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Address by Professor Stanley Fischer, Governor of the Bank of Israel, at the Globes Conference 2009, Tel Aviv, 13 May 2009.
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Stanley Fischer: Bank of Israel’s objectives for 2009 Address by Professor Stanley Fischer, Governor of the Bank of Israel, at the Globes Conference 2009, Tel Aviv, 13 May 2009. * * * A little over four years ago I took up my appointment as Governor, an appointment which was and is a rare privilege and a great honor for me. In about a year my term of office will be over. At the beginning of each year I write down for myself the main tasks for that year. The tasks for this year are: 1. First, to fulfill the function that a central bank is meant to perform. In other words, to formulate and implement a monetary policy that will help achieve the economic targets. At this time the correct monetary policy is an expansionary one that supports economic activity and an economic recovery, as long as inflation is expected to stay within the target range. The policy we are currently pursuing is expansionary in three aspects: (i) The interest rate is low. It is not at its lowest possible level, but is almost there. Research we carried out showed that a further reduction would be of limited help to growth. (ii) We are buying foreign currency. These purchases have almost certainly helped growth, as we export close to 45 percent of GDP. Of no less importance is the stability of the foreign currency market. We have noted on more than one occasion that despite the severe shocks in markets around the world, our foreign currency market has come through relatively unscathed. The foreign currency market showed stability even in exceptional circumstances, such as the resignation of the Minister of Finance and the incapacitation of the Prime Minister. (iii) We are buying government bonds. Despite these purchases, our longer-term (ten-year) interest is relatively high. The difference between long-term and short-term interest rates in Israel is much greater than those in the US and other countries. We are making these purchases to try to lower the cost of long-term credit. These three aspects of monetary policy are acting to steer the economy towards a recovery. I would like to relate to the lag between events in the financial markets and those on the real side. If we are asked whether we see a turnaround in the real economy, we can answer that some of the data do present a more optimistic picture. Israel's economy is facing a difficult period, but in the Bank of Israel expectations for six months hence are optimistic. In my two-monthly meetings with other central bank governors, we discuss the economic situation. In the last meeting, two days ago, they started speaking of optimistic signs. We are currently following an expansionary monetary policy, but we must be ready to change direction if and when necessary, but not before. The markets and the Bank of Israel expect the April CPI to rise by about one percent. Nevertheless, nearly all forecasters expect inflation in 2009 to be below 2 percent, and we do not intend to react to one month's index, especially if it affected by seasonality. The Governor of the Bank has the role of economic adviser to the government. The budget deficit is expected to be six-and-a-half percent of GDP this year, and five percent next year. Growth this year is expected to be a negative one-and-a-half percent, with a rise in the debt/GDP ratio. This is not an advisable direction for the economy to follow. What is of concern is that the debt/GDP ratio at the end of the decade may be back where it was at its beginning. In order to prevent the deficit reaching above 6.5 percent this year and 5 percent next year, expenditure must be reduced. There are several ways of achieving that, e.g., cutting public sector wages and/or postponing reductions in tax rates. With regard to the current deficit, I suggest starting with the 6.5 percent of GDP deficit this year and 5 percent next year, to make it very clear that the path is a downward one. 2. The second of this year's objectives is the new Bank of Israel Law. The current Prime Minister and the Minister of Finance when I took up office expressed support on this issue, and that was one of my conditions on accepting the position. Why is the new law so important? There are several reasons: the new law will formalize the independence of the Bank; it will specify the Bank's obligation regarding transparency; there will be a Monetary Committee that will make interest rate decisions together with the Governor; and there will be an Administrative Council that will approve administrative decisions. Why is a decision by committee preferable to a decision by an individual? Research has shown that on average, decisions made by a committee are better than those of a single decision maker. The current Bank of Israel Law is 55 years old. 3. The third task relates to the integration of Israel's economy into the global economy. Progress has been made, and we are still advancing in this direction. We are following the procedure for joining the OECD, and expect to become members this year. 4. Finally, reform of the bank supervision in Israel. There is a worldwide consensus that supervision reforms are necessary, and this applies to Israel too, and it is important that we proceed rapidly in this area. In conclusion, I would summarize by saying that before I came to the Bank of Israel I set myself several objectives, not all of which have been achieved yet. The list included a new Bank of Israel Law, a new wage agreement in the Bank, and the structural reorganization of the Bank. The reorganization that has taken place in the Bank certainly helped it deal correctly with the crisis. Other targets remain, albeit of somewhat less importance, but still worth mentioning: (i) to improve relations between the Ministry of Finance and the Bank – we share responsibility for the health of the economy, and with two doctors caring for the same patient, it is important that they agree on the correct course of treatment; (ii) to improve the level of public debate in Israel, and there is plenty of room for improvement in that area.
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Revised version of the paper by Prof. Stanley Fischer, Governor of the Bank of Israel, presented as the lunchtime speech at the 33rd Annual Symposium of the Fed of Kansas City, on "Fin. Stability & Macroeconomic Stability", Jackson Hole, 21 August 2009.
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Stanley Fischer: Preparing for future crises Revised version of the paper by Professor Stanley Fischer, Governor of the Bank of Israel, presented as the lunchtime speech at the 33rd Annual Symposium of the Federal Reserve Bank of Kansas City, on "Financial Stability and Macroeconomic Stability", at Jackson Hole, Wyoming, 21 August 2009. The main changes, which relate to the role of the Financial Stability Board, are based on comments made by Mario Draghi. I am grateful to Mervyn King for extremely helpful comments and suggestions, and to Joshua Shnek and Philip Yhelzon of the Bank of Israel for their assistance. * * * At last year's Symposium, "Maintaining Stability in a Changing Financial System", I had the privilege of delivering the concluding remarks of the conference, and ended with the forecast: "But if the authorities in the U.S. and abroad move rapidly and well to stabilize the financial situation, growth could be beginning to resume by the time we meet here again next year." Well, here we are, one year later, and growth does appear to be beginning to resume. 1 Following the Lehman Brothers bankruptcy, the authorities, especially the central banks, in the U.S. and abroad did by and large move rapidly and well to stabilize the financial situation. But the route the world economy traveled between 2008 and August 2009 was extremely bumpy, uncertain, and at times frightening. Further, despite the encouraging signs of recovery, it is too early to declare the economic crisis over. Much remains to be done, not least in bringing banking systems back to health, and there are good – though not conclusive – reasons to fear a sub-standard recovery. Nonetheless, it is reasonable to declare that the worst of the crisis is behind us, and that the first signs of global growth have appeared earlier than was generally expected nine months ago. This, the worst recession in the advanced countries since the Great Depression, is bound to leave major marks on economies – on financial systems, on the public finances, on economic policy, on economics, and more broadly. At its height, in the fourth quarter of 2008 and the first quarter of 2009, the crisis sparked apocalyptic articles about the length and depth of the recession and the possibility that we were facing a rerun of the Great Depression, about the future of capitalism, about the decline of the west and the transfer of the center of gravity of the global economy and its leadership to the emerging countries, particularly China, about the decline of the role of the dollar, about reforming the international financial system, about reforming economics, and more. Fascinating and important as these issues are, I will focus on narrower economic structure and policy topics relating to the question of how to reduce the frequency and mitigate the extent of future crises. Prior to the crisis, two main, interrelated, reasons had been given for fearing a major recession: global imbalances, which had been at the core of dire forecasts for several years, and which had become part of the explanation for low real interest rates during the first half of this decade; and financial fragility, based in part on the bubble in house prices, and in part on the complexities and vulnerabilities of the financial superstructure that had been built up around mortgage financing and associated sophisticated derivative instruments. Concerns about financial fragility had been mounting in the years leading up to the crisis, but not to the point of leading to major changes in the behavior of either the authorities or most of the private financial sector. Both financial fragility and global imbalances contributed to the crisis, and in discussing the measures that need to be taken to reduce the frequency and mitigate the extent of crises, I Among other indicators, IMF forecasts of growth for 2009 have stabilized, and their forecasts for all regions for growth in 2010 have begun to increase. will deal with both – with financial issues and their implications for financial supervision, for corporate governance, and for central banking, and with global imbalances and the international system. I. Financial sector reforms – regulatory and corporate governance In contrast to most of the financial crises of the previous decade, which started in emerging market countries, this crisis started in the center of the global financial system – in the United States – and spread outwards. In the words of Guillermo Ortiz, Governor of the Banco de Mexico, in August 2007: "This time it wasn't us". So the reforms that need to be implemented to reduce the frequency and depth of financial crises have to start at the center. The crisis has generated an explosion of reports recommending wide-ranging reforms of the financial system. 2 For a non-random example, the G30 report, Financial Reform: A Framework for Financial Stability, (January 2009) presents 18 recommendations, grouped under four headings: (i) "Gaps and weaknesses in the coverage of prudential regulation and supervision must be eliminated"; (ii) "The quality and effectiveness of prudential regulation and supervision must be improved"; 3 (iii) "Institutional policies and standards must be strengthened, with particular emphasis on standards for governance, risk management, capital, and liquidity"; and (iv) "Financial markets and products must be made more transparent, with better-aligned risk and prudential incentives. The infrastructure supporting such markets must be made much more robust and resistant to potential failures of even large financial institutions". Regulation and supervision of the financial system Systemic or macroprudential regulation. Almost all the reports on the reform of the financial system see a need for macroprudential or systemic regulation, and many place this responsibility with the central bank. The U.S. Treasury report of June 2009 (p.11) defines macroprudential supervision as supervision that considers risks to the financial system as a whole, and recommends placing the responsibility for such regulation with the Fed. To give the Fed the capacity to meet this responsibility, the report (p.10) specifies that it should have the authority to regulate "[a]ny financial firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed (Tier 1 FHC) …. regardless of whether the firm owns an insured depository institution". Further, the prudential standards for these firms should be The UK and US governments, and the EU Presidency, have all issued reports on financial sector reforms. See HM Treasury, Reforming financial markets, July 2009; US Department of the Treasury, Financial Regulatory Reform, June, 2009; and the Presidency Conclusions of the Council of the European Union, June 19, 2009, which essentially adopt the recommendations of the Report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosiere, Brussels, February 25, 2009, with regard to the establishment of a European Systemic Risk Board, whose chair is to be elected by the members of the General Council of the ECB. See also: the G-30 report, Financial Reform: A Framework for Financial Stability, January 2009; Financial Services Authority, UK, The Turner Review: A regulatory response to the global banking crisis, March 2009; Committee on Capital Markets Regulation, The Global Financial Crisis: A Plan for Regulatory Reform, May 2009, which includes a table comparing its 57 recommendations with those of other reports, pp 221-225; a series of reports on regulatory issues by the Financial Stability Forum, starting with its early and important paper on Enhancing Market and Institutional Resilience, April 2008; G-20, Declaration on Strengthening the Financial System, April 2009, based in part on the recommendations by the Issing Committee, New Financial Order, February, 2009; IMF, Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management, February 2009. One of the recommendations under this heading relates to improved international regulatory and supervisory coordination, an important topic on which I touch only lightly in this speech. stricter and more conservative than those applied to other financial firms; and the supervision of these firms should extend to the parent company and all its subsidiaries. 