to 181.4 million in 2006, against 39.5 million in 2005. External sector developments (BoP) Ladies and Gentlemen According to information reported to September 2006, our Balance of Payments shows encouraging results. However, it still depends significantly on external support, making us more exposed to exogenous shocks, whose macroeconomic impacts are not always easy to predict. Our Country is totally dependent on imports of liquid fuels. The rise of Brent price in the international market results prejudicial in the behaviour of domestic inflation and international reserves. The fuel bill until September 2006 had amounted to about USD 300 million, against 218 million recorded in 2005. This figure worries us, taking into account that our exports, excluding the mega projects effect, are of only USD 600 million, in other words, about a half of the country export revenues are set to finance fuel bill. Until September 2006, Mozambique current account deficit had improved 38% compared with the similar period of 2005, if we include mega projects, and 9% excluding the operations of such projects. In the overall, we continue to import more than we export, having the amount of imports risen 23% in the first nine months of the current year, amounting to about USD 2 billion, whereas that of total exports amounted to USD 1.750 million. Thanks to a relatively more dynamic growth of goods export than that of imports, the imports coverage rate by exports improved again, representing 89.4% in September 2006, including mega projects (10 percentage points rise in comparison with the similar period of 2005), or 32.9%, when excluding mega projects. Even though, this level may be considered low, requiring additional efforts in order to promote greater diversification of exports, which must be done via increased production aimed at replacing imports, a condition to reduce the strong external dependence of our economy. In turn, the coverage ratio of imports of goods and nonfactorial services by gross international reserves stood at 4.7 months in November, above the four programmed months, including the mega projects. Ladies and Gentlemen One of our objectives is to foster a sound, strong and competitive financial system. In the period under analysis, we improved the evaluation instruments of the risk of financial sector through CAMEL methodology – Capital, Asset Quality, Management Quality, Earnings and Liquidity. Financial system and banking supervision Available data showed that, in the overall, our institutions are more sound and robust today, with the main indicators evolving positively and with more encouraging perspectives. The level of capitalization of the institutions continues to grow, standing at a position that can be considered satisfactory. The improvement of the soundness of financial system indicators reflects a combined effort of the Central Bank through the banking supervision and that of the credit institutions in strengthening their internal management and control processes. We can assert that today our system is more prepared to face several risks that the financial activity brings about. In effect, the ratio of non-performing loan reduced to 3.6%, while the solvency ratio grew to 16.7%, against the minimum of 8% required, according to the Basel I Convention terms or 12% under Basel II terms. Metical of the New Family Simultaneously, we continued to undertake efforts aiming at modernizing our payment systems. The process of implementation of the Law Nº 7/2005, regarding the introduction of the notes and coins of the Metical of the New Family began on July 1st, 2006, contributed to the fulfillment of this objective. We launched a broad advertising and civic education campaign addressed to resident citizens and our expatriates, about the details of this process. We praise the involvement of everyone, credit institutions, the local authorities, community leaders and the media, in the campaign of the Metical of the New Family, process running calmly, with no disturbances, having the notes and coins of the Metical of the New Family been accepted widely. We are grateful for having achieved, until now, a rate of substitution of the notes and coins of the former families of the Metical by that of the New Family above 85%, expecting it to stand above 90% by the end of the year, which is a really satisfactory level for our conditions. We would like to remind all the citizens that as from January 1st, 2007, the notes and coins of the former families of the Metical will no longer have a legal tender for any payment, otherwise they should be deposited or exchanged at any banking institution. Therefore, I would like, once again, to invite everyone to change the former families of the Metical by that of the new family through the commercial, banking and financial services existing in the country. Such as established in the Law, during 2007 the currency exchange should be done at the commercial banks, but even so, the people who by serious reasons are unable to change their money during this period, they will have the opportunity to do it at the Banco de Moçambique until 2012. Moreover, we would like to stress that as also prescribed in the Law, December 31st, 2006, marks the end of the use of the register designation “MTn” and the return to the designation “MT”, as well as the end of the mandatory double indication of prices in force since March 31st, 2006. Territorial expansion (branches) Ladies and Gentlemen, The strategy defined by the Government setting districts as the poles of planning and development of our economy, brings increased challenges to the financial sector. We are expected to give our contribution towards this objective, expanding our services throughout the national territory, especially to the less favoured areas but with enormous wealth and business potential. The financial sector should be sensible to the current low saving indices that the country records, which require pragmatic initiatives to encourage saving habits on our population. The increased demand of credit to finance public and private investment projects requires more dynamism in financial savings. On December 15th, 2006, we inaugurated the first branch of the Banco de Moçambique, in Quelimane city and within a few days we are going to Maxixe with a similar purpose. In the coming months we are going to open Tete, Pemba and Lichinga branches. This decision opens a new era in the activity of the Mozambican financial system and within our performance philosophy, as the issuing and supervisory bank of the financial and non-financial institutions. With this measure, we showed a great sign to the banking system on the urgent need to do our best in order to enlarge the financial services and decentralisation of banks throughout the country. The branches of the Banco de Moçambique will enable our mission in terms of issuance and circulation of notes and coins of good quality, modernization of the national payment systems, reduction of storing costs and transport of notes and coins by commercial banks, enable the Government financial operations, in the context of the Treasury single account and more decentralized financial administration, as well as everything related with licensing, support and supervision of microfinance institutions. Our branches are being open in a decisive stage of the process of introduction of the Metical of the New Family. We were pleased to note that in 2006 some credit institutions expanded their branch network and financial services throughout the country, which we encourage recognizing its importance in fostering savings. Together with the Ministry of Finance we will continue to devise strategies and measures aimed at minimizing constraints that today are pointed out by the national banking system as impeditive of a greater territory expansion and extension of financial services outside the main cities. The presence of banks in districts is going to foster the necessary savings for investments that the country really needs in order to face the millennium challenges, related to the fight against poverty. Ladies and Gentlemen, The Parliament has just analysed the Economic and Social Plan of the Government and the Budget for 2007, two important instruments of economic policy. In those instruments the Government envisages 7% real growth and 8% annual average inflation. For such purpose, our intermediate objectives will be set for 17.5% money supply, measured by the variation of stocks of the greater monetary aggregate (M3) and an expansion of Reserve Money, our instrumental variable, not above 14.5%. In 2007, we will continue to deepen the reforms underway in the interbank monetary and foreign exchange markets, the main instruments of execution of our monetary policy. Once set the foreign exchange market stability, we assume to have the conditions created for a gradual removal of the transitional measures introduced in November 2005. We have just approved a new regulation of the Interbank Foreign Exchange Market (IFEM). This normative instrument introduces procedures that were object of a long process of negotiation with commercial banks, namely: (i) inclusion of an adhesion requirement and obligation to quote firm to a reference amount of USD 50.000 (fifty thousand American Dollars), to a maximum of one call per day; (ii) enlargement of the spread between bit and offer rates, from the current 10 Ctn (ten cents) to 20 CTn (twenty cents); (iii) definition with greater detail of the bilateral operations with the Central Bank; (iv) enlargement of the variation maximum limit of the daily rate to 1%, which appears reasonable for greater flexibility of the IFEM operators in the whole business environment, where the foreign exchange stability continues to be our major interest. In order to offer greater credibility and transparency to the management of monetary policy, as well as to conform to the international good practices on the matter, after a long process of preparation, which included, among other aspects, the design of forecasting models and support monetary analysis to decision making, our committee on monetary policy is going to change its format and content, as from next year. The model we are going to adopt will address special attention to communication with the public, with the purpose of disseminating the nature of measures that the Central Bank takes, throughout the market and the whole society, signalling more clearly the monetary policy pursued in the present and future, which will certainly help the process of formation of economic agents expectations. The year 2007 is decisive for the implementation of the International Financial Reporting Standards (IFRS), thus marking the end of a transition process began in 2004. For such purpose, the banking supervision is going to address a future risk approach, conforming with the international practices on the matter. As from February 2007, the Banco de Moçambique will start performing the clearance of visa network credit cards issued by national banks, with the purpose of ensuring that (i) all domestic transactions performed in Meticais using cards issued by national banks, members of Visa are settled in Meticais, (ii) the role of the Metical as national currency is reinforced, (iii) the foreign exchange risk is reduced, (iv) transactions performed with Visa payment cards are accompanied and recorded; (v) the absence of a single payment network is partially fulfilled, and (vi) the ATMs (Automated Teller Machines) and EFT/POS (Point of Sale) services are enlarged. At the regional level, we will continue to give our contribution so that the objectives of macroeconomic convergence and integration defined by the SADC (Southern African Development Community) are achieved, particularly with respect to inflation, harmonization of procedures and legal framework that governs the central banks of the region. Within the African continent, as a member of the Association of African Central Banks (AACB), we will continue to contribute to the objective of the creation of a central bank of the continent. Final remarks Ladies and Gentlemen, We would like to express our profound recognition of the valuable contribution that all national economic agents, the society in general and the international community has been giving us in order to fulfil our mission, particularly in respect of the formulation and execution of a monetary policy in conformity with the objectives of economic growth, with low inflation. Allow me to address special thanks to the employees of the national financial system and in particular, to the collaborators of the Banco de Moçambique, for their devotion and commitment demonstrated during the year. I finish wishing you all and your distinct families, Merry Christmas and a prosperous New Year. Thank you very much. | bank of mozambique | 2,007 | 3 |
Statement by Mr Ernesto Gouveia Gove, Governor of the Central Bank of Mozambique, at the business function organised by the High Commissioner of the Republic of South Africa on the occasion of Nelson Mandela's Day, Maputo, 21 July 2010. | Ernesto Gouveia Gove: Reinforcement of “South–South” cooperation Statement by Mr Ernesto Gouveia Gove, Governor of the Central Bank of Mozambique, at the business function organised by the High Commissioner of the Republic of South Africa on the occasion of Nelson Mandela’s Day, Maputo, 21 July 2010. * * * The Governor of the Banco de Moçambique, Mr. Ernesto Gouveia Gove, defended last Sunday, July 18, the reinforcement of “south–south” cooperation in order to minimize, in future, the access problems to international markets and the volatility of their prices. The Governor’s statement as regards the issue was made during the business function organized by the High Commissioner of the Republic of South Africa, in Maputo, on the occasion of Nelson Mandela’s Day. The function, which had the presence of Mozambican and South African businessmen and Members of the Parliament of that country responsible for economic matters, served to increase synergies between the business sectors of both countries. – This meeting occurs in a moment when the recovery signs of the global economic activity have began to be strong worldwide, after years of major economic and financial crisis, whose effects in countries like ours had a strong impact on external sector, particularly through decline of export revenues as a result of the fall of international prices of almost all the exporting products – said the Governor. In his point of view, the integration process underway in our countries, considering the existing investment opportunities, can contribute to the success of the fight against poverty and underdevelopment. According to the Governor, the Southern Africa needs to be united in order to eliminate information asymmetries. – We need to share our vast experiences and to speak about what each one can do or offer to develop our countries. We need to give content and frame to the process of regional integration underway, implementing the strategic plan that already exists and undertaking the common and integrated projects, particularly the cross-border projects that can boost the regional trade – stressed the Governor. In this context, Mr. Ernesto Gove considers that the SADC member country authorities should proceed with institutional and macroeconomic reforms that allow the attraction of more investments to the region. It is also strongly recommended to deepen the financial sector so that it can develop a modern and strong capital market to fulfill the existing financing gap in so crucial infrastructure projects of the region. | bank of mozambique | 2,010 | 8 |
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to The Sydney Institute on 11/2/97. | Mr. Macfarlane discusses the economics of nostalgia Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to The Sydney Institute on 11/2/97. 1. Introduction It is a great pleasure to be speaking at The Sydney Institute, which has done so much over recent years to keep alive informed discussion of public affairs and the arts. In keeping with this tradition, I have chosen to speak on a subject with a historical, economic and political theme. I would like to look back at the 1950s and 1960s, and evaluate some of the lessons that people take from this period. The further my professional life proceeds, the more value I see in a good knowledge of economic history, even if it is so recent that most of us have lived and worked through it. As you will gather, my views on history are much closer to George Santayana’s than to Henry Ford’s. There can be no quibble with the proposition that macro-economic performance in the immediate post-war period, which for present purposes I will refer to as the 1950s and 1960s, was far superior to any period before or after. This has led a lot of people to use it as a basis for proposing economic policies for today. They look back at how things were done in the 1950s and 1960s, and say “if only we did it the same way today, our macro-economic performance would be as good as it was then”. This approach has some merit but, if we are to use it, it is very important that we get our facts straight about what the policies actually were in the 1950s and 1960s. There are two propositions of policy relevance that are frequently made about this period. The first one is that the macro-economic success at that time was due to the use of activist and expansionary fiscal and monetary policies. The second is that the world economy was moving along very smoothly in the post-war period, with everything under control, until hit by the external shock of the OPEC-induced oil price rise in late 1973 (and again in 1979). I would like to analyse these two propositions with particular reference to Australia, but in doing so it will be necessary to bring in a lot of international economic and political events, particularly those occurring in the United States. 2. Macro-economic performance in the 1950s and 1960s It is not necessary to spend much time demonstrating how successful this period was in terms of macro-economic performance because no-one disputes it. Table 1 shows that the real growth rate for the world economy was more than twice as high in the 1950-1973 period than in the previous 80 years. In Australia there was also a major improvement, although less than a doubling. Inflation, which had been negligible on average until the Second World War, rose to about 4 per cent in the 1950-1973 period, with the average being pushed up by the Korean War period and the early 1970s. At other times it was a good deal lower, and even with these periods included, it was moderate enough to permit economic expansion for most of the period. Unemployment remained low throughout the period, although there was some cyclical movement at times. Overall, macro-economic performance was considerably better in this period than in any time before or since, which has prompted economic historians such as Maddison (1991) to refer to this period as the “Golden Age”. Table 1: Indicators of World(a) and Australian(b) Macro-economic Performance (average annual increase) 1870-1950 1950-1973 1973-1980 GDP CPI 2.3 (2.9) 4.9 (4.7) 2.6 (3.1) 0.1(c) (1.3) 4.1 (4.6) 7.3 (9.7) (a) Sixteen largest OECD countries; (b) Australian figures in brackets; (c) Peacetime years. Source: Maddison (1991). There were a number of factors behind this impressive economic performance, but time and space limit me to mentioning only the main ones. The four most important, I believe, are as follows: (i) There was a big gap to be made up following the Depression and the Second World War. The 1950s and 1960s was a period of post-war reconstruction or “catch-up” for most countries. The largest growth pick-up occurred in the countries most devastated by the war, such as Germany, Italy, Japan and Austria, and the least pronounced (although still significant) were in the United States, Canada, Switzerland, Sweden and Australia. (ii) Although populations and governments were eager for economic growth, there was widespread restraint in economic behaviour. The privations endured during the Depression and the War meant that as incomes rose, a high proportion was saved. Inflationary expectations too had been conditioned by decades of nearly zero inflation, which showed up in modest pricing and wage setting behaviour for much of the period. Some commentators also stress the political cohesion among western countries as a result of the ever-present influence of the Cold War. (iii) International trade was liberalised and exports and imports grew rapidly. This was a sharp contrast with the inter-war period. Maddison says “perhaps the least controversial assertion one can make about the Golden Age is that it involved a remarkable revival of liberalism in international transactions. Trade and payment barriers erected in the 1930s and during the War were removed. The new-style liberalism was buttressed by effective arrangements for regular consultation between Western Countries and for mutual financial assistance” (IMF, OECD and GATT (now WTO).) (iv) Governments conducted good macro-economic policies with a greater emphasis on economic growth than in previous decades. In a number of countries the new-found commitment to growth and low unemployment was enshrined in legislation. In others it was less formal, but in nearly every country the first decades after the Second World War were characterised by well-balanced and successful macro-economic policies. A more detailed examination of these macro-economic policies, particularly in Australia, is the subject of my next section. 3. The role of macro-economic policies There is no doubt that the dominant principle behind macro-economic policy changed after the Second World War in line with Keynesian teaching, but the change occurred more quickly in some countries than others. The main change was that fiscal policy was to be used actively to promote economic growth by deliberately incurring budget deficits at times of weak economic activity. Fiscal policy and monetary policy together were termed demand management policy, and they were to be adjusted to smooth the business cycle, to increase growth and to achieve full employment. In Australia’s case, this approach was enshrined in a document - the 1945 White Paper, “Full Employment in Australia”. This approach to policy was very successful in that it achieved its aims of high growth rates and low unemployment for several decades, and it did so with generally low rates of inflation. The achievement was all the greater, given that the 1950s contained a major shock in the form of the Korean War commodity price boom. This high level of success has led many people to assume that policy must have been operated with a high degree of activism, i.e. by choosing very expansionary settings of policy. But this was not the case. For most of the period we are considering, demand management policy was quite restrained and, where necessary, restrictive. Certainly its guiding principle was Keynesian, but it was operated in a very balanced way and was, in any case, subject to an important constraint, which I will come to later. That this was the case should not be a surprise to people who remember the period. For example, the Fadden “Horror Budget” of 1951/52 and the “Credit Squeeze” of 1961, which nearly cost the Menzies Government office, have gone into folklore. Of course, there were also periods where policy was expansionary, but on average the result was relatively balanced. While growth was high, on average, there was also a business cycle operating during this period, with a couple of reasonably clearly defined recessions and booms. The fact that policy was well balanced can be shown for fiscal policy by a couple of graphs. Unfortunately, comparable data do not go back earlier than 1961/62, so we will have to lose the 1950s from our comparisons. Diagram 1 shows the best general measure of the underlying budget deficit. In the 12 years from 1961/62 to 1973/74 the budget was, on average, Diagram 1 Budget Balance* Per cent of GDP % % 1.5 1.5 0.0 0.0 -1.5 Average 1961/62 to 1973/74 -1.5 -3.0 -3.0 Average 1974/75 to 1995/96 -4.5 -4.5 -6.0 65/66 70/71 75/76 80/81 85/86 90/91 -6.0 95/96 * General government on an underlying basis. in surplus to the extent of ½ per cent of GDP, and the fluctuations around the average were not very large. In the period since then, the budget has nearly always been in deficit, with an average deficit of nearly 2 per cent of GDP. You can see the three attempts made to bring it back towards surplus - the first one when Mr. Howard was Treasurer, the second one under Mr. Keating as Treasurer, and the third one which is being continued at the moment by Mr. Costello. In summary, it is the more recent period that could be characterised as activist and expansionary in that there are bigger swings in the budgetary position and, on average, it tends to show a much bigger deficit. Diagram 2 General Government Outlays Per cent of GDP % % Average 1961/62 to 1973/74 Average 1974/75 to 1995/96 65/66 70/71 75/76 80/81 85/86 90/91 95/96 Another measure of fiscal activism is the size of government expenditure relative to the economy. It will come as no surprise to see that general government outlays relative to GDP were much lower in the 1960s than they are now (Diagram 2); in the earlier period they accounted for about 25 per cent of GDP, but over the last two decades they have averaged 34 per cent of GDP. The stance of monetary policy is more difficult to analyse because interest rates cannot be used as the measure of comparison. This is because before the early 1980s the financial system was heavily regulated, with the Government imposing interest rate ceilings on most forms of lending. Tightenings and easings in monetary policy showed up largely through credit rationing - the ease or difficulty in obtaining a loan at a given interest rate. This would be familiar to people who can remember the difficulty of obtaining a housing mortgage at that time. The best way of judging whether monetary policy was tight or loose in such a system was to see how fast it allowed money and credit to grow. The growth of the money supply is shown in Diagram 3, and again we see relatively low and stable expansion during the 1950s and 1960s (except for the Korean War boom), before the turmoil starts in the 1970s (in this case, the very early 1970s). I referred earlier to the fact that monetary and fiscal policy had to operate under an important constraint during the 1950s and 1960s. The constraint to which I am referring is the gold exchange standard, whereby virtually all OECD countries fixed their exchange rate to the US dollar, which in turn fixed to gold. In Australia’s case, our exchange rate to the US dollar did not change between 1949 and 1971. This was in a way the centrepiece of our economic policy. Monetary policy and fiscal policy could not get too expansionary without either inflation or the balance of payments threatening the exchange rate. This mechanism effectively meant that our macro-economic policies (and those of most OECD economies) could not get too far out of line with the policies pursued by the US Government. A recognition of this link means that if we wish to fully understand what happened in the 1950s, 1960s and early 1970s, we have to look more closely at the trends in US economic policy. This also means that we will have to stop looking at the 1950s, 1960s and early 1970s as a whole, and instead divide it into two quite different sub-periods. Diagram 3 Money Supply* Year-ended percentage change % % -5 -5 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 * M3 4. The end of the Golden Age The role of the United States is crucial here. Despite its having enacted the Employment Act of 1946, the United States continued to run reasonably conservative demand management policies through the Truman and Eisenhower years and even in the early part of the Kennedy Presidency. In this period US economic policy came in for a fair bit of criticism from economists, particularly outside the United States, for being too cautious. There was some basis to this criticism in that US policy makers did seem to be less keen to expand than their counterparts in other countries, particularly in Europe. American attitudes changed in the early 1960s, but nothing concrete occurred until the Johnson years. The turning point was the tax cuts introduced in 1964 and 1965 which were described by one of their architects - Arthur Okun - as “The largest stimulative fiscal action ever undertaken by the federal government in peacetime ... the first major stimulative measure adopted in the post-war era at a time when the economy was neither in, nor threatened imminently by, recession. And, unlike earlier tax reductions, they were taken in a budgetary situation marked by the twin facts that the federal budget was in deficit and federal expenditures were rising.” This certainly got the United States moving and was soon followed by increased defence expenditure occasioned by the Vietnam War, and other government expenditure associated with the Great Society programs. Some of the proponents of the original tax cuts then argued for tax increases but, not surprisingly, they found these were harder to put into place than were the earlier tax cuts. In the second half of the 1960s and early 1970s the US economy grew very quickly and inflation began to rise. For a time it was held in check by the Fed’s willingness to run a tight monetary policy, but with the appointment of Arthur Burns as Fed Chairman, monetary policy became more accommodating. President Nixon found that expansionary policies were popular, and continued in the same vein as his predecessor. By 1971, with the United States running a large current account deficit, it could no longer hold its commitment to gold and the US dollar was effectively devalued against gold and against other major currencies. Table 2: Unemployment Rates in G10 Countries and Australia * 1965* 1973* USA Japan Germany France Italy UK Canada Sweden Belgium Netherlands Average of above 4.5 1.3 0.7 1.3 5.4 1.4 3.9 1.2 2.5 1.0 2.1 4.9 1.4 1.2 2.7 6.7 2.1 5.6 2.5 3.7 3.9 3.1 Australia 1.6 2.3 For 1965, figures are the average for the year; for 1973, they are the average for the first three quarters (i.e. pre-OPEC I). Table 3: Inflation Rates in G10 Countries and Australia USA Japan Germany France Italy UK Canada Sweden Belgium Netherlands Average of above 1.7 5.9 3.8 2.3 3.3 4.4 2.8 6.7 4.0 6.8 3.2 6.9 12.6 6.9 7.4 11.8 9.2 8.2 9.1 8.8 8.4 8.4 Australia 4.1 10.4 Year to December 1965 and to September 1973 (i.e. pre-OPEC I). There was now no longer an anchor to the international financial system. Thus, the post-war period should really be divided into two sub-periods, with the US tax cuts of 1965 marking a convenient dividing line. Thereafter, US policy became expansionary, and it ceased to provide a constraint on the actions of other countries. It is instructive to see what happened in a range of countries during this second period, that is between the turning point in US policy in 1965 and the OPEC shock at the end of 1973. The story is very similar for all OECD countries. Their economies continued to grow strongly, but they were not able to get their unemployment any lower than the already low starting point (see Table 2).The main effect of these expansionary policies was to push inflation to levels that were not consistent with sustainable economic growth. As a general rule, most countries’ unemployment rates rose slightly, but their inflation rates doubled (see Table 3). By 1972 and 1973 the world economy was in an inflationary boom. How did Australia fare in this period? Our story was very similar to the general pattern, although the deterioration in inflation was more marked here. Our inflation rate, which had been about 4 per cent in the mid-1960s, reached 10.4 per cent in the year to the September quarter of 1973. That means that we had already got our inflation rate into double digits before OPEC came along to deliver a further inflationary impulse (see Diagram 4). Our problems were compounded by the inflationary boom that the world found itself in 1972 and 1973. Commodity prices were rising rapidly, as were our export receipts. With the monetary policy instruments then available, and with the fixed exchange rate, it was not possible to quarantine the monetary effects, and the money supply was soon growing at more than 20 per cent per annum. We did not help ourselves very much either with the way we set wages. The National Wage Case of December 1970 resulted in a 6 per cent increase in awards, and the metals industry award of July 1971 added 9 per cent to award wages through that year (when inflation was 5.1 per cent). Diagram 4 Consumer Prices Year-ended percentage change % % Sep Sep Sep Sep Sep Sep Sep Sep Sep The point of all this analysis is to answer the second proposition that was presented in the Introduction. Was the world achieving good macro-economic performance until hit by the OPEC shocks? The answer is clearly no. In the period after 1965, policies became too ambitious and too expansionary. In colloquial terms, we all lost the plot. Of course, it is easy for me to say these things now because I have the benefit of hindsight - it was much harder at the time to see that we were overstretching ourselves. By 1973, the world economy already had an entrenched inflationary problem, not just a temporary one as in the Korean War period. Whether OPEC had come along or not, it would still have been necessary to re-examine demand management policies and do something about restoring the sort of conditions that existed in the 1945-65 period. History shows that what we got instead was an oil price shock to add to our already considerable self-imposed troubles, and so spent the next decade-and-a-half trying to return to some sort of reasonable equilibrium. I do not want to say anything about that period because that is another story. 5. Conclusion The period that is loosely described as the 1950s and 1960s really covers the nearly three decades between the end of the Second World War and the first oil price shock known as OPEC I. Macro-economic policies were successful for most of this time in that they avoided the deflation that had characterised the 1930s, and yet did not move too far in the inflationary direction. However, a closer examination of the whole period suggests that there were two quite distinct sub-periods. The first, from 1945 to 1965 or thereabouts, was the true Golden Age in that sustainable growth with low inflation was achieved against a background of macroeconomic policies that did not try to be too ambitious in the short run. The second period, from 1965 to 1973, looked promising for a time, but was ultimately a period of policy failure. Macroeconomic policy tried to achieve too much and forgot about the need for sustainability. It ended up with the world economy in an inflationary boom, which set the scene for oil prices to rise sharply, as had all other commodity prices during the boom. A policy reversal aimed at restoring the more balanced approach of the 1945-65 period would have been needed even without the shock of OPEC. *************** Bibliography Australian Bureau of Statistics, Government Financial Statistics, Cat. No. 5512.0. DeLong, B. (1996), “America’s Only Peacetime Inflation: The 1970s”, NBER Historical Paper No. 84. FitzGerald, V.W. (1993), “National Saving: A Report to the Treasurer”, Commonwealth Government Printer, Canberra, Australia, June. Maddison, A. (1991), “Dynamic Forces in Capitalist Development: A Long-Run Comparative View”, Oxford University Press, Oxford. Okun, A.M (1970), “The Political Economy of Prosperity”, Brookings Institution, Washington DC. Pagan, A. (1987), “The end of the long boom”, Chapter 5 in “The Australian Economy in the Long Run”, Maddock, R. and McLean, I.W. (eds.), Cambridge University Press, USA. Samuelson, P.A. and Solow, R.M. (1960), “Analytical Aspects of Anti-Inflation Policy”, American Economic Review, May. Samuelson, R.J. (1995), “The Good Life and its Discontents: The American Dream in the Age of Entitlement 1945-1995”, Times Books, Random House of Canada Limited, Toronto. Van der Wee, H. (1987), “Prosperity and Upheaval: The World Economy 1945-1980”, Penguin Books, Middlesex, England, Translated by Hogg, R. and Hall, M.R. | reserve bank of australia | 1,997 | 2 |
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the Australia-Israel Chamber of Commerce in Melbourne on 15/5/97. | Mr. Macfarlane reviews monetary policy, growth and unemployment in Australia Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the Australia-Israel Chamber of Commerce in Melbourne on 15/5/97. It is a pleasure to be here in Melbourne, and to be speaking to the Australia-Israel Chamber of Commerce. I was very pleased to be invited to address this distinguished group so soon after I was appointed. If at the end of this address, you feel that I have still left some important questions unanswered, my suggestion is that your next guest be my opposite number from Israel. Jacob Frenkel, the Governor of the Bank of Israel, is a distinguished economist, but a very busy man. My invitations to him to visit Australia have so far been unsuccessful - perhaps this Chamber can swing the balance. I want to take this opportunity today to talk about the economy, monetary policy, and some aspects of unemployment. I propose to do this by looking over a longer period than normal. Most economic commentary concentrates on very current events and focuses on the latest monthly or quarterly economic statistics. This is an inevitable result of the news-gathering process and the need for financial markets to reassess after each new piece of information. In this environment, the outlook for the year ahead is considered a long time. In my view, even that is too short - for monetary policy purposes, we should be looking at a period as long as an economic expansion. That may not be a lot of immediate help to most people because they would be unsure of what time span was encompassed by an economic expansion. As a point of reference, the last two expansions have lasted for about six-and-a-half years, but I think we can do a lot better on this occasion. Lengthening the expansion The current expansion in Australia has been going on for about 5½ years, which is similar to the United States, the United Kingdom and New Zealand, and a fair bit longer than for countries in continental Europe or Japan. Table 1 shows that over that period we have grown at an annual rate of 3½ per cent and had inflation of 2½ per cent. Our growth rate has been higher than nearly all OECD countries, although not as strong as for the countries of east Asia. Our inflation rate is also very good and close to the average for OECD countries. The results are pretty good by international standards, particularly since there should be a lot more expansion still to come. The main reason that I think we still have a lot more to come is that this has been a low-inflation expansion and remains so. An important reason why inflation has remained low is that monetary policy has been determined to keep it low this time. The centrepiece of our monetary policy approach is a medium-term inflation target endorsed both by the Government and the Reserve Bank. It was also endorsed by the Treasurer in the previous Government and was incorporated into the Accord Mark VIII agreed in June 1995. It is not just something we dreamt up at the Reserve Bank; it has enjoyed wide bipartisan support. And recently, the Industrial Relations Commission made it clear that they felt their own decision had to take note of this framework. The statement agreed between the Treasurer and myself at the time of my appointment saw low inflation as a requirement for sustained growth, which is another part of the Bank’s Charter. Containing inflation is not an end in itself; it is one of the pre-conditions for sustained growth. It is not the only one, but it is obviously the one for which central banks have to accept most responsibility. Table 1: GDP Growth and Inflation GDP Ireland Norway Australia New Zealand United States Canada Denmark Netherlands United Kingdom Finland Germany Japan Spain Belgium France Italy Sweden Switzerland a Consumer Pricesa 6.1 3.8 3.6 3.6 2.7 2.2 2.2 2.2 2.2 1.6 1.4 1.4 1.4 1.3 1.3 1.0 1.0 -0.1 2.4 2.3 2.3 1.7 3.1 1.7 2.0 2.9 3.0 1.9 3.1 0.8 4.8 1.9 1.9 4.3 2.1 2.3 (a) Average annual rate since June 1991 Inflation and growth We do attract criticism, however, from people who think that because we have an inflation target it means we are not interested in economic growth. This is not true - as I have pointed out on a number of occasions. In fact, the reverse is true: we are interested in sustaining a good inflation performance because we are interested in growth. Let me make two points I have made before: (a) The other way of looking at an inflation target is to say that the aim is to grow as fast as possible consistent with maintaining low inflation, but no faster. We say no faster because post-war history has taught us that allowing inflation to rise actually harms growth prospects in the longer term. Strong growth and long expansions have always gone hand-in-hand with low inflation. Weaker growth and short expansions have occurred in the high-inflation era, particularly the 1970s but also in some parts of the 1980s. This “no faster” idea does not mean that we will panic at unexpectedly strong growth over a short period. It does mean we intend to avoid a “full steam ahead and damn the torpedoes” approach to policy. (b) As I said at the start of the talk, we want a long expansion this time. We do not want the expansion to last only six-and-a-half years and be followed by a recession. The damage, particularly to unemployment, occurs during recessions. The net rise in unemployment in Australia over the past 25 years has not been due to prolonged periods of weak economic growth; it has been concentrated into three relatively short periods of recession (see Diagram 1). The best thing monetary policy can do to improve our employment prospects is to prolong the expansion and delay and reduce the size of any subsequent recession. On occasion, that means easing the growth rates back a bit to counter inflationary pressures early, as an alternative to more vigorous application of the brakes when inflation has built more momentum. Diagram 1 Unemployment Rate % % Ideally, we should try to eliminate the business cycle (and recessions) altogether, but that would be too utopian an aspiration. The business cycle has been declared dead before, only to re-assert itself. I do believe, however, that if inflation is kept under control, this expansion will be a lot longer than its predecessors and any subsequent downturn kept milder than in the past. Less pressure would be placed on monetary policy in a late-cycle situation if the aim were only to slow the economy, than if it were necessary both to slow the economy and to reduce an entrenched inflation, as has been the case in the past. Speed limits Some people would characterise our approach to monetary policy as incorporating “a speed limit”. In a very broad sense this is true. We do not want the economy to grow so fast that it pushes up wage and price inflation to unacceptable rates. I have already explained the reason for that. However, the concept of a “speed limit” is unhelpful if we try to use it mechanistically. It has been claimed that the Reserve Bank has a rule that the economy cannot be allowed to grow faster than 3½ per cent. I have seen this claim on a number of occasions, but can assure you that it is not true. I do not know where it came from; perhaps from observing historical growth rates, or perhaps from some misinterpretation of things that the Bank has said on occasion. The figure of 3½ per cent is also sometimes regarded as the Government’s target. Again, I do not know where this claim came from, but it is probably derived from the fact that government projections, such as those underlying the Budget forward estimates, often assume average growth rates like this, particularly for the out-years of multi-year projections. These assumptions should be seen as what they are - an attempt to base government planning on prudent, conservative assumptions rather than wishful thinking - not as iron-clad limits to growth or short-term “targets”. There are a number of reasons why it does not make sense to specify a particular number as the “speed limit” for the coming year. Among those reasons are the following: (a) Even if we have a clear idea of a long-term average rate of growth, an economy can clearly grow faster than that when it is taking up excess capacity. This would be the case if it was coming off a year when growth was a bit on the soft side (as was 1996, for example) and where inflation was very well contained. (b) It is not possible to “fine-tune” an economy to grow at the rate you want over the space of one year. Neither forecasting accuracy, nor the monetary policy process, permits that degree of accuracy. Even with very good economic policy, the economy will grow faster than average half the time and slower the other half. (c) Just because the economy averaged a particular figure in the past, it does not mean that this average is the one we should project into the future when thinking about potential growth. There is some evidence, as is shown in our Semi-Annual Statement on Monetary Policy, that productivity growth has increased, and hence it is possible that potential growth may have risen. On the other hand, population and labour force growth may well be slower than in the past and this would work in the opposite direction. I hope I have made it clear that we do not regard economic growth as excessive because it has breached a particular figure - say, 3½ per cent. We would regard it as excessive if it is pushing up wages and prices in a way which would cause our medium-term target to be exceeded. Obviously, the faster is growth in any particular period, all other things equal, the higher the risk of that problem becomes. But we do not have, and it is not sensible to have, a doctrinaire view of particular growth thresholds which, if breached, are assumed to generate problems. The policy process is rather more pragmatic than that, and proceeds by the rather simple technique of examining the evidence for what it says about inflation pressures in the period ahead. That, to repeat, is the test: not whether a growth rate matches or exceeds a particular pre-determined figure, but whether low inflation performance is being maintained over time. At any point in time we are constantly monitoring wages and prices and making an assessment of the outlook over the next year or so. If we get good news and our assessment is for lower growth in wages and prices, we can, other things equal, let the economy run faster. This may be done by reducing interest rates or, depending on the circumstances, refraining from raising them. If on the other hand we are getting bad news, we may have to tighten or forego an easing. This idea is not all that novel. It is very similar to the way the monetary policy process is described in the United States. Our newspapers are full of the latest speculation about what Alan Greenspan - the Chairman of the Federal Reserve Board - is going to do this month, next month and thereafter. The big story of 1996 in the United States was that nearly everyone expected monetary policy to be tightened. The US economy was already at full capacity and still growing strongly, people expected that inflationary pressures would soon emerge, and the Fed would have to tighten. On three occasions - July, September and December - the markets were convinced it was going to happen, but on each occasion the Fed was able to sit on its hands. Why was it possible to delay the tightening for nearly a year? It was not because the economy weakened; in fact, it grew faster than initially anyone had forecast, expanding by over 3 per cent in 1996, well above previous forecasts and economists’ estimates of its long-run potential growth rate. It was because the Fed continued to receive constant feedback from the economy indicating that rises in prices and wages remained moderate. None of this means that the US economy is somehow entirely freed from all the constraints it has experienced in the past; only that, to date, inflation performance has been a bit better than they expected. To that extent, the Fed has been able to allow the growth to run just a little longer. No-one would be more pleased than the Reserve Bank to see a similar outcome for the Australian economy over the next 12 or 18 months - that is, continuing good news on wages and prices, allowing us to grow faster for longer. It was an assessment of improving prospects for inflation, and the associated scope for additional growth, that lay behind the three easings in the second half of 1996. We would like to have seen that pattern of news continued, but the latest data on wages seems to have been a setback to that expectation. Other views Of course, not everyone agrees with this approach. There are those who think a much higher figure for growth is achievable and should be pursued. Their approach would be to nominate a figure - I have seen 5 per cent mentioned - and expect the Reserve Bank to adjust monetary policy to achieve it in the long run (not just for one year). The trouble with this approach is that it amounts to a gamble with rather poor odds. While we do not wish to take too strong a view on what is “too much” in any particular short period, we need to keep a reasonably sober perspective on what is likely to be feasible over the long run. A growth rate of 5 per cent, for example, is so far above our historical performance that unless you can specify how improvements on the supply side of the economy have lifted the potential growth rate dramatically, it cannot be taken seriously. Now there may well be some significant benefits coming through on the supply side as a result of structural changes and micro-economic reform. For example, reductions in tariffs and increased competition within the domestic market are two that spring to mind. We may also be getting something out of increased flexibility in some parts of the workforce, though the jury is still out at present on exactly how far that process has brought us. But even though there is some tentative evidence of higher productivity, I think we have still got a lot further to go before we could be confident that supply-side reforms have significantly lifted our potential growth rate. More importantly, our current monetary policy procedures, consistently applied, should guide us to the right answer without having to take such a gamble. If the economy really is capable of much faster non-inflationary growth than in the past, constant evaluation of the feedback we receive from the data should enable us to detect this change. If we receive a flow of information pointing to lower pressures on wages and prices, for example, we can let the economy run faster than earlier relationships might have suggested, as in the Greenspan example. This may not satisfy those with a liking for a punt, because the feedback process takes longer. But it carries less risk of miscalculation. Longer-term aspects of unemployment So far, we have been talking about monetary policy in relation to the business cycle. I have argued that we should try to maintain the economy in a position of growth for as long a time as possible. This is best achieved by seeking to remain free of major imbalances, and addressing those which do emerge as quickly as possible. But there is a bigger dimension to Australia’s unemployment problem than managing the business cycle. It becomes clear from a consideration of the longer-term history both of our own economy and those of other countries. What I want to suggest is that a common perception that if we could only grow faster, unemployment would go away, is missing an important part of the story. Consider the data in Table 2, which is for the same group of countries as shown earlier in Table 1. The table sets out the average growth rate per capita in these countries and their unemployment performance. This latter concept is measured by seeing how much higher their current unemployment rate is than it was in the first half of the 1960s. There is one country where the unemployment rate is now lower, namely the United States. At the other end of the spectrum, we have the large European countries where the unemployment rate is enormously higher than it was in the 1960s. We are somewhere in the middle - better than the large Europeans, but not as good as the United States, the United Kingdom or New Zealand. We can then pose the question: have the Europeans suffered because their growth rates were inferior to the United States? Is that the reason for their higher unemployment rates? The answer seems to be no, because column 1 shows that most of the major European countries had quite respectable growth rates over this period; for example, Germany, France, Italy and Spain all grew faster than the United States (or the United Kingdom, New Zealand or us). Their performance on unemployment has been dismal, not because of their growth performance, but despite it. Diagram 2 shows that, over this relatively long period, there is no systematic relationship between the growth of the economy and the change in the unemployment rate (if there was, the dots would be clustered around a downward sloping line). Table 2: Growth Rate and Change in Unemployment GDP per capita Average Growth 1960-1996 United States Norway Japan Canada United Kingdom Switzerland Netherlands New Zealand Denmark Australia Ireland Sweden Italy France Germany Belgium Finland Spain 2.1 3.2 4.5 2.3 2.0 1.5 2.3 1.2 2.3 2.2 3.7 2.0 3.0 2.6 2.4 2.7 2.7 3.4 Unemployment Rate Early 1960s Latest Difference 5.7 1.7 1.3 6.0 1.7 0.0 0.5 0.1 1.5 2.0 5.0 1.6 3.5 1.4 0.7 2.2 1.4 2.3 4.9 3.5 3.2 9.6 6.1 5.6 6.2 6.4 8.0 8.7 11.7 8.4 12.3 12.8 11.2 12.9 15.1 21.7 -0.8 1.8 1.9 3.6 4.4 5.6 5.7 6.3 6.5 6.7 6.7 6.8 8.8 11.5 10.5 10.7 13.7 19.4 There are, no doubt, many aspects to this story, which I cannot go into here. But it seems reasonably apparent that while good economic growth is a very important part of reducing unemployment, growth alone will not be the whole answer. If it was, Europe’s unemployment rates would be much more like that of the United States. There is something in the European system which means that growth is not converted into jobs in the same way as it is in the United States. People who have spent a great deal of time studying these issues have come to the conclusion that the highly regulated labour markets that form part of the continental European world can often work against the interests of job creation. Such labour markets usually have an institutional framework which promotes job security, imposes relatively strict minimum wages and conditions, provides easily accessible sickness and unemployment benefits, and increases trade union involvement in decisions. Diagram 2 % Growth and Unemployment in OECD Countries • • • • • • • • • •• • • • • • • • -5 GDP per capita (average annual growth, 1960 to 1996) % As a result, these systems tend to be good at protecting the interests of those in work - the insiders, but are often not helpful to the longer-term interests of the outsiders - those looking for work. Employers are less keen to offer new jobs because of the higher costs and the difficulty of reversing the decision if it becomes necessary. The unemployed, while having a more generous safety-net than under a US-type system, are less likely to be offered a job and less likely to look for one. A high proportion of long-term unemployed is a feature of continental European countries. Ironically, it seems that measures designed to promote security of employment may well have the effect of limiting the extent of employment. I think we know that there are elements of this story in our own case too. It is not as though the Australian economy has suffered particularly bad growth in the last twenty years. It grew more slowly than in the 1960s, but everyone suffered that slowdown. We have had several periods of reasonably solid growth by international standards. On each occasion, we have, unfortunately, found the limits to growth. But we still have high unemployment by the standards of the United States, New Zealand and the United Kingdom and, more importantly, by the standards of what we ourselves regard as acceptable. Why does our unemployment performance have rather more in common with the continental European countries than we would like? Is it perhaps because our labour market institutions also have much in common? Our labour market was never as deregulated as the United States and we have not gone through recent deregulations to the same extent as have the United Kingdom and New Zealand. Last year the Government enacted some changes to increase flexibility through the Workplace Relations Act. These changes, simplifying and streamlining arrangements and making it easier to strike bargains, seem to be a move in the right direction. It is too early to judge how substantial the beneficial effects of these changes will be (and it will of course depend on how much use the parties choose to make of the flexibility on offer). On the surface, these reforms were less ambitious than those in the United Kingdom or New Zealand. Changes to labour market arrangements are, of course, politically difficult. One reason is that the insiders have to give something up. Job security is clearly reduced, and some hard-won entitlements may have to be relinquished. More flexibility in wage setting almost certainly entails a wider dispersion of wage rates - that is more wage inequality - and reform of unemployment benefits would place tougher conditions on the unemployed. It is understandable that many people are unwilling to make these changes and why they foresee such worrying phenomena as the “working poor”. Most people in our society, in other words, see general fairness as a relevant criterion in choosing policy outcomes. As a result, we would not want to go completely down the US route, with such extreme differences in incomes between senior executives of companies and the shop floor. But we do not have to go as far as the United States - there is a happy medium in this, as in most things. All I am suggesting is that we should re-examine our labour market institutions to see whether they are protecting those in jobs at the expense of those looking for jobs. At the same time, while income inequality may not seem fair, unemployment is not very fair either. Some of our labour market regulations, and many of our attitudes towards labour market outcomes, indeed some of our very ideas about fairness, stem from a time when the unemployment rate was 2 or 3 per cent. It was inconceivable then that unemployment would have an upward trend over twenty years, or that labour market regulation would have any significant role in that process. But the world has changed, and our ideas about what sorts of labour market arrangements are appropriate need to change too. This is already happening, as evidenced by recent reforms. My guess, however, is that this will not complete the process. Conclusion I began by talking about the need to lengthen the economic expansion. This, achieved by keeping inflation at bay, is the best contribution monetary policy can make to the long-term health of the economy. That long-term focus does not mean that we are too cautious, that we never take a risk; it simply means that we weigh the risks and rewards of policy actions over longer time horizons than many of the commentators on the economic scene which fill our newspapers and airwaves each day. We want an expanding economy, and low inflation. That offers the prospect that progress can be made in addressing the rate of unemployment, which remains too high by any standard in Australia. We fear, however, that the debate about whether unemployment will or will not reach supposed “targets” over the next year is missing the main point. Faster growth over the next year or two will help reduce unemployment. But it would be a great shame if that decline obscured the longer-term aspect to unemployment, which endures beyond the business cycle. | reserve bank of australia | 1,997 | 5 |
Talk by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, to the Australian Institute of Banking and Finance in Canberra on 12/6/97. | Mr. Thompson discusses the many faces of risk in banking in Australia Talk by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, to the Australian Institute of Banking and Finance in Canberra on 12/6/97. Introduction I would like to talk today about various aspects of risk in banking. One modern notion is that banking essentially consists of processing information and managing risk. While the average person in the street probably has a more prosaic - not to say jaundiced - view of banks, risk management is indeed very much a core activity for bankers. And it is of fundamental concern to bank supervisors, such as the RBA, that banks are doing this job reasonably well - that all the big risks are identified clearly, measured accurately, monitored continuously and kept within prudent bounds. Bank supervision in recent years has focused much more intensively on the quality of the systems which banks use for these tasks. It seems that banks and their supervisors are having to contend with a steadily growing array of risks. Derivatives risk, operational risk and environmental risk have all come to prominence in the past decade or so. And public relations risk is a major ongoing challenge for banks! One even hears occasionally of “regulation risk” - which seems to relate to the capricious demands of regulatory agencies. Needless to say, this one has not been high on our list of concerns for the Australian banking system! I propose to touch on only three areas of banking risk: - old-fashioned credit risk; interbank settlement risk; and the Year 2000 problem - a kind of operational risk visited upon the world by the approach of the new millenium, and the short-sightedness of 1970s computer programmers with a penchant for abbreviation! Credit risk All of the major periods of stress in Australian banking have been caused by credit losses. In the most recent episode - in the late 1980s and early 1990s - banks wrote off over $25 billion in loan losses. There have been recent comments from some bankers and others that lending standards are slackening once again, perhaps threatening another such round. One reaction would be that these comments are rather alarmist. After all, on most indicators, banks’ asset quality position is very sound. Impaired loans are less than one per cent of their total assets, the lowest point since we started collecting statistics seven years ago. Furthermore, the rate at which assets are becoming impaired has been stable for some time, and shows no signs of an upturn. “Past due” loans kicked up in 1995 and early 1996 but have stabilised recently, still at relatively low levels. The broader environment also has fewer worrying features than in the 1980s: - - aggregate bank credit is expanding much less rapidly than then (although inflation rates are also down quite a bit); the financial position of business borrowers is generally quite healthy with debt to equity ratios lower, and interest coverage higher, than in the late 1980s; and while asset prices are rising, there is no sign of the bubbles we saw in the 1980s; commercial property prices are up only modestly from their low points of 1993. We also have the general impression that banks have a better handle on their credit risks than they did ten years ago. With more centralised credit management, banks can now aggregate exposures to clients and industries, a basic capability which was sadly lacking then. Some of the bigger banks have specialised units to monitor their property exposures. I also suspect that the corporate structures which contributed to problems in the late 1980s are less likely to be tolerated by lenders today. This is all reassuring, but it is certainly no reason for complacency. There is little doubt that current lending standards are less stringent than they were a couple of years ago. Our observations during visits to banks support the market anecdotes on this. There has been a clear narrowing in interest margins for big corporate borrowers and some relaxation in the loan covenants which apply. It’s only a slight exaggeration to say that high quality corporate borrowers can virtually write their own terms and conditions; and some lenders are prepared to lend for very long terms at low margins. For lesser quality clients there appears to have been some drift back toward negative pledge and interest-only lending. The main reason for this is more intense competition among all banks as they strive to keep or build market share in an environment where it is also becoming easier for major corporates to tap debt markets directly. At the smaller end of the market the signs of looser lending standards are less clear. We have, however, seen more facilities where requirements for personal guarantees have been relaxed. It’s also possible that some of the regional banks might, in their eagerness to diversify loan portfolios, be lending to clients that major banks are turning away. It is, of course, not possible to interpret all these trends unequivocally as indicators of unsound banking. And it would be unrealistic to expect impaired assets to stay as low as they are now. Credit quality necessarily ebbs and flows with the fortunes of the economy and particular sectors. What is important is that any deterioration is manageable against banks’ capital, and that they recognise early the need for additional provisions. On balance, we believe that some current lending practices do risk sowing the seeds of future credit quality problems for banks. Chief executives and boards should be considering carefully whether the additional point of market share that might be won now by lending to marginal propositions is worth the pain of future losses, the resources needed for loan workouts, and so on. They should also be alert to the possibility that the household sector might feature more strongly in the next upswing of losses. Household debt has increased a good deal more quickly than incomes in recent years. The RBA recently organised a Credit Conference to review trends in credit risk management, with participants including a number of leading bankers and accountants. A volume of readings and a summary of discussion will be published soon. The main theme from the Conference was how credit risk assessment and management are becoming more objective, more scientific. One speaker described this as moving from an “experience-centric” approach to “data-centric” models. With standard products such as mortgages, consumer loans, credit cards and (to some extent) small business loans, quite sophisticated statistical methods are beginning to be applied to estimating default risk. The aim is to see, from an analysis of history, which data are most helpful in predicting the probability of default. Such analysis produces “scorecards” for use in processing loan requests. Increasingly, consumer loans are being managed on a portfolio basis, with banks calculating expected losses for various broad product categories. Some are tracking the migration of loans through various stages of delinquency to help determine the proportion which will ultimately incur a loss. By updating the amounts at each stage, and adjusting migration rates in the light of current information, banks aim to measure more accurately the current risks in their portfolios. At the “bigger” end of the loan market, a lot of attention is being given to the accuracy and timeliness of risk-grading systems. To grade loans, the more sophisticated banks are now using complex statistical models based on financial information about borrowers or on equity prices. These feed into decisions about pricing, provisioning and portfolio balance. Securitisation, the development of secondary markets and the use of credit derivatives are other facets of the more scientific management of credit risk. These trends are, of course, to be encouraged. The new tools should not, however, be regarded as guarantees against unexpected credit problems. For one thing, their usefulness depends critically on the quality and relevance of the historical information which goes into them. Most banks have detailed asset quality data for no more than a few years, covering not even one full credit cycle. Even where good data are available, it is uncertain how closely past relationships will hold for the future. There would be dangers, therefore, if automated systems were used uncritically, without an understanding of their limitations. Even when these models have been extensively road tested and their predictions assessed carefully, it is unlikely that they will do away with the need for overriding judgments about economic prospects and the outlook for particular industries and sectors. On the other hand, the new techniques do provide an objective framework for decisions about pricing and capital allocation. While it would be foolish to rely blindly on them, it would be as dangerous if they were too easily overridden by competitive pressures. As another participant at our Conference asked: will banks be willing to forego business that is apparently priced in line with the prevailing market just because a risk-based model indicates that it would dilute shareholder value? There is no doubt that such questions should be resolved at the highest levels in banks. They should not be left to business-driven relationship managers. Needless to say, we will be keen observers of banks’ lending practices over the next couple of years. Interbank settlement risk and RTGS Naturally we in the RBA, like almost everyone else, would prefer not to contemplate the failure of a bank. But bank failures have happened from time to time in other countries - despite the best endeavours of managers and regulators. And it would be foolish to turn a blind eye to this possibility in Australia, because a bank failure is not only very damaging for the depositors immediately affected, but it can create a wave of problems flowing well beyond that particular institution. This flow-on damage can occur in various ways, including through effects on depositor confidence, but perhaps the most important channel is the payments system. If a bank in difficulty has large unsettled payment obligations to other banks, those banks will inevitably share some of the pain. There could then be further effects which cannot be predicted with any precision. In the past Australian banks have not paid much attention to interbank settlement risk; indeed, they have had no way of monitoring their exposures to each other during the day. They operated on the presumption that, as long as they exchanged payments only with supervised banks, the central bank would “sort out” a settlement problem in the unlikely event that one arose. This is hardly a sound basis on which to proceed - from either a commercial or a public policy viewpoint. It leaves individual banks potentially exposed to large losses which, because of the broader ramifications, tax payers might end up having to cover. To achieve a more satisfactory position, Australia is now travelling the path of many other countries in introducing a real-time gross settlement - that is, RTGS - system for interbank payments. Under RTGS, high-value payments will be settled continuously across banks’ accounts with the RBA - rather than being accumulated, left hanging overnight and settled up in one hit the following morning. On an average day payments exchanged among banks but not settled until the next day come to over $90 billion. RTGS will, at the outset, eliminate about two-thirds of that overnight exposure. It will also give Australia a fully-fledged delivery-versuspayment system for transactions in debt securities. With banks and other payments providers, the RBA began building the RTGS system in 1995. This has been a major undertaking - with a development cost across the industry of around $120 million. The project is technically complex, but its biggest challenges have been reaching agreement on the architecture and rules for a system which all high-value payments providers will use on an equal and open basis. Progress has not been rapid, or without occasional friction, but it has been steady. The key components of the system are now falling into place: - last month, the RBA’s central site - where interbank payments will be processed in real time - became available for testing by the industry; by early next month, this central site will be fully operational; by August, the industry’s system for delivering payments to the central site using SWIFT messages should be tested and ready to use; - over subsequent months, high-value interbank payments will be moved progressively onto the new system, although ultimate settlement will, for the time being, still be the following morning. Full implementation of RTGS is scheduled for April next year. Whether this is achieved now depends largely on the commitment of the industry, especially the major banks. As we get closer to RTGS “going live”, more thought is being given to its practical implications for banks and their customers. Perhaps the most important of these is the daily management of liquidity. With payments able to flow across banks’ settlement accounts at the RBA only if the paying bank has sufficient funds, liquidity will clearly become more of an issue than it is now - when a bank needs only enough funds to extinguish any net obligation to others each morning. Under RTGS, banks will need to manage their liquidity more carefully or run the risk of being unable to send an important payment at the required time. Banks are starting to give attention to this task - studying the patterns in their payment flows and upgrading their systems so they can monitor and manage flows on an aggregate basis across their business. There will inevitably be implications for corporates in this. RTGS will cause banks to focus more sharply on the amount of credit extended to customers during the day. Because they will have to manage their own liquidity more closely on a real-time basis, banks will (understandably) want to control their customer exposures, and the demands which these place on liquidity, more tightly than before. Payment requests will have priorities attached. Corporates may need to negotiate facilities to ensure that time-critical payments will flow when they are expected by suppliers and counterparties. As a result, some will no doubt choose to plan their payments and receipts more actively than in the past. Our impression from recent discussions with corporate treasurers is that very few, if any, banks have yet done much talking to their customers about these issues. More careful management of liquidity by banks and their customers will reduce the likelihood of payments “gridlock” under RTGS. For its part, the RBA has taken various decisions aimed at ensuring adequate liquidity will be available, at a reasonable cost, across the system as a whole. We will enter into securities repurchase agreements with banks to provide them with intra-day funds at virtually no cost. We will allow banks to dip into their PAR assets for such transactions. The range of assets eligible for repos with the RBA has also just been expanded. Finally, as banker to the Commonwealth, we will use our control over government payments to inject funds early in the day. It remains to be seen whether other devices will be needed to lubricate the system. In some places, such as the United Kingdom and Hong Kong, banks are required to send a minimum proportion of their payments early in the day to provide liquidity for the market. We will monitor flows to assess whether such “affirmative action” is necessary in Australia. It will, of course, be essential that most high-value payments are settled real-time when the new system is available. Anything less would defeat the purpose for which it is being built. There have been suggestions that some banks might by-pass RTGS by using lower cost (but higher risk) channels, such as the Direct Entry system which is designed for high volumes of small payments and settles on a net deferred basis. If this were to happen, we would have to consider what incentives or sanctions were needed to ensure that high-value payments travel along the RTGS path. RTGS will not, of itself, remove the risks that banks incur in international payments - in particular, the risks arising from non-synchronisation of payments and receipts in foreign exchange transactions. Having RTGS for domestic transactions is, however, a necessary step toward tackling this. We’re currently investigating the extent of Australian banks’ settlement risks in their foreign exchange business. This is the next major frontier for risk reduction in banking. Operational risk and Year 2000 As their business becomes more complex and diverse, banks are increasingly reliant on computers for information-processing and control. As a result, they are exposed to various kinds of operational risk. For a bank active in derivatives trading, a breakdown in computer systems for even a relatively short time could be disastrous - preventing it from monitoring its changing market positions and disrupting its capacity to trade and to settle outstanding transactions. I recently heard a keen observer predict that the next big banking disaster would come from a (hypothetical) major international bank losing track of its derivatives positions for 24 hours. To protect against such events, banks invest heavily in the integrity of their computer systems, as well as in back-up and disaster recovery facilities. The RBA is, of course, providing such back-up for the core of the RTGS system. The Year 2000 problem poses a rather novel sort of operational risk because it is the result of past programming decisions which have produced the classic “unintended consequence”. Basically, the risk is computer confusion and malfunction when the year identified in programming as “99” clicks over to “00”. The upshot for Australian banks is the need to spend big sums on replacing or reprogramming their date-dependent computer systems. For the four majors alone, the total cost could be well over $350 million. As the calendar moves forward, the need to get on with addressing this problem becomes more urgent. In the United States, Federal regulators have recommended that financial institutions complete all necessary reprogramming by the end of 1998 to allow time for thorough testing before January 2000. This will be needed because, in changing a lot of banking software, new bugs could be introduced along the way. More aggressive targets have been set for large banks where computer problems could do broad damage to the working of the financial system. The RBA is currently seeking assurance that Australian banks are giving the Year 2000 problem the high priority it warrants. We recently sent them a questionnaire asking each about progress in identifying the size of the problem for its operations, in drawing up a management program to fix it and in assigning the necessary resources. They should also be finding out what their major customers are doing about it. Fixing the Year 2000 problem is not a glamorous task - but it is no less important for that. In this respect, it is much like the challenge of managing banking risks generally. | reserve bank of australia | 1,997 | 7 |
Talk by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the Melbourne Institute of Applied Economic and Social Research Conference on "Business Cycles: Policy and Analysis" held in Melbourne on 5/9/97. | Mr. Grenville discusses the Reserve Bank of Australia and the business cycle* Talk by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the Melbourne Institute of Applied Economic and Social Research Conference on “Business Cycles: Policy and Analysis” held in Melbourne on 5/9/97. “Real output … fluctuates around a rising trend.” (Solow 1997, p. 230). This seemingly innocuous statement encompasses much of what practical, operational macro-economics is about: how to raise the trend; and how to reduce fluctuations around this trend. This talk focuses on what monetary policy might do to reduce fluctuations around the trend. The Governor spoke only a few weeks ago about what monetary policy might do for growth (Macfarlane 1997). In a nutshell, price stability will be generally helpful to long-term growth because it ensures resources are deployed more efficiently, but the main sources of growth are to be found in increases in labour inputs and productivity. What about monetary policy and the cycle? The starting point is that life would be more comfortable all around if the cyclical swings are not too big and if the bumps in various parts of the economy are not too coincident. It seems likely, too, that however convenient it is analytically to separate trend from fluctuations, there will be a link between the cycle and either the level of GDP or its trend growth rate. If the severity of the downturns is reduced and the economy operates with a smaller output gap, then the level of income over time is, on average, higher. As well, big swings (such as 1982 and 1990) risk hysteresis: the process of winding unemployment down again has proved to be slow and difficult. Is there anything to be said on the other side of the argument? You will recall the Schumpeterian argument that cycles have some cathartic, cleansing function. I have more faith in competition to ensure that the benefit of technology is introduced as quickly as it should be, and so I do not see a vital need for the Schumpeterian cleansing process. But, in any case, however successful policy may be, enough of a cycle seems likely to remain, in order to ensure the Schumpeterian process has the opportunity to take place.1 So let us take as given that it is desirable to have as little cycle as possible, and examine two aspects of this. First, the role of monetary policy in the cycle, and secondly, how the cycle may have changed over time to alter the way monetary policy impinges on the cycle. Characteristics of monetary policy A thumb-nail sketch of history serves as a reminder that the role of monetary policy in the cycle has been the subject of changing views over the years. • For the first couple of decades of this century, the gold standard was the undisputed centre-point of monetary policy, anchoring prices. Income smoothing was not an objective of monetary policy. The result -unsurprisingly -- was that price level stability was maintained (in the sense * David Gruen, John Hawkins and Amanda Thornton helped greatly in the preparation of this paper. The usual disclaimer applies. To explore the issues raised by Real Business Cycle theory, with its implication that cycles are the result of optimal responses to supply-side shocks, would take us too far afield here. Let me put my biases on the record by agreeing with Solow’s comment: “This explanation has been an empirical failure, or at best a non-success” (Solow 1997, p. 230). that there was a longer-term anchor which forced the price level back towards its starting point), but there was considerable variation (both in prices and in output) in the short term. • The Depression forced a re-appraisal, but fiscal policy became the instrument to smooth the fluctuations in output -- monetary policy was seen to be caught in the infamous liquidity trap. This idea has not entirely disappeared, and the notion of “pushing on a string” still has currency. • Somewhere in the ensuing decade or two, monetary policy emerged as a counter-cyclical co-player, on a par with fiscal policy. There was no particular, specialised difference between monetary policy and fiscal policy (at least in the eyes of most policy-makers) -- inflation control and cyclical smoothing were more or less the same task. Inevitably, in time, the attempt was made to squeeze more out of the Phillips curve trade-off than was available. • By the 1970s, a clear specialisation had developed (most precisely enunciated in the academic literature, but reflected also in operational monetary policy). The over-use of the Keynesian tools had unanchored price expectations, and the OPEC oil price shock contributed to the reassessment. Most central banks in industrial countries adopted a monetary target, specifically aimed at achieving price stability. • The high water of this monetarist view occurred around 1980. Over the next five years, it rapidly lost its pivotal role, because the key relationship in this view-of-the-world broke down -- the relationship between money and nominal income turned out to be unstable.2 With the breakdown of the anchor of a stable money demand function, practitioners were forced to look elsewhere. In our own case, it has taken us, eventually, to an inflation target. But others have put forward the view that monetary policy should only care about price stability, without any direct concern with output. The origins of this can be found in Friedman’s monetarism (he was, of course, concerned above all with price stability). It seems only a minor elision to slip from monetarism to a single objective for monetary policy. But the point to note here is that the old monetary rules had an important element of income smoothing built into them -- when output slowed in the course of the cycle, money supply rules produced a more-or-less automatic easing of monetary policy, because the central relationship was between money and nominal income. As the stability of the monetary demand relationship broke down, it would have been logical enough to focus on the next link of the causal chain, and replace money by nominal income as the target. There were lasting legacies of this period. An important and useful element of the thinking at the time was the replacement of the earlier “control theory” approach to policy (i.e. the belief that the central point was to find an appropriate spot on the Phillips curve and to stay there), towards a “game theoretic” view, in which the critical issues related to behaviour -- the interaction between the monetary authorities and the public. In Australia, the Reserve Bank never accepted the degree of policy instrument specialisation found in the academic literature, particularly as wages policy was also addressing inflation control. Partly because most inflation problems were demand-driven over the course of the cycle, there was a continuing belief that if the cycle could be smoothed, inflation would be contained, and both fiscal or monetary policy were available instruments in addressing the cycle. Curiously, however, the de facto inheritors of this stream of thought took price stability -- the long-term element of monetarism -- and made it a short-term target. In this view of the world, there was no role at all for monetary policy as a cyclical buffer. How was this justified? The arguments put forward were: • the classical dichotomy between prices and activity: money does not affect activity; • what might be called the “Tinbergen proposition”: with one instrument, only one goal can be achieved; • political economy reasons -- usually associated with “time inconsistency” arguments; • a simple, unambiguous commitment to price stability anchors price expectations most effectively, and this benefit is worth the cost that might come from ignoring activity; • the lags in recognition and implementation of policy are so long that activity stabilisation is futile or even counter-productive. I have looked at these in some detail in an earlier paper (Grenville 1996), so I will be brief here. The classical dichotomy between prices and activity reminds central bankers of their long-term priorities, but even though the long-run Phillips curve may be vertical, the short-run curves are certainly not. The Tinbergen proposition is superficially attractive, but not much help in practical decision-making. Trade-offs between various objectives are common to policy-making (and just about every aspect of life), and these trade-offs have to be handled by a weighing of the conflicting objectives, not by ignoring one of them. The “political economy” aspects have been prominent in the academic literature, and some very neat models can be built to illustrate the issues of time inconsistency. The models usually involve the “monetary authorities” (no distinction is made between governments and central banks) making an ex ante commitment to price stability, but reneging on this to squeeze higher activity in the short term, in the form of an “inflation surprise” (Kydland and Prescott 1977). The simple versions of the arguments have never appealed much to central bankers who believe that their own reputation is at stake and who, because of this, are unlikely to exploit the short-term Phillips curve trade-off. To see central bankers as congenitally inclined to administer “inflation surprises” does not seem to capture their true character.3 If there is a problem here, it seems more likely to lie in the political interaction of policy-making between governments and central banks and it is best addressed by greater independence, not by imposing a single objective on the central bank. What about the role of a simple single price objective in anchoring price expectations? A decade or so ago, there was a realistic hope that the clear enunciation of a target for prices would stabilise price expectations. It would have to be said that the experience of the last decade would suggest that expectations are to a very large degree backward-looking. Central banks give prominence to their price stability objective in an attempt to influence price Blinder (1997, p. 13) describes this as: “One place where academic economists have been barking loudly up the wrong tree”. expectations in this way, and it seems sensible for them to do so. But it would be a mistake to think that there is a big dividend waiting to be reaped here. Whether the lags in recognition and implementation are so long as to make the operation of monetary policy perverse in relation to the business cycle is something that can be established only empirically. Like most empirical matters, there is room for considerable difference of opinion. While the lags seem to be (as Friedman promised) “long and variable”, a policy which leans against the business cycle with a view to containing demand-driven inflation will generally affect activity beneficially rather than perversely.4 At the other end of the spectrum is the view that “central bank manipulation of financial variables has seemingly exaggerated, not smoothed, economic fluctuations” (Makin 1993, p. 12). One problem in this sort of assessment is that we do not know the counter-factual. What we do know, however, is that cycles are endemic to all economies. So the counter-factual is not straight-line growth. We know, too, that Australia’s cycles are broadly the same as those in other similar countries. In a world where cycles are universal and endemic, it is easy to blame the authorities for the failure of the economy to proceed along a steady path, perfectly aligned with trend growth. As the upswing accelerates, policy is tightened: it is then blamed for being too slow to react. When the inevitable downturn comes, the firm policies that are in place at that time are pronounced “guilty by association”. The appropriate counter-factual should specify an alternative policy regime, and compare the performance under this rule.5 One relevant issue here is: how strong are the “self-righting” forces which tend to take unemployment back towards its natural rate? If these are strong, the case for an activity component in policy-making is weaker. To put this more specifically, will the in-built stabilising forces operate more quickly than the lags in monetary policy? The important empirical issue here is the lags in policy, interacting with the uncertainty of forecasts. Most estimates of the lags suggest that a change in interest rates has its maximum effect on activity after about four to six quarters. This is often popularly interpreted to mean that nothing happens, after the monetary policy lever is pulled, for four or six quarters. Of course, this is quite wrong. Even with these estimates, there is a fair bit of action during the first year, and provided forecasts are sufficiently accurate, it is possible for policy to be effective over shorter lengths of time -- for instance, if it was desired to have an effect for the next year only, policy could be reversed some time during the year to achieve rough neutrality beyond the period of a year (Gruen, Romalis and Chandra 1997).6 For some econometric support of this view, see Dungey and Pagan (1997, pp. 31-34). Makin’s alternative is money-base targeting. The Bank has written extensively on money rules (the widest variety of tests appears in de Brouwer, Ng and Subbaraman (1993)). Makin’s model is Switzerland (the only major central bank that has tried to implement a money-base rule) in the 1980s, but this hardly seems a supporting example. Switzerland still has business cycles and experienced inflation of nearly 7 per cent in the late 1980s. I should record, very much in parentheses, my own biases that these lags are consistently over-estimated, and that when we find more subtle techniques of econometric testing, we will find that the lags are shorter. This is based on pure, intuitive observation, particularly of the 1994 experience, where the effect of monetary policy seemed to be quite quick. This is a reminder that there are, essentially, two problems with the econometric method used to establish lag lengths. The first is the implicit assumption that the lags are much the same length from episode to episode (occasionally there are tests for changing lag length, as in Gruen et al. (1997)), whereas it may be that the lag depends very much on the particular episode. Where actors in the economy quickly come to believe that the authorities are determined to slow a speeding economy, it may well be that the lags are quite short. The contrast here is between 1988 (long lags) and 1994 (short). The other problem is the classic one of separately identifying the policy reaction function and the effect of policy on the economy. Relatively early in the upswing, policy is tightened, but there is no discernible response because the upswing still has a good deal of Perhaps a more telling argument is that it is simply not sensible -- or even possible -- to ignore the cycle, unless a suitable “neutral” operating rule can be found for setting monetary policy. The monetary aggregates were, in this sense, a “neutral” rule. They could provide an operating rule for monetary policy which could be relied on to influence activity beneficially in the face of demand shocks: a monetary rule exercises some degree of counter-cyclical influence, without any overt discretionary action. But with the breakdown of the close relationship between money and nominal income, such a monetary rule is not a satisfactory “automatic pilot” for policy, and no similarly neutral rule suggests itself. One possible “neutral” monetary policy would be to leave real interest rates unchanged, but it is hard to see that, in practice, this would be sustainable in the face of an economy either running abnormally quickly or slowly -- there would be continuing questions about whether the real interest rate that had been chosen was neutral or was, in fact, skewed in one direction or the other. Also, such a rule would not tie down the rate of inflation -- for this you need a nominal rather than a real objective. Another possibility that can be rejected fairly quickly is the rule of thumb apparently sometimes offered in the face of medical uncertainty: “First do no harm”. This may be sensible if medical malpractice suits threaten, but hardly seems a proper basis for economic policy, as it seems to be unduly biased towards inaction. Equally easy to dismiss are those who suggest that we should do something to control inflation, but say that the lags between policy and activity are so long and uncertain that we should never try to do anything to influence activity. The problem with this suggestion is that if the lags between policy and activity are long, uncertain and variable, then the lags between policy and inflation are longer and more uncertain still. In a world where demand shocks are common and policy operates on inflation largely via activity, it is hard to conceive of an anti-inflation policy which was somehow directed solely at inflation, in the belief that an attempt to direct it at activity will cause more problems than it solves. 7 Given the long lags in policy, there would seem to be a prima facie case for the authorities moving not just pre-emptively, but by large amounts whenever they believe that the cycle is turning. Such a policy has been advocated by Goodhart (1992).8 Curiously, in the light of these arguments, policy in Australia and just about everywhere seems to do precisely the opposite -- it has the characteristic of “interest rate smoothing”. Others in the Bank have written about this recently (see Lowe and Ellis (1997)), so I can cover this quite briefly. In short, the reasons seem to be: • uncertainty. Thirty years ago, Brainard established that, if policy-makers are uncertain about the effect of their policies, they should do less than they think would otherwise be optimal; • if policy-makers erred by applying too much of the instrument against the cycle, they would surely be severely blamed for it; on the other hand, momentum. In this phase, the econometrics are trying to separate two effects with different signs, and to the extent that these two effects are confounded (because, for example, the equation may not embody a perfect explanation for the non-policy forces operating on activity), this negates or reduces the apparent power of monetary policy in this early phase of the cycle. In this view of the world, the econometrically-estimated lag lengths are as much a reflection of the periodicity of the cycle as they are of the lags of monetary policy. For those who prefer a more formal explanation of the same point, see de Brouwer and O’Regan (1997). “Central bankers need to brave their innate caution and be prepared to vary nominal interest rates sharply, both up and down.” (Goodhart 1992, p. 333). dampening the cycle without entirely eliminating it is seen as an acceptable outcome. In this world, policy-makers are more likely to lean on the side of caution in exercising their instrument. In short, the arguments about the difficulties of influencing activity should make central bankers cautious and modest about their role as cyclical stabilisers, but do not excuse them from taking the cycle into account in setting policy, and doing what they can to lop peaks and fill troughs. With inflation down, a consensus among central banks seems to be emerging. Central banks still give very high priority to inflation control (they are, after all, the embodiment of Rogoff’s anti-inflationary central banker), but they do not, generally, focus exclusively on price stability. The arguments are essentially empirical ones, with the focus on the question: “how fast can the economy grow while maintaining price stability?” You will note the Reserve Bank’s rhetoric is precisely along these lines, with policy driven by common-sense and a strenuous effort to understand the cycle, rather than some doctrinal adherence to a simple rule. Has the cycle changed (and if so, how)? There is much talk, particularly in America, of a New Era in economics -- of rapid growth, no cycles and price stability. While something important and beneficial does seem to be happening in the United States, we need to separate out what is possible from the wishful thinking. We all hope that productivity is higher than before: this is possible and might add modestly to US long-term growth potential, which has in the past been put at around 2-2½ per cent. We hope that, with price stability well established and various other changes in the economy (on which, more later), the amplitude of cycles might be lessened and policy may be more effective. We hope, also, that prices are well anchored by America’s good record of low inflation. But the fundamental law of economics -- scarcity -- has not been repealed. The factors that are held to be responsible for the New Era -- “globalisation of production, changes in finance, the nature of employment, government policy, emerging markets, and information technology” (Weber 1997, p. 71) -- will all be helpful, but they raise the long-term sustainable growth rate only to the extent to which they raise productivity growth on an on-going basis. If the actual rate of growth exceeds the long-term potential, sooner or later pressure comes on resources and inflation will be the result. The same helpful factors may well apply in Australia: • if some kind of multiplier/accelerator process is the driving force of the cycle, we know that the type of investment has changed substantially over the years, with large fixed long-term investment becoming less important and short-term investments (such as computers) becoming more important. The old traditional driving force was the inventory cycle. Work done at the Bank (Flood and Lowe 1993) shows a clear change in the cyclical pattern. The average quarterly contribution of inventory investment to GDP(E) has fallen from close to 1 per cent in 1960/61-1971/72 to around a quarter of that in 1984/85-1995/96 (with smaller standard deviations as well). This confirms our intuitive observation of the prevalence of “just in time” inventory systems.9 What is clear, too, is that service industries (with much more limited stock-holding) have become very much more important; Of course, the story has to be more complicated than this, because “just in time” simply pushes the problem back to a different stage of production, and raises the question that if inventories are not acting as a buffer for production, then perhaps the processes of production become more cyclical. • as cyclical components of production become less dominant, the cycle may be attenuated. Manufacturing, construction and wholesale trade have been the production sectors most correlated with the overall cycle and these, together, have fallen from nearly 40 per cent of production in 1974/75 to just over 30 per cent in 1995/96. As the economy becomes more complex and varied, correlation between sectors diminishes: the tourism sector may be doing well when house construction is slow; • perhaps the most important on-going change to the cycle is the continuing integration of Australia with the international economy. Thirty years ago, 10 per cent of (real) GDP was exported; now it is almost 25 per cent. When domestic demand rises, there is much greater capacity than before for this to “spill” overseas, into imports. All this is for others to examine in more detail. The focus here is on just one aspect of the way the cycle might have changed over time -- that is, how the interaction between monetary policy and the cycle may have altered. First, has financial deregulation changed the interaction between monetary policy and the cycle? This was certainly expected to be one of the impacts of financial deregulation. The Campbell Inquiry talked about it.10 In the housing sector, for example, the upswing of the cycle suddenly came up against the restraints of quantitative controls, and this was enough to turn the cycle down. In the old, regulated world, firms and households were not able to borrow enough to smooth their expenditure over time (they were “liquidity constrained” -- see Blundell-Wignall and Bullock (1992)). It may well be that deregulation has removed these old constraints, but at the same time, it seems to have had some tendency to encourage or at least facilitate large or longer swings of the cycle. To put it crudely, financial deregulation provided more rope for the cycle to swing with greater amplitude. It would be easy to exaggerate the importance of this effect, because there were very large swings in the housing sector before deregulation, and asset-price booms and busts occurred even in the regulated world. We might hope, too, that some lessons have been learned from the asset boom of the late 1980s. The conclusion that can be drawn is that those who expected financial deregulation to smooth the cycle by itself have been disappointed. One specific aspect of deregulation -- the floating of the exchange rate -- has altered the transmission of monetary policy in a way which should have smoothed the cycle. One of the characteristics of the floating exchange rate is that its movement more or less mirrors the course of the cycle, with an appreciation of the exchange rate at those moments when the cycle is running fastest. Partly this reflects the impact of commodity prices on the exchange rate, but it also reflects the policy response of interest rates over the course of the cycle. The result is that demand is more readily “spilt” into imports during the expansionary phase of the cycle, so production is buffered. (This reinforces the effect of greater international integration, mentioned “The Committee concludes that, in the long run, housing financiers’ inflows would be more stable if their interest rates were allowed to move in line with market forces. Coupled with greater overall monetary stability, interest rate decontrol may help appreciably to stabilise housing finance flows, especially as household sector investors have become more interest-rate sensitive. The reduced volatility in funds flows should contribute to a more stable housing sector over the long term. This might result in a slower growth in housing costs.” (Australian Financial System Inquiry 1981, p. 639). above.)11 Even this, however, does not ensure that the new world of the floating exchange rate makes the cycle smoother: it can be argued that in the old fixed-exchange-rate world, policy reacted earlier to stop the expansionary phase of the cycle, for fear of it spilling over into an unacceptable current account deficit. So, once again, financial deregulation has given the cycle, for better or worse, more room for manoeuvre. The old world of “stop/start” did not have much to recommend it, but nor did the world of the late 1980s, where an asset boom developed a big head of steam and inevitably was damaging when it came to an end. The floating exchange rate probably allows expansions to last longer, but does not ensure that they end gently. Graph 1: Graph 2: This history makes us look for a degree of caution in policy-making, aiming for longer, gentler phases in the cycle. There is nothing in the historical patterns of the cycle which suggests that they have a pendulum-like determinancy. On the contrary, the variation in length and amplitude (contrast, for example, 1986 with 1982 or 1990: see also Graph 2) would suggest that the shape of the cycle is not at all regular and pre-determined. While it may be possible to explain cycles in terms of “a stochastically disturbed difference equation of very low order” (Lucas 1977), the true causes seem less mechanical than this might imply, particularly if the implication is that cycles are unaffected by and unresponsive to policy. Graph 1 shows the combined effect. This effect was noted, in the early 1960s, by Burge Cameron. Has greater integration and a flexible exchange rate made this effect stronger over time? There was a fair bit of exchange rate flexibility in the 1970s, so the proper comparison may need to go back earlier. The hope is that the upswing which has been underway since 1991 can go for quite some time yet. This may well require it to travel at a sedate pace at certain stages during the expansion, and we have certainly witnessed this over the past two years or so. But this seems far preferable to an economy which is running clearly too fast and has to be brought to a sudden halt. While it is true that the economy might well have grown a bit faster over the past two years without this igniting inflationary pressures, the one factor that most economists agree on is that monetary policy cannot fine-tune the cycle. Let me develop this idea by looking in detail at the 1994 experience. The starting point here was an economy which began to grow too fast, with demand growing at 7 per cent in the year to the September quarter, and excessive wage demands. The Bank judged that this would produce inflationary pressures, and so raised interest rates three times in relatively quick succession in the second half of 1994. As far as we can tell, this was a necessary adjustment of policy, because the classic symptoms of excess demand emerged over the 1994/95 period with wages accelerating (to reach over 5 per cent by the middle of 1995, despite high unemployment, at around 9 per cent) and then, lagged behind this, inflation rising to 3.3 per cent. Given the fragile nature of price expectations and the importance of getting actual inflation back towards 2½ per cent relatively quickly to reinforce the stability of price expectations, the response of policy, even with the benefit of hindsight, seems about right. (Graph 3) Graph 3: To round off this section, ensuring that you are not left with a false impression about the Bank’s (limited) ability to tame the cycle, I present Graph 4. This might suggest that the Australian cycle (at least from the early 1980s until the mid 1990s) has followed the American cycle so closely that any other explanation seems superfluous. To put this point differently, the problem in explaining the cycle is not to find the causes of cyclical behaviour, but to decide -- in the face of a wide variety of “culprits” -- which one is, in fact, driving the cycle. In some ways this is like an Agatha Christie detective story, with all the characters equally and obviously suspect. Unlike an Agatha Christie novel, however, it is possible that they all did it, if not simultaneously and in concert, at least more or less coincidentally. The Bank’s - 10 - econometric research certainly gives a very important place to the United States in explaining the Australian cycle (see Gruen and Shuetrim (1994)) and we have looked at the puzzle of why the United States seems so much more important than its trade share would imply (see de Roos and Russell (1996), de Brouwer and Romalis (1996) and Debelle and Preston (1995)). But there is still an important role for monetary policy (Gruen and Shuetrim 1994, and Gruen, Romalis and Chandra 1997). The moral is: don’t expect monetary policy to be able to eliminate the cycle, but don’t ignore its ability to “top and tail” the fluctuations. Graph 4: The cycle and prices The Reserve Bank does expect that its activities will have some beneficial effect on the course of the cycle, but the main focus is on inflation. We accept that there will be some movement of inflation over the course of the cycle, but we want to make sure that inflation does not rise over time (now that price stability has been achieved). You can see this sense of priorities -- with medium-term price stability being the sine qua non, and our acceptance that inflation may vary a little over the course of the cycle -- in the specification of the inflation target as being an average “over the course of the cycle”. This has caused quite a bit of misinterpretation about the specification. In talking to an audience such as this, I can take the time to set out quite specifically what we have in mind by “over the course of the cycle”. We can go back a bit in history to illustrate the point here. In the 1950s and 1960s (see Graph 5), inflation moved about quite a bit -- from more or less zero to around 5 per cent per annum -- but people look back on this period as “price stability”. Why is that so? The critical issue here is that even though inflation rose and fell over the course of the cycle, price expectations did not move -- even when inflation was running at 5 per cent, the community at large expected it would soon be back to its normal lower pace. Stabilising and maintaining price expectations is the key issue in thinking about the question of “over the course of the cycle”. The - 11 - Graph 5: Bank should not be so trigger happy that it tightens policy at every threat of a price rise (no matter how slight or temporary).There is a trade-off between output stabilisation and price stabilisation (see Debelle and Stevens (1995)), and an attempt to smooth the path of prices perfectly would make policy destabilising. We want to be on -- and stay on -- the short-term Phillips curve associated with 2-3 per cent price expectations. We would not be too fretted if actual inflation moves about a bit over the short term, provided price expectations do not change (i.e. we stay on this short-run curve). To put this in operational terms, if we have limited price stability credibility, we have to be more careful that inflation does not depart much from 2½ per cent, or depart for too long. As credibility builds over time, monetary policy does not have to respond to every hint of inflation, knowing that the small fluctuations in inflation over the course of the cycle will not have any permanent effects. We would then, in effect, be back to the world of the 1950s and 1960s, at least as far as price expectations are concerned. In raising this issue of price movements over the course of the cycle, I should also record that the relationship between activity and prices probably has changed quite a bit over recent years. I have written about this in more detail (Grenville 1997 ), so I will not go into it in detail today. But summarising the argument, there are a number of factors which should make prices less sensitive to the course of the cycle: • the float of the exchange rate; • greater international integration; • greater competition, coming both from international integration and from domestic measures to enhance competition; • better linkages between markets, largely via better transport and communication. All this fits with the earlier discussion of “New Era economics”. These factors help to prevent inflation being triggered by the expansionary phase of the cycle, and limit the propagation of inflation shocks. While we often think of price stability as being a medium-term and long-term problem, the obvious point is that the medium term is made up of a series of short terms -- if short-term hikes in inflation can be avoided, then the problem of maintaining price - 12 - stability in the medium and long term has been solved. But Chairman Greenspan’s warning, in February 1997, about too-ready acceptance of a “New Era” is still relevant: “But, regrettably, history is strewn with visions of such ‘new eras’ that, in the end, have proven to be a mirage. In short, history counsels caution.” (Greenspan 1997). Price stability still requires good monetary policy supported by an anti-inflation consensus. Conclusion Economics has long been known as the dismal science, but in recent years mortality has become a pre-occupation. Judging by recent book titles, not only is the business cycle dead, but so too are inflation, economics, history and capitalism. Following Greenspan’s lead, it would be wise to withhold judgment on the death of the cycle for the moment, or at least borrow Mark Twain’s line and say that the reports are greatly exaggerated. Economies still seem vulnerable to alternating “over optimism … (and) a contrary error of pessimism” as noted by Keynes. Periodic supply-side shocks still seem likely. And policy-makers have not suddenly become omniscient masters of the previously-recalcitrant economy. But two factors should help. The first is the greater price resilience, noted in the previous section. Inflation is not dead, but enhanced competition in goods and factor markets inhibits the propagation of price shocks across the economy. Second, low inflation has now become the international norm. The variance over the course of the cycle has also fallen. In Australia, inflation has averaged 2½ per cent annually for the past six years. The last two sharp downturns (1982 and 1990) followed sharp rises in inflation (including asset inflation) in the previous upswing. If excessive optimism in the upswing can be resisted and inflation can be kept in check, there is a good chance that such sharp downturns can be avoided. Good, forward-looking and far-sighted policy can reduce the amplitude of cycles and lengthen them. The seven-year upswing which started in 1982 (with a “pause that refreshes” in 1986) should not be regarded as the norm: it can be exceeded. The current upswing has, already, lasted almost as long and seems to have a fair bit of life left in it yet. The price that may have to be paid for these long-lasting upswings is to avoid periods of excessive exuberance -this is what brought the 1980s upswing to a halt. This was the motivation for the 1994 policy response -- to avoid the stop/go policies of earlier years. We should, instead, be prepared to allow growth to build momentum over time, without becoming too impatient. This will produce a world of longer expansions, which will not require the extremes of policy-setting which were needed in the late 1980s (or, for that matter, the early 1980s) to bring that expansion (with its asset-price bubble) back under control. References Australian Financial System Inquiry (1981), Australian Financial System: Final Report of the Committee of Inquiry, September 1981, (J.K. Campbell, Chairman), AGPS, Canberra. Blinder, A.S. (1997), ‘Distinguished Lecture on Economics in Government: What Central Bankers Could Learn from Academics -- and Vice Versa’, Journal of Economic Perspectives, Vol. 11, No. 2(Spring), pp. 3-19. Blundell-Wignall, A. and M. Bullock (1992), ‘Changes in the Characteristics of the Australian Business Cycle: Some Lessons for Monetary Policy from the 1980s and Early 1990s’, Reserve Bank of Australia Research Discussion Paper No. 9212. Brainard, W. (1967), ‘Uncertainty and the Effectiveness of Policy’, American Economic Review, May, 57, pp. 411-425. Debelle, G. and B. Preston (1995), ‘Consumption, Investment and International Linkages’, Reserve Bank of Australia Research Discussion Paper No. 9512. - 13 - Debelle, G. and G. Stevens (1995), ‘Monetary Policy Goals for Inflation in Australia’, Reserve Bank of Australia Research Discussion Paper No. 9503. de Brouwer, G., I. Ng and R. Subbaraman (1993), ‘The Demand for Money in Australia: New Tests on an Old Topic’, Reserve Bank of Australia Research Discussion Paper No. 9314. de Brouwer, G. and J. O’Regan (1997), ‘Evaluating Simple Monetary-Policy Rules for Australia’, in P. Lowe (ed.), Monetary Policy and Inflation Targeting, Reserve Bank of Australia, Sydney (forthcoming). de Brouwer, G. and J. Romalis (1996), ‘External Influences on Output: An Industry Analysis’, Reserve Bank of Australia Research Discussion Paper No. 9612. de Roos, N. and B. Russell (1996), ‘Towards an Understanding of Australia’s Co-Movement with Foreign Business Cycles’, Reserve Bank of Australia Research Discussion Paper No. 9607. Dungey, M. and A. Pagan (1997), ‘Towards a Structural VAR Model of the Australian Economy’, Australian National University Working Paper No. 319. Flood, D. and P. Lowe (1993), ‘Inventories and the Business Cycle’, Reserve Bank of Australia Research Discussion Paper No. 9306. Friedman, B. (1995), ‘Does Monetary Policy Affect Real Economic Activity? Why Do We Still Ask This Question?’, NBER Working Paper 5212, August. Goodhart, C. (1992), ‘The Objectives for, and Conduct of, Monetary Policy in the 1990s’, in A. Blundell-Wignall (ed.), Inflation, Disinflation and Monetary Policy, Reserve Bank of Australia, Sydney, pp. 314-334. Greenspan, A. (1997), Monetary Policy Testimony and Report to the Congress, 26 February. Grenville, S.A. (1996), ‘Recent Developments in Monetary Policy: Australia and Abroad’, The Australian Economic Review, 1st Quarter, pp. 29-39. Grenville, S.A. (1997), ‘The Death of Inflation?’, Reserve Bank of Australia Bulletin, May. Gruen, D., J. Romalis and N. Chandra (1997), ‘The Lags of Monetary Policy’, Reserve Bank of Australia Research Discussion Paper No. 9702. Gruen, D. and G. Sheutrim (1994), ‘Internationalisation and the Macroeconomy’, in P. Lowe and J. Dwyer (eds), International Integration of the Australian Economy, Reserve Bank of Australia, Sydney, pp. 309-363. Kydland, F.E. and E.C. Prescott (1977), ‘Rules Rather than Discretion: The Inconsistency of Optimal Plans’, Journal of Political Economy, LXXXV, pp. 473-492. Lowe, P. and L. Ellis (1997), ‘The Smoothing of Official Interest Rates’, in P. Lowe (ed.), Monetary Policy and Inflation Targeting, Reserve Bank of Australia, Sydney (forthcoming). Lucas, R.E. Jr (1977), ‘Understanding Business Cycles’, Carnegie-Rochester Series on Public Policy, Vol. 5, pp. 7-29. Macfarlane, I.J. (1997), ‘Monetary Policy and Economic Growth’, Reserve Bank of Australia Bulletin, August. Makin, T. (1993), ‘Reserve Bank Independence or a Money-Growth Rule?’, Policy, Vol. 9, No. 4, Summer, pp. 9-12. Rogoff, K. (1985), ‘The Optimal Degree of Commitment to an Intermediate Monetary Target’, Quarterly Journal of Economics, Vol. 100, No. 4, pp. 1169-1189. Solow, R.M. (1997), ‘Is There a Core of Usable Macroeconomics We Should All Believe In?’, The American Economic Review, Vol. 87, No. 2, May, pp. 230-232. Weber, S. (1997), ‘The End of the Business Cycle?’, Foreign Affairs, Vol. 76, No. 4, July/August, pp. 65-82. | reserve bank of australia | 1,997 | 9 |
Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the First Pacific Stockbrokers Australasian Banking Conference in Melbourne on 25/9/97. | Mr. Thompson gives his views on the changing scene in the banking industry in Australia Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the First Pacific Stockbrokers Australasian Banking Conference in Melbourne on 25/9/97. It is traditional to open this Conference with a summary of the state of the banking system, as seen from the RBA’s perspective. I will therefore do that first. Then I would like to make some points about the prudential supervision of bank capital. Finally, I will draw out some implications of the Government’s recent financial system policy announcements for competition in banking and payments. State of the banking industry The banking system remains healthy overall, but banks are under strong pressures from new competitors, the cost of systems development and shifts in the structure of financing. Interest margins have been squeezed further over the past year, both by the continuing, intense competition in home and corporate lending and by the low (and falling) levels of interest rates. Domestic net margins have fallen to just under 4 per cent for the major banks (compared with 5 per cent in the late 1980s), and to around 3 per cent for the regionals. • Notwithstanding this squeeze, major banks’ after-tax profits were around 17-18 per cent of shareholders’ funds in the first half of 1997, much the same as their 1996 result. However, for regional banks, which are more reliant on home loans, return on equity fell from around 15 per cent to 13.5 per cent. • Capital ratios declined further over the past year -- helping to bolster rates of return -- due to acquisitions, asset growth and capital buy-backs. The average risk-weighted capital ratio across all banks was 10.3 per cent in June, compared with 11.1 per cent in June 1996 and 12.1 per cent in June 1995. (The ratio for the major banks fell from 10.6 per cent to 9.8 per cent over the past year, for the regionals from 12.4 to 10.8 per cent, and for foreign banks from 15.1 to 14.8 per cent.) • Securitisation of bank assets has increased as a means of reducing required capital, or freeing it up for other uses. In the past year and a half around $3 billion of assets have been moved off balance sheets in this way. (Of course, bank balance sheets are only one source of assets for the expanding securitisation market -- total assets in securitisation vehicles would now be over $20 billion, double the level of two years ago.) • Bank credit (net of securitisation) has grown at an annual rate of around 10 per cent so far in 1997, compared with about 12 per cent during 1996. The main categories have all grown at close to this average. • Asset quality is in good shape, with impaired assets at 0.8 per cent of assets in June 1997, compared to 1.1 per cent a year earlier. Loan write-offs have continued to fall, and loans newly identified as impaired each quarter remain both low and steady. Banks are responding to margin squeeze on several fronts. There has been further unwinding of the longstanding cross-subsidisation of transactions and account-keeping services out of interest margins. There is a continuing drive to cut costs -- through rationalising branch networks, trimming management structures and investing in labour-saving technology. This has included closer investigation of the potential savings from outsourcing non-core activities (such as cheque processing and information technology) and sharing basic facilities, and the past year has seen some important initiatives of this kind. -2Regional banks, in particular, are looking to diversify their loan portfolios to reduce their dependence on home lending. But all banks are, to varying extents, pursuing a wider range of revenue sources as competition intensifies in traditional business lines, and areas such as funds management seem to offer better long-term prospects. Through acquisitions and organic growth, the ratio of banks’ funds under management to balance sheet assets has risen to around 30 per cent from 20 per cent four years ago. (Despite these efforts, it is interesting that there has been no increase in the ratio of banks’ domestic non-interest income to domestic assets.) The closer management of bank capital has been another notable feature of the past year or so. One result has been the major banks’ share buy-back programs and the repurchasing/restructuring of subordinated debt. The RBA has a keen interest in these developments, given the centrality of capital in our supervisory system. Closer alignment of capital with risks inherent in a bank’s activities (and prospective balance sheet growth) is, of course, not to be discouraged. A banking system with excessive capital will be less efficient and less competitive in performing its financing role for the economy. Supervisors will, however, always wish to be satisfied that capital ratios take full and proper account of all the risks inherent in a bank’s business. I will talk more about supervision of capital in a moment. Speculation about a decline in lending standards under competitive pressures has also been topical in the past year. It is very difficult to get any objective reading on this. As I have noted, the statistics on impaired loans show no sign of any such decline. Problems, if there are any, will be revealed in these data only in the future. What our supervisors do have, however, is a clear impression of a fall in lending standards -- an impression based on both market anecdotes and our observations of credit management in practice during visits to banks. Competition has not only whittled away margins but has led to relaxation of conditions placed on borrowers. This applies especially in lending to large corporations. But in the housing market, too, the imperative to maximise volumes or minimise costs in the world of tighter spreads, creates a temptation for banks to take short-cuts. Two of the more common deficiencies we see are the failure to obtain independent confirmation of a borrower’s income and failure to test a borrower’s capacity to keep making repayments if, over the course of the loan, interest rates were to increase. As competition intensifies, the strength of banks’ risk management systems for commercial and consumer loans is likely also to be tested. We have already expressed our concern that some current lending practices do risk sowing the seeds of future credit quality problems for banks. This concern has not increased in recent months. Nor has it diminished. Despite their various and strenuous efforts to maintain recent profit performance, banks’ earning rates are likely to remain under strong downward pressure in coming years. Eliminating excess capital and cutting into operating costs cannot provide continuous relief. Indeed, it seems unrealistic to think that average ROEs of over 15 per cent could continue in a world of 2 per cent inflation and a return on long bonds between 6 and 7 per cent. One has to go back to the regulated, less competitive world of the early 1970s to find comparable margins between bank earnings and bond yields. Supervision of bank capital I referred earlier to banks managing their capital more actively. The RBA’s main supervision task this year has been extending the capital adequacy rules to cover the market risks in banks’ trading books -- that is, the risks from fluctuations in interest rates, exchange rates, equity prices and commodity prices. The new guidelines become effective at the beginning of 1998. The novel feature of the market risk guidelines, which were developed by the Basle Committee on Banking Supervision and are being adopted internationally, is the reliance they allow to be placed on banks’ own risk management systems. Banks have the option of using their internal models to calculate required capital, or of employing a standard model specified by the Basle Committee. Of course, internal models need to meet certain minimum standards -- both quantitative and qualitative -- before they will be accepted for supervisory purposes. A bank whose systems are not up to scratch will have to use the standard model. The RBA must sign off on the adequacy of internal systems. But the onus for effective day-to-day risk management will remain squarely with the boards and senior management of banks. As an aside, during the past year we introduced arrangements under which a bank’s chief executive, with the endorsement of the board, must attest to the RBA that all key risks have been identified, that systems have been designed to manage those risks, that the descriptions of those systems held by the RBA are current and that the systems are working effectively. We are already seeing important general benefits from these new arrangements. They have resulted in more high-level attention to risk management systems and the system descriptions provided to us. Chief executives now need to see those manuals, which were previously often regarded as an administrative inconvenience for officers handling liaison with the RBA. This has added discipline and rigour to the whole risk management process. Eleven banks have applied to us for internal model status under the market risk rules, and they are all presently upgrading their existing risk measurement and management practices to meet the minimum requirements. As well as to measurement methodology, they are giving attention to such features as the adequacy of separation of front- and back-office operations, procedures to ensure that traders deal only in products for which robust operational and legal arrangements are in place, the rigour of revaluation processes and procedures for stress testing and back testing. We remain hopeful that, by the end of the year, all internal models will have reached a standard with which we can be comfortable, but there is a good deal of work still to be done in some cases. Another eleven banks plan to use the standard model for market risk, while the remainder have insufficient market risks to be affected by the new guidelines or are branches, covered by their home country supervisors. Our assessment remains that the new arrangements will not add materially to required capital for the banking system as a whole. However, the impact on individual capital ratios will vary, depending on the scope of each bank’s trading activities. For some there will be an increase. For others, required capital may actually fall, as the benefits from substituting specific market risk charges for existing credit risk capital will outweigh the additional capital needed for general market risks. The next question about supervision of banks’ capital is whether the present rules covering credit risk might be replaced by a more sophisticated methodology more in line with the market risk framework. The current rules are relatively crude, in the sense that capital ratios are applied against very broad categories of credit exposure without any firm basis in the actual likelihood of loss. In the way that potential losses from a portfolio of traded instruments can be estimated using historical data on daily price movements, potential losses from a portfolio of loans can, in principle, be estimated from an examination of default histories. Supervisors would add a mark-up for safety to these estimates, as they have in the case of market risk. Lack of reliable data on defaults and credit losses has been a major obstacle to this approach. But banks are working to remedy this, and are making progress toward putting the management of credit risk onto a more objective/scientific basis. Modelling techniques can be applied more easily to some components of a loan portfolio -- such as high-volume, standard housing and credit card receivables -- than to others. For this reason, an incremental approach to recognising models for credit risk supervision is likely to emerge. -4There is probably quite a way to go before credit risk is generally as amenable to modelling as market risk is. And since credit risk remains potentially the greatest threat to the soundness of banks and banking systems, supervisors are likely to be conservative about changes to the present rules, with all their imperfections. Implications of new Government policies There is clearly a lot of market-driven change “in the pipeline” for banks. The Government’s policy decisions following the Financial System Inquiry will further alter the environment for banks and others in coming years. Those policy changes, announced by the Treasurer early this month, have many dimensions. I would like to talk about just two of those -- effects on competition in banking and on the payments system. There is no doubt that the proposed policy changes will increase competition, by widening the range of potential players in both deposit-taking and in retail payments. (There will be less change as far as lending is concerned; apart from the need to conform with the consumer protection provisions of the uniform credit laws, there are already few regulatory impediments to the entry of new lenders -- as the recent history of home lending shows clearly enough.) The new rules should add to competition in deposit-taking in several ways. First, creating a single licensing regime for all deposit-taking institutions (DTIs) should help to level the proverbial playing field among credit unions, building societies and banks. A single depositor protection system -- based on depositors having prior claim over the assets of a troubled institution -- will be a key element in this. The actual impact of the new regime on the competitive standing of the various DTI groups will, of course, depend on the effectiveness of the smaller institutions in promoting their new status. Under the single licensing regime banks will still constitute a particular category among deposit-takers, but distinguished primarily by their size. Only institutions with at least $50 million in Tier 1 capital, and having a settlement account with the RBA, will be able to use the label “bank”. The single regulatory regime will, in principle, allow smaller DTIs to grow into this status more readily than they can now. Under new policy, mutual organisations will be able to have a banking licence, or to own a bank -- subject, of course, to satisfying prudential qualifications. Previously, it was possible for mutuals to be associated only with non-bank DTIs. It will also be open for banks to be established under non-operating holding company structures. Until now, with limited exceptions, a bank itself has had to be the holding company of a financial group. No doubt some groups will, for one reason or another, see commercial advantage from reorganising an existing operation under a holding company, or in establishing a new bank under such a structure. It seems likely that groups with bancassurance or allfinanz aspirations will go this way. For some financial groups, the possibility in future of having more than one banking authority (or licence), or a banking authority and a non-bank deposit-taking licence, will also be seen as helpful to their competitive position. Moreover, the Government has foreshadowed that the new licensing agency -- the Australian Prudential Regulation Authority (APRA) -- will have a more flexible attitude to the mixing of financial and non-financial activities in the one group. But this does not mean “open slather”. The general presumption in favour of dispersed ownership of banks and other deposit-takers will remain -- with individual shareholdings above 15 per cent needing to pass a national interest test. And there will be a “demonstrable congruity” test for non-financial activities to sit alongside a bank in a conglomerate. The interpretation and administration of this test will be for the new agency, but the Treasurer has referred to cases “where financial products can be logically bundled with a supply of non-financial goods and services”, and has indicated that APRA’s assessment of applications will be guided by international trends. One can readily imagine activities such as information-processing and communication of various kinds passing a congruence test. There could well be others over time. Incidentally, the intention clearly is that licensed deposit-takers will still be distinct legal entities with dedicated capital, separate management systems and so on. A non-financial company might be able to own a bank, but it could not be licensed in its own right as a bank or other deposit-taker. One can only speculate about the exact effects of these reforms on the evolution of banking and finance in Australia over coming years. These effects will be intermingled with those of technological change, global pressures, the administration of merger policy, and so on. But it seems clear enough that more flexibility in entry rules for new players, and more flexibility in corporate structures, will add to competition and make life a little tougher (at least) for the established deposit-takers. This will be another force bearing down on margins and profitability. One should not forget, of course, that these policy reforms will open up opportunities (such as for holding company structures) previously denied to existing players too. And the eventual elimination of the non-callable deposit regime will remove another sort of unevenness in the playing field -- one which currently penalises authorised banks relative to the non-bank DTIs and merchant banks. Let me turn now to the payments system where similar forces will be at work. From the RBA’s perspective there are three main changes in store. One is that participants in the payments system, other than deposit-takers, could qualify for an exchange settlement account (ESA) at the RBA. The Treasurer’s statement said: “While the immediate scope for greater access is likely to be limited, access will not be constrained to licensed banks or other deposit-taking institutions”. New opportunities might, consequently, be available to companies offering payment services based on credit facilities, such as credit cards. With an ESA, they would be able to offer final settlement of payment obligations to other institutions in their own right, rather than having to negotiate an agency arrangement with a bank. While the details are yet to be worked out -- by the RBA in this case -- two prerequisites for ESA access will be: • no reduction in the safety and stability of the payments system; and • access only for institutions which provide, or propose to provide, extensive third party transactions (as opposed to companies making transactions on their own account). Again, we are not talking “free-for-all”, but we are talking a markedly broader range of payments opportunities for non-traditional players. A second change is that the RBA will have regulatory power over widely-used stored-value instruments -- such as cards, internet tokens and even travellers cheques -- where their issuer is not a licensed deposit-taker. This will be prudential regulation aimed at reducing systemic risks and preserving public confidence in the various forms of electronic cash. -6The more general, and most significant, reform in payments policy is that the RBA will be given formal, statutory responsibilities for the payments and settlements system, with powers to back them up. Its responsibilities will cover not only issues of stability and safety, but will extend to the efficiency and competitiveness of the system, including questions of fair access for new payments providers. The RBA will be required, for instance, to look into the fees and charges levied by the established players on newcomers wishing to join existing networks, or to use existing infrastructure. To carry out these responsibilities, we will need to develop criteria for assessing the acceptability of membership and third party access provisions in the various payments clearing streams. We will also produce and publish benchmarks for judging the safety and efficiency of Australia’s payments system. When the RTGS system commences for high-value payments in the first half of 1998, a major step will have been taken to reduce risk and improve safety in domestic payments. We will be encouraging as many payments as practicable to move onto that system. The next major frontier is to reduce the settlement risks of Australian banks in their international transactions. This will be, if anything, more challenging than domestic RTGS has been, but some progress is being made internationally. I suspect that there is as much to be done to improve the efficiency of the Australian payments system and the “fairness” of access arrangements to retail payments streams. The ACCC has recently found wanting the basis on which smaller players may negotiate participation in the EFTPOS system. I should emphasise that it will be the RBA’s intention to adopt as light a regulatory touch as possible over the payments system. There has, after all, been a good deal of recent progress in reforming that system without the Bank having explicit powers. We hope such progress will continue -- through the Australian Payments Clearing Association and other industry-based bodies. Only where payments arrangements fall short of our efficiency and safety benchmarks -- and there are no serious attempts by the industry to rectify that position reasonably quickly -- will we embark on the path of prescriptive regulation. End piece It is a truism that change is always with us. But I suspect that banks face more than their fair share of it in coming years. I hope my remarks will be useful background for your speculation about the details of this change over the next couple of days. | reserve bank of australia | 1,997 | 10 |
Talk given by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the 26th Conference of Economists in Hobart on 29/9/97. | Mr. Macfarlane draws some conclusions about the direction in which monetary policy regimes are likely to evolve Talk given by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the 26th Conference of Economists in Hobart on 29/9/97. Introduction It is a pleasure to be speaking at this year’s Conference of Economists on a subject which has been central to my own career. I thought of calling the speech “Monetary Regimes I Have Known”, but that would have given too historical an emphasis. While history is extremely important, and provides a useful antidote to excessively abstract thinking, more is needed to satisfy the Conference theme of “policy challenges of the new century”. I have therefore attempted to respond in a forward-looking way, by drawing some conclusions about the direction in which monetary policy regimes are likely to evolve. Historical overview In broad outline, Australia’s post-war monetary policy experience has much in common with that of other countries in the developed world. Certainly the starting point -- a fixed exchange rate under the Bretton Woods system -- was the same, and several of the subsequent phases have been common to a significant number of countries. We can usefully divide the post-war monetary policy experience in Australia into four main parts: the fixed exchange rate period, which lasted until the early 1970s; a period of monetary targeting between 1976 and 1985; a transitional period which followed the demise of monetary targeting and lasted until the early 1990s; and the inflation-targeting regime, in place since around 1993. While every country has its own particular story to tell, something similar to this four-part schema, with suitable adjustments as to timing, could probably be applied to quite a wide range of other countries over the same period. In making this classification of policy regimes, it is wise to avoid being overly precise about dates. Sometimes regime shifts are quite dramatic and can be precisely dated -- for example, the ending of US dollar convertibility into gold, and the United Kingdom’s exit from the European exchange rate mechanism -- but this is not invariably the case. In Australia, the movement between regimes has tended to be evolutionary, and it is not always possible or helpful to date them precisely. How did these four regimes perform, and what were the critical factors that led to the move from each regime to its successor? To answer these questions we need to have in mind some criteria against which the performance of a monetary policy regime can be assessed. Most practitioners and theorists would, I think, agree on two desirable characteristics of a monetary policy regime. First, policy needs to provide a nominal anchor for the economy: the policy regime must have the characteristic that it systematically resists excessive inflation or deflation, and thereby delivers a satisfactory degree of price stability in the long run. The second objective is to provide a degree of stabilisation in the short to medium term in response to shocks, which includes resisting adverse shocks to output and employment. This objective might be met either through the capacity of a regime to undertake deliberate policy responses when shocks occur, or through automatic stabilisers inherent in the regime. The fixed exchange rate period The longest lasting of the four regimes, by a large margin, was the fixed exchange rate, also known as the Bretton Woods system, or the gold exchange standard. At the start of the post-war period, the Australian currency had already been fixed to sterling at an unchanged rate since 1931. Subsequently, there were only two major changes to Australia’s international parities until the 1970s: the first, in 1949, when Australia followed a sterling devaluation against gold and the US dollar, and the second, in 1967, when sterling was further devalued, but Australia did not follow. Thus, Australia’s exchange rate against sterling remained unchanged from 1931 to 1967, while the rate against the US dollar -- which is more important for current purposes -- was unchanged from 1949 to 1971. As was the case for most other countries, the Bretton Woods system of “fixed but adjustable” exchange rates was operated in practice in Australia in the 1950s and 1960s as a firm commitment to fixed parities. The fixed exchange rate was effectively the linchpin of the monetary policy regime. While it is not possible to pinpoint an exact date at which this ceased to be the case, parity adjustments became much more frequent after the next Australian dollar realignment occurred in 1971. Rather than being the anchor of policy, the exchange rate henceforward was increasingly viewed as an adjustable policy instrument. There were six parity changes in the years from 1971 to the adoption of the crawling peg system in November 1976; and this more flexible system, in turn, gave way to the float in December 1983. The history can thus be characterised as involving essentially fixed parities up until 1971, followed by a gradual transition to greater flexibility and a stronger internal policy focus in the years that followed. An important characteristic of a fixed exchange rate system, of course, is that it provides a nominal anchor, as long as the monetary policy of the country to which the exchange rate is fixed is itself conducted in a way that is consistent with reasonable price stability. This was indeed the case for most of the period up to around 1970. Under the Bretton Woods or gold exchange standard, most currencies were pegged to the US dollar, whose value was in turn tied to gold. The central role of the US dollar in the system placed a strong discipline on the macro-economic policies of other countries. Unless countries were prepared to make significant unilateral exchange rate adjustments, which happened only rarely, their inflation performances in the longer run were effectively determined by US monetary policy. Private Consumption Deflator Four-quarter-ended percentage change % % OPEC I (Oct-73) Australia United States -5 -5 As I have argued elsewhere, this system worked reasonably well until the second half of the 1960s. The United States for the most part conducted conservative monetary and fiscal policies that kept budgets close to balance and inflation low, and this underpinned a period of sustained low inflation in other countries. In Australia, apart from some periods influenced by sharp commodity price movements, inflation was generally low and close to US rates. This situation began to change from around the mid 1960s. Tax cuts in the 1964 and 1965 budgets, and subsequent increases in defence spending associated with the Vietnam War, shifted US fiscal policy to an expansionary position. Inflation began to increase, albeit from very low levels, after about 1965, and balance of payments deficits run by the United States meant that a number of other countries began accumulating substantial dollar reserves. This fed the process of money creation in these countries and relaxed the constraints on their domestic macro-economic policies, with the result in many cases that inflation rates increased. Causes of the eventual breakdown of the Bretton Woods system in the face of these pressures have been much debated, but the core of most explanations is that the system lost its capacity to provide effective policy discipline. This, in turn, reflected the loss of suitability of the US dollar as the system’s nominal anchor, the role it had played so effectively over the two previous decades. It is interesting to note that the policy debate in Australia in the 1950s and 1960s paid little or no explicit attention to the nominal anchoring role of the monetary regime. That is not because the problem of inflation was thought to be unimportant -- on the contrary, the need to control inflation was well recognised. Nonetheless the main focus, both of practitioners and of the economics profession more widely, was on the second of the two roles of monetary policy that I outlined earlier, namely its role in responding to shorter-term shocks. In fact, many commentators talked of monetary policy as though it was totally discretionary and free to pursue whatever domestic objective it thought most worthy (see next section on Phillips curve). Perhaps the most important reason for this misapprehension was that the existence of the long-run anchor was simply taken for granted. Policy did not need to focus on achieving a good longer-run inflation performance because the fixed exchange rate regime delivered this result in a semi-automatic fashion. In this environment it was natural to focus on shorter-term objectives, with the balance of payments serving as an important barometer of the need for policy action: whenever domestic demand was too strong, this would quickly show up in a payments deficit which needed to be corrected by tighter policy, and vice versa. In this way, the policy regime ensured that actions taken in response to short-term demand pressures had the effect of consistently tying the economy in to the long-run anchor. The eventual failure of the fixed exchange rate system to ensure continued good macro-economic performance reflected a combination of circumstances. The expansionary shift in US policy, to which I have already referred, meant that the external anchor became increasingly a source of inflationary pressure rather than of price stability. This was the case not just for Australia, but worldwide. In Australia’s case, however, the effect was amplified in the early 1970s by the related phenomenon of rising commodity prices, which had a disproportionate effect on Australia, given our high commodity export exposure. The effect was to relax the balance of payments constraint and allow a further loosening of domestic policy discipline, with the result that the rise in Australia’s inflation rate soon overtook that in the United States. The role of the 1973 oil shock in all of this was also important, but it should be remembered that inflation in Australia had already reached double-digit rates before the oil shock occurred. The rise and fall of the Phillips curve The early to mid 1970s was a period of re-evaluation of the earlier conventional thinking about monetary policy, prompted by the experience of a number of years of rising inflation. It is interesting to focus on the nature of that re-evaluation because it remains relevant to policy today. In the 1960s, the conventional thinking was summed up in the widely-influential notion of a stable downward-sloping Phillips curve. Inflation was thought of in terms of demand-driven processes that would move the economy along the curve, so that high levels of demand would produce a combination of high inflation and low unemployment, and low levels of demand the reverse. The role of policy was to manage aggregate demand so as to achieve a preferred combination of outcomes, taking the position of the Phillips curve as given. Of course, not all economists subscribed to this simplistic world view, but I think it is a fair representation of the consensus among those economists who were most influential and among a broad range of other policy makers, politicians and journalists. There was considerable confidence for a time that policy could effectively manage the trade-off. Policy before about 1970 had been quite successful: periods of clearly excessive inflation had been rare, and were quickly reversed when they occurred. But there developed a general tendency among policy-makers in the late 1960s and early 1970s to try to exploit the trade-off to extract more growth, in the belief that the cost in terms of inflation would not be too great. The experience of the 1970s -- the simultaneous rise in inflation and unemployment, and their persistence at high levels -- proved this understanding of the economy to be too simplistic and an inadequate guide for policy. To a mindset based on the stable Phillips curve, the combination of high inflation and high unemployment could not be readily explained. Indeed, it appeared internally contradictory, since inflation was thought of as a symptom of excess demand while high unemployment signalled that demand was deficient. Two factors needed to be brought into the conventional model in order to understand the 1970s experience. The first, which had been emphasised both by Friedman and by Phelps, was the role of expectations. The short-run Phillips curve was to be thought of not as a permanent trade-off, but as conditional on the expected rate of inflation. Expansionary demand conditions were associated with higher-than-expected inflation, rather than high inflation per se, so the trade-off of higher inflation for lower unemployment could only be exploited over the limited period in which inflation expectations did not fully adjust to the new higher rate. In the longer run, when expectations had adjusted, high inflation would have no stimulatory impact. In Friedman’s words, “a rising rate of inflation may reduce unemployment, a high rate will not”. The operation of this principle had not previously been observable because inflation had never stayed high for long enough to be built into expectations. The second, and related, factor to be brought into the conventional model was the importance of supply shocks. These could be thought of as shocks which reduced the sustainable levels of output and employment consistent with steady inflation. For much of the world the quintessential supply shocks were rises in oil prices but, for Australia, the real wages shock of 1974 was probably at least as important. Recognition of the importance of supply shocks implied a corresponding recognition of the limitations on what could be achieved through conventional demand-management policies. Although economic thinking has advanced in a number of ways since the 1970s, these two basic lessons from the period remain relevant, and often need repeating. While the economics profession was quick to take up the stable Phillips curve, it was also quick in dropping it as a policy prescription. But there are still some in the policy debate -- particularly among politicians, lobbyists and journalists -- who think of the economy in terms of a stable Phillips curve, and who would like us to choose a higher inflation rate on the assumption that this would produce a sustained lift in growth and employment. But that is not the choice we face. Higher inflation can deliver at best only a temporary stimulus to growth and, in the longer run, is more likely to be detrimental. The move to monetary targeting In the light of the early 1970s experience, economists stopped assuming a stable Phillips curve and started looking for ways to anchor monetary policy decisions. The Friedman suggestion of a steady growth of the money supply sufficient to accommodate normal economic growth and low inflation found favour in a number of countries. Several had been focusing on monetary aggregates since the early 1970s and, by 1975, a number, including the United States, Germany, the United Kingdom and Switzerland were announcing monetary targets. Australia followed suit in 1976 by beginning to announce forecasts for the growth of M3. These were subsequently announced each year in the federal budget until the practice was discontinued in 1985. The nature of the targets was somewhat different to what is often assumed in the textbooks or in the somewhat idealised notions of monetary theorists. In no country were targets adhered to with the sort of mechanical precision envisaged in Friedman’s Program for Monetary Stability, the classic statement of the case for monetary targeting. They were usually seen as guides to policy, and as vehicles for explaining the rationale of policy actions, rather than being binding constraints on the policy-maker. Monetary targeting regimes had a moderate degree of success in achieving their intermediate monetary objectives, and somewhat greater success in terms of the ultimate objective of reducing inflation. In the heyday of monetary targeting around the world, roughly from 1975 to 1985, some substantial reductions in inflation were achieved. Australia’s inflation rate was reduced during this period, but was still a lot higher than the OECD average by the mid 1980s. It would be a mistake to attribute the differences in inflation performance across countries primarily to differing degrees of rigour in the pursuit of monetary targets. The countries that brought inflation under control most quickly were not particularly more successful in hitting their monetary targets than the rest. The general pattern, summarised in Table 1, was that countries achieved their targets about half the time. Australia’s success rate was a bit less than that, about a third. On another measure -- the average deviation from the target midpoint -- Australia’s record was quite similar to that of several other countries. Table 1: Monetary Targets and Projections Average absolute Proportion of years Country Period deviation from within target range (%) target mid-point Australia 1977-1985 2.6 33.3 Canada 1976-1982 1.3 71.4 France 1977-1996 2.5 50.0 Germany 1975-1996 1.8 54.5 Italy 1975-1996 2.7 31.8 Switzerland 1975-1996 2.6 47.6 United Kingdom 1976-1996 2.7 52.4 United States M2 1975-1996 1.5 63.6 United States M3 1975-1996 1.8 40.9 Source: Edey The achievement of inflation reduction was a product not so much of the technical merits of monetary targeting as of the general shift in the policy-making consensus towards inflation control. What was critical was the willingness of the authorities to run policies that put a consistent downward pressure on inflation over a period of time. But, that said, the targets did serve a useful purpose. They focused policy on the need to anchor the nominal magnitudes in the economy, and they helped in communicating the anti-inflation strategy to the public and marshalling public acceptance of the required policy actions. The Volcker disinflation period in the United States was a good example of how useful targets could be in this role. Alan Blinder described the monetary target as a “heat shield” which enabled the Fed to maintain a much tougher disinflationary stance than the public would normally have found acceptable. As a result the United States was able to make a definitive transition to low inflation at an early stage. Monetary targeting was always subject to two well-known problems, both of which were important in the Australian experience. The first was the problem of controllability. The fact that targets were often missed was an indication that close control was either not possible, or would have required undesirable movements in the policy instruments. The second was the instability of the relationship between money supply and the ultimate objective of policy such as inflation or nominal GDP. It was this second problem that was decisive in causing most countries to abandon monetary targeting as the basis of their monetary policies. By the mid 1980s, the problem of instability was coming to the fore. The relationship of money to ultimate objectives had always been imprecise, but had been judged to be sufficiently stable to serve as a useful guide to policy. But the structural changes in the financial system that followed deregulation were sufficiently large that this was no longer the case. In Australia, in the mid 1980s, the newly deregulated banks were able to win back market share from other institutions, and the financial system as a whole began to grow more rapidly. To some extent, this was to be expected, but it meant a lengthy period in which the behaviour of the monetary and financial aggregates diverged from inflation or nominal income. In 1985, growth of M3 reached 17.5 per cent, at a time when domestic inflation had been falling. The problem was not unique to Australia. By the time our targets were suspended in February 1985, many other countries had downgraded or abandoned them, for much the same reasons. In the words of Canadian central bank Governor Bouey, “we didn’t abandon the monetary aggregates, they abandoned us”. The transitional period The move away from monetary targets was followed by a period of transition when policies became more pragmatic and there was a search for alternative guiding principles. Once again, Australia’s experience was by no means unique. Virtually all countries were downgrading their monetary targets to one degree or another, and there was no immediately clear direction as to what should be put in their place. Theory offered little help. Some of the alternatives being put up by critics either had already proven unsatisfactory for us -- like a return to fixed exchange rates or forms of monetary targeting -- or were unrealistically radical. Most countries with floating exchange rates developed a pragmatic approach that, broadly speaking, tried to resist excessive inflation and to have some stabilising influence on economic activity in response to shorter-term shocks. Policy in Australia through this transitional period has been criticised for lacking a clear conceptual framework and allowing too much scope for central bank discretion, and there is some validity in these criticisms. In Australia, the policy “checklist”, which entered the discussion for a few years following the abandonment of monetary targets, comprised a wide range of variables which were to be consulted in assessing economic conditions and making policy decisions. The list of variables included interest rates, the exchange rate, the monetary aggregates, inflation, the external accounts, asset prices and the general economic outlook -- in short, an amalgam of instruments, intermediate and final policy objectives, and general macro-economic indicators. The checklist conveyed the idea -- sensible as far as it goes -- that policy needs to look at all relevant information. What was missing was some framework for evaluating that information and converting it into an operational guide for policy. Another way of expressing this is to say that monetary policy needed a “nominal anchor”. Pure pragmatism was not enough because it could lead to monetary policy aiming to achieve a desired result for a “real variable”, which in the long run would be self-defeating. For example, if monetary policy was solely designed to achieve a given unemployment rate (as to some extent it was in the late 1960s/early 1970s in many countries), it would be continually eased whenever the actual unemployment rate was above the desired rate. But if the desired rate was too ambitious, this would be a recipe for continued easing and, in time, continuously rising inflation. At the same time, there would be no guarantee that monetary policy alone would be able to achieve the desired unemployment rate if structural factors were important. Similarly, indeterminacy would arise if monetary policy was directed at the current account of the balance of payments, as a lot of discussion in the late 1980s seemed to suggest. If the current account was too large, should monetary policy be tightened to reduce domestic demand (and imports), or should it be loosened to lower the exchange rate and hence increase competitiveness? These sorts of discussion led policy-makers and academics to again ask the question about what monetary policy could achieve in the long run. The nearly unanimous answer was that it could achieve a desired rate of inflation, but could not, of itself, achieve desired outcomes for real variables like the unemployment rate, the rate of growth, or variables like the balance of payments. Monetary policy can have an influence for good or bad on real variables, particularly in the short run, but it was not appropriate to target it at these variables. As a long-run target, what was needed was a nominal variable like inflation, nominal GDP or the money supply. With the money demand function recognised as being unstable, and nominal GDP being too abstract a concept for easy public perception, attention turned to monetary policy regimes that centred on inflation. Two main alternatives presented themselves: a system where the instrument of monetary policy was operated to achieve a desired result for inflation, without the need for an intermediate target; or a system where the exchange rate was fixed to that of another country which had a good record of maintaining low inflation. In short, the two alternatives which satisfied the condition of providing a “nominal anchor” were inflation targeting or fixing the exchange rate (sometimes called the hard currency option). Australia went down the first path, while most of Europe (including the United Kingdom for a time) went down the second path by tying their currencies to the Deutschemark. Some would argue that this two-way classification of the options is too narrow and that monetary targeting remains a viable third option, at least for some countries. Germany is often cited as an example. This view ignores the reality that the Bundesbank has moved a long way away from strict monetary targeting in recent years, as is evident from the way they move their policy instrument. There is evidence to suggest that prospective inflationary developments are more likely to trigger a monetary policy move than is a deviation of money supply from its target. Inflation targeting Unlike the experience in some other countries like the United Kingdom or New Zealand, where inflation targets came into force in dramatic regime shifts, the elements of Australia’s inflation-targeting regime were put in place gradually. There were a number of reasons for this. While inflation targets had considerable conceptual appeal, the models adopted in the pioneering countries - New Zealand and Canada - seemed to us excessively rigid with their narrow bands and low target mid-points. The fact that these were the only working models available at the time tended to polarise debate, and it took some time for the Bank to develop its own more flexible version. Also important was the need to build public support, including political support, for a target, and again this happened gradually rather than in a single, decisive act. Some of the key elements of the inflation-targeting approach were in place quite early. The conceptual basis of such an approach, with a focus on inflation as the policy objective, no intermediate objective, interest rates as the instrument, and a transmission process that works via the effect of interest rates on private demand, had been analysed in a number of pieces that the Bank published in 1989, including its conference volume. What we now consider one of the key elements of the policy framework, the explicit announcements of cash rate changes, with explanations of the reasons for each change, began in January 1990. Over time, the Bank’s published commentaries on monetary policy and the economy became more detailed and developed a stronger inflation focus. The numerical objective of 2-3 per cent inflation began appearing in public statements by Governor Fraser in 1992 and 1993. The cumulative effect of all these developments was to establish an inflation-targeting regime broadly comparable to those being developed in a number of other countries around the same time. While there was no individual decisive event, international comparative tables such as those published by the BIS date the change in Australia from 1993. A final element was added with the joint statement on the conduct of monetary policy, made by myself and the Treasurer on my appointment as Governor. The statement gave the Government’s formal endorsement to the independence of the Reserve Bank as contained in its Act and to the 2-3 per cent target. It also provided for enhanced accountability through semi-annual statements and parliamentary appearances. Several other countries adopted inflation targets around the same time as Australia. A recent survey by the BIS counts seven inflation targeters, making this currently the most numerically popular regime among medium-sized OECD countries (Table 2). As had been the case with previous regime changes, the immediate reason for change in many cases was either a breakdown of a previous regime or dissatisfaction with its performance. In the United Kingdom, Sweden and Finland, the trigger was the collapse of fixed exchange rate commitments in 1992. New Zealand and Canada adopted their targets in a deliberate strategy of inflation reduction. Australia was somewhat different in that there was no crisis that needed to be responded to, and the target was developed to cement in place an inflation reduction that had already been achieved. Table 2: Inflation Targets Country Target adopted Current target New Zealand March 1990 0-3% Canada February 1991 1-3% United Kingdom October 1992 2½% Sweden January 1993 1-3% Finland February 1993 2% Australia 2-3% Spain Summer 1994 0-3% Source: BIS 1996 Annual Report, updated to incorporate recent changes to targets in the United Kingdom and New Zealand The move to inflation targeting completed a significant conceptual leap from the regimes that had prevailed in the earlier decades. Instead of a focus on intermediate objectives, like the exchange rate or the money supply, the operational framework of policy was now built around a final objective, inflation. In describing inflation as the final objective in this context, I should make clear that inflation control is viewed as a means to an end rather than an end in itself. The reason monetary regimes have been set up to aim for low inflation is that this is the best contribution monetary policy can make in the longer run to growth in output, employment and living standards. In principle, this approach re-establishes a clear nominal anchor while avoiding the main problem of the intermediate-targeting regimes -- namely, that the target variables did not have a sufficiently stable relationship with the final objectives. The approach also preserves, from the transitional period that I described earlier, the common-sense notion of using all relevant information: the difference is that there is now a clear criterion -- the impact on the inflation outlook -- for assessing what the information means for policy. Another property of inflation targets, not always well-recognised, is that they provide scope for counter-cyclical action. This is automatically built into the policy framework if a central bank takes seriously, as we do, both the upper and lower bounds of the target. When the inflation forecast is above the target, the framework requires policy to be tightened, as was the case a couple of years ago, and, when it is below target, policy has to be more expansionary, as at present. In this way the policy framework incorporates a systematic resistance to cyclical demand pressures. I have described this previously by saying that the policy aims to allow the economy to grow as fast as possible, consistent with low inflation, but no faster. Aside from these operational characteristics, an important dimension of the economic rationale for inflation targets is their role as a discipline on the policy process. The academic literature lays great store on this -- particularly in the time inconsistency literature -- although it tends to focus rather too narrowly on the idea of constraining the policy-makers. The targets are seen as correcting an inflationary bias that would otherwise arise from the temptation of central bankers to go for short-term expansion. In this literature, rule-based regimes are said to be superior to discretion because they allow pre-commitment to non-inflationary policies, and thereby overcome the assumed short-termism of the policy-makers. Central bankers are very sceptical of this line of analysis because we do not see ourselves as inherently inflation-prone. But while I think this particular argument for a rule-based approach somewhat misses the point, the ability to specify policy in terms of a relatively simple rule does have some important advantages. In particular, simple rules provide a ready vehicle for accountability and for public communication: they require policy actions to be explained in terms of a clear target, and they help central banks to resist calls for excessively expansionary policies. Also important is that, over time, a simple rule like an inflation target can provide a focal point for inflation expectations by making clear what the central bank is aiming at. One of the reasons that inflation targets have proven attractive to so many countries is that they seem to strike a workable balance, between having these advantages of a simple rule, and retaining a necessary degree of flexibility. The framework has simplicity in terms of an easily communicated objective, at the same time as having flexibility in the interpretation of information and operation of the policy instrument -- a combination of characteristics that Mishkin refers to as “constrained discretion”. While the essential characteristics of inflation targets are common to all the practitioners, there are some interesting variations across countries in the detailed design features. These involve characteristics like the target mid-point, the width of fluctuation bands and the timeframe for evaluating performance. Australia’s system differs from the early models (particularly New Zealand) by focusing on a midpoint of 2-3 per cent (which really means “about 2½”) rather than a range. The most common target mid-point is 2 per cent: Australia and the United Kingdom are slightly higher at 2½ and New Zealand lower at 1½ (having originally been at 1). There is also a difference concerning the meaning of the upper and lower bounds. In the original New Zealand and Canadian models, inflation was meant to be always within the band, but in our variation that was never the intention. - 10 - At this level of detail there is no single consensus model as to how an inflation target should be designed. To some extent, the variations reflect the different historical circumstances of each country. For example, New Zealand, which had the first and the most tightly specified system, also had one of the poorest track records on inflation and therefore the clearest need to signal a regime shift. Notwithstanding these differences, the essentials -- a numerically specified target linked to procedures of public explanation and accountability -- are common to all the inflation targets. The future To the best of my knowledge, inflation targeting was not seriously canvassed as a monetary policy option until the 1980s. By the end of that decade, however, as I have described earlier, there were only two monetary policy regimes that held out the promise of being achievable and of providing a nominal anchor -- the first was the hard currency option and the second was an inflation target. It is my view that, as we approach the next century, the field will narrow further, and that inflation targeting will become the dominant monetary policy regime. This would be a remarkable change for a system that was virtually unheard of until the second half of the 1980s. The reason for this change is that the biggest group of countries that have chosen the hard currency option -- the members of the European Monetary System (EMS) -- are scheduled on 1 January 1999 to achieve monetary union. On that date, there will be one European currency -- the Euro -- and one European Central Bank -- the ECB. What will be the monetary policy regime pursued by the ECB? It cannot be the hard currency option because the Euro will be a floating currency. My guess is that, whatever the ECB chooses, it will rather closely resemble inflation targeting. An alternative view is that in order to impress markets that the Euro is as sound as the Deutschemark, the ECB may follow something akin to the German practice of monetary targeting. As I said earlier, this would not alter the picture very much, as current German practice seems to be at least as much like inflation targeting as it is like monetary targeting. In this new world, there will be three major currencies, which will float against each other -- the US dollar, the yen and the Euro. Of course, none of these are in the group of countries that has an explicit inflation target, but I have argued elsewhere that if you had to fit the United States into one or the other of the formal monetary policy regimes, the one that comes closest is inflation targeting. The target is not explicit, but the Fed makes no secret of the fact that it is its assessment of inflationary pressures and the outlook for inflation that is the major determinant of whether US monetary policy is adjusted. The Fed’s behaviour over the last month has made that abundantly clear. Japan is a more difficult case to classify, but the evidence is that with inflation virtually non-existent, interest rates have been reduced to about the lowest conceivable level (the cash rate is ½ per cent). Thus, among the traditional OECD countries, we have a group of explicit inflation targeters and another group -- the big three -- who have systems which could most appropriately be called implicit inflation targeters. Outside the OECD area, there is still room for countries to choose the hard currency option - Hong Kong for the past 13 years and Argentina (for a considerably shorter time) -- fit this description. But recent events in Asia as well as in other regions such as Eastern Europe in recent years may have made the fixed exchange rate option less attractive in many cases. If we take an even longer sweep of history, we can see that we entered this century with the most irrevocably fixed exchange rate system yet devised, namely the gold standard. As we enter the next century, we enter a world where floating exchange rates are the norm, and where the role of nominal anchor will be predominantly played by an inflation target, whether it is explicit, much as our own, or implicit as is the case in the United States. *************** BIBLIOGRAPHY Bernanke, Ben S. and F.S. Mishkin (1997), “Inflation Targeting: A New Framework for Monetary Policy?”, Journal of Economic Perspectives 11, No. 2 (Spring), 97-116 Blinder, Alan S. (1987), Hard Heads, Soft Hearts, Addison-Wesley Blinder, Alan. S (1995), Central Banking in Theory and Practice, Marshall Lectures presented at the University of Cambridge Clarida, R. and M. Gertler (1996), “How the Bundesbank Conducts Monetary Policy”, NBER Working Paper No. 5581 Coombs, H.C. (1959), “A Matter of Prices”, Presidential Address, Thirty-fourth Congress, ANZAAS, reproduced in Coombs, H.C. Other People’s Money, Australian National University Press, 1971 Duisenberg, W.F. (1997), “Strategies for Monetary Policy in EMU”, address on the occasion of the Board meeting of the Banking Federation of the European Union, Maastricht, March 1997 Edey, M.L. (1997), “The Debate on Alternatives for Monetary Policy in Australia”, in Monetary Policy and Inflation Targeting, P. Lowe (ed), Reserve Bank of Australia, October 1997 Friedman, Milton (1968), “The Role of Monetary Policy”, American Economic Review, 58:1-17 Goodhart, C.A.E. (1989), “The Conduct of Monetary Policy”, Economic Journal, 99(396), 293-346 Grenville, S.A. (1989), “The Operation of Monetary Policy”, presented at the First Annual Melbourne Money and Finance Conference, November 1989 Laubach, T. and A.S. Posen (1997), “Disciplined Discretion: The German and Swiss Monetary Targeting Frameworks in Operation”, Federal Reserve Bank of New York Research Paper No. 9707 Leeson, R. (1996), “The Rise of the Natural Rate of Unemployment Model”, History of Economics Review, 25:249-264 Macfarlane, I.J. and G.R. Stevens (1989) (eds), Studies in Money and Credit, Proceedings of a Conference, Reserve Bank of Australia, October 1989 Macfarlane, I.J. (1989b), “Policy Targets and Operating Procedures: The Australian Case”, in Monetary Policy Issues in the 1990s, Federal Reserve Bank of Kansas City, Kansas City, Missouri, 143-159 McCallum, B.T. (1995), “Two Fallacies Concerning Central Bank Independence”, American Economic Review, 85(2), 207-211 Mishkin, F.S. (1997), “Strategies for Controlling Inflation”, Monetary Policy and Inflation Targeting, P. Lowe (ed), Reserve Bank of Australia, October 1997 Mishkin, F.S. and A.S. Posen (1997), “Inflation Targeting: Lessons from Four Countries”, Federal Reserve Bank of New York Economic Policy Review, August 1997 Phelps, E.S. (1967), “Phillips Curves, Expectations of Inflation and Optimal Unemployment Over Time”, Economica, 34:254-81 Zarnowitz, Victor (1972) (ed), “The Business Cycle Today”, NBER, NY | reserve bank of australia | 1,997 | 10 |
Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the Australian Institute of Banking and Finance Inc., New South Wales State Committee, in Sydney on 28/10/97. | Mr. Thompson considers the topic of risks in banking Speech by the Deputy Governor of the Reserve Bank of Australia, Mr. G.J. Thompson, at the Australian Institute of Banking and Finance Inc., New South Wales State Committee, in Sydney on 28/10/97. Introduction I spoke in June in Canberra to a joint luncheon meeting of the AIBF and two other local organisations. My theme was the many faces of risk in banking. Today I would like to expand on a couple of the risks I touched on then, namely: the Year 2000 problem; payments system risk, particularly in relation to settlement of foreign exchange transactions. This also gives me the opportunity to talk about the results from two surveys recently conducted by the RBA. Year 2000 I think almost everyone is now aware that the Year 2000 will bring not only the euphoria which accompanies the arrival of a new millennium - or the approach of it, for those holding on to the view that the third millennium starts in 2001. It also brings potentially major disruption to finance, commerce and almost every aspect of daily life if computers are not able properly to comprehend the move from the year programmed as ‘99’ to the one shown as ‘00’. Financial institutions are almost totally dependent on computer systems for their continuing day-to-day operations and getting dates correct is a critical element in this. They are, therefore, heavily at risk from the Year 2000 problem. The RBA is taking a close interest in how this problem is being addressed, both as supervisor of banks (for the time being) and with our broader interest in the smooth running of the financial system. The Basle Committee on Banking Supervision recently turned its attention to Year 2000 risk, and has issued a paper which includes a recommended program of remedial action for all banks. The main phases of this are: (i) developing a strategic approach to solving the problem; (ii) creating organisational awareness of its importance; (iii) assessing necessary actions and developing detailed plans; (iv) renovating systems, applications and equipment; (v) validating this renovation through testing; and (vi) implementing tested, compliant systems. The well-prepared financial institution will have completed steps (i) to (iii). It will now be engaged in step (iv) -- renovating systems and applications. The recommended completion date for this work, to allow sufficient time for testing, is the end of 1998. The renovation of critical systems should be finished by the middle of 1998. To assess the preparation of Australian banks for Year 2000, we asked them in May to complete a comprehensive survey. Some of the results from this can be summarised usefully under the first four headings of the Basle Committee’s recommended program. (i) Developing a strategy to tackle the problem: Some banks have been rather slow to do this, and several had not completed their strategies when our survey arrived. Some banks have placed the CEO or a director in charge of their project, while in others an IT staffer has responsibility. There are dangers in the latter course, because Year 2000 is big enough and threatening enough to be treated as a business issue and not simply a technical problem. (ii) Creating organisational awareness: Awareness appears to be strong in IT areas, but it varies dramatically elsewhere. Some banks have (or will soon have) arranged training for all staff, incorporated Year 2000 into credit review procedures and made relationship managers responsible for compliance by customers. In contrast, others had not even arranged formal briefing of people in their non-IT areas who might be developing spreadsheets and small databases in blissful ignorance of the issue. (iii) Assessing actions and developing detailed plans: Nearly half the banks had not completed their assessments at the time of our survey. This might reflect their adoption of an iterative approach, where key systems were identified early and compliance work begun, with minor systems the subject of later investigation. It also indicates, however, that a few banks are having trouble grappling with the problem. (iv) Renovating systems, applications and equipment: Most banks are currently in this stage, but they have made only modest progress. At mid-year less than 10 per cent of the expected total cost of Year 2000 compliance -- of around $600 million -- had been spent. (Although substantial, this figure is itself about 10 per cent of total expected IT expenditures between now and the end of the decade.) The remaining two steps -- validation through testing and the implementing of tested, compliant systems -- are, of course, still ahead. A few other observations are worth making from our survey results. Most banks have adopted the end-1998 target for achieving Year 2000 compliance. Along with the Basle Committee, we regard this as highly desirable. A few banks have acknowledged that full compliance will not be achieved until some time in 1999. Some of these have structured their projects so that non-critical systems will be dealt with last. Banks collectively have assigned over 1,000 in-house IT staff to fixing the problem, although this includes staff doing concurrent redevelopment work. There has been speculation about serious shortages of experienced staff, but nearly half of the banks in our survey did not plan to hire additional people for their projects, and only four expect to increase staffing by more than 10 per cent. Staff resources do not, therefore, appear to be a major issue in Australia, but there is no room for complacency because shortages could well be a bigger problem in other countries and we are part of a global labour market. Furthermore, the resources required for testing could be under-estimated. Year 2000 testing will be more complex, and on a larger scale, than anything attempted previously. Many banks have not yet developed formal contingency plans in the event that systems cannot be made Year 2000 compliant. Only one-third of them have designed business resumption plans -- others are leaving that until closer to the day, in part because they expect that their systems may have altered substantially by then. -3The overall picture on Australian banks’ current state of preparation is, then, rather mixed. At this stage, they all appear capable of addressing their own Year 2000 problems in time. But most of the work is still to be done, and system developments of the scale required are notorious for running over budget and over time -- a luxury which is not available in this case. Moreover, the testing phase could well be the most resource-intensive. Compliance work could also be complicated by other distractions, such as preparing for the euro or managing mergers. (On the latter, the Basle Committee noted that the need to prepare for Year 2000 will greatly complicate mergers and acquisitions among financial institutions, and that the risks in trying to manage projects in more than one institution in the time available could be sufficient reason to defer such mergers.) We will be monitoring the progress of the banks closely, and giving special attention to the laggards. (Although the lack of contingency and business resumption plans is not of current concern, we will also need to revisit this issue.) Most of banks’ compliance work to date has been focused internally, which is where our survey concentrated. This is only part of the challenge. Successful renovation of its internal systems will not necessarily protect a bank from serious problems which may be imported from elsewhere, for instance through payments and trading linkages. Banks will need to co-operate closely to ensure that such cross-institutional links are fully tested. The new RTGS system for high-value payments -- on which I will say more in a moment -- was built with Year 2000 in mind. Even so, a comprehensive test plan has been developed for RTGS and its suitability is being confirmed with a number of system participants. This plan allows for full testing in conjunction with participants’ interface systems, and aims to confirm that the RTGS system is Year 2000 compliant by the end of 1998. Meanwhile, the Australian Payments Clearing Association has formed a special Consultative Group to address issues relating to the other clearing systems. Banks must also prepare for problems affecting their customers (as well as trading counterparties in wholesale markets) and should be inquiring into the Year 2000 readiness of their borrowers and potential borrowers. The effects of Year 2000 could severely interfere with the conduct of borrowers’ businesses and reduce their capacity to meet loan obligations. Customers could also find themselves unable to use electronic links to their banks, and try to revert to manual processing. This would put considerable strain on banks’ resources. If not well-prepared, banks could also be drawn into extensive legal actions flowing from Year 2000 breakdowns. The RBA will continue to disseminate information about Year 2000 issues, and will help to co-ordinate renovation and testing where we can. We are participating in an Inter-bank Working Group which will aim to ensure that core banking systems and other shared infrastructure are fully tested, and that exposure to telecommunications problems are limited; to work with key vendors to ensure that their products conform to agreed compliance guidelines; and to develop contingency measures for critical areas. This Group will also be playing an education role with banks’ business partners and customers. Let me now describe briefly what the RBA is doing about its own house. Our target is to have our systems fully Year 2000 compliant by the end of next year. Our project is overseen by a Steering Group of senior officers. While the scale of the challenge is not as great for us as for many other financial institutions, our technology platform is complex, involving a mix of hardware and software developed inhouse and also provided by third-party suppliers. It encompasses the exchange of data and services with the Commonwealth Government, some State governments and the financial community at large -- banks, non-bank financial institutions, Austraclear and so on. We also have international linkages through SWIFT to our overseas offices and trading counterparties. Our key internal systems run on the mainframe platform. So, this is where we focused our initial efforts. We began assessing and converting our mainframe application systems last year, with -4the aim of flushing out and fixing date-related problems by end 1997. With one exception, which is now planned for completion in mid-1998, we are on target and have renovated, tested and re-implemented more than half of our systems. To prove total compliance, these systems need to be tested on fully compliant platforms where the dates can be rolled forward into 2000. We aim to have compliant platforms by April next year, and to begin testing with financial institutions and our other counterparties and customers from July 1998. We have also begun assessing our less critical PC and spreadsheet applications which have been developed and supported by various user areas. Each business/policy area has “ownership” of the renovation required for these systems, with support from the IT group. We plan to have these fully tested and proven clean by September 1998. Another area of concern for all of us is the potential problems with embedded chips which control the operation of everything from lifts to air conditioning to fax machines. Our Facilities Management people began tackling this last year. Having assessed key equipment, they are now identifying the hidden components of building infrastructure which may have chips and so need to be assessed. Since many of these items cannot easily be tested internally, we will be seeking certification and proven test results from the vendors. Settlement risk -- RTGS Let me turn briefly to the RTGS project which, as you know, will allow high-value interbank payments to be settled on a “real time”, pay-as-you-go basis from the first half of next year. This will eliminate a large proportion of the interbank settlement risk which currently arises because final settlement is deferred to the day after payments are processed. Over the past six months, several major milestones have been achieved in the RTGS project, and now all of the basic infrastructure is in place: The necessary enhancements to RITS (the Reserve Bank Information and Transfer System), which will form the core of RTGS, were completed early in July. The SWIFT Payment Delivery System, which will send customer and foreign exchange payments for real-time settlement, went “live” at the end of August. Last week, this system carried an average daily volume of around 1,100 payments, with average daily value around $13 billion. By the end of this month, we expect 16 banks will be using the system. Austraclear commenced operations as a feeder system at the end of September, with settlement details of all interbank transactions through Austraclear now sent automatically to RITS. Most transactions across these various systems continue to be settled on a next-day basis, but banks are now able to monitor continuously their exchange settlement account (ESA) balances and their net obligations to each other. Prior to full implementation, they will be able to test the queuing, repo and offset functions which will smooth liquidity management in the RTGS world. This project, which represents a major advance in the sophistication of the Australian financial system, is now entering its final stages. Between November and January, payments between the major banks, which are now carried across RITS, will migrate to the SWIFT Payment Delivery System. Then, in February next year, the RBA will set a limit on each bank’s consolidated ESA and “net interbank obligation” position. These limits will be reduced progressively to allow us all to adjust to the new environment. When they reach zero in April 1998, full RTGS will be operative. Foreign exchange settlement RTGS will eliminate settlement risk for high-value payments between domestic banks. Banks will remain exposed to foreign exchange settlement risk because the currencies in a foreign exchange transaction are each settled in a different “domestic” market. That makes synchronised payment-versus-payment extremely difficult because the respective payment systems are often in different time zones. Also, it is unlikely that both parties to the transaction are direct participants (with final settlement capacity) in each market. So correspondent banks were invented. The time taken for correspondent banks to carry out instructions and to notify their principals adds to settlement risk. The exposure -- or amount at risk -- in a foreign exchange trade lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally by a bank until the time the currency purchased is received with finality. And it equals the full amount of the currency purchased. Although foreign exchange settlement risk first became a major concern with the failure of Bankhaus Herstatt in 1974, only in the past few years has a serious attack been made on the problem. The ball was set rolling by the New York Foreign Exchange Committee and the Committee on Payment and Settlement Systems of the Group of Ten Countries. (The most recent report by the latter is known as “the Allsopp Report”). Their work has done much to improve knowledge of the various components of foreign exchange settlement risk and to promote ways of reducing it. Significantly, these bodies have expressed a preference for the private sector to develop solutions, but have made it clear that central banks should encourage and monitor progress with this. One finding of the Allsopp Report was that the magnitude of foreign exchange risk can be very large. To quote: “Given current practices, a bank’s maximum FX settlement exposure could equal, or even surpass, the amount receivable for three days’ worth of trades, so that at any point in time -- including weekends and public holidays -- the amount at risk to even a single counterparty could exceed a bank’s capital.” Another finding was that banks can often reduce settlement risk through relatively simple changes in procedures -- for instance, by renegotiating arrangements with correspondent banks, and by making their own back offices more efficient. More fundamental attacks on settlement risk have been through netting arrangements, both bilateral and multilateral, in which gross obligations are replaced with much smaller, netted amounts. The most ambitious scheme is that developed by the “Group of Twenty” banks, which is known as Continuous Linked Settlement. Many of the details are still to be sorted out, but at the centre of this proposal is having a special-purpose bank as a member of the payment system of each of the currencies included in the scheme. Participating banks would hold individual currency accounts at this special bank, with settlement between them transacted across these accounts. Collateralising arrangements would avoid the creation of credit risk. With extended operating hours in some countries and access to domestic payments systems being on a real-time gross basis, payments by banks in different currencies into and out of the special purpose bank would be made with finality on a continuous basis. FX settlement risk would be eliminated. Unfortunately, groups such as the G10 countries and the G20 banks do not have Australian representation, and their work has not encompassed either the Australian dollar or our market, despite their importance in global foreign exchange trading. Consequently, the RBA set out to replicate some of the international studies to get an idea of the dimensions of the FX risks incurred in Australia, and to identify any special features of the Australian dollar market. We surveyed 24 bank and non-bank foreign exchange dealers during April this year, asking about their settlement practices and the volumes of transactions handled in different ways. It has taken longer than we had expected to analyse the results, but the reasons for the delay -- identifying and -6rectifying errors in a large number of the completed questionnaires -- have been instructive in themselves. Our analysis is still not complete, but we do have some preliminary observations. These impressions from the survey are not particularly comforting. On the other hand, they are also not out of line with overseas findings. The first point is that many banks had considerable difficulty in even completing the survey -- surprisingly including some who had helped us design it. Second, in many banks it took quite some time for our survey to find a “home”, suggesting that they may not have one person (or group) charged with responsibility for FX settlement risk. Giving someone such “ownership” is considered best practice. Many banks seem not to have a good feel for the size of their settlement risk. But it is clear that the magnitudes are huge. Aggregate daily trades of all currencies on the Australian market are probably at least as large as the $90 billion exchanged each day through the domestic payments system. Some banks seem to have a poor understanding of exactly when receipts become final in those countries which do not settle foreign exchange transactions in real time. There is some evidence of a “no news is good news” policy in respect of assuming settlements have occurred. Finally, for even the major currency pairs traded out of Australia, the period of foreign exchange settlement risk (leaving aside weekends and holidays) frequently lasts for more than 24 hours. In some instances, it extends into a third day. For minor currency pairings, and taking into account the period for which a bank might not know whether a trade has been settled or not, it can be as long as 31 days! And remember that settlement risk which is not extinguished during the day it arises, cumulates with the risk incurred the following day. It goes without saying that, in consultation with banks, we will be looking for considerable improvement in the management of FX settlement risk after the full results of our survey are compiled and published in the next month or so. On the positive side, we have seen some evidence of improvement already, as the survey has encouraged senior management to pay more attention to the subject. This is essential, because FX is clearly the next frontier of risk reduction in the payments system. We also believe that it is of utmost importance to our banks, and to our financial system generally, that Australia’s interests are fully represented in any proposed global solutions. We will be working with the Australian banks to achieve this. | reserve bank of australia | 1,997 | 11 |
Statement by the Governor of the Reserve Bank of Australia, Mr. Ian Macfarlane, to the House of Representatives Standing Committee on Financial Institutions and Public Administration in Sydney on 6/11/97. | Mr. Macfarlane’s statement to the House of Representatives Standing Committee on Financial Institutions and Public Administration Statement by the Governor of the Reserve Bank of Australia, Mr. Ian Macfarlane, to the House of Representatives Standing Committee on Financial Institutions and Public Administration in Sydney on 6/11/97. Thank you, Mr Chairman. It is a pleasure to be here in front of your Committee for the second time under the new arrangements set out in the Statement on the Conduct of Monetary Policy. On the basis of the first hearing, we think the new arrangements are working very well. On that occasion, we received some very penetrating and constructive questioning from Committee members, and there seemed to be quite a lot of public interest in the proceedings. Of course, we should always be trying to improve our procedures, but the only improvement we have been able to make on this occasion is to get our half-yearly report to the Committee two hours ahead of the hearing, compared with one hour last time. You will appreciate that in order to follow due process we cannot finalise the document until after our Board Meeting which was on Tuesday. I should also say that I was hoping that we might have been able to have this hearing somewhere other than Sydney. While it is very convenient for us to be meeting again in the New South Wales Parliament House about 100 metres from my office, we see merit in this hearing moving to other State capitals and Canberra on a regular basis if that is possible. The main reason for these hearings is to improve the accountability of the Reserve Bank, both directly to Parliament, and via the press coverage to the public more generally. In the spirit of increased accountability, I should, I suppose, be accountable for what I said to this Committee at the previous hearing, as well as for what I am going to say today. I covered a number of subjects at the previous hearing which I thought were important for an understanding of how the economy was going to perform over coming years. I also mentioned a couple of outcomes we expected for 1997. It is those which will probably be of the most immediate interest. I said that, after a sluggish 1996 where GDP had grown at about 3 per cent -- at one point, it got to not much more than 2 per cent on a 12-months-ended basis, we should expect it to pick up to about 4 per cent in 1997. I also said that I expected inflation to stay at the bottom of the 2-3 per cent range, with the possibility that it could go a little lower for a while. Now I think I could be excused for wanting to walk away from earlier forecasts as a result of the current turmoil in Asian and world financial markets. While I intend to say quite a lot about those events later on, I do not propose to invoke that excuse at this stage, because they have not had any effect on the economy to date. They have affected financial markets, but not the economy yet. Instead, I want to start by saying that the baseline we have to work from, i.e., the growth of the economy in the first three quarters of 1997, has been at least as good as I was pointing to in May, if not a little better. • We now have the GDP growth rates for the first two quarters of 1997, which show the economy grew at an annual rate of nearly 4 per cent during that time. And we have further monthly figures for the September quarter which are somewhat stronger than those recorded during the first half of the year. This is true for the major monthly indicators such as retail trade, imports and exports. It is also true for the labour market, especially for vacancies, and to some extent also for employment. There is also evidence from the business surveys that confidence is picking up, but these surveys were generally compiled before the Asian headlines of a fortnight ago. • On inflation, the outlook changed a little. New figures brought underlying inflation below 2 per cent, and our on-going assessment caused us to lower our forecasts. As a result, we have had two further easings of monetary policy -- one in May and one in July. An important reason for the lower inflation forecasts was the better outlook for wages. You may recall that shortly after the previous hearing in May we received revised figures on earnings from the ABS that suggested not only that they were lower in the quarter in question -- the March quarter of 1997 -- but that an upward trend had been revised away. This better picture was confirmed again in the June quarter figures, but the picture has been muddied somewhat by the recent September quarter figures which show an unexpectedly strong rise. On balance, therefore, we at the Bank judged that the information becoming available over the past six months was tending to confirm this relatively benign view of the future -- GDP growth of about 4 per cent (enough for some further reduction in unemployment from the 8.8 per cent we had at the time of the last hearing) and inflation a little below 2 per cent (enough to justify the May and July easings in monetary policy). The picture was not all rosy -- the slower output growth of 1996 was still making its presence felt in the form of sluggish employment growth in the first half of 1997, there were some doubts about the strength of investment, and the effects of El Niño were around the corner. But economies nearly always present a mixed picture, and this mixture was a lot better than most. In addition, financial conditions had become clearly easier than in May. The overnight cash rate had come down from 6 per cent to 5 per cent as a result of the two easings of monetary policy, and yields on 10-year bonds were down from 7¾ per cent to 6 per cent. The exchange rate against the US dollar has come down from 77.7 US cents to 70.3 US cents; against the trade-weighted index, it has come down from 60.2 to 57.0. I come now to the point where I should say a few things about what has been happening in Asia and the rest of the world. I will do my best to be specific, but you should bear in mind that the ground is constantly changing. The first thing I would like to say is that in the long run I am still very optimistic about Asian growth prospects. These countries still retain a set of characteristics that are conducive to long-run growth: • they can still achieve rapid productivity growth through technology transfer, i.e., they have started from a long way behind and have a fair way to go; • they are oriented towards international trade; • they have high savings rates and high investment and a relatively small government sector; • they have generally sound fiscal and monetary policies -- although they have got some way to go in terms of the soundness of their banking and financial sectors; and • they have great respect for, and devote considerable effort to, education. I do not see the end of the Asian miracle, partly because I do not think it ever was a miracle; it was just the application of some tried and tested rules of good economic policy. It is still fortunate for our long-run prosperity that we have strong links to Asia. Having declared my optimism about the long run, I should now turn to the short run. Clearly, there are going to be difficulties here, in particular among four ASEAN countries -- Thailand, Malaysia, Indonesia and the Philippines. From the moment the Thai baht was floated on 2 July, attention quickly broadened to encompass these four. Their currencies have fallen sharply, as have their stock markets and property prices. These countries are battening down the hatches -- in two cases with the help of the IMF -- to sort out their problems. The principal problem, it is now apparent, concerns how to handle the fall of previously over-inflated asset prices, undisciplined lending by local banks and foreigners, and some very opaque inter-relationships between business and government which have obscured the true financial position of a lot of companies and banks. There also appears to have been over-investment in some areas. Property played its usual major role, but on this occasion there were also more contemporary avenues, particularly electronics and semi-conductors, where there is clear over-capacity and intense competition among these countries (and with Korea and Taiwan). Of course, these problems have been around for years -- they did not just start on 2 July. A part of this adjustment must inevitably involve a sharp curtailment of growth in the short run and a contraction of credit. Imports will fall, and so the effects will be spread to other countries. The good news for Australia is that these four countries account for only 10 per cent of Australia’s exports. If the difficulties remain confined to these four countries, the effect on Australia’s exports, and hence our growth, would be modest. The rest of Asia is, in fact, a lot more important to Australia. Japan -- our largest market -- has been limping along at an average annual growth rate of about 1 per cent now for about five years. Our exports to Japan have virtually not increased at all during that period. The other big Asian markets for Australia are Korea, China, Taiwan and Hong Kong. These are collectively much more important than the ASEAN four. Of course, some of the underlying problems that afflict the ASEAN four also apply, although more modestly, to some of these countries. For a time, it looked as though the ASEAN problems would spill over to these in a big way, but that seems less likely now, although we should not speak too soon. Even so, we should build in the assumption of some slowing in aggregate for these countries. To judge the effects on Australia, we should, in principle, have a view on how each country will fare in regard to economic growth, imports and the health of their banking systems (and we should look outside Asia, which I will do later). It is never easy and some sure bets turn out to be wrong. For example, virtually everyone thought the simultaneous share market crash of 1987 and associated company failures would presage at least a slowdown, if not a recession. In the event, 1988 turned out to be a boom year for the OECD economy and for Australia. Let us hope we can be a little closer to the mark this time. Most analysis to date has consisted of a relatively mechanical application of lower growth and lower imports among the ASEAN four to lower Australian exports and lower Australian GDP growth. The orders of magnitudes are quite small and the most commonly cited figure for GDP growth in Australia is a reduction of about a quarter of a percentage point. According to press reports, the OECD has recently suggested figures of 0.3 per cent for Australia in 1997 and 0.4 per cent in 1998. Quite how they got an effect on 1997, which we are already 80 per cent through, I do not know, but, as I said, I am only relying on newspaper reports. These sorts of figures can become considerably larger if we also bring in lower growth rates for Korea, China, etc., but we are getting into the realms of speculation if we do so. The only guide that we have is that this will not be the first time that it has happened. In 1984 and 1985 we saw a big drop in Asian currencies and a big drop in their growth rates. It had the predicted effect and our exports to Asia for a time were quite weak. Again, last year -- in calendar 1996 -- there was zero growth of imports in the ASEAN four, and our exports to them slowed. I think we will have to put up with a period of weakness again. Frustrating as this instability may be, it seems to be an inevitable part of an open competitive economic system which is the only type capable of achieving strong growth in the long run. So far I have only talked about Asia, but the outcome for the world economy will depend on more than Asia. We have to bring in two bigger regions -- North America and Europe. North America (mainly the United States but also including Canada and Mexico) is growing quite strongly. The recent disturbances in financial markets which were imported into North America from Asia do not seem to have had a lasting impact. If anything, their main effect seems to have been to hose down some overheated asset markets slightly, and hence to reduce the likelihood of an imminent tightening of US monetary policy. Such a tightening in the next six months cannot be ruled out, however. Europe is finally recording some gains after years of disappointingly slow recovery from the early 1990s recession. In fact, European growth has picked up to the point where six European central banks recently tightened monetary policy slightly to head off possible inflationary pressures down the track. So far, I have talked about Asian and world economic events as though their only effect on Australia was via our exports. Of course, that is only part of the story. The other important part is that we now have to face the possibility of further financial market instability. For better or for worse, through knowledge or through fear, the international investment community is taking a more sceptical look at things Asian, and that includes all countries in the Asian region, including Australia. That means they have become more risk-averse, and more likely to judge countries and their policies harshly. We have already seen some of the effects on some Asian countries: • falling exchange rates; • falling share prices; • rising risk margins in interest rates; • downgrades by rating agencies. We are in a better position to handle this financial instability than we have been at any stage in the last 30 years. We formerly had a reputation as a boom-bust economy, and investors used to build in quite a large premium for risk when holding Australian assets. We have come a long way in convincing investors that this is largely a thing of the past. A good example of this is that our bond yields are now virtually the same as US bond yields, whereas five years or ten years ago it was not uncommon for the gap to be as high as five percentage points; some of this was a risk premium and some of it reflected our higher inflation. Another example is that the Australian dollar used to be one of the most volatile currencies in the world, whereas in the 1990s it has been no more volatile than the major currencies such as the US dollar, the yen or the Deutsche Mark. Over the past four or five months, this has served us well. While the Australian dollar has gone down a fair amount against the US dollar, it remained relatively steady in trade-weighted terms. It is true that over the last fortnight the Australian dollar has declined in trade-weighted terms, but it has done this in a relatively orderly fashion, and it is not an unreasonable market response given that our export markets have weakened. This new-found reputation for stability may surprise some people, because there is still a tendency to read so much into the small month-by-month or quarter-by-quarter variations in economic statistics. But if we take a longer sweep, we can see how many of the economic problems that used to concern us have now been eliminated, or are at least under some reasonable sort of control. The headlines are no longer full of stories about the current account deficit or the level of foreign debt. The budget deficit is small. High inflation and its inevitable twin, high interest rates, no longer fill the papers. This does not mean, of course, that we have solved all our economic problems, but we have clearly narrowed them down. This has also tended to concentrate minds on the one that remains -- namely, the level of unemployment. This is a reasonable priority because less progress has been achieved on unemployment than on the other imbalances in the economy that came to the fore in the mid-1970s and persisted through the 1980s. It is not as though no progress has been made -- the unemployment rate has come down from a peak of 11.2 per cent to its present 8.6 per cent -- but it has been disappointing progress. With six years of the expansion now behind us at an average growth rate of 3.6 per cent per annum -- the third highest in the OECD area -- we could have hoped for more. I think some further progress can be made over the next year, although we have to accept that it will probably be slow, and monetary policy will only be part of the story -- in the long run, only a small part. History suggests this will remain the case. Australia moved from 2 per cent unemployment to over 10 per cent in the decade from 1973 to 1983. The damage was really done during that period. Despite good output and employment growth in the 1980s expansion, the unemployment rate was back to 11 per cent following the 1990 recession. So in net terms no progress had been made in a decade. What we want this time is good growth in output and employment, with a difference -- we want it to last a lot longer. The six-and-a-half years that the previous two economic expansions lasted was not good enough. Although progress was made in reducing unemployment -- particularly in the second one -- it was all lost in the ensuing recession. This time around we must make sure we have a much longer expansion, reducing the likelihood and severity of any future slowdown as much as possible. I do not know how that will be possible, but the surest way of ameliorating the business cycle in this way is to avoid the imbalances occurring during the later stages of the expansion. The main imbalance in Australia, as elsewhere, has always been the emergence of inflation. The story is never exactly the same -- inflation can be accompanied by a wage push, an asset price boom or an external imbalance -- but the result has been the same following each of the past three booms. That is why we need to have a more medium-term focus in our monetary policy and why the inflation target is such a central part of it. The inflation target is not anti-growth; low inflation is not an end in itself, we are interested in sustaining a good inflation performance because we are interested in growth and employment. Keeping inflation in check is the key to longer expansions. It has sometimes been said that we are too cautious in following this policy. I think that is a little unfair. Of course, we are cautious in that we like to look at a range of information and think carefully before we make a move on monetary policy. But we try to be forward looking and pre-emptive. For example, we did not wait till measured inflation was below 2 per cent before easing -- in fact, it was 3.1 per cent when we first eased in July last year. Similarly, there have been suggestions that the Reserve Bank has a speed limit above which the economy cannot be allowed to grow (the figure usually cited was 3½ per cent). Such a suggestion is, of course, incorrect and I have pointed this out on several occasions. In case there is still any doubt, you only have to look at our behaviour in 1997. As I said earlier, the economy has been growing at 4 per cent per annum so far in 1997, yet it did not stop us easing monetary policy twice this year. If we are getting reasonable news on inflation and our inflation forecasts are in good shape, we have no objection to the economy growing by 4 per cent or 4 per cent plus. When looking at the whole picture of employment and unemployment, monetary policy is only a small part of the story, and it mainly concerns the cyclical aspect of unemployment. If you look at the really big changes in employment or unemployment over decades, rather than years, monetary policy plays a very small role. The biggest change in employment performance of which I am aware is the contrast between the United States and continental Europe. In the United States, the unemployment rate is back to its 1960s level, whereas in Europe it is about five times as high as it was in the 1960s. A few European countries have done better than that -- including the United Kingdom -- but others have done worse. If you try to explain the superior US employment result by faster economic growth you get nowhere. Europe has grown as fast as the United States over three decades -- it just has not generated jobs. The explanations for the poor European performance on jobs all centre around various types of rigidities, especially in wages and conditions of employment, but also the social security system and the difficulties involved in starting businesses and the subsequent lack of entrepreneurship. I do not intend to go into this in any depth because it is a huge topic. I only raise it to point out that there is much more to the story than the growth of demand, and the role that monetary policy plays in it. In other words, even if we succeed in having good economic growth and sustaining it for a longer period than in earlier expansions, it will not solve all our unemployment problems. We will make some progress, but it is too optimistic to think that we will be able to emulate the Americans and return to the 1960s level of unemployment through macro-economic policies alone. I saw in the paper yesterday someone from ACOSS saying that the big challenge for Australia was to achieve US-style economic growth and low unemployment without US-style inequality and poverty. I think this is a realistic way of looking at it. It shows an awareness of the current trade-off, and I suspect a hope that, with some ingenuity, we might be able to improve on it somewhat. My only quibble is that we already have achieved US growth rates -- in fact, exceeded them -- it is the US unemployment rate that has eluded us. This is something that people like myself, who studied economics in the 1960s, find surprising. In the 1960s it was the United States that was always criticised by countries like Australia and most of Europe for their high unemployment. Now the boot is on the other foot. There is a lot more that I could talk about, but I will confine myself to only one further topic. That is the subject of bank lending and bank margins, particularly bank lending to small business. This is a subject that this Committee has taken a particular interest in. In fact, the first large-scale inter-country study of Australian banks’ margins and banks’ profitability was undertaken by the Reserve Bank at the request of this Committee in August 1994. We did another study at the Committee’s request recently which was published in our October Bulletin. As Committee members also know, the Reserve Bank has been meeting with its Small Business Finance Advisory Panel since 1993 to discuss the provision of finance to that sector. We formed this Panel because we were worried that banks had become excessively risk-averse and were reluctant to lend to small business in the early part of the recovery from the 1990/91 recession. It has been a slow process, but competitive pressures have been gradually working their way into banks’ margins, i.e., the difference between the average rate they earn on their loans and the average rate they pay on their deposits. These margins are now lower than at any time since we have been collecting the statistics, and the biggest fall has occurred over the past two years. Clearly, the entry of mortgage originators into the housing market was a very important development, and it led to the margin on housing lending falling from a level which was high by international standards to one which is about average. We are now beginning to see hotter competition in lending to small and medium-sized businesses. Partly this is a result of the need felt by many banks, particularly the regional ones, to reduce their reliance on the now much less profitable mortgage market. In this sense, it shows how competition slowly works its way through the system. I confess that it has taken longer than I expected, and longer than I hoped, but we are finally getting there. That brings me to the end of my introductory remarks. We have certainly had a very eventful period in the month leading up to this meeting and we have all been working hard to keep up with events, particularly in the international scene. | reserve bank of australia | 1,997 | 11 |
Talk given by Mr Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the 10th Annual Australasian Finance and Banking Conference in Sydney, on 4/12/97. | Mr. Grenville considers Asia and the financial sector Talk given by Mr Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the 10th Annual Australasian Finance and Banking Conference in Sydney, on 4/12/97. The Managing Director of the IMF described the Mexican economic problems of 1994/95 as “the first crisis of the 21st century”, with the implication that this was something new and, more ominously, perhaps there would be more of them. Before the new century has dawned, there has now been a series of similar problems, concentrated in the region of most interest to us -- East Asia. This is relevant to a conference on finance and banking, because the financial sector in each of these countries has been the key factor in the crisis and is central to its resolution. Those who spend time thinking about financial sectors and how they evolve over time may find some interest in examining what went wrong, why it went wrong, and how it might be put right. It is also of considerable importance to Australia -- not just for the effect on our economy (which is hard to quantify at this stage), but also for the opportunity it presents for Australia to deepen its engagement with the region. What went wrong? The problems in Asia, like the Mexican crisis of 1994, exhibit a variety of symptoms, with the most prominent being large falls in exchange rates and equity markets. But exchange rate changes of this size are not unknown in other countries which have not experienced the trauma currently underway in Asia. In Australia in the mid-1980s the exchange rate fell by 35 per cent, and in the early 1990s it fell by close to 25 per cent. Nor is this uncommon internationally. Even the mighty US dollar went up and down by amounts like this in the mid-1980s. More recently, Japan, between April 1995 and April 1997, experienced a depreciation of similar size. These exchange rate changes may well have been a trigger which set off a chain reaction of other events. But by themselves, the exchange rate changes would have been an uncomfortable policy problem, not a crisis. An uncomfortable problem became a crisis because the weakness in the exchange rate infected the financial sector. This occurred through a variety of channels -- in some cases, banks had borrowed heavily in foreign currency; more often, the borrowers were the non-bank business sector. As the exchange rate fell, their burgeoning foreign exchange obligations pushed the enterprises under water, and they defaulted on their debts to the domestic banking sector. At the same time, foreign lenders, who had felt protected by the foreign currency denomination of the loans, now realised that a fall in the exchange rate increased their credit risk, and so they pulled credit lines or failed to roll over short-term debt. This exchange rate shock impinged on financial systems which already had fracture lines and structural tensions. There were a number of specific weaknesses -- connected lending, government-directed loans, poor credit evaluation, lack of transparency, and inadequate prudential supervision. The situation was sustainable if growth and capital flows were maintained, but was not sustainable in the harsh world in which we live, where confidence is fragile, capital flows are flighty, and the stabilising forces of the “fundamentals” are slow to assert themselves. Why did it happen? The first point that should be made is that the praise which had been heaped on these countries for several decades is entirely understandable. These countries have been high savers, budgets have been balanced or in surplus, inflation has been reasonably well contained, and exports had been the dynamic driving-force of growth (with the globalisation that this implies). They ran high current account deficits because, however much they were saving, they were investing even more. Who could, ex ante, have criticised the broad-brush developments in the financial sector? Open capital markets were a merit-badge of economic maturity and a requirement for entry into the industrial-nations’ economics club -- the OECD. Not only were these markets generally opened up and linked in with international capital markets, they embraced this eagerly, including the latest sophisticated products of the financial sector. Equity markets burgeoned and the arcane products of Wall Street were readily available. International agencies urged further and faster deregulation, commercial financial interests (domestic and foreign) were eager to stake out a role for themselves in the fast-growing sector, and sophistication in financial products was seen as being as important as having the latest in industrial technology. While it is easy enough now to see the fracture lines and lack of resilience of these financial sectors, it was less easy to predict the outcomes beforehand. The transition from a regulated financial system to a deregulated financial system is intrinsically difficult. Under the best of circumstances, it was inevitably going to be accompanied by false starts and mis-cues. The pace of growth of credit is difficult to evaluate in a world where you would expect it to be growing quickly because financial repression (McKinnon’s phrase) is ending. The transition leaves the financial system quite fragile during the process. There is a fair bit of evidence that problems have arisen for almost every country during the transition, with the problem usually taking the form of excessive lending as each institution in the deregulated financial sector competes vigorously for its share in the new world. In the process, poor loans are made and asset prices are bid up. These two things come together in mutual reinforcement when the problems come to a head. Lenders who had used collateral as their main loan-evaluation technique find their security to be illiquid and inadequate. At the same time, it is almost inevitable that the process of financial deregulation will run ahead of the capacity of the prudential supervisors to devise a suitable regulatory framework. To start with, the climate of deregulation is often inimical to the regulators. This was certainly our experience in Australia during the 1980s: as we tried to put in place the basis of some “rules of the game” for the new deregulated financial sector, many people who should have known better were calling this “re-regulation by the back-door”, and criticising us for being out of sympathy with the brave new world of deregulation. This experience seems to have been repeated elsewhere. Managers at all levels have been dealing with products and systems with which they are unfamiliar (but to admit this would disqualify them from participating in this exciting new world), and commercial imperatives encouraged them “to boldly go where no man has gone before”. As we look at the problems of foreign currency borrowings in some of our Asian neighbours, one might recall the similar experience with Swiss franc loans in Australia during the 1980s, with the (fortunate) difference that these were, in a macro sense, quite small for Australia. There is another difficult issue here for the authorities. Even when problems were identified, there was the classic dilemma well known to prudential supervisors -- do you “blow the whistle” on the problem and precipitate a crisis (for which you will surely be blamed), or do you quietly work behind the scenes to try to avert the perceived problem, in the hope that you will succeed or the problem will go away of its own accord, but knowing that if it doesn’t, it will be a bigger problem than if you had precipitated it early on. No credit is given for precipitating a crisis early, but there is plenty of blame for being present at the scene of the crime. So it is not surprising that there was, beforehand, a certain amount of hand-wringing about financial sector weaknesses, but this was muted background noise in the general enthusiasm to embrace the new world. What might be done? The first point that should be made here is that the main burden for getting things sorted out again clearly rests with these countries themselves. The related point here is that, for some, (to borrow the catch-cry from positive-thinking management texts) “this isn’t a problem, it’s an opportunity”. For some of these countries, the process of institutional reform may be like punctuated development in evolutionary theory, where progress takes place in jerky stages, with a crisis such as this causing people to focus on the issues and to reform weaknesses. In this view, countries can come out of this trauma stronger than before. It seems quite likely that some countries will be better than others at turning these problems into opportunities. While part of the reaction to these problems must be institutional strengthening of the financial system, there remains a question whether the broad thrust of macro policy -- and, by implication, the spanking rates of growth which these countries have achieved over the past couple of decades -- is sustainable. To put this more specifically, is it possible to achieve the sorts of integration with international markets, the large inflows of capital which went with this and the rapid transformation of economies, without leaving these economies vulnerable to the sorts of changes of sentiment that we have seen in recent months? The constraint on growth is not the conventional one of resources and technology. The constraining factor here is just how resilient can the financial sector be made: the more robust it can be made, the faster these countries will be able to travel. We know the historical experience of Singapore, which ran current account deficits averaging 10 per cent of GDP for more than two decades. We know, too, that this was an important element in the extraordinary progress that Singapore has made. We know, however, that large current account deficits were one of the elements which made the other ASEAN countries vulnerable in recent years (and this vulnerability has always been a concern in Australia, too, despite the academic case that current account deficits resulting from private sector decisions were matters between “consenting adults” and therefore not something with which policy should concern itself). Analysts have pointed to the problems caused by the US-dollar-fixed exchange rates that prevailed in these countries until recently. They argue that, if exchange rates had been allowed to appreciate, credit growth would have been better contained and the economy held on a tighter rein. Greater exchange rate flexibility is surely an element in the new policy regimes. But the lesson of recent months is that, once a fixed exchange rate is freed, it can move by large amounts. Over-shooting is par for the course. All the more reason why a resilient and robust financial sector must be in place if flexible exchange rate regimes are now the norm. Much of this involves careful, slogging, time-consuming institutional improvement -- making accounting systems better, tightening up legal and bankruptcy systems, improving disclosure, and strengthening and deepening experience in prudential supervision. One point that might be noted is that some capital flows seem to create more vulnerability than others, so there is a case for discouraging short-term flows and encouraging direct investment/equity and longer-term bond flows. The best talent in these countries should go into the core financial institutions -- principally banks -- even if this means that the latest whiz-bang innovation of the financial rocket scientists remains unexploited. This is not to argue for stepping back from financial development -- on the contrary, these countries must move forward to deepen markets. But the resources should go into design and implementation of a robust financial architecture and -- to continue the analogy -- useful design parameters are simplicity, a strong basic structure, and attention to detail. One useful objective is to put the banking system in a central position as the guardians on the gateway of investment. If a project has to pass the scrutiny of a bank which will hold the loan on its balance sheet, there is still no guarantee of success, but maybe the chances are improved. What is clear is that private businesses have mis-assessed the risk they faced, tempted by attractively-lower foreign currency interest rates but not sufficiently aware of the need to worry about the variance of the prospective cash flows. An experienced banker might have helped. Of course, this will only work if the banking system is allowed to do its job, untrammelled by connected or directed lending. Banks cannot provide “due diligence” scrutiny on loans which they were required to make. The first priority, always, is to get the banks -- the core of the financial system -- sorted out quickly. The need is to keep the process of financial intermediation flowing: it is the life-blood of the real business sector. The problems are not, in fact, examples of some new “crisis of the 21st century”: they are, at heart, the old problems of bank collapses and the remedy is, in principle, well established. Restoring confidence is the critical factor and for this (as Bagehot observed) central banks should “lend freely, but at a penalty rate”. Insolvent institutions must be separated from the solvent, dealt with, and the remaining institutions supported. None of this is easy. Intractable problems of moral hazard exist, but this should not be allowed to paralyse action. Serious money will be required to fix the problems. Experience over the past couple of decades shows just how expensive these financial sector rescues can be. The 1994 Mexican problems have cost about 12-15 per cent of GDP; the Nordic countries spent 4-8 per cent of their GDP fixing their problems a few years ago; even the S&L problems in the United States (merely a small sub-group of the financial sector) cost around 3 per cent of GDP to sort out. But the cost of failing to address these problems decisively can be more painful still -- a long drawn-out period of financial introspection and inertia which severely retards real activity. A positive point is the strong fiscal positions (and therefore low government debt outstanding) of these countries, so the capacity to fund the restructuring exists. All this is, clearly, largely a matter of domestic policy, with the costs to be borne mainly by taxpayers in these countries. In a more speculative vein, let me return to the idea that what we are witnessing is a problem of the 21st century, and acknowledge that, while what we see has many of the characteristics of an old-fashioned financial sector crisis, it has one important new element -- the major role played by international capital flows. Domestic financial intermediation takes place within a broad set of “rules of the game”, laid down by prudential regulators. There is no international analogue of this. Over time, it can develop, as countries implement consistent rules of prudential supervision, perhaps along the lines of the BIS Core Principles. This might -- together with better information on private capital flows and cross-country position-taking -- provide a response to this new element of the current problems -- the role of large-scale capital flows. What relevance is it to Australia, and to this audience (Australian and overseas)? We acknowledge our stake in the outcome, with two-thirds of our exports going to East Asia (including Japan). Australia is taking part in the IMF-co-ordinated facilities for Thailand, Indonesia and Korea. These funds help restore confidence and help the process of adjustment. We will use our relationships -- via our regional central bankers group EMEAP and, in due course, the newly-formed Asian Surveillance Group -- to provide examples of how prudential systems work elsewhere, analysis of how the specifics might be done in particular countries, technical assistance where it can be useful, and -- the most difficult and subtle task of all -- understated and understanding support for the reform elements who have the task of fashioning a stronger financial sector. A last word directed specifically at this audience. Some of you come from the countries involved: I wish you well in the vital task ahead. For the rest of us, is this, too, not a problem but rather an opportunity? The countries to our near north are going to be devoting considerable resources to strengthening their financial sectors. I hope some of you will find a role for yourselves in this process, and by doing so will look back on this as an opportunity to strengthen our links with our northern neighbours. | reserve bank of australia | 1,997 | 12 |
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to Australian Business Economists on the occasion of the 13th Annual Forecasting Conference Dinner in Sydney on 4/12/97. | Mr. Macfarlane discusses the changing nature of economic crises Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to Australian Business Economists on the occasion of the 13th Annual Forecasting Conference Dinner in Sydney on 4/12/97. It is a pleasure to be here this evening to talk to the Australian Business Economists. I looked back over my files and I noted that this is only the second time I have addressed this group; the previous occasion was nearly seven years ago in February 1991. At that time, I spoke about asset price booms and busts, particularly the latter. You may think I have a one-track mind, but the same subject -- only with a different location -- is going to figure prominently in what I have to say tonight. 1. Types of economic crisis I want to talk about the changing nature of economic crises, and then draw out some conclusions for Australia. At the risk of some oversimplification, I think there have been two basic types of economic crisis. The old-style economic crisis I will call Type I, and the new-style, which has come to prominence over the past decade, I will call Type II. Most of these crises occur in developing countries, but developed ones have not been immune from them. The standard way that countries -- particularly developing countries -- got into trouble in the past was that their governments did the wrong thing by running bad fiscal and monetary policy. Governments ran large budget deficits and did not finance them properly -- they wrote cheques on the central bank, which is colloquially known as printing money. Interest rates were held artificially low (or negative in real terms) and money supply ballooned, resulting in accelerating inflation, a loss of competitiveness, large current account deficits and a collapsing currency. This was a Type I economic crisis, and the IMF has a standard set of arrangements for dealing with this problem. Just about every developing country ended up in this predicament at some time or other. Some of the Latin American countries did it again and again. We skirted perilously close to it in Australia, particularly in the mid-1970s, but did not end up in the hands of the IMF. The United Kingdom, however, did. It suffered a classic Type I economic crisis in 1976, and needed a support package from the IMF, with the usual conditionality requirements. The Type II problem is very different. Although it has become common in the past decade in a wide range of countries, the best examples at present are to be found in Asia. Type II economic crises are not caused primarily by bad fiscal policy or bad monetary policy. One of the reasons I have a lot of sympathy for the Asian countries at the moment is that they did not get into their present trouble through undisciplined fiscal policy, and their monetary policy in the conventional sense1 was quite good. This is shown by the fact that their budgetary positions are on average much better than OECD economies, and most have inflation rates that are quite low for developing countries. A Type II crisis is really financial in nature, rather than stemming from poor macro-economic policies. Its central dynamic is the credit cycle and the main players are companies and banks, or financial institutions more generally. A Type II crisis usually traces its roots to a period when the economy was doing well, growing quickly and becoming popular with investors and lenders. Usually, but not always,2 an inflow of foreign capital is part of the process which bids up asset prices (and attracts more foreign capital). Domestic banks do not sit idly by -- they join in to 1 Conventionally loose monetary policy in a Type I sense would involve monetisation of the budget deficit, low (or negative in real terms) interest rates, continual downward pressure on the exchange rate and rising inflation. In most Asian countries over the past decade, these conditions did not apply; in fact, the opposite was more typically the case. On the other hand, monetary policy was not tight enough to prevent the strong expansion of the balance sheets of the banks. Such a degree of tightness would not have been compatible with the maintenance of a fixed exchange rate. 2 Japan in the 1990s is a classic drawn-out Type II episode, but one in which foreign capital played only a minor role. lend money for all sorts of promising projects and asset purchases. If the economy is growing strongly at the time, which it usually is, it looks as though everyone can make money. Some of the finance is invested wisely and makes a good return, but much of it is inevitably invested unwisely. A lot of it goes into property or is invested in industries which are already oversupplied. At some point, something happens and the whole process goes into reverse. In the case of South East Asian countries, the event that triggered the reversal was the realisation that their currencies (initially the Thai baht) had become over-valued because they were tied to a strongly appreciating US dollar. The real exchange rate was also the trigger in Mexico in 1994. The mechanism by which the reversal occurs is usually capital outflow. Even without an external “shock”, a reversal would eventually occur, as it did in Japan’s case. Domestic and foreign investors sell assets and take their funds out of the country. The early ones realise good profits in the process, the slow movers are motivated by a desire to cut their losses. In the process, the exchange rate falls sharply, and the initial diagnosis is that the country is suffering from a “currency crisis”. Soon asset prices fall, with attention focusing on the most visible indicator of this -- the share price index. Later it becomes apparent that businesses are going to fail, collateral values will fall, loans will go bad, and the inevitable glut of new property coming onto the market will not be able to attract buyers. If, as is usually the case, companies and banks have borrowed in foreign currency, servicing burdens become intolerable. Suspicion turns to the solvency of the banking system because its customers are failing and its capital is diminishing. It is usually not just a problem of an individual bank, but of a significant part of the banking system. Banks are reluctant to make new loans or rollover existing ones as they fight for survival. Compared with a Type I economic crisis -- which was predominantly due to government failure -- the Type II crisis is predominantly a private sector and banking failure. The government is, of course, still implicated, and there are usually Type I elements involved, but the solution to the problem mainly involves reforming the banking system. If the trigger for the crisis in the recent Asian episodes was an over-valued exchange rate, this can be counted as a macro-economic policy error by the government. This is a complicated subject because for quite a while the currency fix seemed to be contributing to the good economic growth performance. But in the end, policy placed too much emphasis on international competitiveness and the current account of the balance of payments, and neglected financial stability and the capital account. The fixed exchange rate also affected the composition of capital inflow in that it encouraged borrowing in US dollars because US interest rates were lower and there was a perception of little or no currency risk. This contributed to serious Type II problems. The second way that governments often get involved is that they own or influence a lot of the banks and firms that get into trouble, and a lot of the physical investments that turn bad have been made at government direction. Finally, an important qualification to the view that Type II crises are predominantly private sector in origin is the recognition that the environment in which the private sector operates is largely determined by government policies. When the insolvencies emerge in the banking sector, people will ask “Why did the government allow this to happen?”, “Why didn’t the government have policies in place which prevented the build-up in this unsustainable situation?”, “What will the government do about resolving the crisis now that it has happened?” The truth is that the government cannot pass the buck. The best they can say is that it was not a failure of conventional demand management policies, it was a failure of a different set of policies altogether -- the policies directed at financial system stability. 2. The increased focus on financial system stability There has been increased recognition in recent years that more attention should be devoted to policies directed at financial system stability. The two best examples of this are the Basle capital adequacy guidelines and, more recently, the Core Principles jointly promoted by the BIS and the IMF. One reason for this is that we now have a better understanding of the huge economic costs that are incurred whenever there is a systemic failure of the financial system. Systemic failure invariably results in a recession and can turn a probable recession into a depression. Modern scholarship now identifies a systemic banking system failure as the principal reason that the US economy experienced a depression in the 1930s, rather than a short-lived recession. The budgetary cost of resolving a systemic failure is also extremely high. Some people may say that one way to avoid this is to let the private sector sort it out. The drawback to this suggestion is that once the problem has reached systemic proportions, the intermediation process has broken down so badly that good borrowers will be hurt as well as bad ones. The government has to step in and close down the insolvent lenders, and take the bad loans off the remaining banks so they can start with a relatively clean slate. This solution is invariably costly and may not appeal to some on long-run moral hazard grounds, but the alternatives are so much worse. In practice, this is the only practical solution to a systemic failure of the financial system. The table below shows some recent examples of the budgetary cost of systemic failures. It covers only recent episodes in OECD countries; much higher figures could have been cited if the coverage had been extended to developing countries. ry Systemic Banking Crises: Cost of Recapitalisation Cost Count eriod as % of GDP Finlan d 8.0 991-1993 Norwa y 4.0 987-1989 Spain 16.0 977-1985 Swede n 6.4 United States (S&L) 3.2 984-1991 Source: Caprio and Klingebiel, World Bank, July 1996 The other reason for the recent emphasis on financial system stability is that economies appear to be more susceptible to instability as a result of the deregulated financial markets. Australia’s experience in the late eighties points in this direction, but it is not an absolute rule. Just as Japan has shown that Type II episodes can occur without a lot of foreign capital flows (in fact, there were net outflows), there are many African and Latin American examples of it happening in a heavily regulated environment. The Asian countries, including Japan, which are now going through these difficulties could not be characterised as possessing highly deregulated financial sectors. The two Asian countries which most closely approximate the deregulated model are Hong Kong and, to a lesser extent, Singapore. To date, these countries have fared reasonably well. The link between deregulation of financial markets and instability is obviously more complicated than meets the eye. It would probably be better to say that the transition phase from regulation to deregulation is a dangerous period. This will be especially so if the transition is rapid, and if it is not accompanied by increased transparency and the enhancement of other policies directed at system stability. 3. Problems and remedies In essence, therefore, a Type II economic crisis is one which is centred around a failure of the financial intermediation process. The centrepiece of it is an environment which leads to excessive competition by banks to lend, resulting in a severe reduction in credit standards. The following features are normally present: • lending to related parties; • excessive concentration of lending to particular borrowers or areas, e.g. property; • excessively high loan to valuation ratios; • inadequate covenants to restrict the activities of borrowers; • lending based on asset values, rather than capacity to service from income; • failure to recognise and provide for deterioration in loan quality; • lending to firms or individuals as a result of government directive, rather than on a commercial basis. All these developments often take place against a background of limited transparency, where investors and depositors have difficulty monitoring the capital adequacy of individual banks. There appear to be no problems during the initial phase of rapid economic growth and rising asset prices, but doubts begin to arise when asset prices fall. The recognition that some banks (and companies) have become insolvent is difficult enough in sophisticated capital markets, but is harder again where there is little necessity to revalue assets and disclose the results. Bank supervisors, as well as market participants, are thwarted by the lack of transparency. Inevitably, insolvent entities continue to operate, and there is widespread distrust of all banks because lenders and depositors cannot distinguish between creditworthy and insolvent institutions. As a result of the presence of Type II economic crises, it is now recognised that governments require improved policies directed at financial system stability. Within this general field of policy, the one that has the most direct relevance is the prudential regulation of banks. This includes both preventative measures and crisis resolution. But prudential supervision of banks is only one policy, although an extremely important one, among the range of policies that are required to achieve reasonable financial stability. Other important policies are those that pertain to the payments system and, of course, the whole field of securities regulation, including disclosure provisions and the enforcement of commercial and criminal law. In fact, it is possible to consider the whole body of law relating to claims over property and accountancy standards as being part of the necessary infrastructure for system stability. 4. Relevance for Australia It is being increasingly recognised that, in the modern world, the most likely route to a self-inflicted economic crisis or, at its extreme, an economic collapse is through a systemic failure of the banking system. Therefore, in order to get good economic outcomes in terms of sustainable economic growth, we need more than just good monetary and fiscal policies. We need good policies directed at financial system stability, including, of course, good prudential supervision of banks. There is a close inter-relationship between monetary policy and policies that affect the stability of the financial system. While the principal aim of monetary policy should be to maintain low inflation as a pre-condition for sustainable growth, it cannot be conducted in isolation from developments in the financial system. For example, how far interest rates need to be raised to bring about a given slowing in the economy will depend partly upon how stretched asset markets are, and how exposed the banking system is to them. Similarly, the extent to which a currency depreciation can be accommodated will depend on banks’ and businesses’ exposure to short-term foreign currency borrowing. Having pointed out the close relationship between monetary policy and system stability policy, I expect some of you in the audience tonight will be thinking that my next step will be to put in a plea to keep bank supervision at the Reserve Bank, rather than to move it to the yet to be formed Australian Prudential Regulatory Authority (APRA). I am sorry to disappoint you, but I am not going to do so; we did this in our submission to the Wallis Inquiry, but that chapter has ended. Although monetary policy and system stability policy are clearly related, we accept that this does not mean that bank supervision can only be carried out at the central bank. The Wallis Inquiry recommended against this, and cited a number of countries which had performed well under arrangements where monetary policy and bank supervision were carried out in separate institutions. The Government agreed with the Wallis Inquiry, as did the Opposition. We therefore accept that due process has been carried out, and that the umpire has made a ruling. We now want to get on with the job and help the Government put into place the arrangements recommended by the Inquiry. The Wallis Inquiry was well aware of the interconnectedness of monetary policy and system stability policy, and recommended that both of these responsibilities remain with the Reserve Bank. In common with many other observers of these matters, the Inquiry saw bank supervision as a clearly identifiable and separable sub-component of system stability policy. Even though bank supervision was to be carried out in APRA, the Inquiry recommended a number of mechanisms to ensure that there was close co-ordination between bank supervision and other aspects of system stability policy. These mechanisms involve Reserve Bank membership of the APRA Board, plus a number of arrangements for information sharing. I want to conclude my address tonight by covering two aspects of the proposed arrangements; first, I want to say something about what system stability policy involves once bank supervision is conducted elsewhere, and second I want to say something about the nature of APRA. With bank supervision being undertaken in APRA, what is left to be done by the Reserve Bank in carrying out its system stability responsibilities? The first and most obvious task remaining with the Reserve Bank is responsibility for the payments system. In fact, the Wallis recommendations increase our responsibilities in this area, so much so that we are getting a separate Board to oversee payments system issues. As you will know, we already have a lot on our plate in this area, with the RTGS project nearing the operational stage and with the next major project likely to be in the area of reducing foreign exchange settlement (including Herstatt) risk. As well as specific responsibilities for the payments system, the Reserve Bank will also retain a capacity to contribute to the overall formulation of policies that impinge on system stability. The Reserve Bank will need to be able to evaluate the likely effects of prudential policy changes, particularly for banks but also for other financial institutions. It will have to keep abreast of the risks associated with the proliferation of new products and possibly new types of financial institutions. It will also need to form its own independent judgment of where the likely “pressure points” are building up insofar as they may imperil system stability. The Reserve Bank’s formal channel into the policy process will be through its membership of the APRA Board. It will also have to develop a close relationship with the Australian Corporations and Financial Services Commission (ACFSC). The new Council of Financial Regulators (CFR) will be one vehicle for this. What we will no longer be doing is face-to-face bank supervision. We will not be dealing with individual banks when they need help with licensing, interpretation of rules, statistical returns, etc. That will all be done by APRA. Inspections will also be the responsibility of APRA, but in the interests of information sharing, the Reserve Bank will be entitled to participate from time to time if it so desires. I do not imagine this would happen very often. Overall, it is APRA which will be setting and enforcing the rules designed to minimise the chances that financial institutions will fail. It will be APRA that has to make the judgment that an institution is in danger of failing, and to take the appropriate action. As you will see from this description of the division of responsibilities, the Reserve Bank will be relying on APRA doing a sound job. In fact, I think the whole country, and particularly the financial sector, has a big stake in ensuring that APRA is a first-rate institution. The ACFSC is also crucial to the long-run stability of the financial system, but it has the advantage that it already largely exists in the form of the ASC. APRA, on the other hand, has to be created almost from scratch. We should all support a speedy formation to make sure that the intellectual capital presently residing in its constituent parts in Sydney, Canberra and Brisbane is not lost, but is speedily brought together in one institution. It is also important that it have a high degree of budgetary independence so that it can augment its resources from private financial markets and so ensure a high degree of interaction between regulators and practitioners. I know that the Government is aware of these needs and is doing its best to bring about an early introduction for APRA. I want to finish tonight by assuring everyone that the Reserve Bank is doing everything it can to assist in the process. | reserve bank of australia | 1,998 | 1 |
Talk by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the Third Biennial Pacific Rim Allied Economic Organizations Conference in Bangkok on 16/1/98. | Mr. Grenville discusses exchange rates and crises against the background of the financial turmoil in Asia* Talk by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the Third Biennial Pacific Rim Allied Economic Organizations Conference in Bangkok on 16/1/98. Economists have an unenviable reputation for being practitioners of the “dismal science”, but this is undeserved. The economist’s characteristic response to a crisis is a positive one: they identify a central crucial factor, and generally this is something that can be put right. Economists rarely throw up their hands and say that it is all too difficult. This capacity to produce simple answers which purport to avoid further problems is, in one sense, admirable. But it carries with it the danger that complex causality will be mis-diagnosed. It opens the possibility, too, that pet panaceas, rules of thumb, and glib nostrums - often driven more by doctrine than by careful analysis - will influence the response. The 1994/95 Mexican crisis, which provides a foretaste of the current problems in Asia, provides a classic example of this. After the crisis (which involved an almost 50 per cent fall in the exchange rate), one might have gained the impression from contemporary analysis that, if only Mexico had published accurate figures of its foreign exchange reserves in a timely way during 1994, the crisis would have been averted or at least greatly lessened. In the case of Thailand, there was a view - particularly in the early days of the episode - that if only Thailand had floated its exchange rate sooner, everything would have been all right. According to this view, there were a couple of relatively simple policy mistakes (fast growth and a fixed exchange rate) and, when these were remedied, everything would quickly return to normal. What I will be arguing here is that the problems are much more complex and multi-faceted than this. To be sure, there have been very large falls in the exchange rate in a number of Asian countries, and this has been an important part of the story. But when we look back on the early analysis, which identified the basic problem as an exchange rate over-valuation of 10-15 per cent which could be corrected by floating the exchange rate, events since then should have demonstrated the inadequacy of this view. I have argued elsewhere (Grenville 1997) that, if there is an identifiable principal problem, it is more deep-seated and lies in the fragility of the financial sector. It has many of the characteristics of an old-fashioned bank liquidity crisis, with failing confidence at the heart of the problem. I am not going to go through this argument again today, because this session is about exchange rates. And, in any case, the exchange rate clearly did play an important part in the story. What I shall argue, however, is that it was not the central, over-riding, element of the story. The facts First, the facts. Table 1 shows the exchange rate movements in a number of East-Asian countries during 1997 and of course there have been some further large falls in the early days of 1998. These have been very large movements and unusually rapid, but the magnitudes, at least during 1997, are not unprecedented. Not long after the exchange rate was floated in Australia in 1983, there was a change of close to 40 per cent in the trade-weighted exchange rate (which would be of the same order of magnitude that we saw in Asia in 1997). For Japan, in the two years beginning in * I am grateful for the help of John Hawkins and Amanda Thornton in preparing this paper. April 1995, the exchange rate depreciated by 34 per cent: over a longer period of time (e.g. ten years), we can find much larger changes in the yen, from around 250 to the dollar at one extreme, to 80 to the dollar at the other extreme. Even the exchange rate between the two “safe havens” - the US dollar and the German mark - experienced changes (both up and down) of around 50 per cent in the mid 1980s. Table 1: East Asian Exchange Rates per cent change during 1997 vs US dollar trade-weighted* Indonesia Malaysia Philippines South Korea Thailand -56 -35 -33 -47 -45 -44 -24 -26 -43 -38 * RBA calculation Why do these big changes in exchange rates occur? This is a central question, to which there is no clear answer yet. But I want to put forward two issues which may be a large part of the story: the first has to do with large capital flows; and the second has to do with what the technicians would call “model uncertainty”: there is no close, well-established relationship between the fundamentals of the economy and the exchange rate. When these uncertainties are great, it is difficult for markets to assess what is the “right” exchange rate. First, capital flows. One of the outstanding (indeed amazing) characteristics of the 1990s has been the extraordinary increase in international capital flows, particularly to the emerging countries, and particularly to the countries of this region. Graph 1 shows a measure of the increase in overall flows. The ten countries that were the main recipients, shown in Graph 2, accounted for about three-quarters of the total, and half of them are in East Asia. Graph 3 is a reminder that these flows were extraordinarily large relative to the size of these economies routinely amounting to 6 per cent or more of GDP. The other characteristic of international capital flows (shown in Graph 4) was the greatly increased importance of portfolio investment first channelled through banks and, more recently, directly from funds management institutions. One of the characteristics of these professional fund managers is that they have applied more formal, structured principles to portfolio management, including the idea that diversification will protect fund holders from some volatility. At the same time, few of these fund managers are experts in the individual emerging markets - they tend to treat these markets as an investment class, rather than develop country-specific detailed information. In this world, contagion is Among the Asian countries themselves, it is worth recalling that Indonesia, as a conscious and deliberate element of macro policy, changed its exchange rate by large amounts three times in the late 1970s and 1980s, at a time when it had a fixed exchange rate and there was no pressing need for exchange rate changes - they were well-conceived macro policy responses to emerging policy problems, and were taken on in the well-founded belief that exchange rate changes of this size could be absorbed by the economy. common and changes of sentiment can be driven by herd behaviour. It is a bold fund manager who stands his ground when the herd is stampeding. Graph 2: Concentration of Private Capital Flows Graph 1: Developing Countries Net Capital Flows 1990-95 Billions of US$ US$B US$B China Mexico Brazil Private Korea Malaysia Argentina Thailand Official Indonesia Russia India -60 -60 Graph 3: Private Gross Capital Flows Billions of US$ % US$B Direct investment Portfolio investment Other investment -40 US$B Graph 4: Developing Countries Net Private Capital Flows 12 largest recipients of private capital, % of GNP % -80 -40 -80 At the same time as these large mutual funds were discovering the attractions of diversification, the financial infrastructure to implement this was also being put in place, mainly driven by international financial institutions searching out expansion opportunities. They were encouraged in this by the general intellectual climate which promoted globalisation, and by the official international financial institutions (IMF, World Bank, and so on) who saw freeing up of financial capital as an important part of the development process. , The recipient countries were happy enough to see these flows, as they themselves embraced the increasing sophistication of their financial infrastructure as a symbol of modernity and as a driving force for the growth. Progressive dismantling of capital controls in the recipient countries was a factor, but in a number of cases the capital accounts had already been substantially opened (in Indonesia, for instance, capital flows were, to all intents and purposes, free from 1970 onwards). One other point worth noting is the disparity between the size of these funds and the size of the recipient countries. Even though these funds have not diversified all that much, their size is enormous. Even if the US mutual funds bought every share listed on the ASEAN stock markets, this would still represent less than a tenth of their assets. Korea, for example, as a pre-condition for entry into the OECD “rich countries’” club, had further to deregulate capital flows. Coming out of this, we saw such developments as the Bangkok International Banking Facility, which began as an offshore banking centre, but very quickly developed into the smooth facilitator of massive flows of capital into Thailand (over $10 billion per year - more than 10 per cent of GDP - since 1993). At the same time, Thai finance companies hoped to improve their claims for banking licences by facilitating inflows. It was not so much change of regulation but change of attitude and perceptions that was the driving force of the enormous increases in capital flows. By 1990, a number of these countries had recorded two decades of high growth and had established an enviable track record of political stability, balanced budgets and lowish inflation. If there was an “economic miracle” occurring (cf. World Bank, 1993), it is not surprising that foreign investors wanted a slice of the action. Not least, domestic investors in these countries took the opportunity of what looked like extremely low borrowing rates on these overseas funds to finance an investment boom, including, inevitably, a good share of over-investment and misplaced investment. These big flows (and the big current account deficits that went with them) were not some kind of aberration, but reflected the normal working of market forces. For those who find these deficits to be aberrant behaviour, could I remind you of the Feldstein and Horioka (1980) analysis, which suggested that the true aberrant behaviour was the close correspondence between saving and investment within most countries in the world. In other words, the amount of capital flow between countries has been smaller than optimal behaviour would seem to suggest. While a number of poor investment opportunities were certainly undertaken (most notably, excessive real estate investment), at an aggregate level it is still correct to say that there were many high profit opportunities available in these countries, as they moved from well inside the technological frontier towards the frontier itself, driven by an eagerness to adopt all sorts of productivity-enhancing techniques. Graph 5: Singapore Current Account Per cent of GDP % % -10 -10 -20 -20 -30 -30 -40 -40 Source: IMF International Financial Statistics . If all this sounds a bit textbook-ish, consider the experience of Singapore. As shown in Graph 5, they ran a current account deficit averaging more than 10 per cent of GDP for two decades, in a period of policy-making which would universally be regarded, with hindsight, as extremely successful. I should remind you also that all these countries ran, in the textbook sense, “good” deficits - i.e. they were used to fund investment and not consumption, and were certainly not funding budget deficits. Some of these countries understood, perhaps intuitively more than by rigorous logic, that big current account deficits made them vulnerable: Indonesia, for instance, was uncomfortable if its current account deficit was above 3 per cent of GDP. Korea, too (in recent years at least), ran quite modest current account deficits. But by and large, once these countries accepted the idea of financial deregulation and open markets, they were going to be on the receiving end of very substantial capital inflows. Table 2: Saving, Investment, Current Account and Budget Balances 1991-1995 average Saving (% of GNP) Investment (% of GNP) CAB (% of GDP) Budget Balance (% of GDP) Indonesia Malaysia Philippines South Korea Thailand 31.8 34.2 18.7 35.4 34.9 34.1 40.5 21.7 36.9 41.8 -2.5 -6.3 -3.4 -1.3 -6.4 0.8 0.1 -0.6 -0.2 2.9 Memo: Mexico United States Germany Japan 17.6 15.5 21.8 34.8 19.4 16.0 22.2 30.4 -5.2 -1.2 -0.9 2.6 0.1 -3.6 -2.0 -0.6 There is not a lot of point in trying to identify precisely whether the capital flows were more supply-driven than demand-driven, because we have known since Marshall that the outcome depends on the two blades of the demand and supply scissors. Nevertheless, it might be worth noting that the financial flows were often significantly larger than the amount that could be absorbed in terms of real flows of goods and services - i.e. the capital inflow was larger than the current account deficit: Graph 6 illustrates this. Graph6: Private Capital Inflows and the Current Account As a percentage of GDP % • Norway Chile (89-94) Indonesia -2 Colombia • • •• •• Sweden Argentina (92-93) Finland • Philippines (89-94) -4 Malaysia (89-94) • Venezuela (92-93) • Thailand (88-94) • Mexico (89-94) -6 Malaysia (80-86) • • -8 -10 % Private capital inflows Source: World Bank We will return, later, to the issue of whether the policy problems created by these huge capital flows (and the resultant rapid growth of domestic credit) could have been avoided by a different exchange rate regime. The basic point made here is that these countries embodied significant profit opportunities (albeit with lots of opportunities to over-invest and invest in the wrong industries), and that it was normal for large amounts of capital to flow from the “old world” of savers towards the new opportunities available in these countries. Indonesia also understood that it was difficult to put in place the necessary prudential structure in time to keep pace with the burgeoning capital inflows. The central bank Governor has noted: “we started building the foundations of a house but suddenly we had to host a party”. The second major issue behind exchange rate fluctuations revolves around perceptions of how the economy works - “the model”. What is the “mind-set” of participants in the market - what do they think is the “proper” exchange rate? This is based not just on their views about some “fundamentals”, but also their guesses about other market participants’ views, so there is certainly plenty of opportunity for exchange rates to move very significantly, and stay away from the underlying fundamentals for significant periods of time. We noted, earlier, that this has happened in the case of countries such as the United States, Japan and Australia, where there are well-developed views about how the economy works and detailed analytical and econometric studies of what proper pricing relativities should be. The “models” or “mind-sets” for the countries in question are much less fully developed and universally held, so there is far more opportunity for prices to shift sharply, and stay at rates which, earlier, would have seemed abnormal. On top of this, there are substantial information asymmetries, asymmetries which made market participants very nervous about going against the run of the market or taking significant contrarian positions. This combination - very large, footloose capital flows and an exchange rate not firmly anchored by “fundamentals” - goes a long way to explain the big exchange rate moves. When sentiment and confidence changed and the original investors began to pull out their capital, the exchange rate fall did nothing to induce new inflows. Where were the stabilising speculators of textbook theory, who were supposed (in the textbook view) to respond to the fall in the exchange rate by recognising that, once the exchange rate was below its fundamental level, there was a profit opportunity for those who bought the currency? In the absence of a firmly-defined “fundamental” equilibrium exchange rate, as the exchange rate fell, the market changed its view on what was the “correct” equilibrium rate. Even when most market participants agreed that exchange rates had gone too far, they recognised the possibility that they could go further still. To stand against the run of the market in a contrarian position might be ultimately vindicated, but in the short run required a degree of courage and confidence that no fund manager (whose performance is evaluated more-or-less constantly) could afford to take. In short, there were no equilibrating flows to anchor the exchange rates. How should exchange rates behave? Let’s try to develop this a bit further to see whether there is any clear, fairly universally-accepted idea of how exchange rates should move in the circumstances in which these countries found themselves. Perhaps the nearest guidance we can get from formal academic ideas is the old discussion about the “transfer problem”. The key point is that as financial flows shift from one country to another, it is necessary to induce equivalent real flows of goods and services (which would take the form of a current account deficit, corresponding to the financial flows in the capital account). The old literature observed that there could be a wide range of outcomes for the “transfer problem”: where the financial flow took the form of direct foreign investment, the same decision about the financial flow generally induced the real flow - as a company decided to invest overseas, it shipped plant and machinery in roughly corresponding amount. But if the flows took the form of portfolio investment, then the exchange rate had to appreciate to encourage the real resource transfer. The other longer-term structural influence on the exchange rate was the rapid productivity increases in the tradeables sectors: in theory, these countries might have expected to find, over time, their real exchange rates appreciating. In the Balassa/Samuelson model, productivity rises fastest in the tradeables sector, and equilibrium requires a higher real exchange rate. Of course, there were other forces at work. In 1996, there was a very significant fall in the terms of trade of these countries. And the story is further complicated by the specific nature of the exchange rate regime - fixed more-or-less to the US dollar - so the effective exchange rate swung with the US dollar. To further complicate the picture, capital flows responded to the changing monetary stance in the big capital-exporting countries - low interest rates in Japan in recent years encouraged the so-called “carry trade” - borrowing at low interest rates in Japan and lending at high rates elsewhere in Asia. These factors were transient, and taking the dominant structural elements as being the capital transfer issue and Balassa/Samuelson, it was not surprising to find upward pressure on exchange rates during the 1990s and some modest appreciation of real exchange rates. The exchange rate strength might have been expected to last for a considerable length of time, and perhaps become permanent because of the structural improvement in productivity. The relatively modest increases in the real exchange rate seen in countries like Thailand were thus not, in themselves, a clear indicator of an over-valued exchange rate or impending depreciation. Table 3: East Asian International Reserves change from December 1991 to December 1996; US$bn Indonesia Malaysia Philippines South Korea Thailand Source: IMF, International Financial Statistics In the face of this upward pressure on the exchange rate, the policy approach of these countries over the decade (until 1997) had been to resist significant appreciation. This is reflected in the increase in their foreign exchange reserves (Table 3). Why did they resist the upward pressure? This was, in part, because the lower exchange rate was seen as offering a beneficial general incentive for the most dynamic parts of the economy - the tradeables sector and, in particular, the export sector. Partly, too, it reflected a perception that high exchange rates left countries vulnerable to sudden changes in sentiment. Looking at the experience of these countries, it is hard to disagree strongly with these sentiments. Dornbusch (1994, p. 280), writing about Mexico, notes “… over-valuation is one of the gravest policy errors along the way. Over-valuation stops growth and, more often than not, ends in a speculative siege on the exchange rate and ultimately currency realignment”. Lessons I have tried to put the case that the capital inflows that occurred into these countries in the first half of the 1990s were not some aberration of policy-making, but were For example, the price of a standard computer chip fell from $50 in late 1995 to under $10 in 1996. Some argue that the reversal of capital flows to East Asia was triggered by market fears that Japanese interest rates were about to rise, putting an end to the “carry trade”. It is worth noting that Mexico’s exchange rate over-valuation problem in 1994 was quite different from any Asian experience - a fixed rate regime had been used by Mexico as an anchor while inflation was reduced, with the inevitable consequence of over-valuation. more-or-less to be expected. But we now know, with hindsight, that they were unsustainable. Where did it go wrong? What should be done? The first lesson is that whatever the “model” suggests is the norm for capital flows, when these flows get large, economies are vulnerable to changes in sentiment. The model does not say much about how policies should handle changes of sentiment which bring very large variance to capital flows and GDP. Wherever there are large foreign capital flows, there is a high probability of rapid changes of mood, because - whoever bears the exchange rate risk (whether borrower or lender) - one of the parties to the transaction is holding an exchange rate position which is not “natural”. This makes that party flighty and quick to re-assess their position. In many cases, the response was that the party with the most information bore the exchange rate risk - i.e. the domestic borrower borrowed in foreign currency. It was not irrational to expect exchange rates to remain reasonably stable, not only because policy in these countries had succeeded in keeping a high degree of stability over a reasonably long period of time, but also because (based on our earlier argument) they might have expected, if anything, the exchange rate to appreciate over time, which would have reduced the cost of their overseas borrowing. But in the end it was the old issue of variance or the variability over time that brought the best-laid plans of borrowers to such an unhappy end. We noted earlier that the textbook equilibrating forces were largely absent - as foreign exchange became dearer, people wanted to buy more, not less. This was reinforced by lenders’ behaviour. As the exchange rates fell, foreign lenders, although protected from exchange rate risk, began to realise that they were exposed to increasing credit risk, and became extremely reluctant to roll over their lending. The credit-rating agencies added their own special twist-of-the-knife, down-grading these countries six months after the problems began, so that portfolio managers were forced to sell into the collapsed markets. Now we have looked at some of the forces operating on the exchange rate, we can ask: “Would an earlier float of the exchange rate have avoided these problems?” With hindsight, it is hard to argue against this view - the actual path proved unsustainable, so any alternative looks attractive. But this does not tell us whether the alternative would, in fact, have handled the situation more satisfactorily: for this, we would need to sketch out what the exchange rate path over time would have been under this alternative scenario. Given the capital-transfer process underway, how much would the exchange rate be expected to appreciate? This is hard to think through, but the key idea here is that an interest rate differential should be balanced by an expectation of exchange rate depreciation if portfolios are to be held in balance. Portfolio equilibrium could not be achieved by lowering domestic (local currency) interest rates, because these were set - in effect - by the high domestic marginal efficiency of capital: high interest rates were needed to rein in the intrinsic dynamism of the domestic economy. If the interest differential was expected to be maintained for a significant period of time (say, a decade or more), then there would need to be a very large appreciation of the exchange rate to balance the likelihood that interest differentials would be maintained over this period of time. How far would it have had to appreciate before foreign investors would have stopped extrapolating the appreciation and begun to expect depreciation? Would this process have been smooth, without the over-shooting we have seen? What sort of knife-edge equilibrium would this have been, in which portfolio managers’ calculations teeter between the recent history of appreciation, but incorporate a steady, gentle, expected depreciation from here on? Would the even-higher current account deficits that would have occurred during the Were they foolish not to hedge their borrowing? This is a common ex post criticism, but it seems to ignore the obvious financial-market identity that if they had hedged their borrowing, then they would have eliminated the interest rate advantage of borrowing in foreign currency. This does not say that it would have been unwise to hedge - merely that it is understandable that they did not. appreciation phase have spooked the market? There are no answers to these “what if” questions, but it seems naive to argue that markets would have maintained a smoothly-evolving equilibrium exchange rate through the extraordinary changes of the 1990s. Greater exchange rate flexibility may well have provided a better outcome (or, more likely, brought on the crisis earlier), but it needed to occur within a financial infrastructure which had the capacity to withstand the exigencies of real-world flexible markets. I now turn to more immediate issues, particularly the events of 1997. Once exchange rates were floated, why didn’t higher interest rates work more effectively to stabilise the exchange rates of these countries? There are new lessons and old lessons to be re-learned: • if the market does not believe that high interest rates will be sustained, then there is no encouragement to capital inflows (and, in fact, the market may think that the exchange rate will fall further when the unsustainable interest rates are lowered); • high interest rates are supposed to work by encouraging domestic borrowers to roll over their foreign exchange debt and borrow more overseas, and by encouraging foreigners to lend more, denominated in domestic currency. But foreigners are now worried about credit risk: higher local-currency interest rates do not encourage them to roll over their foreign exchange loans (in fact, will cause them to worry more about the financial health of their debtors), and it seems unlikely that many foreigners will be tempted to lend in local currency (the Stiglitz and Weiss (1981) “adverse selection” argument is relevant here: only the most daring (and therefore risky) borrowers will be willing to pay higher interest rates). None of this, of course, argues for low interest rates - but it is a reminder that simple manipulation of interest rates will not always protect an exchange rate. What other lessons should be drawn, specifically on the appropriate exchange rate regime for the future? Policy-makers of these countries always accepted, in principle, that as their countries became more integrated with the outside world, they would not be able to control both interest rates and the exchange rate. They understood this, but were perhaps hoping to put off the day for somewhat longer. It seems unlikely, now, that these countries can go back to anything like the fixed exchange rates that they had before: nor would this be desirable. But we could also understand if the policy-makers of the region find both the extent of the movement and the actual levels which the market has now produced to be aberrant, and hardly a recommendation for “leaving it up to the market”. Those of us who have experienced floating exchange rates for some time now might offer a couple of points: • like them, Australia did not float because we had decided that it was a good idea, but because we were forced by circumstances to do so; • like them, Australia found the initial stages of the float to be extremely uncomfortable, and even over the longer term, there seem to have been moments when the exchange rate was not closely anchored by the fundamentals; • nevertheless, most of us have come to the view that floating exchange rates work well for us (although there will be times when we believe we can do beneficial - 10 - intervention in the market). Our systems have built up some resilience as people become more accustomed to exchange rate swings, and build these variations into their decisions. It is also clear that the proper answer is not to restrict capital flows, although these countries may be, in future, less enthusiastic about encouraging some of the more footloose and volatile forms of capital inflow. These countries should move forward with financial deregulation, although the central lesson from this experience is that the prudential framework The sine qua non of should advance in step with the opening up of the financial sector. smooth adaptation to large capital flows must be a resilient and robust formal financial sector, with risk-averse conservative banks forming a large stable core. Such risk-averse institutions would have been reluctant to expose themselves to the sort of exchange rate shocks that have occurred, and so a well-functioning formal financial sector would have borrowed less in foreign currency and would have been more conscious of the credit risk of lending to those who had borrowed extensively overseas. To the extent that this left private non-bank borrowers still borrowing excessively in foreign currency, then we might hope that the “consenting adults” view would prevail, leaving the borrower and lender to sort out repayments on a one-on-one basis without putting the entire economy at risk. But those who are confident that this private non-bank borrowing will be a smooth, well-informed process might contemplate just how quickly private investors changed from wide-eyed enthusiasm to gloomy disillusionment, and how slow the international credit agencies were to see the impending problems. The alarm-bells went off when the building was well-and-truly ablaze. The problems of lack of a clearly-understood model and asymmetrical information may be addressed by greater transparency and provision of data, but it hardly seems likely that they can be overcome. The lesson we should draw from all this is that inconvenient fluctuations in exchange rates are inevitable, and we have to design systems which can cope with them. To put this point in different words, we need to enlarge our view of “the fundamentals”. To the conventional list of “fundamentals”, we need to add another vital one some assessment of the health and resilience of the financial system. Whether these countries can afford to return to their old pace of growth depends very largely on their ability to cope with variance - particularly variance of capital flows and exchange rates. So the constraint on growth will not be the conventional one of available resources, but whether the financial sector has proven itself to be able to withstand vigorous “stress-testing” - can it withstand big exchange rate changes? Can it cope with asset booms and busts? It also needs to be able to handle big swings in perceived company profitability, because we know that a project which is performing well in an environment of 8 per cent growth can turn into a loser when growth slows. This is not to argue that the sort of exchange rate changes which have occurred in Asia are helping to bring about a new and beneficial equilibrium. They are, in fact, very damaging, not just because of the inappropriate price signals they embody, but because of the high interest rates used to contain the exchange rate movements, and the damage to firms which have borrowed in dollars. Much more modest changes would have achieved an improved competitiveness, and as far as capital flows are concerned, big movements in exchange rates seem to be inhibiting rather than encouraging capital flows, by worsening the basic situation in these countries, reducing profitability, limiting GDP growth and creating substantial policymaking uncertainty. It might be worth noting, too, that in the Mexican case, the large nominal exchange rate fall which was initially seen (in 1994/95) as being an important part of the corrective process has been more-or-less offset by subsequent inflation, so that the improvement in the real exchange rate and competitiveness has been largely lost. When people used to argue about the correct sequencing for the deregulatory process, they recognised that financial deregulation should come last, because if there remained any opportunities for disequilibrium profits in the meantime, a very open financial sector would allow these to be exploited. - 11 - I have already noted how important it is to improve prudential supervision in these countries. This is not controversial, although putting it into practice will be difficult and time consuming. One more-controversial element would be an effort on the part of the prudential authorities in the capital supplying countries to go beyond assuring themselves that their own banks are acting prudently and - in addition - asking whether their actions may be putting the recipient country’s financial institutions at risk. This would seem to require a greater degree of co-operation than exists (or is envisaged) at the moment. In short Large and volatile capital inflows are an inevitable part of the international context in which these countries operate. Even with a floating exchange rate, very large medium-term exchange rate changes can be expected. This will put a lot of pressure on the solvency of firms and, more particularly, banks. You therefore need a sound, well-supervised and risk-averse banking system. This is an essential part of a deregulated financial market, but one that many Asian countries lack. It may not be possible to return to the highest of the growth rates seen in the previous three decades, but fast rates of growth are still possible, and eminently desirable. The countries which get back there quickest will be those which are able to put in place institutions which can withstand the changes of sentiment which are part-and-parcel of a globalised economy. References Balassa, B. (1964), ‘The Purchasing Power Parity Doctrine: Economy, Vol. 72, No. 6, pp. 584-596. A Reappraisal’, Journal of Political Dornbusch, R. (1994), ‘Mexico: Stabilization, Reform and No Growth’, Brookings Paper on Economic Activity, pp. 253-315. Feldstein, M.S. and C.Y. Horioka (1980), ‘Domestic Saving and International Capital Flows’, Economic Journal, June, Vol. 90, pp. 314-329. Grenville, S.A. (1997), ‘Asia and the Financial Sector’, Reserve Bank of Australia Bulletin, December. Samuelson, P.A. (1964), ‘Theoretical Notes on Trade Problems’, Review of Economics and Statistics, Vol. 23, pp. 1-60. Stiglitz, J.E. and A. Weiss (1981), ‘Credit Rationing in Markets with Imperfect Information’, American Economic Review, Vol. 71, pp. 393-410. World Bank (1993), East Asian Miracle: Economic Growth and Public Policy, World Bank Policy Research Report. World Bank (1997), Private Capital Flows to Developing Countries: The Road to Financial Integration, World Bank Policy Research Report. | reserve bank of australia | 1,998 | 2 |
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the American Australian Association, in conjunction with the Asia Society, The Downtown Economists Inc., New York Association of Business Economists and the International Economists Club held in New York on 11/3/98. | Mr. Macfarlane gives an overview of the Asian situation from an Australian perspective Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the American Australian Association, in conjunction with the Asia Society, The Downtown Economists Inc., New York Association of Business Economists and the International Economists Club held in New York on 11/3/98. This is my first opportunity to address such an important audience in New York, but I hope it will be the first of many such occasions. I have chosen as my topic the current Asian situation, which as you can well imagine is exercising a lot of our time and thought in Australia at the moment. We like to think that there is a lot of expertise in Asian affairs in Australia among our policy-makers, in our universities and in our press, and that therefore an Australian perspective could have interest for a wider audience. Forecasting economic crises The events in Asia over the last 18 months have raised again the issue of whether it is possible to forecast economic crises. The international community went through the same self-examination after Mexico in 1994, and a large amount of research was done on the subject much of it by the IMF. It sounds as though it should be easy. We can all point to obvious signs of trouble in particular countries - in Mexico, the over-valuation of the real exchange rate; in Thailand, declining exports and widening current account deficit; in Korea and Indonesia, the large amount of unhedged foreign borrowing. This type of casual empiricism, however, is not good enough; it tends to highlight a different factor for each country. To be a useful forecasting device, we need to identify a set of characteristics that is nearly always present in all countries that are about to experience an economic crisis. A number of economic studies have set out to do this, and have found a few useful regularities, but not much more. The results have disappointed those who hoped for a forecasting kit which would enable them to pick the timing of the next crisis and the countries involved. The private sector has not done any better as a forecaster, judged by interest rate spreads and credit ratings. The spreads between Asian interest rates and comparable US rates narrowed during the 1990s to reach a low point in the first half of 1997 just as the problems were about to unfold. The ratings agencies made no downgrades in the first half of 1997, and compounded the problem by making a flurry of downgrades after Asian currencies had already fallen sharply. Notwithstanding the disappointing results of these forecasts, I intend to examine some of the characteristics that seem to lie behind the economic crises of the past decade. But before doing so, I should say a word or two about what is meant by an economic crisis - it could be something temporary and manageable, or, on the other hand, it could be an economic disaster. What do we mean by an economic crisis? Most of the studies on this subject concentrate on a very specific sub-species of economic crisis, namely a currency crisis. This has the advantage that it can be measured by one variable - a currency crisis can be defined as any episode when the exchange rate falls by a large amount in a short period. A definition of this type would usually include, among others, Thailand, Indonesia, Malaysia, Philippines, Korea and the Czech Republic in 1997, Mexico in 1994, the United Kingdom and Italy in 1992, and Australia in 1985. I could add a much bigger list if I wanted to, but the above selection is sufficient to illustrate the points I want to make. The most important point is that a currency crisis need not be much of a crisis at all, in that it may not lead to a broader economic crisis. While it often does lead to a broader crisis - as in Asia today - there are examples in the above list where it was not the case. Few would argue that the United Kingdom’s or Italy’s departure from the ERM precipitated an economic crisis or led to any lasting hardship. I would make the same case for Australia in 1985. The depreciation of the exchange rate in these cases led to a beneficial policy response, had only short-term inflationary impact, and was soon followed by a significant appreciation. It seems to me that a fruitful approach would be to look at the factors which are likely to precipitate a currency crisis, and look elsewhere for another set of factors which would cause a currency crisis to lead to a full-blown economic crisis. By this, I mean a deep recession, high inflation and widespread corporate and banking collapses. Factors leading to a currency crisis There is a literature dating back to the 1980s which deals with speculative attacks on currencies. Not surprisingly, this points out that any country that has a combination of a fixed exchange rate and the free movement of international capital is particularly vulnerable to a successful speculative attack. The ERM departures of 1992 and the Asian currency crises of 1997 fit neatly into this pattern. But other countries with fixed exchange rates have been successful in avoiding depreciation. For example, France maintained its peg in 1992 and Hong Kong has done so for the past 13 years, despite the turmoil in its region. As well, some countries with floating exchange rates have experienced currency crises. All that can be concluded at this stage is that a fixed exchange rate is more likely to result in a currency crisis than a floating one. It is more “brittle” - it allows speculators to build a position without turning the price against themselves. Also, it does not allow the monetary authorities a tactical retreat - they have to keep supplying foreign reserves at a fixed price. The situation described above becomes more marked if three other conditions apply: if there is evidence that the currency is becoming over-valued, either because of domestic inflation (as in Mexico), or because it is fixed to an appreciating currency (such as in Asia in 1997); if there have recently been other currency crises in countries with similar characteristics. Currency crises come in bunches; contagion is as good an indication of impending trouble as are any “fundamental indicators”; if there is evidence to suggest that the Government will not have the necessary support to be able to resist depreciation. Such resistance would normally involve tightenings of fiscal and monetary policy which would be hard if the economy is in or near recession, or where the balance sheets of the corporate sector are very weak. I have not mentioned the traditional villains - large budget deficits financed by central banks, and the resulting rapid monetary expansion and inflation. I do not want to suggest that these will not lead to a currency crisis - obviously, they will, but they have not been the main culprits in recent years.1 The interesting situations - and the ones worth studying - are where currency crises occur in countries with reasonably responsible fiscal and monetary policies, as in most of the cases cited above. In an earlier speech I called these Type I crises and contrasted them to Type II crises where problems centred on the weakness of banking systems and other private sector deficiencies (as discussed below). See “The Changing Nature of Economic Crises”, Reserve Bank of Australia Bulletin, December 1997. Another category of economic characteristics that are traditionally associated with currency crises are those pertaining to a country’s external trade situation, such as its current account deficit or its accumulated external debts. Again, a large current account deficit is often associated with a currency crisis, but there are enough important exceptions to question whether this would be a useful indicator of an impending currency crisis. For example, neither Indonesia nor Korea had large current account deficits in the 1990s (including in 1997), nor did either the United Kingdom or Italy in 1992. The celebrated case in the opposite direction is Singapore, which ran a current account deficit which averaged 15 per cent of GDP for the decade of the 1970s without a currency crisis. As you may have noticed, I have not mentioned any of the economic characteristics that have received so much attention in discussions of the current Asian situation. These include longstanding structural features such as soundness of the domestic banking system, the transparency of business relationships, the degree of government involvement in private investment decisions, or the quality of bank supervision. While these are important, they are important in a different way. Deficiencies in these areas clearly cannot be the cause of the recent currency crisis in Asia, because these deficiencies have been around for decades. They did not deter international capital from flowing in year after year and, therefore, could not be the cause of the change of direction in 1997. They are important, not because they cause a currency crisis, but because they provide an environment where a currency crisis can lead to a severe economic crisis. Severe economic crises Whether a currency crisis leads to a severe economic crisis or not depends on two factors - how far the currency falls, and how resilient the economy is to a lower exchange rate and higher interest rates. (a) The size of the depreciation This may sound as though it is a small diversion from the main theme, but it is not. It is quite possible that an exchange rate may fall by an amount much greater than anyone expected on the basis of ex ante information (anyone can always make up an ex post justification). This should not surprise us because no-one has yet been able to find a satisfactory explanation for movements in the exchange rate. That is, no-one has found an equation linking the exchange rate to various economic variables that is good enough to yield forecasts that outperform crude rules of thumb. We know that certain factors, such as those listed in the previous section, are associated with falls in the exchange rate, but we do not know whether the fall will occur this month or in two years, or whether it will be 10 per cent, 20 per cent or 80 per cent. One thing that seems clear is that in the early days of a floating exchange rate regime, we should expect some very large movements, particularly if the balance of forces is in the direction of depreciation. Markets are unfamiliar with the new system, they have no track record to guide them, there is often an atmosphere of panic among market participants or indecision among policy makers, and reliable information is hard to come by. In these circumstances, overshooting is almost bound to occur. In Australia’s case, the Australian dollar moved from a relatively fixed regime to a float in December 1983 because it was under upward pressure. Yet within 15 months the scene had changed and it began to depreciate sharply; in the space of 17 months it fell by 39 per cent in effective terms. This was a gross overshooting, as subsequent events proved (it regained two-thirds of its fall in the subsequent year). The situation in Asia involves an altogether higher order of uncertainty. Their currencies were floated because they could not resist downward pressure in 1997,2 and they had to give up their fixed rate regimes and move to a float before anyone was prepared for the new system. In these circumstances, floating rate regimes operate very badly and are extremely sensitive to confidence factors. Great skill is required in finding the right policies and managing the crisis. The countries concerned usually have no experience of it, and therefore often turn to the international community for help. It is an equally large challenge for the international institutions and the spirit of international co-operation. When an exchange rate falls quickly to half its former level, or a quarter (as in Indonesia), the strain on the economy becomes intense. Even in those countries with the most advanced banking systems, capital markets and regulatory regimes, such a fall is hard to handle. It is also clear that countries in this situation would have to attempt to reduce the size of the depreciation by raising interest rates, so that the economy would face a combination of a lower exchange rate and higher interest rates. (b) Resilience of the financial sector A large, but not enormous, fall in the exchange rate - say, something between 20 and 40 per cent - could in some circumstances be absorbed without lasting damage, but in others it could lead to a major economic crisis. On the basis of recent experience, it now seems that the factors which are most likely to lead to an economic crisis are financial in nature, and pertain particularly to the structure of the banking system, the financial health of the corporate sector and the general financial infrastructure. A shortlist of the main factors that reduce an economy’s resilience, and hence mean that a currency crisis will be translated into an economic crisis, is as follows: (a) Has it recently experienced a debt-financed asset price boom, and thus become vulnerable to a large fall in asset prices? Have there been a large rise in the ratio of credit to GDP, an increase in corporate gearing, and, of course, large increases in property and equity prices? (b) Is the financial sector in good shape? The main thing to look for here is the quality of bank lending as indicated by the level of bad debts, the extent of lending that has been collateralised by over-priced assets, or more crudely, the proportion of lending to the property sector. It is bound to be difficult to get reliable figures, so an alternative would be to make an assessment of the quality of bank supervision. A starting point here would be to look for a good set of ownership rules; these should limit the extent of lending to related parties. (c) Have banks and commercial firms financed themselves by unhedged foreign borrowing? Every crisis focuses attention on at least one important cause, and this pattern of financing seems to be heavily implicated in each of the current Asian troublespots. (d) Is the financial infrastructure strong enough to handle a crisis? By this, I mean the accounting standards, commercial law, disclosure requirements and bankruptcy procedures. In current parlance, this is often discussed under the title of “governance”, and means an institutional framework that limits the extent of related party transactions (also known as “crony capitalism”). A favourable score in this area is needed to Of course, we should not lose sight of the fact that in the preceding years of the 1990s, these countries were under chronic upward pressure. help investors and lenders gauge whether they are dealing with a solvent or insolvent counterparty. A feature of all these underlying financial characteristics is that they are very slow to change. Just as deficiencies in this area cannot have been the cause of the recent currency crises, it is hard to believe that meaningful improvements to them can be made quickly enough to restore confidence to currency markets. A tax or an interest rate can be raised immediately, and so cause a rapid turnaround in fiscal or monetary policy. Domestic demand can fall sharply, leading to a quick move into surplus in the current account, as we have already seen in Asia. But improvements to financial infrastructure and the sorting out of a weakened banking sector inevitably take a long time, and any immediate measures are more in the nature of a “promise” than an achievement. They will not quickly prevent capital outflow or restore inflow: the immediate solution lies elsewhere. Concluding comments Neither the financial markets, international organisations nor academic economists are good at predicting currency crises. In the past, they have happened in circumstances that appeared quite tranquil, for example mid-1997. The likelihood of crises happening is greatest for countries that have a relatively fixed exchange rate and are open to international capital flows. The speed with which these flows can turn around is astonishing. The five Asian countries at the centre of the current troubles - Thailand, Malaysia, Indonesia, Philippines and Korea - received private capital inflows equivalent to 8 per cent of GDP in 1996, and outflows of nearly 2 per cent in 1997.3 Such a turnaround in capital flows, to quote Chairman Greenspan’s understated style, “do not appear to have resulted wholly from a measured judgment that fundamental forces have turned appreciably more adverse. More likely, its root is a process that is neither measured or rational . . .”4 It is not surprising that these countries’ exchange rate regimes collapsed and they were forced into a rather hurried float. It should also not be surprising that the ensuing depreciations were extremely large, because that seems to be a common pattern. The smallest of the depreciations was still of the order of 40 per cent, and this plus the rise in interest rates was bound to put enormous pressure on domestic financial systems. In my analysis, I have distinguished between factors that are likely to cause a currency crisis and factors that are likely to mean it will become a general economic crisis. I have also said that I do not think the second set of factors - essentially deficiencies in the financial infrastructure - could have triggered the currency crisis, because they have been around for years. The problem, however, is that they can interact with the currency crisis once it has started. Market participants who may have been indifferent to deficiencies in the financial infrastructure at the old exchange rate start to voice disapproval of it once the exchange rate has fallen. But nothing may have changed with respect to financial infrastructure: the only new information on which the change in judgment could be based is the lower exchange rate itself. This could become self-reinforcing and lead to further capital outflow and a yet lower exchange rate. There has been a tendency for this to occur over the past 12 months. For this reason, and others, we have seen exchange rates in some Asian countries that have fallen to half of their level a year ago or, in Indonesia’s case, a quarter. Falls of this size defy economic logic and serve no useful Institute of International Finance. Remarks before the Annual Financial Conference of the Federal Reserve Bank of Atlanta, Miami Beach, Florida, 27 February 1998. economic purpose. Indonesia was a successful trading nation a year ago at its former exchange rate, with a healthy growth of exports and a modest current account deficit. There is no value to Indonesia, to the region or the world in now having an exchange rate at a quarter of its former level. Any collective solution to the current troubles in Asia should have as a priority the aim of restoring exchange rates a fair way towards their former value. We should not lose sight of what we originally intended to do when the international support packages were put together for Thailand, Indonesia and Korea. Our aim was to allow an orderly economic adjustment and to minimise the risk of further contagion into other parts of Asia and the rest of the world. Our aim was not to capitalise on any of these countries’ difficulties in order to bring about a political transformation. Some of the steps towards the restoration of a more realistic set of exchange rates are already occurring. Most, if not all, of the troubled Asian countries have returned to trade surplus and, probably, current account surplus. Although it would be a great help, it is not absolutely necessary to restore capital inflow; in the short term, all that is needed in order to provide some upward pressure on currencies is to prevent further capital outflow. The collective agreement among major banks to rollover Korean bank debt, and then to reschedule it, was a good example of what can be done. If there is insufficient initiative or cohesion among private lenders to Indonesia to follow the Korean lead, then a greater involvement of governments and the IMF is required. Whatever the details that are finally worked out, there can be little doubt that the overwhelming priority is to rollover, reschedule, restructure existing debt or do whatever else is necessary to prevent further capital outflow. | reserve bank of australia | 1,998 | 3 |