4 By contrast, the report of the UK Treasury of July this year (Chapter 6) is more hesitant about assigning this responsibility, though it gives the impression that in the end it would give it to the Financial Services Authority (FSA), the unified financial system regulator. 5 In developing its argument, the UK Treasury report takes note (p.91) of the "broad international consensus that central banks should be independent and should pursue stable inflation, and that regulators should pursue risk-based micro-prudential regulation. But because of the links between financial and macroeconomic stability, they need to work closely together to ensure macroeconomic stability." It further emphasizes that macroprudential tools "would need to be developed and agreed at an international level and implemented in a standardised way in order to avoid jurisdictional and regulatory arbitrage." (p.92) What are these tools likely to be? Among the candidates are the central bank interest rate, and tools that aim directly at the rate of credit creation and the overall riskiness of the financial system, including capital and leverage ratios. In addition, it is possible to use and/or revive more specific regulatory tools that affect the financial system, for instance maximum loan to value ratios and other mortgage terms, margin requirements, and other regulations that were in place during the post-Great Depression and post-World War II period, which have fallen out of use or been repealed. The argument about macroprudential regulation is closely related to a topic that has been discussed repeatedly at these conferences – how the central bank should respond to asset prices, and particularly to perceived asset price bubbles. This discussion has suffered from three distortions. First, if the issue is posed as that of how to burst a bubble when the only tool at the central bank's disposal is its interest rate, it is all too easy to argue that nothing should be done until the bubble bursts. The more general issue is whether the interest rate should respond to asset prices and the financial situation more generally, and there is a strong argument that the answer is yes. Second, there is no reason to confine the central bank's policy tools to the interest rate. Macroprudential tools can be added to its quiver. And third, the right question is not what the central bank should do, but rather what actions need to be taken by the authorities to maintain economic stability and support growth. There is a need for macroprudential regulation, and the question that should be discussed is that of the optimal institutional arrangements to this end. Historically supervision has been structured along sectoral lines – a supervisor of the banks, a supervisor of the insurance companies, and so forth. 6 More recently the approach has been functional, in particular distinguishing between prudential (control of risk) and conductof-business (with respect to both investor and consumer protection) supervision. In the twinpeaks Dutch model, prudential supervision of the entire financial system is located in the central bank, and conduct of business supervision in a separate organization, outside the central bank. In the Irish model, both functions are located in the central bank. 7 In Australia, prudential and conduct-of-business supervision are located in separate organizations, both separate from the central bank. As already noted, in the UK the FSA – the Financial Services Authority – is responsible for supervision of the entire financial system, and is located outside However the report complicates the message by adding that "[f]unctionally regulated and depository institution subsidiaries of a Tier 1 FHC should continue to be supervised and regulated primarily by their functional or bank regulator as the case may be." (p.11). By contrast, the report of the Conservative Party, "From Crisis to Confidence: Plan for Sound Banking" (July, 2009) would abolish the FSA and assign the responsibility for bank and for macroprudential supervision to the Bank of England. I quote here from my concluding remarks last year. More accurately, the organization is known as the "Central Bank and Financial Services Authority of Ireland". the central bank. In the United States, supervisory responsibilities are widely dispersed, there are gaps in the system, and coordination has been difficult; the US Treasury plan seeks to deal with all these problems. I doubt that there is one best model. In Israel bank supervision is under the aegis of the Bank of Israel, and I found the presence of the bank supervisor and the information flows from his department essential in enabling us to deal with the current crisis. Information flows are critical, and the plain fact is that information flows more readily within an organization than between organizations – which is one of the reasons to have prudential supervision within the central bank. Those who have not lived in bureaucracies might suggest that surely it is possible to ensure rapid and accurate information flows between institutions. It may be possible, but it is not the rule – and the importance of timely and accurate information flows to the making of policy decisions in a crisis cannot be exaggerated. In addition there is the crucial question of how to coordinate decisions on monetary policy and macroprudential policy. There may be occasions – as in recent years – when considerations of inflation stabilization and those of systemic stability need to be balanced. If the responsibility for systemic stability is in the central bank, then it decides how to strike the balance. If not, someone else has to do so. Who? It could be the organization responsible for macroprudential policy, but in the words of the UK Treasury, financial regulators usually "pursue risk-based micro-prudential regulation"; that is to say, their concern is with the safety of individual institutions. If the decision is not made the responsibility of the central bank, it will likely end up with an inter-agency committee or with the Treasury. Inter-agency committees have difficulties reaching rapid decisions, and there would be great difficulty in coordinating decisions on monetary and macroprudential policy if one were under the control of the central bank and the other under the control of the Treasury. I conclude that the central bank should be given the responsibility, and the tools to do the macroprudential job. In the case of the United States, the US Treasury proposal gives the Fed the authority to regulate systemically important institutions, which is part of what it would need to fulfill its macroprudential responsibilities, but it is not clear what additional policy tools – such as regulation of financial institution capital ratios – it would be given. The size and complexity of the financial system is bound to be a consideration in determining the structure of the regulatory system, for there are diseconomies of scale in running any large organization. That is to say, the case for a single financial-system wide regulator is typically stronger in a smaller economy. In addition, the political system is likely to be cautious about making any individual independent institution too powerful. Hence financial supervision in a large economy, such as that of the United States is likely to remain dispersed among several institutions, even though it needs to be coordinated, and even though that coordination is difficult. In a small economy, such as that of Israel, it would be possible to place the responsibility for the prudential supervision of the entire financial system in the central bank, and to make another institution or institutions responsible for conduct of business supervision. 8 The new law of the Bank of Israel, which we hope will be passed soon, specifies supporting financial stability as one of the Bank's three main missions, and we believe that our ability to do so would be strengthened by implementing the Dutch model of financial sector supervision, with all prudential supervision in the central bank. As to whether macroprudential tools "need to be developed and agreed at an international level and implemented in a standardised way in order to avoid jurisdictional and regulatory arbitrage", as argued by the UK Treasury report, that would be desirable, but only if it can be Conduct of business supervision could be in one organization or divided between consumer relations and investor relations aspects of behavior. done quickly. If not, there is no time to wait and countries need to begin putting in place their national approaches to macroprudential supervision, while seeking simultaneously to coordinate internationally. 9 Capital and liquidity ratios. It is both likely and desirable that required capital ratios around the world will rise in the wake of the crisis, and that there will be a greater emphasis on Tier I capital. The Spanish model of countercyclical capital ratios has gained widespread support and is likely to be implemented in more countries, and this should contribute to stabilizing the business cycle. 10 In effect the Spanish model treats the countercyclical element in a bank's capital as a reserve for use during a downturn, to enable banks to continue lending as the economic situation deteriorates. Given the constant pressures from financial institutions to find ways to reduce capital requirements, including through off-balance sheet activities, regulators will have to be on their toes in the cat-and-mouse game between regulator and regulatee, to ensure that effective capital ratios do not get whittled away as a result of financial innovation and political pressures. In addition to increasing capital ratios, regulators are likely to introduce required liquidity ratios. Experience, including that of the last year, suggests that there should be a liquidity ratio, and that the range of assets defined as being liquid should be small. Here too is an area where international agreement and coordination would be desirable, but where national regulators should not wait for international agreement before introducing liquidity ratios. Financial institutions are likely to complain that higher capital ratios and the introduction of formal liquidity ratios increase their costs of doing business and are in effect tax increases. Given the vivid demonstration during the last year of the fragility of financial systems faced with a loss of confidence, and the fact that their survival depends on government backing and action – in the last year on a massive scale – it is fully appropriate that financial firms be required to self-insure against future crises by holding more capital and more liquidity. The tax treatment of the counter-cyclical elements in the additional capital may need to be considered. Too big to fail, resolution mechanisms, and moral hazard. The experience of the last year has brought much-needed clarity to the "too big to fail" issue. Some of the great names of financial history have disappeared (e.g. Lehman Brothers), some companies are in the process of working their way out of existence (e.g. AIG), many would not have survived but for government assistance (e.g. Citigroup), and many holders of their shares have suffered very large losses. It is likely that the need to show that the authorities would not save every big financial institution – in other words to counter the effect on financial behavior of the "too big to fail" doctrine – was a factor in the decision not to save Lehman. The worldwide panic brought on by the Lehman failure led directly to the decision two days later to provide massive aid to AIG, making it seem that "too big to fail" was alive and well. But the truth is that if some part of AIG survives, it will not recognizably be the same institution, and that the shareholders of the original AIG will not recoup their investments – in other words, it has failed. Similarly, much of Citigroup is now state-owned, and its private sector shareholders have suffered very large losses. For a concise summary of the issues with regard to international coordination and possible solutions, see "Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management", IMF, February 2009, pp.19-21. See the joint Financial Stability Forum-Basel Committee on Bank Supervision Working Group on Bank Capital Issues report, Reducing Procyclicality Arising from the Bank Capital Framework, March 2009; and FSF, Report of the Financial Stability Forum on Addressing Procyclicality in the Financial System, April 2009. So in what sense were these institutions too big to fail? In at least three senses. First, deposit holders in the relevant institutions were not significantly penalized: as the financial crisis deepened, governments either gave very broad guarantees of bank deposits or at a minimum, greatly augmented formal deposit insurance schemes. This was unavoidable and appropriate, given the need to prevent runs on banks. Second, bondholders in most financial institutions that received state aid and survived in some form were not penalized. The issue here was to prevent "runs" on bank debt, which would have taken the form of even larger system-wide declines in the value of bank debt, and enhanced difficulties for the banks in mobilizing resources through debt issuance. The issue of the standing of bank debt in future crises is not yet resolved, but needs to be; indeed in some countries where bank debts have received government guarantees, a way out of those guarantees needs to be devised. And third, many firms that did survive needed the state's aid to do so: they have been given an opportunity to restore their fortunes and some of them are already apparently well into the process of doing that. This does not sit well with the general public, which seems to feel that a greater price should have been paid by both the owners of companies and their highestpaid employees – even though many of the managers and high-paid employees lost large parts of their wealth as a result of the decline in the value of the stock and options they held in their institutions. Lehman was not an especially big firm. Nonetheless, because its operations involved counterparties all over the U.S. and global financial systems, its failure created widespread damage. In its wake, the category of "too interconnected to fail" was added to "too big to fail". That is a nice category, but the real lesson is not about "big" versus "interconnected"; rather it is about trying to form a realistic estimate of the costs and benefits of alternative courses of action when faced with an institution in trouble. As a result of the crisis, it is now more widely understood that the key to dealing with financial institutions in trouble is that of resolution mechanisms – that is, mechanisms for winding down a firm in trouble in an orderly way, as the FDIC typically does with a failing bank. In the words of Sheila Bair, 11 "… resolution would concentrate on maintaining the liquidity and key activities of the organization so that the entity can be resolved in an orderly fashion without disrupting the functioning of the financial system. Losses would be borne by the stockholders and bondholders of the holding company, and senior management would be replaced. Without a new comprehensive resolution regime, we will be forced to repeat the costly, ad hoc responses of the last year." If there had been a usable resolution mechanism for Lehman, the company could have been taken over by the resolution agency – which would have had to have access to the funds needed to do this – and its liabilities run off over the course of time. Such an approach would have been much less costly than was the Lehman failure. Mervyn King has described the need for efficient resolution mechanisms by saying that every financial firm should be asked to write a will – a document that specifies how its assets are to be allocated in the event of its death. There has also been considerable discussion about how to deal with very large financial firms, including those that are very large relative to the size of their economies, as in the case of the Icelandic banks, or two of the Swiss banks. It seems clear that countries should seek to limit the size of individual financial institutions relative to the size of the economy, both to reduce the costs to the economy of the firm's failing, and to reduce the overall vulnerability of the financial system to individual failures. One way to do this is to require larger banks, or those of systemic importance, to have higher capital and prudential ratios. The Swiss authorities are strongly encouraging their largest banks to add to their capital. In testimony before the Senate Committee on Banking, Housing and Urban Affairs, July 23 2009. Whether the authorities should use other regulatory mechanisms to this end is another issue that is on the table. Even for the largest economies, there is a case for discouraging financial institutions from growing excessively. While it is clear that there are economies of scale in commercial banking up to a certain point, it is less clear that those economies of scale continue at the very largest banks – and the costs of dealing with the failure of an individual bank rise as the size of the bank rises. It is even less clear that there are serious economies of scope in the financial sector – that is, there is little evidence that the financial supermarket view by which the end of Glass-Steagall was justified in the United States leads to more efficient and cheaper provision of financial services. And although investment banks became commercial banks during the last year, to obtain access to the Fed's facilities, there do not appear to be major economic benefits – and there are certainly potential economic disadvantages – from combining trading activities on a serious scale with normal commercial banking. 12 This issue – that of the most efficient structure of financial institutions and of the financial system – is central to the question of how best to regulate the financial system in the years ahead, taking into account the fact that financial institutions are liable to failure as a result of a loss of confidence in them, and that the costs of those failures may be macroeconomic in scale. At this stage we seem to taking it for granted that we should go back to the structure of the financial system as it was on the eve of the crisis. But we need to be thinking more broadly, including the possibility that some radical restructuring is needed, for instance by sharply restricting proprietary trading by banking institutions, or by some other forms of narrower banking. There has been very little progress so far on how to deal with the failure of a major international bank. The main issue is which country or countries take responsibility for dealing with the aftermath of a failure. One possibility is to require internationally active financial institutions to have legally separate subsidiaries in each country, so that each subsidiary is wound up in its country of operation. 13 Finally, on moral hazard: this must be a prime issue in the design and supervision of financial systems. No policymaker wants to be in a position in which concern over moral hazard creates the dilemma of either taking an action that is extremely costly to the economy to teach some people a lesson, or else doing something that may well encourage undesirable behavior in the future. Both in the design of the system, and in its operation, we need to do whatever we can to avoid placing decision-makers in such a situation. If we do find ourselves in such a situation, it is too late – for it is a mistake to inflict serious and unwarranted damage on many people in order to teach a lesson to a few. Corporate governance Although it is natural for policymakers to focus on improving supervision and regulation, the larger failures responsible for the crisis were those of the management of financial institutions. Management, particularly corporate risk management, failed in a big way in this crisis, and that failure is more worrisome than the failure of the regulators, for we should not expect regulators, with their limited resources and inherent limits on how much information they receive and can master, to do better than corporate risk management in understanding and controlling the risks facing a financial institution. The G-30 report recommends (p.59) that "Large, systemically important banking institutions should be restricted in undertaking proprietary activities that present particularly high risks …Sponsorship and management of commingled private pools of capital (….) should ordinarily be prohibited and large proprietary trading should be limited by strict capital and liquidity requirements." See Michael Pomerleano, "Ring-fence cross-border financial institutions", Financial Times, ….,August 10, 2009 http://blogs.ft/com/economistsforum/ John Kay has recently expressed the view that modern banks are too complicated to be managed by mere mortals. 14 Accepting that view as a challenge rather than a counsel of despair, I will briefly discuss potential reforms in the areas of risk management and compensation, drawing mainly on the recent report prepared for the British government by Sir David Walker, and a June 2009 OECD report on corporate governance. 15 Corporate risk management. The Walker Report focuses on the board as the key vehicle for improved corporate governance. It recommends (p.81) the establishment of a board risk committee, separate from the audit committee, "with responsibility for oversight and advice to the board on the current risk exposures of the entity and future risk strategy". The executive risk committee would be required to operate within the parameters and limits set by the board risk committee. The report recommends the appointment of a Chief Risk Officer, who should be totally independent from individual business units, reporting directly to the CEO 16 and to the board risk committee, and who "should be accorded both status and remuneration reflective of the key importance of the role" (p.84). Beyond strengthening the board's capacity to supervise risk, it is necessary also to strengthen risk management within the corporation. Internal risk managers need independence from other business units and the full backing of management and the board to carry out their function, for the pressures that the competitive environment of a large financial firm place on a risk manager are intense. "Just say no" is easy enough to say, but harder to do when it means cutting colleagues off from a potentially highly profitable fee, or trade, or investment. The internal risk managers I met during my short life in the private sector were technically proficient. They may have been under pressure to agree to risky trades. But what was most lacking, in the case I’m aware of, was somebody taking a system-wide view of the risks that were being faced, someone with the capacity to ask tough questions about the possibility of radical changes in the market environment – and then getting management to do something about it. There is a delicate point here. If risk managers are required to assign high probabilities to extreme scenarios, such as those of the last year, the volume of lending and risk-taking more generally will be seriously and dangerously reduced. It is neither wise nor efficient for the management of financial firms or their regulators to require financial institutions to become excessively risk averse in their lending and market activities. But if these institutions pay too little attention to adverse events that have a reasonable probability of occurring, they contribute to excesses of volatility and crises. 17 Compensation and risk taking. 18 In its "Principles for Sound Compensation Policies", the FSF specifies (pp. 2-3) that: compensation must be adjusted for all types of risk; "Our banks are beyond the control of mere mortals", Financial Times, July 8, 2009. A review of corporate governance in UK banks and other financial industry entities, prepared for the UK Prime Minister and the Treasury, July 2009. See also OECD, Corporate Governance and the Financial Crisis: Key Findings and Main Messages, June 2009 ; and FSF, FSF Principles for Sound Compensation Practices, April 2009. The report specifies "CEO or FD", where FD is the finance director. This paragraph is based on the assumption that there is a rational expectations equilibrium in which companies take reasonable risks and make profits commensurate with those risks. See the report by the FSF, FSF Principles for Sound Compensation Practices, April 2009. The OECD report on corporate governance, op cit, contains an excellent summary of the issues relating to remuneration practices, actual and desired from the viewpoint of financial stability and efficiency. For the modern theory see for example Lucian Bebchuk and Jesse Fried, Pay without Performance: The Unfulfilled Promise of Executive compensation outcomes must be symmetric with risk outcomes; compensation payout schedules must be sensitive to the time horizon of risks; and the mix of cash, equity and other forms of compensation must be consistent with risk alignment. Just three comments: First, it is extremely difficult to line up pay with incentives and performance, but it is critical that companies try to do better. Second, the fact that individuals in effect have limited liability creates an asymmetry that encourages excessive risk-taking whatever the form in which conditional compensation might be paid. Third, after the disasters of the last year, and the large costs of government intervention, the financial sector needs to regain the confidence of the public, and returning to previous modes and levels of compensation as if nothing has happened is not the way to achieve that goal. 19 The current discussion of corporate governance places much of the responsibility for achieving better performance on corporate boards. But we should not exaggerate what they and the regulators can do, for both lack the full-time immersion in the problems of the company that company management has. With regard to risk management and to