Speech by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to Australian Business Economists and the Economic Society of Australia (NSW Branch) in Sydney on 12/3/98. | Mr. Grenville discusses the Asian economic crisis and how such problems might be avoided in future Speech by Mr. Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to Australian Business Economists and the Economic Society of Australia (NSW Branch) in Sydney on 12/3/98. It is much too early to draw definitive conclusions about the economic crisis currently being played out in Asia, but there is some point in trying to bring together the emerging ideas as to what went wrong, what might be done to fix the immediate problems, and how, in a more fundamental sense, these problems might be avoided in future. One of the things that strikes me is how much thinking has evolved, already, in the months since the crisis broke. With that in mind, lessons which now seem to be appropriate will, no doubt, be modified over time. Historians can wait to compose the definitive, fully-digested version when the dust settles, but others need to call it continuously, refining and modifying our understanding as we go along, knowing perfectly well that what we write today may seem unperceptive or simply wrong when we come back to it in a year’s time. Ross Garnaut has recently written that: “The shock of 1997 is a defining event in the economic history of East Asia. Like the great Depression in the West, it has the capacity to change thought about economic development and economic policy in fundamental ways.”1. This process is currently underway, and if it sounds more like a damage report rather than the anatomy of a paradigm shift, this may reflect the close range of our current perspective. Among the jumble of likely causes and hypotheses, it is difficult to fit all the pieces together and assign proper weights. That said (and to anticipate one of the later conclusions), the individual elements of the crisis are neither new, nor were they ignored beforehand. But the conjuncture of events produced outcomes that no-one forecast. And once the critical break had come, it was not possible to restore the status quo ante by fixing the individual elements that had gone wrong. General lessons The first lesson, which stems directly from the fact that no-one forecast the nature or the extent of the crisis, is the need for humility. While plenty of observers worried about various aspects of these emerging markets, no serious commentator could be said to have forecast these crises, in the sense of defining the nature of the unfolding story with some precision as to timing.2 Generic weakness in the financial sector was, like Mark Twain’s weather, something that everyone complained about, but no-one did much about. The related point is that there remains much that we do not understand. This issue of failure to forecast is especially embarrassing because these countries, by and large, did the things which economists had said were important. Their budgets were balanced, they kept inflation low, they reduced (over time) protection and increased their openness, both on trade and capital accounts, and they embraced deregulation (although never completely). Even to the extent that they ran what look in hindsight to be dangerously-large current account deficits at times, there was no doubt that these were “good” deficits - i.e. they funded high levels of investment, rather than government expenditure or private consumption. Garnaut (1998, p. 23). For example, Paul Krugman, who was sceptical about aspects of the “Asian miracle”, does not claim to have foreseen the crisis: “Speculative attacks on currencies are nothing new, and some of us even warned a couple of years ago that South-east Asian countries might be at risk. But the scale and depth of this crisis have surprised everyone; this disaster has demonstrated that there are financial dangers undreamt of in our previous philosophy.” (Krugman 1998b). The second general lesson is that it has turned out to be much more complex than it seemed initially. Initially, the crisis was seen in relatively simple terms (President Clinton described it as “a few little glitches in the road”). The belief was that exchange rates had become over-valued, these economies had run a bit faster than their productive capacities would allow, and that in some cases (most notably Thailand) the current account had blown out in a way that made them vulnerable. The implication was that, with exchange rates floated, they would depreciate modestly, fiscal and monetary policies could be tightened a bit in order to slow growth, and in the process current account deficits would shrink. There was a feeling that “this isn’t a problem; it’s an opportunity”. At least, there was a feeling that after some short-term pain, these economies would emerge stronger than before: the crisis would provide the motivation for institutional improvement. These are the generalisations: let’s get more specific about the things that might explain the crisis. The exchange rate If this was a “currency crisis”, then exchange rates must be the key factor, mustn’t they? There are a couple of different aspects of this that need separate discussion. First, did some aspect of the initial exchange rate cause the crisis? Secondly, what can we learn from the behaviour of exchange rates as the crisis emerged? First, did the exchange rate regimes cause the crisis? The early diagnosis was that the central problem was exchange rates which were over-valued, and fixed. Most commentators assess that the exchange rates were over-valued by something in the order of 10 per cent. We know that over-valued exchange rates are vulnerable, so this was clearly an element in the story. But these exchange rates are now at levels around half the starting point, or in the case of Indonesia around a quarter. Whatever over-valuation there was in the exchange rates at the start, markets have taken them much further in the opposite direction. If a 10 per cent exchange rate misalignment in one direction made these countries vulnerable to crisis, where does that leave them now? In short, the initial exchange rate over-valuation seems too small, too routine, and the subsequent behaviour too inexplicable, for this to carry the full weight of being the key cause. Were fixed rates the culprit? Again, fixed rates raise issues of vulnerability, but these countries did not stick to this fixed rate regime out of any perversity - they felt they needed this anchor in their macro policies. At the same time, some of their neighbours which have come through the crisis well also have fixed rates - Hong Kong and China. It might also be noted by those who believe that exchange rate flexibility would have avoided the crisis that these countries’ exchange rates had been under substantial upward pressure during the first half of the 1990s. While the policies they pursued have clearly turned out to be unsustainable, the counter-factual - earlier introduction of floating exchange rates - might also have been a very bumpy ride.3 In short, it may be routine to refer to these as currency crises, but the exchange rate movements are symptomatic of something else. That said, we can learn something, in a pathological sense, about the behaviour of exchange rates from observing their behaviour in times of crisis. The first and most obvious lesson is that when exchange rate regimes shift from fixed to floating, the transition may be quite turbulent, and markets have some trouble establishing a sensible rate. It was naive to believe that a modest over-valuation would be Grenville (1998, p. 33). smoothly corrected by floating. Even in deep, well-established markets, such as Japan and the USA, exchange rates routinely move by 30 per cent or more. Perhaps the most extraordinary aspect of this is the degree of contagion of exchange rates. Just because the Thai baht moved a fair way, why did the rupiah and won have to move also (not to mention the ringgit and peso)? Two factors seem to be involved here. The first is the “wake-up call” argument: the fall of the baht made markets look at other currencies, and find the same matters of concern. The second component of the argument is that, once one exchange rate started to move, the others had to move to maintain their competitiveness.4 While we are talking about exchange rates and their extreme behaviour, I should say something about the apparent failure of high interest rates to support these exchange rates. Interest rates in these countries have been quite high (both in nominal and real terms) for quite a few years (in fact, this is one of the important causes of the large capital inflows). When the crisis arrived, interest rates were put even higher. This was appropriate, but what is clear is that they were not put high enough to prevent the depreciation over-shooting. Why was this so? Some argue that the only thing that went wrong here was that the authorities were not prepared to put them high enough to do the job. There is, however, another side to this story.5 Briefly: extremely high interest rates are not credible: markets expect them to be abandoned quickly; the foreign debt was foreign currency denominated, and higher domestic interest rates would have made foreign creditors even more nervous about the credit risks they faced, and therefore more likely to withdraw their money; very high interest rates raise problems of adverse selection - the only borrowers are those who do not intend to repay. Current account deficits and capital flows The large current account deficits incurred by these countries are now seen to have been a major source of vulnerability. We noted earlier that these were “good” deficits, and in defence of Korea and Indonesia, it should also be noted that neither was running a particularly large deficit over recent years (for Korea 2 per cent of GDP in 1990-96, and 3 per cent for Indonesia). But Thailand certainly was - around 8 per cent of GDP. What is very clear, ex post, is the vulnerability to extraordinary reversals of capital flows (which we have not, for example, seen in Australia). The inflow into these countries was around US$ 40 billion in 1995, more than doubled to nearly US$ 100 billion in 1996, and reversed to an outflow of around US$ 12 billion in 1997. It is hardly surprising that a major adjustment is underway in these countries, to adapt to this reversal. Before we condemn current account deficits as a manifestation of misguided policies, we should note that these deficits were not only “good” (in the sense that they funded investment, not consumption), but were - to a very large degree - the normal working through of market processes. These countries experienced very high productivity growth as technology was brought to bear, combined with low labour costs. They “got their act together” and provided a Those who like this argument would also point to the Chinese effective depreciation of 1994. This is claimed by some to have disturbed international competitiveness and helped to set in train the export shortfalls in other Asian countries, that in turn contributed to the crisis. The following argument is set out in more detail in Grenville (1998, p. 33). hospitable environment for commerce and investment. It is hardly surprising that there has been, over time, a significant flow of capital from the “old” high-saving countries to the “new” investment opportunities in East Asia.6 If there was an economic miracle taking place, foreign investors wanted a slice of the action. The fast-developing financial infrastructure provided the conduit between domestic borrowers and foreign savers. There is, in fact, an earlier example of this. Singapore went for two decades with a current account deficit averaging more than 10 per cent of GDP, and most people look back on this era as an extraordinary success. In short, if we can identify a critical problem here, it is the potential for reversal of the capital flow, rather than the current account deficit per se. This was, of course, exacerbated by two characteristics of the capital flows - their short-term nature and the foreign currency denomination of the debt. These were seen, at the time, as natural-enough characteristics of the institutional structure:7 to interfere would be to go against the tide of market-oriented policies. But we can now identify them as major sources of vulnerability. 8 The financial sector A third key weakness, which was identified early on,9 is that fast-growing financial sectors are very vulnerable, because they inevitably reflect lack of experience, by the commercial bankers, borrowers and prudential supervisors. Just as a rapidly-growing balance sheet is a warning sign for an individual financial institution, the same warning signs existed in these countries. But even this was hard to foresee as a devastating problem. As a country moves away from under-developed financial “repression”,10 it is both inevitable and desirable that the depth of the financial sector increases - i.e. the balance sheets of financial institutions expand faster than nominal GDP. That said, of course there is an issue of “how much faster”? Less excusable are the inadequate efforts to put in place effective prudential supervision. Coincidence and compounding I have argued, so far, that none of the elements which are usually put forward is, in itself, all that unusual, or enough to explain the extent of the crisis. The fatal flaw was the combination.11 To some extent, the problems were self-reinforcing - when one weak link broke, this put more pressure on other linkages, which collapsed under the extra burden placed on them. But it is by no means inevitable that these problems should coincide - I would simply note that Australia in the mid 1980s had an exchange rate fall of the magnitude of Thailand’s and Korea’s without a major crisis, and had an asset price bust of probably the same order of magnitude (in the late 1980s) without this degree of damage. Feldstein and Horioka (1980). Grenville (1998, p. 31). The bumpy international environment made the capital flows more volatile, and help to explain both the exchange rate appreciations and the variation in capital flows. The yen/dollar exchange rate moved 20 per cent in the year beginning April 1996, affecting these countries’ effective exchange rates, their trade and their capital flows. Low Japanese interest rates initially encouraged excess liquidity to flow to these countries, which reversed when markets began to focus on possible interest rate increases. Grenville (1997) and Macfarlane (1997b). McKinnon (1973). An analogy might illustrate the point about compounding causation: in a car crash, who or what is to blame for the injuries? Is it speed, some act of recklessness such as intoxication, a poor road surface, an under-inflated tyre, an inadequate guard-rail, a poorly-designed car, or inadequate seat-belts? Some of these things are mutually compounding, and others are simply unable to cope with the abnormal strains to which they are subject. So it is with the Asian “currency” crisis. The search for a single key cause - and, by implication, a single key solution to prevent recurrence - will miss the complexity of the task ahead. That said, there are clear linkages between the fault lines, and in the Asian case, there was a conjuncture of problems. Large capital inflows led, more-or-less inevitably, to excessive credit growth and growth of the financial sector, because it was not possible to sterilise them fully. The large flows meant, also, that there was easy funding available for projects (both good and bad), and that asset prices were bid up. Similarly, the large capital flows made it difficult to raise interest rates higher (they were already quite high), for fear of inducing even more capital inflow. High domestic interest rates, at the same time, persuaded many borrowers to take the risk of tapping into attractively lower foreign currency-denominated borrowing. Further, with quasi-fixed exchange rate regimes in these countries, there was little incentive for institutions borrowing in foreign currencies to hedge their debt. These issues should have been recognised as sources of vulnerability, but the focus was on growth, without enough concern about resilience in the face of variance in growth. This failure to recognise the interaction of elements was a key misunderstanding as the crisis broke. With hindsight, it should have been realised that simply freeing the exchange rates would cause them to shift a fair way and this would create enormous problems for a financial sector weighed down by bad debts and large foreign currency-denominated debt. This would, in turn, feed back into the exchange rate. If we were to identify the crucial combination, it would be the large volatile foreign capital flows, plus fragile financial sectors. These two factors, in combination, made these economies extremely vulnerable to changes of confidence. We have in our minds financial markets which are constantly digesting and evaluating information to produce a price - an exchange rate - which reflects the “fundamentals”. But we see, here, that the more nebulous concept of “confidence”, at times, dominates the fundamentals. “In a matter of just a few months, the Asian economies went from being the darlings of the investment community to being virtual pariahs. There was a touch of the absurd in the unfolding drama, as international money managers harshly castigated the very same Asian governments they were praising just months before. … But, as often happens in financial markets, euphoria turned to panic without missing a beat. Suddenly, Asia’s leaders could do no right. The money fled.”12 This is not, of course, the first time this has happened. Alan Greenspan, describing this reaction in capital flows as “a visceral, engulfing, fear”, went on to say “The exchange rate changes appear the consequences, not of the accumulation of new knowledge of a deterioration in fundamentals, but of its opposite: the onset of uncertainties that destroy previous understandings of the way the world works. That has induced massive disengagements of investors and declines in Asian currencies that have no tie to reality. In all aspects of life, when confronted with uncertainty, people tend to withdraw. … At one point the economic system appears stable, the next it behaves as though a dam has reached a breaking point, and water (read, confidence) evacuates its reservoir. The United States experienced such a sudden change with the decline in stock prices of more than 20 per cent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuation on that one day. Such market panic does not appear to reflect a simple continuum from the immediately previous period.” Krugman (1998a) has suggested a possible reason for this big shift in confidence. Foreign investors thought they were working in a riskless world, and made their investment decisions accordingly. Then, quite suddenly, they realised the risk, and underwent a fundamental adjustment in expectations. This explanation has some attractions but does not seem to fit the overall reality closely. There were not too many explicit guarantees around, leaving aside bank Sachs (1997). and sovereign debt (which remained guaranteed), so there was not a rational reason for re-evaluation. The more intuitively appealing explanation (at least to me) is that investors simply changed their minds. They had not known much about the countries (or projects) they invested in to start with, so there was lots of opportunity for them to shift between exuberance and deep pessimism, either based on a modest accretion of news on fundamentals or, more likely, on the basis of what their colleagues in the market were doing. Correlated shifts in expectations are the key to understanding what happened. The fundamentals (such as when a thing gets cheaper, people buy more of it) were overwhelmed by something akin to panic - if everyone is running in one direction, we should run too (because it becomes increasingly costly not to). Of course, once the mood had changed, commentators and investors alike found much in these economies that they did not like, particularly issues which come under the broad rubric of “governance”. What can be done? There are two relevant time horizons here - what should be done, in the form of “battle-field dressing”, to cope with the crisis and get these economies back on the rails again? Then, in the longer term, what can be done to make them less vulnerable in the face of future problems? Early on it was recognised that these crises had many of the characteristics of an old-fashioned banking liquidity crisis - a “bank run”. There had been a massive loss of confidence and withdrawal of money, so what was required - reaching back into the 19th century prescription of Bagehot - was: “lend freely, but at a penalty rate”. The “withdrawal” took the form of capital outflow from the country, rather than a domestic shift of funds, but the principle was the same. This was, indeed, the diagnosis and the prescription in Mexico in 1995, and most people, with hindsight, regard this as an overall success. (More on Mexico in a moment.) While this is clear enough in principle, making it operational presents problems. The most prominent of these has been concern about “moral hazard”. Moral hazard arises “when someone can reap the rewards from their actions when things go well but not suffer the full consequences when things go badly”13. In the Asian policy debate, there were lots of left-over arguments from the 1995 Mexican episode, with some arguing that the US$ 50 billion IMF/USA bail-out had been unduly beneficial to fund management institutions, particularly in the USA. It has to be acknowledged that all types of insurance have significant elements of moral hazard, and the issue is not to avoid doing anything involving moral hazard, but how to keep it in check. The idea that Asian creditors have, in general, been protected is wrong.14 The problem is a narrower one than is usually posed - applying specifically to government debt and bank debt - the first because of its sovereign nature, and the second because of the systemic implications of widespread bank failure. In these cases, it is difficult to avoid a degree of “bailing out”, and it is just as difficult to expect investors to ignore this.15 Greenspan (1998, p. 2). Chairman Greenspan has pointed out that: “Asian equity losses, excluding Japan, since June 1997 worldwide are estimated to have exceeded $700 billion of which more than $30 billion has been lost by US investors. Substantial further losses have been recorded in bonds and real estate.” (Greenspan 1998, p. 2). The dramatic fall in interest-rate spreads going into 1997 has to be explained in terms of collective “exuberance” rather than the moral hazard residual from Mexico, because the narrowing of spreads occurred across all types of debt, including debt which by no stretch of the imagination was going to be subject to any kind of bail-out. We will examine, in a moment, what might be done to address moral hazard issues in the longer term. But meanwhile, with the crisis on us, moral hazard should not be used as the all-encompassing excuse for inaction. Bagehot’s prescription worked reasonably well in Mexico, but has not been applied with the same speed and vigour in Asia. What about the longer-term reforms? Given that the damaging combination seems to have been big foreign capital flows plus fragile financial sectors, this is the place to begin. Longer-term reform must include the building of resilient financial sectors, which can withstand substantial shifts in sentiment, and big changes in the exchange rate. Part-and-parcel of prudential measures would be to discourage the sort of short-term and foreign currency exposures which occurred, and where they occur in the private commercial sector, to insulate the banks from them. A well-functioning banking sector might also act as the stable core of the financial sector which would, to some extent, act as the “guardian on the gateway to investment”. For this to be possible, banks need not only to be well staffed by people with real business experience, but need to be free from the pressures of “connected” or “command” lending pressures, which have been all-too-apparent in these countries in the past. The difficulties with moral hazard have to be acknowledged, and the crises dealt with in ways that ensure that those who were involved in failed investments are financially penalised. But if, when all other measures are taken to improve transparency and disclosure, these international capital flows remain flighty and volatile, even those who are searching for market purity will have to either accept restrictions on such flows, or the existence of some lender-of-last-resort. The damaging externalities of the reversal of these capital flows cannot simply be left to run their course, with markets “sorting it out” in the way we are observing currently in Asia. No-one has yet come up with any clever ideas on how to back up the international lender-of-last-resort by prudential rules to address the moral hazard problem. Just as disclosure is an important part of any prudential framework, it will have a role to play - hence the IMF’s Special Data Dissemination Standard and the BIS’ data on bank lending. No-one could argue with the general principle that “more information is better than less information”, or that when markets are “blinded by faulty signals, a competitive free-market system cannot reach a firm balance except by chance”16, but it might be worth focusing on exactly where the information deficiencies lie. Looking back on it, most of the problems which exist were known about in general terms, and it is misleading to argue that if more exact figures had been known, then various market participants would have behaved very differently. Will greater transparency put an end to the problem of correlated expectations in financial markets - the sudden switches from euphoria to gloom? It seems unlikely (there was no shortage of information in stock markets in October 1987). But they might help to limit the extent of the swings. As we have seen in the case of Indonesia, once markets and the press take a set against a country, every new piece of news is given the most pessimistic slant and every negative rumour is treated as established fact. As we search for what more might be done, it is worth keeping in mind that, for every over-eager borrower in these countries, there was an over-eager lender in the capital-supplying country. Are there measures that could be taken by the prudential authorities in the capital-supplying countries so that these authorities look not just at the consequences for their own financial system, but for the financial stability of the capital-receiving country? One obvious lesson is that, in evaluating the “fundamental health” of countries, we should widen the Greenspan (1998, p. 10). scope of the assessment of “fundamentals”, to embrace an assessment of the health of the financial system and the effectiveness of prudential supervision. Much more controversial would be any proposal to restrain capital flows. One of the important initiatives to come out of the IMF’s meeting in Hong Kong in September 1997 (i.e. shortly after the crisis broke) was to develop an amendment of the IMF Articles of Agreement to make the liberalisation of international capital flows one of the purposes of the Fund. There is the potential for vigorous debate on this. Some argue that the problems of capital flow were caused by “half-way liberalisation”, and things would have worked better if financial markets had been deeper, with a greater range of instruments and greater liquidity. The prescription that follows from this is, of course, to proceed with speed and vigour towards more financial deregulation. The counter argument is that prudential supervision and the general apparatus of administering big capital flows need to develop pari passu with the process of financial deregulation, and it is very clear that this did not occur over the past ten years: financial development greatly outpaced the development of the prudential framework. In this view, financial deregulation should only occur as and when the appropriate prudential safeguards can be put in place. Whatever the outcome of this debate, I suspect that these countries will be much less ready to welcome short-term capital flows, and the enthusiasm for developments such as the Bangkok International Banking Facility (which acted as a frictionless conduit for Thai business people to borrow overseas) has been dampened. There is unlikely to be much enthusiasm for vigorous financial deregulation if this means encouraging the sort of free-wheeling, non-bank institutions which were not only eager to sign up borrowers for foreign currency loans, but then turned around and sold this debt into banks elsewhere in the region, with disastrous consequences for both borrower and lender. How quickly will the recovery occur? As the crisis unfolded in the second half of last year, it might have been argued that the best guidance on the likely evolution of these three countries was the Mexican crisis of 1994/95 - styled by the IMF Managing Director as “the first crisis of the 21st century”17. This had the usual characteristics - that the financial aspects unfolded quite quickly, and that after these had stabilised, the real sector effects worked their way through more slowly, over time. The sequence might be characterised like this: there was a 50 per cent depreciation; a $50 billion IMF/USA rescue package was made available: not all of this was needed, and a large part of it was repaid within a year. Private capital flow returned relatively quickly, particularly direct foreign investment (and, in fact, Mexico’s foreign debt is larger now than in 1994); the annual GDP growth figures were minus 6 per cent in the year following the crisis, and plus 5 per cent in the year after that, so that two years later GDP is back somewhere near the original starting point; It was unlike most earlier IMF crises, in that neither budget deficits nor lax monetary policy were the cause - see Macfarlane (1997a). inflation of close to 100 per cent in the ensuing three years, so that the improved competitiveness created by the depreciation was more-or-less unwound (at least measured by the CPI) by subsequent inflation;18 there was a very quick closure of the current account deficit, turning into a balance more-or-less as soon as the economy slowed;19 an amount in excess of 10 per cent of GDP was used to rescue the financial sector. Mexico was, as far as the casual observer can tell, not greatly changed in the process. No doubt the banking system has been strengthened by the cleaning-out of bad debt, but on the basic approach to policy, there has been no paradigm shift. No real-world economic event is just like the pure text-book case, but this does look like the international version of an old-fashioned bank run, and the old-fashioned remedy worked well enough. It might be argued that one of the main legacies of the Mexican rescue was the inhibitions to action that it produced, when the problem recurred elsewhere. Despite its success, it triggered a coalition of forces (led by those who are concerned about the moral hazard aspects of the bail-out) who have hindered the same prescription being applied in Asia. Why might the Asian countries be different? whereas Mexico received something approaching US$ 50 billion in available credit from the IMF/USA (and the required amounts were quickly disbursed), these countries have received much smaller disbursements: Thailand - US$ 8½ billion; Korea - US$ 13 billion; and Indonesia - US$ 3 billion. one reason why Mexico received a quick disbursement of assistance to offset the capital flight was the nature of the foreign debt. It was largely sovereign debt (Tesobonos), and there was little debate (at least beforehand) that it should be paid out in full. The USA/IMF money made this possible. When it came to Asia, none of the short-term debt was sovereign, so there was, initially, no specific plan to pay it off. The hope was that the announcement of the packages would, itself, instil new confidence so that creditors would roll over their debt;20 these countries may well be headed for the same sorts of negative growth rates that Mexico faced in the first year after the crisis. If so, the deceleration in the growth rate is significantly greater, because Mexico had been growing at around 3-4 per cent, whereas these countries grew at 7-8 per cent; Mexico had the advantage of being next to the large and growing US market, whereas Asia’s crisis comes at a time when the US growth is at the mature phase of the cycle, and Japan is still stagnant; In terms of wages, a significant real depreciation remains. Contrast this with the mid 1980s in Australia, where, despite the loss of confidence and concerns about the current account deficit, the inflow continued at more than its historic average. With Korea close to default in late December 1997, the American authorities stepped in (with the IMF) to broker a rollover for bank-to-bank debt, which included a guarantee by the Korean Government. - 10 - • as in Mexico, these countries have very quickly (almost immediately) corrected their current account deficits, by reductions in imports stemming largely from the slowing of GDP; Mexico began with a much more clearly over-valued exchange rate; if Asian exchange rates do not recover, these countries seem headed for very substantial inflation (particularly Indonesia). Mexico was probably more able to handle this, as it had had plenty of recent experience with inflation. The Asian countries have had relative price stability for many decades; the unfinished business of rescuing the financial systems of Thailand and Indonesia have already absorbed the sorts of money Mexico used to support its financial sector (i.e. more than 10 per cent of GDP), and they are “still counting”. This is neither surprising (in Scandinavia, something around 6-8 per cent of GDP was used, and even in the relatively minor case of the American S&Ls, something like 2 per cent of GDP was required), nor is this particularly alarming - all of these countries started with almost no government domestic debt, and they can cope with this degree of future indebtedness. But it is a heavy price to pay, for countries that are still poor. An important issue is whether these countries will emerge with stronger institutional structures. As the crisis broke, there were many of us who thought that “this isn’t a problem, this is an opportunity”. We had in mind the sort of institutional reform which came in Indonesia in the mid 1970s, following the Pertamina crisis - painful and expensive, but resulting in significant institutional improvement. These issues were probably a major motivation in the design of the IMF’s program, which included a large number of structural or governance issues in the “conditionality” - the requirements imposed on Indonesia. This fits with the idea that “out of adversity comes reform”. We probably need more perspective to be able to judge this properly, but in the case of Indonesia, at the moment it looks as if the degree of crisis has far exceeded the “optimal level” and the process of reform is slipping backwards, rather than moving forward. Most notably, we see the position of the group of economists who have guided Indonesia’s economic success over the past thirty years substantially eroded. As they lose their influence, diversions such as the currency board proposal distract attention from facing up to the urgent elements of the crisis - an exchange rate which has wildly over-shot; a wounded banking system; and a degree of foreign indebtedness which puts many Indonesian companies not just illiquid, but insolvent. In the case of Indonesia, the potential crisis is such that it is now time to refocus the reform effort on the core economic issues - the exchange rate, foreign debt; and rebuilding the financial sector. To be sure, reform in the structural issues of governance is eminently desirable, but what is needed now is the kind of triage we see in an emergency room - sorting the life-saving critical priorities from longer-term issues.21,22 Will these countries get back to their old pace of growth relatively soon? They still have many of the attributes that gave them fast growth. There is still plenty of potential to Feldstein (1998). Will financial markets accept something short of root-and-branch reform of Indonesian governance? Who can tell? But we know that they worked happily enough with these problems for thirty years. - 11 - link technology with relatively cheap labour, with all the productivity boost that this implies (to put this point differently, they are still well back from the technological frontier in many areas). That said, it is not going to be easy. As Garnaut has put it: “Two of the pre-conditions of growth in the old East Asian style have obviously been lost for the time being: a reasonable level of macro-economic stability; and political coherence around the growth objective.”23 What have we learnt about our economic paradigm? The text-book model envisages continuous adjustment of prices and quantities as the system gropes towards equilibrium. Good models acknowledge mis-starts and false cues along the way. But none of this seems to fit the process we see underway in Asia. Exchange rates started modestly over-valued, and are now dramatically under-valued. Current account deficits may have been too large, but these countries are now running surpluses: Thailand has gone from a deficit of 8 per cent of GDP to the prospect of a surplus, this year, of 4 per cent of GDP. This is being achieved (if that is the right word) through a fall in domestic spending (not through exchange-rate-boosted export growth). The main manifestation of the crisis - the falls in currency - have not been the principal equilibrating mechanism, but are producing unfortunate (to say the least) side effects and collateral damage - not just inflation, but enormous damage to bank and commercial balance sheets, to saving, and are distorting relative prices. What is underway here is not an equilibrating process of adjustment, but one of economic collapse, where markets are no longer operating to provide sensible price signals. It is, in the words of David Hale, an “unnecessary crisis”. The loss of faith in markets is likely to colour future policy-making (making these governments probably more likely to be tempted by very interventionist policies). Foreign markets are likely to be even more uncertain about their relationships with these countries, particularly their investment relationships. The other side of the coin is that these countries have, until now, been high saving countries and if this saving can be maintained in the face of strong inflation, the wherewithal to fund investment still exists, even without foreign capital flows. One would have to be more pessimistic if one accepts the commonly-held view that the investment done in these countries was predominantly low return. While not claiming any expertise, I am not immediately drawn to this view. If the investment was all that bad, how did they manage to grow at 7-8 per cent for so long? While there has doubtless been excess investment in apartments and office buildings, and when growth prospects change dramatically, over-capacity in other areas is likely, I do not get the impression that there has yet, for instance, been over-investment in city freeways in either Jakarta or Bangkok. To put the point more explicitly, many good, high-return projects have been done, and these will continue to serve their countries well, once the economies can be got back on an even keel. Garnaut (1998, p. 21). - 12 - Conclusion In 1993, the World Bank produced a book called the East Asian Miracle formally anointing something which had been seen by many other observers quite a few years earlier - the extraordinary economic growth of East Asia. This had begun, some three decades earlier, with the four “tigers” - Korea, Hong Kong, Taiwan and Singapore. These economies grew, year after year, at pace two or three times as fast as the industrial countries. The performance spread to a number of others - Malaysia, Thailand and Indonesia - and the biggest miracle of all, China. Two things are worth noting. First, this was not some amazing-but-irrelevantly-trivial miracle, like pulling a white rabbit out of a hat: this made an enormous difference to the living standards of these countries, with per capita income doubling in less than a generation. Hong Kong and Singapore went from being well behind the living standards of Western countries, to being much the same.24 Secondly, it changed the way economists thought about the so-called “developing” countries: no longer were they seen as pathological cases to be discussed with a mixture of pity and resignation that nothing much could be done. Instead, they were seen as having some kind of advantage - at least in growth terms - over the developed countries which had used up all the easy opportunities for expanding production. Economists started to argue that the best qualification for growing fast was to start from behind. That was still the broad picture at the start of 1997. But now, in a matter of a few months, real questions are being asked whether this - like so many other miracles - turns out to be some sleight of hand, or not sustainable over time. One of the original sceptics of the miracle - Paul Krugman - might seem vindicated in his likening of these countries to the early years of the Soviet Union, where fast growth was achieved artificially and in a way that could not be sustained in the longer run.25 Even among the countries themselves, the basis of the miracle - free markets and increasing exposure to the outside world - is now under serious question. In the face of these doubts and the current crisis, should we abandon this new paradigm and return to some version of the old, low-growth, view of these countries? The most powerful reason for not doing this is that the forces which drove growth in the past are still there - the poorer of these countries are still well back from the technological frontier and the application of capital to still-cheap labour, and improvements in organisation and governance mean that fast growth is still achievable. The fact that they are still relatively poor makes this eminently desirable. First priority is to get them back on the rails again. Second priority, when the immediate crisis is over, is to get along with those structural and governance issues that we have heard so much about of late. If they are as economically important as the current debate implies, the growth potential of these countries should be higher still. The countries which can put in place robust, resilient and responsive financial sectors most quickly will be the ones which can return to rapid growth first. As Stiglitz has said: “In 1975, six out of 10 Asians lived on less than $1 a day. In Indonesia the absolute poverty rate was even higher. Today, two out of 10 East Asians are living in absolute poverty. Korea, Malaysia, and Thailand have eliminated absolute poverty and Indonesia is within striking distance of that goal. … No other economic system has delivered so much, to so many, in so short a span of time.” (Stiglitz 1998). Although he was most sceptical about Singapore, which seems to be one of the least affected. - 13 - References Feldstein, M.S. (1998), ‘Trying to do too much’, Financial Times, 5 March. Feldstein, M.S. and C.Y. Horioka (1980), ‘Domestic Saving and International Capital Flows’, Economic Journal, June, Vol. 90, pp. 314-329. Garnaut, R. (1998), The Financial Crisis: A Watershed in Economic Thought About East Asia, paper presented at Economic Society of Australia (Canberra Branch), Canberra, 19 February. (To be published in Asian-Pacific Economic Literature.) Greenspan, A. (1998), Statement of Chairman of the Board of Governors of the Federal Reserve System before the Committee on Banking and Financial Services, US House of Representatives, Washington, DC, 30 January. Grenville, S.A. (1997), ‘Asia and the Financial Sector’, Reserve Bank of Australia Bulletin, December. Grenville, S.A. (1998), ‘Exchange Rates and Crises’, Reserve Bank of Australia Bulletin, February. Krugman, P. (1998a), ‘What Happened to Asia?’, January (unpublished). Krugman, P. (1998b), ‘Asia: What Went Wrong’, Fortune, p. 21, 2 March. Macfarlane, I.J. (1997a), ‘Monetary Policy Regimes: Past and Future”, Reserve Bank of Australia Bulletin, October. Macfarlane, I.J. (1997b), ‘The Changing Nature of Economic Crises’, Reserve Bank of Australia Bulletin, December. Macfarlane, I.J. (1998), Address to American Australian Association, New York, 11 March. McKinnon, R.I. (1973), Money and Capital in Economic Development, The Brookings Institution, Washington, DC. Sachs, J.D. (1997), ‘The Wrong Medicine for Asia’, The New York Times, 3 November. Stiglitz, J. (1998), ‘Restoring the Asian Miracle’, Asian Wall Street Journal, p. 8, 2 February. | reserve bank of australia | 1,998 | 3 |
Speech delivered by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, before the Australian Stock Exchange, the Australian Institute of Company Directors and the Securities Institute of Australia in Brisbane on 26/3/98. | Mr. Macfarlane discusses Australia’s position in light of recent events in Asia Speech delivered by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, before the Australian Stock Exchange, the Australian Institute of Company Directors and the Securities Institute of Australia in Brisbane on 26/3/98. It is a pleasure to be here in Brisbane addressing the Australian Stock Exchange, the Australian Institute of Company Directors and The Securities Institute of Australia at their combined Bull and Bear Luncheon. I do not know whether I should nominate myself as a bull or a bear. Members of this audience will be able to make up their own minds after they have heard my story today. 1. Introduction In the period since the collapse of Asian currencies - roughly since the floating of the Thai baht on 2 July 1997 - I have spent a fair amount of time, as have many others, trying to understand the reasons for that collapse. It has been a salutary experience, and it has caused many of us to re-examine some cherished views. I have already spoken twice on this subject, so I do not intend to cover the same material today. What I hope to do, however, is to draw some lessons from it, and to apply them to Australia. In a previous speech1, I tried to identify the list of economic characteristics that would make a country vulnerable to a currency crisis or, worse, to a full-blown economic crisis. As you probably know, there is no definitive list that enables us to forecast these events with any precision, but there are about a dozen factors that seem to increase a country’s vulnerability. If a country scores a very low mark on all of these factors, or at least most of these factors, there is a good chance that it would be subject to an international loss of confidence and ensuing economic problems. You will not be surprised to hear that Australia is not in this category; indeed, Australia scores a very high mark on most of these factors and thus should be in a very secure position. But we can never be complacent. Like all countries, we do not achieve a perfect score, and therefore it is worthwhile to go through a systematic examination of our strengths and weaknesses in light of the recent events. 2. Criteria for vulnerability The list of factors identified from our research2 on the Asian crisis that pointed to the likelihood of a currency crisis or a wider economic crisis was as follows: 1. Does the country have a fixed exchange rate and free movement of international capital? 2. Is the exchange rate over-valued? 3. Has a country with similar economic characteristics recently experienced a currency crisis? 4. Is there a large budget deficit and a lot of government debt outstanding? 1 "The Asian Situation: An Australian Perspective", Reserve Bank of Australia Bulletin, March 1998. 2 We drew heavily on other work in this area, for example, Morris Goldstein, "Comments on Early Warning Indicators of Financial Instability in Emerging Economies", Federal Reserve Bank of Kansas City (forthcoming) and Graciela Kaminsky, Saul Lizondo and Carmen Reinhart, "Leading Indicators of Currency Crises", IMF Working Paper, July 1997 5. Is there loose monetary policy and high inflation? 6. Is the domestic economy in, or at risk of, a recession? 7. Is there a large current account deficit? 8. Is there a large amount of foreign debt? 9. Is there an asset price boom (especially credit-driven) occurring? 10. Are there a lot of bad debts in the banking system, and a poor system of bank supervision? 11. Has there been a lot of unhedged foreign currency borrowing? 12. Are there poor accounting standards, few disclosure requirements, ambiguous bankruptcy procedures, etc.? A brief scan of this list should reassure people that Australia is in good shape. That is, it would receive a very favourable mark on the vast majority of these indicators, and so should be able to handle the current international turmoil without too much disruption. But we are not perfect, and there are two items on the list - the current account and external debt - where our score is low by international standards. In the remainder of my talk today I would like to set out in more detail how Australia stacks up against the above list, starting with the ten factors on which we receive a very high score, and following roughly the same order as in the list above. I will cover the factors where we receive a high score quite quickly in order to leave room for a closer examination of the two weak points. 3. Australia’s strengths Australia allows the free movement of international capital, but we certainly do not have a fixed exchange rate. The Australian dollar was floated in December 1983, and after a few years of turbulence in the mid 1980s, has generally behaved as a floating rate should in the period since then. While it was more volatile in the 1980s than the major currencies such as the US dollar, yen and Deutschemark, in the nineties it has generally been less volatile than they have. It has varied cyclically over the past dozen years, but around a flat trend. There is no evidence to suggest that it is over-valued. Opinions will always differ on such a subject, but at the moment there are probably more, including some influential offshore institutions, inclining to the opposite view. Like most currencies, it has depreciated against the US dollar over the past 18 months, but against the Trade-Weighted Index it has been relatively stable. Judged by other measures of the exchange rate designed to capture competition with imports or against export competitors, it has shown a small increase in competitiveness.3 The issue of contagion can be addressed by asking whether another country with similar economic characteristics has recently experienced a currency crisis. The answer is in the negative: all the countries that have recently experienced a currency crisis have been at an earlier 3 See "Alternative Measures of the Effects of Exchange Rate Movements on Competitiveness", Reserve Bank of Australia Bulletin, January 1998. stage of economic development than Australia, particularly in respect of the depth of their financial infrastructure and the degree of prudence exercised by borrowers and lenders. The financial markets have made a clear distinction between troubled Asian economies like Thailand, Indonesia and Korea and countries like Australia. On fiscal policy, little needs to be said other than that Australia has a very low underlying budget deficit by world standards and is expecting a surplus next financial year. The stock of government debt to GDP (which effectively measures the extent of accumulated past deficits) is exceptionally low by international standards. On monetary policy, seven years of low inflation has finally received the international recognition it deserves. The international bond markets have expressed their confidence in Australia’s fiscal and monetary policies by reducing the spread between Australian and US yields to the lowest margin in a generation. In the aftermath of the currency crisis which resulted in the partial breakdown of the European Monetary System in 1992, the view developed that if a country was in or near recession, it would be particularly vulnerable to a currency crisis. This is because it would not be able to resist the currency crisis with tighter policies. (Whether it should, of course, would depend upon the circumstances.) Whatever the strength of this argument - and it is strongest for fixed exchange rate cases - it clearly does not apply to Australia, as we have a buoyant domestic economy. Furthermore, Australia is recognised internationally as having had one of the best growth records among OECD countries this decade. (Only Ireland and Norway - two very small economies - have done better.) I will delay discussion of the current account, the balance of payments and foreign debt until after I have completed the list of positive factors for the Australian economy. The next factor on my list was whether the country was in the midst of an asset price boom. The problem with asset price booms is that they are usually followed by asset price busts, which can give rise to company insolvencies and banking problems. Clearly, this is not the case in Australia at present, although we do have fresh in our memories the events of the late eighties and so cannot be too censorious of recent Asian events. While the Australian share market has risen over recent years, it has done so by a smaller amount than the United States or most of Europe. Commercial property prices have also been relatively restrained, and while house prices are rising, the large rises have been confined mainly to inner Sydney and Melbourne. I think we can be confident that our system of bank supervision is at world best practice, and the ratio of bad debts to total loans, at 0.9 per cent, is at its lowest level since statistics have been collected (admittedly, the collection only dates back to 1991). Of course, what currently seems to be a good loan can become a bad debt if circumstances change. Even so, I have a lot of confidence that our figures are a good guide to the health of our banking system.4 I think it is true to say that there has not been a lot of unhedged foreign currency borrowing occurring among Australian corporates since the days of the "Swiss franc loans" of the mid-eighties, but I will postpone discussion of that topic until I deal with foreign debt in the second half of this talk. Accounting standards, disclosure requirements and bankruptcy procedures are what might be termed financial infrastructure. So is the existence of a large group of equity analysts and financial journalists, the ASC and stock market listing 4 In many developing countries, official statistics on bad loans are thought to greatly under-estimate the true figure. Even so, Mexico and Thailand reported ratios of 10.5 per cent and 7.7 per cent in the year before their economic crises. requirements. We tend to take a lot of this for granted, but it is very important that they be up to best international practice. Again, we should not feel too superior to our Asian neighbours in this respect; it takes decades or more to develop these, and as recently as the late eighties we still had some glaring deficiencies. I think we are now at international best practice, but it still involves continued improvement to stay there. 4. Australia’s weaknesses While I am satisfied that the underlying structure of our economy, particularly its financial underpinning, is sound, there is no sensible way we can avoid a widening of our current account deficit in the short term. It is virtually inevitable because a significant number of the countries that make up our major export markets are likely to contract, or not grow as quickly, over the next 18 months. It is what economists call an "external shock". It is also true, of course, that if exports are weaker, then GDP growth will also be lower than it would have been without the "external shock". These "real" effects on exports and growth are already occurring, though their full effects will take some time to be clear. In the case of financial prices, such as the exchange rate, bond yields, commodity prices and share prices, of course, the adjustments occur at once, as market participants can immediately adjust prices to reflect their expectations of what is to come. What I wish to do in the remainder of this talk is to try to address two questions. First, how will the Australian and international financial community accept the widening of the Australian current account? This is important because it has implications in the first instance for financial prices. Second, what are the prospects for our exports, and hence economic growth? I will not answer this question in a quantitative way, which may disappoint those who want numerical forecasts; in fact, I will be making a few criticisms of the simple models that are often employed for this purpose. 4(a) Reaction in financial markets In the mid-eighties, Australian financial markets - particularly the foreign exchange and bond markets - experienced a major reaction to the widening current account deficit. The reason the reaction was so large was that doubts began to emerge about whether the economic situation was sustainable, particularly in view of the implications for foreign debt. There is always the possibility that the same or similar doubts will re-emerge over the next 18 months, but I am inclined to think that will not be the case. The reasons for my view are set out below. If we look at the history of the current account since the early 1980s (Diagram 1), it is apparent that the deficit has varied between about 3 1/2 per cent and 6 1/2 per cent of GDP, with an average of 4 3/4 per cent. Most importantly, there has been no on-going trend deterioration - the trade account has improved at a rate sufficient to offset the increase in net income payable abroad. The widening in the current account deficit that we expect in 1998/99 will be the fifth such cyclical widening in the past 20 years, and I think that people now accept this as a part of our economic cycle. You will note that I am only talking about cyclical movements in the current account. The broader issue of whether we should accept an average current account deficit of 4 3/4 per cent of GDP in the long run would require another paper as long as the one I am presenting today. It would focus on our national savings performance, both in respect to governments and to the incentives that are provided to the private sector. But that is for another day. On previous occasions, the cyclical widening of the current account deficit usually reflected a mixture of external influences, such as a fall in the terms of trade, plus some significant internal imbalances or policy deficiencies. As examples of the latter, domestic demand in the earlier widenings ran at unsustainably fast rates, usually in excess of 7 per cent per annum for a time. Similarly, in all but one of the earlier widenings, Australia’s inflation rate was higher than the world average, and again on two occasions, we were running a significant budget deficit. On this occasion, we have none of these imbalances. The widening of the current account deficit will be essentially the result of an external contraction of demand, with domestic demand running only slightly faster than trend. The foreign debt situation is not as threatening now as the most pessimistic people in the mid-eighties feared. Looking at a graph of the ratio of foreign debt to GDP (Diagram 2) shows that it nearly tripled between 1982 and 1986 (from 12 per cent to 33 per cent). Many people feared that it would continue to rise at this rate, but it has not. In the nineties, it has averaged a little over 40 per cent, where it currently is. Another widely used measure of debt sustainability - the ratio of debt servicing to exports (Diagram 3) - showed a somewhat similar pattern. It rose from 6 per cent to 22 per cent in the 1980s, but then reversed sharply in the early nineties, and is currently at about 12 per cent. The strong growth of Australian exports and the fall in world interest rates are largely responsible for this favourable development. In the 1980s, when the sharp rises in foreign debt and its servicing costs were occurring, the Australian economic debate was, not surprisingly, pre-occupied with these issues. At the time, there were no official statistics comparing foreign debt levels in developed countries, and in their absence there was a tendency for people to assume the worst - that is, to assume that Australia was the highest on the list. Now that the IMF and OECD publish official statistics on the subject (Table 1), we see that we should not have assumed the worst. While Australia is certainly in the top quartile of countries ranked by the net foreign debt to GDP ratio, it is not the highest - New Zealand, Sweden and Canada are higher. Looking at the gross external debt to GDP ratio, Australia is in the bottom half of the table. 5 Table 1: External Debt as per cent of GDP Net Debt New Zealand 64.2 Sweden 45.2 Canada 44.8 Australia 40.2 Gross Debt Ireland 143.1 Sweden 101.7 Switzerland 96.0 Denmark 89.0 5 Depending on the purpose at hand, there can be a case for looking at either net debt or gross debt. If the purpose is to ask how vulnerable a country is to a currency crisis, gross debt (as has been used in the recent Asian episodes) is the better measure. It shows the amount of foreign lending that potentially would not be renewed if serious doubts developed over a country’s future. The fact that the domestic private sector also had some foreign loan assets (as taken into account in net debt measures) would be of little assistance in such a currency crisis. Greece Finland Denmark Ireland United States Austria Italy Spain Norway Germany France Portugal Netherlands Japan Switzerland United Kingdom 33.3 31.6 29.9 29.8 20.2 12.3 6.0 3.8 3.7 -2.1 -2.8 -6.7 -19.7 -19.9 -99.0 n.a. Netherlands Canada New Zealand Finland Austria Greece France Germany Australia Italy Norway Portugal Spain United States Japan United Kingdom 88.3 77.7 75.6 74.0 73.4 62.4 57.2 57.2 55.9 54.0 49.0 48.6 44.3 42.6 33.0 n.a. Source: IMF, Balance of Payments Statistics Yearbook 1997 The other aspect of foreign debt that has received a lot of attention in the light of recent Asian developments is the extent of unhedged foreign currency borrowing. Official figures only tell us that 60 per cent of Australian borrowing is denominated in foreign currency. Of that, a significant proportion has been borrowed by banks, and this is virtually all hedged. Our assessment is that major Australian corporates normally hedge their foreign currency borrowing unless they choose not to because they have a natural hedge through their exports. As I mentioned, financial markets tend to be forward looking, and it is likely that a significant deterioration in the current account is already factored into important financial prices. The reaction of financial markets to date has been more measured than was the case in the 1980s, no doubt reflecting their assessment of the much improved "fundamentals" of the Australian economy. But we should not take this for granted. We have seen in Asia over the past year just how fast the international capital markets can react if they come to the judgment that a country is not being managed in a sustainable way. 4(b) Slowdown in exports We would all like to know how large the current slowdown in exports will prove to be. But, because we have not been through this type of situation before, there is a lot of uncertainty about how to go about this. To date, those trying to be scientific and quantitative have tended to use a model which I would term a "fixed co-efficient input-output model". This approach starts by forecasting the fall in import volumes which each of our trading partners will experience and assumes that the volume of our exports to each country will fall by a similar amount. After adding together the results for each country, it arrives at a figure for Australian exports to the region. This is a time-honoured approach, but I am sceptical of how appropriate it is for a country in Australia’s position. Despite Australia’s impressive export diversification of the past decade, about 60 per cent of our exports are still essentially rural and resource commodities which are sold onto world markets. Most of these are fungible - they are sold to wherever the demand is. If Korean demand for base metals falls, Australia will still probably sell the same amount of base metals worldwide as before, but with more sales to countries other than Korea. Of course, if world demand has weakened, the price will have to fall to clear the market. That is what has been happening - commodity prices are now 9 per cent lower than at their March 1997 high in SDR terms. Thus, from Australia’s perspective, the Asian slowdown may have its biggest effect not through lower export volumes, but through a fall in commodity prices, some (or, conceivably, a lot) of which has already happened because these markets are forward looking. There is still an effect on the economy, of course, since lower prices, other things being equal, mean lower export income, which in turn means lower demand and so on. It is important to note, however, that other things have not been equal: the Australian dollar has depreciated such that in $A terms, commodity prices are actually higher than a year ago. A good example of exporters seeking other markets is shown when we consider the recent history of our exports to Japan, by far our largest export market during the 1990s. As you know, the Japanese economy has been extremely weak over the past five years, and our exports to Japan have been flat over most of that period.6 But this has not stopped overall Australian export volumes growing strongly; they have risen at an average annual rate of 7 1/2 per cent in real terms over the past five years. Where has the growth come from? Just about everywhere but Japan, including, until recently, the other Asian countries that are currently in trouble. The most striking feature, however, has been the growth in a group of countries we have always called "other". As you can see from Diagram 4, this is our fastest growing market in recent years. To satisfy your curiosity, "other" is what we have left after we exclude Asia, the United States and Europe: that means it includes the Middle East, New Zealand, the Indian SubContinent, the Former Soviet Union, Eastern Europe, South America, etc. Another reason why the conventional approach to estimating the effects of Asia on Australian exports may overstate the slowdown is that a significant proportion of our exports are inputs into Asian exports, rather than final consumer or investment goods. This seems to be the case particularly for the two largest Asian markets - Japan and Korea. The situation is not as clear for some other countries, but as a general rule, we are probably better off in current circumstances than most suppliers because of the weight of commodities, foodstuffs and "inputs into exports" in our mix. After the transitional export finance problems are solved, we should 6 Until the last nine months, when they rose apparently in line with a pick-up in Japanese exports. expect to see strong growth in Asian exports as a result of their large increase in competitiveness. I would be a lot more worried if Australian exports consisted of consumer products. Incidentally, this is one of the reasons why tourism has been hit so hard - it is probably our biggest export that is aimed directly at households, and is considered by them something of a luxury. I hope I have not gilded the lily too much in the above discussion. There is no doubt we will find the going tough on the export side, and we will not be able to repeat in the short term the sort of figures we have become used to over the past five years. But I think not enough account in popular discussions has been taken of our particular mix of exports and our capacity to find new markets. 5. Conclusion The events in Asia have confronted us with a challenge that was not foreseen a year ago. In deciding how to handle it, the first step is to recognise that the outlook for the economy is less favourable than it would have been in the absence of these events. The optimal policy response will be to accept that the effects should be spread across several economic variables, rather than attempting to adhere closely to earlier aspirations for any one variable, and letting the others do all the adjustment. It is clear that we should be prepared for a higher current account deficit in the short run - to try to avoid it would place intolerable strains on the rest of the economy. Similarly, we will have to accept a somewhat lower rate of economic growth and slightly higher inflation than seemed likely not so long ago. Notwithstanding these changes, we feel that over the next 12 months, Australia will continue to experience an economic outcome which will place it among the better performers in the OECD area. We also believe that our economic fundamentals will hold us in good stead, and that we will retain our hard-won reputation as a country with responsible economic and financial management. | reserve bank of australia | 1,998 | 4 |
Opening statement by the Governor of the Reserve Bank of Australia, Mr. Ian Macfarlane, to the House of Representatives Standing Committee on Financial Institutions and Public Administration in Melbourne on 7/5/98 (slightly abridged). | Mr. Macfarlane reports on monetary policy and financial stability in the Australian Economy Opening statement by the Governor of the Reserve Bank of Australia, Mr. Ian Macfarlane, to the House of Representatives Standing Committee on Financial Institutions and Public Administration in Melbourne on 7/5/98 (slightly abridged). 1. Introduction Mr Chairman, It is a pleasure to be here in front of your Committee for the third time under the new arrangements set out in the Statement on the Conduct of Monetary Policy. I hope this meeting will be as successful as its predecessors in helping to lift the level of understanding of monetary policy, financial stability, the Australian economy and, of course, the region more generally. I also hope you have found our Semi-Annual Statement on Monetary Policy a useful source of information and a reasonably clear statement of our views. It is especially pleasing that we are meeting here in Melbourne for the first time. If you remember, Mr. Chairman, the attempt to do so last November was foiled by a clash with Melbourne Cup week and the attendant shortage of hotel rooms. Fortunately, the Victorian Government has not been able to put on a sporting extravaganza to foil our plans this time. 2. Review of last time As on the previous occasion, I would like to start today by recognising that accountability includes being accountable for what was said last time. I will do this by reviewing how the past six months have turned out against the background of what I told the Committee we were expecting last November. At that time, I summarised our expectations by saying that I thought 1997 would prove to be a good year for economic growth, with GDP growing by about 4 per cent, that inflation would remain below 2 per cent for a while, but with a tendency to pick up as we went through 1998, and that there was a good chance that unemployment would decline. I said very little about the current account and balance of payments, as the outlook for Asia was still very unclear. We had only two quarters’ data on economic growth in 1997 at the time of our previous meeting - now we have all four. The ABS records that GDP grew by 3.6 per cent over the four quarters, and non-farm GDP by 3.8 per cent, slightly less than the 4 per cent that I was expecting. I do not think there is any point in making much of this small difference. The other reason that I would not make much of this small difference is that the outcome for the labour market turned out to be a bit better than we expected. The average unemployment rate in the first half of 1997 was 8¾ per cent. When we met in November, the most recent figure we had was 8.6 per cent. The run of numbers we have received over the past few months have been either 8.2 per cent or 8.1 per cent. So if you look across the past 12 months, I think you could see a reduction in the unemployment rate of ½ per cent or so. So over the course of 1997 a combination of good growth and moderate outcomes on wages made some inroads into our unemployment rate. On inflation, I have little to add to what I said last time. Underlying inflation has been 1½ per cent over the past 12 months. We are still expecting that it will rise over the next 12 months, largely because falling import prices, which were pushing inflation down, have given way to increasing import prices. In fact, the fall in the exchange rate has meant that wholesale import prices have risen by 7.7 per cent over the past 12 months, and import prices made their first positive contribution at the retail level to the CPI in the March quarter after seven quarters when they detracted from it. These changes are not alarming, but they do tend to suggest that we have passed the low point in the inflation cycle. So I feel reasonably comfortable with our earlier assessment, except in one respect last time we met, the full extent of the Asian slowdown was still uncertain. In fact, it is quite interesting that as recently as six months ago, most discussions treated the ASEAN Four as being the known extent of the Asian slowdown. We did not know at that stage, although the possibility was flagged, that Korea would join them, that Indonesia would deteriorate significantly further, and that Japan would suffer a relapse into recession. When we take these developments into account, it is clear that a bigger external contractionary effect now has to be factored in. I will return to this subject in more detail later. 3. Prospects for 1998 (a) General So much for 1997 - what about 1998? In the absence of the external shock from Asia, 1998 was shaping up to be, if anything, a stronger year than 1997. There was nothing in the internal dynamic of the economy which was pointing to a slowdown, and we had every reason to expect growth of 4 per cent plus. That will no longer be the case, and we are now looking at growth through 1998 of something more of the order of 3 per cent. This would probably mean that after a year in which the unemployment rate came down, we might be looking at a year in which it flattens out. I have already mentioned the outlook for inflation when I reviewed the previous year’s results. Broadly speaking, we think that the trough in the inflation rate has passed, it is moving back again into the 2-3 per cent range, but it is not doing so in an alarming way. We expect it to be in that range by the end of this year, and it probably will rise a bit during next year. (b) Balance of payments Another part of the economy which in Australia has always been closely watched is the current account of the balance of payments. With domestic demand in Australia growing at or above trend, but with a number of our major export markets declining, it is an arithmetical certainty that the current account has to widen, as it has. This is not a sign of an economic policy failure, and I trust markets will treat it accordingly. A number of people, including myself, have made the point that on this occasion the widening of the current account deficit is not the result of excessive growth in domestic demand, nor is it the result of declining competitiveness because of high Australian inflation, nor is it a counterpart to a large budget deficit. For these reasons, we expect it will not arouse the same excitement as it has in the past, though you can never be sure. At present, our expectation is that the current account deficit in 1998 will be about 5½ per cent of GDP, but if you look at the cyclical behaviour of the current account over the last two decades, you could not rule out it touching 6 per cent for a time. Imports are probably slowing from their very high growth rate in the second half of last year, but not by much according to the March quarter figures. Over the course of 1998, we still expect them to show their usual behaviour, that is to grow by a few percentage points faster than domestic demand. Exports, on the other hand, cannot hope to keep up last year’s pace of 8½ per cent, and a small positive figure is probably what we can expect. Most of our exports - our rural products and metals and minerals - are sold into worldwide, rather than country-specific, markets. If we cannot sell zinc or copper to Korea, we sell it to another country: the same goes for our rural exports. It means that for two-thirds of our exports, what we earn is a function of world demand, not of the demand from our specific (largely Asian) trading partners. At the end of the day, the prices for these commodities adjust to clear the market, and that has been happening. The prices of Australian commodity exports have fallen by 9 per cent over the past year when measured in terms of a neutral basket of currencies. At the same time, the Australian dollar has fallen against this neutral basket of currencies, so our commodity prices in Australian dollars - what our exporters actually receive - have gone up slightly. Even for our biggest exports - coal and iron ore - where prices are renegotiated annually, the Australian dollar prices in contracts which commenced in April this year were higher than in the contracts a year earlier. This is an example of the market adjusting - in this case, the foreign exchange market - to shield the export sector (but not the whole economy) from the worst of the Asian downturn. 4. Asia Having made these points, I do not want to give you the impression that I am downplaying the effects of Asia. To the contrary, the biggest difference between the way we view our immediate future today and the way we viewed it a year ago is clearly the external shock we have received from Asia. While it is true that the Australian business cycle is always affected by the world business cycle, the current Asian crisis is the first significant identifiable external shock we have had for a long time. The last time I can remember something as specific as this was OPEC II in 1979, but that was on a much bigger scale and affected the whole OECD area more evenly. The current Asian crisis is unusual in that Australia has a bigger exposure to it than any other OECD country (other than the two who are actually part of the crisis - Japan and Korea). We have always been very conscious of Australia’s vulnerability to a sharp contraction in Asia. But it has always been our hope, and certainly the guiding principle behind Australia’s policy, that the economic problems in Asia could be minimised by prompt action. It was this awareness of possible danger ahead that lay behind Australia’s very quick response to the Thai crisis, and the Reserve Bank’s willingness to put funds from its balance sheet at the Government’s disposal to ensure that Australian participation was not delayed. It also explains why Australia is the only country other than Japan to be a part of all three Asian support packages - those for Thailand, Indonesia and Korea. Australia has done what it can to help minimise the Asian fallout, but clearly events have turned out worse than we had hoped for. The crisis has spread further than was at first thought likely, it is resulting in larger falls in output and employment in the countries concerned, and finally it has been compounded by the relapse of the biggest Asian economy - Japan - into recession. What started as a currency crisis in Thailand is leading to widespread suffering in a range of Asian countries. Of course, those countries have some deep-seated economic policy deficiencies weak banking sectors, too much of what is called “crony capitalism”, too much government direction of investment (including implicit underwriting of loans) and insufficient disclosure, poor accounting standards, etc. These deficiencies are common to most countries at earlier stages of development than ours, and they have been around for decades. They did not deter massive capital inflow for most of this decade, and I suppose it must be galling for some of these countries to listen to sermons on their deficiencies delivered by international bankers who, until recently, were happy to ply them with loans. We all have to agree that these countries made policy errors; that is par for the course. Yet I agree with Paul Krugman who, when commenting on the current situation, said: “Yet governments are no more stupid or irresponsible now than they used to be; how come the punishment has become so much more severe?” These countries have had to make a very rapid adjustment to their external positions to stop their exchange rates from falling below the extremely low levels they reached late in 1997. They could not rely on a resumption of capital inflow to stop the problem, so the only feasible way was to return their current accounts to surplus. This has involved very tight policies, a very large fall in domestic demand, and very large falls in imports. For the three countries in IMF programmes, we estimate that imports have already fallen by between 30 and 40 per cent. Even though there has not been enough time to expand exports in line with their improved competitiveness, their current accounts have already moved into surplus. Australia’s exports to these countries appear to have already fallen roughly in line with their falling imports. Thus, we have received the effects on our trade flows quite early in the piece. In time, when their exports pick up, we should get some benefit from this even if their domestic demand remains weak. 5. How have we coped? To date, we have coped quite well, largely because we were in good shape going into it with strong domestic demand and low inflation. This was in part due to the fact that we had taken expansionary monetary policy action between July 1996 and July 1997. The other way in which we have coped well is that our financial markets have behaved very sensibly. It is true that our exchange rate has depreciated against the US dollar, and against major currencies in general, but this is an understandable market reaction to the deterioration in our international trading environment. Apart from a minor panic in January, the whole process has been very orderly. The bond market too has performed very well. International and domestic investors have clearly drawn a distinction between Australia and our Asian neighbours, and we have not seen any rise in risk premia on Australian bonds. Indeed, we have improved our position over the period, and Australian borrowers can now borrow in A$ at or below the same rate as equally creditworthy US borrowers can borrow in US dollars. The Australian share market has also risen over the past six months and, even though it has not performed quite as well as some overseas markets, is higher than its former peak in mid-1997. What is the implication of Asia for the conduct of monetary policy? The simple answer is that it makes it more difficult. The Australian economy has suffered an external shock - a significant reduction in demand for our exports, which will lead to lower export volumes in some cases and lower export prices in others. This will show up in some combination of lower growth and a widening of the current account of the balance of payments. Because of the fall that has occurred in our exchange rate, it will also show up as higher inflation than otherwise. Even if we had perfect foresight, we cannot adjust policy in a way which would avoid these outcomes altogether. The best we can hope for is a combination which minimises the longer-run disruption to our economy. Choosing the monetary policy to achieve this is not an easy task. It involves constantly reviewing our position in the light of changes to the economy, and our forecasts of future events. Importantly, it will be heavily influenced by how the Asian situation develops. I repeat that the only reason we are foreseeing any slowdown in growth in 1998 is because of the Asian crisis there was nothing in the domestic economy that pointed in that direction - in fact, it pointed to higher growth. I suspect that in the future evolution of our policy, Asia will be the major influence. As you know, the Board of the Reserve Bank met on Tuesday and did not make any change to the setting of monetary policy. There had been some speculation over the preceding month that we might ease, but the majority of observers expected no change. Our on-balance view is the same as the majority of outside observers: that is, we judged that the present setting is the right one. As we see it: • The present stance of monetary policy provides a low interest rate environment which is working to support, rather than restrain, growth. Credit is readily available, borrowers seem to regard current interest rates as attractive, financial wealth is rising, as is private sector leverage. • Developments in the exchange rate and interest rates charged by financial intermediaries since the last reduction in the cash rate in July last year have worked to magnify the effects of lower official rates. The exchange rate has come down against major currencies, and competition among banks has reduced interest rates to business and personal borrowers. • The most likely outcome over the next 12 months at the present policy setting is for inflation to return to its target range and for domestic demand to remain at or above trend growth. With a significant reduction in net exports, GDP will probably grow below its trend rate, but some growth slowdown in the short run is an unavoidable result of the external shock. • Our measured approach to date has served us well in that it has maintained confidence in Australian financial markets. That, of course, does not rule out further changes in policy, but it does impose a constraint in that it means monetary policy has to be adjusted credibly. We do not wish to jeopardise Australia’s current good international standing or revive memories of when Australia was regarded as a “boom and bust” economy. We gain a lot from our current reputation for stability - not only does it reduce our borrowing costs, but we can raise equity more cheaply, and we have become a more attractive place for direct foreign investment. Of course, we recognise that it would also be a mistake to stick too long to a setting of policy in the name of stability if there were good reasons to move. We have to be conscious of the risks to our current assessment, and constantly review them. The major downside risk which we can see is the possibility that the effect of the Asian and Japanese situations might produce a larger slowing in the Australian economy than our current expectations, perhaps indirectly by slowing growth substantially in other trading partners or by seriously dampening domestic demand through income or confidence effects. Such an outcome is not in our view the most likely one - but it has some probability. | reserve bank of australia | 1,998 | 5 |
Talk by the Deputy Governor of the Reserve Bank of Australia, Mr. Stephen Grenville, to Monash University Law School Foundation in Melbourne on 21/5/98. | Mr. Grenville talks on the Asian crisis, capital flows and the international financial architecture1 Talk by the Deputy Governor of the Reserve Bank of Australia, Mr. Stephen Grenville, to Monash University Law School Foundation in Melbourne on 21/5/98. Kindleberger (1978), in his classic study of “Manias, Panics and Crashes”, observed that: “there is hardly a more conventional subject in economic literature than financial crises.” The Asian crisis, while unexpected in its timing, spread and severity, contains many familiar elements. If we were to distil a core weakness from the complex causes, it would be the juxtaposition of fragile domestic financial systems with large and volatile international capital flows. Today, I want to focus on the second element of this fatal combination - the large and volatile capital flows.2 The Pros and Cons of International Capital Flows There is a strong a priori case that international capital flows are a Good Thing. The obvious analogy is with international trade. If it is beneficial for nations to trade in goods and services, then there is a presumption that there will also be advantage in trading in saving. Financial flows supplement domestic saving, allowing more investment to be done in those countries where returns are highest; they buffer the variations over time between exports and imports; foreign direct investment brings the advantages of technological transfer; there are gains for savers from diversification; and, to complete the case for free capital flows, we should record the argument that even speculative capital flows can serve a beneficial purpose.3 Capital flows are generally supported by the economic profession, both academics and practitioners. Open capital markets are part of the widely-accepted Washington Consensus (whose twin elements are that countries should deregulate, and should open their economies to the outside world), and are endorsed by the IMF.4 Why, then, does foreign capital flow rank as a central element in the Asian crisis? The short answer is: painful experience in the practical world. Contrast Keynes’ (1919) views on the pre-WWI world, with his later views on the prospective post-WWII world, transformed by the experience of the 1930s. He describes pre-WWI London, with evident approval, this way: “The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth . . . ; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages . . . He regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.” (pp. 9-10) This was, as Keynes noted, a “paradise” in which “internationalisation was nearly complete in practice”. Contrast this idyllic civilised picture I am grateful for the help of John Hawkins, Suzanna Chiang and Amanda Thornton in preparing this paper. This is not to downplay the deficiencies in domestic policies, which have been discussed elsewhere. For some discussion of the other “twin” problem - financial sector fragility - see Grenville (1997 and 1998b). The best known proponent of this argument is Milton Friedman, who has argued that speculation is inherently stabilising, as any speculator who does not buy cheap and sell dear (thus driving the price towards its fundamental equilibrium) will quickly go out of business. More recent literature is less confident of this result. The IMF Managing Director recently put forward seven building blocks for a stronger financial system, with the first three relating to globalisation: “The first of these building blocks is the tremendous potential for growth and prosperity globalization provides countries fully integrating into the global economy. Formidable sources of dynamism are there, engendered by new information technologies and unifying financial markets. . . . The second building block is integration. By integrating themselves into the mainstream of the globalizing world economy, the poorest countries will avail themselves of a most powerful instrument of acceleration of development. . . . The third building block is the universal consensus on the importance of an increasingly open and liberal system of capital flows in order for globalization to deliver on its promises.” (Camdessus 1998). with the world Keynes envisaged as he wrestled with the problem of reconstruction after the Second World War: “it is widely held that control of capital movements, both inward and outward, should be a permanent feature of the post-War system.”5 “Experience between the Wars clearly demonstrated the mischief of unregulated capital movements, which take no account of the balance of trade available for overseas investment.” 6, 7 The central point here is that some types of capital flows, for all their benefits, are very volatile. Policy-makers are not just interested in the growth of GDP, but its variance. Large volatile influences are a policy nightmare. The Asian Experience Private capital flow into the five troubled economies of Asia (South Korea, Indonesia, Thailand, Malaysia and the Philippines) was very large and variable, both up and down. It had reached almost US$ 100 billion in 1996 - one-third of worldwide flows into emerging countries. This was a five-fold increase over the 1990-93 average. It reversed in 1997, to record an outflow of US$ 12 billion. This turnaround was equivalent to more than 10 per cent of the GDP of these countries. Portfolio equity investment into these five countries almost quadrupled in a single year - 1993. These flows were huge, compared to the size of the domestic financial sectors. It is hardly surprising that the then-Governor of the Indonesian central bank said: “we started building the foundations of a house but suddenly we had to host a party”.8 Kindleberger (1989), describing the post-OPEC period, captures the same point when he says: “multinational banks swollen with dollars, . . . tumbled over one another in trying to uncover new foreign borrowers.” (p. 26) Two other characteristics are worth noting: • • almost 60 per cent of the 1996 private flows to the Asian Five were from foreign commercial banks and 40 per cent were short-term credits. Bank lending was flighty indeed - inflows of US$ 56 billion in 1996 turned into outflows of US$ 27 billion in 1997. Direct equity investment - which might be expected to be more stable - was quite modest (6 per cent of the total), but portfolio equity investment (which can - and did - quickly reverse) was twice as large;9 the flows were driven, to an important extent, from the supply side. The flows in the 1990s were consistently larger than the current account deficits - i.e. they were not drawn in by the need to fund the saving/investment gap. Paradoxically, one source of volatility was the high profit opportunities available in these countries, as they “got their economic act together”, combining technology and cheap labour Treasury memo to the UK War Cabinet’s Reconstruction Problems Committee. Proposal for an International Monetary Fund, Annex A of the Washington Conversations Article VII, Memorandum by the Minister of State, 7 February 1944. Bhagwati (1998), distinguished economist and long-time champion of free trade, provides another example, in his strong scepticism that the arguments for international freedom of trade can be transposed to capital flows. For a description of the measures which Indonesia took in the early 1990s to try to slow the inflows, see IMF (1995, p. 14). In the two decades beginning in the mid 1960s, Singapore succeeded in absorbing very large capital inflows without disruption. This was predominantly foreign direct investment. with capital, to produce high productivity (and high profits) as they moved towards the technological frontier. Hand-in-hand with these high profits go high real interest rates. The international capital flows came, as a normal part of the working of markets, to avail themselves of these opportunities. These capital flows were not some aberration which could be avoided by better macro policies or by enhanced policy transparency, but were the normal manifestation of the working of capital markets.10 The inflows, nevertheless, presented an intractable dilemma for policy. While-ever domestic interest rates were high, this encouraged more foreign inflow which made credit control difficult and was costly to sterilise; but lower interest rates would have fuelled excess domestic demand. More exchange rate flexibility has been suggested as the panacea in these difficult circumstances, but I have argued elsewhere11 that, while it would have helped, the problems were more fundamental. The one way that an equilibrium (of sorts) could be established was to bid up asset prices so that the high intrinsic profit opportunities were counterbalanced by over-priced assets - but of course this distorted investment incentives and fuelled over-optimistic expectations. The result, in short, was a widespread perception that borrowing was cheap, with all the resource misallocations and distortions that go with this. High saving economies routinely produce another destabilising characteristic - high leverage ratios (Wade and Veneroso 1998), which leave enterprises vulnerable to changes in the macro settings, particularly interest rates. Households do the saving, while companies do the investing, so the corporate sector is inevitably highly indebted in fast-growing countries with under-developed equity markets. When investment is funded from overseas, then one of the parties (either the borrower or the lender) is taking an exchange rate risk, which makes these flows volatile and flighty. In short, high-profit/fast-growth economies are intrinsically more vulnerable to the volatility of capital flows. This degree of volatility can be ameliorated by better domestic policies. But volatility is intrinsic to these flows, and there is a long international history in which capital flows were either the catalyst for a crisis, or exacerbated a crisis which was set off by other factors: “the history of investment in South America throughout the last century has been one of confidence followed by disillusionment, of borrowing cycles followed by widespread defaults”.12 We might note also, in passing, that the overall international financial environment has been routinely subject to fits, starts and sudden reassessments. The large swings in the yen/dollar exchange rate during the 1990s and the abnormally-low interest rates in Japan were an important factor in the capital flows under discussion here.13 High levels of international debt and large current account deficits were a reflection of saving/investment imbalances, and to the extent that the economic literature had wrestled with this issue beforehand, the puzzle was that the international capital flows had not been larger, rather than that they were somehow too large (the standard reference here is Feldstein and Horioka (1980)). Grenville (1998a). Latin America provides earlier examples of countries whose real exchange rates were driven up by capital inflows, as a prelude to a sharp substantial fall when confidence changed (see McKinnon and Pill (1995)). Royal Institute of International Affairs, quoted by Dornbusch (1985). See also Kindleberger (1989, Chapter 7) and Arndt (1998). McKinnon and Pill (1995) provide an interesting account of the interaction between capital flows and financial sector weakness in recent Latin American experience. Their final “stylised fact” provides an accurate description of the subsequent Asian problems: “The ‘over-borrowing’ episode culminates in a financial crisis, capital flight and recession - often forcing an uncontrolled deep devaluation of the currency, with a resurgence of inflation.” (p. 6) The characteristics of emerging countries impart to the flows far more volatility than is seen in, say, Australia. In the exchange rate problems of Australia in the mid 1980s, capital inflow continued at its underlying average rate. For discussion of this point, see Eichengreen and Rose (1998). Perceptions and Confidence In this fragile world, the critical issue that changed - motivating the volte face of capital between 1996 and 1997 - was an extraordinary change in confidence - what Stiglitz calls the “instability in beliefs” and Keynes called “animal spirits”. Such reversals of sentiment are not uncommon, even in the United States: one notable example was the October 1987 share market shake-out.14 But the opportunities for these reversals of confidence are greater in the Asian countries, where foreign investors did not know these economies well and the economic fundamentals are not well established. So they were even more susceptible to herd behaviour - once doubts started, they were self-fulfilling. Over-optimism based on imperfect understanding could easily change to over-pessimism, equally based on misunderstanding. Over-inflated asset prices deflated rapidly. A recent Fortune (1998) article captures the post-crisis disillusionment: “You can’t trust the companies, you can’t trust the governments, you can’t trust the analysts, and you can’t trust the mutual funds managers. Watch out.” “There was a touch of the absurd in the unfolding drama, as international money managers harshly castigated the very same Asian governments they were praising just months before. . . . But, as often happens in financial markets, euphoria turned to panic without missing a beat.” (Sachs 1997)15 The recipient countries had only a limited range of instruments that could be used to counter these changes of confidence. The traditional answer is to raise interest rates.16 But this had limited effect: nervous foreign lenders were concerned about the fundamental credit-worthiness of borrowers, not interest income. Many lenders had provided funds denominated in foreign currency, and higher local currency interest rates were irrelevant, except to the extent they added to concerns about the local economy. High interest rates in the defence of the exchange rate were more damaging to these vulnerable economies because of their high corporate leverage. The short-term nature of the flows added to the woes. Proposals for Reform In short, the size and volatility of the foreign capital flows exacerbated the serious and fundamental domestic policy problems, fuelled the boom and made the subsequent crash worse. These problems are all the more intractable for economies which are in the process of opening themselves up to international financial markets, with small inexperienced financial sectors. In the wake of this experience, there is no shortage of reformist proposals. George Soros (1997) - the most famous of the hedge fund managers and a prime beneficiary of the current freedoms of capital flow - has suggested the setting up of an international credit insurance corporation. Henry Kaufman, the doyen of Wall Street economists, has urged the creation of an international supervisory structure, which would “vet” countries’ prudential systems Greenspan (1998) observed that: “there is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuation on that day.” An academic literature is building up around the idea of “rational beliefs”. McKinnon and Pill (1995), referring to the work of Kurz, say: “The rational beliefs approach permits individuals to hold different views about the structure of the economy, provided the models implicit in these views are not refutable by observed or observable data. This structure allows the economy to deviate from ‘sustainable’ paths in the short run - which could last for an extended period - until observed data demonstrate that the structural model implying this ex post unsustainable behavior was incorrect.” (p. 17) Kindleberger (1989, p. 153) cites the case where, in 1849, a 2 per cent (200 basis points) rise in the UK discount rate was enough to cause sailing ships carrying gold to America to turn around and return to the United Kingdom: such fine-tuning of crises seems to be a thing of the past, along with sailing ships. before allowing them to borrow in international financial markets. At the other end of the spectrum, there are those who argue that the main problem was “lack of liquidity” in these financial markets, which they identify as causing large price movements on relatively small volume changes. For the latter group, the solution is simple: to go harder, stronger and quicker towards full deregulation. Larry Summers (1998), US Treasury Deputy Secretary and former leading academic, draws an analogy with the advent of jet travel, which greatly improved convenience and safety of international travel, but when accidents happen, they are more dramatic. Should we, he asks rhetorically, address this problem by banning jet landings? To carry this analogy further, clearly the answer is to make the infrastructure safer for the most beneficial aspects of the innovation, while not precluding the possibility that the more dangerous aspects should be constrained. The Asian experience - following, as it does, similar experience in Mexico in 1994/95 - has set the agenda for the reform of the international financial architecture. The G22 meeting held last month in Washington focused on three requirements: • • • transparency (i.e. greater information to help markets make more rational decisions); strengthening of financial systems to make them more resilient in the face of changes of sentiment; ensuring that the private sector bears a proper share of the burden of any rescue operation. All this makes good sense. To argue that more information is better than less information is as close to a truism as we can get in economics.17 Nor would any informed observer dispute the need for root-and-branch reform of prudential supervision in these countries.18 The issues here are not ones of principle, but are operational: how to put in place an enforceable set of rules which is sufficiently strict to protect the core of the financial system from crises, without making the rules so onerous that financing shifts elsewhere, to an unregulated but equally-vulnerable channel. The third area - private sector burden sharing - requires some elaboration. Despite the best endeavours on information/transparency and in building up prudential strength, it is hard to believe that the problems will be quickly and fully eliminated. For a start, a good prudential system will take many years to develop, considering that it requires counterpart improvement in accounting, legal and bankruptcy arrangements. Transparency is a good thing, but markets can make radical reassessments even when information is abundant - the October 1987 share market shake-out is evidence of this. And, realistically, domestic policy-makers will never be omniscient and single-minded in their pursuit of economic perfection.19 At present, the focus is on greater disclosure from capital-receiving countries, but this could be extended to greater disclosure from capital suppliers, including private intermediaries and investment funds. This focus revives an old issue in economics - the sequencing of reform. The old argument was that financial deregulation should come last, as the financial sector facilitated the exploitation of any remaining regulation-driven distortions in the economy. The new argument is that if financial deregulation precedes the establishment of a strong prudential framework, the inevitable volatility of capital flows will produce a collapse of the financial system. For an interesting discussion of the need for a “global standard”, see Sheng (1998). Stiglitz (1998) puts it this way: “We must bear in mind too in designing policy regimes (such as opening up capital markets) that we cannot assume that other aspects of economic policy, such as macroeconomic policy or exchange rates, will be flawlessly carried out. The policy regimes we adopt must be robust against at least a modicum of human fallibility. Airplanes are not designed to be flown just by ace pilots, and nuclear power plants have built into them a huge margin of safety for human error.” If we accept that, with all the corrections made and “best endeavours” on the policy-making front, there will still be room for sharp breaks in confidence, then this has to be handled in the same way that it is handled domestically in the face of bank crises caused by loss of confidence - through the availability of a lender-of-last-resort. Mexico in 1994/95 provides a classic example of the international lender-of-last-resort in operation, and most observers would regard this as a success. Most people would also regard it as an example of the residual problem of the lender-of-last-resort - “moral hazard”. This type of moral hazard occurs when those who take economic decisions are not required to accept the full consequences, when that decision turns out badly. In the case of the sudden capital outflow from Mexico in 1994, this outflow was replaced by an IMF/US package of US$ 50 billion, which was enough to pay out the government creditors, until confidence was restored (which occurred relatively quickly) There are those who argue that, in doing this, the foreign investors were “bailed out”, and this sets a bad precedent for future investors.20 While the problem of moral hazard has long been recognised, and there was substantial discussion about how to address it following the Mexican rescue, subsequent events have demonstrated just how hard it is to avoid. In late 1997, foreign banks which had lent to Korean private banks were given an ex post government guarantee and concerted arrangements were put in place to avoid the impending default. If Mexico showed that creditors holding government debt can be bailed out and Korea showed that creditors holding bank debt can be assisted, then Indonesia may be providing an example, where foreign creditors holding debt of private firms are assisted.21 It is not hard to see why this occurs: while everyone is against moral hazard in principle, the resolution of particular problems often requires that special assistance be given to those who, by their actions, could make the current crisis worse. As Kindleberger (1989, p. 182) noted: “Actuality inevitably dominates contingency. Today wins over tomorrow.” As with bankruptcy, in practice the balance needs to be drawn between the need to keep continuity of operations, against the need, also, to maintain appropriate incentives for risk-taking. While everyone agrees, in principle, that private investors should not be bailed out, administering the appropriate “haircut” is not operationally easy. Hence the question of private sector burden sharing on the G22 agenda. If the combination of moral hazard and the understandable reluctance of governments to enlarge the international lender-of-last-resort leaves the feeling that the problems have not been fully resolved, then a further - more controversial - element is on the agenda in some quarters. For some people, the problems of short-term capital flows outweigh their benefits. They argue that short-term flows bring little or no technological transfer. William Rees-Mogg (1998), former Editor of The Times, has put it this way: “There is now a huge financial industry which is purely speculative in character; it centres on the currency trading of international banks. It is deeply resented in those countries which have been ravaged by its inflows and outflows, however much they may have contributed to their own misfortune. Because it is entirely short-term in character, casino capitalism makes little net contribution to long-term investment.” “It is impossible to pretend that the traditional case for capital market liberalisation remains unscathed. Either far greater stability than at present is injected into the international monetary system as a whole or the unavoidably fragile emerging countries must protect themselves from the virus of short-term lending, particularly It might be worth noting a common terminological confusion: in a “bail out of Mexico”, for example, it is the foreign investors who are the direct beneficiaries. “Again, the international community faces a dilemma: it often sees no alternative to a bailout - the risks of not undertaking an action seem unacceptable. After each crisis, we bemoan the extent of the bailout and make strong speeches saying that never again will lenders be let off the hook to the same extent. But, if anything, the “moral hazard problem” has increased, not decreased, with each successive crisis.” (Stiglitz 1998, p. 18) by - and to - banks. After the crisis, the question can no longer be whether these flows should be regulated in some way. It can only be how.” (Wolf 1998b) “The evidence now seems clear that any substantial net draft on foreign savings creates huge risks. For countries with savings rates as high as those of the east Asians such risks hardly seem worth running.” (Wolf 1998a) This last point is taken up by Stiglitz (1998, p. 5): “the East Asian countries, with their high savings rates, may have gotten relatively little additional growth from the surge in capital flows”. With the focus on what might be done on short-term capital flows, there is particular interest in the experience of Chile, which for a couple of decades has imposed substantial deposit requirements on capital inflow - a quasi-tax which impinges more heavily on short-term flows. Note that the controls are on inflows, not outflows: the aim is to prevent the problem from arising, rather than attempt to clean up afterwards.22 No-one is arguing for countries to cut themselves off from the benefits of foreign capital. Rather, the aim is to see how the benefits can be reaped while minimising the risks from volatility: in short (returning to Larry Summers’ analogy), how to make jet travel safer. As part of this process, there is more interest in ensuring that there are no positive incentives in favour of short-term flows, for example, via the BIS capital adequacy requirements, or via specific institutional arrangements such as the Bangkok International Banking Facility. Where To From Here? The sort of reform discussed here is not going to be easy to implement. There is always a tension between those who favour a pure laissez-faire version of the market, and those who see a role for government in the international architecture.23 “It is ironic: the age of globalisation may well be defined in part by challenges to the nation-state, but it is still states and governments by the practices they adopt, the arrangements they enter into, and the safety nets they provide - that will determine whether we exploit or squander the potential of this era.” (Haass and Litan 1998, p. 6) Stiglitz (1998, p. 20) makes a similar point: “in approaching the challenges of globalization, we must eschew ideology and over-simplified models. We must not let the perfect be the enemy of the good. . . . There are reforms to the international economic architecture that can bring the advantages of globalization, including global capital markets, while mitigating their risks. Arriving at a consensus about those reforms will not be easy. But it is time for us to intensify the international dialogue on these issues.” Australia could, if it chooses, play a role in this dialogue, out of proportion to its modest standing in world affairs. The Asian crisis is the starting point of the reassessment of the international architecture: while our understanding of Asia and the crisis is imperfect and no doubt distorted in various ways, it may well be ahead of many of the larger countries which have tended to dominate the debate.24 We have well-developed links - across a variety of disciplines - with our The Australian experience with Variable Deposit Requirements in the 1970s is also relevant. There is a common view that these were ineffective, and it would certainly have to be acknowledged that regulations such as this are by no means watertight. But it is worth noting that, at one stage, they worked too effectively, and were a major reason behind the monetary squeeze of 1974, where the safety valve of capital flows was effectively blocked by the VDRs. Kindleberger (1989, p. 7), again, has a sensibly balanced view: “The position that markets generally work but occasionally break down is widely at variance with the views at either of two extremes: that financial and commodity markets work perfectly in all times and places, or that they always work badly and should be replaced by planning or governmental assignments. On the contrary, I contend that markets work well on the whole, and can normally be relied upon to decide the allocation of resources and, within limits, the distribution of income, but that occasionally markets will be overwhelmed and need help. The dilemma, of course, is that if markets know in advance that help is forthcoming under generous dispensations, they break down more frequently and function less effectively.” In Australia, for example, there was a well-informed and bipartisan discussion when these issues came before the Australian Parliament recently (House of Representatives, 26 March 1998), with both sides of politics exhibiting a depth of knowledge which has simply been absent from the legislative debate in America. In contrast, see, for example, Far Eastern Economic Review, 26 February 1998, p. 17. Asian counterparts. An Australian view may be less bound by narrow commercial interests than some others. We have, ourselves, experienced some of the problems of volatile international capital flows. We know something, too, of the trials, tribulations and benefits of a flexible exchange rate regime. Not least, because the international landscape matters more to us (as a small country on the periphery of a culturally-different and diverse region which is fundamental to our economic future), we care more, so we will try harder to improve our international environment. The current international economic architecture has evolved in response to the demands placed on it: many of these add-ons, lean-tos and ad hoc bricolage serve the purpose well enough. But the original floor plan was drawn up in an earlier era and - more importantly for us - the building committee was formed long ago and does not always represent today’s economic realities. We are, of course, represented on the IMF Executive Board, but with more than 180 members, our voice is small. We have a seat at the Bank for International Settlements, but this remains a European-oriented institution. With the G22, we have a group that represents us and our geographical region in a way that did not occur in the older groups such as G10,25 but the future of this group is not assured: it represents a recognition that the old groupings need to be reworked, but this has yet to be done definitively. We have shown a readiness and ability to provide key inputs into international economic relations,26 but we need to see this as a priority issue if we are to have our voice heard in the Councils of the World, and we need persistence and patience to reinforce our credentials. More regionally-focused groups could give us extra leverage. APEC is, of course, the over-arching regional framework. There are, in addition, a variety of smaller and more specialised groups - EMEAP (the East Asian central bankers group), the Manila Framework Group, Four/Six Markets Group27 - which all have memberships relevant to Australia’s regional economic interests. These regional groups might be used, inter alia, to develop more co-ordinated positions and attitudes in worldwide forums, to influence the shape of the reformed structure. The challenge is to use the lessons of the Asian crisis to build a more stable, resilient international framework. Australia has good credentials to play an active role in this. Some of the important post-mortem discussions of the Mexican 1994/95 crisis took place within the G10 (e.g. the “Rey Report”), but as G10 includes only one Asian country (Japan), the opportunity for interaction with this region was minimal. The Australian Treasury played a vital role in fashioning one piece of the New Architecture - the still-pending New Arrangements to Borrow, the successor to the narrowly-based GAB. For discussion of these regional arrangements, see Grenville (1998c). Bibliography Arndt, H. (1998), ‘Globalisation’, Australia-Japan Research Centre Pacific Economic Papers No. 275. Australia, House of Representatives (1998), Parliamentary Debates, 26 March, pp. 1172-1190. Bhagwati, J. (1998), ‘The Capital Myth: The Difference between Trade in Widgets and Dollars’, Foreign Affairs, Vol. 77, No. 3, May/June, pp. 7-12. Camdessus, M. (1998), Toward a New Financial Architecture for a Globalized World, address at the Royal Institute for International Affairs, London, 8 May (http://www.imf.org). Dornbusch, R. (1985), ‘Over-borrowing: Three Case Studies’, in G.W. Smith and J.T. Cuddington (eds), International Debt and the Developing Countries, The World Bank, Washington, DC. Eichengreen, B. and A.K. Rose (1998), ‘Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises’, CEPR Discussion Paper No. 1828. Feldstein, M.S. and C.Y. Horioka (1980), ‘Domestic Saving and International Capital Flows’, Economic Journal, June, Vol. 90, pp. 314-329. Goldstein, M. and J. Hawkins (1998), ‘The Origin of the Asian Financial Turmoil’, Reserve Bank of Australia Research Discussion Paper No. 9805. Greenspan, A. (1998), Statement of Chairman of the Board of Governors of the Federal Reserve System before the Committee on Banking and Financial Services, US House of Representatives, Washington, DC, 30 January. Grenville, S.A. (1997), ‘Asia and the Financial Sector’, Reserve Bank of Australia Bulletin, December. Grenville, S.A. (1998a), ‘Exchange Rates and Crises’, Reserve Bank of Australia Bulletin, February. (The full text can be found on the Bank’s web site - http://www.rba.gov.au) Grenville, S.A. (1998b), ‘The Asian Economic Crisis’, Reserve Bank of Australia Bulletin, April. Grenville, S.A. (1998c), The Asian Crisis and Regional Co-operation, address to International Seminar on East Asia Financial Crisis, Beijing, 21 April (http://www.rba.gov.au). Haass, R.N. and R.E. Litan (1998), ‘Globalization and Its Discontents: Navigating the Dangers of a Tangled World’, Foreign Affairs, Vol. 77, No. 3, May/June, pp. 2-6. Institute of International Finance (1998), Capital Flows to Emerging Market Economies, April (http://www.iif.com). International Monetary Fund (1995), International Capital Markets: Developments, Prospects, and Policy Issues, August. International Monetary Fund (1996), Annual Report. - 10 - Keynes, J.M. (1919), The Economic Consequences of the Peace, Macmillan and Co., Limited, London. Kindleberger, C.P. (1978), Manias, Panics, and Crashes: A History of Financial Crises, Macmillan. Revised edition 1989, Basic Books, Inc., New York. Fortune (1998), ‘The Great Emerging Markets Rip-Off’, 11 May, pp. 68-74. McKinnon, R.I. (1973), Money and Capital in Economic Development, The Brookings Institution, Washington, DC. McKinnon, R.I. and H. Pill (1995), Credible Liberalizations and International Capital Flows: The ‘Over-Borrowing Syndrome’, paper presented at Reserve Bank of Australia Research Seminar, 24 August. (Published in T. Ito and A.O. Krueger (eds), Financial Deregulation and Integration in East Asia, University of Chicago Press, Chicago, pp. 7-50.) Rees-Mogg, W. (1998), ‘Capitalism of the casino’, The Times, 12 March. Rivlin, A.M. (1998), Toward a Better Class of Financial Crises: Some Lessons from Asia, remarks at the Hyman P. Minsky Conference on Financial Structure, The Levy Institute, Annandale-on-Hudson, N.Y., 23 April. Sachs, J.D. (1997), ‘The Wrong Medicine for Asia’, The New York Times, 3 November. Sheng, A. (1998), The Crisis of Money in the 21st Century, address to City University of Hong Kong, 28 April. Soros, G. (1997), ‘Avoiding a breakdown: Asia’s crisis demands a rethink of international regulation’, Financial Times, 31 December, p. 8. Stiglitz, J. (1998), The Role of International Financial Institutions in the Current Global Economy, address to the Chicago Council on Foreign Relations, Chicago, 27 February (http://www.worldbank.org). Summers, L. (1998), ‘Go with the flow’, Financial Times, 11 March. Wade, R. and F. Veneroso (1998), ‘The Asian Crisis: The High Debt Model vs. The Wall Street-Treasury-IMF Complex’, Working Paper No. 128, Russell Sage Foundation, New York, 9 February (http://epn.org/sage/imf24.html). Wolf, M. (1998a), ‘Caging the bankers’, Financial Times, 20 January. Wolf, M. (1998b), ‘Flows and blows’, Financial Times, 3 March, p. 16. | reserve bank of australia | 1,998 | 6 |
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, on the occasion of the 10th International Conference of Banking Supervisors held in Sydney on 21/10/98. | Mr. Macfarlane speaks to banking supervisors on the challenges for the world’s economic policymakers Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, on the occasion of the 10th International Conference of Banking Supervisors held in Sydney on 21/10/98. I would like to start by adding my voice to those who have already welcomed you to this Conference and to the city of Sydney. It goes without saying that there could hardly be a more propitious time for the international leaders in the field of bank supervision to be meeting. When we first started planning this Conference a couple of years ago, we did not know whether it would attract a lot of interest or would be greeted with a yawn. We now know it is the former, and we in the Reserve Bank, and our colleagues at the Australian Prudential Regulation Authority, with whom we are jointly hosting the Conference, are sure that you will be in for a very interesting couple of days. It is hard to pick up a newspaper these days without seeing the word “crisis” prominently displayed in a headline somewhere. First, we had the Asian crisis, then it spread into being an emerging markets crisis, and now we hear so much talk of a world financial crisis. It is interesting that, so far, the focus is on the word “financial” and not on the more general word “economic”. It is also interesting that these troubling financial events are no longer confined to emerging market economies. One consequence of these two trends is that the contrast between economic health and concerns about the financial sector is as marked in the world’s most powerful economy - the United States - as elsewhere. There is a big challenge, therefore, to the bank supervisors of the world, and it seems to be equally large whether they are dealing with the least, or the most, sophisticated of the world’s banking systems. I see two main challenges for the world’s economic policymakers - one for the short term and one for the medium term. In the short run, the challenge is to get through the current crisis - to make sure no more dominoes fall through contagion. The region at risk is clearly Latin America, even though many of these countries are now running infinitely better macroeconomic policies than could have been imagined a decade ago. It would be tragic for them to be blown off course by the spread of financial turbulence that they had no significant part in the making of. It would lead more countries to question the wisdom of adopting sound macroeconomic policies and of opening their economies. One helpful recent development is the acceptance that there should be behind-thescenes discussions between a potential borrower and the IMF. If an IMF package does prove to be necessary in the case of Brazil, for example, it will already have had its voice heard, and it will know exactly what the conditions are in advance. It thus should be able to sign up on Day One and so avoid the situation that occurred in Asia where countries put themselves in the hands of the IMF without knowing what the conditions would be. Thus, the handling of the Brazilian situation seems to be benefiting from one of the lessons of the Asian rescue packages. What can bank supervisors do to assist in the resolution of the present situation? Given that a major part of the problem is an increase in risk aversion by lenders and a possible “credit crunch”, it seems to me that bank supervisors will inevitably have a very big influence on the outcome. I would like to endorse the remarks I recently heard Bill McDonough make that bank supervisors will have to be extremely careful not to inadvertently encourage banks to become even more risk averse than they currently are. This will require great sensitivity on the part of supervisors, and I am sure you will all rise to the challenge. The second big challenge to all of us involved in international finance is to devise a better system for the long run. None of us should be happy about how events have unfolded over the past five years, and none of us could deny the claim that the international financial system is prone to periods of extreme financial turbulence that leave lasting economic costs. At first, this instability was attributed to deficiencies in the financial infrastructure in some emerging market economies. Soon, however, more thoughtful people saw the source of the instability as being the combination of two things - large movements of short-term capital taking place in countries that had small and not very well developed financial infrastructures. We now know that there is a third important factor at work as well - banks in developed countries (often in conjunction with hedge funds) have been taking much bigger risks than their supervisors or their shareholders thought. How do we go about devising a better system or, in current parlance, designing the new international financial architecture? Obviously, this will be a very large task, and I can only offer a few observations here this morning. First, we all recognise that access to the international capital market has, on balance, bestowed enormous benefits on participating countries, particularly developing countries. The world is a much better place when it is outward looking - historical epochs where large international transfers of capital were taking place were those where living standards around the world were rising fastest and where poverty declined most. I, for one, would be saddened if a number of countries responded to the current turmoil in international markets by cutting themselves off from the international marketplace thereby forgoing the benefits that the use of foreign savings can bring. It goes without saying that Australia is completely happy with its policy of permitting the free movement of international capital and sees no case for any change. On the other hand, it is simplistic to insist on the totally free movement of capital in all countries and in all circumstances. To do so would be to ignore the lesson from recent crises, to further risk the stability of the system and to invite a reaction which would make us all worse off. We need to devise a system for maximising the benefits to be gained from international capital while limiting the risks. For example, I think Chile was probably quite wise, and certainly within its rights, for a time to impose a tax on capital inflow which impinged most severely on very short-term flows. (Note, however, that Chile did not impose controls on outflow.) Like Chile, the world economy has to reach a proper balance, and I think there is increasing recognition that it will involve a few trade-offs. Within developed countries, a number of institutions have been designed to encourage investment and risk-taking - the joint stock company, the concept of limited liability, bankruptcy laws and, of course, central banks as lenders of last resort. These are all accepted as necessary parts of a developed financial system, and help provide the right balance between encouraging enterprise while at the same time preventing individual financial distress from turning into widespread financial panic. All these things, by the way, have the by-product of creating an element of moral hazard. Internationally, on the other hand, despite all the talk of globalisation, a borderless world and the integration of financial markets, there has been a reluctance to go very far down the path of finding an international equivalent to the bankruptcy laws or the lender of last resort. The main objections have traditionally been that it would interfere with the free movement of capital and that it would create a moral hazard. That attitude now appears to be changing, and the recent discussions of private sector burden sharing can be viewed as, in some sense, an international equivalent to domestic bankruptcy arrangements. In a company bankruptcy, failure to follow the right approach results in a “fire sale” of assets: in a national financial crisis, it results in a flight of capital and an excessive fall in the exchange rate. The third Working Party Report to the G22 on International Financial Crises addresses the problem where, in a crisis, all individual creditors look after their own private interests and, in so doing, create a situation which is worse for them as a whole (and for the debtor country). This is the problem known colloquially as “everyone rushing for the exit at once”. The Report makes a number of helpful suggestions, all of which revolve around the recognition that a tripartite agreement between creditors, debtors and probably the IMF would be the best way of resolving a crisis once it has begun. The agreement would involve some sort of standfast followed by a workout which would include rollovers of debt and rescheduling. This is a very promising approach, but as recently as last year in the Asian crisis was dismissed on the grounds that it represented an interference with the free flow of capital (which it does). I should take this opportunity of saying how useful Australia has found the G22 Meetings. For a group that has only been in existence for a little over six months and has only met twice at ministerial level, it has achieved a lot. The three Working Party Reports are the most constructive effort to date in laying out some practical steps towards improving the international financial architecture. I have already said how useful I thought the third Report was, but there is also a lot of good sense in the first one which deals with transparency and disclosure, and in the second one which deals with an improved financial system supervision. Both these subjects - disclosure and supervision - have relevance for the very topical subject of hedge funds. In fact, the first Report recommends that “a working party be formed as soon as possible to examine the modalities of compiling and publishing data on the international exposures of investment banks, hedge funds and other institutional investors”. We regard this cautiously worded recommendation as a big step forward, in that for the first time to my knowledge, an official international body has proposed bringing hedge funds into the disclosure net. But I wonder if it is still too cautious. The big macro hedge funds have become, to some extent, an extension of the proprietary trading arms of major banks. There is, in fact, a continuum running from commercial banks to investment banks to hedge funds, and it is hard to see why some of this should be within the supervisory net and some without. This alone would argue for some degree of supervision - for example, limits on gearing - rather than just disclosure. The case becomes stronger when we take into account the fact that the New York Fed has had to organise a support package for a large hedge fund on the grounds that its failure would have had systemic consequences (both nationally and internationally). If, like banks, they are important enough to have systemic consequences, it is hard to see why they should escape supervision of some form or another. I want to conclude by sympathising with you as bank supervisors because of the inherent difficulty of the task you face. To some extent, the biggest challenge is to bring the countries furthest behind world best practice up to standard, and the Core Principles are a very useful step in this direction. But as recent events have reminded us, even in the countries with the most developed systems of bank supervision, we still continue to be surprised by the capacity of the best and the brightest to take risks the magnitude of which even they do not understand. This makes the task extremely hard for bank supervisors - you all have to run very hard just to keep up with developments in markets, and perhaps, the nature of risk itself. | reserve bank of australia | 1,998 | 10 |
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the East Asia Economic Summit in Singapore on 14/10/98. | Mr. Macfarlane comments on the future international financial architecture Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the East Asia Economic Summit in Singapore on 14/10/98. … In my ten minutes here I will try and cover what I see as the main changes in perspective about what we formerly termed the Asian crisis, and then say a few words about future international financial architecture. • The main change is that since August this year we no longer think of an Asian crisis but we now think of either an emerging markets crisis or a general world financial crisis. • A second important change is that the western policy establishment can no longer believe that the root cause of the problem is the inadequacy of the financial infrastructure and governance of some formerly rapidly growing Asian countries. Of course, not everyone used to believe this, but there were some very influential institutions that thought this way. • Everyone is now aware that contagion is a much stronger force than formerly thought. Contagion is an essentially irrational force which tars large groups of countries with the same brush, and causes fear to overrule reason. • Given the bigger role for contagion, more and more people are asking whether the international financial system as it has operated for most of the 1990s is basically unstable. By now, I think the majority of observers have come to the conclusion that it is, and that some changes have to be made. With pretty well everyone now conceding that changes have to be made, you would think it would be a relatively simple matter to move on to the next step. But it will not be, because there are still big differences of opinion about how serious the problem is. • One school of thought held that the main thing required to restore stability was to improve transparency, particularly the Government’s transparency to the private sector - e.g. by more frequent and accurate publication of figures for international reserves. This school of thought also gave a fair bit of weight to improving the quality of bank supervision in emerging market countries. This explains the motivation behind two of the three working groups set up by the G22 in April. • But an increasing majority think something more is required, and the most promising approach here goes under the general title of burden sharing with the private sector (the G22’s third working group). I would like to say a little more about this because I think it will be necessary if we are to make real progress. If we go back and think of the Thai, Korean or Indonesian crises, we can see the problem if there is no formal system of burden sharing. Once the currency doubts started, shortterm lenders knew that if they could get their money out fast enough they would minimise currency losses and loan losses. So when each loan had to be rolled over it was not renewed, and capital flowed out. Each day this happened the exchange rate came under further downward pressure, which encouraged further capital flight. Everyone wanted to be out before the point was reached where the exchange rate was so low, interest rates were so high, and insolvencies were so rife, that those who could not get out of the door would be big losers. This process ensured the maximum fall in the exchange rate. Something clearly has to be done in terms of managing the crisis to reduce the incentives for everyone to try to be the first one out of the door. Some system of standfast followed by an orderly workout involving rollovers, reschedulings and, in extreme cases, debt equity swaps is clearly required. No country wants to be the first one to do this, and unilateral action could cause panic in other countries à la Russia. What is needed is a system that involves cooperation between the host country, private lenders and the IMF. We saw an example of how effective this can be for Korean bank-to-bank debt late last year. Ideally, this should not be on an ad hoc basis, as it was in Korea, but should be thought out well in advance, with the possibility of such workouts included in loan documentation. This, of course, would increase the cost of borrowing by emerging market economies, but that would be no bad thing. One of the problems over the last five years was that it became too cheap and too much of it was done. It would be better than excessive lending followed by capital flight as we have seen over the past few years. This is all becoming reasonably conventional thinking now and, as I said, it is contained in the third Working Party Report of the G22. But it was not that long ago that any suggestions along these lines were greeted with the response that it was out of the question because it involved interfering with the free movement of capital. I would like to conclude by mentioning two other things that have changed over the past year. First, hedge funds. As recently as three months ago if you complained about the activities of hedge funds you were regarded as paranoid and you received a sermon on the dangers of shooting the messenger, etc. Now, no one has got a good word to say for them, and they are likely to soon be brought into either: • • the disclosure net, or some form of supervision via their connections with banks. Second, I see a clear improvement in future crisis management in the way the IMF is talking with Brazil. Unlike the Asian crises, I don’t see any country in future putting itself in the hands of the IMF without knowing pretty clearly beforehand what the IMF conditions will be. If it doesn’t like the conditions, for example, because they are too wide-ranging, it will not go to the Fund. If it is comfortable with the conditions, it will be able to sign up from day one. This way, we should be able to avoid the long periods of semi-public haggling over conditions that characterised the Asian crises and did so much to frighten the markets into pushing exchange rates down excessively. | reserve bank of australia | 1,998 | 10 |
Talk by the Deputy Governor of the Reserve Bank of Australia, Mr. Stephen Grenville, to Credit Suisse First Boston Australia Conference entitled, 'The Global Financial System - The Risks of Closure' in Sydney on 13/11/98 (excluding bibliography). | Mr. Grenville focuses on international capital flows and crises Talk by the Deputy Governor of the Reserve Bank of Australia, Mr. Stephen Grenville, to Credit Suisse First Boston Australia Conference entitled, “The Global Financial System – The Risks of Closure” in Sydney on 13/11/98 (excluding bibliography). There are many things that went wrong for the countries caught up in the Asian crisis of 1997, but out of the myriad causes, two clear central problems can be identified: the fatal combination of large and volatile international capital flows, interacting with fragile domestic financial sectors. Today, I want to focus on the first of these issues: international capital flows. International flows are now centre-stage in the international economic policy debate. This is certainly a higher profile than capital flows usually have. Traditionally, the focus has been on the real sector counterparts of these: the savings/investment balance and the current account surpluses and deficits. Both theory and practical policymaking often assume that these are the “movers” of the action, with capital flows largely a passive, accommodating residual. But the Asian crisis suggests that the action may, instead, be in the capital flows themselves. The capital flows were certainly excessive in the sense that they were greater than could be absorbed (i.e. the capital flows were substantially larger than the current account deficits; see graph). The capital inflows into Indonesia, Malaysia, the Philippines and Thailand in the five years 1990–94 were twice as large as the current account deficits (Calvo and Goldstein. 1996, p. 125). Capital inflows into Thailand in 1996, for example, were equal to 13% of GDP. The “excess” flows went to increase the foreign exchange reserves of the recipient country (in effect, being recycled back to the capital-exporting countries). But in the process they made the normal cycle in the recipient country much worse: providing the funding to make the expansion phase of the cycle go more strongly and last longer, driving up domestic demand and asset prices. While there were both “push” and “pull” factors for the capital flows, it is clear that the capital flows were not simply a passive accommodating force responding to the fundamental economic factors occurring in the capital-importing countries. Graph 1 Capital Inflows and Current Account Deficits percentage of GDP Chile,1978-81 Philippines, 1978-83 Thailand,1978-84 Venezuela, 1992-93 Malaysia,1980-86 Mexico,1989-94 Mexico,1979-81 Thailand,1988-94 Malaysia,1989-94 Philippines,1989-94 Indonesia Argentina, 1992-93 Argentina, 1979-82 Venezuela,1975-80 Chile,1989-94 Colombia Brazil -1 Private Capital Inflow Source: World Bank 1997, p. 243 Table 1: Capital Flows to Emerging Markets (Annual averages, US$ billion) 1977–82 1983–89 1990–94 All emerging markets Total net capital inflows Net foreign direct investment Net portfolio investment Other* 30.5 11.2 –10.5 29.8 8.8 13.3 6.5 –11.0 120.8 46.2 61.1 13.5 192.0 96.0 23.5 72.5 240.8 114.9 49.7 76.2 173.7 138.2 42.9 –7.3 By region Asia Western Hemisphere Other 15.8 26.3 –11.6 16.7 –16.6 8.7 40.1 40.8 39.9 95.8 35.7 60.5 110.4 80.5 50.0 13.9 91.1 68.8 * Includes bank lending. 1977–89 figures exclude economies in transition and some Middle Eastern emerging markets. Source: IMF 1995, p. 33 IMF 1998, p. 13. Two things stand out from this overall picture. First, the extraordinary increase in the flows starting in 1990, with this increase being truly phenomenal in Asia. By the mid-1990s, developing countries were taking 40% of global foreign direct investment (compared with 15% in 1990) and accounted for 30% of global portfolio equity flows (compared with 2% at the start of the decade) (World Bank 1997, p. 9). The second aspect to observe is just how volatile the flows could be, even in these multi-year averages.1 Following the Latin American debt crisis of 1982, inflows to that region turned into outflows nearly as large, and these outflows were sustained until the end of the decade. Just as the law begins with a presumption of innocence, economics begins with a presumption that market outcomes will be beneficial: there is an a priori case that international capital flows are a Good Thing. Financial flows supplement domestic saving, allowing more investment to be done in those countries where returns are highest; they buffer the variations over time between exports and imports; foreign direct investment brings the advantages of technological transfer; there are gains for savers from diversification; and, to complete the case for free capital flows, we should record the argument that even speculative capital flows can serve a beneficial purpose. Perhaps the classic model for the beneficial operation of capital flows is illustrated by Singapore in the 1970s and 1980s. The flows were very large, amounting on average to around 10% of GDP and in some years 15%. They were used to substantially increase the rate of investment (i.e. not for consumption), and there was a substantial technological transfer that went with the foreign direct investment which dominated the flows. Following the “stages of development” academic literature, we can see these flows being used to partially fund the catch-up as Singapore moved towards the technological frontier and its living standards rose to equal those of the industrialised Western countries. This sustained increase in living standards is confirmation that the combination of application of capital and education produced very large and sustainable increases in production per The sort of volatility that concerns us here is not the day-by-day or week-by-week “noise”, but the big disruptive swings. head.2 In a mutually reinforcing process, the profit opportunities fostered the development of the institutional channels which, at the same time, facilitated the capital flows.3 This experience might give us some clues to analysing why these flows occurred more generally, why there was a huge increase in the 1990s, and the role capital flows played in the subsequent Asian crisis. There are two broad groupings of factors involved: • the presence of abnormal profit opportunities as these countries moved towards the technological frontier; • an institutional structure which facilitates the flows of capital. Profit differentials The countries of Asia, with their high rates of growth, provided high profit levels and many opportunities for profitable investment. Expected returns on equity in emerging markets were consistently higher than those in mature markets, and their volatility was slightly below that of the mature markets, indicating high risk-adjusted returns (IMF 1998, p. 32). Equity and stock prices were also performing strongly (IMF 1998, p. 38). Growth and foreign investment certainly went hand in hand, although it might be noted that there was a stronger relationship in the 1980s than during the 1990s.4 Of course, on top of these potential returns, there was also a question of exchange rate expectations, and we will return to this issue when we look at reasons for the volatility of flows. For the moment, it is enough to record that there were ex post large excess returns on investment in the emerging Asian markets, taken as a whole. While it might seem, at first sight, that the main action in terms of profit differentials would come from the great opportunities available in the capital-receiving countries, it seems that quite a bit of the action – at least in the variability of the flows – came from changes in interest rates and exchange rates in the capital-supplying countries: “push” factors rather than “pull” factors. A powerful force encouraging greater flows was the lower interest rates in most developed countries in the early 1990s (US interest rates fell by 200 basis points between 1991 and 1993). The low rates made some investors search out higher returns overseas, and in seeking higher returns, they were ready to accept greater risks. Such was this new attitude that spreads on Brady bonds were bid down sharply in the early 1990s. This is not to take sides in the Krugman debate on Singapore productivity: whether this came from more capital or total factor productivity, the result – in terms of higher living standards – is not in dispute. Foreign direct investment has been the key form of capital inflow for Singapore in its rapid development from the 1970s onwards. Foreign direct investment accounted for around 50% of net capital inflows in the 1970s and were the bulk of capital inflows in the 1980s, largely in manufacturing, trade and financial and business services. Direct investment flows surged from 1987 onwards, spurred by Japanese and European investment, particularly in financial and business services and, to a much lesser extent, in electronics manufacturing, reflecting the changes in Singapore’s industrial structure and comparative advantage. Foreign direct investment as a proportion of investment accelerated during the late 1980s. (This was also the period of the great surge in Singapore’s share accumulation index, which captures capital and income gains from shares.) Excluding cyclical effects, the incremental capital/output ratio for Singapore steadily fell from the 1970s to the 1990s – which suggests that the marginal efficiency of capital was still rising and investment opportunities were there to be exploited. Moreover, real interest rates were relatively high in this period. During the 1990s, however, real interest rates have come down, and, in recent years at least, Singapore’s incremental capital/output ratio seems to have started to rise. At the same time, portfolio flows also rose substantially, in both an absolute and relative sense. See, for example, BIS (June) 1998, p. 36. As the decade progressed, an important source of capital flow was Japan. Not only was it intrinsically a large saver, but the drawn-out recession meant that interest rates were extremely low (reaching half a percentage point) during most of the 1990s. Much of this capital flow went initially to the United States, but with the size of the US current account deficit set by the savings/investment balance, these extra inflows were recycled and, in effect, funded the outflows to emerging countries. The interest differential between the major industrial countries and the emerging countries was greatest for Japan – hence the rise of the “yen-carry” trade – borrowing at low interest rates in yen, and onlending at high returns in other currencies, particularly in Asia. When local currency borrowing rates were around 20% (which was the case, for example, in Indonesia), yen-based interest rates seemed extraordinarily attractive.5 There was another important structural change in Japan which began in the late 1980s but accelerated in the first half of the 1990s. With the very rapid and sustained appreciation of the yen, Japanese manufacturers recognised that they needed to transfer a large proportion of Japan’s manufacturing production (particularly at the low end of the technology spectrum) to the lower labour cost countries of Asia. This was a fundamental factor in driving the increase in foreign direct investment to the region.6 Was “push” or “pull” more important? In a structural sense, the high-profit “pull” of the capitalreceiving countries was clearly fundamental. But short-term variation (surges and reversals) was often triggered by events in world markets. A number of researchers have found a close relationship between interest rate movements in the capital-exporting countries and capital flows.7 The rise in US interest rates in early 1994 was an important trigger in the Mexican problems, and the strengthening of the yen in May/June 1997 was a factor in calling into question the continuing profitability of the “yen carry”. Institutional structure We noted earlier that profit opportunities in the emerging countries were probably greater in the 1980s than in the 1990s, yet the surge of capital did not come until 1990. This would suggest that, while relative profit prospects were important, other factors were also involved. In this section, we explore the importance of the institutional channels of transmission – did the institutions exist to facilitate, in a fairly frictionless way, flows which were attracted by the high profit opportunities? This is, of course, a chicken-and-egg issue: as the capital flowed, it encouraged the further development of financial infrastructure. In the ten years between 1985 and 1994, for example, the combined market capitalisation of the eighteen major developing countries in the IFC Emerging Markets Index increased by a factor of thirteen. This process was spurred by greater knowledge In thirteen of the twenty quarters to mid 1997, the “yen-carry” trade for yen/baht was profitable (i.e. exchange rate changes did not outweigh the interest differential), and for the equivalent yen/US dollar transaction, it proved profitable in eighteen of the twenty quarters (IMF 1998, p. 44). Foreign direct investment from Japan tripled in the decade to 1997, rising from US$ 22.3 billion in 1986 to US$ 66.2 billion in 1997. While the United States and Europe remain important destinations for Japan’s foreign direct investment, the Asian share noted the largest rise, increasing from around 10% of the total in 1986 to 25% in 1997. The rise is most spectacular in foreign direct investment into China, with its share jumping from 1 to almost 9% over this period. Indonesia was another important beneficiary. These flows were very important to the countries concerned; Japanese total foreign direct investment to Korea, Malaysia, the Philippines, Singapore and Thailand accounted for around 46% of total net foreign direct investment to these countries between 1990 and 1995. See World Bank 1997, pp. 81–83. about these countries. One measure of this was the increase in formal credit ratings given by major agencies: eleven countries had ratings in 1989; by 1997 this had risen to over fifty.8 Part of the increase in the 1990s reflects the conclusion of the Latin American debt crisis of the 1980s, marked by the issue of Brady bonds in 1989. With these, previous debt was settled in a way that could give new investors confidence that their debts would be honoured. Not only did the Brady bonds settle the longstanding debt problems from the 1982 crisis, but they also signalled that the authorities in the capital-exporting countries (particularly the United States) might help to sort out problems when they arrived. This would have given institutional investors some comfort. One reason often cited to explain the increase in capital flows in the 1990s was the reduction in various forms of capital controls in the emerging countries. This must certainly have been a factor.9 But a number of these countries had an accommodating attitude to many forms of capital flows well before the 1990s (Indonesia, for example, had essentially open capital markets since 1970). While all of these factors played a part, the dominant new factor of the 1990s, not present in earlier episodes, was the greatly increased importance of institutional funds managers. Table 2: Assets of Institutional Investors 2,45 Total (US$ billion) Total (per cent of GDP) Canada Germany Japan United Kingdom United States 35.2 20.3 23.1 64.1 59.3 7,46 52.2 37.1 50.3 118.3 88.1 12,34 60.3 39.5 77.9 117.5 118.7 13,84 66.9 37.4 75.6 129.7 128.3 14,6 72.6 37.5 79.1 143.3 132.8 16,80 81.2 42.5 84.1 175.2 141.4 18,2 85.6 44.9 85.2 156.1 141.7 20,64 89.2 48.9 87.0 176.0 158.6 Source: IMF 1995, p. 166, IMF 1998, p. 184. Figures from 1990 onwards include other forms of institutional saving outlined in IMF 1998 and include figures for France and Italy. See also BIS (June) 1998, p. 84. With around US$ 1 to 2 trillion increase in the portfolios of the institutional investors each year during the 1990s, there was clearly great potential to fund flows to emerging markets, when attention turned to them. And turn to them it did. Not only were there big increases in these funds, but during the 1990s they became more focused on the need for portfolio diversification and shifted from having almost no exposure to emerging countries to having significant exposure (although still substantially less than most rules of thumb for portfolio diversification would suggest10). At the general level, we can see the increase in international integration from measures of cross-border transactions in bonds and equities. For the United States, these were equal to less than 10% of GDP in 1980, around 100% by 1989, and 200% by 1997.11 Another general measure: nonresident holdings of US public debt were around 15% of total in the 1980s, but 40% by 1997.12 See IMF 1997, p. 244. For example, the index of capital controls calculated by the IMF fell significantly in 1992–94 (see IMF 1997, p. 242). The usual rule is that diversification should match the capitalisation of equity markets. French and Poterba (1991) point out that at the end of the 1980s, US investors held 94% of their equity wealth in US securities, and for Japanese, the figure was 98%. It was higher still for French, Germans and Canadians. See IMF 1998, p. 187. The details of diversification, see World Bank 1997, p. 75; BIS (June) 1998, p. 89; IMF 1998, p. 185. In addition to these institutional investors, banks have become more internationalised, readier to lend to emerging countries. The high profile of the mutual funds (and, in particular, the hedge funds) may distract attention from the central role of the banks. We will see, in a moment, that the bank flows were not just large, but were very volatile. Table 3: International Bank and Bond Finance for Five Asian Countries* (US$ billion) 1990–9 Net interbank lending Bank lending to nonbanks Net bond issuance Total 1995 Q 1996 Q4 1996 Q 1997 Q at annual rates 1997 Q –31 –1 –31 1998 Q at actual rates –31 –4 –2 –37 * Indonesia, Korea, Malaysia, the Philippines and Thailand. Source: BIS (August) 1998, BIS (June) 1998. Variability While the general case in favour of capital flows is a powerful one, the practical problem is their variability: the surges and reversals. There has always been variation in capital flows, as relative interest rates changed over the cycle, as profit opportunities opened up and were competed away, and in response to general factors of confidence and exchange rate expectations. However, for the most part, the variability is not enormous. Picking an example close to home, even when international financial markets lost confidence in the Australian dollar in the mid 1980s (the “Banana Republic” episode), the exchange rate reacted significantly, but capital continued to flow to Australia – in fact, enough to fund a larger current account deficit as the crisis proceeded. The recent experience in Asia has been very different, with strong surges and major reversals of the flows.13 Worth noting is the difference of behaviour between banks and institutional investors, on the one hand, and foreign direct investment, on the other. In this episode at least, foreign direct investment has proven to be the most resilient inflow and bank inflows the most flighty (World Bank 1997, p. 31). This accords with the presumption that direct investment is harder to reverse and is more focused on the “fundamentals”. For the experience elsewhere, see IMF Occasional Paper 108 and World Bank 1997, p. 28. Graph 2 Asian Private Capital Flows Prior to the Crisis US $73 Bil -7 -17 -27 % Percent of GDP (RHS) US$ BILLIONS (LHS) -2 US $ Bil US $ Bil Other Portfolio FDI -5 -5 -15 -15 Source: IMF 1998 Graph 3 Capital Flow Reversals US$ Bil Mexico FDI Portfolio Other (Bank lending) Affected Asian Countries * US$ US$ Bil Bil US$ Bil -10 -10 -5 -5 -10 -10 -20 -20 -15 -15 -30 -30 -20 -20 -40 * Indonesia, Korea, Malaysia, Philippines, and Thailand Source: IMF 1998 -40 It was the banks which reversed their positions dramatically as the crisis broke: having averaged US$ 16 billion annual inflow to the five troubled Asian countries, it rose to US$ 58 billion for most of 1995 and 1996, fell to an annual rate of US$ 22 billion in the last quarter of 1996 and for most of 1997, but by the last quarter of 1997 and the first quarter of 1998 recorded an actual outflow of over US$ 75 billion.14 This might give us the first clue as to reasons for the much sharper variation in flows in the 1990s. Not only did these institutional developments mean that the volume of flows increased, but, with the greatly increased importance of portfolio and banking flows, its nature (and particularly its volatility) changed. In this section, I will argue that the volatility of flows was a product of: See BIS (June) 1998, p. 122. • the tiny size of financial markets in the emerging countries, relative to the capital-exporting countries. Size – or relative size – does matter. Minor portfolio adjustments for fund managers were large changes for the recipient countries; • there was a lack of information and understanding about the emerging markets, which meant that opinion was fickle and not well anchored by the fundamentals; • risk premia do not seem to follow a monotonic process, increasing steadily as risk increases. Rather, risk seems to be more like a binary (“on or off”) process; • finally, the emerging economies were in such a state of transition or flux that it is not sensible to think of this as an equilibrium process, with profit expectations continuously equilibrated across international markets. This disequilibrium manifests itself most clearly in the exchange rate (what Obstfeld (1998, p. 6) calls “an open economy’s most important price”). This central linking price which is at the heart of cross-border profit calculations is uncertain and unanchored – it could shift sharply, and there were no strong forces at work bringing it back towards its starting point. As exchange rate expectations changed, capital flows responded strongly. (a) Relative size These recipients of the capital inflows were small relative to the size of the flows. While net capital inflows into the United States were over US$ 180 billion,15 this figure was only a little over twice the size of the flows going into Indonesia, Korea, Malaysia, the Philippines and Thailand. Compare this to the size of these economies, credit systems and share markets, where the United States dwarfs these countries by a ratio of around ten to one. The problem has been described by the BIS this way: “This asymmetry, coupled with the ebbs and flows that have historically characterised portfolio investment in emerging countries, highlights the potential for instability as a marginal portfolio adjustment by the investor can easily amount to a first-order event for the recipient” (BIS (June) 1998, p. 90). “The sums involved were relatively small from the perspective of individual investors, even if of dangerous size from the perspective of the recipients” (BIS (June) 1998, p. 169). Graph 4 Output, Credit and Equity Capitalisation, 1996 US$ Bil US$ Bil USA Asian affected 5 Net Private Capital Inflow GDP Credit Stock Market Measured as the sum of foreign direct investment, portfolio flows and other. -9(b) Information Some of the explanation for the reversals can be found in the paucity of information, among investors, about the emerging markets. For the most part, their knowledge was so superficial that it could be (and was) overwhelmed by the arrival of relatively small amounts of new information. More importantly, investors without their own knowledge base simply followed the herd. In such a world, it is rational for any individual player to shift with the herd when new perceptions arrive. Whatever the fundamentals, when the herd is running, you run with it. In its usual understated way, the BIS observed that: “highly correlated strategies across different players may have contributed to an aggravation of asset price movements” (BIS (June) 1998, p. 95). The informational problems were compounded by the biased and ill-founded nature of much of the information and commentary. Looking back on it, it might seem surprising that there were not more pundits, highlighting the excessive nature of the flows and the domestic policymaking deficiencies of the recipient countries. But who would these pundits be? Among the policy officials in the recipient countries, the flows (and the development of sophisticated financial sectors) were a sign of progress and modernity: who would want to express doubts about that? In academic circles, the dominant paradigm was “efficient markets” – who would be bold enough to question the outcome of the market? Any unexplained differential was passed off as a “risk premium” – the academic “fifth ace” that could square any circle and explain any regression result, no matter how different from the “priors”. In the financial markets themselves, who was going to bite the hand that fed them?16 Some of the subsequent commentary suggests naivety on the part of the investors (they “received repeated assurances that the financial sector was well supervised… and that there would be no changes in exchange rate policy” (IMF 1998, p. 41)). In hindsight, the degree of ignorance is so great as to border on the comic. Business Week (22 September 1998) reports a fund manager’s response to the Russians’ halting of trade in their domestic debt market in this way: “Nobody in the history of the world has ever done anything this foolish”. Some sense of history! At the same time, it should be noted that information that was available was not used. The BIS banking data provided a comprehensive view on what turned out to be the most volatile element of the flows, but the existence of these data was either unknown or ignored.17 As far as the outcome is concerned, however, unused information was as irrelevant as unavailable information. (c) The behaviour of risk premia The process of assessing and reassessing risk is captured, to some extent, in the pricing of emerging market debt. See Fortune article (11 May 1998). For an exception, see Radelet (1995). - 10 - Graph 5 EMBI Spread to US Treasuries Daily Basis Points Basis Points l l l l l l l Note: Covers Asian and Latin American securities, from JP Morgan But this does not capture the full extent of the problem. As Sachs (1997) observed: “euphoria turned to panic without missing a beat”. One of the characteristics of capital flows in the crisis was their reversal – it was not simply a matter of the capital-receiving countries being forced to pay somewhat more for the capital, because of a changing perception of risk. New flows dried up and existing capital fled, and could not be lured back at any price. Considerations of risk seem to be a binary (on/off) process, rather than a monotonic function. In part, this was a rational response by lenders. Even well-run enterprises had their profit (and repayment) prospects radically altered by the new environment of high interest rates, massive falls in exchange rates and shattered growth prospects. Once interest rates rose sharply, a different calculus became relevant – the credit risk overwhelmed any risk-premium calculation. Credit lines were cut. This is in keeping with the theoretical work of Stiglitz and Weiss (1981), who show that when interest rates go up sharply, lenders recognise that the only borrowers who are willing to pay these high rates are those who do not intend to pay back. This process was not helped by the behaviour of credit rating agencies, who went along with the general pre-crisis euphoria, and exacerbated the turnaround of opinion by substantial downgradings after the crisis had occurred. As these downgrades shifted some financial instruments below investment grade, institutions with portfolio constraints on asset quality were forced to sell – at any price. The fact that many of these portfolios were judged month-by-month or even day-by-day led to strong short-termism. - 11 - Graph 6 Asian Credit Ratings Moody’s Credit Rating Agency Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Singapore Taiwan South Korea Thailand Hong Kong Malaysia Indonesia Philippines 86 88 94 96 9886 88 94 96 It may be useful to recall, also, the old distinction between risk and uncertainty – it was the latter (whose characteristic is unpredictability) rather than the former that was relevant, and perhaps we should not be surprised that uncertainty premia can shift dramatically. (d) A disequilibrium process These capital-receiving emerging countries were being transformed at such a pace that it is not sensible or realistic to see the process in terms of the usual textbook notions of returns equilibrated at the margin and smooth allocation of resources, particularly capital. Systems were in flux, and production functions were changing continuously. This general notion manifested itself in various ways, but three examples will illustrate the issue. The first example of apparent disequilibrium in capital flows was identified nearly two decades ago – the Feldstein/Horioka paradox (1980) – there seemed to be too much correlation between domestic saving and investment rates in individual countries, with the implication that capital flows between countries were smaller than would occur in a well integrated world. So here, perhaps, is another clue to the puzzle. It is not so much that capital flows rose suddenly to achieve abnormally high levels, but that they were – for some reason – less than optimal earlier, and so the big increase was a move towards a more normal or equilibrium situation.18 These are asset or stock equilibria. When these ill-defined and easily changeable temporary equilibria are displaced by a shift of confidence, the flow requirements to shift from the old to the new stock equilibrium may be very large (and very disruptive). Second, profits (or even expected profits) were not equilibrated across countries. For a sustained period (through the 1980s), excess profits had been earned, illustrated by equity returns and high domestic real interest rates in Indonesia, Korea and Thailand. Indeed, the constant revisiting of the Feldstein/Horioka result has found less correlation between domestic saving and investment rates over time, implying increasing international capital integration (Fujiki and Kitamura 1995; Ghosh 1995). - 12 - Graph 7 Asian Share Markets December 1987 = 100 Index Index Indonesia Thailand Malaysia Philippines South Korea 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 Source: Datastream. Table 4: Average Real Interest Rates* South Korea Thailand Indonesia# Malaysia Philippines 1980–89 1990–98 4.6 6.1 5.3 2.7 –6.2 7.7 5.0 6.6 3.0 2.4 * Average of end-month short-term real interest rates. # Note: 1980–89 average for Indonesia starts from 1983 and has 13 monthly observations missing over the period. Source: IFS. The high interest rates were imposed by the authorities to rein in very dynamic economies, where many investors wanted to borrow to exploit the profit opportunities.19 The capital flows which occurred were not sufficient (or could not be absorbed sufficiently quickly) to exploit all the opportunities. There was a widespread belief (based on actual experience, pre-crisis) that whatever factory or office building was constructed would prove profitable, because of the tremendous growth of these economies. No matter how much capital flowed, the marginal investor did not feel that his actions had used up the last abnormal profit opportunity, and that a “normal profit” equilibrium had been reached. Investors could not tell if what they were seeing were temporary abnormal profits (in which they should try to get themselves a share of the action), or high return because of high risk. Too many assumed it was the former. To the extent that markets acted to equilibrate returns, they did so by bidding up asset prices (thus reducing the profit return of the investor who paid the higher price). But this was a knife-edge equilibration: as asset prices rose, investors extrapolated the rise, so that even if the profit flow on the asset was normal, investors expected to benefit from continuing asset price increases. So investment continued until obvious excess capacity emerged, and the bubble burst. They were not, as is sometimes claimed, high to support exchange rates; exchange rates were under upward pressure for most of the period. - 13 - The third manifestation of disequilibrium was in the exchange rate. What is the “right” exchange rate for a country receiving large capital inflows and likely to go on receiving them for a protracted period – perhaps a decade or more – before investment returns are reduced to “normal”? This relates to the old issue of the “transfer problem” – how to bring about the current account deficit that is the real resources counterpart of the financial capital inflow. For this, the exchange rate probably has to appreciate from its underlying value. But how far? Portfolio equilibrium would suggest that the appreciation must be enough to create the expectation of a subsequent depreciation, at a rate to balance the higher expected returns on domestic, compared with foreign, assets, i.e. to balance the differential between the domestic interest rate and the foreign rate. If this view-of-the-world captured reality, we would see a once-off appreciation followed by a long drawn-out steady depreciation, at a rate equal to the difference between domestic and foreign interest rates. It hardly needs saying that this – with its implication of a continuous, enduring, finely balanced calculus – did not fit reality, even remotely. True, exchange rates in these countries were under continual upward pressure in the first half of the 1990s. But this was, by and large, resisted (and did not happen much in real terms, covertly, via faster domestic inflation). Then, more or less once-off and suddenly, exchange rates experienced massive falls. So what story fits the facts better? Capital flows involve, for one or other of the parties, a foreign exchange risk.20 For the period of inflow during the first half of the 1990s, the authorities in these countries were holding more or less fixed exchange rates in order to stop an over-appreciation which would have cut into their international competitiveness and the dynamism which the tradeables sector was providing to the economy (and, incidentally, made them vulnerable to changes of confidence when markets became concerned about overvaluation). Investors knew this (as did borrowers in these countries), so they were prepared to take the risk of having a foreign exchange exposure without covering it (c.f. the “yen carry”), on the view that these exchange rates were more likely to appreciate than depreciate.21 Herd behaviour was important in the capital surge, as well as in the withdrawals of capital. The smart money went to these countries in response to the profit opportunities, and lots of dumb money followed along for the ride, financing dubious investment projects. Once there was a turning-point in confidence, there was a rush for the exits. The herd charged in the reverse direction. As well, the elements of leverage which had built up during the capital inflow stage made it imperative that positions be unwound quickly when the reversal came – leveraged investors cannot wait for the market to return to its senses: they sell or they are sold. To make matters worse, these forced sales took place in markets which had become illiquid – when no one wants to take on these risks, the price falls a long way. In textbook markets, price falls bring out bargain hunters: in these markets, price falls just confirmed the worst fears. The problem is that asset prices (whether real estate or the exchange rate) are quite random in the short run, and the short run is the investment horizon relevant to fund managers – they are judged on their quarter-by-quarter (or month-by-month) performance. In a market dominated by such investors, there are no Friedmanite stabilising speculators to buy when the price falls. Even rational investors join the herd. Even hedging simply shifts this to another party. Some have described this process of fixed exchange rates as “guarantees”, but this misunderstands the nature of the problem: certainly, investors did not expect the exchange rate to depreciate much, but they knew that depreciations had occurred in the past, and those who had exposures in currencies other than the US dollar (by far the majority – see Goldstein and Hawkins (1998)) had been continually experiencing changes in the relevant exchange rate. But few of them saw any reason, in a world in which capital flows were putting upward pressure on exchange rates, to take out expensive cover against the possibility of the exchange rate falling sharply. - 14 - While we might be amazed at the extent of the movements in exchange rates (the rupiah falling to less than a fifth of its initial value, which no one at the time thought was significantly overvalued), we should not be surprised by the failure of the portfolio model of exchange rate behaviour (or any other exchange rate model, for that matter). The most basic and central idea in any view relying on the efficient markets hypothesis is uncovered interest rate parity – that interest rate differentials are the best predictor of subsequent exchange rate movements. Despite the most diligent, strenuous efforts on the part of those who have built models and academic reputations on the efficient markets hypothesis, the data inconveniently but consistently refute it.22 So is it any surprise that, once fixed exchange rates were dislodged (by a combination of large adverse terms-of-trade shifts, some modest over-appreciation through inflation, and adverse international commentary), the unanchored rates could swing to absurd values: there were no accepted views on fundamentals. Investors had seen how much the yen/US dollar rate moved during the 1990s (in well understood, deep markets): it is hardly surprising that they would not stand in the way of huge swings in Asian currencies. By the time extrapolative expectations took hold, demand curves for foreign exchange sloped the wrong way: as the price became cheaper, people bought less. Once this was teamed with large open exposures, the fragile financial sectors of these countries collapsed, under the weight of their own open foreign exchange positions in some cases, but more often under the collapsing creditworthiness of their commercial sector borrowers (who did have large uncovered foreign exchange exposure). This collapse of the financial system interacted with the real economy: even good investment projects (and there were plenty of bad ones) turned sour in the face of credit withdrawal and deep economic recession. The rest, as they say, is history. Conclusion More than a century ago, Bagehot observed: “the same instruments which diffused capital through a nation are gradually diffusing it among nations.” He went on to warn that while “the effect of this will be in the end much to simplify the problems of international trade… for the present, as is commonly the case with incipient causes whose effect is incomplete, it complicates all it touches” (Bagehot 1880, p. 71).23 This encapsulates a key insight: as countries integrate their financial markets with international markets – itself an eminently desirable process – there is a longish period of transition, during which an economy is extremely vulnerable to changes of confidence. There had been plenty of hand-wringing about this issue beforehand. Before the 1997 crisis, the World Bank summarised the situation this way: “The world’s financial markets are rapidly integrating into a single global marketplace, and ready or not, developing countries, starting from different points and moving at various speeds, are being drawn into this process. If they have adequate institutions and sound policies, developing countries may proceed smoothly along the road to financial integration and gain the considerable benefits that integration can bring. Most of them, however, lack the prerequisites for a smooth journey, and some may be so ill-prepared that they lose more than they gain from financial integration.” (World Bank 1997, p. 1). Substantial capital inflows to the emerging countries were not irrational, unnatural or undesirable. While all sensible observers point to the benefits of capital flows, the variability is clearly harmful, but hard to correct: “boom and bust cycles are hardly a sideshow or a minor blemish on international capital flows: they are the main story” (Rodrik 1998, p. 56). As Bhagwati (1998) notes: “the ‘panics, manias and crashes’ that characterise capital flows have no counterpart in trade flows”. The issue is: what to do? The staunchest supporters of interest rate parity must have had their faith sorely tested by the extraordinary movements of the yen in the 1990s, in a climate of interest rate stability. Quoted by World Bank (1997). - 15 - Any policy that attempts to isolate an economy from international capital markets would be costly, in terms of forgone growth. The need, now, is to devise an institutional structure which can reap the benefits of capital flows while diminishing the risks to those countries whose financial infrastructure is not yet resilient enough to cope. What needs to change? One early response was to try to identify some technical deficiency whereby the real world did not mimic the efficient markets of the textbooks, and assume that correcting this will fix the problem. We noted that information deficiencies were one reason why opinions, confidence and critical prices (such as the exchange rate) were unanchored and subject to violent change. After the Mexican crisis of 1994/95, there was a line of argument that came very close to saying that if Mexico had revealed its foreign exchange reserve levels more explicitly during 1994, somehow the crisis would have been averted. A variant of this emerged in the early days of the Thai crisis: if only Thailand had revealed its forward foreign exchange position, markets would have operated smoothly to avoid crisis. This seems to be naïve, but we have to be careful in pointing this out: to question the benefits of greater transparency is like arguing against peace, freedom and motherhood. So let me be quick to say that more transparency would help. But it is another thing again, in a world of complex causality, to see this as a fundamental solution. After all, it is hard to explain the extraordinary movements in asset prices in sophisticated markets (US equities in 1987; the yen in 1995–98). How much more information is needed to prevent swings of this sort? A similar “fix-it” has been suggested, in the form of elimination of “guarantees” and “moral hazard”. We have already noted that many of the so-called guarantees were, more accurately, misassessments by optimistic market players – they were guarantees only in the eyes of the investors. Moral hazard is a more believable market deficiency, at least in some specific cases. For example, financial markets were confident, based on experience, that countries do not devalue or renege on foreign debts while they are under the tutelage of an IMF program, and this gave investors in Russia earlier this year a false sense of security. The answer, on the surface, seems simple: make sure investors lose money from time to time. This, like many solutions, is supported in general but difficult to apply in specific cases. As George Soros (1998) has noted: “Financial markets… resent any kind of government interference, but they hold a belief that, if conditions get rough, the authorities will step in.” Once governments have helped, moral hazard is part of investment decisions from then on. So let us, by all means, try to reduce it by requiring “burden sharing” on the part of private sector investors (see below). But let us not fool ourselves into thinking that it can be entirely eliminated. A further variant on the fix-the-market approach suggested that markets were not sufficiently open. In the early days of the Asian crisis, a common argument held that the problem was simple deficiencies in domestic policymaking and open capital accounts are the best discipline on errant policymakers. There is truth in this argument – countries which do not make policy mistakes certainly stand a better chance of weathering the international storms (c.f. Stiglitz’s rowboats). But it is not realistic to hope for continuously perfect policies. We need a framework that can cope with the inevitable imperfections of the policy process. As well, with the crisis much further developed, we can now see that even countries with good policies, sound infrastructure and high openness can come under enormous pressure (c.f. Hong Kong). So, even if policymakers (working as they do in imperfect, politically driven worlds) were able to produce consistently good policies (a big ask), this is no assurance against volatility in capital flow. We have to accept that markets, even under as favourable conditions as are likely to be found in the real world, have not – and will not – consistently act as a smooth, well informed, far-sighted Walrasian auction process to maximise benefits and minimise the costs of capital flows. “Given the troubling way in which economic, political and social factors interact, it is simply not prudent to - 16 - assume that everything will turn out for the best.” (BIS (June) 1998, p. 170). So, while we strive for good policymaking, and urge more information disclosure (including on the private sector players in international markets), we need to explore other possibilities. Part of the problem in coming to grips with these issues has been the insistent voices of an accidental coalition of academics, and vested interests who used the efficient markets paradigm as an intellectual battering ram to open new commercial opportunities. The intellectual climate is now undergoing a shift. When the doyen of the hedge funds, George Soros, describes capital flows as “a wrecker’s ball”, you know the debate has changed. What specific measures might be explored? Among the spectrum of possibilities, let us start with the least controversial. Much of the focus should be on improving prudential measures – the “rules of the game” governing the financial sector, and banks in particular. Much hard work is needed to make existing rules work properly – limiting connected and government-directed lending; getting asset valuations (and hence provisioning) right; and enforcing foreign currency open-position limits. As well, the rules need to be reinforced. Banks have to be made to take account of their borrowers’ overall balance sheet position, so that the bank is not brought down, at one remove, by the foreign exchange exposure of its borrowers. Poor credit appraisal was clearly a central factor in the Asian crisis, which now has to be addressed. None of this can be done effectively without a good accounting and legal (including bankruptcy) framework, and, realistically, none of it will be put in place quickly. Here is the rub. It is difficult – perhaps impossible – to put in place fully effective supervision before financial development occurs: the markets will be pushing ahead faster than supervisors. The deregulation process itself is a difficult environment in which to get this right: at the same time that one set of regulations is dismantled, another set (the prudential rules) has to be put in place. Hence the debate about sequencing has an academic ring to it. Let’s work hard on the prudential framework. It will be important. But it may not be enough.24 When things go wrong (as they will from time to time, in even the best managed system), there must be clear methods of rapid resolution. This should include a readiness to institute stand-fast and workout arrangements for private debt. Just as bankruptcy arrangements should not be too easily available for resolution of domestic debts, such international stand-fast and workout arrangements should only be instigated by some internationally endorsed process (say, as part of an IMF standby arrangement). But we need to be ready to do this promptly when circumstances warrant. Again, textbook ideas have been unhelpful in practice – the idea that private sector borrowers and lenders (“consenting adults”) will work things out satisfactorily has proved naïve: the collateral damage is too great. Private sector debt was (and remains) a festering sore which inhibits the return to health of some Asian economies. This is not to argue that the private sector should have been bailed out. Rather, that it should have been quickly and decisively “bailed in”, to bear its full share of the costs of crisis resolution, through stand-fast and workout arrangements. Many of these measures will remind lenders of the risks involved, and this will raise the cost of borrowing in good times: but that would be no bad thing. In the same vein, the existence of well24 What of the hedge funds – the butt of both strong attack and spirited defence? It might have been possible, once, to argue that these funds were playing a useful role as stabilising speculators, buying cheap and selling dear, to help markets find equilibrium values and smooth the flows. This position is no longer tenable, at least as a generalisation. There are enough examples, now, of them shorting already undervalued currencies, in the hope (assisted by vigorous self-serving market commentary) that the undervaluation could be pushed further. While they may not be big players in the immediate future, this may be the moment to emphasise that whatever arguments there are for disclosure of official market positions (reserves and forward positions), these apply with equal force for large private players. If fully informed markets work better, then let us aim to ensure that markets are fully informed about the hedge funds. - 17 - defined international stand-fast and workout arrangements (and “collective action” clauses in bonds which make the possibility of workouts explicit) may cause lenders to focus on the possibility of loss, but wouldn’t that help the moral hazard problems? If more carefully designed and rigorously enforced prudential controls inhibit some short-term flows, would there be any great loss in that? Clearly, part of the capital surge of the 1990s could, with benefit, have been done without. Is the problem – like advertising – that you do not know which part to stop? No. We can see elements – short-term rootless flows – which had minimum benefits and greatest costs. A case can be made that it would have been no great loss if the Asian countries had received only the foreign direct investment flow. While it is technically true that “speed doesn’t kill – it’s the stopping”, we should recall that the problems come from excessive inflows, so if the net result of more rigorous “rules of the game” is smaller inflows in the boom times, then that will be a plus. If something has to give way in the “open economy trilemma” (Obstfeld and Taylor 1997), then some limits on the variance of capital flow seem a good place to start. The third – and most controversial – set of possibilities are those which smack of capital controls. Even here, the debate has shifted. Now, Chilean-type controls seem to be acceptable to international opinion. What distinguishes these? They are market-based, upfront and ex ante, and are on inflows rather than outflows. This is all still a lively topic of debate. The consensus view is changing, but slowly. While now acknowledging that temporary controls may be required in certain circumstances, the international consensus has a rather disparaging tone. Just as “real men don’t eat quiche”, real countries don’t resort to capital controls. If such short-term capital controls are a legitimate instrument of policy, we need to define more clearly the circumstances, and be readier to endorse their use in these conditions. The alternative to implementing these ideas is inaction – either in the hope that these problems will go away or because of some ideological position based on the preservation of market purity. This risks losing the very real benefits of capital flows, if it leads to ill-designed measures by emerging countries to isolate themselves from these problems. At the same time, the crisis tarnishes the complex international trading structure, and adds to the growing voices damning “globalisation”. Krugman (1998) has reminded us that Keynes saw his interventionist active fiscal proposals as necessary to save the market system. Now, changes are needed in international financial markets to safeguard the continuance of international capital flows, with all the benefits they bring. | reserve bank of australia | 1,998 | 11 |
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to CEDA Annual General Meeting Dinner in Melbourne on 25/11/98. | Mr. Macfarlane puts recent suggestions for improving the operation of the international financial system into perspective Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to CEDA Annual General Meeting Dinner in Melbourne on 25/11/98. It is a pleasure to be in Melbourne again for CEDA’s Annual General Meeting. The last time I addressed this group two years ago I spoke about the Australian economy, monetary policy and wages. Events have moved on a good deal since then, and I hope what I have to say tonight reflects this. The biggest change is that attention is now more focussed on the international economy than on domestic events. This change can be dated from the start of the Asian crisis in the middle of 1997, and has continued through more recent episodes which have affected other emerging markets as well as financial institutions in developed countries. These events have led a number of participants in international markets, myself included, to question some aspects of the present international financial system, and to make suggestions for improvements. I have said a number of things recently that have sounded a bit out of character from a central banker. Both I and my deputy have shown a lot of sympathy for our Asian neighbours and felt that it is unfair to place the blame for their current plight solely on their own policy inadequacies. We have also said that the present international financial system is unstable, that hedge funds should be brought into the disclosure and supervision net and that the western policy establishment was wrong to encourage emerging markets to embrace the free movement of international capital so early in their development. This has led some people to wonder what has come over us, and to question whether we have deserted orthodox economics to follow more populist creeds. I have been asked whether we no longer believe in markets, and whether we have become proponents of capital controls. These questions worry me because they suggest that, for some people, there are only the two polar positions, and that if you express some reservations about one, you are automatically placed in the other. For these reasons, I want to spend some time tonight trying to place the recent suggestions for improving the operation of the international financial system in some sort of perspective. 1. From the Perspective of Australia From the perspective of the Australian economy, the move to financial deregulation, and to the lifting of restrictions on international capital movements, has been a success. We can date it approximately from the floating of the exchange rate, and the abolition of exchange controls, in 1983. Although we characterise this 15-year period as being an era of deregulation, that is only a very approximate description. While the authorities have stopped setting prices such as the exchange rate or the interest rates banks can charge on mortgages, there is still a large everevolving body of regulation in place aimed at ensuring financial stability and efficient and fair markets. The stock exchange and the futures exchange have a comprehensive set of rules that participants must adhere to, and, of course, they are also regulated by ASIC. The banks and insurance companies are regulated by APRA, the payments system by the Reserve Bank, and competition policy is enforced by the ACCC. Underlying all this, are the body of commercial law and the accounting standards. This approach to organising financial markets - which, in deference to common usage, I will call the deregulated approach - has not been without its critics. A common criticism is that international capital has forced the Australian Government to run macro-economic policies that were not in the interests of the domestic economy. By this, the critics mean policies that are tighter than the ones they favour. I have never agreed with this proposition. There has been an on-going struggle in Australia by governments of both sides to return fiscal and monetary policy to sustainable long-run settings after the turmoil of the 1970s. The influence of financial markets has been a helpful one in bringing this about. Now that policies are in a sustainable and responsible position, I am not aware of financial markets pushing for tighter policies. The other common criticism is that financial markets in Australia have been unstable. The simplest answer to this charge is to point out that they would have been more unstable over the past 15 years if we had tried to find a path through the ups and downs of the world economy with a managed exchange rate and a set of interest rate ceilings. We would not have had the daily movements as under the present system, but the pressure would have built up and when the dam broke, as it assuredly would have, the crisis would have been worse. While I am confident that the deregulated system performed better than a continuation of the old regulated one would have, I do not want to give the impression that it is without fault. We are already on record as accepting that the exchange rate went down too far in the mid-1980s, that asset prices such as shares and, later, commercial property underwent a boom and bust at the end of the 1980s and beginning of the 1990s, partly as a result of excessive lending by newlyderegulated banks. Our whole approach to foreign exchange intervention is based on our view that the foreign exchange market is not “efficient” in the academic sense, but that it is prone to overshooting in both directions from time to time. In other words, we do not have an idealised view of how deregulated asset markets behave - we have a realistic “warts and all” view. But even holding that view, we are confident that a deregulated model with no obstacles to capital movements is the best one for Australia. It took us a long time to adopt it, but there is now wide support for it at the political, policy adviser and community level, and I hear no suggestions that we should change it. But that does not mean that we should be urging every other country to adopt this model regardless of their state of development. Eventually, I think it will be in the interest of emerging market economies to do so, but the sequencing of this and other policies is crucial. 2. An Emerging Market Perspective When we look at international capital movements from the perspective of an emerging market economy, the view can be very different. For a start, the size of the financial sector in an emerging market is often extremely small relative to the flows of capital that emanate from developed countries. As Paul Volcker has put it: “One common characteristic of (emerging market) countries, some large in population and area, is the small size of their financial sector. The aggregate size of the banks in the typical emerging country is now the size of a single regional bank in the United States - precisely the kind of bank that is told that it is too small to survive in today’s turbulent markets.”1 Speech to Institute for International Finance, Washington, October 1998. What is a small adjustment of investment strategy for a few major banks or mutual funds may be a large injection or withdrawal of funds for an emerging market. Second, it is clear that for most of the Asian emerging markets, some of the capital inflow that occurred in the mid to late 1990s was not, in any sense, needed. It was more than the amount required to finance their current account deficit, and it certainly was not needed to support their exchange rate because these were under unwelcome upward pressure throughout the period. The purist would say that if they did not want the inflow they should have let their exchange rates float upwards. This would have eventually curtailed the short-term inflows that result when a fixed exchange rate tries to co-exist with a positive interest differential. But what we do not know is how high the exchange rate would have needed to rise in the process and the extent to which this would have added to the economic difficulties. Remember the Thai currency crisis was triggered by the perception that the baht had become over-valued because it was tied to a rising US dollar. In short, if capital flows are very large relative to the size of the economies, they are, one way or another, going to cause distortions. Of course, the above considerations would not matter if the international capital markets were a smoothly adjusting mechanism that constantly kept the exchange rate in line with the evolving fundamentals. But this is not what people observe - they see booms and busts and do not believe the proposition that the market is always right. Attempts by academic economists to persuade them that the free market always, or nearly always, gives the correct equilibrium price are unconvincing. The public’s scepticism is well placed because the intellectual underpinning of the free market position in relation to asset price determination - the Efficient Markets Hypothesis is very weak. In all the exchange rate tests of which I am aware, the hypothesis has been contradicted by the facts. The third difference from an emerging market viewpoint is their relatively under-developed financial infrastructures and regulatory frameworks. They do not have as strongly a based system of regulating stock markets or banks or the underlying body of commercial (including bankruptcy) law or accounting practices. They also have serious deficiencies in the allocation of investment which unduly favours those who are well-connected to the government, the banks or both (the so-called “crony capitalism”). I have no intention of denying that these are serious shortcomings and that they should be rectified as quickly as possible if the countries concerned are going to achieve first world living standards. But we have to be realistic about how quickly these things can be achieved; in our own countries, these changes took decades or generations rather than years. Such problems are heightened by the phenomenon of contagion, a fourth element particularly strong among emerging markets. In cases of panic, financial markets are not very discriminating. When one country suffers a withdrawal of capital, others come under pressure. Partly, this can be geography, as physical proximity can often mean economic and financial linkages. But even economies on the other side of the globe, with few direct linkages, can be affected for no other reason than that they are classified as “emerging markets”. Such countries might well have some weaknesses such as those noted above which, given time and a measure of economic and financial stability, might be adequately addressed. But under conditions of widespread desire to shed risk, they become immediate stumbling blocks for markets. This can put intense pressure on the policy authorities and economies of these countries - pressure which few countries can withstand easily. For these reasons, the picture looks different from the perspective of the emerging market economies. What is good for us after a long period of evolution need not be good for another country at a much earlier stage of that evolution. In modern parlance, it is essential to get the sequencing right. Countries have to attain a high standard of financial infrastructure and regulation before they can submit themselves to the potential instability inherent in the totally free movement of capital. In the meantime, they should integrate themselves as closely as they can into the international capital market and, as their markets evolve towards maturity, they can take additional steps progressively to liberalise their regulatory regimes. To expect them to do it in the other order is to ask them to run before they can walk. 3. What Should We Do About It? Fortunately, there is now a widespread agreement that something has to be done to improve the international financial system. The degree of instability, if it continues unchecked, could lead many participating countries to question the whole legitimacy of the system. The severity of the contractions in Asia is the most striking example, but so is the sudden recognition that a hedge fund can become so important that its failure could pose a systemic threat to the United States and international economy. The fact that the second most important exchange rate in the world the US dollar-Yen rate - could move by 20 per cent in a month without there being a material change in fundamentals has also caused concern. I think there is now agreement that something has to be done, and it is heartening to see that the United States has taken a leadership role, including by convening the Group of 22 and its three working parties. I also think that the Australian Government has played a very useful role - first by its representations to the IMF urging more flexibility in its handling of the Indonesian crisis, and secondly by its attempt to keep the momentum of APEC heading in the direction of more liberal trade policies. Change is already occurring in that the western policy establishment is no longer pushing emerging market economies to move quickly to full capital account convertibility. As recently as October last year the IMF, at its Annual Meeting in Hong Kong, was hoping to get its members’ endorsement of a change to its Articles to make it easier for it to encourage countries to adopt full convertibility. This proposal was not put forward at the 1998 Annual Meeting in Washington because it was clear that it would not get support. There also seems to be greater tolerance for countries which have a generally outward-looking policy framework, but which have put in place some impediment to very short-term capital movements. I refer here to Chile’s deposit requirement on foreign borrowing and to Singapore’s and Taiwan’s restrictions on their banks lending domestic currency offshore. The more important task is to get on with the job of improving the international monetary system, with the specific aim of reducing the degree of instability. Some of this is the job of the emerging market countries, and in the first instance involves increasing disclosure by these countries’ governments, companies and banks. As well as making markets better informed, and better able to judge the risks they are taking, the aim here is to make some progress on reducing the previously opaque links between governments, banks and companies, or, in other words, to improve governance. In addition, there is a lot of work to be done to bring the supervision of financial institutions up to standard - a task which will take a lot of personnel, training and time. These changes are extremely important and require a lot of effort on the part of the emerging market countries. They also mean that a lot of time-honoured ways of doing things will have to be replaced. This is bound to meet opposition, and it will require political courage as well as economic expertise to achieve results. It will be made a lot easier if the developed economies are also seen to be examining whether there are aspects of their regulations that are contributing to the instability of the international system. The most obvious reform here is to do something about the extent to which current regulations allow excessive leverage in financial markets. The immediate focus should be the close inter-connections between hedge funds, investment banks and commercial banks. The hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities. Our reconstruction of the transactions that hedge funds undertook in Australia in June suggests that they could engage in almost infinite leverage in their off-balance sheet transactions if they so chose. One has to ask whether the Basle capital requirements are excessively generous in their treatment of financial market activities. A related problem is the weakness in banks’ credit assessment processes that allowed them to build up some very large exposures to hedge funds and other financial institutions. No matter how effective the above changes turn out to be, no-one expects that they will eliminate economic crises altogether. There still will be a need for improved crisis management. Here, the most useful suggestion goes under the title of private sector burden sharing. This is designed to be used in a future crisis when a country’s international reserves are exhausted and its exchange rate is plunging as a result of capital flight. In order to reassure markets, countries are often tempted to guarantee a variety of foreign borrowings, with the result that their taxpayers incur large losses while foreign lenders escape unscathed. Private sector burden sharing would stop the capital flight by bringing foreign creditors, the debtor country and the IMF together to work out a rescheduling, probably with a standfast arrangement to hold things together while negotiations take place. Thus, the burden would be shared more evenly, and the pressures on exchange rates could be reduced. Another way in which crises can be handled better is illustrated by the recent IMF package for Brazil. It was an improvement on the Asian packages in two respects. First, the conditions were agreed on in advance in behind-the-scenes negotiations between the IMF and Brazilian authorities. This was much better than the public tug-of-war between national authorities and the IMF that occurred in Thailand and Indonesia. Second, I also note that the conditions are not as wide-ranging as in Indonesia, for instance. I agree with Martin Feldstein2 that the IMF conditions should confine themselves to matters that bear directly on the currency crisis, namely fiscal, monetary and banking policy, rather than trying to reform the automobile, shipbuilding or clove industry, as in Indonesia. 4. Conclusion It is important that we find a way of reducing the present extreme variability in international capital flows. It is also important that we find a way of managing future crises in a way that reduces the cost to the crisis country and shares the burden more evenly, and so reduces the moral hazard to lenders. If we do not succeed in doing these things, we face the prospect of a significant number of countries losing faith in open, market-based economic systems. It would be tragic if our failure to reform an unstable international capital market resulted in a return to inward-looking policies in the international trade in goods and services. And that may yet happen. One reaction to the instability of the international financial system would be for countries to unilaterally impose quite restrictive controls on inward and outward capital movements, and thus miss out on the benefits that access to foreign capital can provide. We have already seen this “Reforming the IMF”, Foreign Affairs, March/April 1998. starting, and it would be regrettable if it were to spread. Even if this does not happen, there is still a possibility of other reactions which may be equally, or more, unhelpful to the world economy. In particular, I fear that a number of emerging market countries will take another form of safetyfirst policy by building up large international reserves - a new type of mercantilism. The problem with this solution is that to build up the reserves they would have to run current account surpluses for the foreseeable future. How will they do this? Will they be tempted to restrict imports, subsidise exports or maintain undervalued exchange rates? All of these are what used to be called “beggar thy neighbour” policies. The whole world cannot do this, so who will run the corresponding current account deficits? The final irony, if this situation eventuates, would be that we would have an international system in which the poor countries lend to the rich so they can spend more than their income. | reserve bank of australia | 1,998 | 11 |
Opening statement by the Governor of the Reserve Bank of Australia, Mr I.J. Macfarlane, to the House of Representatives Standing Committee on Economics, Finance and Public Administration in Sydney on 15/12/98. | Mr Macfarlane’s statement to the House of Representatives Standing Committee on Economics, Finance and Public Administration Opening statement by the Governor of the Reserve Bank of Australia, Mr I.J. Macfarlane, to the House of Representatives Standing Committee on Economics, Finance and Public Administration in Sydney on 15/12/98. Thank you, Mr Chairman, It is a pleasure to be here in front of your Committee again. As you mentioned, the need to make adjustments to the composition of the Committee after the October Federal election means that we are meeting about five weeks later than our normal timetable. Given the uncertainty about the timing of the hearing, and the importance we attach to regular communication with the public about the economy and the Bank’s activities, we decided to keep to the regular timetable for releasing our Semi-Annual Statement on Monetary Policy, which came out in early November. So there is a substantial gap between the Statement and this hearing. On the whole, we feel that our Statement still represents a reasonable summary of our views on events that had taken place over the preceding six months. The world has not changed dramatically since the Statement was issued. We have, however, made an adjustment to the stance of monetary policy, following the December Board meeting. This was as a result of our continual process of evaluating incoming information, and our assessment of the outlook for the year ahead, and the various risks attached to our forecasts. Our judgement was that, even though most of the data coming in were suggesting growth was running ahead of earlier expectations, the likelihood was that growth would decline in 1999. At the same time, the likelihood of overshooting the inflation target was judged to have declined. Hence, we viewed a small further easing of policy as a prudent measure. The good economic outcomes over the past year will, I suspect, be a recurring feature of our discussion today. It might be helpful, therefore, if I start by reviewing the forecasts I presented seven months ago and make some observations about how recent developments compare with them. What I said last time could be summarised as: • GDP would grow by about 3 per cent during 1998; • the unemployment rate would remain relatively stable; • we had passed the trough of inflation and it would rise gradually, reaching about 2 per cent by the end of the year; and • the current account deficit would average about 5½ per cent of GDP for 1998. I also said that I thought this combination of events would be a reasonably good result for Australia in view of the difficult external situation we were facing, particularly among our Asian export markets. In the event, the external situation did not get any better, but Australia’s economic performance has exceeded our expectations, and, to the best of my knowledge, the expectations of virtually all forecasters. It now looks as though GDP growth during 1998 will be about 4 per cent, rather than the 3 per cent that seemed likely in May. A good deal of the additional growth is attributable to stronger outcomes than we had expected in the June and September quarters. The remainder is a result of upward revision to earlier data across most of the recent quarters. Consistent with this stronger than expected growth, the rate of unemployment has continued to edge down, rather than staying flat. Over the past three months it has averaged 7.9 per cent, compared with 8.1 per cent in the first quarter of 1998 and 8.7 per cent in the first quarter of 1997. On inflation, it seems clear that the trough has passed, and our best guess for the rise in the CPI over the four quarters to December 1998 is, in round figures, still about 2 per cent. But it is also true to say that inflation shows signs of not increasing by as much as historical relationships might have led us to expect, given the fall in the exchange rate. On the current account deficit, it now looks as though it has averaged around 5 per cent of GDP in 1998 rather than the 5½ per cent we expected at the last hearing. I would summarise the situation as being one where the forecast errors were within the normal ranges that occur with forecasts of this type. The thing we can take some comfort from, however, is that no-one can accuse us of being Pollyannas because in each case the outcome was slightly better than the forecast. Growth has been stronger, the widening in the current account deficit smaller and, at the margin, the rise in inflation slightly smaller than we had expected. I now propose to make a few general comments about how we are expecting future events to unfold. Over the course of the year before the Asian crisis commenced, that is 1996/97, the economy grew by 4½ per cent. In the first year affected by the Asian crisis - 1997/98 - it grew by 4¼ per cent. Despite starting 1998/99 at a similar pace, we have to accept that we will not be able to continue at this rate. Growth through 1998/99 is more likely to be somewhere between 2½ and 3 per cent. Implicit in this is that the coming quarterly growth rates will be noticeably lower than the ones we experienced over the past year. Some slowing seems to be inevitable, given the weaker outlook for the world economy. Since we last met in May, most forecasters have revised down expectations. The IMF, to take just one example, has revised down its forecast for world growth in 1998 from 3 per cent to 2 per cent, and for 1999 from 3¾ per cent to 2½ per cent. If these estimates are a reasonable guide, then the external environment will remain difficult and income from external sources constrained. Of course, domestic demand has been, and remains, much stronger than external demand, and so Australia’s expenditure has run ahead of national income over the past year. But that gap cannot be expected to continue to grow at the same pace indefinitely, and so both domestic demand and GDP growth must be expected to come down over coming quarters. With slower growth in the offing, we expect that the unemployment rate will flatten out. Of course, we said that last time; now we are suggesting it will occur at a slightly lower rate of unemployment than we formerly expected. We expect the four-quarters-ended increase in the CPI to be about 2½ per cent by the end of the financial year - that is, in the short term, we expect inflation performance to be consistent with our target. Of course, any forecast of inflation beyond that period is only as good as its assumption about the future path of the exchange rate. Given the current tendency towards lower commodity prices, we are assuming some further widening in the current account deficit to about 5½ per cent of GDP in 1998/99. With an annual figure of this size, it would not be surprising to see a quarter or two of it running at over 6 per cent of GDP. I made the same comment in March this year, and again in May at our previous hearing. I expected that it would have come to pass by now, but it has not. It would not surprise me, however, if it does happen some time in the next year. This set of outcomes, or something like it, would represent a good performance for an economy in its eighth year of expansion facing a difficult, but not disastrous, external environment. I expect that it would be well received by the domestic and international investment community, though one can never take this for granted. And, of course, if the assumptions we are making about the world economy turn out to be too optimistic, all bets would be off. I now come to the second part of my testimony, in which I attempt to answer the question of why we have done better than most other countries in Asia or the Pacific Rim. In doing so, I am conscious that the story is not yet over, so this is really an interim report. I think a number of factors have been involved and I will list them in no particular order. As we go through them, it will become apparent that they are all intertwined. First, I think the Asian crisis hit at a time when the Australian economy was in good shape, partly for cyclical reasons. By mid-1997, the economy was growing strongly and inflation was lower than our target. Had we not received a contractionary impulse from the Asian crisis, we may have been facing the need to tighten policy because of a potential overheating. No-one will ever know, but it is a possibility. I am conscious that attributing our performance over the past 18 months to our good starting point is rather superficial because it does not explain why the starting point was so good. But I will come back to that later. Second, I think we have benefited from the flexibility of our exporters, who have switched from the contracting Asian markets into the expanding North American and European ones, and into a number of other markets we do not usually think of as being important to us. The nature of our exports - with so much of them being commodities - has helped, but the efforts of our marketing companies and authorities should not be ignored. Even so, it has not proved possible to prevent exports from falling, and over the year to the September quarter they fell by 2 per cent in volume. Third, Australia has benefited from a greatly improved perception of the soundness of its economic policies. The fact that the budget has moved back into surplus - where it should be in the mature phase of an economic expansion - has been important. So has nearly a decade of low inflation. Also important on this occasion has been the recognition that Australia scores well on such factors as its regulation of banks, other financial institutions and stock exchanges, and that its underlying body of commercial law and accounting practice is at or close to world best practice. Not only have the international capital markets taken a better view of Australia, but we also seem to have more confidence in ourselves. Business and consumer confidence initially fell as the Asian events unfolded, but they did not fall excessively - for the most part they fell from well above average to about average. In the past three months, they have tended to rise moderately again as figures about the economy have confirmed that it has performed better than most expected. The fourth explanation for why growth has held up is a catch-all one - the economy just seems to be more flexible and adaptable than before. The only clear evidence of this is that productivity whether labour productivity or total factor productivity - has increased faster in the 1990s than in earlier decades. For example, total factor productivity has increased at an average annual rate of 1.7 per cent during the expansion of the 1990s, compared with 0.7 per cent in the 1980s and 1.2 per cent in the 1970s. To me, this suggests that the painful adjustments that have been made over the past decade or so are paying off. By this, I mean the changes that have been made to increase competition in previously sheltered industries. This, of course, includes greater export orientation, but also greater competition in utilities and transport, which has reduced costs to other industries. It also includes the downsizing of the public sector, which has released resources. Finally, our labour relations practices and wage setting machinery now have a degree of flexibility that has surprised the sceptics. I now come to a fifth factor, which most commentators view as being important - namely, the fact that in response to a contractionary external shock, the Australian dollar was allowed to float down. This is the way the textbooks say the situation should be handled, and is in sharp contrast to the severe domestic squeeze that can result in the cases of countries with fixed or quasi-fixed exchange rates. The domestic economy has benefited from the lower exchange rate because exporters’ incomes have been held up and the incentive to export maintained (while at the same time assisting those industries that are competing against imports). The domestic economy has also benefited because we have not had to put up interest rates in order to maintain our external parity (as in a fixed exchange rate) or to prop up a floating rate that threatened to fall so far that it would have had undesirable inflationary consequences. Raising interest rates in response to an external contractionary shock is not something that you normally would want to do, although in extreme circumstances it may become necessary. I have heard people say that it is a good thing that, unlike some other countries, we were relaxed in the face of a falling exchange rate. I can assure you all that we were never relaxed. Having followed the Australian dollar on virtually a daily basis for 15 years, I know that you can never take it for granted. While the floating rate is the best system we have had, like all asset prices freely determined in unconstrained markets the Australian dollar is prone to bouts of instability or overshooting. On three occasions - in January, June and August - a downward overshooting threatened and we responded with foreign exchange intervention. On each occasion, stability was re-established and, unlike the experience of the mid-1980s, we did not raise interest rates. But this does not mean that that option was not on the table. It was, and financial markets knew this; as a result, 90-day rates were well above cash rates in both June and August. Fortunately, things turned out well, and so the option did not have to be used. Thus, the exchange rate was centre stage. The general direction of its movement was performing a very useful function, yet the short-term dynamics were such that it often threatened to go too far. It has been a delicate balancing act, but one with a favourable outcome. Over the past two years, the economy has been able to grow at over 4 per cent per annum without significant upward pressure on inflation (which has averaged 1.6 per cent over the same period). This is better than almost anyone expected. Another way of approaching the question is to ask why we at the Reserve Bank were able to accept this continuation of high growth and depreciating exchange rate without having to tighten monetary policy (in fact, being able to ease it slightly at the beginning of this month). The answer is that the combination has not to date seriously threatened our inflation target. Why has it turned out this way? The answer, I think, is that we are beginning to receive the big dividend that low inflation provides. The economy has gradually adjusted to nearly a decade of low inflation and, although the adjustment is still not complete, the benefits are becoming apparent. Inflationary expectations are much lower and more stable; wage contracts are now often two or three years in duration; loans, including housing mortgages, often have interest rates fixed for long periods; and businesses know that they can no longer automatically pass on any cost increase secure in the knowledge that it will get lost among the multitude of other price increases. This new less volatile environment allows the floating exchange rate to do its job of stabilising the domestic economy in the face of an external shock. It does so by reducing the tendency for the expansionary effects of a falling exchange rate to be dissipated in the form of rising inflation. It also goes without saying that the low inflation environment makes the task of monetary management a lot easier. I think we can take some satisfaction about how events have turned out over the past two years, but we should not become complacent. This particular episode, which started as a regional Asian crisis, is far from over. We should not think that we can see the end of it just because it has already been running for 18 months. For a start, the United States has only recently started its slowdown, and uncertainty about the US outlook seems greater at present than for some time. In addition, Japan remains gripped by powerful contractionary forces. That could put continued pressure on commodity prices. Much has been said recently about how Asia has passed the worst of its problems, and on many measures this is so. But the contractions have been very severe in many cases, and no-one is expecting a quick or strong recovery. I do not wish to say any more at this stage. You will note that I have dealt exclusively with the domestic economy, but I think that is appropriate since I have spoken so much recently in other places about Asia, the world economy, and international financial markets. My colleagues and I are, of course, happy to answer any questions you may have on the topics I have not covered, or for that matter, on the ones I have. | reserve bank of australia | 1,998 | 12 |
Talk by the Governor of the Australian Reserve Bank, Mr I J Macfarlane, to the CLSA Investors' Forum in Hong Kong on 21 May 1999. | Mr Macfarlane gives an overview of the Australian economy in the 1990s Talk by the Governor of the Australian Reserve Bank, Mr I J Macfarlane, to the CLSA Investors’ Forum in Hong Kong on 21 May 1999. It is a pleasure to be in Hong Kong talking to the CLSA Investors’ Forum. This conference has built up quite a reputation over the years and I am honoured to be invited to address such an impressive group of investors. I will try my best to avoid presenting you with a “sales pitch”, but that is easier said than done. If you think that I am concentrating too much on the favourable side of the Australian economy, you can always redress the balance when it comes to question time. The Australian economy has attracted a fair bit of favourable attention lately because it has performed so well during the Asian economic and financial crises. Whilst this favourable publicity is very gratifying for people like myself who have been around during the lean years as well as the good ones, I do not intend to spend much time today talking about recent economic events. This is because I think the good performance of the Australian economy is not just a recent event, but something that has been unfolding over the past decade. In other words, the recognition may be recent, but the underlying story has been around for a lot longer. We have now nearly completed the decade of the 1990s, with nine of the ten years already behind us. Over this period of nine years, Australia has grown faster than other comparable OECD countries (Slide 1). Only Ireland and Norway, which taken together are only a little over half the size of Australia, have done better, and there are special reasons in each case. This is the first decade to my knowledge where Australia has put in such a strong growth performance relative to other OECD countries. While there have been other decades - such as the 1950s and 1960s - where Australia grew faster in absolute terms, we did not exceed OECD average growth rates in those periods. The 1990s stands out as the first decade of the post-war era where Australia’s growth would put it in the first quartile of performers. Table 1: Real GDP Growth Average annual rate (past nine years) Ireland Norway Australia Netherlands United States Denmark Germany Spain New Zealand Canada United Kingdom Belgium Japan 6.8 3.5 3.2 2.8 2.5 2.5 2.2 2.2 2.1 1.9 1.9 1.9 1.8 France Finland Italy Sweden Switzerland 1.7 1.2 1.2 1.1 0.8 Source: OECD I should also add, of course, that this economic growth was achieved against a background of very low inflation. Over the same nine-year period, Australia had an average rate of inflation of 2.8 per cent per annum. This is slightly higher than the average of OECD countries but within the range of 2-3 per cent as specified in our inflation target. If we deleted the first two years (1990 and 1991) from our comparison, our average inflation rate would fall to about the OECD average. Of course, the thing that stands out when we look at inflation in the 1990s is not the difference between the countries, but the uniformity in that they all have achieved very low inflation rates. The question I want to address today is this - why has Australia done so much better relative to other countries in the 1990s than it had in previous decades? I will attempt to answer this question by starting with those aspects of the economy I know most about, namely macroeconomic policy, and then moving on to other areas which are a little more speculative. By doing it in this order, I do not wish to imply that improvements in macro-economic policy are the main explanation. They may be, but on the other hand, it is entirely possible that the biggest improvements have come from the structural side. Macro-economic Policies Monetary policy has been put on a much sounder footing in the 1990s than in earlier decades. The inflation targeting regime has been a success in Australia, as it has in other countries that have adopted this approach. The Government’s recognition of the independence of the Reserve Bank has also been an important factor. Monetary policy has, in effect, become depoliticised, and decisions can now be based more on medium-term considerations than in earlier decades. Low inflation, and the fact that it has been maintained without forgoing economic growth, is the clearest testimony to this improvement. Fiscal policy is also in much better shape. The Budget is in surplus and projected to stay there during the period covered by the forward estimates. Perhaps the best medium-term measure of a country’s fiscal position is the ratio of government debt to GDP. Instead of showing one year’s position, this measure summarises the effect of all previous years’ surpluses or deficits. As you can see by the next slide, Australia has the lowest ratio of any OECD country, and it is still declining. Table 2: General Government Debt Per cent of GDP, 1998 Italy Belgium 119.4 117.3 Japan Canada Sweden Spain Netherlands France Germany Denmark Ireland United States United Kingdom Finland New Zealand Norway Australia 99.9 90.0 73.1 72.0 67.9 66.4 62.6 59.3 56.6 57.4 57.2 52.5 37.6 37.1 37.0 Source: OECD One aspect of Australia’s recent economic performance that has received favourable comment is the behaviour of the exchange rate. When the Asian crisis erupted, the exchange rate fell so that at its low point in August last year it had fallen by a very significant amount. Unlike a number of countries in the region, interest rates were not raised to defend the exchange rate. I would like to make two observations about the exchange rate: • The first is that under our floating exchange rate regime, the exchange rate is allowed to vary quite a lot with cyclical developments in the world economy. One of the reasons that we are comfortable with this degree of variability is that we know that it takes place around a basically flat trend. This can be seen from Graph 1 which shows the Australian dollar against the US dollar. Graph 1 Australian Dollar Exchange Rate against US Dollar US$ US$ 1.1 1.1 0.9 0.9 0.7 0.7 Average since 1986 0.5 0.5 • My second point is that some people have tended to exaggerate the size of the fall in the Australian dollar over 1997/98 by looking only at the Australian dollar/US dollar rate. At least half of the story over that period was US dollar strength rather than Australian dollar weakness. This is illustrated in Graph 2 which shows the Australian dollar in trade weighted terms, where the fall was much less pronounced. Again, I would not want to place too much weight on this measure either, because it tends to be pushed up by the large depreciation in a few Asian currencies. The truth probably lies somewhere between the two. Graph 2 Australian Dollar Trade-weighted index Index Index Average since 1986 Recent events in Asia and elsewhere have highlighted how important financial stability is in determining macro-economic outcomes. Although there are many factors which underlie financial stability, one very important one is the prudential supervision of the banking system. In Australia, we learnt quite a lot about that in the late 1980s and early 1990s, and that learning experience has served us well over the past decade. The best single measure of this aspect of financial stability is shown by the level of bad debts of the banking sector. As you can see from Graph 3, these have fallen from their peak of 6 per cent in 1992 to less than 1 per cent at present. This is about as low as they can realistically be expected to go. Graph 3 Banks’ Impaired Assets Share of total assets % % Structural Policies Turning to structural policies, I would like to start by showing a graph of productivity. This graph shows the average increase in productivity in each of the last three economic expansions, i.e. the 1970s, the 1980s and the 1990s. The measure of productivity used is multi-factor productivity. This measure of productivity cannot be increased simply by shedding labour and replacing it with capital. It can only be increased by using both labour and capital more productively. As you can see from Graph 4, productivity growth has been much faster in the 1990s - nearly 2 per cent per annum - than the rates of increase achieved in earlier expansions - about 1 per cent per annum. Whilst we cannot draw very specific conclusions from this improvement, it seems to me that it tells us that we must have been doing something right. My guess is that the main things behind this improvement have been the various micro-economic reforms that have been aimed at increasing the competitiveness of the Australian economy. These include: • the substantial lowering of tariffs; • the deregulation of financial markets; • the introduction of a more stringent regime for competitive policy; • the privatisation of a lot of public utilities, banks, insurance companies; and • the introduction of a good deal more flexibility into wage bargaining. Graph 4 Multi-factor Productivity 1996/97 = 100; non-farm economy Index Index 1.9 % p.a. 1.1 % p.a. 1.0 % p.a. I think we made a lot more progress in these areas than we were ever given credit for internationally. Each of these changes met with resistance, and in many cases compromises were made which would not please the purists. But taken together, along with the private sector restructuring that was occurring at the same time, they have amounted to a major set of reforms, and have made the Australian economy leaner, more flexible and more competitive. Whilst these measures make the economy more efficient and competitive in the longer run, they of course have short-run costs. There is always an increase in uncertainty in an economy where change is occurring, and there are often job losses involved, such as when a large overstaffed public utility is privatised. Of course, there are also enormous benefits which are often overlooked, such as cheaper electricity, cars, telephone calls, airline flights, new export industries, etc. But because the complaints and resistance tend to receive more publicity than the successes, the impression is given that there is a lot of resistance. I think this is a misleading impression and that Australians are actually very adaptable people. Some historical examples of this adaptability include: • the ease with which Australia replaced the old British system of weights and measures with the metric system (compared with the limited success the United States and United Kingdom have had in the same endeavour); and • the ready acceptance of such measures as random breath testing and compulsory seatbelt wearing to reduce the road toll. These were introduced in Australia many years ago and I think we were the first country to do so. These measures are still resisted in a number of countries. Another aspect of this adaptability is the speed with which Australians have taken up new technology, particularly computer-based communications technology. I have two graphs to illustrate this. The first on modem usage per head of population, and the second on electronic commerce servers per head of population. Both measures, not surprisingly, show the United States, at the top of the table, but Australia is also very highly placed, coming third in modem usage and second in electronic commerce servers. In particular, it is notable that Australia, along with Canada, makes considerably greater use of these technologies than European countries, for example. Graph 5 Modem Usage, 1996 Per cent of population United States Canada Australia Netherlands Finland Sweden Germany United Kingdom Japan France Italy Greece Source: MORI Ltd % Graph 6 E-commerce Servers, July 1998 Secure servers per million population United States Australia Canada New Zealand Singapore Switzerland Israel Ireland Scandinavia United Kingdom Hong Kong Continental Europe Japan South Africa Taiwan No. Sources: The Economist,Netcraft, World Bank Risks The picture I have painted is, not surprisingly, a very rosy one. This is partly because I am talking to a group of international investors, but it is mainly due to the fact that the numbers themselves have been very good ones. But the outlook cannot be perfect; every economy has some vulnerable points. Even the Americans, who have done so well over recent years, worry about the level of the stock market and the possibility of incipient inflationary pressures. What are the Australian equivalents? We think that our expansion is going to slow down at some point because that is what business cycles do. We are still forecasting a slowdown even though our previous forecasts of slowdowns have not eventuated. But I would hardly classify a mild slowing of the economy as being a major problem for us. The only way we could get into a major problem on this front is if there is an outright contraction in the world economy, and that does not seem to be a likely outcome. We do not think that our asset markets are over-heated, nor do we see inflationary pressures at present. Credit growth has been very strong, but it has not interacted with asset prices as it did in the 1980s. That could all change in the future, of course, but for the present this sort of over-heating seems a long way off. The usual area that people point to as a danger point for Australia is the balance of payments. Naturally, our current account deficit has widened over the past two years. This is what you would expect, given the buoyancy of the Australian economy and the contraction in so many of our major export markets. This widening is thus more a reflection of the strength of the Australian economy rather than its weakness. If you look back over the past 20 years, you will see that the Australian current account deficit has fluctuated between about 3½ per cent and 6½ per cent of GDP. On four occasions, it has exceeded 6 per cent, and it seems likely that when the final figures come in for the March quarter of 1999, this will have happened for the fifth time. In the past, this has often rung alarm bells, but it is not doing so on this occasion. Why is that so? I think there are basically two reasons for this: Graph 7 Current Account Balance* Per cent of GDP % % Balance on goods and services -2 -2 -4 -4 -6 -6 Current account -8 -8 * Excludes RBA gold transactions; March 1999 estimate. • The first reason is that in the past the widening current account deficit was partly a reflection of domestic imbalances such as a large Budget deficit or a higher rate of inflation than the rest of the world. Neither of those are present on this occasion, and the widening current account deficit can be fully explained by differing growth rates between the Australian economy and its trading partners. • The second reason is that in the 1980s the widening current account deficit raised doubts about its sustainability. People thought that the debt to GDP ratio would keep on rising forever and that debt servicing could become an intolerable burden. Neither of these two eventualities occurred. As Graph 8 shows, the debt to GDP ratio stabilised at around 40 per cent, which is high by world standards but not excessively so (for example, New Zealand, Canada and Sweden all have higher rates). A similar story can be told with regard to debt servicing (Graph 9). Its ratio as a percentage of exports reached a peak of 20 per cent in the late 1980s, but is now less than half of that level. In Australia, we always have to keep a weather eye on the balance of payments, but it does not seem to represent quite the same constraint now that it did in the 1980s. Of course, it is not really up to me to make these judgments. It is really up to the market. It does seem, however, that the market is much more prepared to give the Australian economy the benefit of the doubt than it formerly was. To return to my earlier theme, I think that is because the totality of policies in Australia are now judged much more favourably than they were in earlier years. Virtue does seem to have its own rewards. Graph 8 Net Foreign Debt Per cent of GDP % % Graph 9 Net Debt Servicing Per cent of exports % % | reserve bank of australia | 1,999 | 5 |
Opening statement by the Governor of the Reserve Bank of Australia, Mr I J Macfarlane, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, in Melbourne, Australia on 17 June 1999. | Mr Macfarlane’s overview of monetary policy in Australia Opening statement by the Governor of the Reserve Bank of Australia, Mr I J Macfarlane, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, in Melbourne, Australia on 17 June 1999. Thank you, Mr Chairman. It is a pleasure to be here in Melbourne again appearing in front of the Committee. Like last time, the Semi-Annual Statement on Monetary Policy has already been released a month before the hearing. On this occasion, it was the Budget that caused the delay in the hearing, but I do not think this is a serious matter because the Statement is still relevant. If anything, the advance release of the Statement may have been helpful in giving more time to digest the material contained in it. We have more recently sent to the Committee some new material in the form of a paper on bank fees. I would now like to start off in my customary manner by comparing what I told you last time with what now appears to be the most likely outcome. I do this in the interests of accountability, but I also think it has the advantage of drawing out the limitations of economic forecasting and the necessity of seeing policy formulation as an iterative process. Last time, I indicated our expectation that our growth rate was likely to be lower in 1998/99 and that there would be some pick-up in inflation (though to a rate consistent with our target). I said that the current account deficit would expand, and would probably reach 6 per cent of GDP on a quarterly basis at some stage. I indicated that not much further progress could be expected in reducing unemployment from the rate of 7.9 per cent which had prevailed in the three months before the hearing. It is now well known that growth has not, as yet, declined. In all likelihood, growth for the 1998/99 year has been in excess of 4 per cent, measured either in year average terms or for the four quarters to June. This makes this expansion, which began in the middle of 1991, the longest continuous upswing since the 1960s. Nor is there any sign yet that the expansion will come to an end soon. We are still of the view, however, that some decline in growth is likely, but from a considerably stronger starting point (and, of course, more delayed) than earlier thought. The outcome for calendar 1999 will, in our judgement, be lower than the growth recorded in 1998 – something between 3 and 4 per cent. This is a fairly mild decline, given the size of the external shock to which we have been subject. More importantly, the risks of a sharp slump have lessened considerably since we last met. Last December, we had just been through a period in which confidence in the prospects for the global economy, including, of course, the US economy, had reached its lowest point. Behind this were concerns about extreme instability in global financial markets and the possibility of a “credit crunch”. Since then, the US economy has continued its strong performance and concerns about credit crunches have disappeared. Indeed, there is now a widespread expectation that the strength of the US economy means that a tightening of US monetary policy is on the cards. Evidence has also continued to accumulate of a turn for the better in the countries in East Asia which slumped so sharply during 1997 and 1998. Inflation in Australia, meanwhile, has risen, but very slightly and considerably more slowly than our central forecast of six months ago had suggested. A possibility which we flagged in our November 1998 Statement – that competitive pressures in international markets would have a dampening impact on the rises in prices for imported goods – has in fact turned out to be the case. In our latest Statement, we have forecast inflation to be about 2 per cent in underlying terms by the end of 1999. In headline terms, the CPI also is likely to be about 2 per cent. This is a little higher than we suggested in the Statement, as we have now taken full account of higher international oil prices, which roughly offset the effect of the health care changes. The current account deficit has turned out to be something like 5½ per cent of GDP for 1998/99, and was almost 6 per cent in the March quarter. It is highly likely that a quarterly figure over 6 per cent will be recorded in the June quarter. It seems to us that numbers something like that might well be seen over the next few quarters, with the result that the outcome for 1999 as a whole will be about 6 per cent of GDP. The unemployment rate has fallen further, in line with the stronger than expected growth in the economy, and over the past three months has averaged 7.5 per cent, its lowest for about a decade. Given the amount of growth we have had over the past year, some further moderate decline in unemployment will probably be recorded, in net terms, over the remainder of this calendar year. Even though the outcome has turned out better than expected, if someone wanted to score a point, they could say we are not very good forecasters. I would concede that we have been a little conservative in our forecasts, but it has not led us astray in a policy sense, i.e. it has not jeopardised the achievement of a good economic outcome. As someone who has been involved in forecasting and economic policy in the lean years as well as the good, there is a more interesting question that has to be asked. It is this: How is it that the Australian economy has been able to grow at 4½ per cent plus per annum in the seventh and eighth years of an economic expansion without generating significant wage and price pressures? It certainly was not able to do so in earlier expansions. I have already given part of the answer to this question in my December testimony, and in a couple of speeches since. It is that the economy has achieved improved productivity growth as a result of the micro-economic reforms of the past fifteen years. The main changes have been reductions in tariffs, privatisations, financial deregulation, competition policy and labour market reforms. Of course, businesses have also become much leaner and more adaptable as they have responded to increased competitive pressure. The key piece of evidence for this is the higher growth of multi-factor productivity in Australia in this expansion compared with previous ones. A lot more could be said about this subject, but I will leave it to others, and move on to a related subject. It seems to me to be quite possible to have higher productivity growth and yet to still encounter macro-economic imbalances which would bring an economic expansion to a halt. In other words, higher productivity growth can explain why the economy’s average growth rate is faster, but I do not think it can provide an adequate answer for why the expansion will last longer. To do this, I think a macro-economic explanation is required. Here I have to come back to low inflation and low inflationary expectations, which have characterised the 1990s expansion, but were clearly absent from earlier expansions. As the earlier expansions matured, inflationary pressures built up which simultaneously pushed up prices (requiring a monetary policy response) and squeezed businesses and business confidence. In the mid-1970s and early 1980s the expansions came to an end with a wage explosion, while in the late 1980s it was an asset price boom and bust. This time we have had neither of these. As I said, a recent history of low inflation has been crucial this time. It certainly has helped the wage bargaining process. Employees have seen that quite modest nominal wage increases have translated into decent real wage increases because inflation has been contained. They have not had to build anticipatory increases into their wage bargains to safeguard themselves against inflation getting away from them. Increased flexibility in industrial relations arrangements has also helped. Similarly, low inflation and low interest rates have had a favourable impact on business behaviour. An important reason for this is that with low interest rates, there is little or no scope for negative gearing. Most of the reckless schemes of the entrepreneurs of the 1980s were simply negative gearing writ large. This was the biggest contribution to the boom and bust in asset prices. It was not the only UHDVRQ ,DFFHSWWKDWWKHUDSLGLQFUHDVHLQWKHQXPEHURIOHQGHUVDVVRFLDWHGZLWKWKHGHUHJXODWLRQRI the finance sector also played a role. We could argue about the relative weights of these two factors if we wish, but the relevant fact for today is that neither of these two factors is present in the current expansion. If we do not seem to be developing our usual ailments, as I have argued above, are there some new ailments that may bring our progress to a halt? A number of possibilities could be identified, but one that has attracted a fair bit of attention is the fall in the household saving ratio. In contrast to the business sector, which has become more cautious in the 1990s, the household sector has become less cautious, as shown by: • the household saving ratio falling from 12 per cent in the first half of the 1980s to about 1 per cent at present. This has been a pretty steady trend (see Diagram 1). • Household borrowing rising as a percentage of annual income. Household Saving Ratio % % Diagram 1 This less cautious attitude by households is a surprise to many people because it seems to be at odds with the usual media depiction of a public worrying about its future, anxious about job security and generally insecure. If we were instead to judge the public by what they actually do, we would conclude the opposite. Unlike their parents and grandparents, who saw a great need to save for a rainy day and who had the privations of the Depression still in their minds, the spending and saving pattern of the current generation indicates a totally different attitude. Of course, developments on the supply side have made this a lot easier. At today’s low interest rates, it is possible to service a much bigger loan than it was at the start of the decade. Also banks and other financial intermediaries have found new ways of providing credit based on previously inaccessible collateral. The important issue is whether this trend change in household behaviour is going to cause problems for the economy, particularly whether it is going to endanger the present expansion. I think there are three possible problems that could arise, so I will discuss each one briefly. 1. The first possible problem is that if inadequate household saving persists, it could mean inadequate provision for retirement. This, in turn, would put increased demands on future taxpayers. This is an issue of inter-generational equity. I do not want to suggest that this is not a problem – it may well be a big one, but the solution to it would be found in improvements to our policies regarding retirement income. 2. The second possible problem is that any reduction in saving, other things equal, would lead to an increase in the current account deficit. Has the trend decline in household saving over the past decade caused the balance of payments to deteriorate? The answer seems to be no: the current account deficit has shown roughly the same cyclical movement that it has exhibited over the past twenty years (Diagram 2), but no change in trend. The reason for this is that there is not a one-for-one relationship between household saving and the current account deficit. We have to also take into account government sector saving, business sector saving and, of course, investment before we get to the current account of the balance of payments, and movements in some of these factors have offset the reduction in household saving. C u rren t A cco u n t B alan ce* P e r ce n t of G D P % % -2 -2 -3 -3 -4 -4 -5 -5 -6 -6 -7 -7 -8 1 98 1 -8 * Exclu d e s R BA g o ld tra n sa ctio n s. Diagram 2 3. The third possible problem is that increased indebtedness makes the household sector more vulnerable when interest rates rise. This is probably true, but the main implication is that to achieve a given macro-economic effect, interest rates would not have to be raised as much as formerly was the case. I now want to turn to a totally different subject, but one that will be very important over the next seven months. I refer, of course, to the issue of the end of century date change — or Y2K as it is colloquially known. The main point I want to make is that the Australian financial system is very well prepared for Y2K. The formal processes of fixing and testing their systems began in the mid—1990s and it has been under the scrutiny of APRA and the Reserve Bank since early 1997. Financial intermediaries have devoted over a billion dollars and thousands of staff to checking and updating computer systems. Where problems have been found, they have been fixed. Outmoded ATMs and EFTPOS machines have been replaced, computer programs have been rewritten or new software has been installed. With all this effort, the Australian financial system rightly enjoys a world-class reputation for its high level of Y2K preparedness. The Reserve Bank’s own computer systems are, of course, Year 2000 ready. In particular, the systems that the Reserve Bank uses to distribute pensions and other government payments to banks, building societies and credit unions on behalf of Centrelink have been thoroughly tested. Pension payments will be made on time. So much work has now been completed to ensure that the system works, that the big issue facing us is no longer a technical one – it is instead an issue of public reaction. While I am very confident that the overwhelming majority of the Australian public will act sensibly, there are no doubt a few who are inclined to believe doomsday scenarios. With this in mind, there are a few preparations that we at the Reserve Bank have been putting into place to help reassure the community. An important step was to talk to the banks, building societies and credit unions to make sure that they were communicating with their customers in clear language to reassure them that their deposits were safe. Because the simple fact is that their deposits are safe and their records are not at risk from Y2K related problems. All financial institutions have extensive back-up systems to ensure that each night they keep multiple physical records of all account information. While some members of the public have expressed concerns for the safety of their deposits because they think records might disappear, there is no basis for this type of concern. The safest place for people to keep their savings is in the financial institution that they are already with. Withdrawal and conversion to cash would expose them to a lot of unnecessary risks. The vast majority of people, I believe, do not have those concerns, but they probably still have a few uncertainties. Many will wish to take more cash out to tide them over the New Year period than they normally do. To this group, I just want to make a few points: • Do not, for a minute, fear that you need to take out more cash because there may not be enough to go round. There will be. The Reserve Bank has printed, and is carrying in stock, a lot more notes than usual so that it can meet any increased demand. • If you are worried about high-tech systems such as ATMs or EFTPOS letting you down, remember you are only dependent on them for the first three days of the new year. After that, the banks, building societies and credit unions open their doors again and you can go back to the old-fashioned ways of obtaining cash. You are really only dealing with a long weekend. • Even in those three days, you are not completely dependent on cash – credit cards can, if necessary, still operate in their traditional paper-based mode and cheques can be used as normal. Overall, our view is that the system will be able to operate on a “business as usual” basis and the public should view the new year as just another long weekend. That is what I will be doing. For those who want a little extra reassurance in the form of extra cash, they can be confident that it will be readily available. That is all I wish to say in general terms about Y2K at this stage, but I will be happy to answer any detailed questions you wish to put to me. I am also conscious that I have been talking for quite a while, so that I have not left any time to cover the subject of bank fees. But with a copy of our paper at your disposal, I am sure you will find plenty of material to supply you with questions on that subject also. | reserve bank of australia | 1,999 | 6 |
A paper presented by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Reinventing Bretton Woods Committee Conference on 'International Capital Mobility and Domestic Economic Stability' in Canberra on 15 July 1999. | Mr Grenville discusses financial crises and globalisation from an Australian perspective A paper presented by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Reinventing Bretton Woods Committee Conference on “International Capital Mobility and Domestic Economic Stability” in Canberra on 15 July 1999. As part of the debate on the Asian crisis, two separate views emerged to explain the crisis – those who blamed deficiencies in the crisis countries themselves (cronyism, corruption, misguided policies and so on), and those who found intrinsic flaws in the international capital markets. Time has brought some perspective to these issues, and a consensus is emerging that a variety of problems contributed. Not surprisingly, with complex and multiple causation, there are lots of things to be fixed. The domestic/international dichotomy is still a useful one, here, because it allows us to focus exclusively on the international issues, without implying that the domestic deficiencies were unimportant. A conference on “Reinventing Bretton Woods” lends itself to exclusive focus on the international aspects, and, if “reinventing” is needed, something must have gone wrong with the old structure of discussion, rule - making and crisis response. The focus, in this paper, is on Australia, but we need to put this in a wider context to draw out the lessons for ourselves, and for others: Why were we in Australia not subject to the same degree of contagion as our near neighbours? As participants in the debate on reforming the international economic architecture, what elements of reform should Australia be promoting? Why Australia escaped There were certainly serious concerns, 18 months ago, that the Asian crisis would do significant damage to Australia. But it was not a concern about contagion and a repeat of the Asian problems – in the form of a major reversal of capital flows. Rather, the issue was that our international environment would be unfavourable, with stunted growth in our export markets, particularly in the region which had provided us with such a useful stimulus over recent decades. As things have turned out, domestic demand has remained strong (with very little adverse confidence effects from Asia), and the lower exchange rate effectively buffered us from the worst aspects that had been expected. But it is worth emphasising that no one, as far as I know, ever expected Australia to be sucked down into the same financial maelstrom – our adverse impacts were expected to be from secondary effects. It was always clear that we would avoid the direct contagion, because we were not subject to the fatal combination that had infected Asia – the interaction of large and volatile capital flows, with a fragile domestic financial sector. The capital flows to Australia are nothing like as volatile (and are not even as large): but, more importantly, we did not have a fragile domestic financial sector. It is true that Australia is very dependent on international capital inflows, with an average current account deficit of around 4½ per cent of GDP for the last couple of decades. These flows are large, but nothing like the flows experienced in Asia: in 1996, for example, Thailand received capital flows equal to 13 per cent of its GDP. Just as important, the capital inflows that funded the Australian deficit were, by - and - large, quite stable. Even in the mid - 1980s “Banana Republic crisis”, which saw a large change in the value of the Australian dollar, the most that the current account adjusted in any one year was a little under 2 per cent of GDP (in 1986/87). Compared with changes in current account balances in some countries in East Asia in 1998 of up to 15 per cent of GDP in a single year, our fluctuations were manageable. One - third or more of Australia’s capital inflow is in the form of foreign direct investment, which, even in the crisis countries, tended to be quite stable. A quite minor part was in the form of the elements which turned out to be extraordinarily volatile and flighty in Asia – bank - to - bank flows. The three crisis countries had been receiving bank - to - bank flows at an annual rate of around US$50 billion in the years leading up to the crisis, and were subject to outflows – total reversal – of nearly US$75 billion in the first nine months of the crisis. Nor, incidentally, were we vulnerable as a creditor: Australian banks had not lent much to Asia. Australia has had plenty of experience of changing sentiment – “flavour of the month” at one moment and poor cousin the next – but has not had the kind of total volte face experienced in Asia (“euphoria turned to panic without missing a beat” (Sachs 1997)). One reason why Australia is not subject to these sorts of dramatic reversals is the depth and maturity of our financial markets. The institutions and instruments that foreigners invested in tended to be longstanding and stable, with quite well-defined prices and behaviour, so there was no basis for the kind of blind-panic flight that occurred in Asia. Surprises occur in Australian financial markets, but not to the extent that occurred in Asia. More importantly, Australia’s financial sector (centred on the banks) was particularly strong. It might be worth pausing a moment, simply to record that the strength of the Australian financial sector was in large part because it had already had its “learning-by-doing” crisis nearly a decade earlier. Just about every episode of financial deregulation has been accompanied by a period of crisis and turmoil. In Latin America, in the 1980s, the nub of the issue is captured in the title of the definitive analysis of the period: “Goodbye Financial Repression, Hello Financial Crash” (Diaz - Alejandro 1985). Even the United States, less than a decade ago, experienced the Saving-and-Loans crisis, the direct result of lop-sided deregulation and market-distorting official guarantees. The United Kingdom and Japan had credit-induced asset booms and busts only a decade ago. Sweden experienced a meltdown of its financial sector in the early 1990s. Australia was not an exception to this generalisation, but had its crisis in the 1980s. It is hardly surprising that a cosy, protected financial sector, when newly exposed to the chill winds of international competition and much more hard-edged, sharp-pencil tactics, is at its most vulnerable. Perhaps the most dangerous aspect is that the additional competition lowers credit standards – the new competitors look for customers to lend to, and the old institutions preserve their markets by being readier to lend to customers who previously would not have been regarded as creditworthy. Deregulation gave borrowers a new-found freedom, and for some of them it was a case of giving them more rope with which to hang themselves. “Failure builds character”, they say: so, too, does failure give rise to a corrective process that makes a repeat less likely. We certainly had this experience in Australia during the 1980s, which was the main reason why our financial sector was in such good shape when the Asian crisis hit in the 1990s. The corporate sector also learned the dangers of currency speculation and became much more cautious. While recording the immunising effect of “been there, done that”, it might be worth remembering some aspects of this common experience. We had our own foreign-currency-denominated borrowing experiences (remember the Swiss franc loans?), but fortunately they were, at least in macro terms, insignificant. While we are remembering our luck, we might remind ourselves that Australia’s foreign exchange crisis (which occurred in the mid 1980s, associated with the “Banana Republic” debate) occurred separately from the prudential problems in the banking system, which are associated with the boom and bust of the asset price bubble of the late 1980s. Asia had its foreign exchange crisis superimposed on its prudential crisis. Most of the players in the Australian market have a good understanding of how the foreign exchange rate would normally behave – i.e. the exchange rate is reasonably well anchored in “the fundamentals”. But even in this world, some puzzling things still happen. One such puzzle is the Australian dollar’s tendency to move more than might be expected over the course of the commodity cycle. Even when terms-of-trade changes are temporary, we might expect some change in the exchange rate. But what we have seen, quite persistently since the float, is movement in the exchange rate by around 25 or 30 per cent between peak and trough, and this is much more than can be explained simply in terms of the proper textbook reaction to cyclical terms-of-trade changes (see Gruen and Kortian (1996)). We have, over time, learnt to adapt to this world. With low inflation well established now, there is less danger that these cyclical fluctuations in the exchange rate will damage inflationary expectations – they seem to be absorbed, to a large degree, in margins. The Reserve Bank’s response is to be ready to intervene in the more extreme swings of the exchange rate. We do this principally because there is always some danger, at the extremes, that these swings may damage confidence in the domestic economy (particularly in the downward swings). Incidentally, in the process, we make a tidy profit through the rather old-fashioned form of trading, under which we buy cheap and sell dear (Andrew and Broadbent (1994)). This experience, over more than a decade, has made us sceptical about the Friedmanite idea that speculators always buy cheap and sell dear, and if they do not, they quickly go out of business. Why have the processes of natural selection not weeded out our counterparties from this zero-sum game?1 With this experience in mind, we were less surprised than some when the Asian currencies, once unhooked from their semi-fixed pegs, moved excessively – each of them over-shooting dramatically, by far more than any conceivable initial over-valuation. For all the virtues and advantages of exchange rate flexibility, it is dangerously naïve to “sell” the idea that floating the exchange rate will be a painless solution to international financial integration. Having made the case that Australia was never vulnerable to the sort of catastrophic capital reversal that was experienced by some Asian countries, the question is: “why are we so interested in the issues of new financial architecture?”.The short answer is that we believe that international capital markets are not working as well as they should. Even if Australia can survive in the current world, we all (developed and emerging markets alike) would benefit from some changes in the international architecture. A reform agenda Since the crisis broke, there have been five issues on which Australia has spoken out in international forums: • Representational issues; • Hedge funds; • “Bailing-in” the private sector; • Capital controls; • Transparency. International representation At a recent conference on exchange rates run by one of the big players, they predicted dramatic further strengthening from the then-prevailing level of US66 cents. This was on the basis that the 55-day moving average had moved above the 200-day moving average, and that they were experiencing strong customer demand. I asked them why they had not recommended buying the Australian dollar six months earlier at US55 cents. If moving-average and market-momentum rules are the guide, then it is hardly surprising that over-shooting occurs - there simply are not enough market players looking at the “fundamentals”, and prepared to back their assessment. Well before the Asian crisis, it had been obvious that the international institutions formed shortly after World War II no longer represented the current world economy. As a small country, Australia accepts that many important international decisions will be made in a small sub-set of the largest countries, such as the G3. It is harder to accept that important decisions (such as the development of global prudential rules) should be made in a group as unrepresentative as the G10 – which contains four smallish European countries, of which only one is as large as Australia. If these institutions are Eurocentric (only one Asian: no Latin American representation), the exclusion of emerging markets is just as obvious. The IMF tackles these problems differently, with formal representation of all members – but few would doubt who is calling the shots, with America alone having enough votes to veto issues. Constituencies represent hugely different population sizes and degree of interest in international issues. This is why we were so attracted to the idea of G22, when it formed in the aftermath of the Asian crisis. In this form, it has been vetoed by the European countries not yet ready to give up their over-representation on international economic issues. These issues are on-going and unresolved, but one beneficial result of the Asian crisis is to bring this issue to the fore, and while G22 no longer exists, a wider representation on the working groups discussing some of the important issues (such as highly-leveraged institutions, offshore markets and short-term capital flows) has been achieved.2 Hedge funds As noted above, Australia had its searing experiences with volatile exchange rates in the mid 1980s, but has now come to terms – and is comfortable – with its floating exchange rate. We think that, in general, it works well, and that the float has been enormously beneficial for Australia. We have come to accept some over-shooting as a puzzling but tolerable quirk of the market. In the most recent episode (coinciding with the Asian crisis), however, we saw a variant on this theme – speculators who believe that they can make money by attacking an exchange rate which has already over-shot, so that it over-shoots even further. The tactic is straight-forward enough – quietly take a short position in the currency which is already a bit under-valued, and then, by a mixture of highly-public additional short selling and vigorous orchestration of market and press opinion, get the exchange rate to move down quite a bit further. As it does, a bandwagon forms, with market players anxious to sell the currency as it becomes cheaper, in the belief that it will become cheaper still. As the herd moves in, the original speculators can square-up their position, at a profit. This is the world that we saw in operation in the middle of last year. As a matter of shorthand, we have referred to these attacks as being driven by hedge funds, but this terminology is probably more specific than we need to be to make the point. It is worth emphasising, here, that we think it was useful that the Australian dollar moved down somewhat in 1998, reflecting the fundamentals of a much less benign external environment. This softening of the exchange rate was an important factor in buffering Australia from the external crisis. But too much of a good thing is a bad thing. The gathering downward momentum, one-sided sentiment and thin market were certainly matters of considerable concern to us, in the middle of last year, and this was reflected in our actions to support the exchange rate. The most disturbing element of this is that it was part of a concerted effort at market destabilisation. Some of the players themselves told us, at the time, that their objective was to push down the yen to the stage where the renminbi was under irresistible pressure to devalue, which would have broken the Hong Kong dollar peg. The Australian dollar was a minor secondary target – collateral damage – for these Masters of the Universe. As things turned out, we came through this episode quite well. But it is a matter of historical record that this episode came to an end because of the combined effects of the LTCM near-meltdown and the financial crisis in Russia – we were saved by crises elsewhere. So We note with some satisfaction that the Financial Stability Forum has recently been enlarged to include some non-G7 economies, including Australia. while we came through that episode quite well, and we are confident that we have the resilience to weather similar episodes, we carry from this experience a strong viewpoint into the debate on international financial architecture concerning the hedge funds (or, as they are known in that context, the “highly-leveraged institutions”). There are those who deny, even now, that the hedge funds played any significant role. For these pundits, it may be enough to simply observe that the hedge funds themselves do not deny their actions (George Soros has written a best-selling book about it!) – it walks like a duck, quacks like a duck and says it is a duck – what more evidence do you want? But the movement of exchange rates over the period – even large currencies such as the yen – provides more evidence. As the hedge funds cut their short positions in yen to cover their disasters in the rouble, the yen rose 15 per cent in a little over a day, driven by events unrelated to any Japanese “fundamentals”. Is this a well-functioning market? When we first talked about our experience with hedge funds in mid 1998, this was derided as “the Australian anecdote”. But you may recall the old quip about the plural of “anecdote” being “data”.Hong Kong, South Africa, Malaysia and Thailand all pointed to their “anecdotes”. Then came the near-collapse of LTCM: the tenor of the debate changed. But as the LTCM crisis recedes, international concerns have become more muted, even stifled. The G7 authorities are prepared to concede that there were prudential issues involved in the high leverage of these funds – it threatened those who had lent to them. But there is less recognition of the market integrity issues involved – i.e. the general damage they do by inducing more volatility (and otherwise-unnecessary interest rate increases) into exchange markets (see two papers by the RBA (1999)). Bailing-in the private sector We have argued that there should be a greater readiness, in the event of crisis, to “bail-in” privatesector creditors – i.e. to require a stand-fast on repayments and the working out of orderly arrangements for repayment, which may well involve delay in repayment and, possibly, creditors taking a “hair-cut” on their repayment. Some private-sector participants in this debate have articulated a sort of bewildered resentment at the idea of compulsory bailing-in in the course of an orderly debt arrangement: they talk in terms of “consenting adults”, who have freely made a contract which no-one else should rend asunder. It does, however, seem a bit more complicated than this. First, private creditors accept, within all domestic jurisdictions, the possibility of bankruptcy procedures in extremis, which involve two elements – the declaration of inability to pay in full; and some kind of stand-fast in which the available assets are assembled and decisions made on an equitable distribution. This procedure, everywhere, over-rides individual deals done either before or after the event. The justification for this is that an orderly arrangement is better for just about everyone than an unseemly rush to seize any available assets. This rationale carries over into the international forum in principle, although of course finding legal jurisdiction is another matter altogether. This was well illustrated in late 1997, when Korea was within a couple of days of defaulting on government-guaranteed bank debt owed to foreign banks. Under the detailed orchestration of the US and IMF authorities, a deal was struck whereby US$24 billion of bank-to-bank debt was rolled over, at an attractive interest rate for creditors. This deal changed sentiment towards Korea dramatically, and it would be hard for any creditor to claim that the outcome was anything except greatly beneficial to them. But the case for bailing-in the private sector goes beyond this, at least in cases where the official sector (often through the IMF) has taken part in something analogous to a “lender-of-last-resort”, in which additional funds are made available to shore-up creditor confidence. The rationale for such a facility goes beyond the normal bankruptcy arrangements, to the further argument that where the problem is one of liquidity rather than insolvency, a lender-of-last-resort will avoid “runs” on debtors. Given that it is taxpayers’ money (usually via the IMF) which is being put at risk to bail-out privatesector creditors, taxpayers are entitled to expect some contribution from the creditors. The relevant lessons come from Mexico in 1994/95. Prior to the crisis, investors had received higher returns for the risk they were running. When confidence evaporated and creditors refused to roll-over their loans at the end of 1994, default loomed. The IMF and the US Government acted as lender-of-last-resort, repaying all creditors in full and without delay. This was, in almost all aspects, extremely successful. The “run” was contained, and Mexico experienced a “V-shaped” recovery. But it did highlight the moral hazard that goes with bail-outs – it left the impression that lenders would be protected when things went wrong (see Dooley (1997)). The contrast to this is bailing-in the private sector – enforcing a stand-fast and “hair-cut”. This not only addresses the source of the immediate problem, but it is also equitable, and directly addresses the moral hazard problem. In making this case, Australia has argued that such arrangements should focus exclusively on sovereign or quasi-sovereign debt, in particular the bank-to-bank flows: the bulk of the capital reversal in Asia was taking place between banks, who were using their access to government guarantees in order to finance the capital outflow. This makes an important distinction between those who can easily “take the money and run” (on the basis of government guarantee) and those who lent to non-banks, who will have to work through the domestic bankruptcy system to gain repayment. Much self-righteous indignation has been expressed by private-sector creditors at the very idea that the authorities might impose stand-fasts and hair-cuts on them. This would sound less disingenuous if it was not coming from the same voices who were so astounded by the Russian default of August 1998 – astounded not by the patently parlous creditworthiness of the country they had lent to, but by the absence of any official rescue package to save them from default. Controls on capital flows Two important lessons from the crisis are: • That short-term flows were particularly vulnerable to reversals; • That the transition from financial regulation to deregulation is a particularly vulnerable time. There is now a wide acceptance that, instead of a blanket presumption in favour of quick and complete financial deregulation, deregulation should be “orderly”, keeping pace with the build-up of the necessary institutional infrastructure – particularly capacity for prudential supervision. While this is now generally accepted, the operational corollary of this is not. If the problem was the huge capital inflow, what will prevent a recurrence when the next wave of euphoria arrives, and later evaporates? One aspect is clear enough – far-reaching prudential rules should be put in place – e.g. restrictions on banks’ short-term borrowing and on foreign-currency-denominated borrowing. In putting these prudential rules in place, it is important not to simply shift the risks out of the formal financial sector but leave the risk with those who are even more vulnerable – this just makes room for more problems later. The other issue is whether Chilean-style controls on short-term capital inflow may also be useful. Such restrictions on short-term borrowers may not be perfect, but they make more sense than some of the alternative “solutions” which have been put forward. One suggestion (quoted by Greenspan (1999)) is that countries should hold foreign exchange reserves equal to all the short-term debt which is going to fall due over the next year. If this is a serious suggestion, then it raises the issue of why this short-term debt was useful in the first place, if the proceeds of the short-term borrowing have to be stacked away in reserves (at a lower rate of return than the cost of borrowing). One lesson is that countries should resist the blandishments to set up arrangements like the Bangkok International Banking Facility, and should keep a very wary eye out for the operations of fly-by-night, foot-in-the-door financial entrepreneurs whose aim is to sell sophisticated (i.e. hard to understand) financial products to unsophisticated (i.e. gullible) customers, under the guise of “market broadening” Transparency Great emphasis has been placed on transparency – and it is as hard to disagree with this as it would be to disagree with the notions of peace, freedom and motherhood. But the transparency which is being advocated in the debate is a very partial concept. Whereas a case could be made that markets work better if all participants have full information, the emphasis so far has been confined to getting the official sector to give detailed and frequent information on foreign exchange reserves, for example. Meanwhile, the hedge funds and other major players can hold their cards close to their chest (even the investors in LTCM were not given details of the portfolio). If markets truly work better when better informed, this principle should apply to all players who are big enough to move markets. This view is gradually being accepted in some of the work taking place currently in the international arena, so I am hopeful we will see increased disclosure by all market participants over the coming couple of years. The context of the debate: Globalisation Given the complexity of the issues, it has been disappointing that much of the debate has been driven by ideology. Specifically, ideology seems to add a special piquancy to the debate on capital flows. The argument here is reminiscent of similar debates on “free floating” for the exchange rate: “free”, in this context, has the same connotation as “the free world” or “free speech”, i.e. indisputably a Good Thing. Absence of any rules seems to be a particular virtue. A theologian picked up the flavour of the debate, likening the arguments in The Wall Street Journal to his own specialisation: “Behind descriptions of market reforms, monetary policy and the convolutions of the Dow, I gradually made out the pieces of a grand narrative about the inner meaning of human history, why things had gone wrong, and how to put them right. Theologians call these myths of origin, legends of the fall, and doctrines of sin and redemption.” (Cox 1999).3 Some commentators took this vantage-point because they wanted to view the issues as part of a wider debate on the inevitable global triumph of the free-market paradigm (see, for example, Zuckerman (1998)). It was, in many ways, a curious prism through which to view the issues, because it was pretty clear that – whatever the deficiencies of alternative systems – this was hardly a triumph of market forces. Whatever the advantages of more open capital markets, the collateral damage from the excessive inflows and the subsequent massive capital reversals has been great, and could hardly be justified in terms of some market-clearing or “tâtonnement” process. Whereas it seems hard to deny that for every foolish borrower there had been a foolish lender, the response was to argue that there had been a “shortage of liquidity” (i.e. people could not get out of their positions quickly enough!) or deficient transparency (investors, by some extraordinary oversight, were unaware of cronyism, corruption or lack of effective bankruptcy procedures). For some, this response was part of the commercial imperative for maximising the return on investments – if investors were seen to have been foolish, then this would reduce the chance of them getting official assistance in repayment. At a risk of sounding cynical, it could be argued that the loudest voices came from the representatives of financial markets, who not only saw commercial advantage in continuing to open-up new markets, but for whom the experience of Mexico in 1994/95 was quite satisfactory, and required no modification – they achieved good returns (including a risk premium) in good times, and they were bailed out – to a greater or lesser degree – in the bad times. The same tone had been picked up much earlier: “Economic liberalism was the organizing principle of a society engaged in creating a market system. Born as a mere penchant for non-bureaucratic methods, it evolved into a veritable faith in man’s secular salvation through a self-regulating market.” (Polanyi 1944, p. 135). The free-market triumphalists found allies elsewhere. In academic circles, over the years, considerable intellectual endeavour had gone into showing that markets are efficient – whatever the convoluted and volatile path of financial prices over time, this is not only rational but indeed optimal (see, for example, Garber (1990)). The rationale for any one participant in pushing the price further away from its fundamental equilibrium was often along the lines of the “greater fool” presumption – however artificially high the price, someone would pay more for it later. So the first stage of the debate, following the crisis, had an almost surrealistic air about it, with the IMF pressing at its Annual Meeting in Hong Kong at the end of 1997 to add capital account deregulation to its mandate, at the very moment when the excessive inflows and reversals had been shown to be so damaging. The wider debate on globalisation is, of course, very relevant. One recent contribution (Friedman 1999) provides useful terminology. He talks of the “Electronic Herd” – the anonymous fund managers behind their screens – and sees the proper response for emerging markets being to don the “Golden Straitjacket” – whose specifications are a predominantly private-sector economy, balanced budgets, low tariffs, and open capital markets, including unrestricted foreign investment. This sounds very much like the “Washington Consensus”, and as a framework of reference it makes good sense, particularly if it accepts the feasibility (and indeed the desirability) of some adaptation to the local environment, and acknowledges that there is more to a successful society than an identikit market economy. Friedman acknowledges complexities and subtleties – indeed, his title (The Lexus and the Olive Tree) emphasises the need to balance technology with tradition. And he does not confuse inevitability with desirability, as the triumphalists do. But two aspects – the inevitability of the process and whether the end-point is the pure free-market model – require further comment. Some powerful forces clearly do encompass the globe in an irresistible way – some reflecting superior technology; some reflecting the need for a common standard; and some, the greater world integration through the communications revolution. There are plenty of examples of “winner takes all” – a dominant player or technology. But there are just as many examples of persistent national characteristics and behaviours. To imply that the whole package of essentially-US systems and values has to be accepted holus-bolus over-simplifies the forces at work. Perhaps just as important, it would be a mistake to see these forces of globalisation attaching themselves uniquely to a textbook competitive free-market model.4 Many aspects of globalisation are, in fact, the opposite: a dominant technology, a winner-takes-all player or a set of market behaviour rules such as the Basel Capital Adequacy Rules are hardly the world of atomistic competition of the textbooks. Far from demonstrating Adam Smith’s invisible hand, globalisation is occurring within a complex set of rules, technical standards and regulations – some imposed by governments, but others by technological imperatives or by the private players in markets. This is not to suggest that the end-point should be the 19th century brand of capitalism foreseen by some of the global triumphalists. “On the brink of the 21st century, the United States is at a point reminiscent of its entry into the twentieth. … Today, of course, the new frontier is the global economy.” (Zuckerman 1998, p. 20). Not everyone feels so warmly sentimental towards the age of Robber Baron capitalism, and some may feel uncomfortable with the idea that “unimpeded access to Friedman (1999, p. 85-86) comes close to putting this pure free-market view: “those people who are unhappy with the Darwinian brutality of free-market capitalism don’t have any ready ideological alternative now. When it comes to the question of which system today is the most effective at generating rising standards of living, the historical debate is over. The answer is free-market capitalism … Today there is only free-market vanilla and North Korea.”. that burgeoning marketplace was the one indispensable condition for the flowering of American enterprise” (ibid, p. 20).5 We need to ask, at the same time, whether the allocation decisions of the Electronic Herd make sense from an economic viewpoint – are they shifting the capital (and the real resources it represents) to the highest global usage? On recent performance, the answer would have to be “no”. Leaving aside the extraordinary volte face from optimism to pessimism in Asia (and the mis-allocated investment that preceded the crisis), does the reassessment of US equity prices in 1987 (in the deepest market with the fullest information) make sense? Or the gyration of the yen/US dollar rate, from 80 in April 1995 to 147 a couple of years later? Are markets, with their constant quest to respond to the latest data, factoid, or rumour, the best allocators of capital and reliable guardians on the gateway to investment? Have the umpires – the credit-rating agencies – been forward-looking and insightful in their judgments? What should economies which did wear the Golden Straitjacket but were still subject to speculative attack (e.g. Hong Kong) do? In short, should we be spending more analytical time examining the behaviour of the herd, rather than simply noting its inevitability? If we accept that the outcomes of globalisation are not, in all their manifestations, good, and that countries are not simply pawns on the global chessboard, then what needs to be worked out, on a case-by-case basis, is what modifications to the cut of the Golden Straitjacket can feasibly be achieved. Is it feasible to discourage the more volatile elements of the herd?6 Some have resisted extra rules (collective action clauses and explicit efforts to limit moral hazard), on the grounds that these will reduce the flow of capital to emerging countries. If absence of moral hazard and full pricing of risk meant that capital flows would be smaller, then this has to be a plus rather than a minus. If this meant that very little short-term capital flowed to emerging markets, then it would be hard to argue that there would be any great loss.7 The harder question is how to achieve effective restraint. But this should be possible. Just as anomalies in the Basel Capital Adequacy Requirements artificially encouraged bank-to-bank short-term inflows, feasible rules can influence outcomes in the opposite direction. Countries can, at least, avoid the frictionless conduit represented, for example, by the Bangkok International Banking Facility. Markets can and do accept differences between regulatory regimes, and the view that all capital will flow to the country which prostrates itself lowest before the demands of the market seems nonsensical. After all, each of the crisis countries attracted excessive inflows into regimes which departed substantially from the Golden Straitjacket. More recently, Malaysia tapped international capital markets at a time when its anti-market rhetoric was still fresh in the minds of investors. The starting point should accept the benefits of capital flows and the power of markets in allocating resources, but should also recognise that in just about every domestic market there are (often extensive) “rules of the game” and market infrastructure: what is needed now is a similar set of rules of the game for international flows. And there should be no presumption that the Electronic Herd should, alone, set the specifications of the Golden Straitjacket. There are tricky issues here – for example, the handling of intellectual property rights will determine how the benefits are shared between creator and user. These are not issues which the free market determines well, and a framework of rules is needed to get efficiency and equity.8,9 “The markets” were seen, even in the age of unbridled capitalism, as being especially volatile: “While the productive labors of a society, the functioning of its ships and railroads, its mills and factories, give the effect of a beautiful order and discipline, of the rhythmic regularity of the days and seasons, its markets, by a strange contrast, seem to be in a continual state of anarchy.” (Josephson 1934, p. 192). In Friedman’s terminology, the short-horn cattle. This argument has particular force in relation to Asia, where national saving rates have been so high. Similar variation may be possible in other rules. Bankruptcy rules, for example, have to fit societies’ views on balancing creditor and debtor rights. Competition rules, patent rules, legal decisions, all find their basis in individual societies, with views on property rights and equity which are not ruled solely by the market. Capital will follow risk-adjusted profit opportunities, and within this constraint, countries have opportunities to protect their societal interests. It would be nonsensical for a country to insist on reinventing, ab initio, technology or rules (e.g. Basel Capital rules for prudential supervision or accounting rules), but it seems entirely feasible for countries to put their own supplements on rules, without becoming pariahs in the eyes of international financial markets. Globalisation is an opportunity for countries to improve their living standards. It is up to individual countries to decide how deeply they will avail themselves of this opportunity. It is not an all-or-nothing choice.10 They may well pay a price for this, in terms of GDP, but this is a choice countries can (and will) make. Total failure does not await those who modify the rules, sensibly, to fit their views of society and who recognise that you cannot neatly split production and distribution issues.11 Sovereignty may have been modified by the Internet, but it has not been abolished. The early analogy put forward (by Larry Summers (1998)) was with airline travel – bigger planes had brought great benefits of cheap travel to a wider group, and if this involved the occasional dramatic large accident, this should not be seen as a reason for banning international plane travel. But where does this analogy lead? Surely to the dual acceptance of the benefits to be derived from the new technology, with the need – at the same time – to do whatever can be done to make travel safer – even if this involves some rules and regulations. Seen in this light, we are back where we should always have been in this debate – contemplating the transition from regulation to liberalisation, acknowledging the desirability of moving along this path as quickly as possible, but also acknowledging that it is a bumpy path. There has been, since 1997, some progress. The core rhetoric no longer simply extols the importance of immediate and total deregulation, but now puts in words like “orderly” to describe the process. To acknowledge this is one thing: to put it in place is another. In trying to put some practical content into the idea of “orderly” deregulation, there may be reminders of the old Irish joke about asking the way to Limerick: “I wouldn’t go there from here”. There is fairly unanimous agreement that we do want to go there from here. But deregulation has some of the characteristics of a rolling snowball, whose momentum is self-generated and uncontrollable. While there is a longstanding and extensive literature on “sequencing”, it is rather unsatisfactory. Countries often take the reform/deregulation opportunities in whatever order they come along. More seriously, the necessary infrastructure is not something which can be created instantly,12 or even in advance of the requirement. Rather, it is put in place by trial-and-error and learning-by-doing, and some old-fashioned good luck is required to get this safety net firmly in place before it is needed. What is pretty clear is that the process of “reform-throughcrisis” is a very painful one. Conclusion When the Asian crisis first broke, some of us thought of it as an opportunity for reform: there would be some pain, but the forces of beneficial change would be given impetus. We had in mind, I suppose, some version of the Golden Straitjacket. As the crisis developed, it became clear that for some As more international trade takes place in “weightless” technological services and products whose marginal cost is small compared with the average cost, the copyright and patent rules become more important. Countries which are large producers of high-technology product and intellectual property will be interested in incorporating into the Golden Straitjacket rules which protect their citizens’ commercial position. Singapore and Taiwan provide successful examples - they restrict their banks from lending domestic currency offshore, making it difficult for foreign speculators to “short” the currency. As implied by Friedman’s matrix (1999). Dennis de Tray (1999) describes it this way: “globalization operates at light speed along fiber optic cables, while institutional development takes decades.”. countries (e.g. Indonesia) the downside of the crisis was far outweighing the opportunities for seizing the moment to reform. For all of these countries, the ideas embodied in the Golden Straitjacket, or the Washington Consensus, have much to be said for them. Many of the elements were things which these countries had been striving (however imperfectly) to put in place. The danger, now, is that the idea will be over-simplified and over-sold. I have argued, here, that the basic elements of the Golden Straitjacket are desirable and, over time, feasible. But it should be possible to adapt it, to some extent, to the local environment and – more importantly – modify it so that the Electronic Herd is not so damaging. So this takes us back to the issues raised in Section II – the various proposals made within the context of the New Architecture debate. Each of the elements Australia has advocated are aimed at building on the Rules of the Game – bailing-in the private sector; restraining short-term capital; and increased disclosure by major participants, including hedge funds. Greater transparency is something which all market participants (not just the official sector) should observe. And, finally, wider representation in the economic councils of the world would give more legitimacy to the Rules of the Game. If the Golden Straitjacket is to be the current international fashion, then its design should be a more democratic process, not confined to groups representing the (very different) international world of half a century ago, egged on by those who want to use globalisation as a battering-ram for their narrow commercial advantage. Some of the discussion of globalisation is in terms of a kind of breathless proselytising for a meta-trend whose time has come – “coming ready-or-not” globalism. Rather, it should be an opportunity to reap the rewards which come from sensible international integration. References Andrew, R. and J. Broadbent (1994), ‘Reserve Bank Operations in the Foreign Exchange Market: Effectiveness and Profitability’, Reserve Bank of Australia Research Discussion Paper No. 9406. Cox, H. (1999), ‘The Market as God’, The Atlantic Monthly, March, pp. 18-23. de Tray, Dennis (1999), ‘World Bank’s Lessons from Indonesian Economic Crisis’, Jakarta Post, 14 April. Diaz-Alejandro, Carlos F. (1985), ‘Goodbye Financial Repression, Hello Financial Crash’, Journal of Development Economics, September/October, 19, pp. 1-24. Dooley, M.P. (1997), ‘A Model of Crises in Emerging Markets’, NBER Working Paper No. 6300. Eichengreen, B. (1999), ‘One Economy, Ready or Not’, Foreign Affairs, May/June, 78(3), pp. 118-122. Folkerts-Landau, D. and P.M. Garber (1999), ‘The New Architecture in Official Doctrine’, Global Markets Monthly, Vol. 2, No. 2, April 1999, a publication of Global Markets Research, Deutsche Bank AG. Friedman, Thomas L. (1999), The Lexus and the Olive Tree, Farrar, Straus & Giroux, New York. arber, Peter M. (1990), ‘Famous First Bubbles’, Journal of Economic Perspectives, Vol. 4, No. 2, Spring, pp. 35-54. Greenspan, A. (1999), Remarks by Chairman of the Board of Governors of the Federal Reserve System before The World Bank Conference on Recent Trends in Reserves Management, Washington, DC, 29 April. Gruen, D. and T. Kortian (1996), ‘Why Does the Australian Dollar Move so Closely with the Terms of Trade?’, Reserve Bank of Australia Research Discussion Paper No. 9601. Josephson, M. (1934), The Robber Barons: The Great American Capitalists 1861-1901, Harcourt, Brace and Company, New York. Krugman, P. (1998), ‘America the Boastful’, Foreign Affairs, May/June, 77(3), pp. 32-45. Polanyi, K. (1944), The Great Transformation, Octagon Books, New York. Reserve Bank of Australia (1999), ‘The Impact of Hedge Funds on Financial Markets’, paper submitted to House of Representatives Standing Committee on Economics, Finance and Public Administration’s Inquiry into the International Financial Markets Effects on Government Policy, June. (This paper is available on the Bank’ s web site - http://www.rba.gov.au) Reserve Bank of Australia (1999), ‘Hedge Funds, Financial Stability and Market Integrity’, paper submitted to House of Representatives Standing Committee on Economics, Finance and Public Administration’s Inquiry into the International Financial Markets Effects on Government Policy, June. (This paper is available on the Bank’s web site - http://www.rba.gov.au) Sachs, J.D. (1997), ‘The Wrong Medicine for Asia’, The New York Times, 3 November. Soros, G. (1998), The Crisis of Global Capitalism, Little, Brown and Company (UK), London. Summers, L. (1998), ‘Go with the flow’, Financial Times, 11 March. Zuckerman, M.B. (1998), ‘A Second American Century’, Foreign Affairs, May/June, 77(3), pp. 18-31. | reserve bank of australia | 1,999 | 7 |
Text of the eighteenth R.C. Mills Memorial Lecture delivered by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, in Sydney on 29 July 1999. | Mr Macfarlane elucidates the stability of the financial system and comments on what the Reserve Bank of Australia needs to do to fulfil its financial stability responsibilities Text of the eighteenth R.C. Mills Memorial Lecture delivered by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, in Sydney on 29 July 1999. It is an honour to be here today at the University of Sydney delivering the eighteenth R.C. Mills Memorial Lecture. It is customary to start a Memorial Lecture by paying homage to the person in whose memory the lecture is held, but I would like to break with tradition and do that a little later where it fits in more naturally. On nearly every occasion when I speak before an audience such as this, I talk about some aspect of monetary policy. That is what is expected of me because people – very naturally – associate central banks with monetary policy. Monetary policy’s major task is to contribute to sustainable economic growth through maintaining low inflation, as we have been doing with some success during the 1990s. I have talked about this at length elsewhere, and I am sure that informed people are well acquainted with the current monetary policy regime in Australia, which is based on an inflation target, an independent central bank and a floating exchange rate. As a result, I do not wish to take up any more time going over old ground. The subject of financial stability does, however, call for some public explanation. For a start, a lot of people are unsure of exactly what it means. Additionally, there are those who are unsure of what its relation is to central banking, which, as I have just said, they usually associate with monetary policy. In the remainder of my lecture I would like to cover both these topics, plus two other issues: what does the Reserve Bank need to do to fulfil its financial stability responsibilities; and whether the changes we have seen in the structure of financial systems over recent decades have made the system more or less stable. (i) What is financial stability? Financial stability is the avoidance of a financial crisis. A financial crisis is a more modern term for describing what used to be called “banking panics”, “bank runs” and “banking collapses”. We use the broader term financial because, with today’s more sophisticated financial systems, the source of the crisis could be the capital markets or a non-bank financial institution rather than a bank, although almost certainly banks would become involved. A well functioning financial sector is critical to an economy’s well being because it is so intimately connected to every other sector of the economy through its role of providing credit. When large-scale failures occur among financial institutions, the supply of credit dries up and this quickly leads to cutbacks in other industries. Additionally, the finance sector is the part of the economy that is most susceptible to crises of public confidence. A problem that hits one part of the finance sector can quickly spread to the rest of the sector, and then to the economy more widely. Once it becomes widespread, it is termed a systemic financial crisis to distinguish it from one that is confined to a single institution or a very narrow part of the financial system. Another way of approaching financial stability is to look at it from the perspective of developments in the overall economy. There is widespread recognition in the community that the normal growth path of an economy is not smooth. We have all lived through a number of business cycles, and although we wish that the cycle could be abolished, most of us are resigned to the fact that expansions cannot go on forever, and they will be followed by a recession. Provided that these recessions are not very frequent and not very deep, public confidence in the legitimacy of the economic system remains intact. The problem with a serious bout of financial instability or a systemic crisis – inevitably involving a boom in asset prices, followed by a bust – is that it makes the recession much deeper and longer, and can even turn it into a depression. The best known example of this is the Depression in the United States in the 1930s, the severity of which is now widely attributed by modern scholars to the collapse of the US banking system.1 Australia had a similar experience in the Depression of the 1890s, and some more recent examples, which I will cover later, contained some of the same elements, although fortunately on a smaller scale. Over the past three years, we have witnessed the Asian economic crisis, the depth of which is largely due to the collapse of financial systems in these countries. Although it is not well known in Australia, the Nordic countries (Sweden, Norway and Finland) went through a similar experience a decade ago.2 In short, it is possible to have a normal business cycle where financial stability remains intact. These are usually quite mild cycles. It is also possible to have cycles where financial instability plays a large role. These are usually very severe. Thus, there are very good reasons for a country to do what it can to avoid financial instability. History shows that it does not happen very often, but when it does, its effects can be devastating. Table 1: Cost of Recapitalisation Country Period Cost as per cent of GDP Spain United States (Savings & Loans) 1977-1985 1984-1991 16.8 3.2 Scandinavia Finland Norway Sweden 1991-1993 1987-1989 8.0 4.0 6.4 Latin America Chile Mexico 1981-1983 41.2 13.5 Asia Indonesia Korea Malaysia Philippines Thailand 1997-1998 1997-1998 1997-1998 1981-1987 1997-1998 34.5 24.5 19.5 3.0 34.5 Sources: Caprio and Klingebiel, World Bank, July 1996. World Bank, Asian Growth and Recovery Initiative, 1999. Another direct and measurable cost of financial crises is the cost to taxpayers of fixing them. When there is widespread failure of banks and other deposit-taking institutions, the Government invariably pays out depositors in full or in part, whether or not there is a formal system of deposit insurance. Financial institutions also have to be recapitalised in order to allow them to start lending again. The cost to the Budget of both these types of assistance can be enormous, as shown in Table 1. Note that the figures given for Asian countries are only estimates as the final bill has not yet come in. The outcome could be lower or higher, depending largely on how quickly Asian countries resume their growth path. See, for example, Bernanke (1983) and Romer (1993). See Llewellyn (1992). (ii) Central banks and financial stability The idea that a central bank should have responsibility for financial stability has roots deep in the history of central banking. Indeed, in many countries, financial stability considerations were the original reason for the formation of the central bank. Perhaps the best example is the United States. The establishment of the Federal Reserve System in 1913 was a direct response to the bank runs and financial panic of 1907. It was only later that an explicit monetary policy role was grafted onto the Federal Reserve’s financial stability responsibility. Elsewhere too, financial stability issues played a significant role in central banking. By the end of the 19th century, the Bank of England was well practised in acting as the lender of last resort. In the 1850s and 1860s, following the bursting of speculative bubbles in the US and UK railroad sectors, it lent freely to institutions to prevent financial panic, as it did during the Barings crisis of the 1890s. In France, the unravelling of speculative positions in the stock market in 1882 led the Banque de France to provide secured loans to the Paris Bourse. In Italy, the collapse of a building boom in Rome and Naples in 1893, and the resulting failure of one of Italy’s largest banks, prompted the creation of the central bank, the Banca d’Italia.3 Financial stability considerations also played a role in the development of central banking in Australia, although less explicitly than in the United States. In the early decades of this century there were strong advocates for a central bank along the lines of the Bank of England. Progress, however, was hampered by ideological debates about the role of private banking, and by concern that a central bank would out-compete private banks. While the Commonwealth Bank did take on some central banking functions in the 1920s, including note issue and the provision of settlement accounts, the watershed was the 1936 Royal Commission. It is here that we return to Professor R.C. Mills. In between establishing the economics department of the University of Sydney and chairing the University’s Professorial Board, Professor Mills played a prominent role as a member of the Royal Commission. As S.J. Butlin notes in his biography of Mills, the structure of the Commission’s Report and its drafting owes much to Mills’ hard work and his ability to argue and persuade. Mills was an advocate of a strong central bank with responsibility for ensuring the overall stability of the financial system and the economy. He, and his colleagues on the Royal Commission, argued that the private banks had intensified economic fluctuations by lending aggressively during the boom of the late 1920s and then contracting lending harshly during the Depression. This was seen to be a repeat, although on a smaller scale, of the situation in the 1880s and 1890s. The Commission argued that a strong central bank might have been able to limit the unhealthy expansion that eventually brought about the crisis. The idea that a central bank should seek to restrict those developments in the financial system that threaten the health of the economy strikes a strong resonance today. The difference between today’s interpretation and that advocated by Mills and his colleagues is a subtle, but important, one. In the 1930s, banks dominated the financial system, and a framework of regulation on banks was seen as the best way to ensure financial stability (and to operate monetary policy). Today we realise that heavy regulation stifles competition and innovation, and is an ineffective mechanism for monetary policy – even though it can achieve a high degree of financial stability. We also recognise today that, while banks remain at the core of the financial system, financial markets – and by this I mean the money, debt, equity, derivative and foreign exchange markets – play a much bigger role than they did in the 1930s. Control of banks is no longer the same thing as ensuring financial stability – the issue is now much more complicated. Indeed, following the recommendations of the Wallis Report in 1997, the Government specifically separated the prudential Goodhart (1985) gives a comprehensive review of this history. supervision of banks from the Reserve Bank and vested it in a completely new institution, the Australian Prudential Regulation Authority (APRA). This sounds on the surface to be very different from the sort of world envisaged by Mills, but it is only so in a managerial sense, not in a fundamental economic sense. The Reserve Bank still has dual responsibilities for monetary policy and financial system stability, something of which Mills would have approved. And, of course, these two responsibilities were spelled out again in the Wallis Report, and in the speech by the Treasurer when introducing the Wallis reforms. What is different now is that the day-to-day face-to-face process of bank supervision, with its setting of standards, monitoring, interpretation and data collection, is carried out in a separate agency – APRA – which also has responsibility for the equivalent supervision of other deposit-taking institutions, insurance companies and the superannuation industry. APRA’s role is an extremely important one. Recent events in Asia have reminded us that good supervision of financial institutions is the single biggest contribution that governments can make to ensure financial stability, whether it is the central bank or another agency that carries out the actual work. While the present system is managerially a different arrangement to the one it replaces, it is not fundamentally different in kind. There are still very close relations between bank supervision and financial system stability through the close connections between the Reserve Bank and APRA (with the former having two Board positions on the latter). In addition, there is the Council of Financial Regulators, which brings together the heads of the Reserve Bank, APRA and the Australian Securities and Investments Commission (ASIC). The fact that I chair this group reinforces the point that the Reserve Bank has not vacated its responsibility for overall system stability, even if it no longer does the “hands on” supervision of banks. (iii) The Reserve Bank and financial stability I would now like to turn to the third issue: how the Reserve Bank meets its financial stability responsibility. Here it is useful to think about two broad sets of policies: those that help prevent financial disturbances and those that counteract the effects of disturbances if they occur. I will start with the first set. Policies that help to prevent crises (a) Maintaining low inflation When listing policies that help to prevent financial crises, the first one we come to is the maintenance of low inflation. It stands to reason that a background of low inflation is less likely to underpin rapidly rising asset values, and the speculative excesses that go with them, than a background of high inflation. But we should not take too much comfort from this, as events in Japan remind us. A better formulation would be to say that low inflation is probably a necessary, but not a sufficient, condition for financial stability. The transition phase from high to low inflation and from high to low interest rates can actually raise some asset prices for very good reasons.4 Similarly, if the move to low inflation has coincided with the deregulation of financial markets, the first observed effect may be increased instability.5 As so often in economics, it takes a long time to observe changed behaviour in a new steady state, such as low inflation; most of our recent observations come from transition phases between one regime to another. A transition from a period of high inflation to a period of low inflation usually leads to a reduction in real, as well as nominal, interest rates which, other things equal, would cause a rise in equity prices. Also, at lower nominal interest rates, people’s borrowing capacity rises, which can also lead to rises in asset prices. See Stevens (1997). See Macfarlane (1995). For an earlier Latin American example, see Diaz-Alejandro (1985). (b) Ensuring that the payments system is safe The Bank also has important responsibilities in the payments system. As part of last year’s regulatory changes, a new Payments System Board was established within the Reserve Bank. This Board has explicit legislative responsibility for ensuring the stability and efficiency of the payments system. In the stability area much of the hard work has already been done. The introduction, last June, of our Real-Time Gross Settlement system for high-value payments greatly strengthened the payments system infrastructure, as did the passage of a number of technical pieces of legislation involving bankruptcy proceedings and the netting of obligations. Australia’s payments system is now as robust as any in the world. (c) Maintaining an influence on regulatory arrangements in Australia Before explaining this, I must emphasise again that the Bank has no intention of duplicating the work of APRA. We recognise that APRA is the policy-making body responsible for setting prudential standards in Australia. We also recognise that the responsibility for supervising individual institutions lies with APRA, and, as part of this division, the Bank has taken the decision not to receive confidential prudential data on individual institutions on an ongoing basis. It relies on APRA to monitor the health of these institutions, but it does receive aggregate data, and on occasions attends APRA’s on-site visits as an observer to keep up to date with the changing nature of financial institutions. Where the Bank can make a real contribution to regulatory arrangements is through its knowledge of, and day-to-day dealing in, financial markets and through its broad macro-economic responsibilities. Two examples should help to illustrate this. First, it was through our own dealings in the foreign exchange market that we became aware of the high level of activity of hedge funds in Australia in June last year. This was well ahead of the collapse of Long-Term Capital Management (LTCM), which is the event that alerted the world’s bank supervisors to the risks associated with large hedge funds. The second example comes from the macro-economic studies we have undertaken of the Asian crisis. These reveal that the main contributor to the rapid inflow and outflow of capital to these countries was short-term bank-to-bank lending. One of the reasons that banks in Europe, Japan and the United States were so keen to lend short-term to banks in emerging markets was that the Basle capital weights favoured short-term lending over medium or long-term lending. This is logical from the point of view of an individual bank – there is less risk associated with a short-term loan. But it is not helpful to international stability if banks as a whole show a disproportionate tendency to lend short-term. It is these flows which, with good reason, are often termed “hot money”. The Bank and APRA are grappling with this conflict, and I for one hope that the Basel weights are adjusted to remove the incentive towards short-term international lending. (d) Being able to participate in international fora on financial stability issues As a result of recent instability in international financial markets, there has been renewed interest in official circles in examining the causes, and seeing what can be done to improve the situation. Australia has taken quite a prominent role in these discussions, with a number of arms of the Government involved. The Reserve Bank has contributed to Australia’s efforts, particularly by focussing on two areas where we believe the incentive structure is leading to excessive risk-taking and heightened instability. The two areas are the activities of hedge funds, and the arrangements for handling a crisis once it has occurred – in particular, ensuring that at least some of the losses are borne by the lenders. An indication of the success of the Australian effort to date is that Australia is one of the four countries that has been added to the original Group of Seven to form the new Financial Stability Forum. I will be representing Australia at the next meeting in September in Paris. (e) Keeping abreast of developments in financial markets In carrying out its ordinary business, the Reserve Bank trades in the money, bond, foreign exchange and futures markets. This gives us a familiarity with financial instruments and market practices which can add value to the views of other regulators. I do not wish to suggest that this puts the Reserve Bank in a better position, only a different position. Regulators such as ASIC have a much better legal perspective than the Reserve Bank, while APRA is more knowledgeable on prudential standards and institutional practices. Taken together, therefore, there is a very broad range of skills among the members of the Council of Financial Regulators. (f) Handling “once-off” threats to stability These will arise from time to time and may be difficult to predict in advance. The clearest example of this to date is the challenge of the Year 2000. While the financial system is well prepared for the new year, the best-laid plans could be threatened if the public were to over-react to Year 2000 concerns. For this reason, given our mandate to maintain the stability of the financial system, we are directing a lot of resources to ensure a smooth transition. A lot of the work has been very technical – making sure that computer systems work, that the financial system has sufficient liquidity and that ample currency notes are printed. But in the final analysis, we have to ensure continued public confidence in the financial system, so it is a matter of public reassurance and communication. In each of these policy areas, the Bank needs to be mindful not only of the stability of the financial system, but also its efficiency. While in many cases, policies designed to improve the stability of the financial system also improve its efficiency, this is not always the case. A highly regulated system might well be very stable, but it is unlikely to be very competitive or innovative. The Bank’s broad policy responsibilities require it to balance these various considerations. Handling of a financial crisis The other situation in which the Reserve Bank will be required to play an important role is if a financial disturbance actually occurs. It is unrealistic to expect that financial regulators will be able to prevent all financial disturbances. The Bank, therefore, needs to be able to respond to disturbances when they happen. The main way in which it would do this is through the use of its balance sheet to provide liquidity to the financial system. The Bank’s preference would be to do this through its usual daily operations in the cash market, providing liquidity to the market as a whole, rather than to individual institutions. Nevertheless, in the highly unusual case in which a fundamentally sound institution was experiencing liquidity difficulties, and the potential failure of the institution to make its payments posed a threat to overall stability of the financial system, the Bank would be able to provide a lender-of-last-resort loan directly to that institution. In principle, a lender-of-last-resort loan could be made to any institution supervised by APRA. It is important, however, to make clear that the Reserve Bank’s balance sheet is not available to prop up insolvent institutions. Put more plainly, the Reserve Bank does not guarantee the repayment of deposits in financial institutions. Indeed, the recent legislative changes have removed from the Bank the responsibility for protecting depositors. This is now APRA’s responsibility, and APRA has the power to issue directives to institutions, to revoke licences and to arrange for the orderly exit of troubled institutions. Obviously, if it were necessary to undertake any of these actions, APRA and the Bank would consult closely in order to limit the flow-on effects to the rest of the financial system. (iv) Has the financial system become more or less stable? From a purely Australian perspective, our biggest financial crisis was in the 1890s. Although the 1930s was comparable as an economic contraction, it was a lot smaller as a financial crisis.6 And for the first four post-war decades financial instability was rarely in the foreground. One could be excused for thinking that the problem of financial instability was fading away. The events from the mid-eighties to the early nineties dispelled this illusion. A widely based asset price boom came to an end, and the ensuing asset price falls brought down many highly geared businesses and, more importantly for present purposes, a number of financial institutions. Two large State Government-owned banks failed, as did one of the largest building societies, as well as several merchant banks and fringe financial institutions. The effect on the real economy was profound, particularly in Victoria where a disproportionate share of the financial failures occurred.7 It was a salutary experience, but fortunately many lessons were learned both by the private-sector participants and by the regulators. From an international perspective, it would be easy to gain the impression that financial instability is on the rise. The past decade has included the banking collapses in the Nordic countries, the Mexican crisis of 1994, the Asian crisis of 1997, Russia in 1998 and Japan’s problems stretching over much of the decade. During the same period, we have heard disturbing news of many individual companies and markets, the most celebrated ones being the demise of Barings and the near demise of LTCM. Looking over the experience at home and abroad, I do not think it is possible to say that the risk of serious financial instability has either increased or decreased in the course of the past century. The only reasonable working assumption is that the risks of serious financial disturbance are about the same as they always have been. An important reason for this is the unchanging human propensity to go through periods of extreme optimism which pushes asset prices to great heights, followed by a reaction which causes prices to fall precipitously. What has changed over the course of the century, particularly in the past couple of decades, is the nature of the risks we face. The traditional financial crisis was triggered by the failure of one or more banks, often during a period of declining asset prices. The cause was usually a failure to correctly assess credit risk, for example by lending against temporarily inflated asset values. Fire sales of assets and contagion led to runs on other banks and the emergence of a full-scale financial crisis. Such a scenario is still possible today, particularly in an economy heading into recession, but it no longer represents the stereotype. For a start, bank supervision and banks’ own control of credit risk have improved enormously over the past decade. Also, financial disturbances are now more likely to originate in, and be transmitted through, financial markets than has been the case in the past. Financial markets are now much larger and many transactions are much more complex, making the risks associated with them harder to understand. Derivatives – the biggest growth area – are a good illustration. While they enable many businesses to hedge risks which they formerly had to accept, they also allow others to take risks that they formerly could not. Notably, derivatives can make it easier for some participants to engage in leverage – an old-fashioned activity which can greatly increase risk. The recent LTCM episode brought this out clearly and its near-collapse illustrated how market risks can be large enough to be systemic. Recent events also reminded us that in a globalised market place, financial instability will often come from abroad. Last year, after the Russian and LTCM incidents, risk premia on loans to all but the best credits increased sharply. Even in the United States, lesser corporates found sharply higher borrowing See Fisher and Kent (1999). In the early 1990s recession, final demand in Victoria fell by 6.5 per cent compared with 1.5 per cent for the rest of Australia. There was a similar disparity in employment. See Macfarlane (1992). costs, while in emerging markets even large stable companies could not roll over maturing debt at interest rates which would keep them solvent. Fortunately, this situation did not prevail for long, but action by the US Federal Reserve was required to end it. As an aside, I should add that Australia was only marginally affected in this episode, and our new-found reputation for financial stability was not questioned. Of course, the spread of financial problems across national boundaries is not new. A hundred years ago the default by the Argentinian Government on securities underwritten by Baring Brothers triggered financial turmoil in London, which led to Britain reducing its overseas investments. This, in turn, contributed to major contractions in economic activity in Australia, South Africa and the United States. In Australia, the turnaround in capital flows was as dramatic as that recently experienced in some Asian countries, and the effects on the economy were just as severe. What is new today, however, is the speed with which events are transmitted around the world, and the role that markets, as opposed to institutions, play in the process. (v) Conclusion It is important that we maintain financial stability because of the contribution that it makes to ensuring a more prosperous and more fully employed economy. It is also important that we receive recognition as a country that has a world class financial infrastructure which is capable of maintaining this stability into the future. Our recent exemplary performance has helped in this regard. But the task of ensuring we have an acceptable degree of financial stability in the years and decades ahead is a never-ending one. No-one can or should guarantee that no financial institutions will fail, any more than no manufacturers or retailers will fail. In fact, in an ideal world there would be a scattering of small disturbances every year or two to keep everyone on their toes. Unfortunately, the real world is not like this: there are long periods of calm when virtually no financial disturbances take place and rising prosperity is taken for granted, creating a false sense of security and eventually leading to short periods which contain several failures and the threat of many more. The requirement for all those involved in ensuring financial stability is to be alert and pro-active during the long periods of calm, just as an army must be during peacetime. There is a constant challenge to be found in identifying new risks, avoiding harmful incentives and adjusting the regulatory arrangements to keep pace with changes in financial technology. It is not an easy task, but I am confident that the major regulators – APRA, ASIC and the Reserve Bank – are up to it. BIBLIOGRAPHY Bernanke, B. (1983), “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, American Economic Review, 73(3), pp.257-276. Butlin, S.J. (1958), Richard Charles Mills, The University of Sydney, mimeo. Caprio, G. and D. Klingebiel (1996), “Bank Insolvencies: Cross-Country Experience”, World Bank Policy Research Working Paper, No. 1620. Diaz-Alejandro, C. (1985), “Goodbye Financial Repression, Hello Financial Crash”, Journal of Development Economics, September/October, 19, pp.1-24. Fisher, C. and C. Kent (1999), “Two Depressions, One Banking Collapse”, Reserve Bank of Australia Research Discussion Paper, forthcoming. Goodhart, C. (1985), The Evolution of Central Banks. A Natural Development?, London School of Economics and Political Science, Imediaprint, London. Llewellyn, D. (1992), “The Performance of Banks in the UK and Scandinavia: A Case Study in Competition and Deregulation”, Quarterly Review, Riksbank, 3, pp.20-30. Macfarlane, I.J. (1992), “Making Monetary Policy in an Uncertain World”, Reserve Bank of Australia Bulletin, September, pp.9-16. Macfarlane, I.J. (1995), “Financial Deregulation and Financial Markets”, Reserve Bank of Australia Bulletin, May, pp.1-6. Romer, C. (1993), “The Nation in Depression”, Journal of Economic Perspectives, 7(2), pp.19-39. Stevens, G.R. (1997), “Some Observations on Low Inflation and Household Finances”, Reserve Bank of Australia Bulletin, October, pp.38-47. Wallis (1997), Financial System Inquiry Final Report, Australian Government Publishing Service, March. World Bank (1999), “Financial and Corporate Sector Restructuring Progress and Constraints”, World Bank Background Paper No. 1, Asian Growth and Recovery Initiative. | reserve bank of australia | 1,999 | 7 |