compensation, and to corporate governance more generally, we need to look to firm management at least as much as to corporate boards and regulation to get it right. II. The role of the central bank This was not a normal recession, and nor were the central banking policies used to combat it. The Fed and other leading central banks played an extremely activist role in responding to the crisis, particularly in their interventions in asset markets. The question is whether central bank actions in this crisis were appropriate for crisis response, and whether the innovative policies we have seen in the last year will lead to longer-term changes in central banking doctrine and behavior. Liquidity trap and quantitative and credit easing. The zero interest rate policy of the Bank of Japan in the 1990s was accompanied by a policy of quantitative easing (QE). The simplest notion of quantitative easing is that the central bank purchases assets in order to increase the monetary base, or a broader aggregate. In the present crisis, as the interest rate came close to its zero lower bound 20 in the US, Japan, the Euro area, the UK, Canada, Israel and other countries, central banks began policies of quantitative easing, via asset purchases. Growth rates of various definitions of money have been impressive in many countries, with the growth rates of the monetary aggregates closest to the money base being highest – for instance, in the Israeli case the growth rate of M1 over the past 12 months has been 56 percent, while that of M2 (which includes term deposits, which in light of the ultra-low interest rates on term deposits have migrated into the current accounts that are included in M1) has been 18 percent. Central banks had to contend with the question of how much QE to do. One approach was to use a Taylor rule to calculate what the (negative) interest rate would have been according to the Taylor rule, and then to calculate how much a relevant quantity (say the monetary base) would have had to be increased to attain that interest rate. Another was to use some form of the quantity theory. As an aside, if monetary policy was defined in terms of the growth of the Compensation (Harvard University Press 2004). See also Bebchuk and Fried, "Equity Compensation for LongTerm Results", WSJ.com, June 16, 2009. For a comment on this point, see Lucian Bebchuk and Alma Cohen, "Back to the Good Times on Wall Street", WSJ.com, July 31, 2009. In the General Theory, Keynes discusses Gesell's scheme for creating a negative rate of return on money by stamping it. There are no doubt other schemes to achieve the same end, but as of now there seems to be no practical way of reducing the central bank nominal interest rate below zero. quantity of some asset, such as the monetary base, the central bank could not also announce a given interest rate as its policy rate. This is probably why the Fed has announced the policy rate as a range. In our case, and that of most other central banks that are close to the zero lower bound, the central bank nevertheless announces and fixes a policy rate close to zero. These rates currently vary between 25 and 100 basis points. We stopped cutting the policy rate when it reached 50 basis points, on the basis of an analysis that further cuts would have had only a minimal impact on credit conditions. Several central banks, including the Fed and the Bank of England, have undertaken programs of purchasing longer term government bonds. In the case of the Bank of Israel, where the term structure was very steep when the program was initiated, the goal was to reduce medium term indexed interest rates on government bonds, on which indexed mortgage rates are based. Our estimate is that our program, which lasted for about four months 21 and amounted to a bit less than 3 percent of GDP (less than 10 percent of the stock of relevant bonds) reduced interest rates by about 30-40 basis points. The program also appears to have had an effect on corporate bond rates. Purchases of government bonds led to the concern or accusation that the central bank was financing the government deficit and "printing money" to that end. The Bank of Israel also intervened for over a year in the foreign exchange market, in a program that ended earlier this month. We bought $100 million a day (about 4-5 percent of the daily turnover), increasing our foreign exchange reserves from $27 billion to $52 billion, an increase of about 13 percent of GDP, with the reserves to GDP ratio currently at about 27 percent. 22 These purchases too led to the concern that we were printing money and thereby contributing to inflation. Our foreign exchange interventions were undertaken both because we had for long been concerned that our foreign exchange reserves were too low, and because we did not want to enter a recession in an economy whose exports amount to over 40 percent of GDP, with a sharply appreciated exchange rate. We also anticipated that a depreciating exchange rate would contribute to preventing deflation, as indeed happened. 23 Do these non-standard asset purchase programs "print money"? They may do so, but not necessarily. It depends whether at the margin they are sterilized, in the sense that actions are taken to offset their effects on the short-term interest rate, or on a given monetary or financial quantitative target of monetary policy. Do they contribute to inflation? That was part of the intention – they were intended to ease financial conditions, and to help prevent deflation. In our case, and that of other countries too, the goal of QE programs was to raise the inflation rate from the negative rate that we feared. Here the inflation target was important: we were able to explain that even at a zero interest rate, inflation was expected to The program was terminated at the end of July. We intervened in the foreign exchange market for the first time in nearly ten years when the exchange rate appreciated very rapidly in March 2008, at a time when it was already clear that we were likely to go into a recession. The program started with daily purchases of $25 million, but when the exchange rate of the shekel against the dollar plunged in July 2008, we increased our daily purchases to $100 million. After that the exchange rate against the dollar depreciated over the course of the next six months by about 20-25 percent, taking the nominal and real exchange rates back towards but below the average of the years 2003-2007. Lars Svensson had made this argument in suggesting a way out of Japan's deflation of the 1990s. Such a policy is much easier to implement for a small open economy than for a large economy that already has a significant current account surplus. be negative. 24 Thus our inflation target required us to conduct a monetary policy – quantitative easing – aimed at raising the inflation rate. Lender of last resort. While other central banks were emphasizing their QE policies, Chairman Bernanke for a while described some of the Fed's operations as credit easing, interventions in specific markets that are not functioning normally, such as the commercial paper market following the collapse of Lehman, and the markets for mortgage-based assets following the collapse of the housing price bubble. These innovative interventions are closer to the lender of last resort function than to pure quantitative easing, in the sense that the central bank is lending in markets that have become dysfunctional or that are operating poorly, in significant part due to a loss of confidence in counterparties. But unless sterilized, the operations also involve quantitative easing in its more general sense of expanding the central bank's balance sheet. The Fed's credit-easing policies and the scale on which they were carried out represent an innovation in central bank crisis operations, one that has been described as making the Fed the market-maker of last resort. It is unlikely that such operations will be needed in future in normal cyclical downturns, but they are a valuable tool that could be used in dealing with future financial panics, and that should be used if important markets seize up, as happened in this crisis. In addition, central banks are likely to continue to undertake the classic function of a lender of last resort, of providing liquidity either to institutions in trouble due to a loss of liquidity, or to the market (a form of QE). As is well-known, the distinction between liquidity and solvency difficulties for a financial institution should determine how the central bank behaves. In the case of a liquidity problem, the central bank can solve the problem of the institution in trouble by providing a temporary loan; in solvency cases the firm should be taken over and reorganized, possibly by closing it. Dealing with an insolvent institution is typically a quasifiscal operation, a fact that led to considerable unease about some Fed operations in this crisis. In the Israeli case, the law gives the central bank a free hand in injecting liquidity, but the central bank needs government approval to resolve an insolvent institution. 25 It is also well known that it is typically difficult in the midst of a crisis to distinguish between an illiquid institution and one that is insolvent, an issue that surfaces in arguments about mark-tomarket accounting. Responsibility for financial stability. I have so far been discussing the response to the crisis, implicitly focusing on the period after the collapse of Lehman Brothers. During that period the central banks did extremely well. Some of them did less well in the lead-up to the crisis, when financial vulnerabilities were either not identified or not responded to. It is uncertain whether those central banks would have behaved differently had they already been assigned formal responsibility for macroprudential stability; if they had, they would have had more reason to have acted and at least mitigated the effects of the financial excesses that were already visible in 2006. Inflation targeting. What are the implications of this crisis for central bank policies in future crises? In particular, has the activism of central banks in intervening in financial markets and in rapidly reducing interest rates essentially to zero, along with their possible role in macroprudential stability, invalidated the inflation targeting approach to monetary policy? In the event, the inflation rate was negative for only four months at the turn of the year, and for most of this year, including currently, the 12-month inflation rate has been above the 3 percent upper bound of the target inflation range. However the law does not specify that the government will necessarily pay the costs of resolving an insolvent bank. The simplest answer is that there could on occasion be a conflict between the inflation goal of monetary policy and that of financial stability, implying that recent practice may well be inconsistent with a strict inflation targeting approach. For instance, it is often asserted that the Fed's low interest rate policies coming out of the 2001 recession contributed to the housing bubble of later years. Without wishing to take a stand on that issue, it is plausible to argue that if the Fed had been charged with responsibility not only for inflation and growth, but also macroprudential stability, it might have raised its interest rate more rapidly. However there is no necessary inconsistency between flexible inflation targeting and the actions required of central banks in this crisis. The goals of the central bank as set out in recent legislation around the world are typically three-fold. For example, let me quote the new Bank of Israel law, which we hope will be passed by the Knesset in its winter session: • To maintain price stability, as specified by the government • To support the other goals of government economic policy, particularly the promotion of employment and growth, so long as this does not conflict with price stability over the course of time • To contribute to the stability of the financial system. 