Talk by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the World Economic Forum 1999 East Asia Economic Summit, held in Singapore on 20 October 1999. | Mr Grenville looks at the international reform agenda and focuses on bailing-in the private sector Talk by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the World Economic Forum 1999 East Asia Economic Summit, held in Singapore on 20 October 1999. * * * I would like to leaf with you through the photo album of a baby, whose name is euro. He is now nine. In the two years since the Asian crisis broke, there has been quite a bit of rethinking. As time went on, there was a growing acceptance that - whatever the mistakes and deficiencies of domestic policy - the problem was wider in scope: something was wrong with the international financial framework. If the crisis could be distilled down to two principal elements, it was the deadly interaction of huge and volatile international capital flows with fragile domestic financial sectors. It would be nice to say that the international community has now worked out what needs to be done, and are on the way to doing it. In practice, there is a greater consensus about what needs to be done, but a fair shortfall in actually implementing it. What are the specific achievements? • With the Financial Stability Forum and the G20, there are the makings of a more representative set of forums, more appropriate than the G10-type groups for discussions of this type. If all countries are to be subject to the “Golden Straitjacket” - the rules imposed by the international marketplace then the process of setting those rules should be more democratic. • The early emphasis was on transparency. A higher degree of transparency has been achieved in the official sector. This is a distortion of the original concept, which was that markets would work better if there was greater transparency all round, i.e. including from major private sector players. But, by-and-large, progress has been made. • Until the near-death experience of LTCM in August 1998, there had not been any widespread acknowledgement of the role of hedge funds in exacerbating the problems. As LTCM pulled back from the brink, the urgency to address the question of hedge funds faded somewhat, but it looks like there will be some progress, at least in learning what hedge funds do. • And when it comes to the reform of domestic policies, there is now a wide measure of agreement that very considerable resources need to be put into ensuring financial stability and the health of the financial sector, and that there were aspects to exchange rate management in the crisis countries which made them more vulnerable. So on all of these issues, there has been a fair degree of progress on the financial reform agenda. But today, I want to talk about one aspect where there has been a bit of progress in changing thinking, but not much in terms of actual action - this is in bailing-in the private sector. The case for addressing this problem seems overwhelming. To illustrate with reference to just one component of private capital flow, the annual average inflows of bank-to-bank capital into the five badly-affected Asian countries was around US$50 billion. In the nine months following the crisis, the outflow was US$70 billion. It was the speed of this capital departure which was so devastating, and was reflected in such dramatic falls in the exchange rates. The starting point is to identify the nature of the problem. The reversals of capital flow had all the hallmarks of a bank run - the sudden change of opinion and the perfectly rational desire to get out ahead of the crowd (or at least not to be left behind). The case for doing something about it is threefold: • Mexico in 1994/95 was a successful example of how to deal with the equivalent of a bank run. As Bagehot advised a century ago: the authorities should “lend freely”. But it is not realistic (nor, many would argue, desirable) to go on repeating this formula for succeeding crises. The US$50 billion package which was put together for Mexico was, substantively, far greater than anything made available for the Asian crisis countries - Mexico was seen as a unique once-off event, affecting America’s vital interests. So if the funds are not available to fully meet the bank run, then somehow the runs have to be avoided or greatly lessened; • to bail-in the private sector seems fair. The private-sector inflows have, invariably, come at interest rates which embody a significant risk premium and it seems eminently fair that, where a risk premium has been paid, the lenders should be faced with the consequences of their actions when things do go wrong. It is fair, too, that the authorities impose some modifications to private contracts. Bail-outs are, after all, bail-outs of the creditors at least as much as they are bail-outs for debtors, and the authorities are putting taxpayers’ money on the line to achieve a socially-moreoptimal outcome. This gives them the right to have a big say in the arrangements; • bailing-in would also directly address the problems of moral hazard. In the Mexican bail-out, creditors were paid back quickly in full by the rescue package, and this left a legacy of moral hazard. Whatever existing problems of moral hazard had existed before Mexico, these were substantially exacerbated by what was otherwise a very successful rescue. Unless private sector creditors pay some price when things go wrong (either in terms of delayed repayment or some kind of “hair-cut”), then the market will not make the correct risk assessments, nor will capital be allocated in the right way and, most serious of all, we will get repeats of these enormous and disruptive influxes of capital, with the resulting problems. There has been quite a bit of progress in shifting the debate on the desirability of bailing-in the private sector. When the IMF convened the Tokyo meeting in August 1997 following the Thai crisis, the chairman made it clear that bailing-in the private sector was not only off the agenda, but could not be put on the agenda. The IMF has now moved a long way on this, exploring the issues in great detail, and searching (through experience in a number of individual countries since then) for practical ways to achieve this. It would have to be said that the private sector, generally speaking, is still some distance away from sharing this view. I have described their general attitude as being one of “bewildered resentment” at the idea of compulsory bailing-in in the course of an orderly debt arrangement: they talk in terms of “consenting adults”, who have freely made a contract which no-one else should rend asunder. The curious thing, when we hear them talking about the sanctity of contracts, is that the idea of domestic bankruptcy is routinely accepted as an in extremis response when things go wrong - and this is, after all, exactly the circumstances in which a bail-in would be envisaged. What are the elements of a bail-in? Just as with domestic bankruptcy, there are two critical elements: someone in authority needs to “blow the whistle” (i.e. declare the bankruptcy a legitimate one). This cannot, of course, simply be the debtor acting alone - you cannot expect the protection of some form of bankruptcy simply by declaring it yourself, and similarly a country claiming to be unable to pay its debts will need something more than its own word to convince the international community that it is not unnecessarily defaulting on its debts. The second element is that you need some method of “closing the door” - ensuring that, once the bankruptcy has been declared, no creditors get any preferential treatment, but instead “sit around the table” to work out a fair division of the assets which remain. One way of moving forward on this issue is to confine and define the issue more specifically. If we were to take the Asian crisis as our benchmark, then the most important element is to bail-in the bank-to-bank debt. Why is this the proper focus of attention? The short answer is that most other types of debt were resolved in ways that may not be satisfactory, but at least did not exacerbate the crisis greatly. Sovereign-to-sovereign debt has an existing forum of resolution - the Paris Club. Debt of non-bank borrowers - to a considerable degree - experienced a de facto stand-still and at least did not exacerbate the outflows (although it had big effects in harming confidence and needs to be resolved if normal business relations are to be restored). This left the bank-to-bank outflows as the principal problem - the US$70 billion of outflows mentioned earlier. Domestic banks had the local-currency liquidity to make the repayment because they were guaranteed by the government. While ever the foreign exchange markets were open, therefore, they were in a position to repay. The issue cannot be resolved simply by removing bank guarantees: no government, anywhere, will stand idly by while a systemic problem destroys its banking system, so absence of guarantees (no matter how vigorously asserted) is simply not credible. The Asian crisis gave us an example of the sort of thing that might be done - the Korean bank rescheduling of December 1997/January 1998. This had the two necessary elements - “blowing the whistle” and “closing the doors”. The blowing of the whistle took place when foreign exchange reserves were, essentially, exhausted. The closing of the doors took place in a very low-key way: there was no formal declaration of any capital controls, but the Korean banks could obtain foreign exchange only by going to the central bank, so the central bank could strengthen the banks’ bargaining position vis-à-vis the creditors by simply not making foreign exchange available to them. The outcome looks to have been a good one, from the point of view of debtor and creditor. As soon as the rescheduling was made public, the climate in financial markets markedly improved. Who, among the creditors, could now complain, as they received the certainty of getting their money back plus a higher interest rate? Looking back on it, the only element that might, with hindsight, have been done differently - and this is the forward-looking lesson that might be learnt from this experience - is that there might have been a case for a “hair-cut”. These issues are far from settled and there is certainly no acceptance on the part of the private sector, in general, that they should be bailed-in. But, having shifted its position quite a bit over the past couple of years, the IMF is working quietly and steadily to establish precedents - and case studies - for how this might occur. The present focus is on a number of cases where the private sector holds sovereign debt, with Ecuador providing perhaps the most interesting example. There is a belief that the Fund, if not actually encouraging Ecuador to force another rescheduling, has accepted this as the way to go. This is still quite a big step away from the sort of rescheduling of bank-to-bank private debt that would have been relevant in the Asian case. But at least this is moving in the right direction. We all should support these efforts. Will this, together with the other changes which have been made to the international architecture, be a sufficient change to do the job? If “doing the job” means that future crises will be averted, clearly not. But the real issue is not whether crises can be averted, but whether we have done as much as possible. On this, it would be easy to share the views of Dr Sakakibara who says that it will take a couple more crises before we put in place an adequate system of international financial architecture. I have an open mind on this, partly because a lot can be done within the existing architecture to make it much more stable. The biggest contribution would be for the capital-receiving countries to put great effort into strengthening their own financial systems, and their legal and accounting frameworks as well. This will take quite a bit longer than might have been apparent from the reform timetables laid down for a number of these countries - it is a matter of decades or even generations, rather than a year or two. But quite a bit can be done, within a relatively short time horizon, to make these economies much less vulnerable than they were. As well, there is now a better understanding of the balance between the benefits of foreign capital flows and their dangers. This will not do away with crises - nothing can. But it would make them less common. | reserve bank of australia | 1,999 | 10 |
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the Chris Higgins Memorial Lecture, held in Canberra on 27 October 1999. | Mr I J Macfarlane lectures on monetary policy in economic expansions Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the Chris Higgins Memorial Lecture, held in Canberra on 27 October 1999. * 1. * * Introduction It is an honour to be invited to deliver the fifth Chris Higgins Memorial Lecture. I knew Chris from 1970 till his death in 1990. He was, in my opinion, the best Australian applied macroeconomist of his era and a policymaker of distinction. His views on economics would place him amongst those whom Alan Blinder1 identified as having hard heads but soft hearts. He could have held a Chair at any Australian university and many overseas ones of note if that had been his objective; instead, he had an outstanding career at the OECD and the Australian Treasury, where he rose to become Secretary in 1989. Chris was also an excellent companion - a man of taste, wide reading and wit. It is good to see so many of his friends in the audience tonight. Chris’ death in 1990 robbed us of a good friend, and Australia of an outstanding public servant and economist. I also cannot help but think it was a great shame that Chris did not live to see the 1990s unfold. His professional life was concentrated in the 1970s and 1980s - two periods of relative turmoil - and he did not see many of the things he stood for bear fruit in the 1990s. I would like to take this observation as the theme for my lecture tonight. 2. Growth over five decades I would like to start by looking at economic growth in Australia over the past half-century in terms of decade averages (Table 1). If we do this, the variation in growth rates is not nearly as great as when we compare different phases of the cycle. This is largely because each of the decades contained a recession (or more than one by some estimates2) as well as periods of growth. The 1950s and 1960s showed the strongest average growth at 4.2% and 5.4% per annum respectively, while the 1970s, 1980s and 1990s showed very similar growth rates in the 3.3% to 3.4% range. It is disappointing that we could not keep up the 1950s and 1960s performance into the later decades, but nor could other countries. There was a trend slowdown in growth around the world as the period of postwar reconstruction passed into history. In fact, the fall-off in growth for OECD countries was considerably more pronounced than for Australia, so Australia’s relative performance improved towards the end of this 50-year period. While economic growth in Australia was lower than for the OECD on average over the 1950s and 1960s, it was higher in the 1980s and 1990s, with the biggest advantage in Australia’s favour occurring in the 1990s. Alan Blinder, “Hard Heads, Soft Hearts: Tough-Minded Economics for a Just Society”, Addison-Wesley, 1987. E A Boehm identified two recessions in the 1970s, the first in 1974 and the second from August 1976 to October 1977. See “The Usefulness and Applications of Economic Indicator Analysis”, Institute for Applied Economic and Social Research Working Paper No. 9, 1989. Table 1 Real GDP growth - Average annual rate Australia OECD 1950s 1960s 1970s 1980s 1990s 4.2 5.3 5.4 5.2 3.4 3.5 3.3 2.6 3.3 2.1 This is a surprise to some people and one response is to query it on the grounds that our recent relatively buoyant economic growth could have been mainly the result of our faster population growth. Table 2 examines this issue by taking out the effect of population growth and looking at real GDP per capita over the same five decades. On this basis, the recent relative improvement is now more pronounced than in the earlier Table. The 1990s not only shows a pick-up in Australia’s growth of real GDP per capita compared with the two previous decades, but it is the only decade in which Australian GDP per capita has grown faster than the OECD area, and by an appreciable amount. Table 2 Real GDP growth per capita - Average annual rate Australia OECD 1950s 1960s 1970s 1980s 1990s 1.8 3.5 3.3 3.9 1.7 2.4 1.7 1.8 2.1 1.3 I do not want to suggest that our recent economic performance means that we have returned to a golden age such as we had in the immediate postwar period. Nor do I wish to deny that there is still a backlog of remedial work to be done - our unemployment rate being an obvious example. But, on the other hand, we must be doing something right. Our expansion so far in the 1990s has outlasted its predecessors in the 1970s and 1980s, and it is still going strong. We have withstood a difficult external shock, and should be able to sustain the expansion a good deal longer. 3. Why the improvement? The fact that the annual growth in GDP per capita has increased in the 1990s, and that it is now faster than in OECD countries, is a welcome development. The major reason for improvement in GDP per capita is that a closely-related variable, namely labour productivity, has also shown a clear improvement in the 1990s. In addition, multi-factor productivity - which is a little further removed from GDP per capita - has also shown a clear lift compared with earlier decades. Table 3 shows a comparison of these measures of productivity over the three most recent expansions. Table 3 Productivity growth in expansion - per cent per annum Labour productivity Multi-factor productivity 1970s 1980s 1990s 2.2 1.0 0.9 0.8 2.3 1.8 Note: The expansion periods are: March 1975-June 1982, March 1983-June 1990 and June 1991-June 1999. The reason for the pronounced rise in productivity is essentially microeconomic. It is because labour is being used more efficiently, capital is being allocated to areas of the highest productivity and innovation is occurring more rapidly than before. Partly this may be due to increased managerial efficiency, but a more likely explanation is to be found in the policy changes designed to make the economy more flexible and competitive - in other words, policies designed to affect the supply side of the economy. Among these I include financial market deregulation, tariff reductions, privatisations, competition policy and decentralisation of the labour market. These have all made a contribution, but it is probably the interaction between them that is more important; in this sense, the total effect is more than the sum of the parts. I have talked on this subject on earlier occasions,3 so I will not repeat myself tonight, other than to observe that these have brought tangible benefits that are often overlooked by the beneficiaries. The other distinguishing feature of the 1990s is that the expansion has continued for longer. National accounts data up to the June quarter of 1999 show eight years of expansion at an average rate of 4% per annum, already exceeding the length of the previous two expansions. All forecasters are expecting significant growth in the current financial year, so that, even on the most pessimistic assumptions, the present economic expansion will be a lot longer than its predecessors in the 1970s and 1980s. More importantly, in earlier expansions, serious imbalances had built up by this stage. In the early to mid-1970s and the early 1980s, inflation was in double digits, partly as a result of a surge in wages. In the late 1980s, asset prices and credit growth were rising to unsustainably high levels, and consumer price inflation was still excessive. Both the dynamics of the business cycle itself, and the need for tough anti-inflationary monetary policy, pointed to an abrupt end of the expansion. On this occasion, the picture is different and no one is expecting an abrupt end. 4. Why has the expansion been steadier and longer this time? I would now like to make a few comments on why the expansion of the 1990s has been steadier and longer than its two predecessors. Here I think we have to look for essentially macroeconomic explanations. The first explanation is to be found in a comparison of the rates of inflation this time compared with the two previous expansions. It is curious now to look back to some of the economic debates of the 1960s and 1970s. In those times, there were many people who thought that you had to tolerate “a little bit of extra inflation” to make sure the economy would grow. Many, if not the majority, thought that getting inflation down again would not be worth the price, because it would result in permanently lower growth. The short-term trade-off (the Phillips Curve) was incorrectly interpreted as being a summary of our medium-term choices. Now when we look back (Table 4), nothing could be further from the truth. The low inflation decades - 1950s, 1960s and now the 1990s - are the ones where we did well on growth in absolute terms, or in relative terms. The high inflation decades - the 1970s and 1980s - were the ones where our growth performance was at its poorest. Table 4 Consumer prices - Average annual rate of increase Australia OECD 1950s* 1960s 1970s 1980s 1990s 6.1 2.9 2.5 3.2 10.1 8.0 8.3 5.1 2.2 2.7 * If the short-lived Korean War boom is excluded, the average inflation rates in the 1950s would be 2.5% for Australia and 1.7% for OECD. The most reasonable explanation for the lower inflation and hence steadier and longer expansion in the 1990s is the improvement in macroeconomic policies. By this I mean monetary and fiscal policies, or what used to be known as demand management policies. I J Macfarlane, Statement to Parliamentary Committee, 15 December 1998 and 17 June 1999. I will not say very much about fiscal policy, other than to note that medium-term considerations now play a much larger role, something that Chris Higgins consistently argued for. The improvement has occurred in two stages after the disaster of the 1970s. In the late 1980s, and again in the mid-1990s, the Budget was brought back into surplus where it remains at present. As a result of this fiscal consolidation, the medium-term health of the Government’s accounts has improved greatly. One important indicator of this is the stock of government debt to GDP, which is now lower for Australia than for virtually any other OECD country. On monetary policy, I will say a little more. A similar realignment towards a medium-term approach has certainly occurred in the case of monetary policy. The centrepiece of this has been the inflation target and the Government’s reaffirmation of the independence of the Reserve Bank as outlined in our Act. A similar realignment has occurred in a number of other countries, and a model of this type, whether explicit or implicit, is now the mainstream international approach to monetary policy. This approach has been a major factor behind the low inflation of the 1990s, both here and in most other OECD countries. A central channel through which this approach operates is through maintaining low inflationary expectations. Wage and price setters no longer need to engage in the defensive behaviour they formerly used to protect themselves against future rises in inflation. Similarly, opportunistic tactics aimed at profiting from inflation no longer make sense as a business strategy. And finally, the assumption by businesses that there is no need to resist increasing costs because they can simply be passed on to consumers by raising prices has had to be discarded. While the inflation target has played an important part in maintaining low inflation, there is more to monetary policy than just setting the target - there also has to be a willingness to act in a timely way. This is best illustrated by events in the period from 1994 to 1996 (Diagram 1). Around mid-1994, the economy was growing strongly and there were signs that inflation and wages would soon pick up (this expectation was reflected in a number of places including the yield curve). The first tightening of monetary policy occurred in August 1994 and was followed by two others before the end of the calendar year. It is important to note that at the time the tightening occurred, the current inflation rate was 2% (four-quarter-ended underlying inflation). Thus the tightening was pre-emptive - it was based on an assessment of the outlook rather than current experience. In time, inflation did rise and peaked at 3.3% per annum in the year to March 1996. Diagram 1 Underlying Inflation Year-ended % % CPI excluding interest and health rebate July 1996 Treasury underlying CPI August 1994 Pressures soon abated as the economy slowed and wage claims moderated. By July 1996, the first of a series of monetary policy easings occurred. Again this was pre-emptive because the inflation rate at the time was still above 3%. But, because inflation was forecast to return to the middle of the band, the period of tighter monetary policy that had prevailed since end-1994 was no longer needed, and so interest rates could be taken back to more appropriate levels. The pre-emptive nature of these policy changes, plus the Government’s affirmation of the inflation target and the independence of the Reserve Bank contained in the Statement on the Conduct of Monetary Policy in August 1996, significantly increased the effectiveness of monetary policy and the credibility of the Reserve Bank. This put us in a good position later to handle the contractionary effects of the Asian crisis and the associated period of turbulence in financial markets. The textbook response to a contractionary external shock such as the Asian crisis is not, in our view, to tighten monetary policy. But the turmoil in financial markets, such as a plunging exchange rate and widening bond spreads (both indications of capital flight), can sometimes only be settled by such a show of forceful action. Most countries in the region, whether developed or emerging markets, chose to, or were forced to, raise interest rates at some stage during the Asian crisis, with subsequent detrimental effects on their economic growth and employment. The fact that we were able to withstand the pressures without doing so (in fact, reducing rates slightly in December last year) is a testimony to the increased credibility of monetary policy in Australia, and to the higher reputation that the Australian economy overall commands in the international market place. It is also an illustration of how timely action, such as in 1994, can ultimately contribute to a longer and more robust expansion. Before concluding, I would like to make a couple of other observations on this subject. The first is that pre-emptive monetary policy action only refers to being pre-emptive vis-à-vis actual developments in the economy; it does not mean being pre-emptive vis-à-vis the financial markets’ assessments. Financial markets are looking at the same data as the Reserve Bank, are making forecasts and calculating the probabilities of monetary policy action. Interest rates on bills and bonds always move in anticipation of monetary policy action. To be pre-emptive vis-à-vis the market would be the same as taking the market by surprise. No one should regard this as a worthwhile objective, although it will occur from time to time. In the modern world of greater transparency and accountability, such surprises should be rarer and rarer as the market becomes more aware of the central bank’s objectives and modus operandi. The other implication of this new world of monetary policy is that policy changes will probably be a good deal smaller than in the past. Just as the tightening of 1994 was much smaller than its predecessors in the 1980s, it is reasonable to assume that this trend will continue. The past three years have hardly been a placid period for the world economy, yet in successful economies the movements in interest rates have been relatively small (for example, in the United States they have moved through a range of ¾ of a per cent). The other thing we are seeing is that financial factors are playing a larger role than before. The biggest move in US rates over the second half of the decade was the easing in late 1998 as a result of the “credit crunch” which followed the Russian default and the demise of the hedge fund LTCM. At present, US monetary policy is, of necessity, partly operating through the medium of the stock market as that market moves in anticipation of Fed tightenings. Fortunately in Australia we do not have as highly valued a stock market to contend with, but we cannot ignore these considerations entirely. Our household sector is now a much larger holder of equities and, at the same time, is more highly leveraged than in the past. This is bound to affect the transmission mechanism for monetary policy. My final comment is that whatever monetary policy does, there will be those who disagree with the decision. This is inevitable and probably healthy. Everyone is entitled to their own view, and has a right to express it. That will always be the case. What has changed over recent years is that, by and large, those who disagree with a decision no longer reach for the ready excuse of claiming that it was “only done for political reasons”. This change has been a long time in coming, but now that it has arrived, it is a huge advance. It makes it easier for monetary policy to do what it judges to be right and not be inhibited by fears of public misperception - whether that means temporarily higher interest rates or temporarily lower interest rates - than formerly. In the long run, however, it almost certainly means on average lower and less variable interest rates for the reasons I have outlined above. | reserve bank of australia | 1,999 | 11 |
Notes by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, for a talk to Australian Business Economists on 11 November 1999. | Mr Macfarlane comments on monetary policy in Australia Notes by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, for a talk to Australian Business Economists on 11 November 1999. * * * I will say a few words on monetary policy tonight, but they are not intended to be very profound. This is partly because I have recently held forth on the subject in the Chris Higgins Lecture. You will also be aware that we have made a change to monetary policy, issued an accompanying press release, and also issued our regular half-yearly report within the past week or so. With so many public statements in such a short time, we should have got our point of view over to everyone by now. So my comments tonight are not intended to point to any new direction in monetary policy - they are meant only as an elaboration on a couple of points in what we have already said. We have just been through an exercise in which monetary policy was tightened for the first time in five years. History shows that interest rates have to go up as often as they go down, but although we all know this, Australia has had particular difficulty in handling these rises in the past. Not that the problem has been confined to Australia, many others have had the same experience. Tightenings have tended to be delayed for too long, and when they have finally occurred, they have often been quite abrupt and accompanied by heated political argument. This was certainly the pattern in the 1970s and 1980s, although we made a big step forward in the 1994 tightening as I emphasised in my recent lecture. On this occasion, I would maintain that the tightening was neither delayed nor abrupt, and it certainly took few people by surprise. But more importantly, the response to it by the economic community and by politicians was extremely civilised. Although some people expressed disagreement, I detected no heat or acrimony in their words. In the political sphere, the comments made by the Government, the Opposition and others showed that we have gone a long way down the path of depoliticising monetary policy. This is a very welcome development, and although there were a number of steps along the path, the most important one was the joint signing of the Statement on the Conduct of Monetary Policy in 1996. Those who disagreed with our decision to tighten tended to point out that there were few signs that the economy was overheating, that inflation was not threatening to exceed the target over the forecast horizon, and that wages growth was not heading up (as in 1994). As a description of the economy, that assessment was essentially correct, and we have no desire to dispute it. But the implication for policy which was drawn from this assessment was not, in our view, correct. In our view, it reflected a rather dated approach to the application of monetary policy. The traditional view is that you only begin to tighten monetary policy when things have become, or clearly will become, overheated or, in other words, out of control. The tightening in those circumstances is a sign that something has gone wrong and is, in effect, an admission of policy failure. Hence, the ample scope it provides for criticism, particularly in the political arena. The unusual aspect of the recent tightening is that it occurred before things had become, or were about to become, out of control. If it is successful, it will mean that they do not get out of control in the foreseeable future. That is what is meant by the term “pre-emptive”. But clearly we could not have just picked any period when the economy was performing well and chosen to tighten monetary policy and claimed it was done in order to be pre-emptive. There had to be good reasons why it was now - in the final quarter of 1999 - that we made this decision. Although we have explained this in our Semi-Annual Statement, I would like to spell out a couple of aspects of this in the time remaining tonight. 1. The international aspect Although it is only a year ago, most of us have forgotten how gloomy the prospects seemed in the second half of 1998. This was the time when the Asian problems had spread via Russia and Latin America to Wall Street itself. If you look back at the press release which accompanied our easing of monetary policy in December 1998, you will see it referred to the expectation by official and private forecasters that 1999 would be a worse year than 1998. As we now know, the world did not turn out that way - 1999 has turned out to be a stronger year than 1998, and both official and private forecasters are now expecting 2000 to be stronger again. I do not wish to quibble with this assessment. I merely wish to record that from about the middle of 1999, markets around the world began to recognise that the accommodative stance of monetary policy by major central banks that had been so appropriate for 1998 and early 1999 was starting to look less appropriate as 1999 progressed and strengthened. This reassessment happened first in the United States and was soon followed in other English-speaking countries and then in Europe. As usual, the markets were quicker off the mark to raise market interest rates than they needed to be, but they were broadly correct. Since mid-year, we have seen the United States, the United Kingdom, Australia and the ECB tighten monetary policy. I suspect there will be a few more countries to come in the not too distant future. 2. Domestic events Just as the weakness of the world economy did not come to pass, a similar expectation of weakness in Australia failed to materialise. Real GDP in Australia again grew by over 4% in the 12 months to the June quarter and will probably still be showing a similar rate in the 12 months to the September quarter. This measure may slip for a time as we drop off some of the high quarterly growth rates from our calculations, but we think growth will remain robust over the next 12 months. Similarly, the quite lengthy period during which inflation was undershooting our target seems to have come to an end. The CPI inflation rate would already be a bit over 2% apart from the Government’s reduction in the Health Rebate Levy. Although some of this result has been due to rises in oil prices, measures of underlying or core inflation, which are largely unaffected by oil prices, have also risen by about 2% over the past 12 months. Thus, the period where the Australian economy was experiencing a contractionary impact from abroad and where the outlook was for weaker growth and sub-2% inflation has now well and truly passed. The monetary policy that was appropriate for that period is no longer appropriate to the new circumstances that we face. That is the main reason behind the tightening of monetary policy we undertook after our November Board Meeting. This move was what the flexible inflation targeting framework suggests should happen. There is some confusion, however, on this point and so it is worth spending some time to clarify it. Some interpretations of the target imply that the Bank is not supposed to contemplate any rise in interest rates until the upper end of the target is threatened. This is equivalent to saying that the most expansionary setting reached during the downward phase of the interest rate cycle should be maintained until such time as a move to a clearly restrictive setting is required, and only then should a move be made. (That virtually guarantees that such moves will be large.) It is as though policy has to operate only with settings of maximum “go”, and heavy braking. This is a reading of the framework we do not share. There is a range of settings of the instrument between “maximum go” and “heavy braking”. Most of the time we would expect interest rates to be in that range. Let us look at two possible situations where monetary policy should be changed: • The first is when inflation is above the target. In this situation, the inflation targeting framework would say to raise interest rates to a setting which would bring inflation back to the target. But once the higher rates had done their job, they should be gradually reduced to more normal levels. This is what happened in 1996. We did not wait until our forecast had inflation falling below 2% before we started to ease. • The second is when inflation is below the target. In this case, the framework would call for a setting of interest rates which would, over time, allow inflation to go back up to the target. Once it is clear that such a setting had done its job, the framework calls for it to be replaced by one more likely to keep inflation at the target. The framework does not envisage the policy setting being maintained until something goes wrong. Now some may object that all this smacks of fine tuning. I agree that we should not delude ourselves that the economy can be precisely controlled so that inflation stays within or close to the band, even when there are no external shocks. The point remains, however, that even if the process is not precise, the instrument does not remain at its most extreme setting once that is no longer needed. As the outlook changes, and as the balance of risks shifts, it is appropriate also for the policy instrument to shift. 3. What about the GST? Some people have not been convinced by the arguments I have used above. Some still cannot understand why you would tighten unless the economy was overheating, and assume that there must be a hidden agenda. Others are keen to play the old game of trying to find a political dimension to monetary policy. This has led some people to say that the real reason is our fear of the inflationary effects of the GST, but that we are too diplomatic to say so. I am sorry to disappoint the proponents of this view, but that is not the case. • If the GST was the reason for tightening monetary policy, why have the Fed, the Bank of England and the ECB tightened monetary policy? I am not aware of the forthcoming introduction of a GST in any of these countries. • Our starting point has always been that the imposition of the GST should not have an effect on wages because wage earners will gain more from the accompanying fall in income tax rates than they will lose from the introduction of the GST. The net effect of the tax changes will be to increase the disposable income of wage earners by more than the increase in their expenditure, as is evidenced by the fact that the package involves a cost to the Budget. • Monetary policy is based on a view that inflation will be within the target immediately before the GST is introduced and that it will be back within the target a year later. This view, in turn, is based on the assumption that there will be no second round effects due to higher wage outcomes as outlined above. If we started to observe behaviour that indicates that this assumption was not correct, then monetary policy would act upon it. We are not acting at present on the expectation that this assumption will be violated - we are acting in the expectation that it will hold. 4. The need for a long expansion We have made a point of saying that the recent monetary policy tightening is designed to increase the length of the expansion. Again, this may not be universally accepted, as many people associate tightenings with the end of expansions. Our position may seem the wrong way round to those who have a more traditional view of monetary policy, but I want to make a few points of clarification: • First, this is not a new position on our part. We did not wait until we already had the runs on the board before specifying our aim was to have a long expansion. Before I took up this job in early September 1996, I was asked by the Parliamentary Committee why you would tighten in an expansion, and my reply was as follows: “In the long run, if you want to have a good performance on growth and a good performance on employment, the best thing you can do is to pursue policies that extend the length of the recovery. In the past, we have sometimes had the problem of very strong expansions and a build-up of very big inflationary pressures followed by sharp contractions. In the sharp contraction unemployment goes up very quickly. The way that monetary policy can contribute to a better outcome is not to have a short sharp expansion which generates inflationary pressures, but to have a long slow one. To have a long slow one, it means that you occasionally have to be pre-emptive, at the first signs of things getting out of control you have to squeeze down.” Please excuse the inelegant phrasing - it was an “off the cuff” reply to a question from a Committee member. But at least it shows that we have been consistent on this point since at least mid-1996. • The second point is that if you have a very long expansion, it seems reasonable to me that it will include a number of phases of monetary policy. It is not as though, in order to get the expansion, you continuously ease monetary policy and then as soon as you tighten it, it brings the expansion to an end and you then experience a recession. It seems far more likely now that a long expansion will include perhaps two or three phases of tightening and easing, as monetary policy seeks to extend the length of the expansion. And, of course, if it is a low inflation expansion, as it would have to be to in order to be a long one, the tightenings and easings of monetary policy may then take place over a relatively small range of interest rate settings. 5. Concluding remarks I was going to conclude by saying a few things about communicating with the public, or what is now known as transparency. But the more I think about this, the more complicated it gets. So the one thought I will conclude with is this. Sometimes it is possible to be reasonably direct when talking to the public, as I believe we have been over the past few weeks. That is because we had a clear view about what needed to be done. But more often than not, you find yourself in a grey area where there is not a strong case to do something, where all incoming data have to be evaluated on their merits and policy options weighed up. In such situations, you cannot give views about the direction of policy - you cannot say more than you honestly believe - and that will often disappoint people looking for a clear guide to future action. | reserve bank of australia | 1,999 | 11 |
Opening Statement given by Mr L J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration on 29 November 1999. | Mr Macfarlane’s statement to the House of Representatives Standing Committee on Economics, Finance and Public Administration Opening Statement given by Mr L J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration on 29 November 1999. * * * It is a pleasure to be here in these dignified surroundings to appear before the Committee again. As you know, we take these hearings very seriously because we regard them as an important channel for Parliament, through its representatives, to question the Reserve Bank in depth. It thus plays an important role in ensuring the Bank’s accountability and in the democratic process. As usual, I would like to make an opening statement, but it will not be comprehensive because we put out our Semi-Annual Statement on Monetary Policy earlier in the month. Its contents are still very current and I will refer to it from time to time during the hearing. Also following past practice, I would like to start by reviewing what I said to you in June about how we saw the economy developing. There was still a fair bit of uncertainty around at that stage as to the extent of the expected slowdown in GDP growth from the 4½% plus that had occurred in 1997 and 1998. That is why we had a relatively wide range of projected outcomes from 3% to 4%. The top of that range would indicate almost no slowdown, while the bottom would probably indicate we were heading still lower and would represent genuine weakness in economic activity. We think the position is a little clearer now – our forecast for growth through 1999 is 3½%, and through the financial year 1999/2000 is 4%. A through-the-year growth rate of 4% implies a year-on-year growth rate of 3½%, the same as the Treasury is forecasting in its mid-year review. Thus, these numbers do show a modest slowdown for the Australian economy, but most of it is behind us. It incorporates the low June quarter figure and reflects weakness in business investment, and particularly a decline in net exports in the first half of 1999. Because the latter is unlikely to be repeated, we expect to see growth of around 4% through the year ahead. There has been no reason to change our view on inflation. We thought inflation in the year to December quarter 1999 would be 2%, whether measured by the CPI or some underlying measure. We still think 2% for the CPI and a shade over 2% in underlying terms. When we look out to June 2000, our guess for the CPI is 2¾%, with 2¼% for underlying. On unemployment, we have also not changed our view. When we met last time, the unemployment rate had been averaging 7½%, and we expected it to edge down over the remainder of the year. This is what it has done, so that now it has averaged 7.2% over the past three months. We expect that it will go down further so that we will see some numbers less than 7 by June next year. The balance of payments has also turned out very much as expected. For quite a while, we had been forecasting the quarterly current account deficit to reach 6% of GDP, and it finally did so in the June quarter and will probably remain at about this level through this financial year. It was surprising that the current account did not deteriorate faster and further, given the disparity between our growth rate and that of our trading partners. While the slowness of the deterioration has been a pleasing development, we think that the improvement could be some time in coming. In summary, we are expecting that the current financial year will be another good one for the economy. Growth will be a little lower than its recent peak, but still good, and inflation should be within the average we aim for. Considering that this is the ninth year of the expansion, such a result would mean that no major imbalances had emerged. The aim, as usual, is to keep the expansion going and to avoid the emergence of problems that would threaten its continuation. Monetary policy This brings me to monetary policy. The most important development here was the tightening immediately after our November Board Meeting when the overnight cash rate was raised from 4.75% to 5%. While I think this adjustment has been quite well received by the community, it is still worth spelling out some aspects which lay behind the decision. I would like to start by putting it in the international context, not because we have to follow what other countries do, but because there are some international developments that are a common background to all countries. One such development was the changed perceptions about the world economic outlook in 1999 and 2000. If you remember, 1998 was a weak year for the world economy, largely because of the widespread fallout from the Asian crisis. At the beginning of this year, things looked as though they were getting worse, and most forecasters – public and private – expected 1999 to be weaker than 1998. In the event, it turned out the other way – 1999 has been better than 1998, and 2000 should be better again. As our Semi-Annual Statement said: “This change has led to an increase in both short-term and long-term interest rates in most industrial countries, as markets questioned the continuation of the accommodative monetary stance central banks have generally been following over the past year or two. The upward pressure in interest rates began in the US, the country most advanced in its economic cycle, but quickly spread to other English-speaking countries and, more recently, to Europe.” The market reaction was a bit quicker than it needed to be, but it was broadly correct. The United States was the first to tighten, followed by the United Kingdom. Our tightening in early November was quickly followed by the European Central Bank, and the central banks of Sweden, Canada and New Zealand. I would now like to turn to the Australian economy, where a similar expectation of weakness in 1999 did not come to pass. Real GDP grew by over 4% in the 12 months to the June quarter (the latest data we have) and will probably still be showing a similar rate in the 12 months to the September quarter. This measure may slip for a time as we drop off some of the high quarterly growth rates from our calculations but, as explained earlier, we think growth will be about 4% in the 12 months to June 2000. Similarly, the quite lengthy period during which inflation was undershooting our target seems to have come to an end. The CPI inflation rate would already be a bit over 2% apart from the Government’s reduction in the Health Insurance Rebate. Although some of this result has been due to rises in oil prices, measures of underlying or core inflation, which are largely unaffected by oil prices, have also risen by about 2% over the past 12 months. Thus, the period where the Australian economy was experiencing a contractionary impact from abroad and where the outlook was for weaker growth and sub-2% inflation has now passed. The monetary policy that was appropriate for that period is no longer appropriate to the new circumstances that we face. That is the reason behind the tightening of monetary policy we undertook after our November Board Meeting. At the risk of being overly technical, I would like to spell out some aspects of our flexible inflation targeting regime a little more fully at this stage. In doing so, I want to distinguish between two types of situation: the first is where inflation has been comfortably averaging 2 point something per cent for some time and the economy is performing roughly in line with its potential so there is no obvious upward or downward pressure on the inflation rate. The second is where the starting point is either above or below the range we expect inflation to average. In the first case, where inflation is where we want it, monetary policy would be set to keep it there. The economy would be in a type of dynamic equilibrium and there would be no need for policy action. We then ask ourselves what are the circumstances under which we would wish to change monetary policy. Would we do it if our forecast for inflation rose from 2½% to 2¾% or fell to 2¼%? My answer is that we do not worry about small variations in inflation of that magnitude. To trigger a change in policy would require a forecast which had inflation going clearly above 3% or below 2% and likely to stay there for a while. Our flexible inflation targeting framework does not aim for rigorous fine tuning, and requires a significant variation in the inflation forecast to trigger monetary policy action. This brings me to the second type of situation. This is where we start from a position where inflation is above or below our desired target range. In this case, where the initial situation is one of dynamic disequilibrium, the prescription is a little more complex. Let us look at the situations defined by the two possible starting points. • The first is when inflation is above the target. In this situation, the inflation targeting framework would say to raise interest rates to a setting which would bring inflation back to the target. But once the higher rates had done their job, they should be gradually reduced to more normal levels. This is what happened in 1996. We did not wait until our forecast had inflation falling below 2% before we started to ease. • The second is when inflation is below the target. In this case, the framework would first call for a setting of interest rates which would, over time, allow inflation to go back up to the target. Once it is clear that such a setting had done its job, the framework calls for it to be replaced by one more likely to keep inflation at the target. The framework does not envisage the low interest rate setting being maintained until something goes wrong. It is this reasoning which lies behind the recent tightening of monetary policy and why we refer to it as pre-emptive. To argue against it on the grounds that we should not act until our inflation forecast clearly exceeded 3% would be to argue for a very “stop-go” approach to monetary policy. It would be equivalent to saying that the most expansionary setting reached during the downward phase of the interest rate cycle should be maintained until such time as a move to a clearly restrictive setting is required, and only then should a move be made. This would virtually guarantee that such a move would be a large one. What about the GST? Not everyone will be convinced by the arguments I have used above. Some people still cannot understand why you would tighten unless the economy was overheating, and assume that there must be a hidden agenda. Others are keen to play the old game of trying to find a political dimension to monetary policy. This has led to claims that the real reason is our fear of the inflationary effects of the GST, but that we are too diplomatic to say so. I am sorry to disappoint the proponents of this view, but that is not the case. • If the GST was the reason for tightening monetary policy, why have the Fed, the Bank of England, the ECB, the Bank of Canada, the Reserve Bank of New Zealand, etc. tightened monetary policy? As I have said elsewhere, I am not aware of the forthcoming introduction of a GST in any of these countries. • Our starting point has always been that the imposition of the GST will affect the level of prices, but not the ongoing inflation rate. This will require that businesses do not engage in opportunistic pricing by raising their prices by more than is warranted by the net impact of the GST and reductions in indirect taxes. If that is the case, the GST should not have an effect on wages because wage earners will gain more from the accompanying fall in income tax rates than they will lose from the introduction of the GST. The net effect of the tax changes will be to increase the disposable income of wage earners by more than the increase in their expenditure, as is evidenced by the fact that the package involves a cost to the Budget. • Monetary policy is based on a view that inflation will be within the target immediately before the GST is introduced and that it will be back within the target a year later. This view, in turn, is based on the assumption that there will be no second round effects due to higher wage outcomes or opportunistic price behaviour as outlined above. If we started to observe behaviour that indicates that this assumption was not correct, then monetary policy would act upon it. We are not acting at present on the expectation that this assumption will be violated – we are acting in the expectation that it will hold. Y2K and all that I would now like to make a few comments about Y2K, which is very topical because there are now only 32 days to go to the new century. When I appeared before the Committee in June, I said that Australian banks, building societies and credit unions were very well prepared for Y2K. They had not completed all their final testing at that stage, but now they have, and everything has been done to make sure that their computer systems will be able to handle the change into the new century. This includes not only all their internal accounting and record-keeping systems, but also their ATM, EFTPOS and credit card systems. As well as making sure their systems are compliant, they have also been sending out very clear messages to their customers about the safety of their deposits. We are very pleased to see this because, as I said in June, the simple fact is that deposits are safe and records are not at risk from Y2K-related problems. I should also say a few words about my own institution. You will not be surprised to know that we have also put a lot of effort into our own systems to make sure they are Y2K compliant. One of our most important is our electronic direct entry system which handles all of Australia’s pension payments. You will be pleased to know that all these payments will be made on time. I mentioned last time that it is not just a matter of getting the technical side right, but it is also important that we do not run into a problem of public over-reaction. All the indications here are that the vast majority of the public are taking a sensible and calm approach and have not been influenced by alarmist stories or predictions of doom – not that there have been a lot of these anyhow. In our judgment, the Australian media coverage, with only a few exceptions, has been accurate and balanced. I am often asked by people whether they should take out extra cash to see them over the New Year period. My advice is generally along the following lines: • don’t take the risk of having too much cash on your person or in your home; • the safest place for your savings is in the financial institution that it is presently in; • don’t fear that the country will run out of cash. We have printed enough notes to provide for any conceivable demand; and • remember you are only really dealing with a long weekend. Banks, building societies and credit unions will be open on the three days before New Year’s Day, which is the Saturday, and will re-open on the Tuesday. New Year’s Eve is going to be rather unusual this year in that a lot of people will not be out enjoying the festivities but will be at work to make sure that nothing goes wrong. At the Reserve Bank, we will have a team in place, including myself, and a communications centre to receive up-to-date information from financial institutions on what is happening. This centre will be linked to the Commonwealth Government’s National Coordination Centre in Canberra and to various international networks that have been established. Because Australia (and New Zealand) will be the first countries to enter the new millennium, there will be a lot of international attention focussed on us, including a fair bit of live television coverage to other countries about what is happening in Australia. Remember the United States will only be starting its working day on Friday when we cross over into the new millennium. I am confident that Australia will acquit itself well once again in the eyes of the world when the great day comes. | reserve bank of australia | 1,999 | 11 |
Notes for a talk given by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Department of Foreign Affairs and Trade Seminar, held in Sydney on 30 November 1999. | Mr Grenville deliberates on Asia’s financial markets and on capitalising on reform Notes for a talk given by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Department of Foreign Affairs and Trade Seminar, held in Sydney on 30 November 1999. * * * Causes of the crisis In early diagnosis of the cause of the Asian crisis, there was much emphasis on the mistakes of domestic policy. There was talk of over-valued exchange rates, and much emphasis on “crony capitalism”. There were, it needs to be emphasised, serious problems in domestic policy in these countries, and some of these were an important ingredient in the problems. But it should be noted that, no matter how unattractive crony capitalism, it existed during the 30 years of outstanding economic performance. Over time, serious commentators came to realise that, whatever the problems of domestic policy-making, there also seemed to be serious problems in the international financial order, particularly relating to the volatility of foreign capital flows. So it was not too long before a more balanced and operationally useful assessment appeared, in which the central issue was identified as the juxtaposition of two fatal flaws – huge and volatile foreign capital flows, and a fragile and poorly functioning domestic financial system. How to address these problems? The answer is not to draw back from the broad path of development these countries were on, relying predominantly on markets for the allocation of resources. No one, to my knowledge, has suggested a fundamental departure from the market-based path. The issue, rather, is the recognition that the transition from regulated to unregulated financial markets is a difficult one, with very significant vulnerability along the way. It seems that when the transition is over, and markets and institutions have adapted, many of the dangers disappear, and the benefits are more prominent. It is like the relatively calm waters above and below the Niagara Falls, but with very significant turbulence in the transition between the two tranquil states. This problem has produced a number of different images with a common theme: the central bank governor in one of the crisis countries said that they were asked to host a house-warming party while the house foundations were still being constructed. Another observer talked about the problem of plugging into a high-voltage power grid. Some have drawn the connection with the old sequencing debate, common in the economic literature for some decades. The broad thrust of this message was that the most general, ubiquitous and far-reaching elements of deregulation should be done last. In particular, financial deregulation should come last, because, if it did not, the price distortions inherent in a regulated economy would be exacerbated, exaggerated and exploited by a deregulated financial system. But the reality is that deregulation can and should take place when the opportunities are available. Carpe diem is the watchword of reformers. This was certainly the case in Australia, where financial deregulation preceded other important deregulation – most notably, in the labour market. So there is no simple answer in sequencing. The uncomfortable reality is that much of the “plumbing” that needs to be put in place during the process of financial deregulation – in terms of the experience, reputation and institutional structures – takes time to create. Waiting for some propitious moment does not solve the problem, because it is largely a process of “learning by doing”. But at least if the transition is recognised as tricky, then it may be possible to spread it out over a period to reduce the vulnerability. It might be worth noting that in Australia we went through this awkward and vulnerable transition period, with the most obvious manifestation being the “Banana Republic” difficulties in the mid-1980s. We clearly did not come through this unscathed, but we were lucky that our foreign exchange problems (which occurred in the mid-1980s) did not coincide with our prudential problems (which occurred in the late-1980s and early-1990s). The two elements – often seen coinciding in the transition – were nicely out of phase for us, and we should be thankful for that. What could be done? In the course of looking at possible changes to the international financial architecture, various ideas have been put forward which, provided they are not seen as panaceas, might help. There are efforts currently underway to obtain more disclosure from hedge funds, and to develop some procedures for “bailing in” private-sector creditors. Some have suggested that collective action clauses should be built into bonds, and this seems broadly a good idea. Other suggestions about private contingent credit lines seem, to me, less likely to contribute much to “shock-proofing” the transition, principally because those providing the private-sector contingent credit lines will have an incentive to do offsetting transactions if it seems likely that the contingency will arrive. One helpful change is one of attitude. One problem with the process of financial deregulation that has taken place in the Asian countries over the last 10 years or so is that it was driven partly by doctrine. This doctrinal imperative reflected two separate forces, which came together more or less by accident. The first of these forces was the dominance in academic circles of the “efficient markets paradigm”. This is a powerful analytical device, which has taken thinking in economics down very useful directions. But it, like all paradigms, is an imperfect representation of the real world. Perhaps more seriously, in the course of academic debate, it became quasi-religious, with beliefs and facts becoming confounded. This made it hard to leaven the efficient markets paradigm with some real-world facts – principally, that markets are imperfect. The second force was a simple commercial imperative on the part of foreign financial institutions to gain access to new markets and compete in the most vigorous way. This commercial imperative was successfully transplanted into the political processes, so we saw, for example, the OECD insisting on capital market deregulation as a condition of Korea’s membership of the organisation. These forces combined to form powerful rhetorical pressures, to deregulate as fully as possible, with special virtue being attached to those who opened their markets at the most breakneck speed. One of the notable manifestations of this was the Bangkok International Banking Facility, whereby small Thai businesses were presented with a frictionless conduit to international financial markets, where they could borrow at attractively low interest rates, in foreign currency. In Australia, we know, from our small taste of the Swiss loans in the 1980s, how dangerous it is to have relatively unsophisticated borrowers given the opportunity and incentives to take on sophisticated products involving foreign exchange risk. But in Australia this was relatively modest in macro-economic terms. In Thailand, the inflow through the Bangkok International Banking Facility was not far short of 10% of GDP. With this change of attitude, it should be easier to insert some common sense into the process of deregulation, and have the courage to say “no” (or “not yet”) to some aspects of deregulation which seem to make countries more vulnerable. So it may be quite sensible, from this viewpoint, to put various restrictions on short-term capital inflows, and on foreign-currency borrowing. This is compatible with free-market principles, because these are properly seen as transition measures, to be modified and ultimately abandoned. The other place where common sense might usefully prevail over doctrine is in recognising that, despite the very strong pressures for uniformity of rules and regulations internationally (in Thomas Friedman’s terminology, adoption of the “Golden Straitjacket”), there is still some opportunity for tailoring the set of rules to the particular needs (and political consensus) of a country. Just to give one example, it would be a mistake to think that the full minutiae of bankruptcy laws have to be translated precisely and uniformly across all countries. The particular balance between debtor and creditor which is seen in Anglo-Saxon law is a product of the particular social values of these societies. Other countries have come up with different relationships – I have heard it said that one important reason why creditors have traditionally been in a weak position in Indonesia is the conscious recognition that creditors would often be Chinese businessmen and money-lenders, and the societal judgment was that it was not going to give powerful legal remedies to these creditors. The forces tending to push people towards a rather uniform Golden Straitjacket are powerful indeed, but individual countries can assess to what extent they can and should modify these rules, to make them more palatable to their societies, without at the same time making them more costly. This debate has yet to be joined, or even defined, but it is nonetheless important. The central point here is that Thomas Friedman’s Golden Straitjacket is not an axiom of market economics, but rather is a set of rules which have emerged to meet the needs of current-day developed-country markets. The role of banks One of the lessons commonly drawn from the crisis experience is that countries should quickly diversify their financial institutions, to become less dependent on banks and foreign bank inflows. Chairman Greenspan has referred to the need for a “spare wheel”, which he envisages to be alternative forms of funding when bank financing dries up. There may well be a good case for developing new financial markets, particularly in bonds. But one of the intrinsic problems is shortage of knowledge, particularly commercial intelligence. In a world where information is scarce and at a premium (where the “model” is not well defined), markets which are continuously repricing assets will tend to be very volatile, as small accretions or revisions to information are absorbed by the market. It would seem to me to be a mistake to shift quickly away from the world in which banks are the fundamental financial intermediary, because banks are, par excellence, the institutions which focus on information collection and the assessment of idiosyncratic risk. Information about borrowers is their stock-in-trade. They do not have to reassess and reprice their assets continuously. Given past performance, there seems little likelihood that the credit-rating agencies can quickly improve their performance to the stage where they can provide sufficient information to allow investors to make smooth, non-disruptive investment decisions in markets which are constantly being repriced. If this assessment is correct, then the task is to make sure that the banks do a better job in acting as the guardians of the gateway to investment. This is a formidable task, but there seems a better prospect that banks will be able to act as a filter and provide a second opinion on investment projects, rather than rely on the much more sophisticated, information-intensive and indirect process that we see operating in developed financial markets. Growth In the wash-up to the Asian crisis, one could easily come to the view that the answer was to shift down a gear and grow more slowly. Within reason, this may be sensible and inevitable. But it would be neither sensible nor inevitable for these countries to adopt the lower rates of growth which are regarded as normal in developed countries. The problem is that higher growth is far more vital to these countries than it is to us. For us there are unfilled needs in education and health, but the reality is that much of any extra growth in Australia would go to far less pressing priorities. Given the extraordinary problems and pressing nature of the needs in the crisis countries of Asia, it is not sensible to see the answer being to slow growth. So whatever system and changes are put forward to address the problems of the last couple of years, they should pass the test of being compatible with a good pace of growth. One shouldn’t be too pessimistic about this, because if the sort of efficiency-enhancing reforms which are being pursued on so many fronts are successful, then the potential rate of growth of these countries should be enhanced rather than diminished. In conclusion It is a pleasure to take part in this symposium, which addresses so directly what seems to me to be the central issue – how to make Asia’s financial markets work better. I have touched, today, on some of the measures which go under the rubric of the International Architecture, but I have no doubt that the main task is in the hands of the policymakers of these countries. Central to this is to work much harder on prudential supervision, to create a set of rules which is both feasible of application and thoroughgoing in keeping the banking system as a whole safe. It is a formidable task, which will take dedication and the persistent application of common sense. I wish them well. | reserve bank of australia | 1,999 | 12 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Economic Society of Australia, Victorian Branch, Melbourne on 11 February 2000. | Mr Macfarlane takes the opportunity to expand on the role of monetary policy in managing an economic expansion Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Economic Society of Australia, Victorian Branch, Melbourne on 11 February 2000. * * * It is a great pleasure to be here speaking to the Victorian Branch of the Economic Society. I first spoke before the Society in 1986 and have been back a few times since. On each occasion I have appreciated the interest and attention you have afforded me. I hope that what I have to say today will again be of interest to you. I want to take the opportunity today to expand a little more on the role of monetary policy in managing an economic expansion. This is a subject that I have spoken on in the past, but clearly there is more to be said. On this occasion, I would not only like to restate the Reserve Bank’s position, but also deal with some of the views that have been put forward following our recent raising of interest rates. The current expansion, as you will all probably be aware, has now lasted longer than its predecessors in the 1970s and 1980s, and has also reached a higher level relative to its starting point. This is shown by the accompanying graph, which puts the three expansions on a comparable basis. Another interesting aspect of our current expansion is how similar it is to the much better known expansion in the US economy. While the US expansion has been going for 36 quarters compared to 35 for our own (measured up to the present quarter), our average GDP growth rate of 4.1% is higher than the 3.6% recorded in the US.1 Diagram 1 Expansions in GDP Cyclical trough = 100 Index Index 1990s 1980s 1970s Years since trough While it is satisfying to look back and see how far we have come, it is more useful to look ahead and see what we have to do if we are to continue on this path. For some time now, the task of monetary policy has been just that - to manage the expansion in such a way as to maximise its length. We do not want to repeat the experience of earlier expansions which ended so unhappily, and therefore we must ask ourselves what it is that we have to do this time to avoid that fate. This is the main subject of my These growth rates are calculated up to the September quarter 1999 - the latest data available for Australia: i.e. for Australia average growth rate from 91 Q2 to 99 Q3, for US 91 Q1 to 99 Q3. talk today, but before I get into it, I would like to ask your indulgence to detour through the age-old subject of the business cycle. The business cycle Economists have been analysing the business cycle for a century or more. From time to time after a long expansion, a few feel emboldened enough to suggest that perhaps we have seen the end of the business cycle. This happened in the very early-1970s, and a few people are canvassing the idea now as part of the concept known as the “new economy” or “new paradigm”. While there is undoubtedly substance in these ideas, some of you may be disappointed to know that I am not a member of the school that thinks the business cycle has been banished, although I am happy to recognise that increased productivity growth in the 1990s has made the task of macro-economic management somewhat easier than formerly. The most obvious benefit of this from the monetary policy perspective is that the overall rise in interest rates needed to prevent a potential inflationary situation developing now seems to be a good deal smaller than previously. There are two main mechanisms that lie behind the business cycle: 1. A business cycle of some sort may be the inevitable result of interactions involved in a complex dynamic system such as an economy. We know that cycles are the norm for such natural phenomena as the weather and animal populations, and some tendency in this direction is also probably intrinsic to economic behaviour. The first Nobel Prize in Economics was awarded to Ragnar Frisch for work on how business cycles can be propagated in simple models of the economy, and others such as Samuelson and Hicks expanded on this.2 More recently, the Real Business Cycle3 school of economists have taken this in a new direction by regarding all cycles as being a natural result of changes in the supply side of the economy. I do not want to take any of this too literally, but I would agree with one conclusion that comes out of all this work, namely that it is probably unrealistic to expect a dynamic system like a modern economy to expand in a smooth line; its natural progression is probably characterised by some element of cyclicality. 2. A business cycle may be viewed as resulting from policy mistakes. In this view, policy is kept expansionary for too long during the upswing, resulting in the build-up of serious distortions or imbalances - principally inflation. Eventually something has to be done, but in order to eliminate the by then well entrenched imbalances, the degree of tightening required is quite large. As a result, the economy is pushed into recession and unemployment rises sharply. This explanation essentially sees cycles as the result of a delayed monetary policy reaction function. In the popular discussion of economic developments over recent decades, it is the second type of cause - the tendency for monetary policy to contribute to booms and busts - that has been the focus of attention. Fortunately, it is also the type that we have most chance of avoiding if we play our cards right. This would not mean that all cyclical behaviour would be removed, but a significant part of it could be. Frisch, R (1933), “Propagation Problems and Impulse Problems in Dynamic Economics”, in Economic Essays in Honor of Gustav Cassel (London: George Allen and Unwin). Hicks, J R (1950), A Contribution to the Theory of the Trade Cycle (London: Oxford University Press). Samuelson, P A (1948), Foundations of Economic Analysis (Cambridge: Harvard University Press). Plosser, C I (1989), “Understanding Real Business Cycles”, Journal of Economic Perspectives 3(3), 51-78. The avoidance of imbalances The centrepiece of this approach is to act before the imbalances have had time to become entrenched. If you are seriously aiming to maximise the length of the expansion, the tightening of monetary policy comes earlier than if you are mainly interested in a high growth rate for the year ahead and less concerned with the length of the expansion. Of course, this can sometimes make the explanation of monetary policy moves more difficult, because those opposed to the move may be able to claim that there was not sufficient hard evidence of imbalances to justify it. It is instructive to look back over the past few decades to see how imbalances have built up towards the latter part of economic expansions. No two expansions or their demise have been the same, nor is it the case that a single imbalance was the cause of the problems. In all cases, there were several imbalances whose interaction led to the build-up of an unsustainable situation. Having said that, however, it must be recognised that the pre-eminent imbalance has been inflation. It is now almost universally acknowledged that the maintenance of low inflation is the sine qua non of a sustainable expansion. It was the rise of inflation, in one form or another, which spelled the death knell of our previous expansions. • In the long expansion which began in the 1960s and ended in 1974, inflation had already risen to 10% by the September quarter of 1973, which was before the effects of OPEC I had been felt. Following the rapid wage escalation of 1974, inflation then peaked at 17½% early the following year. • We had a rather weak expansion in the 1970s, which received a boost from the rises in commodity prices associated with OPEC II in 1979. But by 1981 another wage escalation pushed inflation from a low point of 8% in 1978 to a peak of 12½% in 1982. • In the strong, but shorter-lived, expansion of the 1980s the story was rather different. Although the increases in prices and wages were a good deal higher than we have become accustomed to in the 1990s, there was no sudden acceleration in the latter stages of the expansion as there had been in earlier episodes. It was a boom in credit-financed asset prices and the associated speculative activity that did the damage. At some stage the boom was bound to be followed by a bust, whether of its own accord, or as a result of monetary tightening. While asset price inflation is conceptually different to CPI inflation, and is further removed from the ordinary operation of monetary policy, it is nevertheless a classic case of the type of imbalance that can occur in the latter stage of an expansion and lead to its abrupt and painful ending. There are several other types of imbalances that often accompany the latter stages of an expansion and that can be a warning of danger. One is monetary excess, which is usually manifested as excessive provision of credit, and which often ends up financing speculative activity. I have already mentioned this in relation to the 1980s, when the credit expansion was primarily to business and resulted in the over-leveraging of that sector. It is also possible for the imbalance to show up as over-lending to households, as happened in the UK in the late-1980s. Another imbalance that can occur is in physical investment. We are accustomed to thinking of investment as a good thing and only ever worrying about it if it is too low. But over-investment can also be a problem at times in that it can lead to the build-up of over-capacity. This in turn can lead to a subsequent dearth of investment, especially if demand has not been as strong as had been expected by those who put the investment in place. Part of the severity of the recent Asian recession, and particularly the Japanese one, is due to the earlier period of over-investment. Some of that effect also occurred in Australia in the late-1970s/early-1980s during the so-called “resources boom”. Looking back over the post-war years, particularly during the fixed exchange rate period, the imbalance that often played the decisive role was the current account of the balance of payments. If it widened markedly, private capital inflow risked being insufficient to cover it, and interest rates would have to be raised to attract more capital and to reduce the demand for imports. This would be a major cause of the subsequent contraction, such as the “credit squeeze” of 1961. With a floating exchange rate, the current account is a less immediate constraint: it only becomes binding if the market begins to worry about an escalating external debt to GDP ratio, or about the country’s capacity to service the debt. The current expansion This brings me to the current expansion. We have now had two policy tightenings involving a net increase in the overnight cash rate of ¾ of a percentage point. The tightenings were pre-emptive in the sense that they occurred before imbalances developed - in other words, before there was clear evidence of the economy generally overheating. As the foregoing discussion makes clear, we regard these tightenings as an essential component of a strategy which is designed to allow this economic expansion to continue for as long as possible, and not be overwhelmed by the usual imbalances that bring an expansion to an end. This approach to monetary policy is not unique to the Reserve Bank of Australia; one can clearly see the same thinking behind the actions of other central banks. They too have been bruised by the failures of the 1970s and 1980s and are determined to do better this time. While I think this approach is generally well understood, there are obviously some who do not support it. There is nothing like a rise in interest rates to bring out critics of monetary policy who hitherto had been silent. Of course, everyone has a right to express their views, and I have no trouble with the recent debate. I can also see why the public expect explanations from bodies that make important decisions, and we are conscious of the need to meet that requirement. As well as the explanation contained in the press release that accompanied the monetary policy decision, we will be publishing a detailed quarterly report on the economy next week, and I appeared in public before a Parliamentary Committee two days ago. I will also take the opportunity in the remainder of this speech to address these issues. We have for some time been in a period characterised by good economic growth, low inflation and low interest rates. It has been one of the better periods for the Australian economy, especially in light of the turmoil among many of our trading partners. I think there has been a tendency for some observers to think this happy state of affairs could continue indefinitely provided we left it alone. A common theme has been “don’t meddle - just leave it alone”, or a related one, “are you afraid of growth?”. These views seem to us to be very short-sighted - in essence, they boil down to the view that the best way to manage an expansion is to keep interest rates at their low point for as long as possible, and only raise them when things have gone off-track. We think that if we did this, we would look back in a few years’ time and regret it, even though we might have been more popular in the short run. We also think that this approach fails to recognise just how expansionary the stance of monetary policy was in 1999. In either nominal or real terms, interest rates faced by borrowers were very low, as was shown by their eagerness to borrow. This expansionary stance of monetary policy was designed to combat a specific set of circumstances - weak world economy, expected domestic slowdown, and undershooting of the inflation target. When these circumstances changed, it was only reasonable that monetary policy would also change. We have tried to encapsulate the two changes taken together as a return to “neutrality” from a position that was clearly expansionary. Of course, there will always be considerable measurement uncertainties about the term neutrality - perhaps we should have referred to a return to the “neutral zone”. Be that as it may, if you do not have some idea of the concept of neutrality, you run the dual risk of: • being late by not changing monetary policy until overheating has actually occurred (or, in the opposite direction, until a recession is staring you in the face); • then being forced into a large and abrupt adjustment to recover the situation. Both of these outcomes effectively describe a “boom and bust” monetary policy, which is the approach we set out to avoid. Another variation of the argument that monetary policy should not have been tightened, or not by as much, is the appeal to US experience. Proponents of this view claim that Chairman Greenspan has been doing the right thing by letting the US expansion run on, and not being deflected by more conventional voices calling for monetary restraint to avoid future inflation. I certainly have no qualms about joining the chorus of praise for Chairman Greenspan’s and the Federal Reserve Board’s performance during this expansion, but I would like to make two points. First, we should remember that the Australian economy has actually grown faster than the US economy during this expansion. Secondly, the Fed has been prepared to put interest rates up as well as down in its management of the expansion. Interest rates were raised in 1994, again, although by only a small amount, in 1997, and again in a third phase in 1999 and 2000. The US experience argues against a policy of leaving interest rates at their low point for long periods in order to achieve a long expansion. Diagram 2 US Federal Funds Rate During Current Expansion % % l l l l l l l l l There is another argument I want to address before concluding. For various reasons, a number of people have been keen to put forward the view that monetary policy was tightened because of the impending GST. Some have done this for partisan political reasons, and others because they are still adhering to the view that monetary policy should only be tightened if general overheating is present. Since it is not present, they assume there must be some ulterior motive that has been hidden and therefore seize on the GST. I have said on a number of occasions and will say so again today - monetary policy was not tightened because of the GST. The tightening would have happened without the impending GST, just as it has in the United States, the United Kingdom, New Zealand, the Euro Area, Canada, Sweden, etc. We at the Reserve Bank are still operating on the assumption that the GST will affect prices only on a one-forone basis, and that wages will not be raised to compensate for the GST. The second assumption reflects the fact that reductions in income taxes will more than offset the rise in prices due to the GST. To raise wages as well to cover the GST would be to expect “double compensation”. There is no economic logic for this and, if it were to occur, it would be an example of the type of imbalance that could threaten the end of the expansion, and therefore threaten the downward trend in unemployment. Wage surges ended two of the past three expansions - it is important that it does not happen again this time. I think good sense will prevail, and that anyone who is encouraging “double compensation” will think again. Conclusion I think we have still got a long way to go in this expansion. It is already longer than its predecessors, and if we as a community are sensible and do not allow short-term thinking to overcome our long-term interests, it could rival in length the expansions of the 1950s and 1960s. As for monetary policy, we think it can play a very important part in achieving that end. Inevitably, there will be those who agree and those who disagree with what we are doing. We think, however, that monetary policy should be judged, not by any particular movement in interest rates, which will always be surrounded by some element of controversy, but by its performance over the whole of the expansion. | reserve bank of australia | 2,000 | 2 |
Opening address by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Euromoney Australasian Capital Markets Forum, held in Sydney on 14 March 2000. | Mr Macfarlane: Opening address to the Euromoney Australasian Capital Markets Forum Opening address by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Euromoney Australasian Capital Markets Forum, held in Sydney on 14 March 2000. * * * I would like to start by thanking Mr Brady for his introductory remarks, and to say that, in our view, Euromoney made a very sensible choice in scheduling a Capital Markets Forum in Sydney. It recognises the significance and growth potential of our capital markets, and the generally improved prospects for this region. I see a very impressive list of speakers and participants before me and I am sure there will be a lot of fruitful discussion over the next two days. The timing of the Conference is interesting in that it comes at a time when we can safely say that the Asian crisis is behind us and that, with a couple of exceptions, the outlook for this region is good. Perhaps it was Australia’s success in withstanding the contractionary effects of this crisis that encouraged Euromoney to hold its Conference here at this time. Whether that is the case or not, I would like to take the Asian crisis and its spillover to other emerging markets as the starting point for my comments this morning. I do not wish to go over the macro-economic issues because I have already done this before. I would instead like to ask what did we learn from this crisis that was of immediate relevance to capital markets? What are the implications for developed economies such as Australia? My answer to the first question is that we learnt that, for a country to play in the international financial market place, it needs a very sound financial infrastructure. I do not wish to suggest that it was the lack of this which caused the Asian crisis (the cause lay elsewhere), but it was this deficiency which made the crisis so deep when it occurred. By financial infrastructure, I mean: • the body of commercial law which covers everything from the concept of limited liability to bankruptcy provisions; • the conditions under which entities can issue debt and equity; • the body of competition law, trade practices law and securities regulation which ensures arm’s length dealing and limits related party transactions; • the supervision of the banking system, including regulation of near banks such as finance companies and merchant banks; • the provision of a safe payments system; • the application of sound accounting standards; • the existence of a court system which is capable of timely resolution of disputes and which has the confidence of local and foreign participants. This is quite a demanding list for several reasons. First, it is quite broad and involves the legal system, the Government, regulatory bodies, financial market participants and the professions. Secondly, and more importantly in my view, the achievement of a high standard in each of the items on this list takes a very long time. In our case, some of these things took a century to achieve. In many cases, we look back to periods as recent as the 1980s and wonder why we ever thought that we had done enough. That is one of the reasons I have been sympathetic to our Asian neighbours. It is inevitable that at an early stage of development of a country, its financial infrastructure will be only partly formed. Furthermore, even with the best will in the world, it is going to take time to bring these things up to scratch. When people say that the recent financial and economic instability was the inevitable result of a combination of the free flow of international capital plus inadequate financial infrastructure, there is much truth in the statement. But if that is the case, we cannot expect a sudden return to stability because the second essential component - the adequate financial infrastructure - will take years, or possibly decades - to achieve. The second thing we learnt from the Asian crisis, and its spread to other countries, was the necessity of having deep and liquid financial markets. We also learnt it was an advantage to have a floating exchange rate, and to have a capital market that was diversified and not one that was too dependent on the commercial banking sector. This brings me to the Australian financial system, to the capital markets and to financial markets more generally. The Australian financial system has developed rapidly over the past 20 years or so, with deregulation being a major driver of change. Deregulation started in the late 1970s with the gradual removal of controls over bank interest rates. It picked up speed in the early 1980s with the removal of other controls on banks, freeing up interest rates on government securities (by adopting tender arrangements for new issues), floating the exchange rate and opening up the banking system, in the mid 1980s, to foreign competition. Shortly thereafter, bank supervision was formalised, and the Basel framework for capital adequacy of banks was adopted in 1988. The development of the financial markets in Australia is not, of course, the result purely of regulatory change. Financial institutions themselves have taken the opportunity to develop new markets and introduce new products. For example, in 1979 the Sydney Futures Exchange was the first derivatives market outside of the United States to introduce a contract based on a financial instrument when it introduced the futures contract on 90-day bills. Australian financial markets have become larger and more diverse over time and are now regarded as both sophisticated and deep. Turnover in the major Australian markets - the foreign exchange, money, equity and derivatives markets - has grown at average rates of more than 20% a year since deregulation. The exception to this rule is the market for government securities, which has grown more slowly than other markets in recent years because of the Government’s run of budget surpluses. The relatively even pattern of development in Australia reflects both a lack of regulatory distortions or incentives, and the fact that, unlike the entrepot markets in Singapore and Hong Kong, Australian financial markets have a reasonably large domestic economy to serve. As in most countries, the foreign exchange market has the largest turnover, with about $75 billion a day, a little over half of which involves the Australian dollar. The Australian foreign exchange market is the ninth largest in the world and the Australian dollar is the seventh most actively traded, marginally behind the Canadian dollar. To put this in perspective, Australia ranks as the 14th largest economy in the world, so the Australian dollar trades more actively than might be expected given the size of the economy. Its relatively high position globally reflects the place the Australian dollar holds in portfolios of international funds managers because of the opportunities for diversification it affords. The standing of the Australian dollar as a world currency is recognised by its inclusion in the first wave of seven currencies in the CLS System or Continuous Linked Settlement System for foreign exchange settlement which is scheduled to come into operation in 2001. The other currencies are the US dollar, euro, yen, Swiss franc, pound and Canadian dollar. Australia’s position in world financial markets was reinforced recently when it was one of four “significant financial centres” invited to join the G7 countries in the Financial Stability Forum, an inter-governmental group which monitors risks in the international financial system. As a “systemically significant economy”, Australia is also a member of the G20, which has been charged with broadening the dialogue on key economic and financial policy issues globally. A major gap in the development of Australian markets until recently was the domestic non-government bond market. This market, however, has recently grown strongly, representing further welcome diversification for borrowers and lenders. With non-government bonds on issue now totalling about $66 billion, this market is now about as large as the market for Commonwealth Government securities. This development is beginning to produce a “credit curve” in Australia. Now that bond yields in Australia have moved lower on the back of low inflation in recent years, the incremental pick-up for taking credit risk probably looks more attractive to investors than it might have a decade ago when bond yields were perennially double-digit numbers. The financial infrastructure in Australia has evolved to accommodate this growth of financial activity. Practitioners and the authorities have worked together to ensure that the “plumbing” kept pace with the system it was serving. In the case of payments and settlements systems, Austraclear and the Reserve Bank’s RITS system, which introduced delivery-versus-payment, and then the ASX’s CHESS system for equities were important steps forward. Our systems meet the highest international standards, as specified by the Group of 30. They have been inter-linked through the RTGS system to provide a very efficient payments and settlements infrastructure. Australia’s RTGS system is among the most advanced in the world because of the way it closely links to securities settlements, giving it a very high coverage of high-value transactions. We have already witnessed a major reorganisation of our financial regulatory agencies with the formation of APRA and changing responsibilities for the RBA and ASIC. The reform process is, of course, ongoing. The main item on the agenda at present is the so-called CLERP initiative - Corporate Law Economic Reform Program - which aims to achieve best practice in fields such as accounting standards, disclosure, corporate governance, and takeover law. It also aims to facilitate the application of technology to the conduct of business and promote competition in financial markets, including in investment products. The expansion of financial activity in Australia has not been confined to market trading. Holdings of financial assets in general have expanded rapidly. In the early 1980s, holdings of financial assets were about the same size as GDP; these days, they are about 2 1/2 times the size of the economy. The development of financial markets and the financial system has not benefited only the “big end of town” - if anything, the system has become more “democratic”. One measure of this is the spread of ownership of equity, with share ownership by individuals increasing sharply in Australia in the 1990s. The Australian Stock Exchange estimates that 54% of adult Australians now hold shares directly (including through personally managed superannuation funds); in 1991, this figure was 22%. This trend reflects the programs of privatisation and demutualisation in Australia in the 1990s. Another measure of the “democratising” of the financial system is that practically all permanent employees now receive privately funded superannuation benefits, compared with less than half a decade ago. It is the investment of these funds which has provided such an important stimulus to the growth of the funds management industry over the past decade and a half. It is growth in the size and diversity of financial markets that makes life rewarding and profitable for market participants like yourselves. But from my perspective, the size, and particularly the diversity, of financial markets are also important. Representing an institution that is responsible not only for monetary policy, but also for financial stability more generally, I am conscious of the value of a strong and diverse set of financial markets and institutions. To illustrate this point, I want to conclude with a few words from Alan Greenspan. In a speech last September on Lessons from the Global Crisis, he went over the experience of a number of countries and attempted to draw some conclusions, which are of relevance to what I have been discussing. In his view (and I will quote): “The mere existence of a diversified financial system may well insulate all aspects of a financial system from breakdown. Australia serves as an interesting test case in the most recent Asian financial turmoil. Despite its close trade and financial ties to Asia, the Australian economy exhibited few signs of contagion from contiguous economies, arguably because Australia already had well-developed capital markets as well as a sturdy banking system. But going further, it is plausible that dividends of financial diversity extend to more normal times as well.” On that note, I will conclude and wish you all well for a fruitful and stimulating Conference. | reserve bank of australia | 2,000 | 3 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, on 22 May 2000. | I J Macfarlane: Statement to House of Representatives Standing Committee on Economics, Finance and Public Administration Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, on 22 May 2000. * * * It is a pleasure to be here in Melbourne again for our regular half-yearly appearance before the Committee. I know we met in March and touched upon monetary policy, but that meeting was mainly about Reform of the International Financial System. On this occasion, we will no doubt have a lot more time to spend on monetary policy. I would now like to start this meeting in the traditional way by reviewing the forecasts I gave to the Committee last November, and then outlining our current views on likely developments over the year ahead. Last November, with half a year’s data available, I said that we expected GDP growth through 1999 to be 3½%. In the event, it was 4.3%, which continued our record of expecting a modest slowdown that did not arrive. I also said that we expected growth to be 4% in the year to June 2000, and on present indications this still looks likely, even though the rate may well dip below 4% in the year to March. Of course, it will be more difficult than usual to read the true trends this year, with expenditure being shifted between quarters because of the GST, and the boost from the Olympics. Most monthly indicators of economic activity point to a slowing so far in 2000. However, it is too early to know whether this merely represents the slowdown in domestic demand that we have all been waiting for, and we have had built into our forecasts for some time, or whether it represents something bigger - a significant slowing in GDP growth. Our judgment is that we are seeing mainly the former, namely a change in composition of GDP growth. In other words, the slowing in private domestic demand, which is undoubtedly occurring, will be largely offset by the boost that we are getting from net exports and will soon get from fiscal policy. While we expect some slowdown in GDP in the sense that we do not expect to repeat the 4½% average that we achieved in 1997, 1998 and 1999, we still see quite solid growth ahead. We have no quibble with the sort of figures that were contained in the Budget Papers showing growth in GDP of 3¾% over 2000/01. Such an outcome would be quite a remarkable achievement compared with the record of the past three decades, but I will return to that subject later. On inflation, in November we forecast that the CPI would rise by 2% in the year to December 1999 and by 2¾% in the year to June 2000. We got closer to the mark in these forecasts - the outcome for the year to December 1999 was a little lower, at 1.8%, and we now think that the figure for the year to June 2000 will be a little higher, at 3%. Some of the increase in the CPI is due to temporary factors, so that the 3% for the CPI corresponds to about 2½% for underlying inflation. Thus we have finished the period when inflation was below the bottom of our band - a period that lasted longer than any of us expected - and we have moved back to where the CPI is near the top of our band, but partly due to some temporary factors. Where to from now? This will be particularly hard to judge, given that for at least a year the yearended figure for the CPI will be obscured by the once-off lift due to the GST, and then the effects of the abolition of wholesale sales tax. At present, we feel that the most likely outcome for inflation once all the dust has settled - i.e. once we are well into 2001/02 - is that it will be in the 2-3% target range, probably in the upper half. As usual, there is a large margin of uncertainty attached to that forecast, but the adjustments to monetary policy which have been made over the past six months give us more confidence that inflation should be contained. I would now like to move away from the short term and turn to the medium term. Most developments in monetary policy can only be understood fully in this context although, by necessity, most commentary concerns short periods such as month to month, in line with our Board Meeting, or even shorter, such as day to day, reflecting deadlines of the daily press. I will start by restating the logic of the inflation-targeting framework, which is the underpinning of our whole medium-term approach. We have an inflation target that says inflation should average somewhere between 2 and 3% in the medium to long run. We accept that at times it will be outside this range, but if we think this is going to happen more than briefly it calls for adjustments to monetary policy which will return inflation to the target and then keep it there. We have based our monetary policy on this framework not because we only care about inflation, but because we think it will give us the best result for the whole economy in the long run. In particular, if applied sensibly, it will enable the economy’s average growth rate to reflect its potential growth rate and therefore deliver the maximum sustainable increase in employment and living standards. We have already seen nine years of expansion with growth averaging over 4%, a considerably longer expansion than we were able to achieve in the 1970s and 1980s. And there is every prospect that the expansion will continue for a good deal longer. For the first time in my working life, Australia in the 1990s has come near the top of the decade growth rates among developed countries. We grew faster than the United States, and only Ireland, among developed countries, recorded faster growth. This growth occurred at a time when our inflation rate averaged about 2¼%, a good deal lower than in earlier decades, and comparable with international standards. There was also less variability from year to year in growth than in earlier expansions, although some variability is inevitable: we have had annual growth rates at over 5% and at less than 3% during this expansion, yet its fundamental momentum has remained intact. I think the system has proved itself to be a very good one, and I am confident that it is the best way to ensure that monetary policy makes sense in the medium term. It is also worth noting that during the course of the expansion, we have had one complete cycle in interest rates - rises in 1994, then falls in 1996-98. These played their part in sustaining the expansion. The increase in official interest rates of 125 basis points that has occurred over the past seven months has to be seen in this context. For the present expansion to continue as long as possible, monetary policy has to be adjusted as circumstances change. The economy has been undergoing a shift from a period when inflation had been below the target to one where it was going to be in the target range. Without policy adjustment, there was the prospect that it would, in time, rise above the desired range. Until relatively recently, we were receiving information on economic activity that indicated the economy could even have been accelerating beyond the 4½% growth that had prevailed over the 1997 to 1999 period. From our perspective, the decisions to raise interest rates were relatively straightforward. The situation is not as straightforward now. Signs of a near-term acceleration in growth have gone. As discussed earlier, there are now signs of slowing domestic demand, some of which may be in response to the tightenings that have already occurred. Other things being equal, this should be helpful in containing inflationary pressures. Other developments, principally the lower exchange rate, will act in an expansionary direction, and potentially put upward pressure on inflation. It will be a difficult time for reading and forecasting the domestic economy, and all this will take place against the backdrop of an international economy dominated by the uncertainty of the unfolding events in the United States. Markets, as always, will be looking for guidance. The more thoughtful will appreciate the complexity of the situation, the less thoughtful will be expecting to be told the “formula” that we are using. Unfortunately, there is no “formula” other than the guiding principle of the inflation-targeting regime. This means that we will be assessing the outlook for inflation as judged by the factors which form the basis of our forward-looking approach to monetary policy. Growth in demand and output, and the extent to which that places pressure on the economy’s capacity, are clearly important. We judge this by examining all the available monthly and quarterly time series data on economic activity, including those which give an impression of intangible factors like “confidence”. We monitor trends in commodity prices, wholesale prices, and wages, as well as the CPI and the various measures of underlying inflation derived from it. The wages data may be particularly important in the year ahead, given the difficulties in interpreting price indexes. We have to allow for structural changes - such as the increased competitive pressure in goods markets. This has been an important ingredient in maintaining downward pressure on many prices, and should be helpful in negotiating the introduction of the GST. Inflation expectations are important - since it is the anticipation of price rises that drives many decisions. We need also to consider the financial side of the economy - the expansion of credit, trends in asset markets and the extent of risks which may be building up there. We then complement this essentially domestic analysis with an appreciation of what is happening in the international environment in which Australian producers and consumers make their decisions. We can not afford to ignore the world price level, world interest rates, or the variable which connects both of them to the Australian economy - the exchange rate. Changes in the price of imports in foreign currency terms can have a large impact on domestic inflation as the OPEC oil price rises of the 1970s showed. The recent oil price increases demonstrate the same principle, on a much smaller scale. Rises in a range of raw materials prices, driven mostly by global trends, are also having an impact on the cost of producing goods in Australia. In the opposite direction, the subdued world price environment of 1997 and 1998 helped contain any inflationary fallout from the lower exchange rate we experienced during the Asian crisis. Movements in the exchange rate clearly affect inflation and, as such, are an integral part of any inflation-targeting regime. That is why they are frequently mentioned by central banks which operate monetary policy in this way. But there is no mechanical relationship between the level of the most frequently quoted measure of the exchange rate - the rate against the US dollar - and the future domestic price level. For a start, the price effects are better approximated by the trade-weighted index. Second, a temporary movement in the exchange rate may have little or no effect on prices and so some attempt must be made at estimating medium-term developments, or at least market participants’ expectations of medium-term developments. Finally, a change in the exchange rate may have different implications if it primarily represents international views about our economy and policies, or if it is because we are being swept along with other countries in an international adjustment process. All of these factors are relevant and have to be taken into account with due weight. But that is done under the unifying framework of the inflation-targeting approach to policy. As I have noted above, this approach has delivered tangible benefits. I am convinced that it will continue to do so. Mr Chairman, it is a difficult time to be making monetary policy. The world environment is changing. Most of these changes are for the better - our region is in recovery, as opposed to the severe recession of two years ago, and global growth is strong. Our terms of trade are improving. Some other changes in world capital markets, for example - are rather less benign for Australia. Adapting to these changing circumstances presents a challenge. At such times, it is important to keep our eye on the main goals - to sustain a long expansion, and to address early potential imbalances which could impede the expansion’s continuation. However, we cannot assume that we have a choice of outcomes for the Australian economy, in terms of growth and inflation, which is invariant to what happens in the rest of the world. While we are benefiting from the stronger world growth compared with recent years, we will also be affected by the contractionary effects of the lift in world interest rates. As the forecasts I mentioned in the beginning show, the year ahead will most likely be one of slightly reduced growth, and somewhat higher inflation, compared with the exceptional outcomes of recent years. But if we can sustain the economic expansion through a tenth and eleventh year, even if its pace moderates for a time, and at the same time keep inflation low, we will have achieved something which has eluded us for three decades. That is a very worthy goal. It is what we aim to do. | reserve bank of australia | 2,000 | 5 |
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Australian Business in Europe, in London, on 26 May 2000. | I J Macfarlane: Medium-term developments in the Australian economy Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Australian Business in Europe, in London, on 26 May 2000. * * * It is a great pleasure to be in London again speaking under the auspices of Australian Business in Europe. The last time I spoke to this group in London was in mid-1998, which was very close to the low point of the Asian crisis. My main purpose on that occasion was to reassure investors in the City that Australia would get through the Asian crisis in reasonable shape. As you are, no doubt, all aware, the results were better than any of us could have predicted at the time. The economy continued to grow at 4% plus, inflation remained low and, although the balance of payments deteriorated, it was temporary and not all that different to what has occurred on a number of other occasions in the past 20 years. The international situation is a lot different now. Most of the Asian economies are growing again and world output growth is a good deal stronger than in 1998. At the same time, the structure of world interest rates has moved up, as has Australia’s. Whereas two years ago the focus of attention was on Asia and other emerging markets, the focus now seems to be more on the United States than in any earlier stage I can remember. I would like to take the opportunity today to update some of the things I said two years ago, but to do so in a way which focuses on medium-term developments. I will take as my starting point a comparison of economic growth rates of developed countries over the most recent decade (Table 1). These figures from the OECD show that except for Ireland, which everyone in this audience would know is a very special case, the Australian growth rate has been higher than for any comparable OECD country. (Incidentally, each of the countries in this list experienced a recession at some stage earlier in the decade, which helps explain why the decade averages look a bit lower than the growth rates that we have been accustomed to over the past few years.) Table 1: Real GDP Growth Average annual rate (over 1990s) ------------------------------------Ireland 6.7 Australia 3.5 Norway 3.3 United States 3.2 Netherlands 2.9 New Zealand 2.6 Spain 2.4 Canada 2.3 Denmark 2.2 Germany 2.1 Belgium 2.0 United Kingdom 2.0 France 1.7 Finland 1.5 Italy 1.4 Japan 1.3 Sweden 1.3 Switzerland 0.9 ------------------------------------Sources: National Statistics agencies, IMF and OECD. For me, however, the interesting thing about this table is that this is the first decade in my working life where Australia has figured in the top half of the table, let alone being virtually in the top position. We must have been doing something right. One of the things that we are doing right is that we have kept the 1990s expansion going longer than the expansions of the 1970s or the 1980s (Graph 1). The 1980s expansion was quite a strong one but it turned down midway through its seventh year. The 1970s expansion was a much weaker one even though it lasted a bit longer. The 1990s expansion shown in the diagram covers the eight-and-a-half years to December 1999, but we are confident that it has continued through the ninth year, and by the time we reach the September quarter we will be in our tenth year. So, sustainability of the expansion is the first key to our improved performance. The second key is improvements in productivity. Here, if we use the simplest measure of productivity, which is labour productivity, the pattern in Australia is very similar to the pattern in the United States (Graph 2): strong growth in the 1960s, a flattening out in the 1970s and 1980s, followed by a pick-up in the 1990s. But the pick-up in the 1990s in Australia has been more pronounced than in the United States. We have gone from 1.7% per annum to 2.9% per annum, whereas the United States went from 1.5% per annum to 2% per annum. I do not want to suggest that this means we have higher productivity than the United States; remember we are only talking here about rates of change of productivity. The fact that we have been able to speed up more than they have is, in large part, because we were starting from a lower base. Whilst I am on the subject of productivity, I want to make two general points: The first is the obvious one which I have made on numerous occasions that the main reasons behind the pick-up in productivity growth have been structural changes made over the past 15 years in the Australian economy which have increased flexibility and competitive pressures. These changes include: - further tariff reductions; - financial deregulation; - labour market deregulation; - privatisation; and - a more stringent regime of competition policy. It has not been easy to put these changes in place, even though there has been for most of the decade considerable bipartisan political support for change. Inevitably, compromises have had to be made and, viewed in isolation, some of the individual changes do not look to be all that thorough. But taken together, I think the total is larger than the sum of the individual parts. Of course, one aspect of the economy that was not reformed during this period was the tax system. But that will change in about a month’s time when a Goods and Services Tax is introduced to replace the old wholesale sales tax and to take some of the weight off income taxes. The second point about productivity I want to make concerns the new economy/old economy divide. Some people tend to judge a country’s technological sophistication by, for example, the number of listed companies in the IT sector. Although Australia has a number of companies that fit this description, about 70 or so in fact, their combined share of the stock market is not large by international standards. But that is only one measure of technological sophistication. Another equally important one is the country’s or the business sector’s willingness to embrace new technology. This may be a better guide to productivity improvements than focusing only on the IT sector. I have two measures of the spread of technology: - The first is Internet usage per cent of population, which shows Australia in a relatively high position of the countries compiled by the Consulting Group, NUA (Table 2). Table 2: Internet Usage Per cent of population ------------------------------------Norway 49.8 United States 45.3 Sweden 44.3 Canada 42.8 Finland 38.1 Australia 36.4 Denmark 35.5 Netherlands 28.5 UK 26.6 Switzerland 23.4 Slovenia 23.0 Austria 22.7 Taiwan 21.7 South Korea 21.3 Belgium 19.6 Germany 19.4 Japan 16.8 Italy 16.4 Ireland 16.3 New Zealand 15.8 ------------------------------------Source: nua.ie. Most data from late 1999-early 2000 surveys. - A measure that is more specific to the business sector is the number of e-commerce servers per head of population. On this measure, Australia is second only to the United States (Table 3). Table 3: E-Commerce Servers July 1998 ------------------------------------Servers per Country/Region million population United States 55.3 Australia 34.5 Canada 31.0 New Zealand 25.3 Singapore 22.0 Switzerland 21.5 Israel 16.3 Ireland 15.4 Scandinavia 13.6 UK 12.2 Hong Kong 10.9 Continental Europe 5.0 Japan 3.4 South Africa 2.8 Taiwan 1.9 ------------------------------------Source: www.netcraft.com So, in terms of willingness to adapt to new information technology, Australia would get a very high score. This, along with the measures I mentioned earlier, helps to explain why there has been such a significant lift in the rate of growth of productivity over the last decade. A big lift in productivity growth has a beneficial effect on many areas of the economy. A lot of it is passed through to consumers and, in the process, this makes it easier to maintain low inflation. Some of it can also make businesses more profitable, which is, after all, the incentive that drives much of the efforts towards improving productivity in the first place. The two broadest measures of corporate profits as a percentage of GDP in Australia have been trending up over the past decade, with profits after interest showing a much sharper rise than profits before interest, again another indirect benefit of low inflation (Graph 3). You will note that this measure of corporate profits is adjusted for privatisations. If that had not been done, the lines would have trended up more sharply because of the significant number of privatisations that have occurred over the last decade. Largely as a result of these privatisations, the percentage of the population in Australia who are now direct shareholders has risen sharply and is exceptionally high by world standards. The proportion who hold shares directly is 41%. I have not got a table of comparisons with me, but I believe this figure is now about as high as in the United States. If we added to the number who directly hold shares, the number of people who voluntarily hold shares through equity unit trusts (or mutual funds, to use US terminology), the number would go to about 54%. And, of course, if we added in those who contribute to an accumulation pension fund, exposure to shares would be almost universal. Table 4: Consumer Price Inflation Average annual rate (over 1990s) ------------------------------------Spain 4.0 United Kingdom 3.5 Sweden 3.0 United States 2.9 Germany 2.5 Netherlands 2.4 Norway 2.4 Ireland 2.3 Australia 2.3 Switzerland 2.2 Belgium 2.1 Canada 2.1 Denmark 2.1 Finland 2.0 France 1.8 New Zealand 1.8 Japan 1.1 ------------------------------------Source: OECD Can I turn now to inflation? If we look at an international ranking of inflation rates over the past decade comparable to the one I showed for real GDP growth, Australia finishes in the middle of the field with an average inflation rate of 2.3% per annum (Table 4). This is a huge improvement on previous decades, but, of course, virtually every country has also shown a significant improvement. There are a number of factors behind this improvement, but the one I would like to mention today is our monetary policy regime. Like a number of English-speaking countries - the UK, Canada, New Zealand - Australia has a monetary policy regime which is based on the trilogy of an inflation target, an independent central bank and a floating exchange rate. Our inflation target is not all that different from that of the UK in that we aim for an average inflation rate of somewhere between 2 and 3% over the long term, recognising that it could go above or below that range from to time, but like the UK, it is the average that matters. One consequence of lower inflation in Australia is the convergence of our bond yields to international norms, or at least the US norm (Graph 4). Some of you may have been able to remember that as recently as a decade ago, Australian government bonds were 400 basis points higher than US government bonds. We think of that as the bad old days, but if you were an international funds manager, you may look back on it as the good old days. Another factor that has contributed to the improved acceptance of Australian government paper is the recognition that our fiscal policy is very responsible by international standards. The Budget has been in surplus for some time now. This, together with the proceeds of the privatisations I referred to earlier, has meant that the outstanding stock of government debt has fallen in absolute terms, and as a percentage of GDP is now the lowest among developed countries (Table 5). Table 5: Public Debt Per cent of GDP; 1999 ------------------------------------Italy 117.7 Belgium 114.1 Japan 105.4 Canada 86.9 Spain 70.4 Sweden 68.3 France 65.2 Netherlands 62.9 Germany 62.6 United States 59.3 Denmark 55.4 United Kingdom 54.0 Finland 44.9 New Zealand 34.8 Norway 34.3 Australia 31.3 ------------------------------------Source: OECD Economic Outlook, December 1999 I am not sure how fully aware international investors are of these excellent figures on growth, inflation, productivity, public debt, etc., so I have taken the liberty today of indulging in a bit of trumpet blowing. One economic fact, however, that markets are aware of is that Australia always runs a substantial current account deficit and, therefore, is a net importer of capital. I have nothing very new to say on this subject other than to point out that it is the result of private agents’ decisions rather than government’s demands on capital markets, and that its magnitude has not changed very much in the last 20 years. It has varied cyclically, of course, but around a basically flat trend. At its cyclical low points it tends to be about 3% of GDP, and at its high points a bit over 6% (Graph 5). In this cycle, which was heavily influenced by the contraction of our Asian markets, the deficit touched 6.1% of GDP in the September quarter of 1999, but has since fallen noticeably. The conditions are right for further falls over the next year, given that exports are now growing rapidly again (up 19% over the last 12 months). The medium-term issue, of course, is whether the capital we are importing is being put to good use. The output growth, the productivity growth and corporate profit story suggest that it is. So far this year, exchange rates have been in the forefront of attention. For the first few months of this year, the Australian dollar declined quite sharply against the US dollar, more so than other major currencies. More recently, it has been a bit steadier, while a number of other currencies have weakened more noticeably against the US dollar. With firstly the euro, then the pound, then some other smaller currencies joining in, the position of the Australian dollar is now not so lonely. With the United States being perceived as the country most likely to need higher interest rates, we should not be surprised by an international adjustment mechanism which has seen other currencies all falling by a somewhat similar amount against a rising US dollar. Turning to the medium term, these developments have meant a fall in the Australian Trade-Weighted Index or effective exchange rate over the course of 2000. The more noticeable thing, however, is that since about the second year of the period of floating in Australia, i.e. since about 1985, the Australian dollar in effective terms has fluctuated around an essentially flat trend, with its present value being near the low end of this range (Graph 6). I think I have taken enough of your time on the medium term. Turning briefly to the period ahead, we expect that the current expansion will continue into a tenth and eleventh year, i.e. for the length of our current forecasts. Beyond that, the outlook is too distant for us to forecast. We are conscious that the reason we have done so much better this time than in previous expansions is that we did not let the usual late-cycle imbalances develop. The most common of these, of course, is inflation. We are confident that our early action on monetary policy, plus our adherence to the discipline of the inflation targeting regime, will mean that we continue to maintain low inflation in the years ahead. | reserve bank of australia | 2,000 | 6 |
Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to CEDA Gold Series Dinner, held in Sydney, on 29 June 2000. | Stephen Grenville: Globalisation and the international financial architecture: writing (and righting) the rules Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to CEDA Gold Series Dinner, held in Sydney, on 29 June 2000. * * * It is a self-evident truism that globalisation has changed Australia, and the world. We see it in the array of goods available, in our travel habits, in media and entertainment, and in the intellectual debate. While it has its opponents, their arguments are often partial - criticising aspects of globalisation, rather than the overall impact. My central theme is that globalisation brings with it huge benefits, but at the same time, creates a need for a much more comprehensive set of rules to govern the way it will be carried out, analogous to the complex and ubiquitous rules which govern interactions in the domestic economy. These generalisations have application in an area relevant to the central bank role: the development of an appropriate international financial architecture. Are better international rules needed and feasible? Some will argue that this search for more comprehensive rules is either unnecessary or futile. Some would say that, to the extent that globalisation involves economic interchange, we can simply rely on the invisible hand of the free market, and that therefore rules will not be necessary. The vision, for those who hold this view, is of an Adam Smith world in which everyone pursues their own individual self-interest but at the same time achieves society’s goals, with no more than a Walrasian auctioneer to organise the process. This is, I suspect, the sort of world envisaged by Thomas Friedman (1999) when he talks about the “Golden Straitjacket” - the set of rules which globalisation imposes on participants. But what we know from experience with domestic markets is that every transaction and every market is governed by a complex set of rules. Sometimes these are set down by governments, but where they are not, the participants themselves find it advantageous to define a set of rules (in this, the example that springs to mind is futures markets, where the government has left these largely unregulated but the participants need to define their relationships with each other by quite comprehensive rules). Sport, too, provides analogies - there are no games that are a total free-for-all, but each game tries to find a sensible mix of rules which will allow individual talents to come to the fore (a level playing field), team spirit and skills to be rewarded, the challenges to be appropriately demanding, and for the “best man to win”. Some see the effort to develop rules as futile. They argue that in a world of sovereign states, it is very difficult to impose a set of binding rules which go beyond the realm of any one government. There is much force in this argument, and the only counter is to say that, one way or another (either through agreements between governments or informally-developed rules), there are already a complex (if not comprehensive) set of international rules in a wide variety of areas. International cooperation on postal services, telecommunications, and (less successfully) airlines are all relevant examples. The feasibility of developing these further will depend on the nature of the rules required. Some rules will benefit all parties (common sense or “win/win” rules), and agreement on these should be possible. Such cases are not trivial - there are many examples where agreement benefits all: I see these as analogous to the rule which determines which side of the road cars will travel on in a particular country - it does not matter much which side, but it is important that everyone has a clearly-understood set of rules which they stick to. For those with a sporting bent, the examples might be the uniformity of sporting codes internationally: everyone plays soccer to the same set of rules, because it works better that way. These are the easy cases, which do not involve serious distributional issues, where the rules determine winners and losers. But even with thorny distributional issues, domestic jurisdictions successfully arbitrate over distribution and property rights. While rules of this nature will be intrinsically much harder to formulate and enforce internationally, the domestic political process shows that it is possible to achieve general community acceptance of such rules (even when they discriminate or disadvantage a particular group in the community). The same needs exist internationally: only the process is deficient. Technology and the global imperative Not only is globalisation bringing countries closer together and integrating them more fully, but the nature of technology is ensuring that the goods (and, increasingly, services) being traded are a bad fit for the Adam Smith free-market model (or the Ricardian cloth-for-wine model). The old economy, with its bales of wool and slabs of steel, is being replaced by an economy in which services are much more important, and in which information goods or knowledge goods are far more important in consumers’ purchases, and are readily internationally traded. The central characteristic of these goods, which takes them outside the bounds of the simple free-market equilibrium model, is that the marginal cost is much less than the average cost. This not only applies to “weightless” knowledge goods, but for many physical goods, the cost of producing the first is enormous (research and “tooling up” costs), while the cost of producing another unit is minimal (eg pharmaceuticals). The usual rules of economics are either inapplicable or their application is vastly more complicated. No longer will a producer increase output until marginal cost equals price. Under old-fashioned goods, the main effort by the producer is to make them more cheaply through more efficient use of capital and labour inputs. But for goods whose marginal cost is low or zero, the producer has to find a way of avoiding selling goods at marginal cost, because this would leave total costs unmet. To add to the inconvenient lack-of-fit with the free-market equilibrium model, information goods and many of the new service goods have the characteristics of public goods: in the jargon, they are both non-rival and non-excludable - one person’s consumption does not diminish the availability for others, and it is difficult or impossible to exclude one person from consuming these goods. Add to this the idea of networking goods (where the number of consumers of the network increases the benefit to each of them, such as a telephone system), and the greater opportunities for “winner-takes-all” outcomes (where the world-renown sport or entertainment star displaces all the local heroes), and the market dynamic differs greatly from the textbook model. These characteristics force producers in two important directions - towards creating some elements of monopoly attaching to their production, and to seek larger and larger markets. Larry Summers (2000, p 2) captures the first point this way: “The constant pursuit of that monopoly power becomes the central driving thrust of the new economy.” On the second, Zuckerman (1998, p 20), in triumphalist mode, says: “On the brink of the 21st century, the United States is at a point reminiscent of its entry into the twentieth. … Today, of course, the new frontier is the global economy.” There is a common belief that the most obvious manifestation of new technology - the Internet operates in a world without rules. The Economist (2000a, p 77) put it this way: “There is nothing like an absence of regulation for stimulating innovation. Such was the creed of early Internet enthusiasts. The myth that the Internet has thrived only because it is anarchic is now firmly entrenched.” But The Economist goes on to note that even the anarchic Internet is subject to myriad rules: “In fact, cyberspace is highly organised and even regulated, and not just for technical standards.”1 This sounds very “New Economy”. Just how new these concepts are remains a moot point. For instance, Thomas Jefferson gave probably the best description of the public good nature of information when he said “He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me.” (quoted by Summers (2000, p 2)). Some of the characteristics of the New Economy are variants on the old “economies of scale”. But this does not diminish the motivation of producers to become monopolists. And, of course, the Internet began as a public-sector (US Defence Department) project. Whether or not these concepts are an example of old wine in new bottles is beside the point: the powerful dynamic of globalisation is clear in the figures. World trade has grown at more than twice the pace of GDP growth for decades, and foreign direct investment rose six-fold during the decade to 1996 (compared with a mere doubling of domestic investment in the same period). Faced with this reality, we have to find a set of rules which allows and encourages these low-marginal-cost goods to be produced (the development costs have to be recouped) without the dead-weight costs of monopoly. We need a set of rules which provides a fair and efficient international game.2 If the reaction of the individual producer (the quasi monopolist) is to defend and enlarge his monopoly power, then we see this same tendency among nations to pursue their own narrow self-interest. Hal Varian (1999) quotes a neat example from US history of how perceived self-interest was pursued, and also how the incentives might change over time, altering the rules. The United States refused to extend copyright to international authors until the late 19th century, being a large (free-riding) consumer of the books which had been written elsewhere, particularly in England. As the balance of American authorship changed, the United States finally granted copyright protection to international authors (as well as its own), but in order to continue to provide protection to American typesetters, insisted that this copyright protection extend only to those foreign works that were typeset in the United States. This provision remained until the mid 1960s. While we have noted that where governments do not lay down rules, private individuals will tend to work out their own set of rules, perhaps the most interesting cases are where individual producers have managed to set the rules and then coopt the state to enforce their rules. At one level, one might ask why our own authorities should prevent us from buying fake brand-name designer-goods, and pirated CDs and software, when the main beneficiary of the higher prices we currently pay is a foreigner. This is obviously a controversial area, and before I get into trouble here, I should also acknowledge that as soon as we admit that there are legitimate things such as intellectual property rights, then there is a strong case for getting the state’s apparatus to defend these, in the same way that it defends other property rights such as our cars and our houses. But having acknowledged the importance of the concept of intellectual property rights, the unanswered issue then is exactly what value we should put on these. When I go to buy a copy of Microsoft Windows for $200, say, is this the “correct” price, in the sense of giving an appropriate incentive for software producers to go on producing software and selling it in Australia? There is clearly a powerful case for such protection (to reward and encourage innovation), but one would have more faith in the economic rationale behind this if it were not so heavily based on legislation and rules from the horse-and-buggy era. Is the duration of a patent, as legislated for the steam age, still appropriate for the electronic age? Should the idea of a patent be so wide as to allow, for example, proprietary control of an industry standard? I find this a fascinating area, and could be drawn into this debate on whether patent protection should be provided for general ideas (the classic example is Amazon’s protection for the idea of “single-click purchasing”), but this would take me too far afield. I have strayed well outside the usual territory of central bankers, and I am going to get back, now, onto familiar ground - to discuss the New International Financial Architecture. But I want to key off from the generalities discussed so far: that successful globalisation will require a set of rules no less complex than the rules which govern domestic economies. These rules will have to address the strong monopolistic dynamic of the New Economy and the self-interested motivation of individual countries. These rules have to be hammered out under the most difficult of circumstances, where there is no While some of the rules will be directed at these New Economy characteristics, other rules should be aimed at enhancing competition and all the elements which go with a well-functioning market system. So the general thrust of the WTO towards greater opening-up of international trade and the policies embodied in the “Washington Consensus” (deregulation and opening-up of markets) is, of course, still very important. Some fine distinctions are needed here: deregulation does not mean “no rules”: as detailed, intrusive, prescriptive regulations are relaxed, they should be replaced by general rules-of-the-game. This distinction may seem subtle, but it is the one which applied to the process of domestic financial deregulation in Australia: as the old prescriptive rules were dismantled, they had to be replaced by the broad framework of prudential supervision. well-established political process to adjudicate between rival claims and achieve some kind of consensus. Nevertheless, we have to try to do this, because if we do not, the rules will be hammered out by others, and not necessarily in our best interests. Again, I would refer back to the Thomas Friedman idea that a Golden Straitjacket has been developed (and will be further developed) and that countries will, to a greater or lesser degree, have to adjust to it, like it or not. The need is to find some kind of decision-making process (because, after all, the Golden Straitjacket is not the product of some impersonal Adam Smith free market process) to write (and right) the rules governing the financial relationships between countries. The post-war period produced the Bretton-Woods rules a great improvement on the gold standard. The motivation which produced the Bretton-Woods institutions (the IMF and the World Bank) has been lost, but needs to be regained if we are to achieve an appropriate New Financial Architecture. Rules and the Asian crisis The Asian crisis revealed significant weaknesses in the rules governing international capital flows, and those relevant to the international response to a crisis: • the IMF is seen, by many of us, to have been misguided in aspects of its response, at least to some of the countries in crisis (and here I am thinking in particular of Indonesia). A better deliberative process might have eased this problem; • the international discussion and decision-making process seemed quite unrepresentative, with many of the rules being formed in quite narrow groups such as G7 and G10.3 Even where there are wider groups such as the IMF itself, the debate was dominated by one (or a few) voices. As the crisis developed, a more representative body (G22) was formed, which did important work not so much in the resolution of the crisis as it was occurring, but in preparing for the re-writing of some of the rules. I have talked elsewhere about some of the issues which required new or different rules, and the real progress which has been made in addressing these issues.4 These issues are: • bailing-in the private sector (also known as “burden-sharing”); • hedge funds; • the volatility of capital flows and what might be done about this. I will not go over this territory again, but I would just record that in each of these areas there is a domestic analogue, governed by rules which are accepted as beneficial. Within domestic jurisdictions, each country has a set of bankruptcy and liquidation rules, which acknowledge that things can go sufficiently wrong for a business that it makes sense for the enterprise to be wound up, prior contracts rescinded, and provides equitable rules to govern this process. Similarly, domestic rules govern the behaviour and obligations of mutual funds. And in many countries there are arrangements, in extremis, for lender-of-last-resort for core institutions of the financial sector. In each of these cases, the rules have been devised because the untrammelled working of the free market does not produce an optimal (or even acceptable) result. Perhaps the most important success coming out of the discussions on international architecture is the more representative network of discussion (and perhaps even decision-making) bodies: • the IMF has done a certain amount of introspection and will do more; G10 - in its manifestation as the Basel Committee on Banking - provides a neat example of rule-writing. It set down the Basel Rules on Bank Capital, which became the rules for all banks worldwide, even though they had been written for G10 banks. See Grenville (1999a, 1999b). • the Bank for International Settlements (the central banks’ international coordinator) has greatly enlarged its membership (in particular from Asia) and has swung decisively away from its earlier European orientation; • while G22 was disbanded (largely because of pressure from the smaller Europeans who felt excluded in the new process), a worthy successor - G20 - has been set up. The Financial Stability Forum has been created to coordinate prudential rule-making. The FSF has the technical expertise and representation to formulate rules and guidelines for the financial sector, and G20 has the clout to put them in place. It is now up to the various participants (including Australia, which is represented on both the FSF and the G20) to make sure that G20 becomes an effective forum for achieving consensus among a core group of countries. This battle is far from won. I said earlier how difficult it is to develop international rules, beyond any individual sovereign jurisdiction, and with the hope of enforcing them. But we may be able to make some progress on those rules which are, drawing on my earlier distinction, common sense or “win/win” - the Basel Capital Accord (which lays down prudential rules for banks) was of this nature. I should note, here, that it is not necessary, in gaining acceptance of rules, for every single player to be a winner always. The sporting analogy may be helpful: all that is required is for the players to agree to abide by a set of rules. Some players may “spit the dummy” or “take their bat home”: but most accept that, in the long run, it is sensible to stick to a set of rules under which they sometimes lose. We may even be able to find some forum for trade-offs where the issues are those more difficult ones involving distributional decisions. If success is to be achieved, it is more likely to come from different sets of rules reached between experts in individual fields of expertise, rather than one great centralised rule-making process (like the UN).5 We already see international forums which grapple with specific problems - WTO is one example, although it is not an unalloyed success. In any rule-making process, there is a danger of over-prescription. Within domestic jurisdictions, this is an ever-present concern - that governments are asked to use regulation to fix every problem. Domestically, there is now healthy scepticism that rules can provide the universal fix-all. In the international arena, the starting point is not one of over-regulation. Widespread acceptance of the starting point given by the Washington Consensus (“deregulate and open-up internationally”) and acceptance of an international version of the medicos’ dictum “first do no harm” should avoid the mistakes of over-zealousness. Part of a good rule-making regime is a recognition that parsimony is a virtue and that some rules are bad - where vested interests or misguided lobby groups gain influence in the process, we can end up with the wrong rules. Conclusion My starting point was that globalisation has been enormously beneficial for Australia, and for the world. Even if we cannot design a perfect set of rules to govern its development, it will go on being enormously beneficial, and most will share in that process. But this does not in any way diminish the importance of trying to ensure that the rules are appropriate both in their technical aspects (providing the right incentives for further innovation and dissemination of ideas), and in an income-distribution sense, both between countries and within countries. During the Asian crisis, Larry Summers argued that we would not wish to restrict the use of airline travel just because of the occasional plane crash, and by analogy that we would not want to slow globalisation. This seems to me to be correct, but to emphasise the wrong issue: we respond to crashes (and crises) by putting in place rules, regulations and procedures to diminish the chance of a recurrence, and to be better prepared should that eventuality arrive. Australia cannot, as a medium-sized player on the international stage, hope to dominate the outcomes or achieve all its objectives. But we need to be at the table, to speak up, and to work actively for a better set of international rules, not only for the set of issues encompassed by the international financial architecture, but for the entire gamut of the globalisation process. Although the UN is attempting to coordinate international patents - see The Economist (2000b, p 99). References Friedman, Thomas L (1999), The Lexus and the Olive Tree, Farrar, Straus and Giroux, New York. Grenville, S A (1999a), “Financial Crises and Globalisation”, Reserve Bank of Australia Bulletin, August (http://www.rba.gov.au). Grenville, S A (1999b), “The International Reform Agenda: Unfinished Business”, Reserve Bank of Australia Bulletin, December (http://www.rba.gov.au). Summers, L (1998), “Go with the flow”, Financial Times, 11 March. Summers, L H (2000), “The New Wealth of Nations”, remarks by Treasury Secretary Lawrence H Summers, Hambrecht & Quist Technology Conference, San Francisco, 10 May (http://www.ustreas.gov/press/releases/ps617.htm). The Economist (2000a), “Regulating the Internet: The Consensus Machine”, 10 June, pp 77-79. The Economist (2000b), “Patent Law: Going Global”, 17 June, p 99. Varian, H R (1999), “Markets for Information Goods”, Bank of Japan IMES Discussion Paper No 99-E-9. Zuckerman, M B (1998), “A Second American Century”, Foreign Affairs, May/June, 77(3), pp 18-31. | reserve bank of australia | 2,000 | 7 |
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Queensland University of Technology Business Leaders' Forum, held in Brisbane, on 10 August 2000. | I J Macfarlane: A medium-term perspective on monetary policy Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Queensland University of Technology Business Leaders’ Forum, held in Brisbane, on 10 August 2000. * * * It is a pleasure to be here in Brisbane to address the Leaders’ Forum Luncheon. I am not sure that I will have much to say about leadership, but I hope that my comments will be of interest and relevance to those attending today. I would also like to thank the Queensland University of Technology, which is to be congratulated for running this excellent series of lectures. I would like to take the opportunity today to restate the underlying logic behind our approach to monetary policy. My reason for doing so is not that it is intrinsically difficult, and therefore in need of repetition in order to aid understanding. It is because the logic is essentially medium to long-term in nature, and hence tends to get lost in the day-to-day welter of economic statistics and associated commentary. For those whose interest is in the details of the current economic statistics, we will be publishing our quarterly review, The Economy and Financial Markets next week. Our approach to monetary policy, like that of a number of other countries in similar positions, is based on the achievement of an inflation target. This says that over the medium term, inflation should average somewhere between 2 and 3%. We recognise that it will not always stay in this range - that is why it is expressed as an average over the medium term. The actual adjustment of interest rates, of course, is done on the basis of our assessment of the outlook for inflation, including a central forecast and a judgment about the balance of risks. But if we have done the job well, we should be able to look back and see that over a reasonable run of years inflation has averaged 2 point something per cent per annum. So far in stating our approach I have not mentioned economic growth or employment, but there is a reason for approaching things in this order. It is not because we downplay the importance of growth and employment - we certainly do not, and in any case our Act makes it clear that to do so would be contrary to our mandate. We approach monetary policy in this order because there is overwhelming evidence to suggest that countries can only have sustained expansions if they are accompanied by low inflation. It is the sustainability of the expansion which is the key to maximising economic growth and employment. Thus, another way of expressing the aims of a monetary policy based on inflationtargeting is to say that its aim is to maximise the length of the economic expansion. A cynical observer might say that it is all very well to emphasise the length of the expansion as the crucial test now that we all know that the current expansion has been a long one. But this is an approach which we have had for quite a long time. I remember explaining it to a Parliamentary Committee in early September 1996 immediately before I took up my present position. Diagram 1 Expansions in GDP Cyclical trough = 100 INDEX INDEX 1990S 1980S 1970S Years since trough I think there is a reasonable consensus forming in Australia, as there is in a number of other countries, that inflation-targeting is a good approach to monetary policy. The most persuasive argument in its favour is that the results achieved so far have been very good. For example: • The current economic expansion, which started in the September quarter of 1991, has already lasted longer than its two predecessors and, on current indications, still has a fair way to go. The accompanying graph shows the expansions which started in the 1970s, 1980s and 1990s. For the current expansion, the figures only go up to the March quarter 2000. Incidentally, the length of our expansion is very similar to the much better known US expansion - ours has lasted for 36 completed quarters (including June 2000), theirs has lasted for 37 completed quarters. • During this time, economic growth has averaged 4.1% per annum, with inflation averaging in the low two’s. So the good result on inflation was not achieved by sacrificing our growth performance. • While a lot of countries have done well over the past decade, the Australian performance stands out. We have grown faster than other comparable countries (including the United States) and our inflation rate puts us in the middle of the field. The table below shows that only Ireland, which had very special circumstances, grew faster than Australia. In short, the results suggest that the inflation-targeting approach to monetary policy has been successful in achieving its aim. Also, the fact that Australia has been virtually at the top of the international growth league, while achieving a respectable middle order ranking on inflation, shows that we have not over-emphasised inflation control at the expense of economic growth. While I think there is now a consensus that the inflation-targeting approach to monetary policy makes sense, there is always room for disagreement about how it is applied in practice. Such differences of view are part and parcel of the normal policy debate, and we of course participate in it and listen to other views. In passing, I should say that I think the debate is carried out in a much more civilised way these days, compared with a number of earlier periods I can remember. I attribute this improvement to the fact that there is now wider agreement on the underlying model than in earlier periods. Table 1: Real GDP Growth and Consumer Price Inflation Average annual rate since 1990 Country GDP Country CPI Ireland 6.3 Japan 1.0 Australia 3.5 France 1.8 Norway 3.3 New Zealand 1.9 United States 3.3 Switzerland 2.1 Netherlands 2.9 Denmark 2.2 New Zealand 2.6 Finland 2.2 Canada 2.5 Canada 2.2 Spain 2.5 Belgium 2.3 Belgium 2.2 Australia 2.3 Denmark 2.1 Netherlands 2.5 Germany 2.1 Germany 2.5 United Kingdom 2.1 Norway 2.5 Finland 1.8 Ireland 2.6 France 1.7 Sweden 2.9 Japan 1.5 United States 3.0 Italy 1.5 United Kingdom 3.5 Sweden 1.4 Italy 3.9 Switzerland 1.0 Spain 4.0 Source: OECD. Nevertheless, differences of view remain, and I would like to say a few words about some of them today. The first area where there is always room for differences of view is on how to interpret the many individual pieces of economic data that come in virtually every day. How important is any particular statistic? Is it indicating strength or weakness? Are there special factors that have to be taken into account before it can be interpreted? Does it have any implications for monetary policy? This “bottomup” approach is widely used and it means that there is almost daily discussion in the media and elsewhere of the current and future strength of the economy. My observation over the past four years is that the bulk of people expressing a view on this subject invariably argue that the economy is weaker than the Reserve Bank judges it to be. There are very few on the other side to act as a balance. The majority of people who present a view think that the Reserve Bank has a recurring tendency to over-estimate the strength of the economy. This view is quite wrong: the fact is that we have consistently under-estimated its strength. You only have to consult my half-yearly appearances before the Parliamentary Committee to see that on every occasion I have had to explain to them why the modest slowdown in growth that we forecast did not arrive. The correct way of summarising the various views is to say that the Reserve Bank has underestimated the strength of the Australian economy, while its critics have under-estimated by a larger margin. This is not unusual. There is a tendency during the expansionary phase of the business cycle to be unduly influenced by the inevitable signs of weakness in some of the individual indicators and hence to lose sight of its underlying strength. There is a tendency for people to not be able to see the wood for the trees. This is true of most economists, bureaucrats, politicians, the press and, as I pointed out above, central bankers are not immune from it. It is one of the reasons why historically there has been a tendency to leave the tightening of monetary policy till too late in the cycle. By then, various imbalances - particularly, but not only, inflation - have become established and policy has had to be tightened by a larger amount than if it had been done in a more timely manner. This has been an important contributor in many countries to shortening the expansion phase or to making the contraction deeper and so producing a boom-bust cycle. That is why if the central bank wants to have any hope of getting its timing right it has to move ahead of public opinion. This will mean that the tightening phase will inevitably attract criticism from various quarters and will be labelled by some as unnecessary or, at least, premature. That is why governments have entrusted monetary policy to independent central banks - in order to ensure that monetary policy is insulated from day-to-day political pressures, and to make it clear to the public that this is the case. A second area where differences of opinion are often expressed is on how to reduce the level of unemployment. Now, in my opinion, there are a lot of policies that have a role to play in this task, one of which is monetary policy. There was a time not so long ago when economic purists, including some central bankers, often denied that monetary policy could affect unemployment - in their view, monetary policy only affected inflation. You will be pleased to know that I am not a member of that school. Bad monetary policy can certainly make unemployment worse, so it follows that good monetary policy can make it better than it would otherwise have been. What is the best contribution that monetary policy can make to lowering unemployment? My answer is that the best thing it can do in the long run is to provide the conditions which maximise the length of economic expansions. We do not want a seven or eight-year expansion followed by a serious recession as we have had in the past. The damage to unemployment occurs during recessions. The significant rise in unemployment that occurred in Australia from the early 1970s to the early 1990s was not due to a prolonged period of weak economic growth, it was due to the fact that we had three relatively short periods of recession, each of which resulted in a big lift in the unemployment rate. Diagram 2 Unemployment rate % % To repeat, it is not the insufficiency of growth during the expansions which accounts for Australia’s current rate of unemployment - it is due to the sharp rises that occurred during the recessions. To illustrate by reference to the US again: • during our current expansion GDP has grown at a rate of 4.1% per annum in Australia, compared with 3.7% in the US; • over the same period, we have reduced our unemployment rate from its peak by 4.6 percentage points compared with 3.8 percentage points for the US. The fact that their rate at 4.0% is lower than ours at 6.6% is entirely due to their lower starting point, which was due to the relatively mild nature of their early 1990s recession. In short, it is clear that the best thing that monetary policy can do to reduce unemployment is to prolong the expansion and delay and reduce the size of any subsequent recession. On occasion, that means tightening monetary policy early to forestall inflationary pressures, as an alternative to more vigorous application of the brakes when inflation has built more momentum. A third question which could be asked about our approach concerns Australia’s potential growth rate. We are, I think, rightly proud of our growth performance during the current expansion, especially of our average of 4½% per annum since mid-1997 when we were hit by the Asian crisis. But some may ask why we think 4½% is a good result - maybe the economy was capable of growing a good deal faster without pushing up inflation by much. We have all heard of Australia’s improved productivity performance in the 1990s, so why can’t this allow us even more growth? There are two answers to these questions - a mechanical one and a policy one: • The mechanical one is that the potential growth rate is determined on the supply side of the economy by the growth of the labour force and the rate of labour productivity. While the second of these is now about 1½% per annum higher than in the eighties, the first - the growth of the labour force - is 1¼% per annum lower. This is largely due to lower growth in the working-age population, and a much smaller rise in the participation rate as the female participation rate is now already quite high and the male participation rate is declining. So the improved productivity trend has contributed to higher living standards, but its effect on total GDP growth has not been as marked. • The more important answer is the policy response; it is one that I gave three years ago at a time when a number of critics were claiming that the RBA would not permit the Australian economy to grow by more than 3½% per annum. The answer then, as it is now, is that we do not have firm views about a speed limit. Our tightenings or loosenings of monetary policy are determined by the inflation outlook. If the economy wants to grow faster than it currently is, and inflation is not showing any tendency to rise to the point where it could threaten our medium-term objective, then we would not restrict the economy’s growth. That was true three years ago, and it is still true: the difference is that now inflation has moved up, whereas three years ago it was moving down. The rise in inflation over the past year, though a little larger than forecasters had expected, is not an alarming event. But it is a reminder to us that it would have been unwise to continue with the stance of monetary policy we had in mid-1999. Monetary policy at that time was at its “maximumexpansionary” setting for the decade, and in our view some degree of tightening was going to be needed if we were to successfully manage further progress in the expansion. A number of other countries reached a similar conclusion over the past 18 months for reasons not very different to the ones I have outlined above. Conclusion I have tried to give an outline of how the inflation-targeting approach operates and how it contributes to improved performance, not only on inflation, but also on output and employment growth. The outline is necessarily broad and I am afraid it will disappoint those who wish to have answers to specific questions such as why did we raise rates in one month rather than the next? - or why did we raise rates by 50 basis points rather than 25? Inevitably, the answers to these questions involve an element of judgment. But the truth is that the answers are not very important in the medium term. Rather, it is the average level of interest rates that matters. Have we allowed them to stay too low and so encouraged the build-up of an inflationary process, or have we raised them too high and so set in train a contractionary or deflationary process? These are the important questions, and any judgment on them must be based on the medium-term performance of the Australian economy. This may not be a simple task, but I would suggest that a favourable judgment would require that the macro-economic performance of the Australian economy be better than in earlier decades, and that it stand up well in comparisons with the experience of other countries over the same period. | reserve bank of australia | 2,000 | 8 |
Speech by Mr S A Grenville, Deputy Governor of the Reserve Bank of Australia, at the Anu International Conference on Financial Markets and Policies in East Asia, held in Canberra, on 4 September 2000. | S A Grenville: Notes on East Asian financial cooperation Speech by Mr S A Grenville, Deputy Governor of the Reserve Bank of Australia, at the Anu International Conference on Financial Markets and Policies in East Asia, held in Canberra, on 4 September 2000. * * * In an increasingly globalised world, it is reasonable to ask why regional financial arrangements might still be important and worth striving for. Aren’t we all going to be ruled by Thomas Friedman’s Golden Straitjacket, under the gimlet-eyed surveillance of the Electronic Herd? What place, in this seamlessly integrated world, for regional arrangements? The key point driving any regional arrangement is commonality of interests - even in a globalised world, we care more about what happens to our neighbours than we would about countries of equal size but geographically remote. Just as there will be different levels of government (local, national) within a country, not all international issues will be best dealt with on a one-world universal basis. Perhaps the most positive specific element of regional arrangements is their great potential for fruitful interaction which will raise understanding, cooperation, coordination and technical standards all round. One specific economic aspect of this is the so-called “peer surveillance” which has emerged in a number of regional arrangements. But the much more informal exchanges between technicians will probably be more important still - someone notices that one of their regional neighbours has a good way of doing something, so they copy it. In large part as a consequence of this continuing interaction, another important benefit from regional arrangements is their superior knowledge of what is happening in the region. I can recall that in July 1997, when East Asian central bankers met in Shanghai, it was very obvious to everyone at that meeting that the Asian crisis was going to be very serious indeed. Four months later, the US President was still talking about the crisis as “a few glitches on the road” - no reflection on his own competence in an enormously complex world, but a reflection of the poor advice going into the US decision-making process, which was reflected elsewhere, for instance in the lack of participation in the Thai support program in August 1997. At the same time, it would have to be acknowledged that we were not able to use this better knowledge to improve the decision-making process in the multilateral agencies (particularly the IMF). But this just says that we have to try harder in future, and turn potential into actual. We have to look for the opportunities to use these regional forums as a way of refining, concentrating and amplifying our voice, so that the distilled wisdom of this interaction is heard more effectively in the multilateral forums. To provide a specific example: there can hardly be any doubt that the IMF Indonesian program would have been quite different if it had had an effective input from the region - the longterm desirability (but low priority) of doing something about the clove monopoly would have been kept in better perspective against the pressingly urgent short-term crisis of massive capital outflow. In macro policy, the overly tight budgets of the IMF’s initial prescription might have been avoided. A strong regional representation could catalyse a better articulation of other aspects of our interests at the multilateral level. There is a danger that, at the multilateral level, the United States will promote the cause of those areas of principal interest to it (principally Latin America) and Europe will promote the interests of its Eastern European neighbours (including Russia), but that the interests of the countries of Asia may be without a big country champion and advocate at the multilateral debate. We see this danger in the Contingent Credit Line program being devised at the IMF, where countries which receive a prior “seal of approval” will be able to draw on Fund support more or less automatically in time of need. There is a real danger that countries which get this seal of approval are likely to be the countries of principal interest to the largest members of the IMF who dominate the Board. We may be able to redress this balance if our regional voice is well coordinated. A further factor in favour of regional arrangements is that, when it comes to collecting funds, a regional group can mobilise the strong forces of self-interest and immediate concern that are felt within a small, geographically contiguous group. The Thai support package - where the regional contribution was almost three times the size of the IMF’s contribution - illustrates that regional arrangements can be effective when multilateral agencies are slow across the ground or hindered by imperfect assessments of the situation. The form of the arrangements What form should these regional arrangements take? The point that should be made here is that a fair amount of overlap is inevitable, and no bad thing. Certainly, representational resources are a constraint, but within this broad constraint, we should not be too fretted that a particular subject is discussed in more than one place. That said, there may be room for pruning and specialisation in the quite wide variety of organisations which already exist within the region. New developments Perhaps the most important and striking new development is the embryonic currency arrangements coming out of ASEAN+3. The initial suggestion is one of foreign currency swaps, but there may be some implication that this could lead to various currency linkages, perhaps ultimately culminating in some form of currency union. There is a good debate already underway as to whether regional currency baskets make sense (a debate carried on at this conference), and whether Asia seems a suitable case for a currency union. It is important for us, here in Australia, to make sure we do not confuse the issue of evaluating these various proposals with the desirability of being present at the table when these discussions take place. Whatever the merits of particular arrangements, these discussions are, in themselves, an important part of the process of swapping ideas and coming to understand each other better. So the case for Australia wanting to be there is a clear one, and we should state this clearly (as we have done), without wishing to elbow our way into any arrangement in which we are not wanted. The critical thing, for Australia, is to be able to establish our goodwill and competence in such a way that the countries in this group will feel it to their own advantage to have us present. We are some distance away from this at the moment, but the starting point is to recognise the desirability of being at the table. We might remember, too, that the Euro took 50 years to get off the ground, and that at the start there must have been far more scepticism than support among countries which had so recently been in mortal combat. The other idea, waiting offstage in the wings at the moment, is for an Asian Monetary Fund. When this was first proposed during the Asian crisis, Australia had some reservations about the particular format which had been proposed. But whatever the views at the time, we need to keep an open mind. Some of the initial opposition (particularly from the United States) may have its origins in viewing all of this through the IMF prism, and the advantages set out above for regional arrangements apply here also - that smaller groups will often be more appropriate to particular problems and bring special expertise and focus. So a postscript can be added to these discussions. We should not see different groups as rivals: any such arrangements should be seen as complementary, not competing with multilateral arrangements. Leadership One serious issue for the future of regional arrangements in this region is the unresolved issues of leadership. In terms of GDP and technological sophistication, the obvious regional leader is Japan. Partly for historical reasons, and partly because of its internal focus, Japan has not exercised the sort of leadership which is commensurate with its economic clout. In terms of population and potential economic size in the long run, China might claim the role. Hong Kong, Singapore and Australia have sophisticated financial markets, but each of these economies is relatively small. Within ASEAN, the dominant country (Indonesia) is, unfortunately, in no position, for the moment, to be a vigorous leader of regional arrangements. So there is a major unresolved issue here. Where to from here? From the Australian viewpoint, this is in some ways a low point for regional arrangements. The real progress which has been made in getting better representation in the multilateral forums for non-European (and particularly Asian) voices is undisputed. G20 (the lineal successor to G22) now has the potential to become a premier group for discussing the critical issues of globalisation, with a representative audience no longer dominated by Europeans. The Financial Stability Forum has been formed, again with good representation from the region, to hammer out the specifics of financial rules and regulations. Membership of the Bank for International Settlements has been significantly opened up to non-European members. So there has been real progress at the multilateral level. But at the regional level, the Asian crisis has been an enormous distraction from the mundane task of building regional institutions, with the officials who had got to know each other well in such forums as EMEAP and the Manila Framework being very substantially weakened and dispersed in the aftermath of the crisis. Peer surveillance has not taken the major role that it might have, lacking any clear functional model or strong leadership. The current focus on the Chiang Mai swap proposals could be the basis of some important ties, but we should keep in mind that ASEAN has had such swap arrangements in place for quite some time, and EMEAP had in place somewhat similar repo arrangements, which did not provide much advantage in the Asian crisis in 1997. Such arrangements are valuable in that they get people together and talking about other issues, but it would be a mistake to see them, taken by themselves, as massive breakthroughs in regional cooperation. As for Australia’s role and links in all of this, it would have to be said that the present moment is a rather disappointing one. A good case can be made that Australia served a useful role during the crisis, first of all as participant in the support packages (Japan was the only other country to contribute to all three), but more importantly in its assessment of the crisis as it unfolded, and its attempts to point out deficiencies in the multilateral approach, with the visit of our Foreign Minister and the RBA Governor to the United States in early 1998. However, it would have to be said that this voice was not heard, and very little was achieved. Australia’s own performance during the Asian crisis might be a positive example and a reminder of the benefits of competent policies, but may well have been mistaken, by our Asian neighbours, as boastful blowing of our own trumpet during a time of their misfortune. The souring of our relationship with Indonesia over Timor has blocked off a potentially important entrée into the ASEAN arrangements. Our best chance, now, is to build on the myriad spider-web ties which bind all sorts of Australians - business people, academics and officials - to their counterparts in Asia, in the hope that this network proves a strong enough foundation for us to take a vigorous role in whatever regional arrangements are formed in Asia. | reserve bank of australia | 2,000 | 9 |
Talk by Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, to the World Economic Forum Asia Pacific Economic Summit Melbourne, on 11 September 2000. | Ian Macfarlane: Recent major developments in the Australian economy Talk by Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, to the World Economic Forum Asia Pacific Economic Summit Melbourne, on 11 September 2000. * * * It is a pleasure to be speaking before the World Economic Forum again. I have done so before in Hong Kong and Singapore, and I am proud that I can now add Melbourne to the list. It is also very pleasing that the Forum has successfully expanded beyond its Davos base, and made the Asia Pacific region an important part of its operations. In the short time I have available tonight, I would like to outline some of the major developments in the Australian economy over recent years, and then say a few words about the outlook. Where possible, I will compare our performance to that of other countries. Inevitably, I will make a number of comparisons with the United States as it is the yardstick by which everyone’s performance seems to be judged these days. I will take as my starting point a comparison of economic growth rates of developed countries over the most recent decade (Column 1 of Table 1). These figures from the OECD show that except for Ireland, which is a very special case, the Australian growth rate has been higher than for any comparable OECD country. For me, the interesting thing about this table is that this is the first decade in my working life where Australia has figured in the top half of the table, let alone being virtually in the top position. Incidentally, these figures cover the whole decade and so include a recession for each country, usually in the early part of the decade. This holds the average growth rates down. Another approach would be to look at growth rates during current expansions. Up to the current quarter, our expansion has lasted 37 quarters and averaged growth of 4.1% per annum: the comparable figures for the United States are 38 quarters and 3.7% per annum. If we turn to an international ranking of inflation rates over the past decade (Column 2 of Table 1), Australia finishes in the middle of the field, with an average inflation rate of 2.3% per annum. This is a huge improvement on recent decades, but, of course, virtually every country has shown a significant improvement. There are a number of factors behind this improvement, but one I would like to mention today is our monetary policy regime. Like a number of countries in the above list, Australia has a monetary policy regime which is based on the trilogy of an inflation target, an independent central bank and a floating exchange rate. An important factor behind our good growth and low inflation has been our productivity performance. Here, if we use the simplest measure of productivity, which is labour productivity, the pattern in Australia is very similar to the pattern in the United States (Graph 1): strong growth in the 1960s, a flattening out in the 1970s and 1980s, followed by a pick-up in growth in the 1990s. But the pick-up in the 1990s in Australia has been more pronounced than in the United States. We have gone from growth of 1.7% per annum to 3.0% per annum, whereas the United States went from growth of 1.5 er cent per annum to 2% per annum. I do not want to suggest that this means we have higher productivity than the United States; remember we are only talking here about rates of change of productivity. The fact that we have been able to speed up more than they have is, in large part, because we were starting from a lower base. Incidentally, the OECD recently completed a study called “Is There A New Economy?” in which it looked at similar calculations to the ones I have shown above for a range of countries. It found that out of the 29 OECD economies, only six had achieved a higher trend growth of GDP per capita in the 1990s compared with the 1980s. They were the United States, Australia, Ireland, Denmark, Norway and the Netherlands. Table 1 Real GDP growth and consumer price inflation Average annual rate (since 1990) Country GDP Country GDI Ireland 6.3 Japan 1.0 Australia 3.5 France 1.8 Norway 3.3 New Zealand 1.9 United States 3.3 Switzerland 2.1 Netherlands 2.9 Denmark 2.1 New Zealand 2.6 Finland 2.1 Canada 2.5 Canada 2.2 Spain 2.5 Belgium 2.3 Germany 2.2 Australia 2.3 Belgium 2.2 Netherlands 2.5 Denmark 2.1 Norway 2.5 United Kingdom 2.1 Germany 2.5 Finland 1.8 Ireland 2.6 France 1.7 Sweden 2.9 Japan 1.5 United States 3.0 Italy 1.5 United Kingdom 3.5 Sweden 1.4 Italy 3.8 Sweden 1.0 Spain 4.0 Source: OECD Whilst I am on the subject of productivity, I want to make two general points: • The first is the obvious one which I have made on numerous occasions that the main reasons behind the pick-up in productivity growth have been structural changes made over the past 15 years in the Australian economy which have increased flexibility and competitive pressures. These changes include: – further tariff reductions; – financial deregulation; – labour market deregulation; – privatisation; and – a more stringent regime of competition policy. It has not been easy to put these changes in place, even though there has been for most of the decade considerable bipartisan political support for change. Inevitably, compromises have had to be made and, viewed in isolation, some of the individual changes do not look to be all that thorough-going. But taken together, I think the total is larger than the sum of the individual parts. Of course, one aspect of the economy that was not reformed during the period covered by these calculations was the tax system. But that finally changed a couple of months ago when a Goods and Services Tax was introduced to replace the old wholesale sales tax and to take some of the weight off income taxes. • The second point about productivity I want to make concerns the new economy/old economy divide. Some people tend to judge a country’s technological sophistication by, for example, the number of listed companies in the IT sector. Although Australia has a number of companies that fit this description, about 70 or so in fact, their combined share of the stock market is not large by international standards. But that is only one measure of technological sophistication. Another equally important one is the country’s willingness to embrace new technology. This may be a better guide to productivity improvements than focusing only on the IT sector. I have two measures of the spread of technology: – The first is Internet usage as a percentage of the population, which shows Australia in a relatively high position among the countries compiled by the Consulting Group, NUA (Table 2). – A measure that is more specific to the business sector is the number of e-commerce servers per head of population. On this measure, Australia is second only to the United States (Table 3). Table 2 Internet usage (per cent of population) Norway United States Sweden Canada Finland Australia Denmark Netherlands UK Switzerland Slovenia Austria Taiwan South Korea Belgium Germany Japan Italy Ireland New Zealand Source: nua.ie. Most data from late 1999-early 2000 surveys Table 3 E-Commerce servers Country/region Servers per million population July 1998 March 2000 United States Australia New Zealand Switzerland Canada Scandinavia UK Other EU Japan Korea Source: www.netcraft.com and OECD So, in terms of willingness to adapt to new information technology, Australia would get a very high score. This, along with the measures I mentioned earlier, helps to explain why there has recently been such a significant lift in the rate of growth of productivity. A big lift in productivity growth has a beneficial effect on many areas of the economy. A lot of it is passed through to consumers and, in the process, this makes it easier to maintain low inflation. Some of it can also make businesses more profitable, which is, after all, the incentive that drives much of the efforts towards improving productivity in the first place. The two broadest measures of corporate profits as a percentage of GDP in Australia have been trending up over the past decade, with profits after interest showing a much sharper rise than profits before interest, again another indirect benefit of a low inflation (Graph 2) decade. With good growth and good profitability, businesses have been keen to hire staff. As a result, employment has grown strongly and the unemployment rate continues to decline (Graph 3). Again, a comparison with the United States is interesting - during our expansion, the unemployment rate has fallen by 4.8 percentage points compared with a fall of 3.7 percentage points for the United States. The fact that their level of the unemployment rate, at 4.1%, is lower than ours, at 6.4%, is due to their lower starting point, in part a result of the relatively mild nature of their early 1990s recession. There are two other things I wish to touch on before concluding. The first is the exchange rate, which has attracted a lot of attention and soul searching this year. It is surprising that in an economy showing the medium-term characteristics I have just outlined, the exchange rate is so weak. If we refocus our attention to the immediate period, the puzzle is, if anything, greater. We have an economy growing at well over 4%, and probably more like 5%, with exports rising rapidly in the context of the strongest world growth for a decade, rising commodity prices and high corporate profitability. Why markets are placing such a low valuation on the Australian dollar is not a question I can easily answer, any more than I can answer why valuations in some equity markets seem so high relative to normal. These things can occur for periods in markets. They eventually come out right in most cases, but it can take some time, and in the meantime the effect can be uncomfortable, unhelpful and even damaging. For my part, I think that an important contributing factor this time is that markets underestimated (and are still underestimating) the Australian economy’s underlying strength. The coincidence of a strong world economy plus a low Australian dollar is virtually unprecedented, and is one of the several reasons why we at the Reserve Bank have been confident in the strength of the Australian economy. The influence of the world economy has been quite expansionary for Australia over the past year, most notably in the form of a 28% increase in exports. This has been the result of both strong volume growth and rising prices. Even with substantial growth in imports, the foreign balance is now making a good contribution to Australian growth and, at the same time, reducing the current account deficit (Graph 4). The reduction in the current account deficit from 6% of GDP a few quarters ago to 4.9% now may not look to be a big story. However, what is unusual about it is that it has occurred at a time when the Australian economy has been growing strongly. In all other instances where a turnaround of this size has occurred, a major cause has been a slowdown or contraction in the Australian economy (and consequent fall in imports). On this occasion, the manner of the improvement in the current account portends much better for the future. Conclusion We are now in the tenth year of our current expansion, and are in much better shape than in the mature phase of previous expansions. This year is an eventful one in that it contains a number of one-off occurrences such as the Y2K changeover, the introduction of the GST and, in a few days, the Olympic Games. These events have the effect of adding to demand and of shifting it around from month to month and quarter to quarter. This is making a number of indicators of the economy more difficult to read than normal, but I do not think it alters the overall assessment that this is an economy which retains a fair bit of momentum, and where the economic fundamentals, both here and abroad, are continuing to provide a stimulus to growth. | reserve bank of australia | 2,000 | 9 |
Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Economic Society of Australia, Inc., (New South Wales Branch) Sydney, on 30 October 2000. | Stephen Grenville: Exchange rate regimes for emerging markets Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Economic Society of Australia, Inc., (New South Wales Branch) Sydney, on 30 October 2000. * * * At the outset, I should explain what motivates my interest in this topic. It goes without saying that none of what I say today implies any dissatisfaction with the Australian exchange rate regime. The float has worked well in Australia and there is no reason to reassess or reconsider. Today’s talk is intended to be part of a vigorous debate currently going on in the international community about which exchange rate regime should (and, more specifically, should not) be adopted in emerging countries, with this particularly aimed at countries which are undergoing financial deregulation. These countries are being exhorted to adopt exchange rate regimes at the ends of the spectrum - either a pure free floating rate, or a strongly fixed rate (preferably with institutional backing in the form of a currency union or even dollarisation). One argument with superficial attractiveness is that the old regimes failed these countries, and therefore something else - preferably very different from the old regime - will solve the problem. A principal purpose of this paper is to argue that the appropriate regime will differ between countries and perhaps also over time - there are no simple rules and no easy solutions. Whatever regime is chosen, it has pluses and minuses, and any regime will require careful nurturing and support from other policies. The crisis countries should learn from their experience, but should not assume that, because one regime failed, another will be trouble-free. It is certainly true that the countries at the centre of the Asian crisis - Thailand, Indonesia and Korea - had rates that were de facto soft fixes - a high degree of stability in the good times, but not any serious institutional defences when they came under pressure. One clear lesson is that these exchange rate regimes did not perform well in the crisis. Some have also noted that Hong Kong and Argentina, with hard pegs, were able to withstand the pressure, in the sense that their exchange rate regimes did not break down. Others have observed that countries such as China and India were able to maintain parities by virtue of the application of capital controls, so an equally-vigorous debate on the role of capital controls is intertwined with the debate on regimes. This paper attempts to draw together this diverse experience. What have we learnt from the recent crisis? As a preface to this section, I should note that, as usual, the crisis has been used by various people to advance their own theories on the way the world works and the way it should work. As with many debates, the coalitions which form to advocate a particular outcome often have diverse motives, and not everyone comes from the same starting point or uses the same analytical framework. Any sensible observer of the crisis understands that there were a variety of causes, and identifying one single cause is unlikely to move us to a world of perfection. With this preamble, let us look at the immediate and obvious lessons for exchange rates from the crisis. • Exchange rates overshoot, resulting in substantial and sustained shifts of real exchange rates not explicable in terms of fundamentals. Indonesia entered the crisis with its exchange rate only modestly overvalued, but the rate fell to one-fifth(!) of its pre-crisis value. Markets are prone to exhibiting a herd mentality and, once an exchange rate starts to move, or a peg is broken, it can be difficult to limit adjustments to modest amounts. • Contagion is a problem. While markets did discriminate among countries to a degree, this was more noticeable in the longer run than in the short run. • There has been a lack of players willing to take contrarian foreign exchange positions in newly-emerging countries. This is a self-reinforcing problem. There are few stabilising speculators so the exchange rate moves a long way; but because the rate moves a long way, there are few who are willing to take on the risk of stabilising speculation. This lack of contrarian position-taking might reflect some relative lack of information about these economies, which should be straightforward to remedy. But more often the problem is more deep-seated and the remedy more difficult. Part of the problem here is that the market’s view of exchange rate fundamentals (“the model”) is nebulous and fragile. As well, there may be a lack of policy credibility, which can only be redressed over time. • The transition from regulated to liberalised financial systems is a vulnerable period. Careful sequencing may help, but it is difficult to create the necessary infrastructure quickly. • Massive capital flows (inflows prior to the crisis, and outflows after) were a dominant factor. For example, Thailand experienced inflows equal to 13% of GDP in 1996. Choice of regime needs to take into consideration not only current account issues but also the greatly increased mobility of capital and the international integration of financial markets. Choice of regime Some high-profile commentators drew from the Asian Crisis experience the conclusion that countries should opt for either a very “hard” fix or a very free float. “Thus the new language of speculative attacks, multiple equilibria and moral hazard is in many ways simply a new overlay on an old debate. And yet, a genuinely new element has recently been thrown into the mix. This is the proposition that countries are - or should be - moving to the corner solutions. They are said to be opting either, on the one hand, for full flexibility, or, on the other hand, for rigid institutional commitments to fixed exchanges, in the form of currency boards or full monetary union with the dollar or euro. It is said that the intermediate exchange rate regimes are no longer feasible - the target zones, crawls, basket pegs, and pegs-adjustable-under-an-implicit-escape-clause - are going the way of the dinosaur.” (Frankel et al 2000). The Economist (1999, pp 15-16) put the same point more briefly: “Most academics now believe that only radical solutions will work: either currencies must float freely, or they must be tightly tied (through a currency board or, even better, currency union).” The rationale is rather different from the traditional textbook arguments about the choice of exchange rate regime.1 The new argument is a response to the volatility of capital flows and the threat of self-fulfilling speculative attacks: both strong fixes and free floats are immune from attack, at least in a definitional sense. At the fixed end, the emphasis is on credibility, so irrevocability is an important element of the fix - hence the interest in currency boards and the ultimate fix - dollarisation. At the other end of the spectrum, the pure float also has the attraction of its ability to withstand an attack (or large volatile capital flows) without the exchange rate regime collapsing. Considering the depth and sophistication of traditional arguments, pro and con, for a wide range of different regimes, the new slant on this seems at first sight rather superficial, not far from a truism (if an attack on a fixed rate succeeds, the “fix” wasn’t strong enough:2 and an attack on a floating rate leaves it immune only to the extent that the authorities can put up with whatever movement in the rate occurs). If this new slant on choice of regime is to make a useful contribution to the debate, it has to be seen as another layer on top of the other (still valid) arguments about regimes and has to be seen to address, more specifically, why the perceived advantages of intermediate regimes (“the middle of the spectrum”) are overridden. The traditional case for a fixed rate rested on one of two grounds. The first could be broadly termed “optimal currency area” arguments - when there are close trade ties and similarity of productive structure, a fixed rate will encourage beneficial trade and capital flows. The second traditional strand of arguments in favour of fixed rates sees the exchange rate regime as the anchor for monetary policy. The traditional argument in favour of flexible rates was that it freed a country to apply an independent monetary policy, directed at the needs of its own domestic economy. The exchange rate could then be a buffer to soften the impact of external shocks such as changes in the terms of trade. And Obstfeld and Rogoff (1995) note that few fixes last longer than five years. One flawed argument in support of the “disappearing middle” of the spectrum goes under the shorthand of the “Impossible Trinity”: it is not possible to have, simultaneously, an open capital market, a fixed exchange rate, and an independent monetary policy. While the trinity may indeed be impossible, it relates only to a fixed rate and therefore says nothing about the possibility of having intermediate positions - a flexible but managed rate, a reasonable degree of monetary independence, and an open capital account. For that matter, the criticisms arising from the Asian Crisis could be properly directed only at the “fixed but adjustable” segment of the spectrum, where reserves were spent in futile defence of a rate which markets no longer believed was viable. Even here, the argument is far from clear-cut: Indonesia did not defend its exchange rate when it came under pressure, and yet suffered the greatest fall (and the most serious consequences from this fall). The valid elements of the case against a “fixed but adjustable” regime are two-fold: • that the fixed element may have encouraged borrowers to be too confident in taking out foreign-exchange-denominated loans; • that when pressure came on the exchange rate, it created the same incentives which drive bank runs - the one-way bet which makes rational investors close out their position ahead of a possible collapse, and creates the incentive on the part of the authorities to defend the status quo to avoid triggering the run. The prescription seems easy, but these “ends of the spectrum” may not be comfortable or easy to maintain. Only a limited number of countries will find the policy constraints of a currency board or the loss of sovereignty involved in dollarisation politically palatable. Smaller countries with a suitable pegging partner may find this an acceptable and viable solution, but - leaving aside the special case of the euro - medium-sized countries will only be attracted to a hard fix if there are very compelling constraints on their choice, and they will find the degree of adaptation needed in the domestic economy can be painful indeed. Where relative prices cannot change through exchange rate adjustment, domestic prices must adapt.3 Even super-flexible Hong Kong has found this hard, with GDP falls as large as Korea’s during the Asian crisis. Argentina’s choice of a strong fix may well be correct policy, but it is clearly painful.4 If the fixed end of the spectrum does not facilitate the sorts of adjustment which the underlying fundamental may require, then the free float end of the spectrum may well deliver much more variability than the fundamentals require. Views on how a free float would work in practice have changed over the past thirty years, in the light of experience. Early protagonists were confident that floating exchange rates would be stable and would reflect fundamentals. Harry Johnson (1973, p 208) assured us that: “A freely flexible exchange rate would tend to remain constant so long as underlying economic conditions (including government policies) remain constant; random deviations from the equilibrium level would be limited by the activities of speculators.”5 Friedman (1953) believed: “… instability of exchange rates is a symptom of instability in the underlying economic structure … a flexible exchange rate need not be an unstable exchange rate. If it is, it is primarily because there is underlying instability in the economic conditions …’. In practice, the general experience might be summed up this way: Friedman, arguing the case for floating, drew an analogy with daylight-saving time - it is easier to move to summer time than to co-ordinate everyone to move the time of their activities. Those countries which adopted a fixed exchange rate in order to anchor prices in the face of persistent inflation usually found that this worked well in reducing inflation, but at the cost of loss of international competitiveness, leaving a legacy which had to be addressed by other painful remedies. It is worth noting, also, that even hard fixes are subject to attack: it just takes a different form - a run on domestic banks which drives up interest rates. Quoted by Cooper (1999, p 9). • nominal exchange rates are, unaccountably, closely correlated with real exchange rates;6 • the switch from fixed to floating rates has produced much more variability (“an order of magnitude more”), even when fundamentals are not more variable (Flood and Rose 1999); • fundamentals cannot explain the behaviour of the exchange rate over a short/medium-term horizon;7 • exchange rates have at times exhibited long-lived swings, with no apparent changes in fundamentals significant enough to justify them. The US dollar appreciated by about 90% against the Deutsche mark in the first half of the 1980s, only to completely unwind this appreciation by 1988. The yen appreciated by about 75% against the US dollar in the first half of the 1990s, and unwound this appreciation by 1998. As a result of this experience, a textbook free float with interest rates set exclusively for the needs of the domestic economy (ie “benign neglect”) is out of favour. The exchange rate is routinely a factor in setting interest rates. Many countries intervene (if only occasionally) in foreign exchange markets, and when this is done with finesse and sensibly (ie not to defend a particular exchange rate), it has often been helpful.8 The intrinsic problems of exchange rates in emerging countries If all this produces volatility and misalignment in developed countries’ exchange rates, how much more serious is it for emerging countries which have: • much less well-defined trade-based fundamentals; • no long historical experience of market-determined exchange rates; • rapidly evolving production structures; • few Friedmanite stabilising speculators; • much larger and more volatile capital flows, in relation to the size of their domestic capital markets and economies more generally. On top of this, we have the evidence from Hausmann et al (1999) that those Latin American countries which embraced floating during the 1990s experienced substantially larger changes in interest rates See Cooper (1999, p 16). The classic reference, Meese and Rogoff (1983), showed that existing exchange rate models based on economic fundamentals could not reliably out-predict the naïve alternative of a “no-change” forecast for year-to-year changes in major-industrial-country exchange rates. Some more recent models can out-predict a “no-change” forecast (for example, MacDonald and Taylor 1993) but the basic empirical fact remains largely intact. No-one has yet been able to uncover macroeconomic fundamentals that explain more than a modest fraction of year-to-year changes in industrial-country floating exchange rates. Frankel and Rose (1995, p 1707) summarise the dismal state of exchange rate empirical research: “… the case for macroeconomic determinants of exchange rates is in a sorry state. With the exception of some significance in bits of statistical innovation and announcements at very short horizons, and some hazy predictive power at long horizons, there is little support for standard macroeconomic models”. Flood and Rose (1999) find that the switch to a floating rate produces much more variability, even if the fundamentals are no more variable: “The policy switch between fixed and flexible exchange rates entails an essential shift in market structure across regimes … Expectations are policy-dependent.” (p F668). It is not the purpose of this paper to address the issue of stability among the G3 currencies, but it might be noted that greater stability would clearly have been very helpful for the other countries. When the yen moved from 80 yen per dollar in April 1995 to almost 150 in the middle of 1998, this was clearly quite disruptive for countries with liabilities denominated in either dollar or yen. A case can be made that a trigger or catalyst for some of the crisis has, in fact, been movements in foreign exchange rates or interest rates - with the tightening of US interest rates in early 1994 being a factor in Mexico, and the depreciation of the yen after April 1995 being a factor in causing yen-denominated borrowers to focus on their yen-carry borrowing strategies. than fixed-rate countries (ie they were not, in fact, able to direct monetary policy to the needs of the domestic economy, but had to use it to defend their exchange rates). But the main problem faced by emerging countries which chose a free float is how the rate would behave in the face of the large and volatile capital flows which these countries experienced in the 1990s. In due course, these flows seem likely to resume for many, if not all, of the countries which experienced them in the 1990s. They are driven by two powerful factors. First, the desire for diversification on the part of the managers of the huge stock of investment funds in America and Europe, whose weight of foreign assets is well below the theoretical desideratum. Secondly, by the intrinsically high profit prospects in the Asian emerging countries (more on this later). It is worthwhile spending some time to see just how difficult a problem this is. In standard versions of the exchange rate story, the real exchange rate is determined by productivity developments in the real economy, and capital flows tend to play a rather secondary role. They are often treated, essentially, as a residual. Implicitly, there is a ready supply of world capital, so that the current account is determined by a country’s saving/investment balance, and the capital account is a residual to fund this. There is also a presumption that there is a ready supply of stabilising speculators, so any significant departures from fundamentals will be ironed out promptly. The standard model for incorporating capital flows into the analysis is the portfolio balance view, where the main action is with interest differentials. With some interest differential in place (usually reflecting differing cyclical positions), enough capital flows to the country to push up the exchange rate so that expected returns are equalised internationally (risk-adjusted, of course) by the prospect of a subsequent reversal of the exchange rate. The higher exchange rate helps to open up a current account deficit, which provides the real transfer counterpart of the financial flows. But if we try to apply this to the emerging countries, the fit is not good. Perhaps most fundamentally, the countries which received huge capital inflows in the first half of the 1990s offered high interest rates (real and nominal), not as a temporary cyclical policy response to the phase of the cycle, but on a continuing basis. While these countries are making the transition towards the technological frontier, it is quite likely that higher returns will be available to capital, so a real interest rate differential will persist over the medium term - decades rather than years. Capital inflow cannot immediately reduce this interest differential. In the meantime, portfolio equilibrium could, in theory, be maintained by the real exchange rate being bid up, so that the higher domestic interest rate is balanced by the prospect of subsequent depreciation.9, 10 How should the exchange rate behave in these circumstances? Real interest differentials of, say, 3% might persist for a decade or more. If these numbers are realistic, the portfolio balance model would suggest that the exchange rate has to appreciate initially by some 30% (and will appear seriously and persistently uncompetitive for trade in goods and services), before depreciating by 3% per year over the following decade. So the potential swings in real exchange rates, even if well-behaved in terms of the model, are much greater for emerging markets. Add to this some extrapolative expectations, some herding, and above all a risk premium which varies with the latest wave of euphoria or pessimism, and the potential both for volatility, and for significant and sustained misalignment - in both directions - is clear. It seems unlikely, to say the least, that an exchange rate could follow this portfolio-balance path of appreciation followed by depreciation without the market balking at the large shifts and the overvaluation during the long transition. Is it not surprising, in such a world, that countries have sought to limit the extent of the swings (misalignments). They have sought to resist the appreciations of the exchange rate during the periods Whether these persistently high rates were a response of the underlying fundamentals, or a period of prolonged euphoria, is not the point. I favour the first explanation, but whatever the reason, domestic borrowers had strong incentives to seek foreign-currency-denominated (ie lower interest rate) funding overseas, and foreigners had incentive to provide funds. Keynes (1980) had identified this problem in 1942: “In my view the whole management of the domestic economy depends upon being free to have the appropriate rate of interest without reference to rates prevailing elsewhere in the world. Capital control is the corollary of this.” of large capital inflow partly because of an intuition (which gains some support from the Japanese experiences in the 1950s and 1960s) that strong international competitiveness provided beneficial price signals for the most dynamic sector of the economy - tradeables, especially exports. Elements of old-fashioned mercantalism may be present also. Perhaps more important still, the large foreign capital inflow creates a destabilising feedback loop while the inflow is strong, the rising exchange rate reduces the cost of borrowing in foreign currency, and encourages more borrowing. At the first sign of some weakness in inflow or the exchange rate, domestic borrowers (including, sometimes, banks) are exposed to greater credit risk, and their lenders (understandably) will want to withdraw funding. This has many of the characteristics of a domestic bank run. If confidence could be maintained (in this case, in the stability of the exchange rate), then the withdrawal of funds will not occur. If confidence weakens, the process is self-reinforcing. This self-reinforcing instability cannot be easily removed. Some have suggested hedging as the answer. There is, first, the question of whether the country as a whole can hedge its foreign exchange risk. While an individual can shift the risk to another party, a country in aggregate can only hedge its risk if it can persuade foreigners to take on the foreign exchange risk - in effect, lend in the domestic currency. Even if this could be achieved, one party in foreign capital flow transactions (either the borrower or the lender) will be exposed to foreign-currency risk, and will have the incentive to unwind the transaction in the face of a threat to the exchange rate. In this rather unstable world, it is hardly surprising that countries have resisted the upward pressure on exchange rates that accompanies big capital inflows, because they feel (with some justification) that it makes them vulnerable to later sharp depreciation. When, after the crisis, many commentators attribute the crisis to overvalued exchange rates, and others urge these countries to hold reserves equal to their short-term debt (the so-called Guidotti Rule), is it surprising that authorities intuitively feel justified in resisting appreciations? But if the correct lessons are to be taken from the crisis, then those countries which do not have strong reasons to go to a hard fix should move decisively away from “fixed-but-adjustable”, to adopt a version of what has become widely-used best practice: allowing the market to determine the rate, leaving considerable volatility (ie not leaning against the wind through frequent intervention), and even when the rate moves significantly away from what are judged to be the “fundamentals”, being prepared to put up with this, and stay the resort to intervention, until the case is overwhelming and the prospect of success good. Interest rate changes in support of the exchange rate are a legitimate part of this regime, while acknowledging that feasible interest rate settings may not be enough to counter extreme market pessimism. This is clearly distinct from the totally passive position of a free float (“benign neglect”), but it is what is generally done in most developed countries. And, most importantly, it is a long way from the day-by-day activism that has been discredited by the crisis. Unless we take into account why countries have a “fear of floating”, and have often gravitated to soft fixes in the face of capital inflows, we will be in no position to provide persuasive arguments for the adoption of greater flexibility. Perhaps the basis of persuasion might be three-fold: • that some flexibility will be helpful in absorbing the capital inflow, in buffering external shocks, and responding to the changing productive capacity of their economies; • that this flexibility (aka short-term volatility) may inhibit some short-term flows, by serving as a constant reminder that exchange rate volatility can outweigh the interest-rate advantage of foreign-currency borrowings;11 The value of this should not be overstated. Much of the foreign borrowing in the Asian countries before 1997 was in currencies other than US dollars (mainly yen - see Table 11 of Goldstein and Hawkins (1998)), and so the volatility of exchange rates would have been abundantly plain to borrowers. This did not seem to inhibit their borrowing. • allowing (even encouraging) a fair degree of volatility around a real exchange rate which is stable over time (or moves only slowly, in response to changing fundamentals) provides the opportunity for the authorities to have the best of flexibility, while leaving open the possibility of intervention (both via interest rates and directly in foreign exchange markets) when the rate has already moved quite some distance away from the fundamentals. There are obviously difficult practical issues regarding the operation of intervention, but the intuitive idea is straight-forward enough - the further the actual exchange rate has departed from the equilibrium, the more damage the misalignment will do; the more confident the authorities can be that they will be acting as profitable stabilising speculators (buying cheap and selling dear); and the greater likelihood of success of any intervention on the part of the authorities (see Volcker (1995)). In short, there is scope for emerging economies to operate flexible exchange rate regimes without them having to adopt a textbook type of pure float. Indeed, it would be odd if the international debate urged emerging markets to adopt more pure forms of floating than the industrial countries have been able to sustain, especially when the conditions necessary for a successful pure float are less likely to be present in such economies. Even this strategy will be uncomfortable, and is not guaranteed to succeed. Large reserves and uncomfortable interest rates might be needed to mount an effective defence, and it will be tempting to mount this defence too early (not to allow enough flex). If a concrete example is needed to illustrate the point, Singapore provides it. It was, arguably, the most successful country exposed to the full force of the crisis, with a managed exchange rate (managed both in the sense of intervention and through well-designed active capital account policies) (see Lee Hsien Loong (2000)). Back-up or support for the exchange rate regime What more could be done by emerging markets to enhance the possibility of a successful exchange rate regime? If we accept that one of the central factors presenting pressures on exchange rate regimes in emerging markets is large and volatile capital flows, then the obvious issue is whether measures can be taken to reduce the size and volatility of the flows. The first possibility here is capital controls. Mere mention of this possibility creates deep rifts in the debate, with views strongly held and a fair bit of heat generated in the process. The process of transition (financial deregulation) is tricky and time-consuming. Perhaps the common-sense way to approach this is to accept the possibility that Chilean-style controls (taxes on short-term inflows) may be useful for some countries during the transition, but not too much should be expected of them (see the conclusions on Chile itself, which suggest that the controls managed to lengthen the maturity of the debt, without being able to prevent the exchange rate from appreciating during the phase of capital inflow) (see Edwards (1998)).12 It may also be useful to adopt the techniques used successfully by Singapore (and now others) to limit the ability of domestic banks to lend to foreigners in domestic currency, thus making it much harder for foreign speculators to take large short positions on the currency. Other than these specific types of capital control, there are a set of issues which can be put in terms of prudential supervision, rather than capital controls. The sorts of prudential controls which might be used are to limit the opportunities for residents to borrow in foreign currency (ie to prevent a repeat of the Bangkok International Banking Facility) and to monitor them when they do; and to keep very tight (indeed, unashamedly intrusive) constraints on banks’ ability to have open foreign exchange positions or indirect exposure through foreign exchange loans. The brief lesson here is that emerging countries should be very ready to put on tough prudential controls, and should ignore those who claim (as happened in Australia during the 1980s) that such prudential controls are “re-regulation by the back The other much rarer possible use of capital controls is that, in extremis, a crisis might be sufficiently bad to justify a standstill on repayment of debt, in the context of “private sector involvement” (“bailing-in the private sector”). door”. The doctrinal protagonists of free markets (usually arguing their own self-interest above all) must not be allowed to intimidate regulatory authorities into ignoring the case for “rules of the game”. On a wider canvas, the emerging countries should press forward with the efforts to put in place best-practice accounting, legal and corporate systems and regulations. The quality of credit and investment standards, and the strength of management of corporate risks and balance sheets will determine how closely capital flows match fundamental investment opportunities. This will determine how effectively a country captures the benefits of access to world capital markets. Paradoxically, marked improvement in these areas may well encourage even greater inflows: but it should, at least, lessen the likelihood of sudden reversals of capital. A tentative operational classification Countries might be categorised this way: (a) Those whose size or market development justify floating (ie those who will want to have an independent monetary policy, and have the institutions to make this feasible). While credible monetary and fiscal policy will contribute to exchange rate stability, even these countries will, at times, find that exchange rates move too far relative to fundamentals. There may be a legitimate role for intervention in these circumstances, but it should be used sparingly to have the desired impact upon expectations and the behaviour of market participants. In a flexible rate regime, what is the appropriate nominal anchor to pin down market expectations (eg an inflation target)? (b) Those in transition to this state. While accepting the advantages of flexibility, these countries may want a greater degree of fixity for a time, to help anchor expectations where these are fragile. These countries may reinforce their exchange rate stability by policies that reduce the attractiveness and the potentially harmful effects of short-term, easily-reversible capital flows. Countries in these categories might need to focus on systems that encourage long-term financing and on maintaining stable current account deficits. These countries may want to contemplate Chilean-style capital controls (price-based aimed at short-term flows) and to moderate the pace of financial liberalisation, to keep in step with the pace of development of financial infrastructure. Adoption of sound and consistent economic policies may gradually build credibility, but the economy may remain vulnerable during this building process. Financial infrastructure will develop and gain depth over time. As this happens and markets gain knowledge of and confidence in the regime, exchange rates should become less vulnerable and less in need of defensive capital controls. In the meantime, countries should be ready to move quickly away from defence of an unsustainable rate (which obviously requires fine judgment about “sustainability”). Allowing exchange rate movement (even if excessive) will, generally, be preferable to exhausting foreign exchange reserves defending a particular level of the exchange rate. (c) Those countries where the case for a fixed rate is compelling might want to consider the rival merits of some form of strong policy commitment - a currency board or dollarisation. This would include small countries with a similar economic structure to the potential anchor country; countries (including larger countries) with a high degree of economic integration, measured by trade or investment flows; or those with a history of poor economic management and currency crises, where governments cannot borrow long-term domestically, or in domestic currency offshore. For many small, and typically open, countries, the cost of an independent monetary policy will often be greater than the stabilising benefit of a flexible exchange rate. But there are costs, too, in these strongly fixed systems - if lender of last resort is to be provided, it would be a fiscal rather than central bank matter; and dollarisation may imply loss of seigniorage. If a hard fix is elected, what is the most appropriate anchor currency? Conclusion The Harry Johnson and Milton Friedman quotes cited above now seem touchingly naïve, or at best outdated advocacy, overtaken by the experience of three decades of floating rates. Flexible rates have turned out to flex more than expected. Developed countries have learned to live successfully with this, but it is harder going for emerging countries with big capital flows. The best-practice regime commonly used in developed countries allows wide latitude for the market to set the rate, supported by occasional intervention and rather more frequent help from interest rates. Many emerging countries could benefit from moving to this generic type of regime, and to help this process, we need a vigorous debate about when to intervene (and, more importantly, when not to); what role interest rates and inflation targets might play; and what additional measures might help to handle large and volatile capital flows. This will take the debate far away from the fixed-but-adjustable regimes that failed during the crisis, towards the floating end of the spectrum. But no good case is improved by exaggeration: “benign neglect” is not best practice anywhere, and a rhetoric which fuzzes this issue is unhelpful. To truncate the debate by excluding, from the outset, the valid modifications to this “end spectrum” solution runs the risk that countries will not only fuzz the debating points, but fuzz their own understanding of the issues, and leave them unprepared for the coming challenges. The last word could be given to a veteran of this debate, Richard Cooper (1999, pp 16-17): “What is less obvious is that floating rates, independent monetary policy, and freedom of capital movements may also be incompatible, at least for countries with small and poorly developed domestic capital markets, ie for most countries. That would leave a more limited menu of choice for such countries: between floating rates with capital account restrictions and some monetary autonomy, or fixed rates free of capital restrictions but with loss of monetary autonomy. Put bluntly, two prescriptions regularly extended to developing countries by the international community, including the IMF and the US Treasury, namely to move toward greater exchange rate flexibility and to liberalize international capital movements, may be in deep tension, even deep contradiction.” References Cooper, Richard N (1999), “Exchange rate choices”, Harvard Institute of Economic Research Discussion Paper No 1877, July. Dornbusch, R (1976), “Expectations and exchange rate dynamics”, Journal of Political Economy, 84, pp 1161-76. Edwards, Sebastian (1998), “Capital flows, real exchange rates and capital controls: some Latin American experience”, NBER Working Paper 6800. Flood, Robert P and Andrew K Rose (1999), “Understanding exchange rate volatility without the contrivance of macroeconomics”, The Economic Journal, 109 (November), pp F660-F672. Frankel, J A and A K Rose (1995), “Empirical research on nominal exchange rates”, in G Grossman and K Rogoff (eds), Handbook of International Economics, Vol III, Elsevier Science, pp 1689–1729. Frankel, Jeffrey, Sergio Schmukler and Luis Servén (2000), “Verifiability and the vanishing intermediate exchange rate regime”, NBER Working Paper 7901. Friedman, Milton (1953), “The case for flexible exchange rates”, in Essays in Positive Economics, Chicago: University Press. Goldstein, Morris and John Hawkins (1998), “The origin of the Asian financial turmoil”, Reserve Bank of Australia Research Discussion Paper 9805 (http://www.rba.gov.au). Hausmann, Ricardo, Ugo Panizza and Ernesto Stein (1999), “Why do countries float the way they float?”, Inter-American Development Bank Research Department Working Paper No 418, May (http://www.iadb.org/OCE/pdf/418.pdf). Johnson, H G (1973), “The case for flexible exchange rates, 1969”, Further Essays in Monetary Economics, Cambridge: Harvard University Press. Keynes, J M (1980), “Letter to R F Harrod, 19 April 1942”, in The Collected Writings of J.M. Keynes, ed. D Moggridge, Vol 25, Chapter 3, London: Macmillan. Lee Hsien Loong (2000), “Post crisis Asia - the way forward”, William Taylor Memorial Lecture by Deputy Prime Minister, Singapore, and Chairman, Monetary Authority of Singapore, Basel, Switzerland, 21 September (http://www.mas.gov.sg/newsarchive/sp_20000921-c.html). MacDonald, R and M P Taylor (1993), “The monetary approach to the exchange rate: rational expectations, long-run equilibrium and forecasting”, IMF Staff Papers, 40, pp 89–107. Meese, R A and K Rogoff (1983), “Empirical exchange rate models of the seventies: do they fit out of sample?”, Journal of International Economics, 14, pp 3–24. Obstfeld, Maurice and Kenneth Rogoff (1995), “The mirage of fixed exchange rates”, NBER Working Paper 5191. The Economist (1999), “Global finance: time for a redesign?”, 30 January, pp 1-18. Volcker, Paul A (1995), “The quest for exchange rate stability: realistic or quixotic?”, The Stamp 50th Anniversary Lecture, University of London, 29 November (http://www.iie.com/TESTMONY/ volcker.htm). | reserve bank of australia | 2,000 | 11 |
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to CEDA Annual General Meeting Dinner, held in Melbourne, on 9 November 2000. | I J Macfarlane: Recent influences on the exchange rate Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to CEDA Annual General Meeting Dinner, held in Melbourne, on 9 November 2000. * * * I am very pleased to have been asked to address CEDA’s Annual General Meeting for the third time in Melbourne. When deciding on a topic for tonight, I realised that it would be very difficult to discuss the Australian economy without spending some time on the exchange rate and the various reasons advanced for its recent fall. So I have decided to plunge in and devote the whole speech to this topic. Obviously, we have been doing a lot of thinking about it, and I will see if I can say something useful about it in the 20 minutes I have available tonight. What has happened? The exchange rate has behaved during 2000 in a way that noone predicted. There used to be some elements of predictability for the Australian dollar in that its broad movements could usually be explained by changes in our terms of trade (or its close relative, commodity prices) and the difference between domestic and foreign interest rates. The relationship was not close on a month-to-month or quarter-to-quarter basis, but it could explain the large swings. This broad relationship is shown in Diagram 1 which compares the predicted exchange rate and the actual exchange rate using an equation which has been used in the Bank over the years. (By the way, there is nothing unique about this equation as several of the large banks active in the foreign exchange market have also used a similar formulation.) What Diagram 1 shows is that, on the basis of previous experience during the floating rate period, we could have expected a rise in the exchange rate in 2000. Instead, we have seen a fall and the gap between actual and predicted is over three standard deviations - the largest in the past fifteen years. Something therefore has changed, at least for the present. Diagram 1 Real Trade-Weighted Exchange Rate Index Index Predicted* Actual 1985-1999 average * Shaded area represents +/- one standard deviation from predicted value. Another way of making the same point is to say that the Australian dollar has never previously shown a significant fall with economic conditions as they presently are. Over the course of 2000, we have had a strong world economy, improving Australian terms of trade (rising commodity prices), a buoyant domestic economy, a declining current account deficit, a fiscal surplus and rising domestic interest rates. In the past, a significant fall in the Australian dollar has coincided with the opposite - a weak domestic economy and world economy, and falling commodity prices. It has also usually occurred against a background where there has been widespread public criticism of fiscal and monetary policy for being too expansionary. None of these elements is present on this occasion. The comments I have made so far have treated the year as a single development, but I think it is possible to distinguish two phases. For the first seven months or so, the biggest influence on the exchange rate was the expectation of what was going to happen to Australian and US interest rates. The predominant view was that the strong US economy would mean that US interest rates would rise more than those in other countries (including Australia), and this contributed to a strong US dollar and falling Australian dollar. Any suggestion that the Australian economy was weakening (or the US economy strengthening) led to a fall in the Australian dollar. In the first seven months of the year, virtually all of the large movements in the Australian dollar could be explained this way. For example, on two occasions, a weak monthly retail trade figure caused the Australian dollar to fall by more than one US cent in a day. Our forthcoming Statement on Monetary Policy (due next Monday) examines this in detail. The irony of this situation was that this process actually involved a misinterpretation of the Australian economy. The signs of weakness that were seized upon were anomalies; the underlying economy remained very strong, incipient inflationary pressures were starting to appear, and during this period our interest rates were raised, as it turned out, more or less by the same amount as those in the United States. Nevertheless, the misinterpretation prevailed and the currency fell. Over the six months from late January, the Australian dollar fell by 11% against the US dollar and 8% in trade-weighted terms. The second phase occurred from around mid-year, when it became widely expected by the market that the US economy was going to have a soft landing, and that no further increases in US interest rates were likely. As a result, the market’s expectation of future interest differentials moved in a direction favourable to Australia. Had the foreign exchange market continued to behave as it did in the first half of the year, the Australian dollar would have risen, but it did not. It steadied for a while, and then fell appreciably from mid-August. It was this period that convinced a lot of people that some new factor must be at work, which was overwhelming the normal determinants of the exchange rate. It was also in this period that the alternative explanations were put forward most volubly. The influences Before getting on to some of the newer explanations for the currency’s movements, it is worth looking at some more conventional explanations. The first of these is the strength of the US dollar itself, which has been the biggest reason behind our recent experience. This has affected us in a mechanical sense in that if the US dollar is rising, the currency on the other side of the bilateral exchange rate must fall. We have been part of this, as is shown by the fact that the Australian dollar has fallen more against the US dollar than in tradeweighted terms. There has also been an indirect effect in that the rising US dollar has affected the investment preferences of many market participants in an extrapolative way which I will discuss later. The US dollar in 2000 has risen against the currencies of all other industrial countries, although its rise against the Yen has been relatively small. These two currencies - the US dollar and the Yen - have been the strongest currencies in 2000, and they happen to be our largest trading partners and so have the largest weights in our trade-weighted index. Interestingly, the newer explanations for currency movements are largely based on the assumption that countries with strong currencies will have characteristics similar to the United States (see later). But Japan is almost the opposite to the United States - weak economy, barely positive interest rates, massive fiscal deficit, trade surplus and an economic culture based on conventional manufacturing. I do not wish to dwell on these differences, other than to note that they show the dangers of coming up with a general explanation of exchange rate movements which turns out to be only applicable to one country or one period of time. The second explanation relies on the well-known tendency for exchange rates to be driven by momentum. That is - once a trend has been established, for example, by the events in the first half of the year - it tends to continue and thereby to overshoot the level implied by fundamentals. There have been many documented examples of this,1 and market participants often place weight on this factor when explaining movements in exchange rates. I have no doubt that this has been an important factor over recent months, as it has been on several earlier occasions in our past. A related market rule of thumb that has appeared this year, but was entirely absent last year, is the one which relates movements in the Australian dollar to movements in the Euro. The good thing is that these trends and rules of thumb do not continue indefinitely, and the further the exchange rate departs from fundamentals, the more likely it is that some unforeseen event will come along to jolt the rate into a new direction. The third conventional explanation gives prominence to Australia’s external position - the current account deficit and the accumulation of foreign debt and other liabilities. This explanation emerges whenever the Australian dollar is falling, and then goes into hibernation whenever it is rising. The problem with this explanation is that our external position has been relatively stable over the past decade or more, and so it is difficult to use it as the explanation for an event that only occurred as recently as this year. Over the past decade, the current account deficit has cycled around an average of about 4½% of GDP, and our foreign debt has stayed a little over 40% of GDP. It is true that total external liabilities to GDP has risen, but against this, the ratio of debt servicing to exports has halved over the past decade, and the current account deficit itself has been declining during the period of the falling Australian dollar. I think it is very difficult to make the case that our external position has recently deteriorated, or that it is the explanation for the falling Australian dollar in 2000. While I am generally sceptical that this year’s events can be explained by a sudden focus on trends in the current account position, it may be more promising to think about developments from the perspective of capital flows. If, for one reason or another, investors found Australia a relatively less attractive destination for their funds, compared with some other destination - eg the United States - we would expect that this will have implications for the exchange rate. Some will want to assert that this occurred because people suddenly focused on Australia’s current account, but this seems unsatisfactory because the recipient of the flows - the United States - is seeing its current account deficit expand to unprecedented size. In fact, as a share of GDP, Australia’s current account deficit is well on the way to being smaller than its US counterpart, yet the US dollar has been rising, and the Australian dollar falling. So to make sense of what has been happening, it is necessary to think in terms of capital flows being driven by changes in the perceived returns in the different countries. In the remainder of this talk, I would like to examine this apparent shift in capital flows, and to think about whether it is temporary or permanent. Attitudes of international investors There are two reasons put forward for why overseas investors may now have a smaller appetite for investing in Australian assets - the first applies to debt and the second to equity. On Australian debt, whether at the short or long end or whether private or public, current interest rates are now lower than formerly was the case. For a good part of the past two decades, Australian interest rates were well above US rates, as we struggled to get Australian inflation back to a respectably low rate. Even when inflation fell, a number of years passed before the fall was finally reflected in inflationary expectations and interest rates. As a result, it was only over the past three or so years that Australian interest rates lost their significant premium over US rates (Diagram 2). For example, the US dollar in 1989, the Japanese Yen in 1995, in a strengthening direction, and then in 1998 in a weakening direction. Diagram 2 Ten Year Bond Yields % % Australia US l l l l l l l The argument essentially says that, since Australian interest bearing securities no longer contain a premium, investors’ appetite for them has declined, and so the demand for Australian dollars to buy them has fallen. On the surface, this sounds plausible, but we should ask why have rates fallen. Surely they fell because Australian debt became more attractive to investors. Whereas in 1994 rates of 300 basis points above US rates were required to get investors to hold our bonds, they now do so willingly at rates only slightly above US rates. Clearly, the simple form of this argument has a few logical gaps. However, there does seem to be something at work here - perhaps due to differing appetites for Australian bonds on behalf of local compared with foreign investors - because there has been a reversal in recent years of the former high levels of capital inflow into Australian bonds. In the five years between June 1992 and June 1997, these inflows averaged $4.3 billion per year, whereas over the past two years there have been outflows of $5.2 billion per year. The second argument, namely that there has been a change in preference by equity investors, is a relatively recent one, but it has been put forward very forcefully. It essentially says that equity investment (direct and portfolio) is less attracted to Australia than formerly since we are viewed as an “old economy” because we do not have a big enough exposure to the new growth areas, particularly the information and communications technology sector (ICT). The contrast is drawn between the United States, which is seen as the “new economy”, and other countries, including Australia and Europe, which are seen as the “old economy”. Let me say at the outset, there are two questions at issue - first, do a substantial number of providers of capital think this way? - and second, is there economic substance to the contrast between the two types of economy? There can be little doubt that the answer to the first question is in the affirmative - this line of thinking is very widespread at present, and therefore has no doubt been an important recent influence on our exchange rate.2 The answer to the second is, in my view, in the negative - the differences between the two types of economy - “old” as applied to Australia and “new” as applied to the United States - have been greatly exaggerated and the similarities ignored. This is important because if there is not fundamental economic substance to the view, it will not last - it will be seen as a phase through which capital markets passed. I would like to spend the remainder of my time tonight explaining why I believe this is so. The thing that stands out about the economic performance of Australia and the United States over the past decade or the past few years is not the contrast, but the remarkable similarity. For an investor, the most likely place to make money is where there is strong growth and a rapid increase in productivity. The United States is justly proud of its performance in these two areas, but the one comparable Net equity flows into Australia in 1999/2000 (only data for the first three quarters are available) appear to have been less than in the two preceding years. country in the OECD area that can match it - in fact, exceed it - has been Australia. I have shown the growth and productivity figures before, so I will not repeat them again, but will rely on a US source to make my point. An article in the US Federal Reserve Board’s October Bulletin sets out to explain the remarkable recent pick-up in US productivity and to contrast it with 16 other OECD countries. It is an excellent and thoroughly researched article which broadly achieves its objectives, but it keeps finding an irritating exception.3 Whether it is growth of labour productivity, growth of multi-factor productivity or the extent of capital deepening, Australia matches or exceeds the excellent US performance, rather than sharing the lacklustre performance of the majority of other countries. But proponents of the “new economy” view would reply that they are not interested in the whole economy, they are interested primarily in the ICT part where the United States unquestionably is the world leader. But only 3.9% of the US workforce is employed in the ICT sector (the comparable figure for Australia is 2.6%). Why you should make an assessment of a country by concentrating on the 3.9% and ignoring the other 96.1% is a question I cannot answer. On a similar note, the willingness to adopt new technology is surely the key to improving productivity, and here there are a number of indicators that place Australia very high in the world rankings. A recent OECD publication4 on this subject finds that, among the 27 or so OECD countries, Australia is: • third highest in ICT expenditure as a percentage of GDP; • sixth highest in PC penetration; • eighth highest in internet hosts per 1000 population; • third best in internet access cost; • third best in secure web-servers for electronic commerce. Not surprisingly, we do not match the United States in most of these measures, but we are almost always in the top quartile or higher, suggesting that among OECD countries we should be regarded as being towards the top end of the range in willingness to embrace new technology. Again, the proponents of the “new economy” view find this reasoning unconvincing. They tend to concentrate on the production of the ICT sector, and give Australia low marks for not having more resources in this area. While there is no doubt that the very sophisticated fringe of ICT, as exemplified by Silicon Valley, would be an asset to any country, most of the production side of ICT is much more humdrum. In fact, the country with the highest share of GDP derived from ICT is not the United States; Korea and Hungary, for example, both have higher shares. The United States has outsourced a good deal of the production to less sophisticated countries with lower cost structures, with the result that the United States now has the largest deficit in trade in ICT of all countries.5 This, I think, helps make the point that a policy of trying to direct resources into ICT, particularly its production at the expense of other aspects of the economy, could be self-defeating. It would be all the more disappointing if such a policy were sold on the grounds that it would be a constructive response to the current fall in the exchange rate. Perhaps the biggest weakness with the “new economy” argument as an explanation of exchange rate movements can be found in the recent behaviour of the US dollar and US investments. It is frequently asserted that the reason the US dollar is rising is because everyone wants to buy US equities, particularly tech stocks, because that is where the high returns are. In fact, anyone who followed this approach this year would have been disappointed. Not only were they buying into something with an already high price and low yield, they would have seen the prices fall noticeably over the year - the C Gust and J Marquez, “Productivity developments abroad”, Federal Reserve Bulletin, October 2000. “The knowledge-based economy: a set of facts and figures”, OECD, Paris, 2000. “Measuring the ICT sector”, OECD, Paris, 2000. Dow by 5% and the NASDAQ by 16%. (In Australia, the all-ordinaries has risen over the same period.) To the extent that the US investments made positive returns, it would have been only due to the appreciation of the US dollar itself, not to the assets purchased, which turns the underlying reasoning on its head. Conclusion The Australian dollar has shown some big swings in both directions since it was floated in 1983. This is the fourth time in that era that the Australian dollar has fallen by more than 10% in trade-weighted terms in a year. On each of the earlier occasions, it seemed at the time that the fall would go on forever, and there were plenty of people who had explanations to support its continuation. However, on each occasion, it recovered and it will do so again this time. The principal reason for the fall over recent months has been the rising US dollar, which has affected us directly and indirectly. Another reason is to be found in the interaction between the early fall based on expectations of interest differentials plus the intrinsic tendency for foreign exchange markets to continue to go in one direction, ie to overshoot, and to come up with explanations to justify the overshooting. Finally, over recent months, there has been a tendency for markets to judge countries and their exchange rates by the “new economy model”. Ironically, this is exactly the period when US technology stocks have languished. I should now conclude by saying something about the implications for monetary policy. Monetary policy will continue to be conducted according to the medium-term principles contained in our inflation-targeting approach. This means that the exchange rate will be taken into account, along with the other variables that contribute to our inflation outlook (where this is appropriately defined to exclude once-off factors such as petroleum prices and the GST). On the other hand, as can be seen from our current behaviour, we have no intention of departing from our medium-term approach in an ad hoc attempt to push up the exchange rate for its own sake. The period ahead will contain many uncertainties, both here and abroad, but we have coped with uncertainty before. Over the past year, we have had the unusual combination of strong domestic growth, a falling current account deficit and a declining exchange rate, all of which are conducive to future growth. We still have to ensure that the medium-term outlook for inflation stays on track which means making sure that several temporary factors have only a “once-off” effect and are not reflected in the ongoing inflation rate. If we succeed in doing that, we will be in a good position to continue the expansion we have had since 1991. | reserve bank of australia | 2,000 | 11 |
Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, at the Bank of Thailand's International Economic Conference "Practical Experiences on Inflation Targeting", held in Bangkok on 20 October 2000. | Stephen Grenville: Inflation targeting in the world of volatile capital flows Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, at the Bank of Thailand’s International Economic Conference “Practical Experiences on Inflation Targeting”, held in Bangkok on 20 October 2000. * * * While a number of developed countries adopted inflation targeting in the early part of the 1990s, there was a commonly held view that it would not be easy to apply this approach to monetary policy in emerging countries. For instance, Paul Masson et al. (1997) set out the prerequisites and building blocks of this monetary framework, identifying the main ones as being: • the ability to carry out a substantially independent monetary policy, especially one not constrained by fiscal considerations; and • freedom from commitment to another nominal anchor such as the exchange rate or wages. They concluded that “these fairly stringent technical and institutional requirements cannot be met by many developing countries because seigniorage remains an important source of finance and/or because there is no consensus that attainment of low inflation should be the overriding objective of monetary policy. We thus conclude that the way to improve the monetary and inflation performance of developing countries may not be through the adoption of a framework akin to inflation targeting, at least not in the near term”. In the short period since then, there has been a lot more attention and interest in inflation targeting in emerging-market countries. What has caused this change of view? One answer is that the literature had been overly influenced by the poor inflationary record in Latin America in the 1980s, and as the better record in Latin America in the 1990s became clearer, commentators and analysis came to recognise the benefits of an inflation targeting framework. Perhaps more importantly still (and relevant to this paper because of its emphasis on the external sector and capital flows), decisions about exchange rate regimes have put inflation targeting more in the forefront. To the extent that a number of Latin American countries had chosen a fixed exchange rate as the nominal anchor for their monetary policy, in the hope of driving down the rate of inflation and keeping it low by a commitment to a fixed exchange rate, there was no place for inflation targeting in this strategy: this was clearly an alternative strategy to inflation targeting. But over time, the fashionable paradigm on exchange rate regimes has shifted, for several reasons. First, a number of countries found the use of the exchange rate as a nominal target presented serious problems during the phase of inflation reduction. Even though this strategy might have been quite effective in getting inflation down, inflation came down slowly and greatly eroded their international competitiveness. There was, also, the “exit” problem. Secondly, there was much more attention on finding an exchange rate regime which would help with the difficult task of adapting to a world of large and sometimes volatile capital flows. While some countries responded to this by “hardening” their fixed exchange rate policies (even to the extent of adopting currency boards or dollarisation), a number of other countries have moved to the opposite end of the exchange regime spectrum, to some variation on floating rates. Thirdly, of course, there were crises in several fixed rate countries (Mexico and Brazil), and they adopted flexible exchange rates as a result. It is this more widespread adoption of exchange rate regimes at the floating end of the spectrum which I would like to call “flexible” rather than “floating” (more on this later) - that brought inflation targeting to centre-stage. Once a fixed exchange rate is abandoned as the nominal anchor of monetary policy, the question is what should be put in its place. Going back several decades, the answer might have been to adopt some form of monetary target. But we have come to recognise (some of us painfully) that there is a very uncertain relationship between the monetary aggregates and the final objectives of macro policy (inflation and output). If there is a relationship, it does not have enough stability and predictability to make it an effective basis for monetary policy. So if this option is not feasible or desirable, and if fixed exchange rates are not the answer (for some other reason), then the third main alternative to unconstrained discretion for monetary policy is some form of inflation targeting. While it might still be possible to have an informal regime with a lot of discretion (it could be argued that the United States is in this category), the “total discretion” regime is one that requires a long history of good performance and quite a bit of confidence on the part of the markets in the monetary authorities. For most of us, what we need is a regime which provides what has been called “constrained discretion” - a consistent framework which will help the authorities to resist the various political pressures which are on them (often captured under the rubric of “time inconsistency”); which the markets will judge to be in some sense “best practice”; but which allows the authorities sufficient discretion to handle successfully the exigencies and shocks which inevitably arise and which have been the downfall of simple mechanical rules. Hence the attraction of inflation targeting, not only to those developed countries which adopted it in the early 1990s, but to emerging countries which, having come through the Asian crisis, now accept that a high degree of flexibility of the exchange rate is desirable. In this world, we need some kind of framework to help in the increasingly complex (both economically and politically) task of running good monetary policy which, in the end, will be judged very largely in terms of the inflation performance. What is inflation targeting? Rick Mishkin (2000, p 1) puts the heart of inflation targeting this way: “Inflation targeting is a monetary policy strategy that encompasses five main elements: (1) the public announcement of medium-term numerical targets for inflation; (2) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated; (3) an information inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments; (4) increased transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives, and decisions of the monetary authorities; and (5) increased accountability of the central bank for attaining its inflation objectives. The list should clarify one crucial point about inflation targeting: it entails much more than a public announcement of numerical targets for inflation for the year ahead”. Note, in particular, point 3. It is important to keep in mind that the inflation target is an alternative (not a complement) to an exchange rate target. Mishkin and Savastano (2000), in examining the Chilean experience, noted that Chile had embraced both an inflation target and an exchange rate target (a moving band), but was always prepared to make the exchange rate target subservient to the inflation target to the extent that there was any conflict. So the first strong point we want to make is that countries need to settle on their exchange rate regime before they decide to adopt inflation targeting, and if they have a strong commitment to a particular exchange rate target, then it will be very difficult to simultaneously pursue an inflation target. This does not mean that the exchange rate is irrelevant to the inflation targeting regime - far from it. In fact, I will spend a fair bit of my talk today trying to figure out just where the exchange rate does feature within an inflation target. But the basic starting point is that it has to be part of and subservient to the inflation targeting regime.1 So inflation targeting should be seen as part of an overall approach to macro policy, encompassing fiscal policy and the exchange rate regime. Mishkin and Savastano (2000, p 7) observe: “What is important to stress, however, is that from the perspective of monetary policy a strategy of monetary targeting or inflation targeting does not imply or require “benign neglect” of the exchange rate and no intervention in the foreign exchange market (ie a ‘clean’ float). What matters is that the central bank makes it clear to the public, through both its actions and pronouncements, that the nominal exchange rate will always move in the direction set by the market and, crucially, that the exchange rate is not a nominal anchor for monetary policy and inflation expectations”. Evolution of the inflation targeting framework, and the role of economic activity At the same time that changes in views about exchange rate regimes have made inflation targeting a relevant option for a wider range of countries, so too the inflation targeting framework has, itself, become more complex over time, with an increasing recognition that a simple interpretation of an inflation target is misleading, or at least incomplete, as a guide for policy. Whereas early versions of inflation targeting simply specified a target (usually reasonably rigorously, ie narrowly), and even went out of their way to avoid any mention of economic activity (or its related variables, such as unemployment) in the target itself or in inflation reports, over time there has been an increasing recognition that the target is operationally much more complicated than this, and that for it to be successful it must embody a considerable degree of flexibility. Hence, the notion of “constrained discretion”. It is a reminder, if you like, that whatever you do in economic policy must be able to pass through the filter of common sense. You must always keep your eyes open and wits alert, taking in all the signals which the economy is giving.2 In broad-brush terms, the change which has come about in the specification of inflation targeting regimes comes from the recognition that if the inflation target is specified narrowly and the time horizon over which it must be achieved is tight, then the effort to keep the actual inflation rate constantly within a narrow band will involve quite a bit of short-term variation of the interest rate lever (and, consequentially, the exchange rate), and policy will be jerking output around disruptively, probably unnecessarily. Central banks may regard their sole objective as inflation, but it seems pretty clear that the community’s wishes (their objective function) have output in there as well. Any central bank which achieves its inflation objective but damages output in a way unacceptable to the community will not keep its mandate for long. It is the recognition of this point which has produced a voluminous discussion and academic literature, which basically asks the question: what is the right trade-off between rigid adherence, moment by moment, to the inflation target (on the one hand) and a steady path of output (on the other). So the issue here is the specification of the target: if it is too “tight”, output will be unnecessarily volatile. If too loose, policy will lack credibility and the inflation objective will not be achieved. There are obviously difficult issues here, which differ from country to country and, even within a particular country, probably change as the inflation targeting framework gets more acceptance. When an inflation target is first put in place, it probably needs to be more rigid in order to gain acceptability and credibility, but as credibility is established, there is more opportunity to let go a bit of slack on inflation variability over time, in order to smooth other variables such as interest rates, exchange rates and output. All these issues will be covered by other speakers, so I should focus on the one which stems directly from issues of capital flow - ie the exchange rate - and ask if, and how, the inflation targeting regime should be modified to adapt it to the fact that the economy is open, and this openness (providing shocks both on the trade and capital account) is transmitted via exchange rate changes. How should this be incorporated into the inflation framework? Capital flows First of all, just a reminder of how big, volatile and potentially damaging capital flows can be for the countries of this region. The most graphic measure of how big they are is to remind you that in 1996 Thailand received capital inflows equal to 13 per cent of its GDP - an inflow which no country could have absorbed easily. To see how volatile these flows are, we again need to look no further than the recent experience, where inflows of US$90 billion per year turned into outflows of US$50 billion per year. To add to these historical observations of size and volatility, let me assert that flows of this kind will return, and will be the norm rather than the exception. What makes me confident in asserting this is the As policymakers we should be pleased by this view, because the alternative - that it is a mechanical process which can be captured by a relatively simple one-line rule - would mean that there is no serious job for us to do. existence of huge portfolios in the developed countries, in the form of actively-managed funds seeking the highest return in a globalised world. The managers will inevitably shift part of their portfolios to the countries of this region, if only because their actual degree of diversification is well below the theoretical norm: these portfolios do not yet have enough weight of emerging market assets. On top of this (again a subjective assertion), the countries of this region will have above-average profit opportunities over the next decades as they move towards the technological frontier. Diversification and profit prospects will drive developed countries’ portfolio managers to shift funds into this region. The question of scale is not simply that the supply of these funds comes from portfolios which are huge: the point that Paul Volcker has emphasised again and again is one of relative size, in that the recipient financial institutions and even the entire countries are quite small compared with the size of the portfolios which have already been built up in America and Europe - and these portfolios seem likely to continue to grow strongly, as private individuals increasingly respond to concerns about their retirement incomes. One more subjective assessment: these flows are likely to be volatile; this view comes from the persistent evidence that financial markets overshoot and behind this overshooting is herding and contagion - “fear, greed and ignorance” are still important motivations of capital flow, and are likely to remain so. So the starting point, the environment in which we will have to work, is one of large and volatile capital flows. Exchange rate regimes This takes us directly to questions of exchange rate regime. While there will be legitimate and indeed powerful cases where individual countries might want to adopt a fixed rate (Hong Kong is the classic example), these are special cases driven by the specifics of their environment. The much more common case will encourage countries to move towards the flexible end of the exchange rate regime spectrum, and this immediately raises the issue: with the exchange rate floating or flexible, what will be the nominal anchor for monetary policy? The extra element which we should discuss here is that it cannot realistically be expected that flexible exchange rates will be stable. Even between the Big Three, where there are deep financial institutions, and well-developed ideas on the behaviour of the exchange rate which should guide markets and anchor their exchange rate expectations, it is now abundantly clear that the exchange rate can move substantially, not driven by the fundamentals. One only has to quote the yen at 80 per US dollar in April 1995, followed by 147 in mid 1998 to see the problem. We are, in all probability, observing some similar phenomenon in relation to the US dollar and the euro. If such large fluctuations can occur in deep, well-developed markets with long history of flexible rates and clear ideas on how the price discovery process works (ie a well-defined “model”), then how much more difficult for emerging countries with no long histories of exchange rate behaviour, relatively undeveloped financial institutions, and very few players (either at home or abroad) who are prepared to “take a position” on the exchange rate, which - in the textbook story - is the anchor holding the exchange rate reasonably stable. So this takes us to what I believe is the central issue in this topic - given that large and volatile capital flows will produce quite large swings in exchange rates, how should this be incorporated into an inflation targeting framework? Exchange rates and the inflation target This has been the subject of considerable academic research in recent years (see Ball (2000), Bharucha and Kent (1998), Ryan and Thompson (2000) and Svensson (1998)). I will not attempt to add to this, but merely to give an intuitive, heuristic interpretation of the issues. Perhaps the easiest way to think about this is in terms of a sharp depreciation of the exchange rate. To the extent that this pushes up inflation (via “cost push” channels, and also via the stimulus to activity which a depreciation provides), how should an inflation targeting regime respond? Of course the depreciation cannot be an excuse for allowing inflation to rise to a permanently higher rate. So, to the extent that the central bank’s objective is stated simply in terms of an inflation target, this clearly still has to be met. The issue is: “over what time horizon”? Knowing that any change in interest rates will have an effect on activity (after all, this is one of the principal channels of monetary policy transmission), how much “damage” should be done to activity to offset not only the extra stimulus to activity from the depreciation, but the cost push effects as the effects of the depreciation feed through to prices? If the authorities had perfect foresight and were sure that the depreciation was temporary and shortlived, then they might well want to do nothing - whatever upward pressures there are on prices will be unwound in due course, and provided price expectations are not dislodged during this process, then no great harm is done by any temporary increase in inflation.3 But on the other hand, if the depreciation is permanent, even if the pressure on inflation via the cost push channel is a one-shot boost, the depreciation gives an ongoing stimulus to activity which needs to be offset. We are already getting, from this example, a hint of the central issue - that is, that policymakers need more information than is available from a mechanical interpretation of (or rigid adherence to) a simple inflation target, if they are to distinguish between these cases and get the right answer, which will differ depending on the circumstances. Most specifications for an inflation target do not include something which begins: “it depends …”. But in an uncertain world, this is the right starting point. It is intuitively tempting to suggest that the inflation target should be rejigged so as to focus on domestic prices (either non-traded goods or, the more deeply-embedded version, wages). The intuition here is that, if the exchange rate depreciation is indeed temporary and not very long-lived, then it is good policy to ignore it, allowing the temporary rise in inflation. While this gets the right answer in the case of a temporary and reversed change in the exchange rate, it does not seem to get the right answer if the exchange rate change is long-lived or structural. It is true that the direct cost push effect of the depreciation on inflation may well be once-off and therefore will pass out of the system (hopefully without disturbing price expectations). But the depreciation leaves a permanent boost to activity which remains there unless or until inflation wipes out the effect of the nominal depreciation.4 When we are in the world of “it depends …”, then we need to relate the policy advice much more specifically to the particular economy in question. At the Reserve Bank of Australia, we have done some work asking the question whether focusing on non-traded prices in the face of a variety of shocks would tend to give better answers, and the short answer is “no”. “Non-traded inflation (and unit labour cost growth) rules appear to generate at least as much variability in output and aggregate inflation - it is aggregate inflation that we care about - without any significant reduction in interest rate variability” (Ryan and Thompson 2000). These same issues were examined by Larry Ball (2000). He is attracted to the idea that “optimal rules in open economies differ considerably from optimal rules in closed economies. In open economies, stability is best achieved by targeting “long-run inflation” - a measure of inflation adjusted to remove transitory effects of exchange rate movements”. But this is just another way of stating the intuition with which this section opened - that in the face of temporary exchange rate shocks, the authorities should not react but in the face of a permanent or structural change in the exchange rate, they should. The trick is knowing, as the exchange rate moves, whether it is temporary or structural. In practice, it would seem sensible to assume that at least some of the movement is structural, or at least will last long enough to either damage price expectations, or affect economic activity (too much expansion, in the case of a depreciation). So I am not sure that the Ball rule has advanced us much past the intuition. The damage done by short-term exchange rate movements may change over time, and be regime-dependent: “It is also important for central banks to recognise that, as is the case for most economic relationships, the passthrough from exchange rate changes to prices is likely to be regime-dependent. After a sustained period of low inflation with effective, as opposed to fictional, exchange rate flexibility, the informational content of the exchange rate in the expectationsformation process and price-setting practices of households and firms is likely to fall. Thus, the widespread view that a currently high passthrough from exchange rate changes to prices is a barrier to successful inflation targeting is probably exaggerated” (Mishkin and Savastano 2000, pp 56-57). After all, in this world, there is no point in wiping out the real effect of the exchange rate change, because we are assuming that this is reflecting some long-term fundamentals, to which the economy should be adapting. But perhaps this is the important point to make - we still need to use intuition, and common sense, in implementing inflation targets.5 Ball also raises another controversial but important issue in trying to incorporate the exchange rate into an inflation targeting rule. He makes the case that the authorities should use as their operating rule (ie their policy reaction function) a monetary conditions index, rather than an interest rate. It is interesting that an academic should come to examine this issue at this stage, because it has been an issue tried in practice by at least two countries - Canada and New Zealand - and both have abandoned or de-emphasised the use of an MCI. In Australia, it was urged on us (by the OECD). Ball examines this issue with great finesse and subtlety, but let me try to set out the issues intuitively. It is true that when an exchange rate goes down, this will be expansionary on an economy and if nothing else has happened, then interest rates will need to be higher. So if the right weightings can be found between interest rates and the exchange rate, it might be possible to produce an index which reflects, in some sense, the stance of monetary policy. In practice, however, things do not remain the same. In particular, there is often a good reason why the exchange rate is moving down, and in the case of Australia in particular, it is often because commodity prices have moved unfavourably. In this world of lower commodity prices, we need a more expansionary stance of monetary policy, and the fall in the exchange rate provides this more or less automatically. It would not be appropriate or good policy to offset this by raising interest rates. Once again, I am afraid, good policymaking starts off with the proviso: “it depends …”. So far I have talked about the sorts of problems we have faced in countries like Australia and New Zealand. My intuition is that the countries of this region will face a different problem if they use the combination of a floating exchange rate and inflation targeting as a guide to the “constrained discretion” of policymaking. The problem is a familiar one, faced during the first half of the 1990s. That is, that there are very large and increasing capital inflows, which put continuing upward pressure on the exchange rate. Following the reasoning I have outlined so far, the proper response to this is to allow the exchange rate to appreciate. To the extent that this is a long-term or structural change, the inflation targeting framework would allow the appreciation to be reflected in inflation, to the extent that it meant that non-traded (domestic) prices would rise faster than the target. On most counts, this is o.k. - it is proper that the relative price between tradeables and non-tradeables changes (in order to encourage the current account deficit that is the counterpart of the financial capital inflows). But it is a legitimate question to ask whether, having set an inflation target on the basis that this rate of inflation is not disruptive, to accept that some of the most central and basic prices (principally wages) will rise faster than this - see footnote 4. There is, of course, also the very substantial danger that a rise in nontradeable prices faster than the target inflation rate will trigger an asset boom, particularly in the classic non-traded asset of real estate property. There is also the issue that, compared with the situation before the capital inflow and appreciation of the exchange rate, interest rates will have to fall: we know that the extra capital inflows are putting pressure on domestic asset prices, and it might well be asked whether this is an appropriate time to be easing domestic interest rates - which seems to be the implication of a simple reading of an inflation targeting regime. I hope I have said enough about this case (which I believe will be relevant to many of you before long), to alert you to the policy difficulties which are faced in this environment. I hope I have not left you with the impression that I know what the right answer is in this case. I would return to what I There may be another, subtly different, reason for focusing on domestic prices, separate from the point that movement in exchange-rate-driven tradeable prices may be temporary. From the point of view of the smooth running of the domestic economy, some notion of domestic prices (either non-traded goods or wages) may be in itself the proper target for inflation. This depends to some extent on economics, but to some extent on the community’s “objective function”. It may be possible to argue that an economy will work best if wages (or domestic prices) are growing at a particular constant rate, and this is properly the main focus of stability. But if this argument were made, it would be important to keep in mind that the change in relative prices between tradeable and non-tradeable goods is an important signal for investment and resource allocation, and it would not be sensible to have this relative price moving about too much: it is not only domestic prices that matter for price signals to the domestic economy. And, in any case, consumers care about the cost of living (ie aggregate prices). regard as the bedrock or base of good economic policymaking - the application of common sense. In circumstances where countries are receiving large capital inflows which are difficult to absorb, the first question might be whether something could be done to slow down these capital inflows without distorting the economy too badly, in order to help the transition process. The sorts of things which might be done here are very intrusive prudential supervision and various rules (or at least monitoring) on all those who borrow overseas, if only to try to put some “sand in the wheels”. Chilean-style capital inflow controls might also be a possibility. Direct foreign investment may be easier to absorb (the goods inflow comes as part-and-parcel of the capital inflow, so the transfer takes place with less upward pressure on the exchange rate). Having done whatever is feasible and sensible to try to rein in the capital flows (and hopefully make them less volatile by slowing down the herd), what should be done then? There is little doubt in my mind that the exchange rate should appreciate. This is part of the necessary process of bringing about the real transfer of resources (a current account deficit) which is the counterpart of the financial flows. But, to the extent that the exchange rate may well overshoot in this process, intervention is a legitimate policy option. We all know the constraints and difficulties with this. In particular, it is fiscally very expensive. But it can be a useful instrument in the toolbox, for moderate, occasional and discrete use. The extra element which can, it seems to me, be legitimately applied in these circumstances is to be vigilant in the face of asset price rises, and to use whatever instrument (within reason) can be used to prevent such bubbles from occurring - prudential rules, taxation, and even the classic fall-back, bureaucratic red tape. Of course, there is some hope that the rising exchange rate might discourage the capital inflows (the textbooks say that it should), although I have little faith that this mechanism will work at all smoothly, and there is too much evidence of herd and euphoria behaviour to give me any confidence that flexibility in the exchange rate will be an effective break on the sorts of capital inflows which you may well see within a few years. Conclusion In conclusion, I would argue just one simple line - the inflation targeting regime has been enormously useful to us in Australia, and used as a form of “constrained discretion” it may well be an important part of a good regime in other Asian countries which do not have a strong commitment to a fixed exchange rate. The inflation target provides an organisational framework for the debate on the impact of capital flows and the exchange rate. But good policy does not come from simple one-dimensional rules - it comes from strong institutions, a rigorous policy debate, and a dominant priority given to that rarest element in policymaking - common sense. References Ball, Laurence (2000), “Policy Rules and External Shocks”, NBER Working Paper 7910. Bharucha, Nargis and Christopher Kent (1998), “Inflation Targeting in a Small Open Economy”, Reserve Bank of Australia Research Discussion Paper No 9807. Available at http://www.rba.gov.au. Debelle, Guy (1997), “Inflation Targeting in Practice”, IMF Working Paper WP/97/35, March. Debelle, Guy (1999), “Inflation Targeting and Output Stabilisation”, Reserve Bank of Australia Research Discussion Paper No 1999-08. Available at http://www.rba.gov.au. Debelle, Guy (2000), “The Viability of Inflation Targeting for Emerging Market Economies”, paper presented at Australian National University Conference, “Financial Markets and Policies in East Asia”, Canberra, 4-5 September. Masson, PR, MA Savastano and S Sharma (1997), “The Scope for Inflation Targeting in Developing Countries”, IMF Working Paper WP/97/130, October. Mishkin, Frederic S (2000), “Inflation Targeting in Emerging Market Countries”, NBER Working Paper 7618. Mishkin, Frederic S and Miguel A Savastano (2000), “Monetary Policy Strategies for Latin America”, NBER Working Paper 7617. Ryan, C and C Thompson (2000), “Inflation Targeting and Exchange Rate Fluctuations in Australia”, Reserve Bank of Australia Research Discussion Paper No 2000-06 (forthcoming). Svensson, Lars (1998), “Open Economy Inflation Targeting”, NBER Working Paper 6545. | reserve bank of australia | 2,000 | 11 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, in Wagga Wagga on 1 December 2000. | I J Macfarlane: Economic growth, inflation and monetary policy in Australia Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, in Wagga Wagga on 1 December 2000. * * * I would like to start by endorsing the remarks of the Chairman and saying what a pleasure it is to be in Wagga Wagga for the first hearing to be conducted outside Sydney, Melbourne or Canberra. Like you, Mr Chairman, I think it sets a good precedent for future meetings, even if it does represent a cautious start, given that Wagga Wagga is half-way between Melbourne and Sydney and not that far from Canberra. Perhaps the Committee will be more adventurous in its future choices. I would also like to record our thanks to the Mayor of Wagga Wagga and his colleagues and to Kay Hull (a member of this Committee) for their hospitality earlier this morning. As usual, I would like to start by reviewing the forecasts I put before the Committee at the previous meeting in Melbourne in May. Starting with economic growth, you may recall that the Australian economy grew by about 4½ per cent per annum in 1997, 1998 and 1999, and, as usual, we were expecting a modest slowdown in the year to June 2000. The forecast I put forward for that period was 4 per cent, and the outcome was 4.7 per cent, continuing our tradition of modest underestimates of economic growth. For the year to June 2001, I said that we had no quibble with the figure of 3¾ per cent contained in the Budget Papers, nor would we quibble with the recent update which puts it at about 4 per cent. It is largely a matter of rounding, and not much should be made of small differences: the figure is meant to suggest again some modest slowing from past growth rates. I would note that the number for GDP growth involves a substantial slowdown in final domestic demand – from about 6 per cent growth to about 3 per cent – which is mostly offset by a further swing in net exports into positive territory and the assumption that the inventory rundown recorded over the past year does not occur again. On inflation, the story is a little more complicated. Last time we met, I said I expected the CPI to rise by 3 per cent in the year to June 2000 – the actual outcome was 3.2 per cent. Not a very big difference, but the first time for quite a while that the outcome was higher than forecast. The reason for this was the higher-than-expected oil prices. When we look ahead, we should make sure our forecast goes beyond June 2001 in order to avoid the “once-off” lift to the price level attributable to the GST. At the last hearing, I suggested that inflation could be in the upper half of the 2 to 3 per cent range once we are well into 2001/2002. Our Statement on Monetary Policy, which was released about two weeks ago, forecasts that inflation would be around 3 per cent by that time. This small increase is primarily due to the lower exchange rate now prevailing compared with the middle of the year. You are probably tired of being reminded that we are still in the longest expansion we have had for three decades, but that fact has to be the starting point for any economic discussion. When we receive the September quarter national accounts in a couple of weeks time, I expect to see them confirm that the expansion has continued unabated into its tenth year. During this period, the growth rate has averaged 4.2 per cent per annum, and most of the annual rates have been between 3 per cent and 5 per cent, with a few outliers above and below this. Over the whole period, inflation has remained low, which, of course, has been a major factor behind the expansion’s longevity. And, in turn, this has contributed to a fall in the unemployment rate of nearly 5 percentage points to 6.3 per cent. Despite this record, we should not become complacent – we should always be looking ahead to see where the risks to the outlook are likely to come from. Not surprisingly for an economy like ours, which is in reasonable balance, the risks are on both sides. That is, while we are comfortable with our present forecast, there are circumstances which could lead to a stronger economy and hence a speedup in inflation, and others that could lead to a greater slowdown in economic activity than our current numbers indicate. I will start with the risks to the inflation outlook. Obviously, the current year has not been an easy one in this respect. In addition to the GST-induced lift in the price level – which was easily foreseeable and appears to have gone according to plan or better – we have experienced two upward “shocks” in the form of the rise in oil prices and the fall in the exchange rate. It is never easy to digest three such events in one year, so we have to be especially vigilant to make sure that any rise in prices is “onceoff”, and on-going inflation does not rise to the point where it threatens our medium-term objectives. So far, we seem to be on track to pass this test. The GST caused a smaller rise in the September quarter CPI than expected and, on balance, the data on wages suggest that wages are growing in a way consistent with our inflation target. But there is still some way to go before we can be confident that these temporary factors do not push us off course. If it turned out that the economy was more buoyant than we think, the chances of the shocks feeding into higher on-going inflation would rise. I will now talk about risks that the outlook for economic activity could be weaker than we currently envisage. But before doing so, I should remind you that our forecasts already embody a slowing in GDP growth compared with last year, and a more pronounced slowing in domestic demand. So we are not oblivious to the presence of some factors which point to a less buoyant outlook than we have had over recent years. The first of these risks is the world economy, and the United States in particular. For some time now, most observers have expected lower growth in 2001 than in 2000 for both the world economy and the United States, but there is always the risk that the turnaround could be sharper, particularly if there is a shake-out in asset prices. No-one can be sure that, after such a long expansion, the United States can achieve a soft landing, but at present the odds point to this result. On the domestic front, the area of weakness that many people point to is in housing construction. There is no doubt that there will be a big contraction here, but we should remember that it was predictable (and has been predicted by virtually all forecasters for some time). We have just gone through a period when activity in the housing sector was really quite frenzied. At its peak in the June quarter, investment in dwellings was at its highest level ever as a percentage of GDP. A lot of activity in the housing sector that would normally have taken place this financial year was brought forward into last financial year in order to get in before the GST, so the cycle in housing is likely to be more pronounced than normal. The rises in interest rates, no doubt, also played a role, but they were small compared to the GST effect. The third risk that some people have focussed on is business confidence. We have to be careful here because we have over a dozen surveys of business confidence and they do not all show the same results. Even so, it is true to say that business confidence is not as high as it was a year ago and that it has fallen in recent months. I think the recent fall owes a lot to the realisation that the housing and construction sector will be weak, to the fact that a number of businesses have only recently had to face up to the practical implementation of paying the GST, and to rising petrol prices. What does the foregoing mean for the economy and for monetary policy? Starting with monetary policy, our main message is that it will continue to be conducted according to the medium-term principles contained in our inflation targeting approach. We think this approach has served the economy extremely well, not only in the direct sense that it has maintained low inflation, but in the wider sense that it has provided the preconditions for sustainable growth. We will be looking closely at all the influences on inflation over the coming year – including the demand pressures in the economy, the growth of wages, and the level of the exchange rate – in order to judge how they will collectively influence the outlook. Monetary policy will then be set accordingly. We will also, of course, be closely watching developments in the real economy, the labour market, financial markets and our exports and imports. There is a wide range of statistics available on an almost daily basis, from the Bureau of Statistics and from other sources, which chart the course of these economic variables. You only have to read the daily press to see how much attention is paid to these statistics. We at the Reserve Bank, of course, follow them in great detail, something we are able to do because we have a good staff and a lot of experience at examining them. But I want to suggest to you that this sort of data gazing, important though it is, is only one aspect of assessing likely developments in the economy and, on its own, can at times give misleading signals. The problem with statistics is that, as well as containing systematic information, they also contain a fair bit of random variation and sampling error. Sometimes this means that we get a group of strong statistics arriving together or a group of weak ones, which may signify nothing more than the statistical anomalies referred to above. If we rely only on these statistics to form our view of the outlook, we run the risk of regularly swinging from optimism to pessimism and back again, depending on relatively short-term variation in the data. Obviously, other approaches are needed to augment exclusive reliance on statistical observation and so help to identify the underlying direction of the economy. There are many advocates of approaches such as sophisticated econometric modelling, extensive industry liaison, and examination of leading and lagging indicators or the forecasts embodied in financial prices. All of these have their merits and can provide a broader perspective. But there are two other approaches that I would like to remind you of. The first is to go back and examine previous expansions and ask what were the imbalances that brought about their demise, and then to see whether those imbalances exist at present. I did this earlier this year in a speech in Melbourne,1 where I identified a number of domestic imbalances in previous cycles: high inflation, a wage surge, overvalued asset prices, excessive physical investment and excessive credit growth. Not all of these were present towards the end of earlier expansions, but usually two or more were. In looking at the Australian economy at present, it is hard to see evidence of any of these imbalances. • Underlying inflation is about 2¼ per cent, rising to 3 per cent over the forecast horizon. • Wages are growing at somewhere between 3 and 4 per cent. • The share market has risen over the year, but does not seem overvalued compared with many overseas markets. House prices have risen over recent years, but appear to be stabilising at present; rises in commercial property prices have been quite restrained. • There has been no evidence of over-investment or over-capacity in plant and equipment or construction. • Credit to households is still growing strongly, but appears to be moderating. Credit growth to businesses has not been unduly strong at any stage in recent years. Overall, I think it is hard to find signs of the type of imbalances that occurred in the early 1970s, late 1970s/early 1980s and late 1980s which led to such unhappy results. Many people would add the current account of the balance of payments to my list, and point out that in the later stages of previous expansions, fast economic growth led to a widening in the current account deficit. Again, we are different this time in that the buoyant domestic demand growth we have experienced over the past year has been accompanied by a decline in the current account deficit. Of course, I have only listed domestic factors that give rise to imbalances and imperil the expansion. As I said earlier in my introduction, the world economy plays an equally important role, but we have no control, or even influence, over that. It is possible to construct disaster scenarios for the world economy, and no doubt some will, but I am comfortable sticking with the majority in assuming a modest slowdown in world growth or, in current parlance, a soft landing. No two economic expansions are the same; each of the previous ones differed, and the present one has its own unique features. As a result, we cannot rely only on cyclical comparisons such as I have just presented, but they are a helpful part of any overall assessment. A second approach, which I think is a useful reality check, is to look at how the present setting of policies is affecting the economy. “Managing the Expansion”, Address to the Economic Society of Australia (Victorian Branch), Melbourne, 11 February 2000. On monetary policy, there is a tendency for attention to be focussed on changes in interest rates, even when each change is quite small. It is at least as important to look at the level of interest rates in nominal and real terms, and ask whether their present setting involves a significant risk that the economy will overheat or contract. As you know, a year ago we thought that the continuation of the then setting of interest rates would risk the former outcome. That is why we moved to our present setting, which we would characterise as being in the neutral zone, i.e. not presenting either of the two risks to any substantial extent. Because it is in this zone, there is no overwhelming case to move it in a particular direction at present. Overall, the main point for present purposes is that you could not claim that the current setting of interest rates is inhibiting the growth of the economy. Another important influence on the economy which is often put under the heading of monetary policy is the level of the exchange rate. I do not wish to spend much time on this subject today because I devoted a whole speech to it less than a month ago.2 Suffice to say that I do not think there is anyone who would deny that the current level of the Australian dollar makes our exporting and importcompeting industries super-competitive, and hence it is exerting an expansionary influence on the economy. On fiscal policy, the need to more than compensate consumers for the imposition of the GST ensured that it moved in an expansionary direction between last financial year and the present one. Again, I think we can all agree that, even though the budgetary position will remain in surplus for mediumterm purposes, the current stance of fiscal policy is not imposing a contractionary influence on the economy. Overall, therefore, I conclude that because the economy has not developed the imbalances of the past, it has not been necessary to attempt to remedy them with the sort of counter measures in the fiscal and monetary areas that were often needed in the past. This is another way of saying that we have, in my opinion, avoided the boom-bust cycle in economic policy, and hence have an excellent outlook for the coming year. I have no further comments to make on the economy at this stage, but will be happy to answer your questions. The only other point I would like to make concerns the economics of banking. In the past, we have often provided to the Committee a paper on some banking subject, such as bank margins or bank fees and charges. On this occasion, there is no special paper, but we have recently finished a major study, in conjunction with the ACCC, on interchange fees in credit and debit card schemes. We will be happy to answer any questions on that study. “Recent Influences on the Exchange Rate”, Address to CEDA Annual General Meeting Dinner, Melbourne, 9 November 2000. | reserve bank of australia | 2,000 | 12 |
Notes for a talk by Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to ABN AMRO Australia Day Conference, held in Tokyo on 23 March 2001 | Stephen Grenville: The Australian economy Notes for a talk by Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to ABN AMRO Australia Day Conference, held in Tokyo on 23 March 2001. * * * After nine years of excellent growth, the Australian national accounts recorded a fall in the December quarter. I want to put this in context, saying something about what happened and what it might mean for the future. Australia's record of growth in the 1990s was not a fluke or coincidence - it was a result of good fundamentals: that has not changed, and so our prospects are still good. What happened? With the benefit of hindsight, the fall in the December quarter might be seen this way: • in the first half of the year, there was an upsurge in residential construction, with a very substantial "pull forward" of work to avoid the GST. This "pull forward", mechanically, left a big hole in the second half of the year; • in a low inflation world - where producers pass on price increases only with some trepidation - the threefold sources of pressure on prices (GST, exchange rate and oil) squeezed cash-flows and profits. When this is combined with the disruption and general choler associated with the introduction of the new tax regime, small and medium business confidence took a hit, • policy settings operated in an environment where cost-push price pressures were very strong. Let me say a bit more about each of these aspects - the cause of the GDP fall; the short-term temporary shocks which the economy experienced in the second half of 2000; and the stance of policy. (a) The construction sector It may seem improbable that a sector accounting for only 5 per cent of the economy should bulk so large in this story. So I will have to ask your patience while I give the detail. Residential construction was, even without the GST, reaching the mature phase of its usual cycle as the economy entered 2000. Such was the frenzy to get construction done before the GST, that avoiding the tax became an end in itself: people were paying more than 10 per cent extra in order to attempt to complete work ahead of a 10 per cent tax. We heard few complaints from the construction sector, but many stories of seven-day working weeks and very significant pressures on construction contract prices, as builders attempted to ration the demands on their capacity. It was to be expected indeed it was inevitable - that this frenzy had to end in the second half of the year, with the reversal coinciding with what was probably the natural inflection-point of the building cycle. This conjuncture gave rise to the sharpest quarterly fall in housing activity ever recorded in the Australian statistics (and the largest half-yearly fall too - by a large margin). Overall, the September quarter was hard to evaluate, because of the effect of the Olympics - where sports-crazed fans added to demand by spending their money on getting to the Games, and subtracted from it by staying at home to watch on TV. If we take out dwellings and a crude adjustment for the Olympics, we note that the remaining 95 per cent of the economy was growing at a rate of a little under 4 per cent through 2000 (in fact, a little faster in the second half than in the first). You might say that the profile of residential construction should have been predicted (and in its broad outline was certainly foreseen). What was not foreseen was, first, the size of this fall and, second, the degree of confidence-sapping annoyance with the administration of the GST. The basic point here is clear: without the "tail" of the construction sector wagging the dog of GDP, any slowdown would have been moderate, thus continuing the economic performance of the 1990s. (b) Cost pressures Business confidence, particularly that of small businesses, was falling well before the GDP figures were made public. Part of this was clearly related to the decline in the housing sector and part to difficulties which small business was having in adapting to the administration of the GST. But, by January 2001, there was another piece of data pointing to an additional factor. Paradoxically, it was the unexpectedly good performance of the CPI in the December quarter. The second half of the year had seen three strong cost-push inflationary pressures - the GST adding 10 per cent to many prices; an exchange rate which had fallen 15 per cent over the first ten months of 2000; and a world petroleum price which was 87 per cent higher (in terms of Australian dollars) than eighteen months earlier. The cost-push pressures from oil and the exchange rate were showing quite clearly in producer prices, with input prices for manufacturing rising by almost 20 per cent during the calendar year. Faced with these cost pressures, it looks as though many producers (particularly in manufacturing) found it difficult or impossible to pass on these price increases quickly, particularly in an environment where low inflation was well established, competition was vigorous and there was a fair bit of "moral suasion". Quantifying this price squeeze is quite difficult, and assessing its role in the slowdown more difficult still, because the starting point of profits was so strong. And, of course, there were some sectors (notably exports) where profits were substantially boosted by the lower exchange rate. But there is little doubt that some businesses felt squeezed, and this had a general dampening effect on their animal spirits. (c) Policy setting It is hard to argue that the downturn was caused by tight macro-policy settings. The GST was accompanied by a reduction in income tax which was designed to be larger than the GST effect - i.e. there was over-compensation for the GST. While the budget continued to show a surplus, it was a surplus smaller than the previous year, which in macro-policy terms is expansionary. Official interest rates were raised by 150 basis points between November 1999 and August 2000, starting from a low point established during the Asian economic crisis. Not only is it hard to believe that monetary policy is anything like that powerful (particularly as the last of the increases - in August - had so little time to have effect), but the proximate cause of the sharp slowing is clearly found elsewhere. This is not to claim that monetary policy has no effect on the economy - I am hardly going to do that. But it is to assert that - with lending rates lower (in nominal and real terms) at their recent peak than at the low point of the mid 1990s and with demand for credit still strong at these interest rates - the setting of monetary policy cannot be seen as a principal actor. Could the economy have successfully negotiated the period of robust growth, and rising inflation, in the first half of 2000, in the face of strong downward pressure on the exchange rate, with interest rates maintained at 43/4 per cent? That setting would, of course, have been well below the United States and we would have been the only country in the developed world not to raise interest rates. The policy environment in the second half of 2000 was no easier. Among the three price shocks (GST, exchange rate and oil prices), only the last was a pure textbook "supply-side" shock. But, together, they had many of the same characteristics - cost-push pressures on prices. As it became clear, with the CPI result in January, that these cost pressures were well contained, policy responded quickly and half the increase has been reversed. Why was it unexpected? One answer would be to acknowledge the imprecision of forecasts - one of the few certainties of forecasting is that outcomes will differ from forecasts. After a lifetime of observing the economy, a sage concluded that "nothing is certain; anything is possible; and everything depends on everything else". And of course this is part of the story. But a powerful element in this story is simply that the economic fundamentals were (and are) so good, that it is still, even now, hard to accept that an economy without imbalances, which has capacity to grow further, and with accommodative policy settings should change direction so suddenly. Contrast the state of the economy in 2000 with the history of post-WWII cycles. The grand, if depressing, tradition was that Australian expansions came to a halt either because they ran into an external constraint (in the pre-1984 world, a current account crisis), or because there was a wages/inflation break-out. Policy could not offset these imbalances in a subtle or gentle way, so strong use of the policy levers was often also "present at the scene of the crime". Hence the characterisation of policy as "stop/go". How different was the world of 2000: an improving external position (improving, uncharacteristically, despite good growth); inflation well contained both currently and in prospect (reflected in bond yields, where the $A bond yield has remained just a few tenths of a per cent higher than the US$ bond); wages growing at a moderate pace; a budget continuing in surplus but nevertheless able to provide offset to the GST and overall macro stimulus. Moreover, the economy itself was in good shape. Fifteen years of reform (on tariffs, privatisation, labour market, competition and policy framework) had produced productivity growth during the nine-year expansion of the 1990s better, even, than the much-vaunted US performance. Productivity brought with it the virtuous circle of strong profits and non-inflationary real wage increases: there were none of the factor-share imbalances that hobbled growth in the 1970s. One further point is worth making. The main criticism of the Australian economy during 2000 was that we were an "Old" economy, unfavourably contrasting with the "New" economy populated by companies which worked Click to exclusively in the ethereal world of cyberspace. A view larger procession of foreign business luminaries visited Australia last year (curiously, those who came extolling the virtues of the virtual economy still found old-fashioned enjoyment in watching the Olympics in the flesh) to promote their companies, advising us to ignore our comparative advantage by following their example. We argued that the application of the new technology was where the productivity benefits would lie, and that Australia was on the forefront in exploiting these - and we had the runs on the board to prove it. But this was lost in the paeans of praise and thunderous applause for the stars of the cyberworld. How a year of collapsing NASDAQ can change perceptions! As Warren Buffett has observed: "nothing sedates rationality like large doses of effortless money", but eventually reality returns.The productivity-enhanced Old Economy is looking rather better (would we want to be competing with Korea and Taiwan to produce computer chips, whose price is falling even faster than the NASDAQ?). It was Buffett who reminded us all, several years ago, that being "first mover" in a vast and exciting new industry was not a guarantee of success or profits: history records the low survivorship among the pioneer firms in automobiles and aircraft. This is not to deny the enormous benefits of the new technology - just to observe that in history it has been the users of the technology, rather than the producers, who have benefited most. Just as Buffett's Berkshire Hathaway has returned to favour following several years in the wilderness (having recently bought into such unfashionable industries as boots, brick-making, carpet-manufacture and insulation), so too the tide of opinion may turn on Australia's product mix. Despite the longevity of the expansion, the imbalances which normally characterise the mature phase of the cycle are not present in Australia. I can make this point more vividly by contrasting the Australian position with that of the United States, where there is a renewed interest in the "trade cycle" analysis which, in the immediate post-WWII decades, dominated short-term economic commentary. Its characteristics were: • an inventory cycle, where there was over-production during the upswing to meet growing inventory needs, followed by an exacerbation of the downturn as inventories adjusted in the opposite direction; • an investment boom which uses up all the best investment opportunities and whose euphoria drives investment into marginally profitable projects; • related to this, funding (particularly equity finance) which had been liberally given in the early phase of the cycle dries up as the financial sector comes to recognise the degree of overcommitment and attempts to compensate (or over-compensate) for this; • asset prices, driven up by over-optimism about profit potential, spill over into investment decisions; • households, buoyed by rising asset prices and the general euphoria, run down their savings, leaving them vulnerable to a sudden change in confidence. All this jerky dynamic seems very relevant to America, and inapplicable to Australia. Let's contrast the cyclical position in the two countries. First and foremost is the contrast between the share markets. With no NASDAQ bubble, the Australian equity market has continued to increase steadily throughout the period, and is currently still close to its peak, contrasting to, say, the Wilshire which is nearly 30 per cent below. Australia has no stories of 14-year-old boy-millionaires who ramped their chosen shares via a chat-room canard: nor, more substantively, of entrepreneurs with backwards-facing baseball caps attracting serious funding on the promise of a rapid "cash-burn". So we didn't get the same degree of distorted investment decisions and ephemeral wealth-driven consumption. Business fixed investment expanded rapidly in America during the 1990s, to well above its historical average. Investment in information technology and communications equipment surged, with capacity to produce this equipment expanding by 50 per cent in the past year alone. In contrast, in Australia business investment has trended upwards during much of the 1990s, but in recent years has fallen back a little, to remain around its long-term average. There is in no sense a problem of over-investment. Slow but steady wins the race. Similarly, Australian household saving has not followed the American example into negative territory. The US financial sector is showing all the signs of concern about rising risks and lowering profit expectations in the business sector. Spreads between yields on US Treasury securities and corporate bonds have widened noticeably. The data on IPOs shows that it became increasingly difficult during the year to get these away. Commercial banks became more cautious in their lending, particularly after the large amounts they had directed to Telecom companies. By contrast, in Australia there has been no noticeable widening of risk spreads in the corporate bond market over the past year, and credit has been easily available from intermediaries, with no reports of significant changes in banks' lending attitudes. The financial sector itself is in good shape. One of the more interesting contrasts is with the exchange rate. The normal cyclical response of exchange rates is to strengthen in the face of economic expansion. So it was not surprising to see the strength of the US dollar over recent years - only that it has continued to strengthen in the face of a growing perception of a likely slowing. Given that the evidence of the early 1980s pointed to a twoyear lag between exchange rates and their effect on activity in the United States, an exchange rate well above its average of the past decade would not seem to provide much protection in the face of a slowing. The Australian dollar, in contrast, has been low in real effective terms, providing a useful buffering in the face of a slower world economy, as was demonstrated during the 1998 Asian economic crisis. Looking ahead Just as the events of the second half of last year look clearer in hindsight, we doubtless have more to learn about this period, and may well need to add to our current interpretation. But if this analysis is correct, then the events so far would point to a relatively short-lived slowing. As the temporary once-off effects of GST, construction "pull forward", the Olympics and the threefold price pressures pass through the system, the fundamental health of the economy can reassert itself. This is all the more so because the economy has two significant forces of stimulus working on it - the Budget and a very competitive exchange rate. Let me say more about these two issues. I can recall, some years ago, Larry Summers talking very positively about America having "reloaded the fiscal cannon" - with the clear implication that it was ready, primed and could be used if necessary for fiscal policy to take its role in supporting activity. The same is clearly the case in Australia, where several years of good surpluses have created the opportunity to provide macro stimulus while maintaining the longer-term credentials of fiscal responsibility. The second clear form of macro stimulus comes from the super-competitive exchange rate. Central banks are always uncomfortable with a weakening exchange rate, and there have certainly been moments of great discomfort over the past year. But, as usual in economics, it's an ill wind that blows nobody any good - the supercompetitive exchange rate is a sure form of stimulus for the economy, and while there are (as usual) lags in its operation - particularly on the export side - there is little doubt that it is a powerful effect. This is already showing on imports and exports (where non-rural exports are up 12 per cent in volume terms over 2000), and in a current account deficit which is running at a little over 3 per cent of GDP, and closing rapidly. To make such positive assessments risks being declared to be another Pollyanna. To provide some balance, let me recall a couple of possibilities that might make such a satisfactory outcome harder to achieve. The first caveat that should be registered is the state of the world. The extraordinary period of growth experienced by America has been a powerful force for good in the world at large, and if America slows sharply and stays slow (which the earlier discussion of the imbalances there would suggest has to be more than a mere possibility), then, as one of my colleagues said recently, it would be hard for Australia to remain unaffected by this. What should be said, at the same time, is that the good fundamentals and super-competitive exchange rate give us the best immunisation available: no-one can do more. I spent some time saying why Australia is not subject to the old-fashioned form of cyclical overexpansion, as is characterised by America. But there is one element of the old textbook cycle which is both unpredictable and pervasive in its effects - animal spirits. It is a truism that the path of the economy depends to a large degree on the maintenance of confidence and business optimism. Conclusion It is possible, of course, for an economy to "talk itself" into a period of slow growth, and to some extent we are in danger of doing this. The schadenfreude that comes with being the stoic bearer of gloomy tidings - the delicious adrenalin-pumping frisson that accompanies the breathless reporting of any piece of weak data - is an understandable characteristic of human nature. Bad news is always more interesting than good. Plane crashes are more noteworthy than safe arrivals. But some clear-air turbulence shouldn't be a cause for panic. With the fundamentals of the economy in such good shape, no imbalances, capacity for the expansion to run further and policy settings designed to help growth, the prospects must be for a relatively quick rebound of activity. | reserve bank of australia | 2,001 | 3 |
Speech by Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, to the Economic Society of Australia (Victorian Branch), Melbourne, 10 April 2001 | Ian Macfarlane: The economy and monetary policy Speech by Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, to the Economic Society of Australia (Victorian Branch), Melbourne, 10 April 2001. * * * Introduction It is a pleasure to be here in Melbourne speaking to the Economic Society again at this very interesting time in the evolution of the world economy, the Australian economy and our monetary policy. With so much happening, I trust you will find what I have to say about our current economic circumstances and monetary policy of interest. There has certainly been a remarkable change over the past four or five months in virtually everyone’s view of the economic outlook. I think the biggest change is at the global level, where forecasts for economic growth in major countries have been lowered. The most important economy, and the one that has been leading this reassessment, is the United States. But Japan has relapsed, and the rest of Asia is also feeling some chill trade winds. The process of monetary policy easing that began in the United States in early January has now spread to Canada, the United Kingdom, New Zealand, Switzerland, Japan, many other Asian economies, and, of course, Australia. The Euro area is the exception. In a medium-term sense, we should not be surprised that after such a long global expansion, some aspects of the business cycle are reasserting themselves, or that developments in the US economy are playing such a leading role and attracting so much attention. As always, the evolution of the international business cycle and international financial markets has a major bearing on economic developments in Australia and therefore for Australian monetary policy. But there have been some very unusual developments in Australia which call for explanation, and which also have had implications for our monetary policy. Before returning to the bigger picture, I would like to spend some time on these unusual developments. Output developments in Australia I have frequently said that under the inflation targeting approach to monetary policy, our aim was to maximise the length of the economic expansion and, as a corollary, to delay and minimise the severity of any downturn. Over the past decade, monetary policy, helped by other policies, has been relatively successful in this endeavour in that the current expansion has been longer than its predecessors in the 1970s and the 1980s. And when I last spoke publicly on this subject towards the end of last year, I expected this state of affairs to continue. Like virtually everyone else who follows economic developments in Australia, I was surprised and disappointed to learn what the national accounts had to say about our growth performance in the second half of 2000. The grounds for optimism about our growth prospects, which were shared by most private sector forecasters, have been spelled out on a number of occasions, but let me recap briefly: • the Australian economy had strong momentum — it had been growing at about 4½ per cent for a number of years, yet it had not built up any of the imbalances that are common late in an expansion; • inflation, although rising slightly, was moderate, as was the growth of wages; • asset prices, although on a rising trend, were not obviously overheated and the balance sheets of the corporate and financial sectors were in good shape; • a similar situation applied to physical investment, which meant the risk of excess capacity developing was minimal; • the current account of the balance of payments was being reduced under the influence of rapid export growth; • the fiscal impact of the various tax measures associated with the introduction of the GST was expansionary by all the conventional measures; and • although monetary policy had been tightened, the level of real interest rates was not high by historical standards, credit was easily available, and the exchange rate had fallen to a point where it was very competitive. Of course, there were some worrying signs, but they seemed less significant than the factors listed above. Households in particular had taken on a lot of debt by their past standards, though not by international standards; they were also having to cope with higher oil prices. There were a few rumblings from falls in the US share market which had been going on since March 2000 but, other than that, the mood in the United States was still confident. Business surveys showed substantial falls in confidence in the second half of 2000, just as they had in 1998, and employment fell for a time, but these things were consistent with a slowdown, not a contraction. There was also the inevitable uncertainty surrounding the GST and the Sydney Olympics. What happened and why? So the question is: Why was there such a sudden reversal in the second half of the year, particularly the December quarter? Economies as well balanced as the Australian economy was at mid-2000 do not just run out of steam: there has to be a reason, or perhaps several reasons. I think it is now generally recognised that there was one overwhelming reason for the change in direction. The feature of the national accounts that leaps out is the extraordinary role of house-building in explaining the weakness of GDP. This was surprising in one sense, because house-building only accounts for 5 per cent of the economy. But its decline in the second half of 2000 was so pronounced that it meant that the figure for the total economy showed a decline of 0.4 per cent at an annual rate. If we take out house-building and look at how the other 95 per cent of GDP performed, we see that it rose at an annual rate of over 4 per cent. This is much the same as its rate of growth in the previous year. Now I do not want to suggest that there was no slowing in some other sectors of the economy, but if it was not for the extraordinary behaviour of house-building, the story would be in line with most observers’ previous expectations. Similarly, the behaviour of aggregate employment in the second half of 2000 can largely be explained by the construction sector and those parts of manufacturing supplying it. Table 1: Growth rates Four quarters to June 2000 Two quarters to December 2000 (Annual rate) GDP 4.9 -0.4 GDP excluding housebuilding 3.8 4.3 Why did house-building have this extraordinary pattern? I do not think there is anyone who doubts that it was due to the bringing forward of house-building pre 1 July 2000 to beat the GST, and the subsequent dearth of house-building in following quarters. We all knew this transition effect was occurring, and our forecasts showed substantial falls in house-building in the second half of 2000, but not falls big enough to outweigh everything else that was going on in the economy. The size of these falls was truly outside the range of previous recorded experience, and that is always difficult to forecast. Incidentally, similar large shifts in expenditure on housing did not happen in the other countries we had looked at that introduced GST (see Diagram 1). Diagram 1 Let me make a disclaimer before I go any further, lest anyone think I am trying to blacken the name of the GST and imply it was all a horrible mistake. I have always thought that a GST is a good thing for the economy, principally because it could take some of the weight off the high marginal tax rates on middle incomes in Australia. I still do support it and note that it will still form an important part of the Australian tax system beyond the next election. My only point is that when making a major reform, such as a tax reform, the transition effects associated with implementing such a large change are nearly always unpredictable and cause short-term dislocation. But that is not a reason not to do them, otherwise we would never get any reform. Monetary policy I will now turn to monetary policy. Since early February, the Reserve Bank has reduced the overnight cash rate by 125 basis points to 5 per cent. A number of people have pointed out that this is an uncharacteristically large reduction over such a relatively short period of time. Why have we seen the need for such a change? My response revolves around two points. First, even though the outlook for the economy remains positive, the risks on the downside have increased this year. Second, the continuing good inflation performance of the economy provides scope for the Bank to be pro-active in trying to minimise these risks. Let me begin with the risks. The principal circumstance that has changed in recent months has been international, not domestic. All countries, at about the turn of the year, started to revise down their expectations relatively quickly for the year ahead. The reductions in forecasts for growth were not drastic, but they applied to most countries, and hence to the world economy in aggregate. The reassessment was centred on the United States, with Japan and other parts of Asia prominent. It cannot be denied that the fall in share prices in the United States, which was largely matched by falls in European and Asian exchanges, played a significant role in this reassessment, just as their earlier buoyancy had held up economic activity. As a result of the reassessment, the year 2001 so far has been one of monetary policy easings around the world, just as its predecessor had been one of monetary policy tightenings. The reduction in forecasts for world growth is not alarming — for example, the IMF is forecasting growth of 3.4 per cent in 2001, compared with growth of 4.8 per cent in 2000. But forecasts are still probably being revised down and the balance of risks has definitely shifted to worries about a larger downturn. This is seen most clearly in the capital markets, where investors are moving out of equities into bonds, and some banks are becoming more cautious in their lending behaviour. On the other hand, labour markets around the world have so far shown very little deterioration. The second risk relates to the domestic situation. I have already explained that the major change to our circumstances was that we now needed to factor in the 2.2 percentage point subtraction from GDP that was caused by the fall in housing in the second half of last year. Why should this be important if it has already happened? Indeed, you could make a case to say that if the world economy had continued to grow at the same pace that it did in 2000, the housing effect would have been purely transitory, even if it was much bigger than we or anyone else expected. But the world economy has slowed, which makes this reasoning somewhat academic. It is unlikely that such a large contraction in housing, and attendant falls in demand for those industries supplying the housing sector, could occur without some wider ramifications. I pointed out in my testimony to Parliament in December last year that I thought the contraction in housing (even though I did not know how big it was at the time) was the major reason for the fall in business confidence. We saw a similar setback to expectations recently when consumer confidence, which had held at above average levels until March, fell sharply in the latest survey, which unfortunately was taken a few days after the release of the December accounts and was heavily influenced by the publicity surrounding it. The other domestic change that influenced our thinking on monetary policy was the lower outlook for inflation. The December quarter CPI followed the pattern set in the September quarter in showing a level of inflation well below our expectation, and implied that our forecasts for inflation would need to be revised downwards. As I have noted earlier, this gave scope for monetary policy to be eased more quickly than would have been possible on earlier occasions. Over most of the past 30 years, the classic dilemma for monetary policy was that, even when there was a need to ease on domestic activity grounds, there were often still strong inflationary pressures which cautioned against doing so. One of the many benefits of a low inflation environment is that it restores to monetary policy a degree of freedom that is denied in a high inflation environment. With inflation not imposing a constraint, it has been possible for the Bank to respond quickly to the need for a significantly lower level of interest rates. That is, we needed a level of real interest rates that was unambiguously expansionary, just as it had been in the period from mid 1997 to end 1999. The actual mechanics of getting from one level to another is a secondary issue. Whether to move by 25 points or 50 points, whether to move between meetings or not, or whether to have a pause or not, are essentially tactical issues related to market perception, rather than fundamental economic ones. It is the medium-term effect of the level of real interest rates, not the number or size of individual changes, that matters for the development of the economy. So once we realised that a significantly lower level was required, our aim was to move there as quickly as was practicable, without unduly unsettling markets. Where does this leave us? We have traversed a very difficult period. We knew well before we entered it that the second half of 2000, which included the introduction of the GST and the Olympics, was going to be difficult to forecast. We also knew that, even while we were living through it, it was difficult to assess developments, especially as we had the added complications of rising oil prices and a falling exchange rate. A great range of surprises was possible, but now that the period has passed, we know what the surprise was, and it is now part of history. We also know with reasonable confidence that housing should pick up strongly through the remainder of the year. Looking at the broader picture, the major influence on our outlook is the world economy and, inevitably, the biggest influence on this will be the US economy. Obviously, there is nothing we can do to influence world economic developments, but what we need to try to do is to foster as much resilience in the Australian economy vis-à-vis the world economy as we can. For a start, we can move to a stance more supportive of growth, and we have done so over recent months with monetary policy, using the scope to do so provided by good inflation performance. More fundamentally, we should have some resilience given that, in several respects, we have a better starting point than the United States. We did not have the extent of share price appreciation over the past couple of years that the United States had, and therefore we have not seen the unwinding of this that they have recently experienced. The United States has had an investment boom which has created some excess capacity in some sectors, whereas in Australia there is no such problem. In Australia the current account deficit has been falling, and is back at the low points seen over the past 20 years, whereas in the United States it is at a 20-year high. The Australian dollar is low, and hence supporting economic activity, whereas the US dollar is high, and hence dampening US growth prospects. This inevitably brings me to the exchange rate. The behaviour of the Australian dollar over the past 15 months has been difficult to explain, and those attempting to do so have moved from explanation to explanation as developments have changed. There has been no doubt, however, that over the past month much of the fall has been due to the general gloom that accompanied the release of the December quarter accounts, and this should fade as they are put into perspective. Of course, the other explanation has been the strength of the US dollar, which is in itself a bigger puzzle than the Australian dollar. We were told last year that the US dollar strength was due to the strength of the US economy, the high returns from investing in US equities, and the rising interest rates. In 2001, all three of these factors have gone into reverse, yet the US dollar is over 5 per cent higher than at the end of last year. There is not much doubt that a lower US dollar would be better for the United States and the world economy in general. The fall in the Australian dollar has been, in my view, an overshoot. It is not something I look upon with any comfort. But it is also something which we could not hope to prevent in the short term, short of drastic measures which in our judgement were not in the best interests of the economy, especially given the risks to growth from abroad. At its present level, or even one appreciably higher, the Australian dollar confers a major competitive advantage to Australian producers and has contributed to an exceptional performance by the traded sector. Although exports may not be able to keep up this growth rate over the next 12 months, they should still help to underpin the economy. Conclusion To conclude, developments in the world economy obviously pose a risk to economic performance in the near term. Since there is little we can do to change that, we must focus on managing our own affairs in Australia in the best possible fashion. Monetary policy has been eased, in recognition of the changing circumstances, and should prove to have some expansionary influence over the period ahead. Domestically, the major risk we face is that public confidence over-reacts to the fact that we are not going to be doing as well as we did a year ago, or, somewhat perversely, to the lower exchange rate itself. But, in order to put these things into perspective, we should remember that the large list of positive factors I gave above still applies — we still have strong export growth, sound balance sheets in the corporate and financial sectors, asset markets which are not overheated, no over-capacity in physical investment, low inflation and macro-economic policies that are exerting an expansionary influence on the economy. | reserve bank of australia | 2,001 | 4 |