26 The behavior of inflation targeting central banks in this crisis was consistent with the flexible inflation targeting approach as set out above. As soon as it became clear after the failure of Lehman that economies were heading for negative inflation, the inflation targeting approach dictated that monetary policy should be expansionary, thus being consistent with both the first and second goals of policy. In addition, many central banks were involved in attempts to bolster financial stability, both through their ultra-low interest rates and in their decisions to undertake both quantitative and credit easing. The answers to the questions posed at the beginning of this section are (i) yes, central bank actions in this crisis were by and large not only appropriate, but also innovatively so, in responding to the economic crisis of 2007-2009, though less so in the earlier years in which financial excesses developed; (ii) for those banks practicing flexible inflation targeting and with a financial stability responsibility and tools to do the job (e.g. because bank supervision is within the central bank) neither doctrine nor policy is likely to change much; (iii) for those banks that hitherto did not have a financial stability responsibility, and that will be given tools for the job, policies and doctrines are likely to change to reflect their new responsibilities; and (iv) flexible inflation targeting will continue to be a good approach to monetary policy making. III. International coordination – the FSB 27 The G-20's Declaration on Strengthening the Financial System, 28 issued at the London Summit on April 2, 2009 expands the FSF, giving it a broad and ambitious mandate 29 to Two explanatory notes: (i) the government's definition of price stability is that the inflation rate should be in the range of one to three percent; and (ii) the draft law contains a definition of "over the course of time" as meaning that the inflation rate is expected by the monetary policy committee to return to within the target range within two years. In practice the Bank of Israel has used a one-year horizon to define the flexibility of the inflation target. I am grateful for comments at Jackson Hole by Mario Draghi that clarified the role and achievements of the FSF/FSB. At www.number10.gov.uk/Page18929. The G-20 summit was preceded by a November 13, 2008 joint letter by the heads of the IMF and the FSF to the G-20 Ministers and Governors, laying out principles for coordination between the two institutions. The G-20 communique appears to go further in the direction of the FSF/FSB than the joint letter. Specifically, the first point in the joint letter states "Surveillance of the global financially system is the responsibility of the IMF". That appears to be inconsistent with the first bullet point immediately below, drawn from the April 2009 G20 communique. promote financial stability and "a stronger institutional basis and enhanced capacity as the financial stability board (FSB)." Among the main tasks with which the FSB is charged are • assessing vulnerabilities affecting the financial system and identifying and overseeing action needed to address them (italics added) • monitoring and advising on market developments and their implications for regulatory policy • undertaking joint strategic reviews of the policy development work of the international Standard Setting Bodies • setting guidelines for the functioning of supervisory colleges (the group of regulators from the main countries in which a given international financial company is active, charged with coordinating the international supervision of that company) • supporting contingency planning for cross-border crisis management; and • collaborating with the IMF to conduct Early Warning Exercises … on the build up of macroeconomic and financial risks and the actions needed to address them. This is an extraordinarily ambitious program for an organization consisting of the various supervisors of the G-20 and a few other countries, and supported by a small secretariat at the BIS. Note that national supervisors frequently have difficulty coordinating among themselves domestically. It remains to be seen whether they can coordinate better in the international forum offered by the FSB in pointing fingers and assessing what needs to be done. By making an organization of typically collegial national supervisors responsible for international surveillance of financial systems, the G-20 injected a potential weakness into the proposed system of global financial surveillance. It also remains to be seen in what way the FSF will be "re-established with a stronger institutional basis and enhanced capacity" as the FSB. The FSF has done an excellent job in producing high-quality reports on regulation and supervision. It has also been exceptionally rapid in reaching agreement on a number of important regulatory reforms. But the tasks of surveillance – of assessing vulnerabilities affecting the financial system and of identifying the actions needed to address them – are far more demanding. Even more demanding is the task of overseeing the actions that countries should be implementing to deal with those vulnerabilities. It is puzzling that in defining the tasks of the FSB, the G-20 mentions the IMF only in the context of joint Early Warning Exercises, and not in the context of surveillance and oversight of policies to strengthen national and international financial systems. It is important for the stability of the international financial system that this issue be clarified. IV. The role of the IMF As part of their response to the crisis, the G-20 leaders decided at their April 2 2009 meeting significantly to increase the IMF's financial resources, to enable the Fund to play a more vigorous role in helping countries badly hit by the global financial crisis, and to equip it to deal with potential future crises. They also welcomed the Fund's new lending facility, the FCL, (Flexible Credit Line) designed to provide liquidity to countries with strong policies and policy frameworks. Both these changes are significant and will help deal with future crises. See Masahiro Kawai and Michael Pomerleano, International financial stability architecture for the 21st century, http://blogs.ft.com/economistsforum/2009/08/..., 02/08/2009 for a critique of the current structure of the FSB in relation to its mandate. Major reforms in Fund governance are also getting under way, with the goal of enabling emerging market countries, particularly the BRICs, to take a larger share in Fund quotas and in Fund decisions. This is part of the process of recognizing the shifting center of gravity of the global economy. But the process will not be easy, mainly because countries whose quota shares need to decline are less than enthusiastic about the changes. However, I do not want to concentrate here on Fund governance, important as that is to the future of international cooperation and coordination. Rather I would like to focus on the surveillance issue and on global imbalances. After every crisis there is a call to strengthen IMF surveillance of the global economy. For instance, in the IMFC communiqué of October 11, 2008, "[t]he Committee underscores the central role of Fund surveillance in providing clear, advance warning of risks, helping members understand the interdependence of their economies, and promoting globally consistent policy responses." There is no question that Fund surveillance should be important, possibly central, in warning member countries of the risks they face. Those warnings are likely to be taken more seriously the better the surveillance record of the Fund, which is the reason to strengthen Fund surveillance. But it is less clear that clear warnings of risks generally lead to action. The impression created by the statement quoted in the previous paragraph is that what countries require to get them to take action in time to prevent a crisis is adequate warning of the risks of a crisis, or an adequate understanding of international interdependencies. That is not likely. Fund warnings of risks that an OECD economy may be courting do not generally come as a surprise to policymakers in those countries. For instance, it cannot conceivably be the case that the experts have only now recognized the need for all the financial sector reforms that are being proposed in the flood of recent reports. The question is what countries do about the warnings. In my experience in the Fund, which I'm sure is still relevant, policymakers typically do nothing except claim that Fund staff are too conservative, too unimaginative, and overstate the risks. And since we are talking about probabilities, it is hard to refute that claim. We are often asked, "Why weren't we warned about this crisis?" We were warned, in the sense that we knew there was a risk of a major crisis, even if that was not the majority view. Policy makers generally deal with risks, not with certainties. There are no iron-clad warnings in this business, except those about processes that cannot go on forever. A rational costbenefit analysis would probably have suggested that some mitigating steps to deal with the housing price bubble and with a possible financial crisis should have been taken before 2007. But that did not happen. Why? In part because there is always someone out there warning of some impending disaster, and it is very difficult to judge how accurate the warnings are, particularly if they have been repeated year after year. In part because taking away the punch bowl is difficult when everyone is having a good time. Or to say virtually the same thing in different words, in part because unpopular measures to deal with what seems like a low probability risk are difficult to justify. In part because policymakers may be willing to take greater risks than those doing the surveillance regard as wise. And in part because those giving the warnings and/or the policymakers may simply have misread the situation 30 – for there will always be surprises, and that is a key factor we need to take into account in reforming the financial system, by focusing on its robustness in dealing with unexpected events. Now, finally, to global imbalances: Why was nothing done about global imbalances before the crisis happened? The IMF was set up in part, and its rules were designed, to deal with the asymmetry between the ability of the international system to discipline those countries In thinking about this issue, I have read some of the literature on major intelligence failures of the past, including Pearl Harbor and the Yom Kippur war. Some of the lessons of that literature may be helpful in thinking about making policy decisions about uncertain events or threats. that run deficits in their balance of payments and those that run surpluses 31 – an issue with which Keynes was very familiar from interwar experience. If you run deficits in your balance of payments, at some point you get into trouble, so you are going to be disciplined. If you run surpluses all you do 32 is to continue to build up your reserves. If you are willing to keep doing that, you can keep going with that strategy forever, or at least for a very long time. But that surplus is reflected in deficits somewhere else in the system. The IMF experimented with multilateral surveillance to deal with the China-US current account imbalances. That attempt failed. What else can you do about this phenomenon? You can try to make the system more resilient, which is what the move to floating exchange rates did as the original Bretton Woods system collapsed. Or you can try to give the relevant countries a greater sense of responsibility for the international economic system, by giving them a greater role in running the system. In doing this, though, we have also to recognize that no country, including the United States, is going to put all the focus in its mutual relations with a major country on the issue of the management of their exchange rate. Nobody, including the United States, is going to base all its relations with a country as important as China on the exchange rate issue, however important it may be economically. That is to say, we don’t really have a good way of dealing with the problem of the asymmetry of the adjustment pressures on deficit and surplus countries, the problem that underlies global imbalances. That is a source of weakness in the international system's ability to reduce the frequency and severity of future crises. VI. Concluding comments How will all the proposed reforms affect the frequency and seriousness of future financial and economic crises? That question can be divided into two parts. The first is whether the advice now being offered would make a serious difference if implemented. The second is how much of the advice will be implemented. My tentative answer to the first question is that the advice on macroprudential supervision and its location in central banks would improve our ability to deal with crises; that other suggestions for improving supervision and regulation of financial corporations – most of them not discussed in this speech, but included for example in the G30 report – would also make an important difference; that improvements in corporate governance, particularly in risk control, would be helpful; that the tasks suggested for the new FSB would be very useful if they can be implemented; and that we still do not have an answer for dealing with global imbalances arising from a pegged undervalued exchange rate. And the tentative answer to the second question: that we may be relaxing too soon, thinking the crisis is past when that is far from sure; that in dealing with financial fragility, we need to think about reforming the structure of the financial system as well as dealing with the weaknesses that led to the current crisis; that inter-agency rivalries may prevent desirable reforms of financial sector supervision; that proposed reforms in corporate governance may be putting too large a weight on the ability of corporate boards to control management, and too small a weight on the need for improvements in management performance; that the current FSB structure is not adequate to the ambitious goals it has been set, and that the system would work better if the FSB were more closely tied to the IMF, particularly in doing surveillance; that the central role for the IMF that was proposed by the G-20 at the height of the crisis may be slipping away as the urgency of acting appears to be diminishing; that we do not have a solution for global imbalances; and that we need to focus more on what it will I draw here on material presented in a speech to the European meeting of the Trilateral Commission, in Paris, on November 8, 2008. This assumes the foreign exchange purchases can be sterilized. take to get governments to act in accordance with warnings of future risks than to focus purely on improving the quality of the warnings. We need also to remember that every financial crisis is different, each in its own way, and that in seeking to prevent future crises we need to seek out and deal not only with the factors that caused the present crisis, but also with those that could cause the crises of the future. And finally, the final word: despite all these concerns, on the whole we are making progress.
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Address by Professor Stanley Fischer, Governor of the Bank of Israel, at the President's residence on the occasion of his appointment for a second term as Governor of the Bank of Israel, Jerusalem, 2 May 2010.
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Stanley Fischer: Challenges confronting the Bank of Israel and the economy Address by Professor Stanley Fischer, Governor of the Bank of Israel, at the President’s residence on the occasion of his appointment for a second term as Governor of the Bank of Israel, Jerusalem, 2 May 2010. * * * Mr. President, Mr. Prime Minister, Madam President of the Supreme Court, the Minister of Finance, members of the Government, members of the Knesset, Honorable Ambassadors, former Governors of the Bank of Israel, leaders of Israel’s banking and business sectors, members of the management and staff of the Bank of Israel – my colleagues and friends, representatives of the media, members of our family, friends and honored guests: I would like to thank the Prime Minister, the Minister of Finance, and the government for nominating me for a second term as Governor of the Bank of Israel, and thank the President for agreeing to the nomination, and for his warm words. I am grateful to the government and especially the Prime Minister for the trust they have placed in me. It continues to be an honor and a privilege for me to lead the Bank of Israel, and to represent our country at home and abroad. I would like to express thanks to many others who have played an essential role in the operation of the Bank of Israel over the past five years: to the dedicated and highly professional management and staff of the Bank of Israel, without whom the Israeli economy would not have come through the global economic crisis as well as it has, and whose capacities and outstanding professionalism are recognized world wide; to the many citizens of Israel who have expressed their support in different and often touching ways; to friends and family who have made living in Israel a pleasure for Rhoda and me; and above all to Rhoda, who has shared in the ups and downs of each day’s events in the Bank of Israel and in the country, and whose love and support have sustained me in this period, as in the previous forty years. Five years and one day ago, standing in this same place, as a new immigrant, I said that the history of Israel’s economy is fundamentally a success story. After the ceremony several friends politely told me that I didn’t understand the real situation. In some respects they were right. But not about the strength of our economy. Between the middle of 2003 and the middle of 2008, we grew at an annual rate of over 5 percent. Then we were struck by the worst global crisis in 80 years, and as everyone knows, we came through it relatively well. The most recent data confirm the strength of the recovery taking place in our economy. This success is based on two factors: a sound economic policy framework; and a vibrant and innovative private sector. The economic framework combines the basic approach of integration into the world economy – in light of the fact that a small open economy like ours has no chance of succeeding on its own – with an understanding of the need to maintain a sound macroeconomic framework, through fiscal discipline and a monetary policy dedicated primarily to maintaining price stability and thus the purchasing power of the shekel. With regard to fiscal discipline, I want to pay tribute to the Minister of Finance and to his predecessors, as well as to the professional staff of the Treasury, who can be relied on to fight for sound budgets, and whose efforts have been essential to the successful development of the economy. The private sector has been the engine of growth of the economy for the last quarter century, and the success of Israeli innovation and enterprise is the envy of many countries. The private sector does not need much from the government in order to succeed – primarily it needs a clear and predictable market-oriented economic framework in which to operate, and a set of incentives that encourages the entrepreneurs and the professionals who are essential to our success to work and invest in Israel. There has been a great deal of attention in recent weeks to the very high incomes that are earned in parts of the private sector. Some incomes in some sectors, including the banking industry, do seem to be too high, but we need to be very careful in dealing with the problem, for we can all too easily exaggerate and cause severe damage to the Israeli economy. The Supervisor of Banks has sent instructions to the banks on salaries, and is closely monitoring their implementation and the need for additional measures to deal with the pay of senior management. With regard to other public companies, we must find a way of strengthening the supervision of managers’ salaries by Boards of Directors. Our economic success is the basis for our possible acceptance later this year into the OECD, the organization of the most advanced economic countries. These achievements are essential not only to the economic wellbeing of Israelis, but also to the existence of the state of Israel, the Jewish state, our hope of two thousand years. Over the longer term, we need to be economically successful no less than we need to be able to defend ourselves militarily. These two factors – the economic and the military – are intertwined, and their interconnections are very complex, too complex to begin to discuss today. To describe our success to date is not to say that all is well in the economy and the society. For much is not well, and we face many challenges. I start with the challenges confronting the Bank of Israel, the first of which is the implementation of the new Bank of Israel law, passed recently by the Knesset. The law is designed to protect the independence of the Bank of Israel, within a framework that will revolutionize decision-making processes in the Bank, and further increase our transparency and accountability to the Knesset, the government, and the public. In the last five years we have gone a long way in increasing transparency, including by publishing the minutes of the meetings in which interest rate decisions are made. In addition, the law clearly defines the policy goals and the responsibilities of the Bank, and clarifies working relationships between the Ministry of Finance and the Bank of Israel in areas where we overlap. The new law sharply constrains the power of the Governor of the Bank. Today, and for the last fifty six years, the Governor alone has made both the policy and the managerial decisions in the Bank. Under the new law, monetary policy decisions will be made by the Monetary Policy Committee, which has six members, three of them external to the Bank, with the Governor as chairman and with a double vote in cases of a tie. Major administrative decisions will need the approval of the Board of Directors, which has seven members, five of them external, with one of the external members being appointed as Chairman. Why did we propose these new arrangements? Because experience and research have shown that on average committees make better decisions than a single individual. For that to happen, the members of both committees have to be chosen for their professional capabilities, and not on a political basis. The appointments process specified in the new law for choosing the members of the two bodies is designed to prevent political factors from influencing the choice of their members. Further, I neither expect nor want either internal or external members to vote as a bloc – insiders versus outsiders. Rather each member should exercise her or his independent professional judgment on the issues at hand. The most important non-policy task confronting the Bank of Israel in the next few years is to make the new system of governance of the Bank work effectively for the good of the economy and the citizens of Israel. That will not be easy, but we know that what we do now will establish the decision-making processes of the Bank until the next law of the Bank of Israel is passed, somewhere around 2066. So we had better get it right. Implementing the new law requires the Bank of Israel to achieve, as far as possible, the goals of monetary policy as set out in the law: first, to maintain price stability; second, to support the other goals of government economic policy – particularly growth, employment and the narrowing of social gaps, so long as this does not conflict with price stability over the course of time; and third, to support the stability of the financial system. In implementing the new law, we will have to draw the lessons of the global crisis, the Great Recession. Among the most important lessons are those being drawn about the structure and regulation of the financial system. The Supervisor of Banks is carefully following the regulatory reforms in the area of corporate governance and risk management suggested by the newly established Financial Stability Board and the Basel Committee, and where relevant, is adapting them and requiring their implementation in the Israeli banking system. In addition, we are studying the new topic of macroprudential surveillance, and considering its implementation. We will also have to take another look at the overall system of financial sector supervision in Israel. Our financial system emerged from the crisis in relatively good shape, but the crisis nevertheless revealed several weaknesses that need to be corrected. The second set of challenges I want to discuss are those confronting the economy and society outside the direct policy responsibility of the Bank of Israel, those that relate to the role of the Governor as the economic adviser to the government. Many of these issues are analyzed in the Bank of Israel’s Annual Report for 2009, which was published recently. Broadly speaking, the two wider economic challenges that confront us are to maintain and even accelerate the growth rate of the economy, and to reduce poverty and social gaps. These two goals are closely related, for the most important way of reducing absolute poverty is through sustained economic growth, even though in the short term there may be a trade-off between growth and the reduction of social gaps. The government has already announced ambitious plans for infrastructure – especially transportation – projects to be undertaken starting in the near future. These and other projects in the water, electricity, and ports areas are essential for growth to be sustained in the long term. The educational system and our educational achievements are critical to the achievement of sustained growth, and trends in this area are extremely worrying. We do not have one educational