Opening statement by Mr IJ Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, 11 May 2001 | Ian Macfarlane: Statement to House of Representatives Standing Committee on Economics, Finance and Public Administration Opening statement by Mr IJ Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, 11 May 2001. * * * Mr Chairman, a lot has happened in the economy since we last met in Wagga Wagga at the beginning of December. This has resulted in a significant shift in the stance of monetary policy. I think I owe it to the Committee to give a full account of these developments and the thinking behind our reactions. There were two major changes to the economic landscape that occurred shortly after we met in December. The first was that the outlook for the world economy changed rather sharply in a downward direction at the turn of the year. This was mainly a result of developments in the United States, but it was widespread enough to cause significant downward revisions to world growth prospects. The second major change was that it became apparent that the Australian economy had been a lot weaker in the second half of 2000 than we had formerly thought. Although this was information about a period that had by then passed, and was mainly due to a transitory factor, it had significant implications for the development of the economy in the period ahead. I would now like to explain these two developments more fully, then move on to our monetary policy reaction, before concluding with some comments on the current outlook. The slowdown in the US economy is something that had been widely expected for a few years, but the economy kept surprising everyone by powering ahead. Almost six months ago, it became apparent that the slowdown was in process, and had the potential to be very pronounced. The United States had several economic imbalances that, fortunately, we do not have. Their share prices were (and still are) very high by historical standards, there had been an investment boom in plant and equipment (particularly IT and telecommunications) which was probably unsustainable, and the US dollar was high and rising. The US Fed moved very quickly to lower interest rates. Such action could not be expected to prevent a slowing in the economy, but it would reduce the chances of something more serious, such as a recession occurring. The first Fed easing on 3 January was a clear recognition that the world business cycle had entered a new phase, and this had implications for all countries. We soon saw easings of monetary policy in Canada, the United Kingdom, New Zealand, Switzerland, Sweden and most Asian countries — and, of course, Australia — the Euro area was the exception. The slowing US economy, and particularly the cutbacks in investment in computing and electronics, also has had an impact on exports from Asia, with the result that aggregate east Asian GDP growth in the final quarter of 2000 seems to have been about zero (leaving aside the special case of China). The Euro area has been less affected, but there is evidence from the manufacturing sector and from business surveys that growth is edging down nevertheless. I turn now to the second factor, namely the weakness in the Australian economy in the second half of 2000, and its flow-on effects to the first part of this year. As I have conceded before, we did not foresee the extent of this weakness, and I am not aware of anyone who did, although some probably got closer than us. If you had told me before the event that the fall in house-building, a sector which only accounts for 5 per cent of the economy, would be large enough to outweigh reasonable growth in the other 95 per cent of the economy, I would not have believed you. Our analysis of other countries’ GST experience had suggested a much smaller fall than actually occurred. I am not saying that the housing contraction was the only thing that happened to the economy; other things have also clearly slowed. But it was the thing that turned a relatively unexceptional slowdown into a small contraction. Of course, what we were witnessing was not the normal cyclical development of an economy, but the transitional effects of a once-in-a-generation structural change to the tax system. The fact that it led to a negative number for the change in GDP had a big effect on people’s confidence. We saw this most clearly in the reaction to the release of the December quarter national accounts in early March. The Australian dollar lost 3 US cents over the next ten days to fall below 50 US cents for the first time. At about the same time, consumer confidence, which had until then held above its long-term average, fell sharply to well below that average. The reaction was so large that a number of commentators raised the possibility that the country could "talk itself into a recession". I am pleased to say that the mood has improved somewhat since that time. There were some other signs of weakness during the second half of last year, such as the fall in business confidence. This was something we spoke about at the December hearing, when I suggested it could be largely due to the fall in house-building and resulting reductions in sales by those parts of the manufacturing sector which service the housing sector. It was difficult for a while to discern the trend in consumption behaviour because of shifts in spending patterns caused by the introduction of the GST and the Olympic Games. But now that the dust has settled, it is clear that consumption, while doing quite well over recent months, is no longer growing at the heady rates it was a year or 18 months ago. Employment also fell for a few months in the second half of 2000, and there is no doubt that the labour market has softened following the strong growth recorded in the middle two quarters of 2000. Again, however, the construction sector is the main explanation for the weakness in the second half of last year. Over the period from August last year to February this year, construction employment fell by 48,000, while employment other than in construction rose by 41,000. At the same time as we were receiving this information on business confidence, spending and employment, we were also receiving news on inflation. Here the most important data were the CPIs for the September and December quarters, both of which were below our expectation. They suggested that inflation was well under control — in fact, we lowered our estimate of underlying inflation after receipt of the December quarter figure in late January — and they also pointed to the possibility that business profit margins were being squeezed. They thus reinforced the impression that was building of an economy that was slowing more than expected, in a world that was slowing more than expected, and where current inflation and future inflation were within the target zone we aim for under our inflation-targeting regime for monetary policy. The decision to ease monetary policy at our first meeting this year was a relatively easy one, and as you know, we eased again at the following two meetings so that the cash rate fell by 125 basis points in a little over two months. Collectively, this represented an uncharacteristically large move and deserves some explanation. Basically, we realised that a significantly lower level of real interest rates was required so that the stance of monetary policy would be clearly expansionary in that it would be supportive of economic activity. We felt we should, and could, get to such a position relatively quickly for two main reasons: (i) We had undergone a relatively abrupt change in our view of the world. As I said before, it became clear that the world was entering a new phase of its business cycle – a fact that was recognised in most countries. The fall in house-building, because it brought forward our own slowdown, reinforced the message from the world. (ii) Because inflation was not threatening to rise above our target, we had no conflict of objectives, and so could act quickly. In view of the foregoing, you will not be surprised to hear that the forecast of GDP growth that I put before the Committee six months ago has been well and truly overtaken by events. I said that I would not quibble with Treasury’s figure of 4 per cent for year-on-year growth in the 2000/01 financial year. It now looks like being about half of that figure, but we would expect considerably stronger growth in the following year, probably somewhere between 3 and 3½ per cent. Incidentally, this is only the second time out of the eight occasions that I have been putting these reviews of forecasts before you that we have over-estimated the outlook for growth; all the others have been small under-estimates. On inflation, I said last time that it could be approaching 3 per cent by the second half of 2001, that is after the impact of the GST has dropped out of the four-quarter-ended growth rate. Our current guess, now that we have two quarters more of CPI data, is about 2½ per cent for the same period. So far, I have spent most of my time covering events leading up to our decision to ease monetary policy, so it is time I moved on to more recent events. As I said before, March was a bad month for the economy, mainly because people received the news that there had been a decline in GDP in the December quarter. This was a great disappointment to most people, and they could not easily understand how such an outcome could have happened so soon after the buoyant conditions of midyear. Inevitably, it affected people’s confidence, and their views of the future. The area where this lack of confidence showed up most visibly was in the exchange rate. On 6 March, the day before the release of the national accounts data, the Australian dollar was worth 52.2 cents and was 49.1 in trade-weighted terms. By 3 April, it had fallen to an intra-day low of 47.75 US cents and 46.6 in trade-weighted terms — a fall of 9 per cent against the US dollar and 5 per cent against the TWI. In the process, the Australian dollar set new low points on both these measures, although against the TWI it was only by a tiny margin. I mention these details because I want to make two points. The first is that at a very detached and macro-economic level, we all know that a low, and hence competitive, real exchange rate helps a country cope more easily with external adversity. Indeed, a floating exchange rate has as one of its virtues its capacity to automatically bring this about. This is one reason why our exports have been so strong, and why there is a widespread opinion that the exchange rate is a factor supporting future growth in the Australian economy. The second point is that when you already have a low exchange rate, further falls can be very unsettling, especially if they are accompanied by headlines about new lows being reached and new barriers being breached. People inevitably see this as a loss of international confidence in their country, and they in turn lose confidence. The falling Australian dollar was a widely cited reason by respondents to the consumer sentiment survey for why their confidence had fallen. The fall in the Australian dollar in March did not do the country any good, and it is pleasing to see that it has been reversed. April was a much better month than March, and it is possible to discern some signs that confidence is returning. Internationally, all eyes are still on the United States, where financial markets have gained confidence over the past month. All US share indices have risen appreciably, as have bond yields, consumers have continued to spend, and the first quarter GDP figure was better than expected. These developments are good news for Australia, at least in the short term. On the other hand, US employment has fallen over the past two months and businesses do not seem to be as cheerful as financial markets. There is still a lot of uncertainty overhanging the outlook for the US economy. Domestically, we have also had some developments indicating greater confidence in the outlook. The stock market has risen by 7 per cent since late March and is again close to record levels, bond yields have risen, and we have also had the recovery in the exchange rate I referred to earlier. Here, as in the United States, greater confidence returned to financial markets, even if wider measures of business confidence have not shown it. There are also some indications from banks and the Housing Industry Association that house-building — which had been the chief contractionary force – is in the process of turning around, and that its upswing could be very pronounced. Under these circumstances, it was perhaps not altogether surprising that financial markets’ expectations about monetary policy began to change. They became less sure that we would ease again in May and, in fact, by the time of the meeting the majority of economists surveyed expected no change in interest rates. In our own thinking, we asked the question "what behaviour of ours can most contribute to building confidence?" At the April meeting, knowing that we still had some more work to do to get interest rates down to levels that were clearly expansionary, we had decided that a move larger than some people expected would probably be preferred to a more cautious approach, and might foster confidence. By May, we had three moves in quick time under our belt. We knew that interest rates were not acting as a constraint on the economy, but rather were at levels likely to assist growth. With financial markets slightly more upbeat about the outlook, we felt that a steady setting of monetary policy would help confidence. We were also sensitive to the possibility that, on this occasion, a surprise fall in interest rates could easily cause people to think that "things must be worse than we thought" and prompt the question "what does the Reserve Bank know that we don’t?" Such a reaction, had it occurred, would have been counter-productive. What can we say about the future? Inevitably, we can say less, I suspect, than you would like! Policy has been returned to an expansionary setting, with the easing "front-loaded". Interest rates are close to the low points reached in the two most recent episodes of monetary policy easing. Given that fact, and given that we see some promising signs in the economy and financial markets, there is a reasonable chance that the current stance of policy will turn out to be easy enough to achieve the desired results. But equally, while it is reasonable to expect that the promising trends of late will develop into stronger momentum for growth, we cannot as yet be confident. This, in turn, means that we cannot be sure that further monetary policy easing will not be required. The growth outlook rests on various assumptions, not least that international conditions stabilise before too long, and improve somewhat during 2002. That is a reasonable assumption on which to make a central forecast, but we need to be, and are, alert to the possibility of a weaker outcome, which would have implications for the Australian economy. We will continue to evaluate new information as it arrives, particularly as it bears on the outlook for growth and, of course, inflation as compared with our target. We remain prepared to adjust monetary policy in response to changes in the balance of risks. | reserve bank of australia | 2,001 | 5 |
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Joint Australian Business Economists and Economic Society (New South Wales Branch), Sydney, 10 July 2001. | Ian Macfarlane: Economic developments at home and abroad Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Joint Australian Business Economists and Economic Society (New South Wales Branch), Sydney, 10 July 2001. * * * It is a pleasure to be here again talking to the Australian Business Economists and the Economic Society. On occasions like this, I often feel it would be nice to be able to speak in a detached way on some interesting public policy or historical topic. But in periods where the domestic and world economies are evolving quite quickly, current economic developments keep pushing their way to the front. So I will have to save my more scholarly piece for another day, and confine my remarks tonight to some observations on recent economic events here and abroad. I would like to take as my starting point the way we viewed the economic outlook for Australia about a year ago, that is, as we were entering the 2000/01 financial year. At that time, there were two main components to our view of the economic outlook. The first was a view on the medium-term cyclical development of the economy, which was predominantly optimistic. The second was a view about the effect of "once-off" events such as the introduction of the GST and the Sydney Olympics on the financial year 2000/01; here, the tone was one of uncertainty. I would now like to spell out how these two overlapping views have fared in the light of unfolding developments. 1. The medium-term cyclical outlook For some years now, we have pointed to the prospect of achieving a longer economic expansion if the economy can be managed in a way which avoids the type of imbalances that have brought about our downfall in the past. By the middle of last year, we were able to point out that it had already happened, in that the present expansion was already longer than its predecessors. But we were saying more than this – we were saying that, even though it was longer, it still had not shown any of the imbalances that characterised the latter stages of earlier expansions: · although inflation of goods and services prices had risen, it was not by enough to threaten our medium-term objective; · asset price inflation of either shares or property had not become a problem; · wages growth remained moderate; · there had not been excessive physical investment with its attendant risk of over-capacity; and · the current account deficit was not high by the standards of the past 20 years, and falling quickly. For these reasons (and for others that I will come to later), we always felt optimistic about our medium-term economic prospects. This does not mean that we felt that the strong expansion of the 1990s could continue indefinitely at the average growth rate we were then recording. We were conscious that the business cycle, whether domestic or international, has not been eliminated, even though it may have been ameliorated. This meant that slower growth was to be expected as the cycle unfolded. But we did feel that there was no domestic reason why the economy should undergo anything more serious than a moderate slowing phase within the general context of continued expansion. Of course, we recognised that we were not immune to developments in the rest of the world. To the extent that there was a risk of something more serious than a moderate slowing of the Australian economy, we identified that risk as coming from overseas. But even here there was an element of optimism in that we felt that in the event of a world downturn, we would be affected less and later than most other countries because of the resilience of our economy I have just outlined. I now turn to the second component of our view referred to earlier. 2. "Once-off" developments in 2000/01 Everyone knew that developments in 2000/01, particularly the first half, were going to be difficult to forecast and interpret. This was because economic statistics would be very "lumpy" as they reflected the introduction of the GST on 1 July, and the holding of the Olympic Games at the end of the September quarter. The introduction of the GST, and associated changes to other taxes, was a major event – structural changes of this type are likely to occur only once in a decade, or even once in a generation, and so are always difficult to forecast. Economists had very little to go on in assessing the likely effects, but we all tried to do so by looking at the experience of other countries that had made a similar change. This was not a lot of help, and no-one could be confident what the main effect would be. Judging from the questioning I received during this period, the most likely effect was thought to be on inflation, with shifts in consumption being the other factor most often mentioned. I am not aware of anyone who thought that house-building would be the main area affected, although everyone expected a decline. 3. What happened? In the event, the major transition effect of the GST was to bring about a fall in house-building in the second half of 2000 that was much bigger than anyone had forecast or we had ever previously experienced (Graph 1). While house-building only comprises 5 per cent of GDP, its fall of 37 per cent in two quarters was enough to outweigh reasonably healthy growth in the other 95 per cent of the economy, and so produce a contraction in GDP for the half-year. There were other factors at work as well, for example, the rising oil price, and there were other parts of the economy that were affected, for example, the labour market. But the figures clearly show that the fall in house-building subtracted 2.2 percentage points from the half-year’s GDP growth, and hence accounted for the overall contraction in economic activity (Graph 2). This was a transition effect of the GST, which would soon reverse, and therefore should, in principle, have no effect on our average prospects over the medium term. The problem with transition effects, however, is that they can affect people’s confidence and their expectations because at the time no-one can be sure they are transitory. This happened on this occasion as business confidence fell, although not precipitously, over the second half of 2000. When the decline in GDP was revealed in early March, confidence took a sharper turn for the worse. Not only did business confidence fall further, but consumer confidence and the exchange rate joined in, and the share market did not escape without damage. This was a period of considerable gloom, when some observers went so far as to suggest that Australia might talk itself into recession. In terms of the two components of our view, the second seemed to have completely eclipsed the first, and you could be forgiven for believing that there was no longer any substance to the first view. What we now know is that at precisely the time that confidence was reaching its low point – the March quarter of 2001 – the transitional effects were dropping out of the calculations and the economy was returning to reasonable growth. The March quarter national accounts show this clearly, and a range of other indicators show a distinct improvement from their March low point (Graph 3). · Consumer sentiment, although declining in the second half of 2000, had remained above its long-term average until it fell sharply in March. It has now regained a level above its long-term average. · The share market has been generally very buoyant by world standards, but fell by 6 per cent in March before recovering in April and May. · The exchange rate reacted to the weak economic activity news and reached a low point in early April. It subsequently rose by 7 per cent against the US dollar and in trade-weighted terms. · There is evidence from a number of business survey responses to questions about the economic outlook that confidence has improved. 4. Where does that leave us? My assessment is that we are now back in a position where the first view represents a good summary of our position. The major threat to our future growth prospects now comes from the international economy, not from domestic factors. The list of domestic factors which provided underlying resilience a year ago still applies. And we could add to that list the fact that monetary policy and fiscal policy have both moved in an expansionary direction since then, and that the exchange rate continues to provide stimulus to the internationally traded sector. Before moving on to discuss the world economy, I would like to touch on one further question pertaining to the domestic economy. The question is the following: Does the fact that we had such a poor second half of 2000 put us in a worse or a better position to handle any future weakness in the world economy? On the surface of it, you might be inclined to say that it has made things more difficult for us because it has given us a weaker starting point. On the other hand, you could mount a defensible case that it may help us in the medium term. First, we have now got some of the usual cyclical contractionary forces behind us, which in a more normal business cycle we might still be facing. The housing contraction is the most obvious of these, but the inventory cycle has also been probably brought forward and therefore may be already half completed. Second, the greater and earlier-than-expected weakening of the domestic economy focussed the attention of policy makers on the need for easing somewhat earlier in the process than if the cycle had had a more normal shape. On monetary policy it is hard to be definite on this point, because other important factors were also at work – for example, the recognition that the international cycle was turning and that inflation remained low – but, at the margin, the weakness in the second half of 2000 contributed to an earlier easing. On fiscal policy, the increase in the first home buyers’ grant is an example. Finally, the perception of weakness in the Australian economy probably contributed to holding down the value of the Australian dollar. I do not want to make too much out of these arguments, other than to point out that some clouds do have silver linings. 5. The international economy When we think of the international economy, or its leading member – the US economy – we tend to remember that there has been a reasonably pronounced business cycle over recent decades. Recessions occurred in the mid seventies, the early eighties and the early nineties. A lot of people think in terms of a relatively regular cycle, and hence think we are due for another US and world recession now. We cannot summarily dismiss this simple approach, and I find it hard to argue against the view that economies contain some unavoidable element of cyclicality in their path of development. The issues are: Does a cycle necessarily involve a recession, and are there characteristics of the current cycle that make it different to its predecessors? I think these can be answered together. The current international cycle is different to its predecessors in one extremely important respect – the expansion phase did not culminate in an excessive rise in inflation. In fact, the rise in inflation was quite modest. This had two important consequences. First, because the rise in inflation was small, interest rates did not need to rise by very much during the relatively short period that they had to perform their anti-inflationary task. (Table 1 looks at the peak in inflation and interest rates at the end of various expansions.) Second, monetary policy could be eased much earlier in the slowing phase of the cycle than in the past. Thus, to the extent that the cycle is the result of changes in monetary conditions and monetary policy, it should unambiguously be more muted on this occasion. Similarly, to the extent that major downturns are the result of financial fragility, the situation should be better on this occasion as financial intermediaries in virtually all western countries are in much sounder shape than a decade ago. Thus, in the areas dear to a central banker’s heart – monetary and financial stability – the situation is appreciably better on this occasion than earlier ones. Table 1: Inflation and interest rates OECD inflation (year-ended) G3 nominal policy interest rate 1970s peak 14.8 10.6 1980s peak 13.1 14.1 early 1990s peak 5.7 8.4 3.2 5.8 2000 peak (a) (a) Excluding Japan It would be very reassuring if this were the end of the story for the world economy, but it would be too simple. There clearly are some important imbalances we still have to contend with, particularly in the United States. The most often mentioned of these are high share prices, the high US dollar and an overhang of capital expenditure, particularly in technology. It is worth looking a little more closely at them. When share prices were on the way up, and setting new highs for the price-earning-ratio, many people were expecting that this would eventually be followed by a crash like 1987, if not one of 1929 proportions. That scenario seems less likely now that we have about 15 months of correction behind us. While the fall in the NASDAQ was large enough (70 per cent) to warrant the term "crash", and its preceding rise the term "bubble", the share market as a whole has retreated in a more orderly fashion. The fall in the broad indices such as the S&P 500 or the Wilshire has been about 20 per cent over the past 15 months, and the price-earning-ratio has come down from a peak of 36 to 26. Now, I do not want to get into the business of forecasting future share prices – the only point I wish to make is that the risk of a fall severe enough to frighten people into stopping spending must be smaller now that we have some of the correction behind us, than when we had none. The high level of the US dollar, and the fact that it is still tending to rise, cannot be helpful to the US economy. It must be harming US exporters and those who compete with imports, and no doubt is one of the reasons why US manufacturing output has fallen for each of the past eight months. But these effects on trade flows, while unhelpful to the United States, must be helpful to its trading partners including ourselves. So it is hard to see the trade effects of the strong US dollar being harmful to the world economy as a whole. Where the rising dollar is harmful is in reinforcing the widely held view that you cannot go wrong in buying US assets – if their value goes down, at least you will gain on the exchange rate. This sort of thinking does distort capital flows and can lead to misalignments in asset markets. The area where I think a US imbalance is having unfortunate consequences both inside and outside the United States is in physical investment. In the year to June 1999, equipment investment grew by 13 per cent, and by 16 per cent in the year to June 2000. In the same two years, investment in high technology products grew by over 23 per cent and 27 per cent. Whenever there is an extremely fast growth of investment, there is always the danger that excess capacity has been put in place and that the necessary correction will involve a period of sharply declining investment. That is happening now with US equipment investment declining by 2.3 per cent in the most recent quarter, and investment in technology by 10 per cent. These cutbacks have had a big effect on Asia where exports of electronic equipment have fallen by 25 per cent, which helps explain why Asian GDP growth has flattened out over recent quarters. Of course, this is a purely cyclical event, and will reverse in time, but it is an important channel whereby a US imbalance transmits itself to the world economy. While there are obvious imbalances in the US economy as outlined above, I would judge them to be smaller in aggregate than at a similar stage of earlier cycles, particularly if we give a lot of weight to inflation and financial stability. Japan is in a weak state as it has been on several occasions over the past decade and its outlook is not improving. Europe has also slowed, but no obvious imbalances of the US type have emerged. We are presently in a period of sub-par growth for all three areas, and this is inevitably a time of great uncertainty. Even though I expect the world economy to do better than it did a decade ago, we can probably expect to hear some more bad news before the better news arrives. 6. Conclusion I hope what I have said tonight has been reasonably even-handed. While I note that money markets have recently become more optimistic about our outlook, I think for most people the main unanswered question is still whether the world economy is going to face something materially worse than a period of slow growth over the coming year. The substance of what I have said tonight is that, while such an outcome cannot be ruled out, its likelihood is lower than it appeared at the turn of the year, or as recently as March this year. When these downside risks were mounting earlier in the year, we were prepared to ease monetary policy reasonably quickly and by a significant amount. If the outlook I have sketched comes to pass, further such decisive action may not be necessary. If the alternative occurs and significant downside risks re-emerge, we will not hold back from further action. | reserve bank of australia | 2,001 | 7 |
Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, at the Monetary Authority of Singapore's 30th Anniversary Conference on Central Banking in the New Economic and Financial Landscape, Singapore, 20 July 2001. | Stephen Grenville: Monetary policy: the end of history? Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, at the Monetary Authority of Singapore’s 30th Anniversary Conference on Central Banking in the New Economic and Financial Landscape, Singapore, 20 July 2001. * * * This session has a more philosophical theme, about the broad sweep of monetary policy. So I would like to use the opportunity to look at some history – where we have come from; where we are; and where we might possibly be going. It would be hard to exaggerate the changes of monetary policy in the past thirty years or so. The question I want to ask, given these extraordinary historical changes, is whether we have now reached the ”end of history” in the sense that Francis Fukijama had in mind when he talked about political systems, which had evolved so that one successful system dominates and displaces others. Has this happened with monetary policy? Before I get into any detail here I want to record a summary answer – that monetary policy has reached a satisfactory state where it has a clearly defined ”bestpractice” framework which is performing well; but that it would be wrong to think we have reached some nirvana, from which no further perfecting is possible. So the short answer is ”no” – there is more history to come. Where we have come from When I first studied economics, going back more than thirty years, my recollection is that we thought about monetary policy in the following terms: · monetary and fiscal policy were near-perfect substitutes, used in tandem to achieve the same short-term goal – the smoothing of the business cycle. If the cycle could be smoothed, all would be well in the best of worlds, with inflation under control and growth as good as it could be; · the analytical framework behind this was a non-vertical Phillips curve – i.e. there was some trade-off between real output and inflation, although we did not think much about whether this trade-off would remain in the longer term; · monetary policy worked through regulation and quantitative controls (which were, it should be said, quite effective in this simple world); · low interest rates were widely regarded as a ”good thing”, perhaps because the number of borrowers was greater than the number of rentiers, but more probably because we thought that growth and investment were in themselves good things, and that these would be encouraged by low, stable interest rates. It may also be relevant that governments were reluctant to inflict losses on bond-holders, and wanted to borrow more, cheaply; · there was not too much concern about international integration, particularly in the capital market. To the extent that we worried about the external sector, it was always in terms of the current account and the pressure that might come on the (fixed) exchange rate; · there were, of course, financial crises in those days, but they seemed to have a different nature. I was reminded of this when I read the recent quote of one banker who, when asked why his bank had come through the U.K. 1973 secondary banking crisis so well, replied that ”it was simple: we only lent to people who had been to Eton”. Things happened differently in that gentlemanly and old-fashioned world; · the close working relationship between the central bank and the government might be illustrated by quoting H C Coombs’ endorsement of the Montagu Norman view ”that a central bank should be like a good wife. It should manage its household competently and quietly; it should stand ready to assist and advise; it can properly persuade and cajole and Coombs, H C (1971), Other People's Money, Australian National University Press, Canberra. on occasions even nag; but in the end it should recognise that the government is the boss.” (p. 63) . The transition All this came to an end in the 1970s, with stagflation, the disappearance of the Phillips curve trade-off, exchange rate collapses and subsequent floats, and large and disruptive foreign capital flows around the world. There was a relatively brief flirtation with monetarism (to a large extent a direct response to the high inflation of the 1970s). Its basic tenet – a stable money demand function and control over money supply – could not be maintained in practice. Monetarism may well have provided some kind of ”heat-shield” which, for example, helped the Americans get inflation down in the Volcker deflation period of 1979-1983. Its empirical foundations, however, were not stable enough to allow it to be the continuing basis of policy. But there were three lasting legacies of this period: · monetary policy was seen as a separate, specialised function, with a comparative advantage clearly distinguishable from fiscal policy; · it required a nominal anchor; · the framework should constrain the decision-making process (i.e. it was not just a technical or analytical construct). Without this, the authorities might be led astray by siren voices. This was formalised in the idea of ”time inconsistency”, although much of the discussion in this literature provided a woefully inadequate representation of the motivation of central banks. Meanwhile, the twin snowballs of financial deregulation and globalisation were rolling forward, gathering weight and altering the landscape as they went. The current system We took aboard the three legacies, while abandoning money targeting. For many of us, the alternative was to aim directly for the target of price stability. In the formalised version of this – inflation targeting – there are a variety of attractive characteristics: · a properly specified inflation target is achievable (i.e. under the control of the authorities), unlike a money target; · it addresses the issue of the political decision-making process, and its proclivity to be diverted by biases which will be inflationary in the long run. The central bank needs protection from these forces, in the form of independence; · at the same time, it would be unreasonable to expect the democratic process to provide unelected officials with decision-making capacity of this nature without any guiding or limiting rules. Central to this paradigm (although by no means uniquely associated with inflation targeting) is a high degree of accountability and transparency on the part of the monetary authorities. They have to explain themselves not only to the Parliament (as the source of their ultimate authority), but also to the public at large and to financial markets in particular. Markets have become not only the transmission path of monetary policy, but are also the guardians and watch-dogs on monetary policy, ready to sound the alarm should the authorities stray from the straight and narrow; · these inflation targets also provide an anchor for price expectations (thus addressing the problem of the shifting short-term Phillips curve). This model was pioneered by New Zealand (who introduced it, not as a specific model tailored to the unique needs of monetary policy, but rather as part of a process of reforming governance and accountability, where the various arms of policy would be given clear goals and expected to achieve them). Many of us (in due course, the New Zealanders included) found that this narrow version of inflation targeting was unsuitable for one reason or another and we have adopted more sophisticated, less rigid or narrow versions, principally addressing the issue of how much variance in inflation is tolerated. While there may not be a long-term trade-off between inflation and output, there is a trade2 Views about the appropriate relationship between governments and central banks have changed almost as much as those about men and women! off between inflation variability and output variability – to try to adhere too closely and too constantly to a narrow inflation target is likely to be unnecessarily disruptive of output. Various inflation targeters have addressed this problem with different specifications of the target, but it is notable just how similar most of us have become. In addition to the dozen or so countries which are card-carrying inflation targeters, there are a number of others which have systems generically quite similar, if less formalised (as is the case in the United States – see the recent speech by Larry Meyer ). And, of course, there are others who have chosen a different nominal anchor – Singapore, where the exchange rate provides the equivalent and analogous anchor, with the same ultimate objective. Where are we going? With so many countries having evolved to quite similar systems, have we reached the ”end of history”? I think, for the moment, we have reached some kind of stable resting point: certainly in Australia we are very satisfied with the performance of this framework. We regard this system as having reached an advanced stage of evolution, with the formal exchange of letters between the Treasurer and the Governor in 1996, endorsing the framework which had then been in existence for some years. It can no doubt be tweaked in various operational ways, but we would regard these as minor modifications, rather than full upgrades. So there is no obvious or compelling logic which would move us to a subsequent stage of history. Of course, ”things” happen, and they may happen so as to invalidate the inflation targeting framework. One way we might be knocked off this framework is if the problematic task of forecasting inflation proves too difficult – in effect, if the lags in monetary policy are longer than our ability to forecast inflation. Similarly (observing Japan at present) it is possible that an economy could find itself in a period of prolonged deflation, with monetary policy apparently not able to counter these forces. However, I cannot help thinking that the real issue lies elsewhere. With continuing success, the feeling will arise that it is all a bit too easy: that the old inflation monster, now tamed, seems a bit of a pussy-cat and not, by itself, of such enormous importance to justify devoting monetary policy solely to its control. Just about the whole of the world (whether inflation targeters or not) has reduced inflation to manageable levels. It seems at least possible that people will begin to regard this task as so easy, and so assured of success, that monetary policy could be asked to do more. I can think of two directions in which we might be asked to do more. First, we have established a wide consensus that monetary policy can do something to smooth the course of the business cycle, but this should not be the primary goal. But if inflation control begins to look easy, people may ask central banks to focus the power of monetary policy more fully in the direction of smoothing the cycle. I do not propose to say more about this, other than to observe that this can, at least in principle, be encompassed within the inflation targeting framework, recognising the legitimate trade-off between inflation variability and output variability. But we also need to remember how much more painful it is to have to wind inflation back down, once price expectations have been disturbed. More interesting, in the current debate, is whether monetary policy should do more to achieve financial stability. A clear dichotomy or specialisation has developed, in which monetary policy is seen as the instrument for maintaining price stability, and prudential regulation is ”assigned to” financial stability. This dichotomy is increasingly reflected in the vogue of separating the central bank from the prudential regulator. But financial stability is under constant bombardment – reflected in the increasing complexity of the Basel II rules; the pressure to widen the reach of financial regulation; the increasing recognition that financial stability problems are coming not just from institutions, but from markets and their evolution; and the difficulty of staying ahead of the evolution of ever-more-complex financial instruments and products (driven by competition and sometimes by the objective of getting around prudential regulations). The LTCM experience is a reminder of how the leading-edge players will be constantly pushing beyond the regulators’ capacity to understand, let alone react effectively. On top of this we see the evolution of markets, often driven by the desire to minimise risk to individuals, taking actions which may make the overall system more vulnerable – the examples here are the various forms of “Inflation Targets and Inflation Targeting“, remarks by Governor Laurence H Meyer at the University of California at San Diego Economics Roundtable, San Diego, California, 17 July 2001. (Also published in BIS Review no 65, 17 July 2001). equity insurance which were put in place prior to the 1987 equity correction, and (more recently) the increasing use of VaRs (value-at-risk models) and various risk management procedures which will tend to ensure correlation of changes of opinion (the herd changes direction simultaneously) and of mistakes. All this is happening in a world of enormously increased capital flows. In this world, it will be surprising if we are not asked whether monetary policy can make a bigger contribution to maintaining financial stability. The obvious place to start would be with asset prices. Asset prices already have some role in inflation targeting, in as far as they impinge on the prospect for CPI inflation. But looking at the experience of Japan during the 1980s (and perhaps the United States more recently), it might be asked whether monetary policy should do more to directly influence asset prices which (in the case of Japan) were a central cause of financial instability and the subsequent decade-long stagnation. Asset ”bubbles” are clearly enormously disruptive: the issue in debate is not the desirability of minimising them, but whether they can be identified beforehand and whether the instrument available is suited to the task. Without a clear mandate to do this, and an analytical framework for identifying a bubble, it would be a bold central bank which deliberately set out to burst the bubble, knowing that many in the economy were enjoying the euphoria. How are these issues to be resolved? One hopes that the answer is: with analytical and intellectual endeavour; and with common sense not coloured or distorted by dogma. Given the importance of the issues at stake, it seems unlikely that the history of monetary policy has ended, with no further evolution likely or possible. | reserve bank of australia | 2,001 | 7 |
Giblin Lecture by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the University of Tasmania/Economic Society of Australia (Tasmanian Branch), Hobart, 18 September 2001. | I J Macfarlane: The movement of interest rates Giblin Lecture by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the University of Tasmania/Economic Society of Australia (Tasmanian Branch), Hobart, 18 September 2001. * * * Let me start by thanking the University of Tasmania for inviting me to give this lecture, which commemorates one of Australia’s truly remarkable men. My choice of topic tonight was made long before the tragic events in the United States last week. Before moving on to the main body of my speech, a few comments are in order about recent events. The first order of business for central banks at times such as this is to ensure that the financial markets and the payments system can operate effectively. This has been accomplished. The Federal Reserve was open and the US payments system operating on the day of the attack. Central banks around the world operated to assure market participants that there would be ample liquidity. We here in Australia did likewise, and have added substantial additional funds into the cash market, and are continuing to ensure that additional liquidity is available as required. Assessing the lasting economic impacts of the events will take longer. Much will hinge, obviously, on the extent to which investors and consumers in the United States respond to the tragedy by scaling back their activities and plans. That is almost impossible to predict. In the United States, where economic conditions were deteriorating and confidence waning prior to the attack, the Federal Reserve has brought forward an easing of monetary policy. Some other countries already directly affected by the US weakness (Canada), or seeing unexpected weakness of their own (continental Europe) have likewise eased monetary policy. These moves themselves will help, of course, to address the risks to global growth which already existed and those — as yet almost impossible to assess — which may result from the reaction to the attacks themselves. I know there were some who speculated about whether Australia might join this action today, easing further the already expansionary setting of monetary policy currently in place. We have, as usual, closely monitored events abroad and at home on a continuous basis. We have had better economic data in Australia lately than observed in the United States or Europe. The weakness of global conditions in the short term will affect Australia, as we said in our statement announcing an easing of policy just two weeks ago. But we have not seen, in the past week, anything relating to Australian monetary policy’s field of operation which was so urgent that it warranted the suspension of the normal timetable of the deliberative processes of our Board. With that said, let me now return to the main body of my speech. Sometimes it requires an effort to find the complimentary remarks that usually preface a lecture such as this. But not so in the case of Giblin. While he is remembered principally as an economist, he did not take up this calling on a full-time basis until he was 47 years old, by which time he had already done so much in other areas. After graduating from Cambridge, during which time he played rugby for England, he spent some time prospecting for gold in Canada, became a merchant seaman, a plantation manager in the Solomon Islands, an orchardist in Tasmania, a Member of the Tasmanian Parliament, and was decorated for bravery in World War I. As an economist, he made contributions in a number of areas and had a close association with central banking through his membership of the Board of the Commonwealth Bank. But it is another aspect of this extraordinarily gifted man that I would like to commemorate tonight – his willingness to communicate difficult economic ideas to the broader public. Giblin wrote a series of articles in 1930 called Letters to John Smith in which he set out the economic issues facing Australia at the start of the Depression. This series faced economic issues head on, but did not talk down to its readers. I will try to follow his example this evening. What I intend to do is to answer three questions that are sometimes put to me by members of the public, rather than by regular participants in monetary policy debates. Because the questions are from “lay” people, they may appear naive to a professional audience, but I often find that blunt untutored questions are the hardest to answer, and they can often force a re-examination of previously unquestioned assumptions. They See Copland (1960). ibid. can also open up some interesting historical and academic issues. I should also add that my choice of topic tonight is not prompted by any current economic events, but is the outcome of some reflections going back a decade or two. The three questions are the following: 1. Why does the Reserve Bank have to change interest rates at all: why can’t they be left constant? 2. Why does the Reserve Bank have to be involved in the first place: why can’t the determination of interest rates be left to the market? 3. Why do we need to set our own interest rates in Australia: why can’t we just accept the rates of another country, e.g. the United States? Obviously these three questions come from quite different perspectives, and the people who ask them are making very different assumptions about how an alternative system for setting interest rates should work. But there is, I think, a common thread that connects them. That is the view that it would be desirable to take away the element of discretion from interest rate setting, whether by making them constant, by "leaving it to the market" in some sense, or by ceding the discretion to another country. In other words, the questions arise out of a certain scepticism as to whether interest rate setting really requires an active decision making role for the central bank. One preliminary point to be dealt with before going to the substance of these issues is what we mean by "the interest rate". There are, in fact, many interest rates – short-term, long-term, private, government, on loans or on securities, etc. – so which one do we mean? In this discussion, it makes most sense to focus on the short-term interbank rate that is typically set by a central bank – in Australia, the overnight cash rate (usually referred to as just the cash rate). The rest of the rate structure can be thought of as keying off current and expected cash rates, and it is the cash rate that is the main driver of movements in the interest rates that borrowers actually pay. So questions about the appropriate system of interest rate setting in this context really amount, in essence, to questions about how the cash rate should be determined. Let me turn now to the three questions I have just outlined. Question 1: Why do interest rates have to vary? A lot of people are unhappy about changes in interest rates. When rates rise, there are always a lot of complaints in the media drawing attention to the plight of people with mortgages. When rates fall, the media usually treat this as good news, but I get a lot of letters from retirees who take the opposite view. One solution would be to instruct the open market desk at the Reserve Bank to operate in a way which kept interest rates at their current level indefinitely. Why would we not wish to do this? There are two answers to this question: one which is historical, the other more theoretical. The historical approach is to ask whether there has ever been a monetary system that did not involve variations in interest rates. The answer is no. Interest rates have always moved up and down under all the monetary regimes that have existed, whether the regime was a gold standard, a currency board, a normal fixed exchange rate, a monetary target, an inflation target, or a regime of pure discretion by the central bank. If someone can think of an example of a successful monetary system where interest rates never had to change, I would be very interested to hear of it. But while most people can instinctively appreciate this point, there are, no doubt, some who would like to know what would be wrong with trying to hold interest rates permanently fixed, even if it has not been done before. This brings me to the second part of the answer, based on economics: a fixed interest rate policy would be unsustainable because it would inevitably lead to either an inflationary or a deflationary spiral. This conclusion is well established in the theoretical literature, but it does not require any great familiarity with monetary theory to appreciate how it is arrived at. Suppose, for example, that a central bank attempted to set the interest rate at a low level which imparted a strong stimulus to demand and The technical way of describing the weakness of permanently fixing the interest rate is to say that it is an unstable rule because it leads to indeterminacy of the price level. This point has been appreciated at least as far back as Henry Thornton (1802) who analysed the inflationary consequences of the fixed interest rate policy then favoured by the Bank of England. activity. Over time, if that were maintained, it would cause inflation to rise, and, with a fixed nominal interest rate, the real interest rate would decline, thus leading to further increases in demand and inflation. This process would continue through successive rounds resulting in an inflationary spiral. By a similar logic, if the initial level of the interest rate were set too high, a self-reinforcing process in the opposite direction would ensue, culminating in a deflationary spiral and rising unemployment. Only if the interest rate could be set at an exact equilibrium point would these two extremes be avoided, and, even then, the equilibrium would be temporary. Any economic event that pushed the economy slightly away from its equilibrium would set off one of the two self-reinforcing processes I have just described. One response to this line of argument might be to suggest that the central bank try to stabilise the real rather than the nominal interest rate, but this already concedes the main point: that the nominal rate has to be adjusted in response to information about current and prospective inflation. Having made this point, I have to concede that there are not many people who would advocate that interest rates should literally be kept permanently fixed. But there is a more subtle version of this viewpoint which is much more widely held: that is the view that policy should always aim to keep interest rates as stable as possible. Expressed in this way, the idea sounds more reasonable, and I think it is fair to say that it pervades some of the commentary that follows interest rate adjustments – the idea that changes in interest rates (and especially increases) should be avoided if possible. We need to be clear that this is an incorrect view, for the same reasons I have just outlined. If policy were to give too great a weight to stabilising interest rates, as an end in itself, it would risk destabilising the economy, because it would fail to keep up with inflationary or deflationary pressures as they emerge. Of course, it would also be a fallacy to jump to the opposite conclusion, that more interest rate variation is always better. Obviously, a policy which made large and hastily-decided changes in interest rates would also be a destabilising force, so it has to be recognised that interest rates can be moved by too much as well as too little. How much variation, then, is the right amount? This is not the sort of question that is open to a precise quantitative answer, but it is certainly possible to give some general principles. • First, it depends on the size of the shocks that the economy experiences. Bigger interest rate adjustments will probably be needed the bigger the shocks to which you are responding. When the shocks and imbalances are small, interest rates do not need to move as much • Second, it depends on how responsive the economy is to a given change in interest rates. Arguably in the 1970s and 1980s, when inflation was high and variable, the economy was less responsive to a given change in interest rates than it has been subsequently. Hence, larger changes in interest rates were needed to achieve a given effect. Since the early 1990s, interest rate changes have generally been much smaller than in the earlier period. • Third, it depends on how much uncertainty there is. When you are very sure about your reading of the economy and about the likely effects of a change in interest rates, it may be possible to move rates very quickly in response to an important piece of information. But when you are highly uncertain about how to interpret events, it pays to be more cautious and gradual in your approach. To use an analogy with driving — you should slow down in a fog. It follows from this that the "right" amount of movement in interest rates depends very much on the circumstances. Sometimes rates will be highly variable, as they were in the 1980s, and sometimes they will be quite stable, as they have been in the most recent decade. In all of this, interest rate stability should be seen not as a goal in itself, but as a by-product of a stable macro-economic environment. Let me turn now to the second of my three questions. Question 2: Why not leave interest rates to the market? This question, again, is based on a plausible-sounding premise, but the proponents of this view are often rather unclear about what "leaving it to the market" would really mean in an operational sense. It might mean several things. One possible meaning, that will not be discussed here, is that open market operations should be directed actively to controlling growth of the money base and thereby letting interest rates be determined as a residual. Since this suggestion involves active intervention by the central bank, it is hardly in keeping with a "leave it to the market" approach. For those In its simplest form, leaving interest rates to the market would mean simply telling the Reserve Bank to cease all open market operations. It is worth exploring what would be the consequences of such a policy. In a world where the Reserve Bank was undertaking no open market operations, the amount of cash that underpins the money market (exchange settlement funds, or what the academics call "highpowered money") would depend on the Government’s fiscal balance, and it is not hard to see that this would be likely to result in monetary instability. Any government deficits not financed by an exactly coincident issue of debt to the public, for example, would mean a rise in cash and a fall in interest rates. Similarly, a surplus not exactly matched by debt retirement would lead to a shrinkage of the amount of cash and an escalation of interest rates. In both cases, there would be much more short-run volatility in interest rates than exists at present. This is because the day-to-day fluctuations in the Government’s position, which can be quite large, would no longer be smoothed out by Reserve Bank open market operations. A further point to add here is that even maintaining a balanced fiscal position on a daily basis would not ensure these effects would be avoided. Even with the fiscal position in balance, the system could be destabilised by changes in the public’s demand for currency. Because the public’s demand for currency expands with the growth of the economy, it could only be accommodated in this regime by some other source of cash such as provided by RBA open market operations. Failing this, there would be continuing upward pressure on interest rates and economic contraction. I have spelled this out in some detail because proponents of the "leave it to the market" view often do not have a clear idea of what their position really means. But if they mean simply ceasing Reserve Bank operations, and leaving interest rates to the market in that sense, then it is clear that such a system would not be workable. It would be a recipe for more interest rate volatility, not less. To be fair to those saying rates should be left to the market, there are some who have a more sophisticated view. They would argue that I have made two assumptions that could easily be changed. First, if the Government did not bank with the central bank, then its fiscal position would not affect high-powered money. And second, if the central bank did not issue bank notes, but bank notes were instead issued by commercial banks, then it would not involve the central bank having to provide cash to the system. These changes would eliminate the central bank from the picture entirely, and bring us to the world of "free banking" so beloved of a small group of academics. Among supporters of the free banking ideal, there are at least two schools of thought as to how such a system should work. One view is that money should be ultimately linked to a commodity such as gold, so that bank notes issued by commercial banks would essentially be "gold certificates" redeemable in gold on demand. Therefore, the supply of gold would act as a discipline against over-issue of notes and the system would ensure that interest rates were determined by the supply and demand for funds. While examples that resemble this outline do exist in early banking systems such as Australia before 1910, they all eventually gave way to what are now conventional systems based around a central bank. The reason was that such "free" banking systems were found to be prone to instability without a central bank to manage liquidity and provide last-resort funding in a crisis. Banking systems tied to a commodity standard were simply not flexible enough to cope with periodic bank runs and liquidity crises. No doubt, the true believers in free banking would argue that the theory was never properly tried, and that, if it were, the market would find a solution to the apparent problems. But that is to make the theory unassailable by pure assumption. The other school of thought on free banking is an even more radical one. It proposes a system of competing private currencies that would not have to be linked to any standard of value. The banks operating in such a system would compete with one another to offer sound currencies on terms that who would like to introduce money base targeting, see Macfarlane (1984 and 1989) and Goodhart (1995) for the contrary view. Another interpretation of what "leaving it to the market" could mean is that the Reserve Bank should move the cash rate to where the market expects it to be. This could mean, for example, moving the cash rate to where the 90-day rate currently is. The problem with this approach is that the current level of the 90-day rate is mainly a reflection of where the market expects the Reserve Bank to set the cash rate 90 days hence. The process then becomes completely circular. See Pope (1989) for a discussion of "free banking" in Australia prior to 1910. The more commonly cited case of free banking is in the 18th century Scottish banking system (see White, 1984). Note, however, that other writers such as Goodhart express scepticism that this was a true case of "free banking". The best known proponent of this view is Hayek (1976). were attractive to the public. In effect, a country operating such a system would depend upon competition between commercial banks to ensure stability in the financial system and low inflation. To my mind, these free-banking proposals really belong in the world of technical curiosities. They can be argued to work in theory, but the fact is that there is no working example of such a system anywhere in the modern world. So I have to conclude that those who say interest rates should be left to the market are proposing something that is either not workable (if they mean simply shutting down central bank operations) or something that is much more radical than most people would be prepared to accept. This brings me to my third question. Question 3: Why not just accept US interest rates? The premise behind this question is that we could do away with the discretionary role of the Reserve Bank by having a rule that interest rates would always be equal to those set by the US Fed. My first comment on this is that it is hard to see why anyone would see this as a particularly attractive goal. It certainly would not do away with central bank discretion, but only replace the discretion of one central bank with that of another. And it would be a discretion tailored to meet US conditions, not to policy requirements in Australia. But leaving aside the question of whether it would be desirable, the main question I want to focus on is: is it feasible? The answer is, it depends on how it is done. If the mechanism for achieving equal interest rates with the United States was that we adopt the US dollar, or establish a fixed exchange rate, then it should be technically achievable. Interest rate convergence would then be a by-product of fixing our currency to the US dollar, and, the more credible the exchange rate peg, the more closely our interest rates would shadow those in the United States. That was how interest rate convergence was achieved within Europe, though the same process is proving extremely difficult in Argentina. So if the people asking us to adopt US interest rates are really arguing for a change of exchange rate regime, then there is no dispute that it could probably technically be done. But this is really a different debate from the one about how to set interest rates. If, on the other hand, someone is arguing for adopting US interest rates under the existing exchange rate regime, I would have to say that such a strategy would not be workable. The reasons for this are quite similar to those I outlined earlier under question 1. Suppose we began such a regime in a position of equilibrium, in which Australia and the United States had the same inflation rates and there were no imbalances tending to push the exchange rate in one direction or the other. In these conditions, we could expect the level of interest rates in the two countries to be the same. But if we then established a rule that Australian interest rates would always be equal to those in the United States, the system would be extremely vulnerable to any event that affected the relative performance of the two economies. For example, if there were contractionary forces operating on Australia, but not the United States, the level of interest rates would not be able to respond, and the result would be a downturn in the Australian economy, and in extremis, deflation. An expansionary shock would likewise destabilise the economy in the other direction. The strategy could only be maintained if, by a fluke, economic conditions in the two countries remained perfectly synchronised. Having made this point, it is interesting to note that interest rates in Australia and the United States have at times moved quite closely together in recent years. There is nothing wrong with that. We just need to be clear that when this occurs, it is a result of the two countries experiencing similar economic conditions, not something that has been set up as an end in itself. Conclusion In the history of monetary economics there has been no shortage of proposals to make the system automatic, and thereby to eliminate the need for central banks to be involved in setting interest rates. I have looked at three simple proposals of this sort, and tried to show why they would not be viable or would have very different consequences from those imagined by their proponents. In a modern monetary system, it is not possible to have interest rates on automatic pilot, and so a discretionary role for the central bank in setting interest rates cannot sensibly be avoided. All of this is a long way from saying how the decision-making process should work: what should be the objectives and how the process should be governed. I have given my views on these matters in public on many occasions, as have a number of my colleagues, so I will not go over the same ground again tonight. Here, I would just note that the most important modern advance is to ensure the decisionmaking takes place within a framework of well-defined objectives and clear accountability. This is indeed one of the strengths of the inflation targeting regimes that have been adopted in so many countries during the past decade. They recognise the need for a decision-maker, so that interest rates can be adjusted in response to unfolding events, but they also place the process within a framework of clear objectives and accountability. Bibliography Copland, Douglas B. (ed) (1960), "Giblin: The Scholar and the Man: Papers in Memory of Lyndhurst Falkiner Giblin, D.S.O., M.C.", edited by Douglas Copland, Melbourne, Cheshire. Goodhart, C.A.E. (1995), "Money Supply Control: Base or Interest Rates" in Goodhart, The Central Bank and the Financial System, MIT Press, Cambridge, Mass. Goodhart, C.A.E. (1988), "The Evolution of Central Banks", 2nd ed, MIT Press, Cambridge, Mass. Hayek, F.A. (1976), "Denationalisation of Money", Institute of Economic Affairs, London, Hobart Paper No. 70. Macfarlane, I.J. (1984), "Methods of Monetary Control in Australia", New Zealand Association of Economists Annual Conference, Massey University, August, 1984. Reprinted in J.D. Juttner and T. Valentine (eds), The Economics and Management of Financial Institutions, Longmans Cheshire, 1987. Macfarlane, I.J. (1989), "Policy Targets and Operating Procedures: The Australian Case", Monetary Policy Issues in the 1990s, Jackson Hole Symposium, Federal Reserve Bank of Kansas City, August. Pope, D. (1989), "Free Banking in Australia Before World War I", Australian National University, Working Papers in Economic History, Working Paper No. 129. Thornton, Henry (1802), "An Enquiry into the Nature and Effects of the Paper Credit of Great Britain", F.A. von Hayek (ed), London, George Allen and Unwin, 1939. White, L.H. (1984), "Free Banking in Britain: Theory, Experience and Debate: 1800-1845", Cambridge University Press. | reserve bank of australia | 2,001 | 9 |
Speech by Mr Glenn Stevens Assistant Governor, Economic Group of the Reserve Bank of Australia, at the Economic Society of Australia (Victorian Branch) Forecasting Conference, Melbourne, 10 October 2001. | Glenn Stevens: The monetary policy process at the Reserve Bank of Australia Speech by Mr Glenn Stevens Assistant Governor, Economic Group of the Reserve Bank of Australia, at the Economic Society of Australia (Victorian Branch) Forecasting Conference, Melbourne, 10 October 2001. The references for the speech can be found on the Reserve Bank of Australia’s website. * * * Introduction Thank you to the Victorian Branch of the Economic Society for another invitation to speak at your conference here in Melbourne. You have heard a number of thoughtful presentations this morning about the state of the world and the outlook. I have little to add to that, and do not intend to offer comments on the conjuncture. I have chosen instead to speak on something which is less immediate, but about which I have found there to be a good deal of interest at times, namely the procedural elements of the monthly monetary policy process inside the Reserve Bank. You may think that this is a bit tedious, but there have on occasion been claims that the whole process is somehow mysterious, and that more information about it should be divulged. This view is, I suspect, most often put by people who do not agree with particular policy outcomes. But there is, nonetheless, a case for having an account of the process on the record. I aim to show that there is nothing mysterious about the monetary policy process, by outlining the routine the staff and management of the Bank go through each month in formulating their view about the economy, and the recommendation to be taken to the Board meeting – which of course is the critical decision node. I will be speaking from the perspective of someone heavily involved in the process, including taking part in the Board meeting, but not as a decision maker – only an adviser. Hence I do not, it should be clear, pretend to speak for the Board members, nor will I address questions of governance, or the Reserve Bank’s communications with the Government. As a staff member rather than a Board member, I am not in a position to comment on such matters. I shall try to make a few points which I think are important along the way, and I will end with a few observations about the policy process. Before setting out, let me emphasise that I have not come today to deliver any particular message about the short-term outlook for monetary policy. The meeting schedule The decision process revolves around the Board meeting schedule. As you know, the Reserve Bank Board meets eleven times each year to consider monetary policy. For the past twenty years, the meetings have been held on the first Tuesday of each month, except in January. Of course, meetings can be convened at any time, if needed, and the Board can be contacted by phone in the event of some urgent matter. Such events are rare, though they have occurred occasionally in the past. It has come to be regarded as a good thing, however, that policy decisions are, in normal circumstances, taken at meetings with a known schedule. Such a schedule for decision-making meetings, as well as for regular documents (such as the quarterly Statement on Monetary Policy) is increasingly the norm internationally. Even some countries that do not have a decision-making board have established a fixed timetable for making and announcing decisions on monetary policy. This is quite efficient, in that it helps financial markets and other observers in allocating their own resources – they know when to pay attention! – and lessens unnecessary speculative activity. Internal processes The monthly schedule naturally provides the rhythm for the staff’s efforts. In the case of the Economic Group, the process begins about two weeks or so before the Board meeting date (that is, not long after the previous meeting has finished). Relevant desk staff who monitor the data flow begin the preparation of comprehensive documents giving details of all the relevant information. This documentation ultimately forms part of the detailed briefing paper on the economy presented to the Board, and is updated continually as the information comes in (some of the key data, like the CPI, typically come in quite late in the process). At the same time as the documents are in preparation, there is a sequence of meetings. Around twelve days prior to the Board meeting, we in the Economic Group hold a staff meeting to focus on the available economic information. We review data on the rest of the world, domestic economic activity, prices, wages, the labour market, and financial conditions. The full range of economic data is quite extensive: we track over 2000 data series on the Australian and international economy. Hence the focus has to be on those pieces of information that are most significant and potentially view-changing. We are also exposed to relevant pieces of analytical or research work which can inform our assessment of the economy’s development. At this meeting, there is a good deal of questioning about various elements of the figures, and in particular about apparent contradictions or tensions which inevitably arise in the short run data flow. Much of the process of data analysis for the purposes of policy advice is, in fact, of the nature of detective work: trying to fit all the pieces together in a way which makes the most sense. Usually, this proceeds by forming a working hypothesis about what is occurring in the economy, then being on the lookout for anomalies, and then hunting down why those anomalies are occurring, which may in turn lead to a revision of the original hypothesis. For example, is a key variable moving the way it should be, given our view of the outlook? If not, can a sensible reason for this be found? If it can’t, perhaps our working hypothesis is in need of amendment. One such question in recent months was: why were imports so weak? Was it because the exchange rate was doing a lot of work to shift demand to domestic production? Was it that much of the impact of the business sector inventory run-down was being reflected in imports? Or was domestic demand in fact much weaker than we thought? Or all three of the above to some extent? Another was whether the large fall in full-time employment in July was consistent with other information about the labour market (it wasn’t). Yet another was whether the large fall recorded in business credit in July was a genuine signal or was affected significantly by technical changes in the way the data are compiled and shifts in seasonal patterns driven by changes to the tax system. In this case, statistical doubts don’t seem to be enough to remove the impression that business credit is quite weak. The analysis is not entirely focused on official statistics. As you know, the Bank has in the past year upgraded its economic liaison capacity, establishing Regional Offices in Melbourne, Perth and Brisbane. We have recently added an economist in Adelaide, who is attached to the Bank’s Branch in that city. While we have for many years undertaken regular liaison with major retailers, the Offices have been quite active in developing additional contacts in the business community, state governments, industry groups and academia. Their work is coordinated from Sydney and we make considerable effort to ensure the results are integrated into Head Office’s evaluation of the economy. Each month, an economist from one of the Offices has the responsibility of distilling the insights gained from the collective liaison effort into a document, and will travel to Sydney to present the results at the staff meeting. To date, we have been pleased both by the reception our liaison visits have received, and by the insights we have gained into some topical issues on which there is no timely official data to which we can appeal.1 In all of this, we are aiming to come to as comprehensive an understanding as we can of the state of the economy and its likely trajectory in the period ahead. We are ultimately seeking an assessment of the likely state of aggregate demand, supply and prices – which, of course, is the key focus for policy under an inflation-targeting framework. As part of making this assessment, and of forming a view about whether the stance of policy ought to be altered, it is important to have a clear view of exactly what the current stance of monetary policy is, and what effect it is likely to be having on the economy, bearing in mind the widely-acknowledged lags. To gauge this we start by doing relatively simple things, like looking at the level of interest rates – in nominal and real terms – compared with history, examining the pattern and strength of credit growth, the state of asset markets, the level of the exchange rate and so on. In all this, we make allowance as best we can for the state of the business cycle, and for structural changes which may be affecting the course of these variables. We place a good deal of weight on the range of financial variables in the economy – monetary policy works, after all, by changing financial prices. I would make one other observation that I think is important here, and that is that we believe it is very important to keep in mind the level of interest rates, not just their changes. Many commentators, of course, do the reverse – they focus heavily on the changes in rates. This is understandable in that a change in monetary policy is much more interesting news to report than no change. And, naturally, the way in which a particular movement (or non-movement) will be received by markets, the business community and the general public is an important tactical consideration for the policy makers. But while the changes in rates make the news, it is surely the level which does most of the work on the economy. Consideration of the current stance of policy can be supplemented by two other pieces of analysis. The first is the output of a suite of Taylor rule-type calculations. As I am sure you know, Taylor rules are a simple formula which give a benchmark for the real short-term interest rate, conditional on the latest information about output relative to estimated potential output and inflation relative to the target rate (and conditional on an assumption of a so-called "neutral" real interest rate). Staff research over the years has identified a couple of Taylor rule formulations which we think are worth checking periodically. We also compile and monitor monetary conditions indexes – which combine interest rates and exchange rates – though we have significant reservations about the use of these indexes in more formal ways.2 The second additional piece of analysis is a simulation exercise using a small macro-econometric model of the economy developed by Economic Research Department. This model can be used as a forecasting tool (as an input to, or cross check of, the central staff forecasts which are predominantly judgemental – and much more detailed – in nature). It can also be used in "optimal policy mode". That is, given the current state of the economy, and given the objectives for policy (the inflation target and a preference for avoiding undue instability in real GDP), the model can be asked: what is the path for interest rates over the relevant horizon which will minimise the variance of the objective variables around their targets? Now I do not want to leave you with the impression that the staff unquestioningly accept these results and rush breathlessly off to the Governor to suggest interest rates immediately be adjusted in accordance with them. Such technical work is undertaken with a view to informing our judgement, rather than as a substitute for it. The model results can some times be sufficiently counter-intuitive (at least to me) that we spend a lot of time questioning how they came about, which usually means examining properties of the models which produce the results. But that process can be quite illuminating, in that it prompts us to confront the implications of assumptions we make, either in a formal model or in our heads, about the way the world works.3 Nor do I wish to leave the impression that there is a single model of the economy which commands complete support, in every detail, from everyone in the Reserve Bank. That has never been, and will never be, so. I personally think we should be unashamedly eclectic in our use of models. Recognising that there is more than one way to think about things, comparing the results from those different approaches, and thinking about why they occur, is vastly preferable to being tied too tightly to a single model or view of the world. We have, in fact, examined a range of model approaches over the years, and routinely use more than one piece of modelling to inform key forecasts, including in particular for inflation. Incidentally, before the clamour for more detail of the nature of these models grows too loud, I should state that the models, and the Taylor rule research we have carried out, have all been in the public domain for some time.4 While all this is occurring in the Economic area, our colleagues in the Financial Markets Group have had a parallel process going on, with a particular focus on assessing developments in international and local financial markets. Once the two areas have had a chance to form preliminary views, the senior management of the two Groups meet to compare notes. This is important for ensuring that for the Bank as a whole, our reading of the economy and the policy options has integrated financial developments with the "real" side data as far as possible, and that the policy options worked up have taken proper account of financial market dynamics and expectations. Board materials At this point, it is useful to say something about the documents for the Board meeting. Economic Group prepares a paper called "The Economy and Monetary Policy", which summarises our analysis of economic conditions, provides a summary of the outlook and sets out the policy issues we believe the Board should have in mind for the forthcoming meeting. The paper has a four to five page overview essay prepared by the senior management. It also has detailed supporting documentation including tables, charts, and forecasts etc as attachments, prepared by the staff. A companion paper from the Financial Markets Group containing a comprehensive treatment of developments in financial markets is also prepared. About a week prior to the Board meeting, draft versions of these papers are circulated to a Policy Discussion Group (PDG), made up of the most senior management of the Bank, and the Governor and Deputy Governor. The Governor then convenes a meeting of that Group to discuss the policy situation and the draft papers. The discussion is fairly broad ranging, and benefits from the fact that a number of senior colleagues attend who are familiar with the broad issues associated with monetary policy, but whose every-day job is to think about other things. These people bring a fresh perspective to the issues and offer quite substantive comments on the drafting of the papers, and the recommendations contained therein. This process helps to tighten up our thinking. Following the PDG meeting, the papers are finalised and sent out to Board members ahead of the weekend, so that they have time to peruse them prior to the Board meeting on the Tuesday of the following week. In our system, the final decision on what we will recommend to the Board is taken by the Governor, having heard the views expressed by the staff. On occasions where he feels the answer is sufficiently clear ahead of the Board meeting, the papers will contain a clear policy recommendation. On other occasions, where things are more finely balanced, the papers might set out the issues but leave the policy recommendation open, with a firm recommendation presented at the Board meeting itself. The Board Meeting The RBA Board is charged with making decisions on monetary policy, subject to the legislation governing the Bank. Hence the decision process involves a recommendation to the Board, which they consider at their meeting. The Board meeting occurs during the Tuesday morning, and usually concludes by lunchtime. Supplementing the written material, the Board receives quite extensive presentations on the economy and on the financial markets. At this point, I have to reiterate that my involvement at the meeting is in the capacity of a staff member. Obviously, I cannot and do not pretend to speak for the Board members on the details of the meeting’s conduct, or on what they might make of the material we give them. But I can say that they can (and do) ask a great many questions, offer their own interpretation of events and, of course, bring perspective from their own regular activities. They also bring from their experience an instinctive grasp of the problem of decision-making under uncertainty, which is at the heart of monetary policy making. After the presentations are made and questions addressed, the Governor will invite a discussion of the recommendation, and whether or not members support it. Once a decision has been reached, we go from there. On occasions where the decision is to change interest rates, we spend much of the Tuesday afternoon working on the statement which will announce the change the following morning. Apart from the process of writing up the minutes, this completes the policy round. Reflections on the process All of this is, I hope, roughly what you would expect would happen. The purpose of recounting it all is to show that there is no mystery in this process. The staff of the Bank evaluate the data, the management help the Governor form a judgement, and he puts a recommendation to the Board. The Board consider that, make their decision and then the Bank implements that decision, explaining it as necessary. Do we have a secret set of information, unavailable to other people, on which the Board are invited to base their decision? No, we don’t. Virtually all of the statistical information processed by the staff of the bank is public. There is very little data we have that you don’t have, apart from knowing the shape of those data we are responsible for compiling (such as the financial aggregates) before they are published. The liaison information is, by its nature, given by individual firms and organisations in confidence and hence cannot normally be made public, but I think most people would accept that restriction. So the decision process does not rely on a superior information set to that which the market possesses. Indeed, it seems to me that, ideally, financial markets and other interested parties would understand our policy framework sufficiently well that, most of the time, the flow of data would be the main thing which shifts expectations about future policy moves. There will always be, of course, room for differences of opinion about the importance of a particular piece of information, and the markets will not always be able to pick the exact interpretation the decision makers will place on it. Hence there will be some surprises. Nonetheless, given a good understanding of the framework, which I think now exists, there should normally be a reasonable degree of predictability of the general course of action the Bank will take over time, even if not necessarily month by month. This is helped, we trust, by the efforts made over the years to explain our evaluation of the full range of economic and financial data. The Statements on Monetary Policy, appearing four times each year, and now on a schedule known in advance, have become increasingly bulky over time as we have tried to make our analytical coverage of the economy and financial markets more comprehensive. They are probably too big to read at one sitting for most people, but the main messages are well flagged and the detail, we hope, repays careful reading by interested observers. It is also worth noting that the compilation of these Statements every third month coincides with the build up to that month’s Board meeting. The same (scarce) people work on that document as on the material for the Board. Hence it will hardly surprise you to learn that the analytical and descriptive material in the Statement bears a rather strong resemblance to that in the Board papers. In other words, the analysis available to the Board that month is, for the most part, in the public domain within days of the meeting (the pattern we have evolved towards is for the Statement to be released the Monday following the Board meeting). Since the themes in the economy tend to evolve gradually most of the time, moreover, the analysis is usually not that different to what was said to the Board in the preceding month or two. The material in the Statement on the policy considerations behind recent decisions is also very similar, as you would expect, to the arguments put in the Board papers. I would add that the policy process does not rely as heavily as some believe on specific forecasts. This is a point I have made before but bears repeating. In policy making, we have to be forward looking. So there has to be a forecast as a benchmark for thinking about the future. But it would be a mistake to focus only on the point forecast; it makes much more sense to think of the central forecast as simply the modal point on the distribution of the possible outcomes, with a sequence of progressively less likely outcomes on either side. Nor is that distribution necessarily symmetric – it may be skewed one way or the other. A useful forecast, then, is one which contains not just a single number, but also some sense of the balance of risks: is it more likely, for example, that inflation will be above the central forecast than below it? The policy implications of such a distribution of risks might be quite different to those of the same central forecast but with the distribution of risks skewed in the other direction. This is why some central banks have presented their forecasts in terms of so-called fan charts, which are an attempt to quantify both the degree of (im)precision in the forecast and the extent of skewness in the distribution of possible outcomes. We do not use fan charts per se, but we do try to consider alternative scenarios to the central forecast. We attempt to use the results of that process to articulate some sense of the balance of risks – both on the inflation outlook and on growth prospects – in the published statements. This is very important because it is to that balance of risks that policy makers will want, quite properly, to respond. The future is, by definition, uncertain and so policy is never a matter of simply making a point forecast and solving for the "correct" interest rate that goes with that forecast. It is also about thinking through what might go wrong with the forecast, and formulating some notion of what response is appropriate in the event that things do go off track, or even to the risk of such an event. The fact that policy makers seek to respond to risks, as opposed to waiting for problems to build up before responding, is what makes for a degree of controversy on some occasions. If the economy is already in recession, or if inflation is already high and rising, and policy has not yet made any response, almost everyone will agree that something should be done – in fact, they will agree that something should already have been done. But there is a lot more room for disagreement over what should be done when policy is seeking to head off possible problems in advance, because on these occasions the evidence for a problem is almost certainly far from conclusive. Such evidence may never emerge clearly if a pro-active policy is successful in heading off the problem. And, of course, policy makers seeking to be pre-emptive do run some risk of responding to perceived problems which do not, in the end, eventuate. But in all these cases, the policy maker will be seeking an answer to the question: which mistake, of those I could possibly make, would I be likely to regret most? The policy maker is then likely to try to make reasonably sure that that particular mistake is not being made, perhaps at some risk of making another but, less costly, mistake. This question is likely to be most important near business-cycle turning points, when interest rates are already a fair way from their normal level, and when holding on to an unusually high or low setting for too long is likely to have more significant consequences than other errors which might be made. It is also likely to be important when a large shock comes along, with the potential to fundamentally change the whole outlook. Another way of putting this, in slightly more technical language, is that policy making involves consideration both of the shape of the distribution of forecast outcomes, and of the "loss function" which the policy maker is carrying around in his or her head. I believe this is what Dr Greenspan had in mind when he said the following: "The center of the forecast distribution, of necessity, is still important to our deliberations but, more than many people realize, policymaking is to a substantial extent focused on the potential deviations from the central forecast and the costs should those outcomes prevail. In short, our policy behavior is the result of examining the implications of the interaction of probability distributions and loss functions. We do not engage in the formal mathematics of such a model, of course, but we do follow its underlying philosophy."5 Conclusion The degree of scrutiny of the monetary policy process these days is an order of magnitude more intense than it was when I started my career at the Reserve Bank nearly twenty-two years ago. That is fair enough, in that decisions taken in the RBA Board room are important in the life of the nation’s economy, and the RBA operates independently of the political process, albeit within clearly agreed goals. A requirement for an official organisation to have a fairly transparent process and to communicate the basis for decisions is part and parcel of operating in a free society. Yet sometimes the discussion about monetary policy proceeds as if there is a degree of mystery about the process, and it has to be admitted that in times past, central bankers cultivated this to some extent. What I have tried to do today is to de-mystify the process, and show that it involves what most people would expect: it examines data and evaluates competing hypotheses about the economy’s current and likely future performance. With due consideration for the uncertainty surrounding these assessments, it tries to develop a sense of the balance of risks, so as to provide a basis for coming to an informed decision on interest rates each month. The analysis comes into public view on a regular basis through the published Statements, and is based overwhelmingly on data which is known to everyone. All of this is in the context of a framework for monetary policy – a medium-term inflation target – which is I think well understood. You may, as I suspected at the outset, have found all of this terribly dull. If so, I have achieved my objective of making clear that the process is what common sense would expect, with no mystery. No one would claim that all our processes are perfect. We are always, of course, on the lookout for ways of improving them. I’m sure you will have plenty of suggestions in the question time. | reserve bank of australia | 2,001 | 10 |
Talk by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Australian National University Conference on Regional Financial Arrangements in East Asia, Canberra, 12?13 November 2001. | Stephen Grenville: Policy dialogue in East Asia What are the criteria for determining the number of groups for policy dialogue in East Asia? And the criteria for participation? Talk by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Australian National University Conference on Regional Financial Arrangements in East Asia, Canberra, 12-13 November 2001. The references for the speech can be found on the Reserve Bank of Australia’s website. * * * I want to begin by clarifying the issues, as I see them. If we can define what we are trying to achieve with regional co-operation, then we will be in a better position to determine the nature of the regional groupings needed to achieve this. My brief today is to discuss the relevant criteria for groups which carry out a policy dialogue in East Asia. In defining the area of interest, I may widen this brief somewhat, because the sort of regionalism which I hope will develop over time goes well beyond policy dialogue, and indeed policy dialogue in its narrow sense does not seem to me to be the most pressing need. Policy dialogue, as it evolved in the post-War period, was largely about macro-economic policy co-ordination, and this was really only relevant for the largest countries – essentially the G3. For the rest of us, this was not a case of policy dialogue, but rather monologue – the G3 did what they could in terms of international co-ordination, and we wore the results, principally in the form of substantial fluctuation in the G3 exchange rates, which was often inconvenient to many. So there certainly remains a major issue of international macro policy co-ordination, and perhaps we might hope to have some input to it from the periphery, but this will not be central to our regional arrangements. There are, however, important areas where regional arrangements have the potential to be very important for the development of policy: these are trade and (less certain) exchange rate arrangements. The first of these seems beyond the scope and brief of this paper, so I will leave it untouched: the second is the focus of discussions tomorrow, so that, too, I leave to others. This still leaves important regional policy issues, including the possibility of policy co-ordination in the face of a repeat - or variation - of the 1997/98 Asian crisis - I will certainly talk about this. But the much more general, wider and perhaps more important issue relates to globalisation – how to maintain the momentum which has brought so much benefit (particularly to this region); how to make it work better with better rules; and how to get proper representation for our interests in the forums which determine the parameters – the “rules of the game” – for globalisation. This, in my view, should be a central focus of regional policy dialogue. With this general introduction, let me turn to the specifics of what different functions regional cooperation might serve, grouped under the two omnibus headings of “policy co-ordination” and “globalisation”. Policy co-ordination Having downplayed the centrality of macro policy co-ordination in my introduction, let me now try to be more specific about where a degree of policy co–ordination will still be important. I have left aside trade and exchange rates, acknowledging the importance of each of these. But beyond these, I do not see a compelling reason why, say, the countries of Asia should be running similar monetary or fiscal policies, or even why they should co-ordinate their different macro policies. The heavy-lifting of macro policy-making is, broadly speaking, a domestic matter. I have argued that there is only a minor role for international macro policy co-ordination (and this largely confined to the G3). But as international interdependence increases, the need to know and understand what is happening in the world economy increases. The current international conjuncture is perhaps more coincident in its cyclical shape than would be imposed on it by globalisation as such – the coincidence of downturns in the G3 is, to a large extent, idiosyncratic. But there can be little doubt that the international linkages are much stronger than ten years ago, and in all probability will be much stronger still in ten years' time. For all of us, an ability to forecast how the rest of the world is moving will be critical to our own policy-making. There is, however, one aspect of policy-making where regional co-operation might make a real and substantial contribution – i.e. surveillance. Surveillance is, perhaps, an unfortunate way of describing the process, because it has connotations of checking up and looking over the shoulder of policy-making in individual countries, i.e. something more intrusive than is generally acceptable in this region. When does “peer pressure” become interference? The principal objective of surveillance should not be to “catch out” and expose any policymakers who are doing the wrong thing, but rather to act as an advocate of good policies and as a catalyst for reform: the context has to be positive and supportive, not negative, proselytising, and adversarial. Reluctance to be too assertive is, to some degree, the current characteristic, but the process needs to be given more content if surveillance is to have a beneficial effect. Perhaps I can explain the point more clearly by referring to the surveillance process as it occurs in the OECD, and in particular as it occurred in relation to Australia during the 1980s. Each year we faced the interrogation of our peers (the OECD Secretariat and two “examining” countries), who quizzed us on both macro and micro policies, invariably from the viewpoint of hard-edged economic analysis. This is not to say that they were always right, but they were always putting forward the viewpoint and input of best-practice economics. Why was this so valuable to the policy-making process? It made it easier for the national bureaucrats (who, by-and-large, agreed with these policies) to get these policies implemented, within a diverse decision-making framework in which other less-economically-rational views might well have prevailed. The fact that these surveillance examinations received quite wide publicity and added spice and fire to the policy debate was often inconvenient at the time (because we bureaucrats had to defend the then-current – imperfect – policies), but was almost always salutary and useful in moving us towards better policies. The additional area where policy co-ordination may well be relevant is in crisis response. Other sessions at this conference will be looking at this issue in more detail. Specifically, the main area of co-operation here will be in the pooling of foreign exchange reserves. Building up large foreign exchange reserves has been the clearly demonstrated response to the crisis: faute de mieux, international capital flow volatility will be handled by substantial reserve-holding. This rather inefficient response can be made less inefficient by pooling. It is also true that regional groups share enough self-interest to encourage them to go beyond simple altruism: we are all going to be readier to help our neighbours than to participate in some kind of collective action for a more distant region (which argues for regional arrangements to supplement the IMF, rather than the more universal approach of the New Arrangements to Borrow). Rather than anticipate the later debate on this issue here, let me quote, with approval, Yung Chul Park (2000): “One development that has encouraged the regional cooperation in East Asia has been the slow progress of the reform of the international financial system. The urgency of reform in the G-7 countries has receded considerably with the rapid recovery of East Asia. … As long as the structural problems on the supply side of capital are not addressed, the East Asian countries will remain as vulnerable to future crises as they were before. Instead of waiting until the G-7 creates a new architecture, whose effectiveness is at best questionable, it would be in the interest of East Asia to work together to create their own system of defence.”. Globalisation As I foreshadowed, my feeling is that the issues of globalisation are even more important to regional co-operation than is policy co-ordination. Let me record briefly some of the characteristics of globalisation, to try to establish why policy must be attuned to the needs of this new globalised world, in order to foster globalisation and – at the same time – ensure that we all get maximum benefit from it. First, a point which is close to tautology, but full of policy implication nevertheless: globalisation means that an increasing part of our economic relations are with external parties (for many of the East Asian economies, foreign trade (exports and imports taken together) far exceeds GDP. As Dobson (2001, p. 26) observes: “Peers must be willing to supply constructive criticism and those in potential or actual difficulty must be willing to accept objective analysis. Unless governments are willing to enter into this kind of give and take, the regional mechanism will simply become another overlay of officialdom.” Foreign Trade (per cent to GDP) Australia China Hong Kong Indonesia Japan Korea Malaysia New Zealand Philippines Singapore Thailand United States Domestic trade and investment is subject to myriad controls and regulations, even in the most “free market” economies. In contrast, international relations are lightly regulated. “The dilemma we face as we enter the 21st Century is that markets are striving to become global while the institutions needed to support them remain by and large national.” (Rodrik - quoted in The Economist, 29 September 2001, page 19 of 'A survey of globalisation'). Is this disparity in regulatory density reflecting some innate characteristic – that these relationships are, say, simpler – or does it reflect the greater difficulty of regulating across sovereign borders? It seems to me to be the latter, and we should address this deficiency. The need for “rules of the game” seems, if anything, to be greater in a globalised world than in a less integrated world. One of the defining characteristics of globalisation is the importance of scale, as technology drives the optimal business units larger and larger in a number of important areas. The other defining characteristic is “winner takes all”, and its related concept of “first mover advantage”. These characteristics combine together to produce areas where monopoly or quasi-monopoly will be important. The old response to monopoly – to break it up and force competition – will be precluded or restricted because of the inefficiencies that would result from this action. So the alternative channel will be to achieve a network of rules which addresses the issues raised by these imperfectly competitive firms. Given the increasingly international nature of enterprise, what is needed to complement this development are international rules, not specific to any one country, but developed in a uniform way and acceptable to all. These would address issues such as monopoly, intellectual property rights, and legal issues. Prudential supervision, capital flows, taxes and “industry policy” may also be suitable cases for treatment. In short, as closer relations impose greater need for uniformity (e.g. in tax or investment regimes), the need is to develop these in a collective international environment. Tom Friedman (1999) has called such rules the “Golden Straitjacket”, which captures two important characteristics of the process – the degree of uniformity which globalisation will impose; and the generally beneficial nature of these rules. Rules to govern global relationships will generally need to be on a uniform multinational basis, but this does not preclude the need for important regional input, in order to ensure the applicability of the universal rules to all countries. A good set of rules requires recognition of the great diversity of circumstances and institutions between countries. One specific example here is the rules on prudential supervision. It seems quite likely that the rules relevant to banks in this region would be somewhat It would be easy to exaggerate just how universal and all-encompassing the Golden Straitjacket may be. It does not seem true, for example, that tax rates will have to become uniform across countries. different (reflecting the different degree of complexity and make-up of banks). We certainly would not want a set of international rules which unfairly penalised banks in this region, simply on the grounds that they were not the same as banks in London or New York. At the general level, the collective wisdom of worldwide experience needs to be incorporated into the Golden Straitjacket more effectively than it has been to date. It is now part of the conventional wisdom that there were various deficiencies of perception and analysis in the international response to the Asian financial crisis. The “one size fits all” approach came out of earlier Latin American experience, and was a poor fit for East Asia in 1997. To some extent these deficiencies were driven either by inadequate representation, or by inability to have our voice heard above the confident assertions of those whose policy prescription was driven either by doctrinal interests, vested interests, or sometimes simple ignorance. Regional groupings are the principal way of addressing this “democratic deficit”. There seems little room for debate that this region is inadequately represented in many of the forums which determine the important issues of globalisation. There seems little doubt, also, that the region pays a price for this. East Asia, with an IMF quota of less than 15 per cent, accounts for more than 20 per cent of world GDP, almost a quarter of world trade, and almost half of world foreign exchange reserves. Prominent American economist David Hale (2001, p. 8) has observed: “In the past, the U.S. government has only supported major (IMF) interventions for countries in which the U.S. had a military base. During the Asia crisis, for example, the U.S. acted aggressively to support Korea, but played a much less significant role in Thailand and Indonesia.”. The case I want to make here is that much of our efforts in regional groups should be directed towards correcting this. There have been very important improvements in international financial architecture since the crisis. The IMF has added new lending facilities that should be better able to handle the demands of capital account crises. The Fund has also started to pay greater attention in its work to financial markets and financial systems and has been critically examining both its policy prescriptions and its general approach to conditionality. Representation has greatly improved, with an additional eight Asian countries gaining membership of the BIS. The creation of G20 (with six Asian members) is, potentially, a good breakthrough. At a more detailed level, the negotiation of Basel II involved a degree of consultation entirely missing from Basel I (which had been tailored specifically for G10). There has been a push from the FSF, the IMF and the G20 to improve countries' resilience to crises by promoting adherence to standards and codes and there has been much discussion of ways to secure a greater role for the private sector in crisis prevention and resolution. Within central banking circles, there had been some support for the formation of an Asian BIS given the Eurocentric focus of the existing organisation. In the event, this has been satisfied by the settingup of a BIS office in Hong Kong and the creation of the Asian Consultative Council (ACC) of the BIS, which will give Asian central banks a greater say in the operation of the organisation. Some Asian countries have also been invited to attend some of the Basel/G10 committees associated with the BIS, although sadly not on a permanent full-member basis. But the issue of ensuring that our voice is heard remains unresolved, with the IMF still giving inadequate place to this region, and other more representative groups (such as the G20) still to find a role for themselves in a world which is crowded with competing and overlapping institutions, none ready to diminish their own status and power, and many governed by inadequately representative views. Who should be represented in the councils of the world? This should not simply depend on GDP – this is important, but an equally important issue is what contribution each participant can make to the debate, and to the production of a universally acceptable set of rules. To be more specific, the G10 representation is deficient not just because of its limited numbers, but because of the uniformity of view of its European-dominated membership – too many people with the same viewpoint. The development of the Globalisation Rules should be a two-way process – the regional groups give input into the rule-making, and then act to put these rules in place in their individual countries (or at least adapt their own rules to fit the straitjacket). The regional groups “spread the word” in order to improve policy. This is closely related to the idea that policy improvement can come out of the surveillance process, but it adds the extra point that better policy can also come out of a process of swapping ideas and simply observing the way other countries go about doing things. The process of globalisation is forcing a degree of uniformity or similarity on policies, and to the extent that this is “best practice”, the quicker we all adapt to it the better. For more discussion of the role and rationale for regional arrangements, see Grenville (1998). What does this mean for the shape of regional arrangements? As a preliminary to these issues, we need to note that international dialogue takes place at the multilateral, regional and bilateral levels. We should not be surprised or concerned at this “layering”. Nor should we be overly concerned if there is a fair degree of overlap between groups and meetings. If an issue is important, then it probably needs to be discussed in a variety of forums, each of which will bring different insights to bear. Checks and balances are important. Groups are not simply about getting together to make decisions: they are often about getting together in order to learn about decisions or discussions which have taken place elsewhere. So we should not be surprised to see, for example, Finance Ministers meeting together separately from Central Bankers, and then, separately, the two will meet collectively. We certainly should not allow some ill-defined principle of “territorial exclusivity” to constrain dialogue which would otherwise be useful. When the Asian Monetary Fund was proposed after the onset of the Asian crisis, some people argued that it would overlap with the IMF (and this no doubt coloured the views not only of the Fund itself, but those who had a more prominent position within the Fund than they would have had within an Asian Monetary Fund). We should recall that, in many countries, there are three levels of government, each with its own contribution to make, and each interacting with the others in ways that should be fruitful – passing up regional issues which have been digested (in the sense of having achieved a degree of consensus), and passing down more nation-wide macro views to the regional levels. Petty territorial jealousies have no place in working out the proper number of organisations and their relationships: the issues should relate to bringing together groups with commonality of interest, and ensuring that they are linked (both upwards and downwards) in fruitful ways. This commonality of interest is the most important criterion for useful interaction. This does not mean that all the participants have to be at the same stage of development, but it probably does mean that they should be travelling along much the same path, albeit at different distances and speeds along that path. This commonality of interest allows the possibility of an effective consensus, which can be passed to the next level, representing the group as a whole. What are the right numbers for a group? If the issues revolved around trade or currency unions, then economic analysis can offer useful guidance on which countries should be included. Who are (or potentially could be) good trade partners? What countries meet the criteria for an optimal currency area? The original APEC membership, for example, makes economic sense as a trading group because of established trading ties. But we have suggested here that some fruitful dialogue is more general and nebulous. At one level, one might ask whether it matters: the membership of European single currency was indeterminate until the last minute - it turned out to be much more numerous than most people had expected, and looking ahead it will probably become far more numerous than the original proponents envisaged. That said, there seems to be a lot to be said for keeping numbers down to manageable levels, which for practical purposes might be defined in terms of how many people can comfortably sit around the same table (I am tempted to add “and communicate with each other without the use of microphones”). What we know is that when we get to the size of universal “one country one vote” representation (as seen in the UN), effective decision-making becomes extraordinarily difficult and “lowest common denominator” outcomes often prevail. To give a concrete example of a response to the vexed issue of numbers: the G20 was, at one stage in its evolution, rather larger, but it was recognised that it had to be contracted. For surveillance, the relevant point will be that smaller groups can have much more candid (and therefore useful) discussion than can larger groups. “Small may well be beautiful”. If, over time, the various participants develop knowledge, empathy and understanding of the practical policy constraints, then so much the better. When it comes to the task of developing rules (see the discussion above on globalisation), the important thing is for the rules to be developed by experts or technicians – those who know the nuts and bolts of a particular issue rather than the arm-waving generalists. If the degree of detail in domestic rules and regulations is any indication of what it takes to ensure good and efficient commerce within countries, why should international dealings require less complexity? These rules may well be the same ones which apply in domestic jurisdictions, but it is only the technicians who can give an accurate reading on whether this is appropriate or not. When compromise is needed, the compromise will be on the basis of technical and expert issues, and not on the basis of voting power at the table. See Garnaut (1993, p. 308). Two historical analogies The obvious model for policy co-ordination in the broad sense is Europe, which over a period of four decades has progressed to economic union despite a history of hostile relations between members. Europe's success can be attributed to two main factors. Firstly, the economic dynamic: exploiting the obvious economic advantages which follow from geographic proximity. A second important factor in Europe's success was the underlying political imperative – a firmly held view on the part of a number of politicians of the need to pursue greater integration so as to reduce the prospects of future conflict. This was actively supported by the United States. The G10 had a much more specific genesis, formed from the countries that agreed to provide a loan facility to back up the IMF's resources in 1962. These resources were to be made available in the event of potential impairment of the international financial system, and therefore only to the G10 countries themselves. Over the intervening years, the G10 has come to be central to issues governing the world financial system, both in the context of the IMF and the BIS. The enormously influential Basel Rules for Prudential Supervision were developed by (and, initially, for) the restricted club of the G10. The point to emphasise here is that groups which form for one purpose can metamorphose into new functions – in this case, far more important than the initial function. (We note that the G10 is also an illustration of why it is important to gain a seat at the table from the outset, since the incumbent members – particularly the smaller ones – will try to avoid having their power diluted.) The group's effectiveness over an extended period probably reflects a relatively small and focused membership. However, as the world has developed, the G10 has looked increasingly unrepresentative of the global economy, giving a disproportionate say to small European economies and no say to the rapidly developing countries of Asia and Latin America. A couple of lessons might be drawn from the historic experience: • groups need specific tasks to weld them together – “frank and fruitful exchanges of views” are good but not enough. The Europeans started with the Coal and Steel Community: i.e. something of real substance; • patience is not just a virtue: it is a necessity in a world where it takes time to build institutions. Progress is not steady: it may stall for a time, and the group has to hold together waiting for the tide to turn; • there is a sense of community and common interest stemming from geographic contiguity, which goes beyond simple economic linkages. If progress towards closer international relations is important, then institution building will be an important element. “Virtual” secretariats may have their place, but real bricks-and-mortar institutions, with effective and active secretariats, will be needed. Charles Wyplosz (2001) makes a compelling case that the progress of European integration was hugely assisted by the presence of Europe-wide institutions, which could provide some on-going momentum and in particular could “pull a plan out of the drawer” when the country representatives were ready to discuss the next step. It is only if there are bureaucrats with an on-going vested interest in pushing forward that such plans will be ready – waiting in the “bottom drawer” – to put on the table when circumstances are propitious. How well do current groups “fit”? In the detailed discussion here, I have put to one side the issues of trade and exchange rate coordination. But now, when we turn to see how the existing regional institutions meet these needs, we should put the full range of regional arrangements on the table. • APEC is the broadest regional grouping, bridging, most importantly, East Asia and North America, but also incorporating the likes of Chile, Mexico and Russia. Its predominantly trade focus has seen its fortunes wax and wane with developments in global trade, although the addition of Finance Ministers' and Leaders' meetings have broadened its coverage. Its principal achievement to date has been the Bogor Declaration under which developed countries agreed to strive for free trade and investment by 2010 and developing countries by 2020. However, even this has shown the tensions inherent with a relatively disparate group, with initial calls by some countries for a binding and measurable process significantly watered down. The Finance Ministers' process has focused on encouraging regional dialogue and promoting capacity building and may not be suited to a more substantive agenda, particularly given political tensions between China and Taiwan. • The Manila Framework Group has a broadly similar East Asian-North American structure. It had its genesis in the push for an Asian Monetary Fund in the midst of the Asian crisis. It is seen as proving one of the better surveillance mechanisms among the regional groups and also takes an interest in global architecture issues. It could be (but is not yet) the forum for developing regional positions which are then taken to world forums such as IMFC and G20. One of its main initial functions was to provide a co-operative financing arrangement to supplement IMF resources. This was initially reflected in the second line of defence facilities offered to Indonesia and Korea. More recently the idea has been revived, with discussions underway on the possibility of a more formal on-going arrangement. • EMEAP is a narrower group in two senses. It is a purely central bank forum, drawn from the East Asian core of the above two groups. EMEAP's stated goal has been to strengthen the co-operative relationship among the central banks of the region, although various members have held ambitions of the group becoming a more substantial organisation, along the lines of the BIS. The furthest EMEAP has moved down this track is a system of bilateral repurchase agreements over US Treasuries, to provide short-term foreign currency liquidity support. EMEAP's strength is its specialist working groups, which promote good practices and better understanding at a technical level. This is, potentially, the forum for developing regional consensus on such issues as capital flows (Chilean-style inflow taxes: dealing with in extremis crisis resolution). The value of the forum at the highest level is now being tested by the formation of the BIS Asian Consultative Council, which has drawn Asian countries more into the mainstream of BIS activities. This is already the forum for developing regional positions on financial issues, so the close link with the BIS is natural and logical. • Compared with other regional groups, there is perhaps a greater uniformity of interests and views within ASEAN, and it has been going longest. ASEAN has some runs on the board already with the ASEAN Free Trade Area (which has been strengthened since the crisis) and a multilateral foreign currency swap arrangement. More recently, ASEAN has set up a surveillance mechanism, with the assistance of the ADB, in an effort to foresee and forestall crises. • The broad agenda of ASEAN+3 covers economic, social and political fields. However, its most important achievement has been the Chiang Mai initiative, which incorporates, among other things, a regional financing arrangement (building on the ASEAN arrangements) to supplement existing international facilities. The significant momentum in ASEAN+3 may reflect East Asia's equivalent to Europe's “integrate to avoid further conflict” imperative. There is also a strong belief that the international institutions are not set up to work in Asia's favour and that Asia must therefore look after itself – particularly given the large proportion of world reserves held in Asia. This has been felt very strongly since the Asian crisis and it is no co-incidence that the Chiang Mai initiative grew around those countries that felt most aggrieved. Similarly, countries in this group have more in common than the groups that bridge the Pacific. It could also be argued that the size of the arrangement made it a more workable decisionmaking entity, although it is difficult to determine whether this reflects physical numbers or simply the greater uniformity of country interests embodied in the group. Reserve pooling arrangements could have occurred within the Manila Framework Group or EMEAP, but ASEAN+3 seems to be where the action is at present. Just as G10 gravitated from its original narrow specific purpose to become the centre of prudential supervision, ASEAN+3 might be where the more general foreign exchange rate discussions occur. For our part in Australia, we are supportive of these moves, regardless of the forum in which they evolve. Obviously, we would like to have a seat at the table, since we believe Australia has much to offer from its own experience and resources. We also feel our own policy-making has been enriched through our engagement with Asia and we have certainly appreciated the input of like-minded countries from the region in the difficult international debates of recent years. SEACEN is a longstanding grouping of central bankers, focused on South-East Asia, but with membership spread as wide as Sri Lanka, Korea and Mongolia. One of the initial aims of SEACEN was to establish an ASEAN voting group for the IMF and the IBRD. The voting group still exists and SEACEN Governors continue to meet annually, although SEACEN's significant outward contribution appears to be its training and research efforts through the SEACEN Centre. Should the Chiang Mai initiative continue to develop towards an ultimate goal of becoming a regional monetary fund, my view is that we should support it. If there were major developments in this regard, participants presumably would want to assess whether the Manila Framework Group, the APEC Finance Ministers, EMEAP and SEACEN are still playing a unique role. The bottom line is that it is probably too early to assess which groups will continue to play a useful role, given uncertainty over a future world trade round, G20's unformed mandate, and the future directions of ASEAN+3. We should, nonetheless, be critically watching developments among the regional groupings over the next two to three years with a view to making tough decisions when the time is right. Conclusion I have tried to make the case, here, that the rationale for regional groupings will not be to achieve macro policy co-ordination. The powerful case is a wider one – we have a commonality of interest because geography and contiguity still matter, even in a world of globalisation (or even more than before). It is part of a more general view that “we are not alone”. We can learn much from the experience of those around us, and the gaining of this experience is the often nebulous and formless process of talking issues through with people of common interests. We meet to discuss a specific topic, and we end up with wider knowledge, and better general understanding, of each other. If this view is correct, then regional dialogue is not inimical to globalisation: it is, in fact, its hand-maiden and ally. | reserve bank of australia | 2,001 | 11 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to CEDA Economic and Political Outlook Conference, Adelaide, 18 February 2002. | Glenn Stevens: The economic outlook in 2002 Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to CEDA Economic and Political Outlook Conference, Adelaide, 18 February 2002. * * * It is a pleasure to be invited to speak to CEDA’s Economic and Political Outlook in Adelaide. I have taken part in CEDA functions at this time of the year in other cities, but it is particularly nice to come to Adelaide. I would like to note at the outset, for the benefit of the local audience, that the Bank has undertaken a considerable increase in the resources put into "on the ground" economic intelligence around the country. During 2001, we established Regional Offices in Victoria, Western Australia and Queensland. In those States, the Bank’s branches had earlier been closed because their original functions – banking and registry operations, currency distribution – were either no longer demanded by customers or had been overtaken by improved technology. The purpose of the Offices is to retain some RBA presence and, more fundamentally, to gather information about local economic conditions. In South Australia, of course, the Bank still has a presence in the form of a Branch operation which conducts banking business for the South Australian Government. So as part of the process of strengthening our liaison effort, during last year we re-positioned one of our economists from Head Office to the Adelaide Branch. The local staff are in continual contact with the Economic Group in Head Office and they take an active part in the assessment of the economy in the preparation for the monthly Board meetings. We have found the information gathered at the local level to be extremely helpful and are very grateful for the way businesses, government departments and agencies and other groups have responded to our questions. The South Australian economy has turned in a reasonably strong performance over the past year, with growth in household demand running above the national average. In common with some of the other States, South Australia’s export exposure no doubt means that businesses here will be keeping a watchful eye on events abroad. Equally, the apparent intention of the mining sector to begin raising its capital spending, according to the available surveys, will probably be good for South Australia. I do not intend to attempt a detailed analysis of local economic conditions. Instead, most of my remarks will be about the global and national scenes. The world economy presents no fewer sources of uncertainty, and hence no less potential for surprises, than it has for a number of years now, though from the perspective of the international business cycle, there are some quite encouraging signs at present of a turning point. In Australia, the economy has clearly coped with the international downturn pretty well so far, and there are good reasons for confidence about its performance over the coming year. As it happens, the Bank has just published a Statement on Monetary Policy, containing our comprehensive analysis of the international and Australian economies. My task today is to elaborate some of the themes in that document, rather than to bring any new messages. The US business cycle On 26 November 2001, the US National Bureau of Economic Research announced that, according to the methodology they use for dating business cycles, the US economy had reached the end of a decade-long expansion in March 2001, after which it had been in a period of contraction. That pronouncement effectively ended the debate about whether there would or would not be a recession – defined by the NBER as “a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade”. One had apparently been under way for eight months. It is not that unusual, by the way, for such classifications of recession and expansion to lag the actual event by a good few months. In fact, it is not unknown for a recession to be actually finished by the time the data make it clear that one had begun (though the fact that it had finished was itself, of course, not known until later). This was the case in the early-1990s recession in the United States. Note also that there have not, as yet anyway, been two consecutive quarters of declining GDP in the United States – the definition of "technical" recession so beloved of the headline writers. Debate quickly moved on, focusing briefly on the role of the September 11 events affecting the economy. Clearly, those events did not cause the recession. All the dynamics typically associated with a contraction in output were in train prior to mid September – otherwise the NBER would not have been able to decide by November that there was a recession under way. Moreover, the direct impact of the attacks themselves was, despite the horrifying images, not all that large on the US economy. Arguably, though, they came at a time when the US economy was already contracting and accelerated the adjustments by businesses to the underlying reality which was emerging. Certainly, the event was a watershed for commentators. Those voices saying there would not be a recession went quiet immediately, some weeks before the NBER’s pronouncement. But a business cycle contraction was definitely under way prior to September 11. The NBER’s statement was only 12 weeks ago. Between late November and today, many observers have begun talking about a US recovery. Financial market prices reflected this change relatively early on, as they tend to do. Share markets rallied strongly through the last weeks of 2001 and into the early part of this year, though the shine has come off a little since then. Bond markets pushed up long-term interest rates somewhat, and credit spreads for corporate bonds have tended to decline. Forecasts of economic growth in the United States appear to have stopped falling, and the latest actual figure for GDP, while weak in an absolute sense, was stronger than most had expected, and much stronger than many feared in the early days after September 11. To no small extent, this reflects the fact that the underlying US economy weathered the impact of the terrorist attacks themselves very well. Post-attack, the financial system was up and running again very quickly, especially given the destruction of physical infrastructure at the heart of the system. And while American corporations have cut their investment spending very sharply indeed, households have continued to increase their spending on consumer goods and services. Macroeconomic policy has been supportive, with a tax cut affecting household incomes during the second half of 2001 – right when it was most needed – and a very rapid easing of monetary policy beginning in early January 2001, and continuing with force right through the year. In fact, if one were to adopt the view that a recession began last March and, noting that recessions typically (if there is a typical recession) last about a year, to set about looking for signs that an upturn might be near, one would find some evidence in the real economy to support that view. Inventory adjustment, part of the classical business cycle story – and very much a part of this recession in the "new economy", especially in the production of IT goods themselves – began quite early, and is by now well advanced. The adjustment to investment spending has been quick. Signs of a bottoming in parts of the tech sector have begun to emerge. The adjustment to business payrolls may also have gone a long way towards completion, judging by recent labour market data. So an analysis of the normal business-cycle dynamics does increasingly suggest that the US economy could well begin a new expansion soon. If it does, the US recession would have been no deeper, and probably shallower, than the one in 1990–91, which was the mildest recession in the past three decades. Such an outcome is by no means yet assured, and it is entirely possible that there will be setbacks, and associated fluctuations in sentiment. Those inclined to a pessimistic view would, of course, point to some other features of the US economy which I have not, as yet, mentioned. It seems likely, for example, that there was excessive investment in certain areas during the height of the euphoria over returns to information technology. Even though new investment has been slashed, an overhang of past investment might remain – and hence scope for an early return to rising business investment spending may be limited, though this depends on the speed with which equipment becomes obsolete, which is much higher for ITC-type investment than for, say, buildings. To the extent that a good deal of the investment was simply "wasted", there is presumably not much overhang – but in that case the question is whether the full extent of the lost wealth entailed is yet apparent. We could also add that the true state of corporate balance sheets is more uncertain in general, as highlighted by the recent revelations of accounting irregularities in some high-profile US firms, and that American share valuations still seem high by historical standards, supported by exceptionally strong forecasts of earnings growth. Households have expanded spending beyond the rise in their income over the past year – indeed they have done so over a number of years. That can be sustained only for so long, especially given more subdued gains in wealth. Can the household sector keep the US economy ticking over while the business sector sorts itself out? Or will the loss of wage income resulting from the higher unemployment dampen consumers’ enthusiasm? Opinions on these and other uncertainties differ. The weight of opinion has, I think rightly, become more optimistic lately, but the pessimists who doubt that a recession can be over so quickly are not without their reasons. Even some of those who are relatively optimistic might concede that factors such as these may well mean that the rate of expansion is initially relatively modest, and certainly slower than the growth seen in the late 1990s. Other areas of the world economy What of other regions? I think we can see evidence in a number of countries in east Asia that the contraction in industrial production came to an end during the closing months of 2001. These countries were hit very hard by the global tech sector slump during 2000 and 2001, which affected their exports. Some countries which were not badly affected by the Asian crisis in 1997 and 1998, but which have very extensive exposure to technology production, such as Singapore and Taiwan, have suffered much more on this occasion than they did three or four years ago. But for east Asia as a whole, the impact has not been as serious. In contrast to events during the Asian crisis, macroeconomic policies on this occasion have acted in a way which has cushioned, rather than reinforced, the impact of global events. Exchange rates have been allowed to decline, and monetary and fiscal policies have generally been eased. Activity seems to have stabilised recently. Semi-conductor prices have firmed appreciably, having collapsed over the first nine months or so of 2001. As an example of the roller-coaster ride producers in this area have experienced, consider the price of memory modules published by a web-site called DRAMexchange.com. In October 2000, the price quoted for a 128mb SDRAM module was about US$10. By October 2001, it had fallen to US$1. Some of the fall was, no doubt, the decline over the (very short) life span of high-technology components with which we are familiar – driven by productivity improvement and competition. However, much of the fall presumably reflects the cyclical dynamics. Over the past few months, prices have risen to around US$3.50. It is encouraging for the small east Asian countries to see this, and to see hopeful signs of expansion in the United States, which remains such a powerful force driving the business cycle for externally oriented economies. In Europe, growth slowed noticeably in 2001. However, in some surveys one can see very early signs of what should turn out to be an improvement in economic conditions over the year ahead. Japan, unfortunately, is in quite a different position. Japan was affected by the tech sector slump, but it is also afflicted with very powerful forces at work in its domestic economy. Deflating asset prices, associated pressure on corporations and banking sector asset quality, and generalised price deflation in producer prices and even consumer prices, make for a very difficult situation. These dynamics have been in operation for some years, but appear to have intensified over the past year or so. Conventional macroeconomic policies have been pushed to their limits. Structural reform is necessary but will be painful in the short term. While attention has been (understandably) fixed on developments in the United States, the biggest threat to the world economy in terms of the drag on aggregate economic activity may well be Japan. How things will play out there remains extremely uncertain. But overall, barring a sudden and major further intensification of contractionary forces in Japan, there are reasons to think that global economic activity will begin to improve this year. A pretty strong policy stimulus has been applied, led by the United States, in a timely fashion. Global short-term interest rates are unusually low. In addition, the price of oil, which played an important role in producing the slowdown, has fallen substantially over the past year. These two factors, plus the outworking of inventory overhangs, would usually be enough to produce a cyclical upturn. As I have sketched above, we can see evidence beginning to appear which is consistent with that view. For these reasons, as our recent Statement on Monetary Policy made clear, some of the pessimism about the United States, and hence the world economy, that existed a few months ago has waned. The question may soon be, not whether there is an upturn, but how strong and durable it will prove to be. At this stage, that is unclear, and it probably will remain so for a while. Implications for Australia It is well recognised that the Australian economy has been quite resilient in the face of the global recession. Growth through the first three quarters of 2001 ran at an annualised rate of 4 per cent. Even a moderate increase in GDP in the December quarter, which is what most observers expect, would mean that growth through the full year would be of the order of 3½ per cent. That compares well with the growth for the United States of about zero for the same period, and with the outcome for the major countries as a group, which was also about zero. In past periods of global downturn, Australia has rarely outperformed the major countries; historically, our tendency was to have a period of weakness that was, if anything, more pronounced than those of the G7 group. This time it has been different, though not because the global recession has not affected Australia: the impact on exports has become increasingly clear over the past six months or so. The value of exports, which was growing at 25-30 per cent per annum at one point, is little changed now compared with a year ago. The contribution to growth in GDP from net export volumes ran to about 2 percentage points in the year to June 2001, but was negative during the second half of 2001. So two questions can be posed. First, why is it that on this occasion, so far at least, we have done better than on others? And second, will it continue? A lot has been made of the housing upswing which is currently increasing activity and employment in the construction sector and associated parts of manufacturing. It is true that this is helping growth at present, and that it will most likely fade from the middle of the year. But of course it is equally true that we "paid for" this boost with a large contraction – of unprecedented size, in fact – during the second half of 2000. We took a brief but very large housing downturn at a time when the world economy was still doing acceptably well, and then got the benefit of an upswing in housing as the world slowed. The timing of this was not, of course, something over which we had any control. Looking through the ups and downs of the housing sector, it is still the case that the Australian economy has performed better than in other episodes of global recession. This is not to deny that growth has declined – in some underlying sense, stripping out the housing fluctuations, growth might have run at something like 2½ per cent over each of 2000 and 2001. That is noticeably slower than the outcomes for 1998 and 1999 (which were exceptional). But it is still a better performance than those in the US and most other major countries, and better than an extrapolation of historical experience in previous global downturns might have suggested. We should also, of course, keep in mind that the full effects of the global downturn on Australia are probably not yet apparent. Even so, as we begin to get the very early pieces of economic information for 2002, it seems that business and consumer confidence has held up quite well, and there are some signs of improvement in demand for labour. All this is consistent with growth continuing thus far. So the question remains as to why that has occurred. One major factor which has helped has been that few of the problems which have dogged us in past episodes, and hence exacerbated business cycle downturns, have been present on this occasion. The obvious one which a central banker would nominate is inflation, which has increased, but not beyond manageable levels. Core inflation picked up from about 1½ per cent in 1998 and 1999, to about 3¼ per cent, on our reading, in 2001. As I am sure you know, the centre-piece of Australia’s monetary policy regime is an inflation target of 2-3 per cent, on average. This system has been in place since 1993, and has worked well for Australia over that period. It requires the Bank to move our policy instrument so as to keep medium-term inflation outcomes consistent with the target. During 1997 and 1998, inflation was below target. Monetary policy’s response was to ease, seeking interest rates low enough to engender a stronger expansion of aggregate demand in the economy. The intention of this was to allow inflation to increase a little, back up to the target. By the second half of 1999, it was apparent that the period of below-target inflation was drawing to a close. In anticipation of higher inflation, policy began to move interest rates up from unusually low levels to more "normal" levels, a process which continued through to August 2000. During 2001, even as inflation was still increasing, ultimately moving above our target, monetary policy was eased substantially. We felt that the previous tightening phase had done enough to ensure that this rising trend would not persist, and therefore that we had some latitude to offer support to growth in the face of the contractionary shock heading our way from abroad. Even though the recent CPI figure was interpreted by many as a bit on the high side, we still think that the outlook is for inflation to return to target over the next four to six quarters. The reasoning behind that is set out in the Statement. For our purposes here today, the point is that the flexibility to put interest rates down pre-emptively is earned by being prepared to put them up when a rise in inflation is on the cards. Policy has operated in such a fashion. Another imbalance we have managed to avoid on this occasion is excessive investment. Here there is a distinct contrast with the United States, where business investment spending was exceptionally high by historical standards until 2000, and then slumped sharply. It is that item of spending which, more than any other component of aggregate demand, pushed the United States into recession. In Australia, business investment as a share of GDP peaked as far back as 1998, and has gradually declined for three years. While some people might look at this and say that that is a terrible outcome, I tend to look at it and say that it won’t fall further. Indeed, with investment at historically low levels, a rise is more likely than a fall in the next couple of years. The forward-looking data provided by the ABS survey say the same thing. To the above we could add that the Australian share market was never characterised by the extent of excesses seen elsewhere, and that household and corporate balance sheets are, by and large, in pretty good shape – though households are now carrying a good deal more debt than they did in the past. Prior financial excesses would be highly likely to play a part in worsening any downturn if and when it occurred; having avoided the worst of such excesses is a big help. We can further add that fiscal policy expansion during 2000 was remarkably well-timed from the perspective of stabilising the business cycle. Yet another factor is that Australia’s terms of trade have not slumped in the way they have so often done in the past; indeed, until quite recently the terms of trade had been rising. This is of some importance in that it supports domestic incomes, at a point in the cycle when, historically, those incomes have been reduced by global price developments. Then there is the exchange rate. The decline in the currency in the first half of 2000 was not well explained at the time, but there is no doubt it has conferred an advantage on Australian producers of tradeable goods and services. There is, however, more to the exchange rate story than that. A floating exchange rate system means that an adverse change in capital markets’ sentiment towards the country is not automatically reflected in tighter domestic financial conditions: the exchange rate can take at least some of the adjustment. That means that domestic demand is not crunched because of pressure on the currency. This particular piece of our economic structure helps the economy adapt to shocks in international capital markets more effectively than the alternative, of a fixed exchange rate, would allow. That flexibility is not without limit, of course, and needs to be complemented by an effective monetary policy strategy to provide an anchor for the system – which is where inflation targeting comes in. So a number of factors have assisted the economy in coping with the external shock. Can this good performance continue? To state the obvious, it depends how long the international economy remains weak. No economy can remain insulated from global problems indefinitely. But if the consensus view of global growth – that things will begin to improve as 2002 progresses – is correct, then Australia’s prospects are pretty good. The general effects of low interest rates will still be filtering through the economy for some time yet. Prospects for an upswing in business investment would be good in this scenario, which would help to counteract the impact on domestic demand of a waning in the housing cycle. The good growth seen in 2001 will help to put a floor under the labour market, and in due course, improved conditions abroad would offer better prospects for exporters. This does not rule out a temporary weak period for Australian growth at some point during this year, but if the world economy is improving, macroeconomic policies are supporting growth and investment is beginning an upswing, it would be unlikely that activity would fall away very sharply or for long. None of this is assured, in large part because the global recovery itself, while apparently more likely than it was, is no sure thing. But then nothing is ever assured. What appears to have changed in recent months is that the balance of risks to global growth and to the Australian economy is no longer "tilted to the downside", in the way it was. It is still possible to conceive of a weaker outcome than the consensus expects – but for the first time in over a year, it is also just possible to conceive of the possibility that things could be stronger than generally expected. Conclusion The year 2001 saw a major change in perceptions about the health of the world economy, with recessions or near-recessions in several major countries. As of early 2002, it appears that the point of deepest gloom is behind us, and that people are starting to think about the shape of a renewed period of expansion which will probably get under way this year. This improvement is not assured and there could be setbacks. But the position we are in now is, in most respects, decidedly preferable to that of a year ago. For Australia, this is good news, even though the benefits of it will show up with a lag. The economy has held up quite well in the face of international weakness, and it should continue to do so, for some time at least. If the recent hopeful signs of a global pick-up do turn into a sustained period of expansion, even if only at a moderate pace, Australia will be well placed to continue turning in good macroeconomic outcomes over the slightly longer term. | reserve bank of australia | 2,002 | 2 |
Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Industry Group 'Economy 2002 - Forecasting Industry Prospects', Sydney, 6 March 2002. | Glenn Stevens: Economic performance and issues in 2002 Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Industry Group "Economy 2002 - Forecasting Industry Prospects", Sydney, 6 March 2002. * * * Thank you to the Australian Industry Group for an invitation to return to your annual conference. It is a pleasure to be here. Since this is my third appearance here, I thought it might be useful to give a brief history of the past couple of years as a prelude to making some observations about the current state of things, and about some of the issues for the year ahead. The world economy As we all know, the year 2000 was a strong year for global growth. In that year, world GDP rose by almost 5 per cent, and growth in the major countries (the G7) ran at about 3½ per cent. This was led by the US, which enjoyed a very strong performance through the second half of the 1990s, though the growth was not confined to the US, and a number of countries did quite well, including, in particular, Australia. The Asian region generally recovered from the crisis of 1997 and 1998, with several countries riding the global boom in spending on information technology. Japan was perhaps the most conspicuous exception, with a very weak performance overall through most of the 1990s – which held down the G7 aggregate mentioned above quite noticeably. But towards the end of 2000, it began to become clear that a slowing in the US economy, which had been talked about, but not seen, for several years, was finally beginning to occur. At that time, expectations were for lower growth in the major economies in 2001 than in the preceding year, but still for growth at about average rates. Then, in the early months of 2001, assessments of the health of the US economy, and by extension much of the rest of the world, were revised dramatically. For those who closely watch the US economy, the bell was rung in early January last year, with a reduction in interest rates by the Federal Reserve, undertaken in between their normally scheduled meetings. That was to be followed by a sequence of policy changes which were aggressive compared with the experience of the preceding decade. When we met here about a year ago, then, we were in a period in which expectations were moving quickly, both about the international scene and about the Australian economy. Perceptions about the world economy were to worsen noticeably in the subsequent months. Those about the Australian economy worsened as well, though not as far, or for as long, as those abroad. It is reasonable to claim that sentiment about the Australian economy reached a low point around March-April last year. Since then, perceptions have improved, reflecting the actual course of the economy, which has held up well given the global downturn. Talk of recession in America began to grow, though there was vigorous debate about that for some time. By June 2001, the manufacturing sector of the US economy had been contracting for about a year. The exceptionally strong growth in demand for ITC products initially disguised the weakness more broadly in manufacturing, but that strength itself faded during 2001. Employment began to fall. There was active debate about whether all of this constituted a "recession" in the normal sense of that word. Then the events of 11 September 2001 occurred, and ended that debate pretty quickly. Pessimists and optimists alike revised down their assessments of growth and worried about the possibility of a much more pronounced and long-lasting contraction in the US economy. To date, however, such fears have not been borne out. It is true that there was an initial shock to confidence in the US. It is also true that the long-term responses to the terrorist events could well be of considerable importance for economic performance. Higher costs of security and insurance will have to be borne. Ways in which businesses organise themselves, in both the goods and service producing sectors in the US, may well change. On top of this, no-one can foretell the way in which the military response to terrorism may change the world, either strategically or economically. But so far, the path of the US economy we have observed since the attacks has shown remarkably little lasting direct impact beyond the initial disruption lasting a few weeks. The financial system was quickly back in operation. Patterns of consumer behaviour were apparently only affected briefly. Industrial output, which fell for a year prior to the attacks, looks as though it may have stopped falling not long thereafter, a picture corroborated by some important surveys of that sector. There has been a recession, according to the US National Bureau of Economic Research, but it was not caused by the attacks. That much is clear from the fact that the NBER had the evidence to declare a recession with very little post-attack data: it was the data from earlier in the year on which they mostly relied. Moreover, if a recession began about March 2001, as the NBER suggests – that is, almost a year ago – we would normally expect to see some signs of a turning point getting close by now. The behaviour of manufacturing production and orders, inventories, some labour market data, and financial market prices are all consistent with that idea. To cap that off, there was of course the news last week that real GDP in the final quarter of 2001 rose a little more than had earlier been estimated. So it is not surprising that people have recently begun to talk increasingly about the shape of a pick-up in US growth. The forecasters polled by Consensus Economics collectively increased their forecasts for US growth in 2002 quite substantially when asked in February – even prior to the latest GDP revision. If what we are seeing is indeed the first stage of a recovery, and if it continues, then the recession of 2001 will have been very mild indeed by historical standards. That itself may well mean that the recovery will be a pretty moderate affair compared with previous upswings. There are also one or two apparent imbalances which might slow down a business cycle upswing during the coming few quarters. Exceptionally high levels of business investment in recent years raise the question of whether there might be excess capacity in some areas. US equity prices remain high by historical standards, and so may be subject to correction. Certainly profitability of US corporations appears to be particularly poor at present, which ordinarily is not conducive to expanding investment. Some argue that households are financially stretched. How all this will play out remains to be seen. Nonetheless, the weight of opinion has recently become more optimistic than it was a few months ago, and not without reason. An improved US outlook, if it comes to fruition, will be good for other regions of the world. In Asia, we can already see signs of a stabilisation in industrial output after a pronounced contraction through most of 2001. This was the effect back through the supply chain of the slump in the demand for computer and information technology products last year. While the shape of any pick-up in this area remains far from clear, the contraction at least appears to have abated. European growth slowed more than anticipated in 2001 – indeed the economies of the Euro zone recorded no more growth than the US. Signs of a cyclical turning point are emerging there as well, though again it is early days. Japan, as is well known, is another story altogether. Contractionary and deflationary forces have continued, and arguably become stronger, in the past year. Restoring Japan to economic health will be a long process. Were Japan to continue its recent performance, but not be materially worse than that – which seems to be the consensus view – growth in the world economy in total should start to look up as 2002 progresses. Measured on a year average basis, Consensus forecasters suggest that the G7 countries will record growth of about 1 per cent in 2002. This number is about the same as for 2001, but as the chart below shows, this conceals a more pronounced pick-up in the profile of growth through the year – from zero through 2001 to 2½ per cent through 2002. The Australian economy Let me turn now to the Australian economy. As I am sure you are well aware, we have been affected by the global recession, through a few channels. The most obvious one is a reduction in export growth. Eighteen months ago, export values were growing at 25–30 per cent, with growth in prices and underlying quantities each contributing about half of the overall increase. That growth has stopped completely over the most recent year. Parts of the tourism sector have been affected quite badly by the decline in international travel and the collapse of Ansett. Australian businesses, especially large businesses, look abroad quite actively, and their confidence cannot help but have been affected by the unfolding global story. My impression is that, across a wide range of firms, managers have responded to the threat of difficult times by curtailing discretionary spending on things like travel, advertising, consultants and the like. They have also, one must presume, looked carefully at planned capital expenditure. In addition, the general populace has had a daily diet of reading about the difficulties in the US and other countries. In light of all this, it is perhaps all the more remarkable that, on the available evidence, the economy seems to have recorded quite reasonable growth through 2001 and, based on the very preliminary data available, into the early part of 2002. The responses of businesses to surveys suggest that they are beginning to increase investment spending again. Consumer confidence is also holding up very well. Hence, as best we can judge, the economy is not only continuing to expand, but has reasonable prospects of continuing to do so in the near term. Nor is this all due to the current strength in the housing sector. This is a point I have made in more detail elsewhere, but even stripping out the contribution from housing – which has operated in both directions in recent years – we find moderate growth in the economy over the past couple of years, of the order of 2½ per cent. In the past twelve months at least, this compares well with outcomes in the US, Europe, Japan and much of Asia. It is slower, of course, than the 4–5 per cent growth of 1998 and 1999. But some slowing was always going to occur from such levels, and in the context of widespread recession around the world, Australia's performance is good, and much better than would have been anticipated had our performance in previous global downturns been extrapolated. To what do we attribute this favourable outcome? As was pointed out in our most recent Statement on Monetary Policy, it is rare for an external event, on its own, to precipitate recession in Australia. To be sure, the impact effect of such events in the past has been quite substantial and, no doubt, there is a "multiplier" effect of such shocks through the economy. But for an economy which typically grows at 3-4 per cent, a shock which affects production by 1 or even 2 per cent needs something else at work to precipitate a contraction in the economy overall. There usually needs to be a slump in domestic demand to precipitate an outright contraction in overall GDP. That can occur because, say, an excess of capital spending by businesses, or excessive leverage, leads to a sharp correction in investment (and employment), which exacerbates a slowdown which was already under way because of external events. It might occur because some shock comes along which fundamentally erodes business profitability and hence reduces prospects for investment. It might occur because domestic macroeconomic policies, responding belatedly to serious inflation pressure, are faced with a need to tighten abruptly late in the business cycle. As has been pointed out on several occasions by the Governor, the extent of such problems on this occasion has, we judge, been small. True, a rise in inflation has occurred, but the Bank believes that the tightening phase of 1999–2000 addressed any longer-term problems which might have threatened on this front. We therefore felt we could ease policy in 2001, and did so some considerable time ahead of the likely peak in inflation. That inflation expectations remained well anchored through the past year or more helped in this. Investment has not been excessive overall (though this does not rule out some individual "mistakes") and, on the whole, businesses do not appear to be over-leveraged. This means that the likelihood is rising, rather than falling, investment during the coming year. The recent survey on capital expenditure intentions confirms that this is occurring; indeed, it suggests the pace will strengthen considerably in the second half of the year – although of course this is a very early estimate of such expenditure. Profits and productivity It is probably worth spending a little more time on profits. Businesses were affected by the rise in prices for inputs over the past couple of years, which resulted from the decline in the exchange rate. In addition, the moderate slowdown in the economy itself presumably affected earnings. As a result, corporate sector gross operating earnings tended to weaken, though the most recent data suggest this decline may have ended. There has been a much larger decline in profits in the US. The chart below, prepared by staff in our Economic area, undertakes a comparison of corporate sector profits in the national accounts as a share of GDP, for the US and Australia. The Australian data here have been adjusted to remove interest costs and depreciation so as to make them more comparable with the way US data are usually published. The Australian profits share is higher than in the US, but we should not make too much of the difference in levels – there are possible differences in the relative sizes of incorporated and non-incorporated sectors, the extent of public versus private sector ownership of the capital stock, and so on. But the trends, and levels relative to longer-term averages, can be more meaningfully compared. The differences in the extent of the falls in profits since 1998 are quite striking. US profits are back to 1990 levels; Australian profits are similar to the post-recession average, and look nothing like a recession scenario. This is obviously partly because the downturn in the economy itself has been milder. But it also makes for better prospects for growth in the short term, because it greatly lessens the likelihood of abrupt adjustments in investment, or employment. Longer term, prospects for profits rely heavily on productivity performance, an issue in which the business and policymaking community both have a vital interest. Productivity is key both for businesses in sustaining profitable performance and for the community as a whole since it is productivity growth which is ultimately the source of higher living standards. It is well known that Australian productivity growth accelerated during the 1990s, to a rate about one percentage point per year higher than what had been observed during the preceding ten to fifteen years. (This was, incidentally, both a higher average rate of productivity growth and a greater degree of acceleration in productivity than seen in the US over the same period.) It is no coincidence that profits did relatively well through most of that period, and that this was able to co-exist with rising real wages. During the past couple of years, the rate of expansion in productivity first slowed markedly, then sped up again. This is a standard cyclical pattern, in which employment moves in response to economic activity, but with a lag. Hence employment lags the slowing in activity, and measured productivity slows or even declines. The reverse happens when growth picks up, as it did during the first three quarters of 2001. The extensive program of liberalisation of the economy during the past couple of decades was a major driving force behind the improvement in trend productivity growth. As a side note, we in Australia have not tended to allow much role for "new economy" developments, such as the adoption of information technology, though some research does suggest that this may have played a greater role than conventional wisdom has allowed. But the bigger question is the future. Leaving aside recent cyclical ups and downs, will the strong trend productivity growth of the 1990s continue into the next ten years? On this there are, I suppose, optimists and pessimists. Optimists would argue that the faster productivity growth we have seen in the past decade represents an accelerated process of "catch up" to the leading edge levels of productivity we see globally, usually in the US economy. Moreover, they accept that there is still some gap between productivity levels in Australia and those of the world frontier in at least some sectors. Hence the catch up is not complete, and a process of good productivity growth can continue for some time yet. Pessimists tend to point out that this depends on the right policies. They worry that if the process of liberalising markets does not continue, or is even reversed, productivity performance will suffer. They voice the concern that it is getting harder to build support for liberalising ideas. Both of these views have some merit, and it is possible to have an optimistic outlook, but equally to see the importance of sustaining the liberal market arrangements which already exist, and of being disposed towards further sensible reforms that may be possible over time. Good policies will be important, of course – that goes without saying. But policies can only establish pre-conditions conducive to enhanced productivity. The outcomes will depend quite heavily on you, the business community. It is you, after all, who, in the pursuit of profit, have to seek out the opportunities for new products and markets, better ways of organising business activity, and better ways of motivating your employees and tapping and developing their human capital. In the simple growth accounting exercises used to measure productivity, the source of the genuine improvements in productive techniques is not considered (though there is a considerable separate literature aimed at establishing that). But productivity does not get handed down from somewhere – it is the outcome of the efforts of people across the economy to find better ways of doing things. What macroeconomic policy can contribute to this endeavour is a measure of stability. We will never be rid of the business cycle, nor of the tendency for businesses, households and especially financial markets, to alternate between moods of optimism and pessimism. But through the past decade or so, the Australian economy has been somewhat less volatile from year to year than it used to be. That may be explained partly by smaller shocks hitting us from abroad for much of the 1990s (though both the Asian crisis and the global recession of 2001 were big shocks). The economy's capacity to handle shocks has also improved, a factor due in some degree to the liberalising reforms themselves. I would argue that macroeconomic policies have played a role too, and in particular that a monetary policy regime which seeks to respond to the likelihood of significant build-ups of inflationary or disinflationary pressure, has made its contribution. It is, of course, our intention to continue in that vein. Conclusion In most respects, the global situation, while not without uncertainty, is better than it was a year ago. A renewed expansion in the world economy may well be beginning, though it will probably be moderate, rather than strong. Even though we do not want to throw our hats too far in the air just yet, it is very encouraging to see such signs. Australia has come through the international difficulties well to date. In an underlying sense, we have slower growth than we experienced in the late 1990s, and slower growth than we would ideally like to sustain in the medium term. But we have not had the deep slump characteristic of earlier world downturns, and the probability of experiencing one soon seems recently to have diminished. This is good news, and perhaps should have us all casting our minds past the short term, towards the question of how to sustain good, stable growth, and good productivity performance, into the medium term. I am sure you will all be doing just that. | reserve bank of australia | 2,002 | 3 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to 2002 Melbourne Institute Economic and Social Outlook Conference Dinner, Melbourne, 4 April 2002. | I J Macfarlane: The Australian economy - past, present and future Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to 2002 Melbourne Institute Economic and Social Outlook Conference Dinner, Melbourne, 4 April 2002. * * * It is an honour to be invited here this evening to give this address, although I must confess I am somewhat daunted by the task. We have heard so much in this conference on such a broad range of economic subjects by such a distinguished group of speakers that I have been presented with a difficult act to follow. I have also been given a very broad topic, so I will have to confine myself to making only a few comments on each part of it. I would like to start with the proposition that Australians, on the whole, tend to be pessimists about the country’s economic situation and about its future. This is not always the case as there are occasions, such as the present, where a degree of optimism breaks out, but these are the exceptions rather than the rule. While Australians are often optimistic about their personal economic prospects, they are seldom so about the economy’s prospects. I have spoken about this before and produced various pieces of anecdotal evidence to support my view. More objective evidence is available in the form of answers to surveys , which show a clear propensity for respondents to judge the economy more harshly than their own economic prospects (about which they presumably know more). Why is there such low confidence in our economic situation, even by people who are reasonably confident about their own economic circumstances and prospects? The usual answer is to blame the press, but I think this is a bit superficial. The allegation is true in only one sense: there are a lot more economic stories on the front pages of newspapers in Australia than in other countries. And since there is a natural tendency for the press to give more prominence to bad news than good – just as we hear more about war-torn countries than peaceful ones – this tends to increase people’s exposure to bad economic news. The Past I think a deeper answer to why we tend to be pessimistic is to be found in our attitude to our economic past, which tends to be dominated by a strong element of nostalgia. While in other areas of our political and social history we may be revising downwards our assessment of our forebears’ achievements, this is not so in the economic sphere. There is still a tendency to look back favourably on the economic peace and certainty of the past and contrast it with the perception of insecurity and instability that surrounds the present economy. Why is this so? (a) Those who know a little bit of history are aware of the fact that in about 1900 we were probably the richest country in the world in terms of income per head. Now we are in the middle of the pack of developed OECD economies. So this gives the impression of a country in long run decline, but from a somewhat artificial starting point. We were the ‘Kuwait of 1900’: a country with a very small population and a large resource endowment producing commodities which were very highly priced at the time. But like any prosperity based on scarcity prices it could not last , as the decline in our terms of trade during the century showed. I will return to this theme when I discuss the future. There are three surveys which ask respondents to report their confidence in (a) their own personal economic situation and (b) the state of the economy; these are the Westpac-Melbourne Institute Consumer Sentiment Index, the ACCI Survey of Investor Confidence, and the Yellow Pages Business Index. All three surveys show that nearly always the majority of respondents show less confidence in the economy than in their own personal economic position. In 97 per cent of occasions this is true for the Westpac-Melbourne Institute and Yellow Pages surveys, and on 94 per cent of occasions it is true for the ACCI Survey. An extreme example of changing economic fortunes as a result of changing terms of trade comes from 18th century French history, and the contrasting attitude of France to defending its two main American colonial possessions – Canada and Haiti. Canada was given up with relatively little resistance, but two costly wars were fought in a vain effort to retain Haiti. The ranking of Haiti as more valuable than Canada was purely an economic one based on the high price of sugar two hundred years ago. A similar story involves the English and the Dutch in the 17th century. Under the Treaty of Breda of 1667, the Dutch gave up their claims on Manhattan to the English in order to retain the island of Run (in what is now Indonesia). The superior value they placed on Run was due to it being the principal source of nutmeg. (b) For others, the nostalgia is directed at the 1950s and 60s. There is no doubt that around the world this period of post-war reconstruction was a ‘golden era’ for economic growth that had not been seen before or been equalled since. But we should remember that the Australian economy did not keep up with the rest of the world during this period: the growth in GDP per capita was lower than the OECD average in the 1950s and 60s. We also tend to underestimate just how poor we were compared with what we take for granted now. Much of the post-war housing expansion into the newer suburbs involved building two-bedroom-onebathroom houses with external toilets: sealed roads, sewerage and telephones came years later. There are many other examples of the difference in living standards I could quote. The Present By the present I mean the economic expansion over the past decade which we are currently still experiencing. Fortunately we do not view the 1970s and 1980s with much nostalgia, so most people are willing to accept that the current expansion represents an improvement compared with those earlier decades. This can be seen in that: (a) The current expansion is longer. So far it has lasted for 41 quarters compared with 31 and 28 respectively for the expansions in the 1970s and 1980s. (b) Our rate of growth of productivity has picked up compared with earlier decades. We are one of a very small group (about 5) of OECD countries to have achieved this. (c) We have weathered two quite large contractionary external shocks without significant adverse effects. I am referring here to the Asian crisis of 1997/98 and the world slowdown/recession of 2001. (d) There is evidence to suggest that some economic distortions that seemed to be entrenched have been removed or at least improved. The most obvious of these is the reduction in inflation from the very high rates of the 1970s and the quite high rates of the 1980s. Indeed, if we had not succeeded in regaining low inflation in the 1990s, we would have had no hope of achieving the long economic expansion we have had. There has also been some success on the balance of payments. It is now clear that the pronounced deterioration in the external accounts occurred during the 1970s, reached a plateau from the early 1980s to the present, and may have shown its first, although tentative sign of improvement over the past few years. There is also evidence that progress is finally being made on unemployment, a subject I would like to cover in a little more detail. There were international recessions in the early 1970s, 1980s and 1990s. We have also just been through one in the early 2000s, although economists are still debating whether it was deep enough to be added to the list of its three predecessors. In the 1970s, 80s and 90s, Australia also experienced recessions roughly co-incident with the international ones. On each occasion our unemployment rate rose sharply – to 6.5 per cent in the 1970s, to 10.3 per cent in the 1980s and to 10.8 per cent in the 1990s. While we were able to reduce the unemployment rate during the later expansionary phases, each recession pushed it up again to a new peak (see Table 1). The real story behind the upward trend in unemployment was the shakeouts that occurred during the recessions, not the insufficiency of the growth rate during the expansions. Table 1 Unemployment rate in recessions Rise in unemployment (percentage points) Peak level (per cent) 1970s 4.9 6.5 1980s 4.8 10.3 1990s 4.8 10.8 During the international downturn/recession of 2001, Australia was able to avoid a recession so our expansion is still proceeding. Nevertheless, there was some slowing in the pace of economic growth and the unemployment rate rose by about 1 percentage point. Although I am always wary of counting chickens before they hatch, it now appears that over the past six months the unemployment rate may have peaked at, or a little above, 7 per cent. If this is the outcome, it will be the first time for three decades that we have been through an international downturn that has resulted in the peak unemployment rate in Australia being lower than its predecessor. I hope that I am not premature in making this assessment, and am aware that it could all be unwound if we encountered a recession in the near future. But that is not likely in my view, at least not in the forecasting horizon. If my assessment is correct it will reinforce the view that the principal contribution that macroeconomic policy can make to reducing unemployment is to have the longest expansion possible (but not the fastest), and to have the mildest slowdown. It also suggests that the reduction in unemployment to an acceptable rate is a task that was always going to take longer than the timeframe encompassed by a typical economic expansion. The Future As you can see from the foregoing, I think Australians have tended to be quite hard on themselves when making judgements about the economy. This has its good side of course, because it has meant we have been more prepared to take tough decisions than many other countries, particularly European ones, when it comes to reducing government debt, opening up the economy, privatising, deregulating the labour market and imposing stricter competition standards. When we look to the future, I see no need for us to retain our long held pessimism about our country’s economic future. For a start, we should gain some comfort from the fact that in economic terms, there was a clear improvement from the 1970s to the 1980s and an even bigger one to the 1990s. This is true in absolute terms and even more so in relative terms: the 1990s was the first decade that we clearly grew faster in income per head terms than the OECD average. We should not be looking at ourselves as one of the laggards, but as one of the few pacesetters among developed OECD countries. What about the longer-run trends? There is still a feeling in many quarters that "we were dealt a good hand to play in the world economy of 1900, but a bad hand for the world economy a century later". This is tied up with the view that we are mainly good at exporting resource-based goods (in which I include mining, metals and agriculture), and hence our terms of trade are bound to continue the deterioration that started a century ago. I think this fatalism is misplaced for two main reasons. The first and conventional response to this charge is to point out how the economy is changing, and in particular, how we are diversifying our export mix. Over the past sixteen years, the fastest growing categories of exports in real terms have been manufactured exports and exports of services. The annual growth rates of each category of exports is shown in Table 2. We all know of some success stories, but each one is relatively small in itself. What we don’t tend to realise, is just how many there are, and how widespread they are. Table 2 Growth rates of export volumes 1985 to 2001 – % pa Manufactures 12.4 Services 7.5 Resource-based of which: – minerals and metals – rural 6.4 3.4 There is a second and more interesting response, however, than the conventional one, and it is one I would like to spend a bit of time on. It concedes that even with export diversification occurring, we are still going to be a country with a high proportion of our exports coming from the resource sector. In twenty years of diversification, the proportion of exports, which is resource-based, has fallen from nearly 80 per cent of the total to 60 per cent of the total at present. This is still very high by the standards of an OECD country, and even if it goes down to 50 per cent in another fifteen years, it will still be high by the standards of developed countries. Is this something we should worry about? A lot of people would say yes, because resource-based goods are "commodities", and this means their prices will fluctuate widely in a cyclical sense, but more disturbingly, their trend will continue to show a long-run decline. This is the same assumption I have referred to a few times in my talk, namely, our terms of trade will continue to decline. But I think we have to doubt this assumption. The products whose prices will show long-run declines are likely to be those whose production can be expanded most easily. And nothing fits this description better than large areas of manufacturing. Governments around the world, particularly in Asia, are competing to build larger and larger plants, and companies from developed countries are assisting them through private direct investment. We all know how far the price of computer chips has fallen, but this is only one example of many. Large areas of manufacturing, such as textiles, clothing, footwear, electrical equipment and even automobiles have shown downward trends in prices. These are precisely the sorts of things that we in Australia import, and increasingly what developing countries export. In a recent study, the World Bank pointed out that manufactures now make up 80 per cent of developing country exports, compared with only 25 per cent as recently as 1980. Over the past three years the prices of 26 out of 29 categories of our imports have fallen (when adjusted for exchange rate effects). In other words the stigma of the word ‘commodity’ could now be more appropriately applied to our imports than to our exports. This may be the reason that for the first time in memory, our terms of trade actually rose during a world recession (i.e. over the past three years). It is also consistent with the fact that the low point in our terms of trade was in 1986: there have been cyclical lows since, but they have been at successively higher levels. Now I don’t want to get into an argument about whether it is better to put our scarce investment resources into the resource sector or into the manufacturing sector. In fact, I would strongly resist the government setting out to decide the answer to this question. All I am saying is that we shouldn’t assume that our future is unfavourable just because we happen to have started with the industry mix we have. A corollary of my view, of course, is that it would be very unwise for the government to provide incentives for the private sector to move out of one activity into the other. It could easily end up being seen the same way as the decision of the South Australian authorities in 1986 to pay grape growers to pull up their red wine vines (some of which were the now highly-prized old growth shiraz) and get into something more promising. We have had a history of being told that we have the wrong model for our economy, and that we should change it to the one currently in vogue. I can remember in the 1970s when the continental European (including Swedish) model was seen as the way forward. In the 1980s there were numerous books and articles predicting that Japan would soon overtake the US as the world’s largest economy, and by implication that its corporatist approach was superior to more market-based approaches. In the first half of the 1990s Australia was regularly criticised for lacking the vigour of the emerging-market Asian economies (the Tigers) with their activist government-led development approach. In the past few years, it has been American triumphalism. The extreme expression of this was the recent infatuation with the ‘New Economy’ and denigration of activities regarded as ‘Old Economy’. Two years ago at the World Economic Forum meeting in Melbourne, Australia was being heavily criticised for not making enough of the IT and telecommunications investments that are currently being written off by the former stars of the NASDAQ. As you can gather from the above, I am extremely sceptical that we can identify a ‘new economic model’ and have the government move us to it. But, on the other hand, I recognise that as a country we have to be continually adapting in order to exploit emerging economic opportunities, including at the more sophisticated and high-value added end of the spectrum. This is a job not just for the private sector, but a challenge for public policymaking. Among the purely economic policies with which I am familiar, such as monetary policy, fiscal policy and financial supervision, I think there has been enormous improvement over the past decade or two, and we can claim membership of the relatively small group of countries that represent world best practice. But good economic performance as we move into the future will depend on more than purely economic policies; it will depend on the incentives provided by our whole political, legal, social and educational environment. It is somewhat disturbing therefore to read the recent assessment by the ViceChancellor of Melbourne University that Australia no longer has a university that could be ranked in the top one hundred in the world. I have no reason to dispute his opinion as I have heard similar views from other academics. What it suggests is that, although we have made great progress in the breadth of our education system, we cannot make the same claim about the depth. At the highest level of higher education we are not keeping up. I am usually reluctant to stray into areas of public policy outside my immediate area of expertise, but I am prepared to do so tonight in keeping with the broad range of issues discussed at this conference. I do not have a shopping list of suggestions, but I am happy to conclude my address tonight with a plea to all those involved in higher education – governments, bureaucrats, academics and their spokespersons, taxpayers and businesses to do something about this situation. The remedy will almost certainly involve the overthrow of some long-held conventions that attempt to impose uniformity. It will probably also elicit the old catchcry of ‘elitism’, but far better that, than the complacency which accepts that our higher education can slip further behind world best standard. | reserve bank of australia | 2,002 | 4 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Banking & Finance News Magazine, Asia Australia Investment Conference & Expo, Sydney, 16 May 2002. | Glenn Stevens: International economic and financial issues - an RBA perspective Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Banking & Finance News Magazine, Asia Australia Investment Conference & Expo, Sydney, 16 May 2002. * * * Let me begin by thanking Australian Banking & Finance News Magazine for the invitation to speak to you today. It is very pleasing to see such a distinguished group of speakers talking about the financial services industry in the region, an activity in which Australia, and especially Sydney, is very heavily involved. I have been asked to give a perspective on the international economy. This is something of a change of gear from most of the other presentations you have heard today, and as I set out to prepare these remarks I wondered what I might say that would retain your attention. On reflection, however, I think the current state of the world economy is of quite some interest for those who are involved in the financial services sector. Moreover, there are some long-run trends where the financial services sector’s role will be critical. I’d like to explore some of these issues briefly in the time available. I will not say much at all about the Australian economy, because the focus here is on the region and the world. Of course, the Bank’s views about the Australian economy were spelled out in detail in the Statement on Monetary Policy released last Friday. This week we have also had the Budget. That is surely enough to digest on Australia. What’s happening in the global economy at present? Let me begin by talking about where we are. The global economy, and especially the Asian region, has seen its share of fluctuations over the past few years. On the latest estimates it appears that, as measured by the IMF, the world economy expanded by about 2½ per cent in 2001. This was about half the pace recorded in 2000, which was an exceptionally strong year. Growth in the major industrial countries (the G7) was even lower. Over the four quarters to the end of 2001, real GDP for this group of countries recorded almost no growth, which was the weakest result in any twelve-month period since the early-1980s global recession. This reflects, of course, the fact that the US economy experienced a recession during last year, and so did Japan and Germany. Yet this outcome was better than might have been thought likely. During the second half of 2001, people began to worry that the US in particular would encounter a more severe and protracted recession than has, in fact, turned out to be the case. We at the RBA became quite concerned about this as well, not so much because of the terrorist attacks per se - whose direct short-term economic impact we thought likely to be relatively small - but simply because economic problems can accumulate towards the end of long expansions, which then intensify any subsequent downturn. Arguably, the US economy had acquired some such imbalances - with some asset values falling from very high levels, an unusually high level of business investment raising the question of whether there might have been over-investment, and questioning in some quarters about whether consumer spending had run too far ahead of income. As things have turned out, fears of a sharp slump have not been realised. On the contrary, as of May 2002, it seems that the US has begun to recover from what now appears to have been the shallowest recession in recent history, at least as measured by the behaviour of GDP. Using the metric of unemployment, if it wasn’t the shallowest recession in recent times, it was close. This is a better outcome than most thought likely during the second half of last year, and is much better than the “downside risk” scenarios which were contemplated at that time. Reflecting these outcomes, forecasters stopped continually downgrading their assessments about the future earlier this year, and have become more confident over recent months that global economic activity will strengthen as 2002 progresses and that 2003 will be a pretty good year. They expect this to be led by an improving US, with Europe and East Asia turning up as well. Not much contribution to growth is expected from Japan in the short term, but at least performance there is not expected to worsen. There is, of course, a long way to go to see whether those expectations turn out to be correct, but they are not unreasonable expectations to hold in the present circumstances. The US turning point is clearly already behind us. It is pretty obvious, furthermore, that macroeconomic policies in the US are exerting a considerable expansionary impetus. In fact, monetary policies in almost all countries have been quite easy over the past year, which in itself increases the probability that growth will strengthen rather than fade away. In short, while it is not time to throw our hats in the air about the world economy, things look distinctly better than six months ago. Aspects of the US economy It is worth dwelling for a little while on the recent experiences of the US, and not just because it is the world’s largest national economy in terms of production of goods and services. The US economy is also a dominant force affecting global capital markets, and in the past five years it has been subject to some unusual influences which are still running their course. There has been a remarkable degree of investment in information technology and communication capacity in the US. This has been a feature of other countries too, but it was most pronounced in the US, raising the share of overall business investment in GDP to historically high levels in the late 1990s. Expectations about returns to this investment have, until quite recently at least, been very optimistic. For that reason, the US has been a powerful magnet for capital, and much of America’s additional investment has been funded with savings sourced in other countries. Associated with that has been a rising level of the US dollar, high levels of domestic asset prices and hence substantial gains in household wealth. That, in turn, helped to support a prolonged period of strength in household consumption spending. All of this contributed to a robust and lengthy period of economic expansion until early 2001. It is striking, moreover, that this long expansion followed a pretty mild recession in the early 1990s, which had itself followed a pretty good expansion in the 1980s. So, in fact, the US has had a good two decades by the standards of other advanced economies, with its performance outstripping those of Europe, or Japan, with the margin quite wide during the 1990s. This persistent out-performance by the US economy has made it the benchmark for most things economic and financial. The dominance of the US model of market capitalism seemed, by the end of the 1990s, to be unassailable. The role of the financial sector in all this, moreover, was pivotal. US equity and debt markets channeled vast quantities of capital into the corporate sector, and especially the high-tech sector, at quite low cost. In 2000, equity market issuance by US corporates was eight times the rate just three years earlier, at price-earnings ratios which were exceptionally high. This rapid increase in the supply of almost costless equity capital seems to have been driven by the conviction that returns from some of the new technologies would be enormous for their producers and, dispersed across the US economy, their users in terms of productivity. The financial services sector provided the machinery for all this to happen, itself using the improvements in information and communications technology to lower its costs. Up to a point, this was a model of what the financial sector is supposed to do: allocate capital, and by seeking out the highest returns, maximise the growth potential of the economy. Regrettably, as often happens in a prolonged boom, excesses emerged. Investors increasingly tended to become mesmerised by the apparent success of firms with business models whose worth, in more sober times, would have been regarded as dubious. In addition, practices developed in some areas which, in hindsight, are pretty hard to defend. Statements of corporate earnings, for example, turned out to be quite misleading in some celebrated instances, raising questions about the behaviour of management, and the role of auditors. Distorted incentive structures and accounting rules are seen as having contributed to this process, and to the fact that the advice given by analysts to their clients was, in a number of cases, less than impartial. And so on. I do not recount this to point fingers of blame at anyone in particular - it is, I fear, part of the human condition that such things happen near the end of most booms, even ones whose initial development is well based in fundamentals. The temptation to talk up prospects, and the desire on the part of investors to believe the talk, becomes almost irresistible. But these things do have real costs: capital is misallocated, or simply lost; as a result, someone’s savings are depleted, and the economy is the poorer for not having used those resources more wisely. Hence the importance of the financial sector’s role in the economy. What appears to be occurring now is that pressure is building in the US for reforms to the problem areas. Without wanting to speculate about the outcomes, most would agree that some reforms will help to re-build confidence, which is beneficial for the finance industry in the US and, by extension, globally. We should keep in mind, though, that that will not stop the tendency towards extremes of optimism and pessimism - that’s just human nature. All that said, any legacy from all this has not stopped a recovery in the US economy from beginning, even though it may well have some impact on the shape of it. Over recent months, people have switched from debating the possible size of the downturn to talking about the likely strength of the upswing. The spurt of US growth in the March quarter was largely driven by a rise in production in the goods-producing part of the economy, where previous levels of production had been sufficiently low that inventories of goods had been falling. The current level of production can be sustained, but for ongoing growth in production what is needed is expansion in demand and prospects for demand are regarded as, to use the current language of choice, “uncertain”. It is not that demand is falling - it is growing. The issue is to what extent, and how soon, it might accelerate. In this context, the behaviour of business investment has been nominated (by the Federal Reserve, for example) as crucial. After such a prolonged period of massive capital investment, there was a very sharp fall-off in capital spending by US businesses during 2001. It was this component of demand which was responsible for pushing the US into recession. The pace of decline looks like it began to abate in the early part of 2002, but it is not clear when investment spending might actually pick up again. Central to the outlook for investment will be the state of US corporate profits. The chart shows the best available measure of economic profits, from the US national accounts, measured as a share of US GDP. There was a period of strong profit growth from 1994 to 1997, but then the profit share tended to drift lower, before falling sharply during the first nine months of 2000. US corporations acted to reduce costs with alacrity over the past year. Profits then began to recover in the last quarter of 2001 and, based on preliminary information for the March quarter, that has probably continued. Equity analysts who make forecasts are expecting continued very strong growth in earnings over the coming year. Those inclined to have reservations about the robustness of the US recovery would wonder whether earnings growth expectations might be somewhat optimistic (and, for that matter, whether profits were actually as strong as commonly believed in the late phases of the expansion). That is not to argue that the US recovery, which is clearly under way, will peter out, just that it might be a fairly moderate affair compared with some other recoveries. Nonetheless, it is apparent that a pick-up of some degree is under way in profits, and even a moderate overall recovery after a fairly shallow recession is a good outcome. Furthermore, given that the US economy has surprised many by its resilience to date, there has to be the possibility that it will continue to do so. Aspects of the Asian region Turning to the Asian region, we have seen encouraging evidence that a number of countries have turned the corner on economic growth in the second half of 2001, after a period of contraction. For the region as a whole, the global downturn of 2001 was much less traumatic than the Asian financial crisis of 1997 and 1998 (though this is not true for every individual country). There are a number of reasons for this but one contributing factor, in my view, was that economic policies responded differently. Floating exchange rates were allowed to decline when under pressure, which helped to avoid any sense of crisis and associated contagion from one country to another. Monetary and fiscal policies were generally eased, something which, in many instances, was not possible during the initial phase of the earlier crisis. This meant that while the global slump did affect East Asia, the effects were ameliorated, rather than exacerbated, by the policy structures and responses. Nonetheless, the recent experience may prompt some of the East Asian economies to think about the extent of their exposure to the high-technology sector. A notable feature of performance after the Asian crisis was the way in which the global boom in that sector drove growth for the exposed economies. And in the subsequent downturn, there seems to have been, not surprisingly, some association between the degree of technology exposure and the extent of the economic slowdown across countries (see chart). A question which these countries may face - probably they are already asking it of themselves - is whether the sorts of growth rates they want to sustain can be so reliant on a relatively concentrated, export-led approach in industries where the products are increasingly commoditised, or whether a more diversified approach, including more growth in domestic demand, would be better. The answer which emerges will no doubt be important for trade and capital flows in the region in the future. No less important than that set of issues, and in many respects quite related to it, is the potential longrun impact of the rapid growth and internationalisation of the Chinese economy. China’s economic growth, at least as recorded by the official data, is remarkable for its pace and consistency during the past decade. China is fast becoming quite large as both a source of, and a destination for, goods and services. It is the second largest regional economy after Japan, for example, by a large margin. It is also a very large destination for international capital, receiving a significant share of the world’s crossborder flows of direct investment in recent years (see table). Annual private direct capital flows to emerging markets US$ billion; 1999-2001 average Asia of which China Western hemisphere “Transition” countries of Eastern Europe Other All emerging markets Some of my colleagues in the RBA point out that the associated build-up of manufacturing capacity in China must have something to do with the tendency for international prices for manufactured products to decline over recent years, even in periods where global growth was pretty strong. Equally, the rapid growth of income and wealth in China will boost demand from that country, and presents opportunities for foreign companies, not least in financial services and communications. So China is becoming increasingly important for the international, and especially the regional, economies. Other countries have an increasing interest in the success of the efforts of the Chinese authorities to achieve balanced growth, financial stability and efficient allocation of the capital resources which are flowing into China from abroad. The Japanese economy remains in a very difficult position. A decade ago, no-one would have predicted that Japan, an economy which recorded extraordinary growth for a generation, would struggle to grow by an average of 1½ per cent per year during the 1990s. The mix of factors at work is quite a potent one, and includes again the aftermath of a period in which the financial system (among other things) did not function as it should have. Asset prices have fallen massively since the heady peak reached in the “bubble economy” period a decade or so ago. Hence the value of collateral for bank loans has also collapsed, putting enormous strain on corporate borrowers and the financial system. The general level of prices is declining. Government finances are strained to the limit after a long sequence of fiscal packages. Monetary policy has lowered short-term interest rates to zero, and pushed an enormous quantity of cash into the system in an attempt to get some expansionary impetus to an economy where there has been no appetite for borrowing. In this respect, the debate about macroeconomics in Japan has seen the return of a number of themes prominent in the 1930s, and it is proving much more difficult to get Japan’s growth moving and its prices back to small positive rates of increase than most people would have expected. The US authorities have observed these problems and my belief is that their desire to avoid encountering such a scenario helps explain the aggressive nature of the monetary policy reaction of the Federal Reserve during 2001. The world economy would surely be better off were Japan to be able to make a decisive return to solid growth, but in the short term, forecasters seem to have little confidence that that will occur. Still, if Japan performs in future like the average of the past few years, a pick-up in growth in other countries will see better global conditions. Europe Europe’s economies slowed noticeably in 2001. Germany, in years past the strongest of the major European economies, has under-performed some others in recent years, such as France or the UK, and in 2001 saw a contraction in output in the second half of the year. In recent months, there have been some encouraging signs of a turn for the better, with surveys of business confidence generally looking firmer. Most people expect that trend to continue, though business people in Europe are presumably concerned about the current industrial unrest. The financial services sector and regional economies Other speakers today have no doubt talked at length about the growth prospects for the financial services sector around the region, so I will not say much on that, but a few remarks are possibly in order. As an economy develops, the wealth of the community increases, and an increasing proportion of it is held in the form of financial claims. Banking systems develop and, usually later, capital markets where companies and governments can tap savings directly. In the old western industrial economies, this process typically took quite a long time. In Asia, these developments have been accelerated, as part of the rapid industrialisation and development of these economies in the past generation. By now, in some cases the sizes of financial systems are getting pretty large. In countries such as Malaysia, China and Korea, some very crude calculations (shown below) suggest that financial assets are, relative to the size of the respective economies, getting to be as large as those in many high-income countries. In Singapore and Hong Kong, operating offshore financial centres, financial systems are also, of course, fairly large. Gross financial assets* US$ billion % of GDP Japan 14,026 China 2,288 Hong Kong Korea India Australia Thailand Singapore Malaysia Indonesia Philippines 28,451 USA * Calculated as monetary assets, plus bonds and equities. Data for 2001-02. Sources: IMF; BIS; FIBV. In several countries, a good deal of repair work is being done on banking systems whose net worth was seriously eroded by the Asian financial crisis in 1997 and 1998. While this has often been labelled as a currency crisis, at its heart it was also a banking crisis. Banks - and not just the ones on the ground in Asia - did not perform the function of allocating capital and managing risk as well as they should have. Lest this comment sound patronising, I hasten to add that we in Australia had an experience of a similar nature, though thankfully of a smaller order of magnitude, in the late 1980s and early 1990s. Indeed, most countries have had this happen at some stage, and usually more than once. In the past ten to fifteen years, the experience in the old industrial countries has resulted in a strengthening of risk management in banks and in the supervisory process, something which is now being worked on in Asia. The authorities in a number of Asian countries are also seeking to promote capital market development so as to lessen their high degree of reliance on banking systems. It has been suggested that in times of stress, having more than one conduit for the provision of funding is a handy degree of diversification. Share markets have long been a feature of the Asian financial landscape and now bond markets are developing more quickly. China again features here, with a stock of bonds outstanding now second only to Japan’s in size in the region. The future seems likely to involve considerable further growth in the financial systems of many of the countries of Asia. I would think that Australian market participants are particularly well-placed to take part in the development of these markets, given the maturity and sophistication of our markets for sovereign and corporate debt, and derivatives markets which are quite active and reasonably large in world terms. Conclusion The world economy appears to be gradually improving, and we are seeing this reflected in better conditions for many of the Asian region’s economies. We are still unsure how things will pan out in the US, but the fact that we can debate the strength of an upswing, as opposed to the depth of recession, is a clear indication that things have been going better than expected. In this region, there remain some short-term problems, but there are also some quite important medium-term trends - of which I would nominate the rapid growth of China as probably the most important. The role of the financial services sector is key in accommodating these trends and in helping savers and investors alike to maximise their opportunities. I am sure you all have fascinating challenges ahead. | reserve bank of australia | 2,002 | 5 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 31 May 2002. | I J Macfarlane: Overview of the Australian economy Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 31 May 2002. * * * Mr Chairman, with the normal timetable interrupted by last November’s election, it is slightly over a year since we appeared before this Committee. Since it has been an extremely eventful year, I will have a fair bit of work to do today to fill the gap. Looking back over the Hansard of the last meeting in May 2001, I see that I was explaining why we had lowered interest rates three times (in February, March and April). At the time of our meeting, I was pretty confident that the Australian economy was on a recovery path after a short housing-induced setback in the second half of 2000, but none of us were sure about what was going to happen in the United States and the rest of the world. External events were seen to be crucial to our fortunes and to the evolution of our monetary policy. As it turned out, these events unfolded in two distinct phases: – Over the rest of 2001, the world economy continued to weaken. The United States had a mild recession, with consumer spending holding up and so preventing it from being as deep as earlier ones. On the other hand, the business sector had a pronounced recession judging from the fall in industrial production, business investment and corporate earnings. Most other major countries had negligible growth during the year, so that for the G7 countries as a whole, growth was virtually zero over the year. Even so, it looked for a time that it could have been much worse. For most of last year, therefore, we were receiving gloomy news on the world economy. After a brief respite in mid-year, bad news began to re-emerge in July-August, so much so that we in Australia eased monetary policy on 5 September. Then the events of 11 September induced a new bout of gloom, and there was a real fear that the world economy would weaken further in 2002 and so experience a prolonged and deep recession. Monetary policy was eased virtually everywhere. In our case, even though our own economy remained in good shape, we eased in anticipation that the weakening prospects for the world economy would eventually flow through to the domestic economy. – The second phase began in the early months of this year, when it became increasingly clear that our earlier fears about 2002 were not going to be realised. The US economy grew more quickly in the final months of 2001 and the first quarter of 2002 than anyone had expected. In addition, we received better news from non-Japan Asia and Europe. It is now pretty clear that 2002 will be a year of recovery for the world economy, and the IMF is forecasting good growth through the year. The debate is no longer about whether there will be a recovery, but about whether it will be an average or below-average recovery. There is still a good deal of uncertainty about how robust the US recovery will be once the inventory correction has passed, i.e. in the second half of the year. Some of the bubble-type distortions have not been fully unwound so there is still a fair bit of caution around, including in the Federal Reserve Board. So we are in a world economy with a more comfortable outlook than a year ago, but with still some uncertainties remaining. What of the Australian economy? The story here has been much less exciting, but the results a lot more satisfying. As you know, GDP grew by 4.1 per cent over 2001, which was the highest among comparable OECD countries. We can now safely claim that the Australian economy has weathered a world recession without itself experiencing one. This is the first time in my experience that such an outcome has occurred, and it must give us confidence in the soundness of our economy. But before getting carried away, we should concede: • By the standards of earlier world recessions, last year’s was a mild and short one, and some observers may be reluctant to classify it as a fully-fledged recession. • We did not escape scot-free. If you average our growth in 2000 and 2001, it comes out at 3 per cent so we did experience a modest slowing. As well as good GDP growth, we have experienced quite good employment growth over the past year. It appears that the slowdown in our economic activity resulted in a trough-to-peak rise in unemployment from 6 to 7 per cent, and that half of the rise has already been whittled away so far in 2002. This is extremely good news because it is the first time for three decades that we have been through an international downturn that has resulted in the peak unemployment rate in Australia being lower than its predecessor. At this point in proceedings, I usually review the previous set of forecasts I gave the Committee and then present a new set for the period ahead. I will continue that tradition, but we should bear in mind there is a full year of new data available to us so there is more to review. Last May, when we had only two of the four quarters of 2000/01 available to us, I said we expected year-on-year GDP growth in that year to be about 2 per cent; in the event, it came in at 1.9 per cent. My forecast for year-on-year GDP growth in 2001/02 was 3 to 3½ per cent, and our current forecast (still with two quarters yet to come) is 3.6 per cent. So, even though there have been big swings in the international outlook in the meantime, the last 18 months seem to have turned out much as we expected (unlike the previous six months where the extent of the housing-induced setback took us largely by surprise). On the prices front, we still had not seen the GST bulge pass through the system when we met last May. The forecast I presented at the time was that when it had passed through, the rate of inflation measured by the CPI would settle at 2½ per cent. In fact, that was “spot on” for the four quarters to the September quarter of 2001, but by the December quarter inflation had risen to 3.1 per cent, and by the March quarter 2002 it was 2.9 per cent. So, on average, we slightly underestimated the rise in inflation. For the year ahead, i.e. 2002/03, we are forecasting the economy to continue growing at 3½ to 4 per cent as it completes the eleventh year of its expansion and enters the twelfth. The outlook for inflation over the same period could best be summarised as remaining near the top of our target range, although we expect it to go down slightly for a time, and then to come back up. This was the view expressed in our quarterly Statement on Monetary Policy released earlier this month. In short, the outlook for economic growth and inflation is such that the economy no longer needs the boost provided by an expansionary stance of monetary policy. We took the first step towards returning monetary policy to a more neutral setting earlier this month, and, unless unforeseen developments intrude, we should continue the process as we go ahead, while all the time carefully examining incoming data, both from here and abroad, to ensure that developments remain on track. I will return to this theme later in my presentation, but before doing so I should examine the economic outlook in a little more detail. In looking ahead, we always have to ask ourselves where the balance of risks lies. Another way of expressing this is to ask: what is the main risk for the economy if we did not adjust monetary policy? In our view, the most important risk would be that the expansionary forces in the economy would increase to an excessive degree, bringing with it the likelihood that inflation would rise from its present position at the top of our target range to something in excess of it. In the process, we would also expect other imbalances to emerge which would ultimately bring the current expansion to an end. Of course, we cannot entirely rule out the alternative outcome whereby the economy slows and puts sufficient downward pressure on inflation that it threatens to fall below the bottom of our range, but we would put a low probability on that outcome. As has been the case now for some time, to the extent we can identify risks on the downside, they come mainly from abroad. Even though the US economy grew quickly in the first quarter of the year, the strength of its recovery is still uncertain, and there are risks to the world economy from the unstable political situations in the Middle East and Indian sub-continent. On the domestic front, the most easily identifiable area of spending that will exert a dampening influence later in the year is likely to be house-building, largely because so many houses will have been built that construction will not be able to continue at its former rate. But overall, barring some unforeseen international event, we find it hard to see serious risks on the downside for the Australian economy. We cannot rule out slightly below-average growth, but we would regard anything significantly more adverse as unlikely. Instead, conditions are much more conducive to stronger economic growth than last year. The turnaround in the world economy will mean that it will be a positive force for growth over the year ahead rather than a dampening influence. This should be good for exports, investment and confidence in general. As well, both consumer and business confidence have returned to quite high levels after a couple of setbacks last year. Business investment has been quite restrained over the past couple of years but is about to pick up according to the plans businesses supply to the ABS’s Capex Survey. This is not surprising given the relatively healthy profit situation, the high level of business confidence and the expected growth in spending. These more buoyant conditions may also encourage businesses to attempt to rebuild profit margins, which will be a factor underpinning inflation over the next year or so. Thus, we believe that if monetary policy maintained its present stance for too much longer, there is little risk of a serious slowdown, but a high risk that the economy in time would overheat. This provides the basis for our view that monetary policy should be returned to a more neutral setting. I think there is widespread agreement with this assessment of the situation, but inevitably there will be people who do not agree. One doubt you sometimes see expressed is the fear that any rise in interest rates will “choke off the expansion”. Not surprisingly, we feel that this fear is misplaced. At one level, it amounts to saying that the expansion is so fragile that it can only be continued if monetary policy is kept permanently at an expansionary setting. We also care about continuing the expansion, but feel that the least risky way of doing so is with a more neutral interest rate setting. At another level, the fear may be that we at the Reserve Bank will err on the tight side. Of course, that is possible, but our track record does not support this view. Over the past decade or so, the thing that stands out about our monetary policy is the fast rate of economic growth it has permitted compared with other comparable countries, not any tendency to over-achieve with inflation reduction. Where we differ from some observers is that we are mainly interested in the medium run, i.e. we want to sustain the expansion rather than to maximise its speed over the next year. We have been consistent in this approach for the best part of a decade, and it has served us well. I would now like to change to a subject that was highlighted by this Committee in its press release announcing today’s hearing, namely credit card reform. The Reserve Bank released its consultation document in December last year. In it, we proposed, subject to further consultation, three major changes to the four party credit card schemes that operate in Australia: – first, a new and transparent standard for setting the interchange fees on credit card transactions which would lead to a reduction in those fees, and thus in the merchant service fees paid by businesses; – second, the ending of the prohibition imposed by the card schemes that prevents merchants from passing the cost of accepting credit cards on to cardholders; and – third, the elimination of the restriction on entry to the credit card schemes that keeps out potential competitors that are not deposit-taking institutions. After we released our document, we allowed interested parties till mid-March to prepare submissions, and we have been going through those submissions thoroughly with them since then. We want to give each party every opportunity to put their view forward, even if it involves multiple meetings. We are still in this process and, when we have finished, we will release our findings sometime after the end of June. During this period, we at the Reserve Bank have not engaged in public debate on this subject, even though some of the other participants in the credit card industry have been quite vocal. We see our role during this stage essentially as the umpire adjudicating between the competing views of the financial institutions and card schemes on one side, and the consumers, retailers, billers, etc. on the other side. Of course, our umpire role should not inhibit the Committee from asking any questions it wishes to. | reserve bank of australia | 2,002 | 5 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to The Economist Group¿s 7th Foreign Investor Roundtable with the Government of Australia, Canberra, 25 June 2002. | I J Macfarlane: Relative advance or relative decline? Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to The Economist Group’s 7th Foreign Investor Roundtable with the Government of Australia, Canberra, 25 June 2002. * * * I would like to start by thanking The Economist Group for inviting me to be the guest speaker at the 7th Roundtable. These Roundtables have served a very useful purpose since their inception in the late 1960s, and I am sure this one will be just as productive. When I was invited to give this address, I was told that it would be part of a session entitled “Australia in 2020: strikingly similar, significantly different, or in relative decline”. From this, I assumed that I was required to speak on medium-term issues, which I am always very happy to do. But since I have a couple of difficulties with the session title above, I may not stick to the script expected of me. My first difficulty is that I am wary of forecasts going out as far as 2020. These have a tendency to be not much more than projections of current short-term trends and can be quite misleading; this was the case with those produced by the Club of Rome in the seventies showing the world running out of commodities, and those made in the eighties showing the level of GDP in Japan exceeding that of the United States. My other difficulty is with the inclusion of the phrase “relative decline” as a possibility, without specifically mentioning the possibility of “relative advance”. This may be nothing more than a “Freudian slip”, but nevertheless, I will use it as the theme for my talk tonight. It is a theme I have touched on before - the tendency for Australians to be pessimistic about their economic future. The reasons for this pessimism have varied from decade to decade, and there have been a few new ones added in recent years, but the overall tone seems to be relatively constant, and relatively impervious to changes in our actual economic condition. I would have thought that, after a decade in which our growth performance has been the best in the OECD area (with a couple of minor exceptions), most of the pessimism should have receded, but I doubt that it has. In order to assist in this process, I would like to recall some facts before moving on to discuss the arguments. I have already mentioned our growth performance in the past decade. The actual numbers are shown in Table 1, which uses calendar year 1990 as the base and shows the average growth rate up to the most recent quarter (March quarter 2002). Note that by using 1990 as the base, we include the early nineties recession for all countries in the average, as well as the later expansion. The exceptions are Ireland and Luxembourg. Table 1 Real GDP growth (annual rate, per cent) 1990-current* Australia 3.4 Norway 3.0 United States 3.0 Canada 2.7 Netherlands 2.6 New Zealand 2.6 Portugal 2.6 Spain 2.6 Austria 2.4 United Kingdom 2.2 Denmark 2.1 Belgium 2.0 Finland 1.9 France 1.8 Germany 1.6 Sweden 1.6 Italy 1.5 Japan 1.1 Switzerland 0.9 * Greece, Iceland, Ireland and Luxembourg not included due to data limitations. Part of our stronger growth can be explained by faster population growth, but we also have put in an excellent productivity performance over the decade as well. In the work done by the Federal Reserve Board in the United States and by the OECD in Paris, Australia is identified as one of the group of countries that has increased its rate of productivity growth (whether measured by labour or multi-factor productivity) in the nineties compared with the eighties. Chart 1, which is reproduced from the OECD, shows Australia is second only to Finland in its acceleration in multi-factor productivity. The trends I have mentioned are not confined to the 1990s, although that was clearly our best decade in terms of relative advance. If we look at the broader picture over the past 20 years, Australia is still in the very small group of advanced countries to have increased its share of world output. Using the IMF’s annual database , it is possible to discern some interesting longer-term trends from developments over the past 20 years. This is a useful exercise because it is an antidote to the type of thinking which concentrates on very recent developments, some of which I will cover later. C. Gust and J. Marquez, “Productivity Developments Abroad”, Federal Reserve Bulletin, October 2000. “The New Economy Beyond the Hype”, OECD, Paris, 2001. IMF, World Economic Outlook, database, http://www.imf.org/external/pubs/ft/weo/2002/01/data/index.htm. The two main trends that are of relevance for tonight’s topic are as follows: Our region - which is mainly the developing countries of Asia - has grown a lot quicker than the world as a whole and so its share of world output has risen from 10½ per cent in 1980 to 24 per cent in 2001. Not only has the total risen, but each country, with the exception of the Philippines, has been able to increase its share of world output (Table 2). It is worth reminding ourselves of this major trend, because it tends to be overshadowed by our more recent memory of the Asian crisis of 1997 and 1998. Table 2 Asian output (per cent) Share of world output Change in share 1980-2001 China India Korea Indonesia Taiwan Thailand Philippines Malaysia Hong Kong Vietnam Singapore 3.42 2.78 0.73 1.12 0.50 0.54 0.79 0.24 0.26 0.18 0.11 12.03 4.68 1.69 1.55 0.99 0.93 0.67 0.44 0.40 0.36 0.24 251.9 68.6 131.2 38.1 99.4 73.2 –15.6 86.0 50.6 93.6 111.6 Total Total (excl. China) 10.67 7.25 23.96 11.93 124.7 64.6 In contrast, the developed countries of the OECD area have grown less rapidly than the world average and their share of world output has fallen from 57.5 per cent in 1980 to 52.4 per cent in 2001. Within the group of developed countries, only three have managed to increase their share of world output - the United States, Australia and Ireland. If we leave out Ireland because of its small size and its exceptional circumstances, Australia and the United States are the only two developed countries of reasonable size and reasonable initial income per head to have increased their share of world output. Some people would discount our achievement by pointing out that a fair bit of our increase in share was due to higher population growth resulting from higher levels of immigration. But that should be seen as a strength rather than a weakness if we are interested in which areas are growing and which are declining in relative importance. Also, it points to favourable developments in the future, as high-immigration countries are less susceptible to the strains imposed by an aging population. Table 3 OECD output (per cent) Share of world output Change in share 1980-2001 United States Japan Germany France United Kingdom Italy Canada Spain Australia 21.27 8.05 5.66 3.91 3.60 4.00 2.14 1.89 1.06 21.31 7.28 4.50 3.21 3.13 3.09 1.98 1.76 1.13 0.2 –9.6 –20.5 –18.1 –13.2 –22.8 –7.7 –7.2 6.4 Netherlands Belgium Sweden Austria Switzerland Greece Portugal Denmark Norway Finland Ireland New Zealand 1.03 0.77 0.63 0.57 0.64 0.48 0.41 0.40 0.31 0.32 0.16 0.21 0.90 0.60 0.49 0.47 0.46 0.39 0.38 0.34 0.29 0.29 0.25 0.17 –12.8 –21.7 –23.2 –18.3 –28.4 –19.3 –8.4 –16.1 –5.9 –10.4 58.1 –17.9 Total 57.5 52.4 –8.9 I have presented enough statistics for the time being. The purpose of highlighting these 20-year trends was not to imply that they must continue - they may not. My purpose was to ask the question “given this has happened over the past 20 years, why would you start with the presumption for Australia of relative decline - why wouldn’t you start from the expectation of relative advance?” Another way of viewing these statistics is to observe that, while there may have been some influences running against us, they have obviously been outweighed by influences acting in our favour. What are these influences that are generally cited as acting against our long-term interests? I will start with the familiar, then move on to some of the more recently-cited ones. The time-honoured reason for pessimism was the belief that there would be an inevitable long-run decline in Australia’s terms of trade, i.e. that our export prices would stagnate, while our import prices would rise inexorably. This was tied up with the general lament that we had too small a manufacturing base, and were too dependent on “commodities” produced by the rural and resource sector. There certainly was a lot of substance to this argument until recently, so I do not wish to belittle it, or declare it dead prematurely. But events over the past two decades or so have cast a lot of doubt on its future applicability. For example: (a) Australia’s terms of trade bottomed in 1986 and have risen since. It has not been an even rise, but each subsequent trough has been at a higher level than its predecessor. The main reason for this is not that export prices have been particularly buoyant, but that import prices, predominantly manufactures, have been weaker. (b) This should come as no surprise since the nature of the world’s manufacturing sector has undergone an enormous transformation over the past two decades. In 1980, only 25 per cent of the world’s manufactured exports came from developing countries: by 2000, 80 per cent did so. There has been a role reversal, and this has been accompanied by a loss of pricing power by exporters of manufactures that has effectively shifted real income to importing countries. It is hard to see how this process could not continue, with China and India still having so much capacity for further expansion. The more recent sources of pessimism are of a very different nature, and very hard to analyse in simple economic terms. Let me start with a frequently-heard complaint in financial markets, and work from there. The complaint is summarised by the phrase “we (meaning Australia) are just not on the radar screen”. By this is meant the tendency for investors around the world to concentrate their efforts in the big markets, such as the United States and Europe, and to ignore us because of our small size and lack of strategic importance. There is no doubt that this tendency can be important at times, but we should not assume that it is permanent. Recently, we suffered from its effects, but there is no reason why it should continue, and it has not continued. Chart 2 on recent international capital flows into and out of Australia tells an interesting story. First, it is certainly true that inward portfolio investment into Australian equities dried up for a time in 2000 and early 2001. This was consistent with the “we are off the radar screen” explanation, which itself was part of the international investment community’s infatuation with the “new economy” and its disdain for the rest, including us. But the important thing is that it seems to be a phase that has passed into history with the rest of the “tech bubble” - inward portfolio investment has resumed again in recent quarters. Incidentally, inward direct investment continued at a relatively steady pace over recent years, and was largely unaffected by the tendency described above. In the past, it was inward direct investment that attracted unfavourable comment. Foreign investment and multinational corporations were viewed with suspicion and accused of buying our best companies (in some sense, the opposite of the “we are off the radar screen” argument). Now the interesting tendency is in the opposite direction - Australian direct investment abroad is greater than foreign direct investment in Australia. Also, Australian portfolio investment abroad has risen strongly. What does this mean? Does it support another often-heard view that there are no good investment opportunities in Australia, and firms and investors are forced to go abroad? The first thing to note is that Australia is still an overall net importer of capital, i.e. more is invested in and lent to Australia from abroad than we lend to or invest in other countries (a necessary corollary of running a current account deficit). Since the Government has little or no role in these investment flows, it is the world and Australia’s private sector players that have chosen this outcome. Notwithstanding this consideration, some people are still troubled by the amount of portfolio investment abroad by Australian institutions and direct investment abroad by Australian companies, accusing them of turning their backs on Australia. I think the situation is a bit better than this. My guess is that the bulk of the portfolio investment abroad is just a sensible diversification of assets by Australian investors and institutions. In 1983, before exchange controls were abolished, Australian portfolios had zero international diversification, and in time we will reach a level that is appropriate to our circumstances. In the meantime, we will see outflows as we move from zero to the optimal level. In addition, we should not forget that other countries are also diversifying their portfolios, and in the process purchasing Australian equities and bonds. World Bank, “Globalisation, Growth and Poverty”, 2002. On direct investment, we are going through the second phase of Australian companies buying overseas assets. In the first phase in the late eighties, it was done rather indiscriminately with a lot of investment outside the investor’s normal area of expertise. The results were not very good. More recently, however, most of it has been done by successful Australian firms that have reached their limit of expansion in their own industry locally, but are good enough to compete in other markets in their area of expertise. Thus, we have seen them expanding directly into overseas markets in transport, packaging, building supplies, shopping malls, property services, etc., mainly activities that cannot be serviced via exports, but require direct investment. I think this trend is to be applauded, and is a sign of the success of Australian business rather than its inadequacy. Although we are nowhere near as far down this path as, say, the Netherlands or Switzerland, their success shows that it is not only the major countries that can create viable international companies. So far, I have not mentioned the other catchphrase - the “branch economy” - the belief that the companies in the peripheral countries will be swallowed up by larger companies centred mainly in the United States (and, to a lesser extent, Europe), leaving only branch operations behind. This is a more difficult concept to pin down, although I do not wish to dismiss it as a concern. There certainly are powerful forces towards centralisation that operate within economies, and between economies. These centripetal forces are primarily the result of improved technology, particularly in communications, media and transport. They are best analysed within the framework of “winner-take-all markets” rather than in the more conventional discussion on globalisation. If this is our concern, i.e. our best companies are falling into foreign hands, the thing we should mainly worry about would be a big rise in inward direct investment, but we have not seen this - we have seen R.H. Frank and P.J. Cook, “The Winner Take-All Society”, The Free Press, N.Y., 1995. a reasonably steady trend over recent years. Again, if this is our concern, we should applaud the success of Australian companies operating abroad, as shown by the recent strength of outward direct investment - although there will inevitably be tensions about where these companies will be listed and headquartered. It will take a long time before we can put these issues into perspective. We are still too heavily influenced by the events of recent years whereby everyone seemed to be comparing themselves unfavourably against the US economy, and finding that they were losing out in the investment community’s esteem. That situation is changing and, when the dust settles, I suppose some of the more extreme views about the magnetic pull of investment to the United States will recede. As explained, we have already seen this happening in the Australian figures on foreign investment and it is also showing up elsewhere, including in the US figures on capital movements, where net capital movements have returned to outflows after a few years of heavy inflows. This is the note on which I think I should finish. We cannot predict the future: all we can do as a country is to try and make sure that we have an economy that is resilient enough to handle the shocks that it will inevitably face. We have done so successfully twice in recent years when we faced the Asian crisis of 1997/98 and the world recession of 2001. This should give us some confidence that we can handle the next one - whatever it is - as successfully. | reserve bank of australia | 2,002 | 7 |
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the 12th Colin Clark Memorial Lecture, Brisbane, 21 August 2002. | I J Macfarlane: What does good monetary policy look like? Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the 12th Colin Clark Memorial Lecture, Brisbane, 21 August 2002. * * * I would like to start by thanking the University of Queensland for inviting me to deliver the 12th Colin Clark Memorial Lecture. It is an honour that I very much appreciate. I met Colin Clark very briefly at Monash University in the late 1960s when I was starting my professional career and he was finishing his and easing into retirement. He was a remarkable man who was widely respected by the world’s economics profession, but who received less recognition in Australia than he deserved. Previous speakers in the series have given accounts of his career so I will confine myself to two anecdotes. The first is based on something I spotted quite recently. Out of nothing more than idle curiosity, I looked up the journal Econometrica for 1950 to see one of John Nash’s original articles. While searching for it, I came across a list of the eleven members of the Council of the Econometric Society at that time. It was the cream of the economics profession, five of whom subsequently won Nobel Prizes, and all but one from prestigious universities. The exception was Colin Clark, who won acceptance into this august company yet listed his affiliation as the Queensland Bureau of Industry. The second anecdote is based on my memory of an article on India he wrote in the Melbourne Age more than 30 years ago. It provoked an angry response from a local Indian academic, the essence of which could be summed up as “what would you know about the subject?”. In his reply, Clark listed the people with whom he had discussed the subject over the previous 40 years - the list started with Gandhi, Nehru and Mountbatten and continued from there. To some, it might seem to be a case of name-dropping, but to people who knew him it was just another illustration of his extraordinary breadth of experience and his endless search for knowledge. Monetary policy in the medium term Let me now turn to the topic of my address today which, not surprisingly, is about monetary policy. I want to start with the apparently simple question, “what would good monetary policy in a healthy economy look like?” Usually, when people answer such a question, they end up by giving an account of what monetary policy should set out to do. They point out that its primary focus should be on a nominal variable such as inflation because this maximises the chances of achieving sustainable economic growth. Sustainability is the key concept here; attempting to maximise growth in the short run is counter-productive, as is exclusive concentration on trying to smooth the business cycle, or the attempt to get the economy on to a trend growth path higher than its potential. I have no wish to argue with any of these propositions, and indeed they are all encompassed within our inflation-targeting approach to monetary policy. They are admirable statements of the aims of monetary policy, but they are not descriptions of what good monetary policy in a healthy economy would look like, i.e. they do not tell us how the instrument of monetary policy would behave. Perhaps it is best to start at a very simple level. Most people do not like very high interest rates and associate them with bad monetary policy. Of course, if the country is already experiencing high inflation, the high interest rates may be a necessary evil, and the alternative would probably be a lot worse in the long run. Be that as it may, we can hardly say that such a situation could be described as good monetary policy in a healthy economy, because the economy is not healthy - it is suffering from high inflation. This all seems pretty obvious, but the obverse is not so obvious. I sometimes hear people say “why don’t we have lower interest rates like country X?” as though the lower the interest rate, the better off we would be. On closer examination, we see that very low interest rates, although they may also be a necessary evil in the circumstances, usually indicate an unhealthy economy - one that is in recession or, even worse, deflation. We do not have to look very far to see examples of this over the past few years. So if very high is bad, and very low is bad, is there not a happy medium somewhere? Is this how we would recognise good monetary policy in a healthy economy? The answer is yes - that is certainly part of the story, but only part. I would now like to go on and tell the rest. Twenty or thirty years ago if we had asked my simple question, the answer would have been something like the following. If the potential growth rate of the economy is, say, 3½ per cent per annum and the desired rate of inflation is 2½ per cent, then the long-term trend rate of growth of nominal GDP will be about 6 per cent per annum. We should, therefore, aim to make sure that the supply of money grows at a constant rate which is consistent with this. The actual rate will depend on the trend in the velocity of circulation, but the important thing is that when we find the right rate, we stick to it. In this world, interest rates are determined as the residual - they rise or fall enough to ensure that the growth of money supply stays on its constant path. Note, of course, that economic growth will not be constant: its annual growth will fluctuate around the long-term trend. This is a very simple model and a very appealing one. Unfortunately, things were never really able to work out this way. The assumed stable long-term relationship between money and nominal GDP broke down because of changes brought about by financial innovation and deregulation. But it is still a very good starting point for discussions, and many of its characteristics still hold good in a world without a stable demand for money. In the modern monetary policy framework as practised around the world, we cannot, and should not, directly “control” the supply of money and wait for interest rates to drop out as the residual. We now control the very shortest interest rate (the cash rate) directly, and so it acts as our instrument of monetary policy. So how should its average level and its short-term movement behave in a healthy economy? The answer: very much as they would in the earlier example I gave with a stable demand for money. For example: • Nominal interest rates would not show either a rising or falling long-run trend. Their fluctuations would be around a stable average - in technical terms, they would have the statistical characteristic known as stationarity. • The numerical value of this long-run average would be the level that was consistent with a low-inflation sustainable growth path for the economy. • For a healthy economy, the inflation rate would neither rise nor fall in trend terms, and so the long-run average real interest rate would also be stable. It is this rate which is often referred to as the “neutral rate of interest”. • The actual real rate of interest would rise and fall as it responded to increasing and decreasing inflationary pressures in the economy. If the real rate of interest did not go up and down in response to these changing pressures, the underlying dynamics of the economy would be unstable for the reasons I outlined in my recent Giblin Lecture. The actual time path of real interest rates would closely resemble the time path that would occur in the stable money demand example I gave earlier. The difference is that it would result from a sequence of deliberate monetary policy decisions, rather than occurring as a residual. This is the sort of behaviour of interest rates that has been observed in Australia over the past decade. A stable rate of inflation, a stable average growth rate, a stable average short-term interest rate whether measured in nominal or real terms, but some variation in actual interest rates as monetary policy responds to alternating periods of inflationary or disinflationary pressures. That is, a stabilising monetary policy involves interest rates moving. It is entirely consistent with the inflation-targeting framework we employ, and it is employed either explicitly or implicitly by virtually all other major countries. Some current considerations What is the relevance of the foregoing for what is happening now? If we look around the world, we see some examples which illustrate some of these points. “The Movement of Interest Rates“, Reserve Bank Bulletin, October 2001. A technical addendum to the above might recognise that if the economy’s potential growth rate had increased, for example, as a result of faster productivity growth, then its neutral real rate of interest should be higher. This would, however, be very difficult to identify other than on a decade-by-decade basis. It would be further complicated by the fact that, in the short run, faster productivity growth could initially show up as reduced inflationary pressures. For these reasons, it is better to stick to the simple version as outlined in the text. It is very hard to find examples of countries with very high interest rates, other than a few emergingmarket countries trying to stave off a currency crisis. Examples of very low interest rates come more readily to hand. The best example is Japan where the cash rate is zero; this is obviously a result of an economy experiencing deflation and a closely spaced series of recessions. In the United States the cash rate is 1.75 per cent, the lowest since the early 1960s. Again, this is an economy which has just been through a recession and is still experiencing the unwinding of the equity price bubble. In the case of the Euro area, the situation is closer to normality, but growth over the past year has been negligible; not surprisingly, the cash rate is still only 3¼ per cent. Then we come to a few countries like Australia, New Zealand, Sweden and the United Kingdom where conditions are relatively normal and the cash rate is in the range of 4 per cent to 5¾ per cent. I should also mention in passing that this group of countries all employ inflation targeting as their monetary policy regime. Most of the countries in this group have raised interest rates this year, because there has been a good case to do so on domestic grounds. But, at the same time, they have been keeping a close watch on the global economy and global financial markets to see whether these developments could outweigh the domestic influences. That has clearly been our case over the past two months. In May, I told a Parliamentary Committee that, since the Australian economy was behaving normally, and the world economy was getting back to normal, our interest rates should also be moved up to normal (or neutral). That is still a good general guide to policy, and is consistent with what was said in the first part of this lecture. But policy always has to retain the capacity to respond to unexpected events, and hence I did include a qualification to this guide in that I said that “as long as nothing intruded”. Also, I did not specify a timetable. As a result, the financial markets were not surprised when monetary policy was not tightened at the July and August Reserve Bank Board Meetings. Something clearly had intruded, as was obvious to anyone who kept abreast of world economic and financial developments. The expected development of the domestic economy was still on track, but for the world economy, and particularly the US economy, some serious doubts had arisen. Whatever guiding principle underlies a monetary policy strategy, it has to contain the flexibility to absorb incoming information and be adjusted accordingly. So if unforeseen events intrude, they should correctly be allowed to delay the return to normality, or if the events were severe enough, they could in extremis overturn the direction of movement. Although the latter possibility has to be recognised, we think it is very unlikely. There has been more focus on equity markets over the past two years than any other time I can recall in the post-war period. Most of the focus is on the United States, but European markets have fallen just as far. Falls in equity prices are principally a concern to us because of the risk they pose to global economic recovery. The most obvious channel is through wealth effects to consumers, but business spending is also vulnerable to the rising cost of equity capital, and to the cost of debt as credit spreads widen. There may also be an increase in general uncertainty and preparedness to invest as a result of community disillusionment with some recent business practices. I want to stress that these risks come from international markets, not the domestic ones. Even though Australian share prices have fallen, compared with others they have done so by a smaller amount, from a much lower peak, and the fall has been much more recent. Most importantly, we did not have a “bubble” in our stock market as Diagram 1 attests. Nor have we had anywhere near the widening of credit spreads in debt markets that has occurred in the United States (Diagram 2). Our business environment has not been without incident, as several prominent failures show, but with the exception of One.Tel, they have not been the result of a boom and bust in the share markets. As has Canada, but it is a special case in that it followed US rates down to very low levels. It has since raised them three times this year, but they are still only at 2.75 per cent. Diagram 1 Click to view larger Diagram 2 Click to view larger The other thing I would like to mention before I close is another aspect of asset prices. We in Australia have been very fortunate in the current expansion in not having a boom or a bust in asset prices - the closest we come to such a situation would, I suppose, be the large rises that have occurred over the past five years in house prices. Now, many of you may be aware that this situation is one that we at the Reserve Bank are not entirely comfortable with. While it may give home owners a happy feeling, we cannot help but also think of the people - mainly in the younger age groups - who aspire to own a home, but are finding it increasingly difficult to do so because rising prices are putting home ownership out of their reach. But since this is mainly a wealth distributional issue, rather than something that directly affects the economy’s ability to continue its low-inflation economic expansion, it is not something that can or should be directly This is not the first time the Reserve Bank has “bought into” this issue. See my speech, “Inflation and Changing Public Attitudes“, Reserve Bank Bulletin, December 1995, which made the same points during a period when there was some public dissatisfaction with the failure of house prices to rise! addressed by monetary policy. As always, monetary policy has to be directed towards how the average of the whole economy is evolving, not to what a particular sector is doing. Although we should not allow our perceptions of developments in the housing sector to determine our stance on monetary policy, in our view that does not mean we should remain silent on the subject, and we have not. The situation over the past 18 months, where more than half of the total increase in housing loan approvals has gone into the investor market, is a very unusual one. When we see that this is occurring against a background where vacancy rates are rising, rents are stagnant or falling, and a large increase in new supply is coming on stream, it suggests to us a mis-allocation of investment, and the likelihood of a shakeout in the market, at least in the major cities. If that is to occur, it is better that it occur sooner rather than later. Conclusion My main conclusion is that in assessing monetary policy, it is important to see it in a medium or longterm perspective. It is also important not to get the impression that monetary policy is only exerting an influence if it is changing. It is true that monetary policy only makes news when it is changing, but its influence is really the result of what the level of interest rates is. It is quite easy to conceive of situations where monetary policy has not been changed for a considerable time, but where the level of interest rates is exerting a strong expansionary or contractionary effect on the economy. Once we recognise that the level is important, we inevitably have to ask what we should compare the current level with, and this leads us to think of the concept of normality or neutrality. Of course, we only expect interest rates to be normal in periods when the economy is operating in a normal or healthy way. In situations where it is under either sustained inflationary or disinflationary pressure, there are more important matters at hand than to ponder such theoretical concepts as the neutral level of interest rates. Fortunately, the Australian economy is in that small group of countries that can rightly be described as operating in a normal or healthy way; in fact, in many ways, we are the best example around at present. | reserve bank of australia | 2,002 | 8 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to 40th Australia-Japan Joint Business Conference, Sydney, 14 October 2002. | Glenn Stevens: Medium-term economic prospects for Australia Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to 40th AustraliaJapan Joint Business Conference, Sydney, 14 October 2002. * * * It was very kind of the Australia Japan Business Co-operation Committee to invite me to speak to you today and it is a pleasure to accept the invitation. The fact that this is the 40th conference of its type attests to the longstanding relationship between the business communities in our two countries. This stretches back half a century to a time when far-sighted individuals saw that Australia's enormous resource wealth and Japan's growing industrial size were complementary. That marked the beginning of a long process, for Australia, of our trade patterns altering from the predominance of the United Kingdom and continental Europe towards the fast-growing economies of the Asia-Pacific region, a process which has continued to the present. The relationship has matured in many respects. Despite the setbacks of the Asian financial crisis of five years ago, Australia's trade is still dominated by flows to and from the east Asian region. Even with the almost intractable economic difficulties faced by Japan over the past decade, it is still the largest single trading partner nation in merchandise for Australia. While resource shipments are still very large, and farm produce retains an important place in Australia's trade, flows of manufactures and services are more prominent these days. Capital flows are also increasingly important, and those coming to Australia from Japan are large at present, as Japanese retail investors seek higher yields by investing abroad. Both countries have been, and remain, active at the official level in seeking to improve the economic and financial structures underpinning the region. So there is good reason to gather and discuss issues of mutual interest. The organisers of today's proceedings have invited me to think about the Australian economy over the next three years or so. I don't intend to adopt a precise three-year horizon, but I am going to interpret the brief as a general invitation to talk about the medium term, rather than the very short term. This will hardly be a comprehensive and detailed forecast, but more an impressionistic sketch of a few themes. The Current International Scene Inevitably, some of these themes have to be international ones, and given the current state of affairs I need to touch briefly on the conjuncture. At the time of our August Statement on Monetary Policy, a gradual but modest pick-up in global economic activity was under way, but sentiment in international financial markets had turned decidedly more pessimistic in mid year. That was most clearly seen in the fall in share prices, which was a reaction to the realisation that, even with some economic recovery, corporate profits in the major countries were not going to record the growth which was needed to support the earlier level of share prices. On top of that, there was suddenly a lot more doubt about what US profits had been in the past, let alone what they would be in the future. Since then, we have seen a continuation of financial market behaviour which indicates heightened risk aversion and diminished confidence: there have been further falls in share prices, and bond yields have continued to decline, reaching unusually low levels. There has been some marking down of forecasts for nearterm global growth and murmurings about “double dips” for the US economy, though that is not, at present, a majority view. We will give a full account of all this in our forthcoming November Statement. For the moment, I would record that the bulk of the data still suggests that an expansion has been under way in the United States since late last year, but quite a weak one. At the same time, the economic and financial data from Europe over the past several months have been quite disappointing, and in some respects weaker than those of the US. Signs of the elusive Japanese recovery are fewer than they were earlier in the year, while asset values there have continued to decline. As of now, therefore, we are still in a period of great uncertainty. Will the tender shoots of growth develop into a period of sustained expansion? Or are they about to be overwhelmed by the lingering effects of the problems which emerged during the recession phase? And, given such a backdrop, what would be the economic effects of military conflict in the Middle East? It is not unusual to encounter such a period around economic turning points. A decade ago, for example, observers coined the term “jobless growth” to describe the sluggish US recovery. Eventually, however, the US upswing became more robust, and the US economy ended the 1990s with the lowest unemployment for several decades. So far in the current episode, which might be labelled “profitless growth”, the behaviour of the key “real economy” indicators for the United States looks remarkably similar to that recorded in the early 1990s recovery - a very modest pick-up after a fairly mild contraction. So while we cannot pretend that there are not very real concerns about the short-term outlook, it is still not unreasonable to think that the world economy will gradually work off the excesses of the boom and that we will in due course experience better conditions than we see just now. That remains the majority view of observers. Some medium-term possibilities On the assumption, for the moment, that that view is right, it is worth asking what similarities or differences we might expect in the next half decade as compared with the preceding period of growth in the second half of the 1990s. Here are some possibilities that occur to me. 1. Overall, US growth will probably be more moderate than it was from 1995 to 2000, which was an exceptional period and contributed to some macroeconomic imbalances. Whether that means global growth will also be lower than in the second half of the 1990s, or about the same but better balanced between major regions, is not yet clear. It could be hoped that we might see better growth in Japan than we have seen in recent times. We could also hope for the same from Europe. Better balanced growth ordinarily would be a recipe for less variability in exchange rates and capital flows among the major countries, although such a conclusion would depend on currency alignments being about right to begin with. 2. Non-Japan east Asia will once again be the world's fastest growth area (in fact, that is already the case). More specifically, China will continue to emerge as an increasingly big economy and will account for an increasing share of global trade. China has doubled its share of the world export market over the past decade. Of course, China is not only an exporter, but an importer as well, which creates opportunities for other nations' firms. China also has some structural challenges, which are still in the process of resolution. 3. Prices overall seem likely to be pretty stable, with inflation rates low. In both Europe and the United States, core inflation rates will probably be declining for the next year or so, and will by then be quite low. Examples of deflation - that is an actual fall in the price level, as opposed to disinflation, a decline in its rate of increase - could conceivably become a little more common around the world in this half-decade. In fact, at present this is particularly noticeable in Asia, with several countries (including both Japan and China, the two largest regional economies) experiencing falling prices over the past couple of years. 4. Expectations about returns on capital in the major countries are likely to be lower. It is now clear, of course, that expectations about equity returns were unrealistically high, and perceptions of risk too low, in the late 1990s. Moreover, the bursting of the tech bubble, and the corporate scandals in the United States, could well leave many investors feeling unenthusiastic about equity markets for some time. If so, the search for alternative investments will see bond yields held down, and possibly greater interest in some of the emerging markets, particularly in Asia. Trends in the Australian Economy So much for global matters. Assuming the above or something like it comes to pass, how might the Australian economy fare over the medium term? Australia has recorded growth of almost 4 per cent for most of the past decade. I think it is by now well known that this compares very favourably with virtually all developed economies. Subject to some possible caveats which I will come to shortly, it is reasonable to expect, given careful public policies and sensible private behaviour, that good growth can be sustained. For the moment, let me assume it will be, and draw out some implications. I'll then return to considering what could go wrong. One implication of the growth described above, if it can be achieved, is that we would see the rate of unemployment noticeably lower than it is today. In the past 20 years or so, the Australian economy has, virtually without fail, seen unemployment fall when growth is 4 per cent or more (and rise when growth is less than 3 per cent). On that calculus, the unemployment rate could, all other things being equal, fall from its current 6.2 per cent to 5 per cent or below within a few years. It's worth noting in this context that demographic factors associated with population ageing mean that the supply of labour will be rising more slowly in the next decade than it has in the past. This is a long1 run tendency, but already the labour force is growing less quickly than it was a few years ago . For a detailed discussion of demographic issues as they affect the labour market, see “Demographic influences on longterm economic growth in Australia”, Treasury Economic Roundup, Spring 2000; “Factors influencing medium-term employment growth”, Economic Roundup, Winter 1999; “Recent movements in the labour force participation rate” Economic Roundup, Summer 1999. One implication of that would presumably be heightened competition between firms seeking to attract and retain the right workers. For the workforce, this is a good prospect in that they might expect to enjoy somewhat stronger growth in real wages than otherwise. Firms would also face greater incentives to economise on labour through labour-saving capital investment, which will raise perworker productivity. In time, we may also see a reversal of the tendency towards early retirement that we have seen over the past 20 years or so. My guess would be that the value of older, experienced employees with a lot of accumulated human capital is likely to be re-appraised by employers, so from the demand side there might be a desire to retain these employees in a world where younger workers are relatively less abundant. And on the supply side, the intersection of longer life expectancy and modest returns on assets may prompt some re-evaluation of retirement ages on the part of older workers. No doubt government policies could influence these choices too. Depending on how all that plays out, a further implication is that we might find at some point that the GDP growth rate of 4 per cent or more, which has been quite sustainable for a number of years as we have gradually wound in the spare capacity in the economy, has to give way to something a bit lower. There are two obvious reasons for this which stem from the discussion above. First, the scope to harness existing under-utilised labour is finite and would be mostly used up in the scenario in question. Second, the growth rate of the total labour force will be lower than in the past due to demographic factors. In other words, the economy's growth rate would have to slow to its medium-term potential rate, which is a bit lower than the actual growth we have experienced in recent years, and that potential growth rate itself is coming down a little - all assuming nothing else changes. Under such circumstances, one of the things we will presumably see is continued, or even heightened, discussion of the forces which affect the economy's medium-term potential growth rate apart from the growth in factors of production (i.e. labour and capital of various kinds). There's only one: productivity performance. Here Australia's recent record has been good. In international studies, the Australian economy stands out as having had a remarkable pick-up in productivity growth during the 1990s. Among the reasons behind this performance, and probably the most important one, is the widespread liberalisation and opening up of the economy to competitive forces that commenced in the 1980s and continued through the 1990s and which prompted Australian businesses to lift performance closer to global benchmarks. All of the Australian business people here today are, I know, intimately familiar with this phenomenon. Furthermore, it is unlikely that the process of converging to global best practice is yet complete, and those practices themselves are continually improving - hence there is every reason to think that strong ongoing productivity gains can occur in the current decade. As the process of putting surplus resources to work approaches its limit, the task of lifting the productivity of the already-employed resources takes on even more importance, if growth in material living standards is to be maintained at the current rate. What can go wrong? The above is not an unattractive scenario. But of course it presumes that growth continues. The business cycle has not been repealed, however, and so with 11 years of growth under our belt already, rather than presume on growth indefinitely, we should ask: what can go wrong? Many of us might immediately think of some global calamity, with one or more of the major regions relapsing into recession, delivering an even more difficult international environment than we face now. Our view, as I noted earlier, is that this is not the most likely scenario - but it is obvious to all that the risks of weaker international outcomes have risen considerably over the past six months. If that did occur, it would naturally affect Australia. We have come through a few tests in recent years fairly well and we would have good grounds to believe that we would be less adversely affected than many other countries in this scenario. In the recent international cycle, it has helped to have been a user, rather than a producer, of ITC (Information Technology and Communications) goods. It has helped to have avoided the worst of the hype and excess of the “new economy” mania, and to have had a long list of well-managed, profitable “old economy” businesses. And it has helped to have all the supply side flexibility resulting from many years of difficult economic reforms, as well as flexible macroeconomic policy structures. But even with all that, we have been affected by the global weakness of the past year, and we could not expect to sail through unscathed if the world economy were to falter in the near future. We cannot do much about the world economy, other than watch what happens and respond as best we can to whatever unfolds. But we should look to the possible domestic imbalances that could occur to bring the growth to an end, or render us more vulnerable to shocks from abroad. The one that has ended many expansions is a generalised overheating, leading to a late and therefore fairly aggressive policy tightening, and subsequent downturn. Our approach at the RBA has been, of course, to seek to avoid this particular problem. That is what our inflation-targeting system has been doing: by measured, early responses to a significant probability that inflation will rise, we have headed off serious inflation problems before they have become entrenched. That policy has also been prepared to lower interest rates in response to prospective economic weakness and falling inflation. This symmetric approach has helped to deliver not only low inflation, but also pretty low average interest rates for the past decade, and has been associated with a good overall economic performance. For that reason, the approach has quite wide support, and is in our view the best of the approaches to monetary policy which is available. A more difficult issue to confront is the instability which can result from big movements in asset prices. Here, our Japanese friends have intimate knowledge of the problems of asset price booms and busts and their aftermath. That, indeed, has been the defining feature of the Japanese economy from the late 1980s until now. Japan's experience shows how hard it is to recover from the deflationary pressure engendered by the bust if it seriously compromises the banking system. Australia had an experience qualitatively like this, though not quantitatively as serious, with commercial property in the late 1980s and early 1990s. At the same time, and closely related, there was a big run-up in corporate sector leverage. The unwinding of those excesses was painful for the borrowers, the banks who had lent to them and ultimately the macro economy. Since then, corporate borrowing behaviour in Australia has been much more circumspect. In recent times, the attention has been focused on household balance sheets, and on house prices in particular, where there has been a big run-up over the past five years, associated with a substantial increase in household debt. The chart shows a long-run time series of the ratio of household assets to current household income. Assets here include financial assets, and physical assets (mainly the dwelling stock). For many years, assets were about 4 times annual income. Over the past 15 years, that has risen to about 7 times. That is quite a striking result. It is at least as large, for example, as the relative increase in assets of American households, which occurred in the stock market boom there in the late 1990s. The difference is that, in Australia, much of this increase in asset values, particularly over the past few years, has been a result of rising house prices. With financial liberalisation allowing more access to debt, and with the decline in interest rates making debt more affordable to the average household, this asset accumulation has been accompanied by a rise in debt, though the ratio of debt to assets has risen only moderately, from around 14-15 per cent in the late 1980s, to about 17-18 per cent now. The structural decline in inflation and interest rates explains much of the rise in borrowing and buying by owner-occupiers. The effects of the gains in wealth on their behaviour are still working their way through the economy. But at present, our focus is on the role of investors in rental dwellings, which has become much more prominent in the past couple of years. These are people who presumably have been attracted by perceptions of capital gains and tax advantages of leverage, and who recently may have been disappointed with returns in the share market. Nearly 50 cents of every loan dollar approved for housing purposes is now going to investors, which is unprecedented. The RBA has examined all this in detail in other places and I will not repeat that analysis today. It does raise the question, however, of whether housing values can continue to increase like this. Ultimately, there has to be an income stream which anchors asset values. In the case of investor housing, that stream is, of course, the rent on the property. Rental yields have fallen noticeably in recent years, and there is widespread talk of rentals being under continued downward pressure at present, as the supply of dwellings for rent outstrips demand, something which appears likely to continue, and perhaps intensify, for a while at least. It is getting harder and harder to believe that the prospective returns from that outlook are high enough either to sustain valuations which are so high relative to historical experience, or to warrant the $4-5 billion which is being loaned to investors each month. Hence we are keen to see the pace of both price gains and the run-up in debt abate. This is not motivated by a puritan disdain for debt, or a desire to target some “correct” level of house prices, nor by concerns about pressure on CPI inflation over the short term. Nor does it stem from a belief that the Australian housing market in 2002 is the counterpart of Japanese stock or land prices in 1992, with the implication that a long period of severe problems lies ahead. But one doesn't have to believe that to be concerned about the possibility that enough people will end up over-extended that there could be discernible adverse macroeconomic consequences. A housing market boom and bust in itself doesn't seem likely to cause a recession, but the working out of financial excesses could well exacerbate a downturn which occurred due to some other factor, and delay the subsequent recovery. At this stage, there are differing views about whether the housing market has calmed down, though it appears from the most recent data we have that borrowing is continuing apace. This is clearly an area that warrants, and is receiving, very careful attention. Conclusion The world economy is going through a very difficult period. It is still reasonable to expect it to improve over time, but that is looking like being a very slow process, and in the interim the major economies will be vulnerable to further shocks. The Australian economy, in contrast, is in pretty good shape, and we have enjoyed an unusually long period of expansion. We have a good policy framework which we believe can handle regular cyclical dynamics acceptably well, and at this stage we do not see any imminent end to the expansion. Even so, it pays to be on the lookout for potential problems. We have to live with the risks emanating from the world economy. On the domestic front, the durability of medium-term growth would in our view be enhanced if the recent fervour for residential property were to give way to a more balanced and realistic assessment of the various potential avenues for investment. That probably involves an acceptance of more modest investment returns across the board than people may have been used to in the past decade or more. But unrealistic expectations, and the inevitable disappointment which follows, have elsewhere proven, through the swings in broader behaviour that those experiences bring, to be the biggest source of macroeconomic problems in recent years. If we can avoid that trap, we will have done a good deal to set the ground for continued good performance over the medium term, to add to the decade of good outcomes we have already enjoyed. If this happy state of affairs comes to pass, we could expect to see higher incomes, lower unemployment and gradual gains in general prosperity - overall, a rather favourable picture for the Australian community. | reserve bank of australia | 2,002 | 10 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to CEDA Annual General Meeting Dinner, Melbourne, 13 November 2002. | I J Macfarlane: Monetary policy in an uncertain world Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to CEDA Annual General Meeting Dinner, Melbourne, 13 November 2002. * * * This is the fourth time I have addressed CEDA’s Annual General Meeting in Melbourne, and following the practice adopted on earlier occasions, I would like to focus on a topic of current interest. Last time I was here two years ago, I devoted the whole speech to the exchange rate. This time I have found no need to mention it, as there are other more important things on our mind and, I think, of more interest to you. Last year - that is, calendar 2001 - was a difficult year for the world economy, in particular for the G7 countries, where over the course of the year output declined. So for the developed world it was a recession year, although a mild one by past standards. Monetary policy was eased virtually everywhere, particularly towards the end of the year when confidence about the future course of the world economy declined further following the events of September 11. As you know, the Australian economy grew very well during the international contraction of 2001, although we looked abroad and to the future with some apprehension. As the year 2002 began, it appeared that the worst fears for the future had evaporated. The US economy was always likely to enjoy only a relatively modest recovery, but appeared to be making a pretty quick turnaround, exceeding even the most optimistic forecasts, and confidence picked up - not only there, but in Europe, and even for a time in Japan. Those countries with strong domestic fundamentals - such as Australia, Canada, Sweden and New Zealand - began the process of getting their interest rates back to levels that were more commensurate with their domestic needs. But in about the middle of the year this confidence about the recovery of the world economy began to wane, and one of the consequences was that the upward adjustment of interest rates by the countries with strong domestic fundamentals was discontinued. I would like to spend some time examining this period from the middle of the year in more detail to see what it tells us about the future of the world economy. The outlook for the world economy A good way of illustrating the change in outlook is to see how consensus forecasts for 2002 and 2003 for the major economies - the United States, the Euro area and Japan - have been adjusted since mid year. The first thing to notice is that they have all been adjusted downwards, which is consistent with the change in confidence I described above (Table 1). Table 1: Forecasts for Major Economies Year-on-Year Growth Rates 2001 2002 Made in Made in Made in Made in June 02 Oct 02 June 02 Oct 02 US 0.3 2.7 2.4 3.6 3.0 Japan -0.3 -0.5 -0.9 1.1 0.9 Europe 1.5 1.3 0.8 2.7 1.9 G7 1.8 1.4 2.9 2.3 0.6 Also, forecast output growth in each year is below potential, implying a widening of the gap between actual and potential output, and hence disinflationary pressure. But on the other hand, the downward revisions are not large, so they are not predicting a future recession. In fact, the sequence of three years shows a pick-up in activity from 0.6 per cent in 2001 to 1.4 per cent in 2002 to 2.3 per cent in 2003. If this outcome were to occur, the recovery would be slightly better than that from the early 1990s recession and the whole episode much better than those in the early 1980s and mid 1970s. Furthermore, when we add in the non-G7 countries, particularly the major developing ones such as China and India, projected growth rates for the world economy are appreciably higher. The IMF’s forecast for world growth in 2003 is 3.7 per cent. I think these numbers are a reasonable working assumption on which to begin our consideration of policy. In this case, although the next eighteen months or so will not be great, they could hardly be called disastrous. But we also have to keep in mind the risks to this scenario, and here, I think there now seems to be widespread agreement that they are mainly on the downside. That is, if an outcome very different to the consensus was to occur, it would be more likely to be a weaker one than a stronger one. That, at least, is what the financial markets are saying if I interpret them correctly. Since mid-year, US share prices have fallen by about 15 per cent, bringing the cumulative fall since the 2000 peak to over 40 per cent. In Europe, the falls in both periods have been larger. Of perhaps more interest is the fact that bond yields in the United States have fallen by over 100 basis points since mid-year to levels not seen since the 1950s. This suggests a very high degree of risk aversion on the part of investors, as does the fact that the spread over treasuries for many well-known corporate borrowers has widened appreciably. Not surprisingly, yield curves, which in mid-year had indicated an expectation of future tightening of monetary policy in most countries, have gradually moved to showing either no tightening or an easing. In the United States, events have unfolded even further, with the Fed reducing the Fed Funds rate by 50 basis points last week. In summary, I think we could say that while economic forecasters have become mildly more pessimistic since mid-year, financial markets have become much more pessimistic. Why is this so? I think the answer to this is that there are a lot of things happening in the financial and corporate sector that are very unsettling, but which are difficult to incorporate into a conventional economic forecast. The main reason is that none of us really understands the full implications of the bursting of the equity bubble that occurred in the United States and, in a slightly different form, in Europe. Although each of the 20th century’s major asset price booms and busts unfolded differently, the contractionary influences were usually felt over quite a long time span, with many of the effects only showing up a few years after the initial downturn. There is still a fair bit of apprehension that further bad news will appear, and a lot of questioning as to whether the full extent of the fall in corporate earnings has been revealed or is accurately reflected in current forecasts of future earnings. Failures of accountancy, auditing and corporate disclosure have left a lot of investors and businesses in a position where they are reluctant to commit themselves because they are unsure of the veracity of the information on which they must base decisions. Some major sectors of important economies are still under pressure as they adjust to a situation of over-capacity and extreme competition. This applies to the world’s telecommunications, media and IT industries. Others are suffering directly from the worldwide fall in the value of equities, for example the European insurance and re-insurance sector, plus those well-established companies on both sides of the Atlantic which are facing under-funded employee pension and health schemes. We at the Reserve Bank have closely followed these market developments, and they do naturally influence our judgment about the balance of risks to the forecasts of the world economy referred to above. It is this judgment - much more so than the central forecasts - which explains our approach to monetary policy since mid-year. The Australian economy I turn now to the Australian economy which, despite this uncertainty about the world economy, has remained in good shape. I will not go into much detail because we released our quarterly Statement on Monetary Policy only two days ago. Suffice to say that over the course of the current year, output and employment have grown well and unemployment has fallen to a decade low. Inflation in underlying terms is within our target range, and we now think likely to stay there over the forecast horizon. Even the balance of payments has held up much better than could be expected in an environment of strong domestic demand and weak external demand. Not surprisingly, given our better underlying economic fundamentals, financial markets in Australia have performed better than elsewhere. Although share prices have fallen, they have done so by less than in major markets. The same applies to the decline in bond yields and to the widening in the spread that private sector issuers must pay over government bond yields. Similarly, over the last year, the market valuation of our banks and insurance companies has held up better than elsewhere. When we look ahead, we can still do so with a fair amount of confidence. While GDP growth over the next 12 months will, no doubt, slow from its current rate, the main drivers of growth - private consumption and private fixed investment - should make further strong contributions. Indeed, it is the strength of the latter which marks us as different to other major economies. This, in turn, is due to the good profitability and balance sheet strength of the Australian corporate sector, and to the fact that we did not go through a recent period of over-investment which resulted in over-capacity. To the extent that negative influences on the economy are larger than when I last spoke in August, they are principally in two areas over which we have no control, namely the world economy and the drought. As to the world economy, we expect to see the change in our real trade balance subtract from GDP growth in 2002/03, but by a smaller amount than in the previous financial year. Similarly, the drought is estimated to also subtract about a percentage point, which means it is approaching the severity of the drought of 1982. Drawing these pieces together, we see the Australian economic expansion, that has now completed its eleventh year, continuing in the forecast period, although at a slower pace than over the past year. It has been a remarkable achievement by the economy to keep expanding for so long while so many other economies have fallen by the wayside. Usually, when an economy has a very long expansion, over-confidence or hubris creeps in and potentially dangerous distortions or imbalances start to appear. As I have pointed out on a number of occasions, these imbalances often take the form of an asset price boom, usually in equities or commercial property, a boom in physical investment or, in earlier years, a surge in real wages. We have not had any of these in Australia in this expansion, which goes a long way to explaining why it has endured. The closest we have come to such an imbalance is the rise in residential property prices, which has produced distortions in some parts of that market. I will conclude by saying a few words about that subject. Residential property prices It is not surprising that house prices have risen a lot over the past half decade or so. With Australia’s return to being a low-inflation economy, the general level of interest rates, including mortgage rates, fell to less than half their level of the previous decade. This enabled households to take on higher levels of debt, which they did, with most of it put towards buying better and more expensive houses. If a decade ago we had known with certainty what was going to happen to inflation and, hence, interest rates, we should have been able to predict this outcome. The difficult part, however, is to determine how much of the rise in house prices was the logical outcome of this economic adjustment, and how much, if any, indicated overshooting or bubble-like behaviour. My guess is that nearly all of the rise in house prices was in the first category, and I have been very reluctant to conclude that any was in the second category, at least until early this year. But when it became apparent that over the past year or so an exceptionally high proportion of lending for housing was being directed towards investors rather than owner-occupiers, we at the Reserve Bank started to become concerned. In fact, the figures we presented in our Statement on Monetary Policy showed that over the year to August, lending approvals to investors rose by 42 per cent, while approvals to owneroccupiers rose by 1 per cent. Something very unusual was clearly happening, and this was confirmed by the building approval figures showing much stronger increases for apartments than for houses. All this, of course, was occurring at a time when owners of investment properties were having difficulty in finding tenants and when rents were falling. It seemed pretty clear to us that investors were moving into an already over-supplied market, and this behaviour could only be explained by their usual desire for tax minimisation plus their expectation that they would benefit from future large capital gains, an expectation which was encouraged by the marketing programs employed by developers of investment properties. Recent events, however, suggest that the market is actually beginning to work, if belatedly, as it is supposed to. There is certainly a change of sentiment as indicated by the numerous stories in the press highlighting potential over-supply and urging caution on the part of would-be investors. There is also evidence from micro-data that apartment prices have flattened out or fallen in the September quarter. By micro-data I mean the detailed suburb-by-suburb, or even building-by-building, analyses that are carried out by the research firms that sell data to the real estate industry, some of which we quote in the recent Statement. Thus, although lending for investor housing has not slowed yet, we have the unusual situation where most of the finance available for housing is going into the sector where prices are rising least, or not at all. This is likely to be a transitory phase. Finally, we are now reading accounts of how some large multi-unit developments that were planned to start construction have been shelved because of insufficient pre-commitment by investors to get them started. This has to be a good development as it will limit the extent of over-supply, a fact that is appreciated by many in the property industry. Conclusion My final comment on house prices is that what we have seen - a very high rate of increase in residential property prices and excessive lending for investment properties over the past year or so was a problem of coping with success. We only have to remember that if we had followed the experience of previous decades, the rise in property prices would have come to an abrupt halt three or four years ago as a result of the economy entering a recession. It is the length of this expansion, as much as the other things I have described, that provided the environment which encouraged this type of investor behaviour. When we come to monetary policy more generally, and we look around us at the challenges facing central banks in other countries, we are reminded that decisions are never easy. But if ever I am tempted to regard the Reserve Bank of Australia’s task as difficult, I quickly banish such thoughts when I look at the task faced by our counterparts elsewhere. I do not think any of us at this time would wish to trade our economy for another, or our monetary policy outlook for that of any other country of which I am aware. | reserve bank of australia | 2,002 | 11 |
Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to Australian Business Economists 2002 Forecasting Conference Dinner, Sydney, 4 December 2002. | Glenn Stevens: Inflation, deflation and all that Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to Australian Business Economists 2002 Forecasting Conference Dinner, Sydney, 4 December 2002. * * * Introduction In the formative years of the current generation of economists, inflation was considered to be one of the most pressing macroeconomic problems. That's not surprising, since most of the net rise in prices that has occurred in human history took place between the late 1940s and about 1990, as a plot of any price index in any industrial country would show. In Australia's case, it was observable during the 1950s that, in periods of business cycle downturn, prices stopped rising but didn't actually fall. This was in contrast to the pre-World War II experience, where price levels did fall during recessions. By the second half of the 1960s, it was even clearer that the price level had acquired a persistent upward trend, and around that time it became normal to look at the price level in its first difference form (i.e. the inflation rate) rather than its level. As all of us here remember only too well, inflation reached nearly 20 per cent during the mid 1970s. Thereafter polices aimed at reducing it, with mixed success at first, but more lasting success in the aftermath of the early-1990s downturn. A number of other countries had more clearly broken the back of serious inflation in the early 1980s; we took a little longer. But in general it could be said that the period of really serious inflation in the western world lasted from the late 1960s until the early 1990s. The subsequent decade has been a period of low inflation almost everywhere. Most recently, with a global business cycle downturn, inflation globally has declined further, and is currently low to very low in most places. So it is natural to ask whether, after a generation worrying about inflation, we might be faced with deflation. Certainly the word 'deflation' is used with much greater frequency than it has been for a long time. Its use usually conjures up some vague notion of the Great Depression, which was the last time a widespread deflation occurred. So it is worth examining this in more detail. I want first to be clear what we mean by deflation, then to ask whether it is in fact occurring. Then I want to ask whether we should worry about it, and if so, what we might do to counter it. As a gauge of this I consulted successive RBA Annual Reports. Throughout the 1960s, the level of the CPI was plotted in charts. The first time it appeared in changes was in the Report for 1969/70. Let me be very clear at the outset, and I will repeat this more than once in what follows, that Australia is not experiencing deflation now, and is unlikely to do so any time soon. The issue is an international one much more than a domestic one, but given its prominence it is worth some consideration. 1. What is deflation, and why would it be a problem? Deflation is a generalised and persistent decline in most, if not all, prices for goods and services. More likely than not this, if it occurred, would be accompanied by declines in prices for many real assets and pressure for, even if not the actuality of, declines in wage and salary incomes. A situation where we observe declines in the prices of some products does not qualify as deflation in this sense. It is nearly always the case that prices for some things are falling, while prices for other things are rising. Were we to look at the 100-odd expenditure classes in the Australian consumer price index, we would find that about 30 of them record a decline in any particular quarter. This has been a feature of the low inflation era since 1990. Even in the high inflation period of the 1970s and 1980s, it was normal to see 10 to 15 per cent of expenditure classes recording price declines in any given quarter. This kind of relative price change is the price mechanism at work in the market economy, and is to be distinguished from general deflation where prices of most or all things decline. A simple but useful working definition of deflation, then, is when the prices of enough goods and services decline to cause aggregate price indexes like the CPI to record a fall. Deflation of that general nature was once a not-uncommon event. For example, in the nineteenth century, it was normal to think of a relatively stable average price level over fairly long periods, but with noticeable fluctuations around the mean over periods of some years – with periods of inflation being followed by periods of deflation. In Australia, up to 1914, deflation occurred in almost half the years for which we have data, an outcome not dissimilar to those seen in other countries (see following table). It was really only in the last few decades of the twentieth century that we became accustomed to the idea that the price level normally rises, even in times of peace, and almost never declines. Deflation Proportion of years in which CPI fell (year-average basis) 1870-1914 Inter-War Post War Australia 45.5 36.4 1.8 Canada 31.8 40.9 1.8 United Kingdom 38.6 36.4 0.0 United States 25.0 50.0 3.5 Austria 50.0 22.7 1.8 Belgium 43.2 31.8 7.0 Denmark 54.5 45.5 3.5 Finland 34.1 40.9 1.8 France 59.1 40.9 3.5 Germany 38.6 22.7 5.3 Italy 45.5 31.8 1.8 Japan 31.4 36.4 12.3 Netherlands 31.8 54.5 1.8 Norway 36.4 50.0 3.5 Sweden 43.2 50.0 1.8 Switzerland 31.8 50.0 8.8 Source: 1870-1980 from Angus Maddison (1991) Dynamic Forces in Capitalist Development, Oxford University Press, Oxford.Subsequently, national sources. Deflation need not be harmful. In cases where exceptionally strong productivity growth accompanies very strong demand growth, the price level can fall even as incomes, profits and economic activity expand. This sort of 'good' deflation can, in principle, be seen in the aftermath of some sort of technology breakthrough, or perhaps the opening up of a previously over-regulated or closed economy to the incentives of the competitive market place. No-one is likely to worry much about this sort of deflation, as it will coincide with a feeling of increasing prosperity. Why might deflation be harmful? The main reason is because of fixed nominal contracting of wages, debts, etc. The real value of a dollar is higher after deflation than it was before. So if you owe a dollar, your debt burden is higher. If you are owed a dollar, or earning a dollar, your real wealth or income is higher. Price changes of this nature, if they are unanticipated, lead to a different distribution of wealth and income than people had banked on when they made their contracts. Usually, this is disruptive to the economy (not to mention unfair). This is a problem of exactly the same nature as those which arise with inflation, except in reverse. In time, of course, people learn that price changes are occurring, and adjust their behaviour accordingly. But adjusting incomes downward for deflation is typically harder to do than adjusting them upwards for inflation. So percentage point for percentage point, deflation is arguably a bit more painful than inflation. Harmful deflation typically occurs in parallel to developments in prices for assets and balance sheets. This is usually in the aftermath of a boom accommodated by a big run up in debt, involving a large increase in capacity in response to very optimistic expectations about future sales and profits. When the optimistic expectations cannot be met, it is apparent that firms are over-invested and overleveraged. They are then under pressure to shore up their balance sheets. Asset prices fall, as firms seek to disinvest. Banks and other lenders find that the quality of their assets has deteriorated, and are tempted to reduce the flow of new credit in order to conserve their own capital. Aggregate demand in the economy declines, and prices for goods and services fall. This is the 'debt deflation' described by Irving Fisher many years ago. Depending on the size of the preceding boom, and on the policies pursued during the bust, this process can be exceedingly painful. In the case where expectations of ongoing deflation become strongly held, moreover, it is possible that some fairly serious problems of economic management can emerge. Expectations that prices will continually fall may lead people to postpone spending, which of course amplifies the deflationary pressure. The rate of deflation might, in extreme circumstances, also mean that attempts to boost growth by reducing interest rates run into the problem that the nominal interest rate cannot fall below zero, which might mean that the real interest rate is too high for the economy's needs. I return to this below. 2. Is deflation happening? Might it happen more widely? Deflation is certainly not happening in Australia. For the year just past, the CPI rose by about 3 per cent. Underlying measures rose slightly less than that. About 70 per cent of the items in the CPI basket recorded increases, while 30 per cent of them fell, which as I noted above is fairly typical of the experience of the past decade. In the part of the economy where prices are determined by market forces (as opposed to being subject to direct influence of government), prices for goods rose by about 2 per cent, while prices for services rose by nearly 5 per cent. In the period ahead, our forecast is that inflation will continue to be about where it is now. Nor is deflation happening, by any normal definition, in North America or Europe. The US CPI rose by about 1½ per cent over the past year. Goods prices declined by about 1 per cent, partly as a result of the strength of the US dollar, but services prices rose by over 3½ per cent. In Europe, the CPI rose in core terms by a bit over 2 per cent, with goods prices up a little over 1 per cent, and services prices by over 3 per cent. The lowest rates of price increase are occurring in Germany and Belgium, with inflation of about 1 per cent in both cases. So there is no deflation here on average, or even in the lower tail of the distribution. Rates of price increase are, however, pretty low around the world. The chart shows some characteristics of the set of inflation outcomes for a group of countries, 48 in all, classified by the IMF as advanced industrial countries or emerging market countries. The median inflation rate here is about 2½ per cent, which is down from about 6½ per cent in 1990. The twentieth percentile inflation rate in this simple unweighted distribution is about 1½ per cent – i.e. one country in five in this sample has inflation of 1½ per cent or lower. The eightieth percentile inflation rate is about 5½ per cent, compared with about 25 per cent in 1990. Given the central tendency for inflation to be this low, it is not surprising that, when we look to the lower tail of the distribution for this broader group, we find that a handful of countries have deflation. Interestingly, they are all in Asia. The chart shows annual average inflation rates which hide some of the short-run dynamics. But one can count about five countries in Asia whose annual CPI inflation figures are now, or at some point within the past year have been, below zero. These are China, Japan, Hong Kong, Singapore and Taiwan. One could debate in each individual case what the proximate causes of this are, and whether it is 'good' deflation or bad. China's deflation is arguably a candidate to be classified as 'good' deflation, since it seems to be associated with rapid overall growth and rising living standards. Hong Kong's deflation is partly necessitated by the peg to the strong US dollar, though of the cumulative decline of about 13 per cent in Hong Kong's CPI since mid 1998, about half is due to declining rents, which is more associated with the decline in housing values after the earlier boom there. Of course, Hong Kong has an impressive capacity to adjust to these shocks, but even so it is a painful process. There is no doubt that Japan's deflation is of the bad kind. Various factors are at work in the other countries. But standing back from the individual cases, there is something of a pattern. While this hardly amounts to widespread deflation, or a deflationary spiral, it is clear that instances of falling prices are now a little more common, and tend to be a little more persistent, than used to be the case. Nor is the process of declining inflation necessarily finished. According to IMF forecasts, the world economy grew by less than average in 2001 and is doing so again in 2002, while 2003 is forecast to see roughly average growth. In other words, crudely measured, global spare capacity is increasing, and will remain elevated next year. Short of some inflationary shock occurring on the supply side, it would not be unreasonable to expect global inflation on average to decline over the next year or two. So a year or two from now, average inflation could be very low indeed, and there could easily be more countries in the lower tail of the distribution of outcomes that experience deflation. For the major countries apart from Japan, deflation does not seem to be the most likely outcome, but a dip below zero for the inflation rate is, perhaps, within the distribution of possible outcomes in some cases. So even though this outlook could not be classed as general deflation in a global sense, there will probably be enough instances of deflation around that people will be talking about it for a year or two. Argentina was in deflation prior to the collapse of the currency board arrangement early this year, but that has now been followed by the rather more familiar problem of inflation, accompanied by a host of other serious difficulties. 3. Should we worry about deflation? I have already said that it seems unlikely that anyone will worry much about 'good' deflation, given that it is part of a story of rising prosperity. It is obviously the other kind of deflation that people worry about. This is a symptom of a sick economy, where profits are poor and hence prospects for near-term growth are relatively weak, unless consumers or government can be induced to expand their spending more quickly than they have been doing to date. But to the extent that this kind of deflation is a symptom of a problem of weak demand, it is more that weakness which should worry us than the deflation per se. Imagine two scenarios. The first is one where inflation has been, and is expected to remain, at a steady 3 per cent. Everyone's behaviour is fully adjusted to that expectation. Then, as a result of a period of temporary demand weakness, inflation falls to 1 per cent. The second is one where inflation has been, and is expected to remain, at a steady 1 per cent, with everyone's behaviour fully adjusted to that expectation. Then, as a result of a period of temporary demand weakness of the same extent as that in the first scenario, inflation falls to -1 per cent. Apart from the absolute numbers, these two cases are identical. Should we worry about the latter more than the former, simply because the zero line has been crossed? I am obviously abstracting here from Australian circumstances. If the target inflation rate is 2½ per cent, then were inflation to fall to -1 per cent, that would be a serious miss of the target. That would be reason for concern – every bit as big a concern as inflation going to 6 per cent – but it is mostly the deviation from the target rather than the negative sign which would be the worry. On a first pass, it is not clear that we should. Both outcomes are caused by weak demand, which should worry us equally in both cases. Both have inflation 2 percentage points lower than anticipated – which means that income and wealth are behaving differently to people's expectations. That is disruptive and is of equal concern in each case. In both cases, the outcome is, of course, cause for action to expand demand. There may be sufficient nominal rigidity around zero that the adjustment to a temporary period of unexpectedly low inflation is more awkward in the second case. If true, this is a reason not to aim at inflation of only 1 per cent to start with – but that's another story. But apart from that, a temporary drop below the zero line due to a cyclical period of demand weakness in an otherwise healthy economy is not obviously cause for much more concern than crossing the 2 per cent line would be in the other imaginary economy here. At least, that is so provided that the drop is temporary, and that expectations about future price changes remain well-anchored at a bit above zero. But what happens when expectations about ongoing deflation take hold? That is different. Here is the scenario which I think people worry most about: not the kind of mild temporary deflation which is a symptom of a period of short-term economic weakness, but the kind of deflation which might itself be a cause of further economic weakness in future. The reason they get so concerned is the possibility that it may not be easy to escape from such a situation. To put this at its most stark, imagine an economy in which deflation is strongly expected to continue, at a rate which exceeds the natural real interest rate in the economy – that is the equilibrium return on real capital. In that situation, because nominal interest rates cannot fall below zero, the real interest rate set by the central bank cannot go below the natural or 'neutral' rate. Since conventional monetary policy works in an expansionary direction by lowering interest rates in the financial sector below the neutral rate, it follows that conventional monetary policy is rendered incapable of applying stimulus to an economy in this situation. The real interest rate is too high, which means that policy remains too contractionary, prolonging the deflationary pressure. There is a 'deflation trap', or what we learned about in undergraduate economics as a 'liquidity trap'. Some have argued that this is the right diagnosis of Japan's situation. The question is: how likely is it that other countries will get into this sort of problem? My view is that it is less likely to occur in most of the other more dynamic economies of Asia. These countries must have tremendous opportunities for profitable investment in future. On that assumption, the natural interest rate is almost certainly much higher than the present or likely future rate of deflation. So while deflation or very low inflation in these countries is probably a sign of temporarily weak demand, which is something that policymakers there presumably wish to address, it still does not seem all that likely that they will find themselves in a deflation trap of the kind sketched out above. What about the US? We have been told for years that returns to capital are high, associated with the stronger productivity growth. For most of the late 1990s, markets certainly behaved as though that was their expectation. If it were still thought that prospective returns are pretty good, then one would be unlikely to worry about getting into a deflation trap. It would take a pretty large, persistently expected deflation rate to spring such a trap. Of course, if there has been an excessive build-up of capital, then returns might be poor for a while, so that the natural rate might be very low during the period it takes for that excess to be worked off. That case can be made for some of the investment in information technology and communications made in the second half of the 1990s in the US and elsewhere. But large chunks of the 'old economy' probably have reasonable, even if not spectacular, prospects for returns, so it does not obviously follow that the US economy is in danger of the kind of deflationary experience which would be very awkward to stop. That is not to say, of course, that US monetary policy can necessarily work miracles to return the US economy to full health and strength in a hurry – that always takes time, even with policy effectiveness. The point is simply that we should not conclude that monetary policy has, as yet, lost all its potency. Perhaps the case is a little less clear cut in parts of Europe, where various economic rigidities may constrain business profitability in some countries. But many of the countries on the periphery of the euro area, or potential entrants to the common currency, would appear to have strong investment opportunities. If this is at the expense of investment in some of the core countries, that is a matter of I am going to skip the issue of whether 'quantitative'measures are of any help here. adjustment (including in relative price levels, as Charlie Bean recently pointed out). It does not look like a generalised deflation trap. Widening our perspective to a global one, while we can observe excess supply in many global industries, it is hard to believe that there is too much capital everywhere, or that where there is excess there will be no rationalisation. Is the US, for example, satiated with infrastructure in airports, roads, electricity generation, to name a few? Are all the world's emerging markets so satiated? And has the process of innovation and development of new products and markets ground to a halt? That's unlikely. It's more likely that the medium term holds many opportunities for profitable deployment of capital, just in different places to those which were the rage in the late 1990s. 4. What to do if deflation does occur? To summarise the above discussion: • Deflation is a widespread, persistent decline in the level of prices. • It is not happening in Australia, nor is it likely to do so in the foreseeable future. It has been happening in Japan for several years. It is not happening in the other major countries, though inflation rates are quite low there now, and deflation is a little more common internationally than it has been in the past few decades. It is quite possible that more countries will experience a mild degree of deflation at some point in the next few years, and not entirely inconceivable that one or two of the major countries might be among them. • In the majority of cases deflation clearly is a symptom of weakness of demand and output, or would be if it occurred, and is a matter of concern for that reason. • In relatively few cases is it likely that expected deflation will itself cause further economic weakness. Japan is arguably in that position, but few if any of the other countries currently experiencing deflation seem likely to find that the natural rate of interest is so low that policy rates cannot get below it. Whether or not one thinks the zero interest rate constraint is likely to bind in the US or the euro area, were they to experience deflation, hinges on one's view about the outlook for returns to capital. These might be poor in some sectors, but it does not follow that they are that poor across the board. Having said all that, Japan's experience shows that deflation can happen, and so we should still ask: what should be the response of policymakers given the possibility, or the reality, of deflation? The first thing to say is that, for most countries, deflation is an outcome which is to be avoided, just like inflation is to be avoided. Stability in the general level of prices, interpreted in practice as a low but positive rate of price increase, is the appropriate goal. Forward-looking monetary policies should be seeking to maintain inflation above zero, just as actively as they look to keep it below some maximum rate. So, to state the obvious, the first order of business is: set out to avoid deflation. Second, if some deflation occurs unexpectedly, it is not the end of the world. Don't panic. But in most countries it would probably signify insufficient aggregate demand relative to supply. Demand management policies, if they could not pre-empt this situation, should respond forcefully to it ex post. Third, the thing to be avoided most strenuously is a persistent deflation which becomes embodied in expectations. It is in this situation where questions of deflation traps become relevant, particularly in countries where the natural interest rate has come down to very low levels. Policy must work at keeping price expectations from falling too far, just as hard as it worked to get expectations down from excessive levels in earlier times, by articulating goals clearly, and being seen to take action consistent with achieving those goals. Fourth, if, despite the efforts of monetary policy, persistent deflation does become embodied in expectations and the zero interest rate does become, or threaten to become, a binding constraint, there will be a role for other policies. If there are structural rigidities which reduce the returns to capital, See 'The MPC and UK Economy: Should we fear the D-words?', speech by Charles Bean, Chief Economist, Bank of England, to The Emmanuel Society, London, November available at http://www.bankofengland.co.uk/speeches/speech182.pdf for example, in a deflationary environment, these things will hamper macro policy's efforts to engender recovery. So policies which address any such problems would be important. These would include making sure that excess capacity is rationalised by allowing the failure of the weakest suppliers, so that the most efficient surviving producers can expect to earn a reasonable return. Further, the active use of fiscal policy to promote recovery would be quite in order in the case of an entrenched deflation, especially in countries where fiscal consolidation had been achieved during the good times. In a situation where investors saw little return to private investment, it is hard to believe there would not be good economic and social returns to various forms of public investment. Hence there would be, in this scenario, a strong case on short-term stabilisation grounds for the government to borrow and invest. Conclusion I am not sure there is any more one can sensibly say about deflation at present. The fact that we are talking about the possibility of it at all is a remarkable change from only a few years ago. Insofar as that means that the 'great inflation'is well and truly finished, that is a good thing, provided of course that we are alert to the new sorts of risks which can emerge. There is probably a bit too much emotive baggage which is carried about with the word 'deflation'. For the average country, a short-lived experience with mild deflation, if it occurred, would be not the end of the world, nor even unprecedented. It would just be a sign that there is a problem of insufficient aggregate demand which ideally should have been avoided, but which, failing that, should be addressed quickly. The observed deflation would be telling us the same thing as various real activity indicators: things are weak and the economy needs encouragement to grow. The bigger concern would be the possibility of a ‘deflation trap’ where conventional monetary policy would become largely ineffective. It seems to me that in most countries this is not all that likely an outcome anyway, but good policies all round should be able to lessen the probability of it further. Even were a country to find itself in such a situation unexpectedly, it should not be beyond the capacity of policymakers to devise ways of getting out of it, although they would want to have the full armoury of policies at their disposal. Australia would be one of the last economies in the world where deflation would be expected. In the remote possibility that it did occur here, we could expect that there would still be plenty of investment possibilities. So unless the corporate and financial sectors' financial structures had become seriously flawed – something of which there is no sign at present – there would be ample scope for monetary policy stimulus to be effective. In the (even more unlikely) event that that were not enough, a government sector with an exceptionally strong balance sheet would be well-positioned to use fiscal policy to assist the economy, in this extreme situation. I hope that this has helped us to have a realistic and balanced assessment about deflation, in what ways we should be concerned about it and how it should affect our thinking about policies. Thank you for your attention. | reserve bank of australia | 2,002 | 12 |
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