system, we have many. There is no core curriculum that ensures that every student learns the basic skills that are needed to compete in the ever-changing global economy. Our results in the OECD’s PISA (Programme for International Student Assessment) tests are woeful, and we are falling in the international rankings. We cannot build the nation and our future if we do not educate our people – all our people – to equip them to live in the modern world. At some point, the sooner the better, we have to confront the separate educational systems and their political context, and stop and reverse the deterioration of our educational standards. We are all concerned about the growing social gaps in our society. Naturally we think of the gaps between the very top salaries and those at the bottom of the salary scale. Those trends too are worrying, and they are not easy to deal with, though improving the educational system will surely contribute to creating a more just society. But in thinking about social gaps, we need to recognize that the biggest gaps are between different groups in our society – among the Arab sector and the haredi sector in which poverty is concentrated – and the remainder of our society. So we need also to focus our attention on increasing the educational achievements and the labor force participation of those groups – and this is an even more difficult, but no less essential, task. The notable successes of the Israeli economy and Israeli science, signified by the Nobel Prizes awarded to Israeli scientists this decade, are based on the educational system of Israel of thirty to forty years ago. We need to restore the quality of both the school system and the system of higher education if we are to maintain the qualitative edge on the basis of which the Israeli economy has thrived and on which Israel’s future depends. In this context we have recently seen the first signs of positive reform in the educational system, and we hope this will continue and yield the desired results. Improving the educational system will require both reforms and financing. The government has recently passed a new fiscal rule to determine the growth rate of government spending, accompanied by a declining path for the budget deficit and the government debt to GDP ratio. The government has also announced its intention of continuing to cut marginal tax rates, with the goal of encouraging growth. Provided the economy can return to growth at about 5 percent – which looks somewhat ambitious at present – both the deficit and the tax rate cutting targets can be met. But if growth is slower, the government will have to decide whether to cut the growth rate of government spending, or rather forgo some of the planned tax rate decreases, or to do some of both. This will be a difficult decision. In making it the government will have to weigh the benefits of maintaining government programs in a variety of areas, including education, against the benefits of cutting taxes. In international comparisons, Israel is typically somewhere around 25–30 in the country rankings as a place in which to do business. We seem to be unusual in the variance of the rankings of the individual components of the indices: we do well on the ease of financing and the openness of the economy; we do not well on the complexities of the tax system; and we do very badly on bureaucracy. I fear also that in years to come we will do much worse on the corruption index. If we are to sustain growth, we need to reduce bureaucracy and fight the corruption that so often accompanies it. These too are not easy tasks, but they are essential for the wellbeing of Israeli society. Israel’s economic record is all the more remarkable for having been achieved despite our not being at peace with all our neighbors. Even in the last five years, we have twice fought limited wars against neighbors. This economy, with its dynamism and creativity, could grow much faster if we were to achieve peace with our neighbors – and there are of course much better reasons than economic growth to hope and work for peace with our neighbors. This is an ambitious agenda. If we were to achieve it, we could within one or two decades find ourselves living in one of the most advanced economies in the world. Is it possible? Yes, entirely. If you wish it, it is no legend – but it will take extremely hard work and determination to turn the wish into reality. Thank you.
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Address by Mr Stanley Fischer, Governor of the Bank of Israel, at the annual conference of the Association of Banks in Israel, Tel Aviv, 30 November 2010.
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Stanley Fischer: Lessons from the crisis Address by Mr Stanley Fischer, Governor of the Bank of Israel, at the annual conference of the Association of Banks in Israel, Tel Aviv, 30 November 2010. * * * The Governor of the Bank of Israel delivered remarks today at the annual conference of the Association of Banks in Israel in Tel Aviv. An abstract of his address follows: I would like to congratulate the banking system for having returned to profitability and growth and for posting outstanding balance sheets by international standards. This is immensely important not only for the banking system but for the Israeli economy at large. The global economy appears to have weathered the worst of the crisis, but the economic world in which we live remains very complicated because different countries are recovering from the crisis at different speeds. The United States, and a fortiori several European countries, are still finding it difficult to rebound and grow, whereas many countries in Asia and Latin America are growing at handsome rates. Let us not forget that the decoupling that we see today was not visible when the crisis began. In the first months, we saw the collapse of trade in many countries, affecting the entire global economy. Today, however, we do observe this decoupling as countries in the West, of all places – the destinations of most of Israel’s exports – have encountered difficulties. The Bank of Israel began writing a document describing how the crisis was confronted and how its lessons were learned, and next year the Bank will be organizing an international conference of central banks on the lessons of the crisis. The main lesson – as we see clearly today and has long been clear – is that the countries most affected by the crisis are those in which the crisis was not only macroeconomic but also financial – the United Sates, Ireland, and Iceland, to name only three. Countries that sustained no crisis in their financial systems recovered relatively quickly; Israel and many countries in eastern Asia fall into this group. As stated, however, the global environment remains complicated and we must beware of complacency. Another lesson relates to the origin of a very large number of financial crises in the realestate industry. The United States is a conspicuous example of this, of course. Another example is Ireland, which conducted an excellent economic policy except for one thing – its policymakers did not apply adequate supervision to their banking system and, among other things, the effect of the real-estate market on it. By implication, financial supervision generally, and Israel’s banking supervision particularly, must remain vigilant in supervising the banking system generally and the mortgage-lending industry specifically. The structure of Israel’s mortgage-lending market is different today than it had once been, and it is important to understand the risks that exist today, address them, and avoid complacency arising from the thought that this market was once considered especially stable. The Bank of Israel is duty-bound by law to maintain financial stability in the economy at large. In this context, the concept of macroprudential supervision – supervision of stability at the macro level – has been mentioned recently. This concept means that even if the situation in any particular market or financial institution may look good, systemic problems that endanger overall stability may exist. In the U.S., for example, people thought that the subprime market was relatively small and that Lehman Brothers’ balance sheet was not especially big. Both of them, however – the subprime market and Lehman Brothers – ultimately dealt the system a very grave blow when they collapsed. The Bank of Israel has already taken macroprudential steps in regard to the real-estate market and the Government has taken measures that should increase housing supply. At the moment, there are indications – no more than indications – that the housing market is leveling off. Current data from various sources are painting contrasting tableaux; we need to wait for the situation to become clear. If we find that real-estate prices are continuing to rise rapidly, we will have to take additional measures. We are also concerned about the growing use of nonbank credit to finance property investments in Eastern Europe. Complacency, as stated, is highly dangerous in this context. Even if no financial institution has collapsed in the current crisis in Israel, we should remember that it was a damn close run thin. We were forced, for example, to unfurl a safety net for the pension funds during the crisis, some domestic corporate bonds had to the reorganized, and so on. One cannot rely on the regulators only. The key to a safe banking system is risk management at every bank and every financial institution individually. We need to remember that bad loans are issued in good times. An important part of learning the lessons from the crisis takes place at the international institutions. The center of gravity in the global economy is shifting from west to east and this finds expression at the international agencies as well. These entities engaged, for example, in developing systematic bankruptcy mechanisms for insolvent banks, mechanisms for the approval of senior executives’ remuneration, etc. I would like to congratulate the outgoing Supervisor of Banks, Mr. Rony Hizkiyahu, for his excellent work in coping with crises. He is leaving the Banking Supervision Department in much better condition than he had found it. We thank Rony for his important contribution to Israel’s financial system and economy. Much work awaits his successor, David Zaken. David, you will have to continue the processes that Rony began and then continue to plot the course in your own way. You have the personal credentials to succeed in the very difficult and important task that you have taken upon yourself. I wish you success.
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Summary of the address by Professor Stanley Fischer, Governor of the Bank of Israel, at the Israel Business Conference, Tel Aviv, 13 December 2010.
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Stanley Fischer: Israel’s economy Summary of the address by Professor Stanley Fischer, Governor of the Bank of Israel, at the Israel Business Conference, Tel Aviv, 13 December 2010. * * * Israel’s economy is doing well, but there are still many long-term goals that need to be dealt with. Each one of them needs to be approached differently, and requires hard work and difficult decisions. I will outline what I consider to be the major challenges confronting us in the next decade. First, we must ask ourselves about the strategy that will lead us towards long-term growth. It is clear that Israel’s economy, like every open economy, must continue to be based on exports as the engine of growth and to be open to competition from other economies. The results of international tests showing a persistent decline in the relative achievements of Israeli students indicate that we must continue to promote the education system and to solve the problems it faces in all segments and across the entire age structure. The problem of education is directly connected with the problem of poverty, which in Israel is concentrated in two sectors in the population – the ultra-orthodox, and the Arab sector. Only 30 percent of ultra-orthodox men participate in the work force, with the inevitable result that a large part of that population is below the poverty line. In the Arab sector the main problem is the low level of employment of women, as well as discrimination, and the need to improve the education system. If we do not deal with these problems we will be unable to maintain our standard of living – that of the advanced economies. Israel also suffers from a lack of infrastructures, and related to that, from bureaucracy, slow decision making, and a low level of public-sector efficiency. Our geopolitical situation is clearly another factor; if that problem would be solved, the standard of living in the whole region, and in Israel too, would improve significantly. The problems I have enumerated till now are long-term ones. I will turn now to some shortterm macroeconomic issues that come within the scope of the responsibility of the central bank. The main goal of the Bank of Israel, under the Bank of Israel Law passed by the Knesset this year, is the preservation of price stability, i.e., to keep inflation down to between 1 percent and 3 percent a year. In addition, the Bank’s objectives are to work towards the achievement of the other goals of the government’s economic policy, in particular growth, employment and the narrowing of social gaps, and to maintain the stability of the financial system and its proper functioning. Recently inflation has been within the target range, and will probably remain within it until the end of this year. Inflation expectations for next year, however, are relatively high. As the expectations are around the upper limit of the target inflation range, this does not present a serious problem at this stage, but it is our task to ensure that inflation should not exceed the upper limit of the target. To achieve that requires a slightly tighter monetary policy. Let us turn now to the second goal, employment. The rate of unemployment, which increased during the crisis and declined during the recovery almost to its pre-crisis level, has recently risen slightly. This, in effect, is good news, as the unemployment rate has increased because of an increase in the rate of participation in the labor force, and not because of a drop in the number of employed persons. If the rate of participation had not risen, the rate of unemployment would today be about 5.5 percent. Our function is also to promote economic growth, and we therefore also keep an eye on developments in the exchange rate. The latest figures show that exports remained steady while imports declined, so that we expect the current account surplus to increase despite the relatively strong shekel exchange rate. Nonetheless, we must continue to support exports, and we will therefore continue to intervene in the foreign currency market, and like every other country, we must be prepared for every possible economic scenario. With regard to financial stability, we are currently mainly concerned over developments in the housing market. The Ministry of Finance reports that prices of new houses have fallen, while the Central Bureau of Statistics (CBS) reports that overall housing prices continue to increase. Until the trends in the real estate market become clearer, the Bank of Israel must ensure that no bubble in housing prices develops that would harm financial stability. The best solution is to boost the supply of houses and thus lower their prices, and together with the Ministry of Finance we are examining ways of doing that. Meanwhile, as I said, we must ensure that financial stability is maintained. Another issue I would like to address is that of the medium term. The question is asked whether the recent discoveries of natural gas will have a major impact on Israel’s economy. It is too soon to answer. We have to continue encouraging the various investors to keep searching for gas, and must await results. The immediate issue here is that of royalties, reviewed by the Sheshinski Committee. I support the Committee’s approach, the aim of which is to find a way of dividing the gas profits between the entrepreneurs who search for and find the gas and Israel’s citizens. In this context I refer you to what I said when the Committee’s recommendations were published and I stand behind the views I expressed then. The gas discoveries raise a related issue, known as the Dutch disease. I have stated in the past that in my opinion the right way to deal with the problem is the Norwegian model, in which the royalties and the relevant government’s tax revenues are invested in a sovereign fund. The fund invests its income abroad, and the government’s income from this investment is more stable over time, and the fund moderates the short-term effect of the gas income on the exchange rate, an effect that could prove disastrous for the tradable goods industries, as happened in the Netherlands and other countries. I would now like to introduce the next speaker. Dr Jihad Al-Wazir, Governor and Chairman of the Board of the Palestine Monetary Authority (PMA), was born in 1963. Dr Al-Wazir obtained his Ph.D. in Business Administration from Loughborough University in the United Kingdom, and in the past served as Deputy Minister of Finance and Acting Minister of Finance in the Palestinian Authority. Relations between the Bank of Israel and the PMA under Dr Al-Wazir’s leadership are marked by effective and productive cooperation, and I hope that they will continue to be so.
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Summary of the address by Professor Stanley Fischer, Governor of the Bank of Israel, to the general assembly of the Association of Publicly Traded Companies, Jerusalem, 23 December 2010.
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Stanley Fischer: Corporate governance in Israel Summary of the address by Professor Stanley Fischer, Governor of the Bank of Israel, to the general assembly of the Association of Publicly Traded Companies, Jerusalem, 23 December 2010. * * * I would like to talk of three issues relating to corporate governance in different economic entities in Israel. The Bank of Israel will soon undergo a significant change in the way it makes its decisions. Till now, the Governor has had sole responsibility for interest rate decisions. That situation was the result of, among other things, the generally accepted practice around the world when the Bank of Israel was established, and also of the outstanding personality of the first Governor, Mr. David Horowitz. There are still today several central banks in which the Governor formally makes the decision alone. However, I do not know a single Governor who actually does decide entirely by himself. In the Bank of Israel, for example, there is a set mechanism of the monetary discussion in a narrow forum, in which a discussion is held at the highest professional level. Research has shown that on average group decisions are better than decisions taken by one person. The fact that, till now, one person makes operational decisions in the Bank of Israel, and that there is no board of directors as there is in public companies, is certainly not the ideal situation. The new Bank of Israel Law states that the Bank of Israel will have a Monetary Committee that will make the policy decisions and an Administrative Council that will make the operational decisions. As well as managers from the Bank of Israel, the Committee and Council will have representatives of the public. The Government has appointed a search committee under retired Judge Winograd charged with putting forward a list of candidates for these entities. The search committee is required to consult with the Governor about the proposed members of the Committee and Council, but the final decision is that of the government. I hope that members of the two bodies will be appointed soon, and I am sure that the decisions they will take in the new system in the Bank of Israel will be better. The second subject I would like to speak about is corporate governance in the banking system. The crisis greatly deepened our understanding of the need to strengthen corporate governance in banks. The main measures introduced in Israel in this context are based on the Basle Committee on Banking Supervision and on the Financial Stability Board. The most important topic on which our attention is focused is an update of Directive No. 301 in the Proper Conduct of Banking Business, which deals with several aspects of the work of the board of directors: Clarifying the role of the board of directors and emphasizing the difference between the functions of the board and those of management; Strengthening the composition of the board, and the independence and professionalism of the outside directors; Raising the level of director’s qualifications, and clarifying expectations regarding their functions; Improving the board’s working practices. The Bank Supervision Department has drawn up the principles regarding the existence of a main risk management function in banks, and all banks have appointed a chief risks officer. The principles of a proper compensation policy have also been formulated, and changes in this sphere are becoming evident world wide. My third subject is what is known as the shadow banking system. The practical significance of this term is that it deals with aspects of the financial system that the regulators do not know how to supervise. In the US and the UK, and to a lesser extent in Europe too, a large part of the credit market is now outside the banking system. In Israel the banking system currently covers slightly above 50 percent of total credit, credit from abroad accounts for some 18 percent, so that nonbank credit has increased to more than 30 percent of the total, mainly as a result of the pensions reform and the Bachar Committee reform. No system of regulation can be perfect, but it is essential that we find a way to supervise nonbank credit. It is no coincidence that many of the companies affected by the crisis belonged to one industry, the real estate industry, and that tells us something. The Securities Authority is responsible for transparency, but it does not regulate due diligence in new issues. In the final analysis, it is the institutions that manage the public’s money that must take the investment decisions. These areas have advanced and improved recently, but we must continue to enhance the quality of supervision over the conduct of these entities, and the quality of corporate governance in companies.
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Dinner lecture by Professor Stanley Fischer, Governor of the Bank of Israel, at the Bank of Israel conference on "Lessons of the Global Crisis", Jerusalem, 31 March 2011.
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Stanley Fischer: Central bank lessons from the global crisis Dinner lecture by Professor Stanley Fischer, Governor of the Bank of Israel, at the Bank of Israel conference on “Lessons of the Global Crisis”, Jerusalem, 31 March 2011. This lecture is slightly modified from a series of lectures given during recent months: the Brahmananda Lecture at the Reserve Bank of India in February 2011; a lecture at the CEPR/ESI conference in Izmir on October 28, 2010; and a lecture at the conference of the Cyprus Economic Society in October 2010. I am grateful to colleagues at the Bank of Israel with whom I have discussed and lived through the issues of monetary policy during the last five years, and to Joshua Schneck of the Bank of Israel for research assistance. * * * During and after the Great Depression, many central bankers and economists concluded that monetary policy could not be used to stimulate economic activity in a situation in which the interest rate was essentially zero, as it was in the United States during the 1930s – a situation that later became known as the liquidity trap. In the United States it was also a situation in which the financial system was grievously damaged. It was only in 1963, with the publication of Friedman and Schwartz’s Monetary History of the United States that the profession as a whole1 began to accept the contrary view, that “The contraction is in fact a testimonial to the importance of monetary forces”.2 Twenty years later, in 1983, Ben Bernanke presented the view that it was the breakdown of the credit system that was the critical feature of the Great Depression3 – that it was the credit side of the banks’ balance sheets, the failure or inability to make a sufficient volume of loans, rather than the behavior of the money supply per se, that was primarily responsible for the breakdown of the monetary transmission mechanism during the Great Depression. The Bernanke thesis gained adherents over the years, and must recently have gained many more as a result of the Great Recession. In this lecture, I present preliminary lessons – ten of them – for monetary and financial policy from the Great Recession. I do this with some trepidation, since it is possible that there will later be an eleventh lesson: that given that it took fifty years for the profession to develop its current understanding of the monetary policy transmission mechanism during the Great Depression, just two and a half years after the Lehmann Brothers bankruptcy is too early to be drawing even preliminary lessons from the Great Recession. But let me join the crowd and begin doing so. Lesson 1: Reaching the zero interest lower bound is not the end of expansionary monetary policy Until this crisis, the textbooks said that when the nominal interest rate reaches zero, monetary policy loses its effectiveness and only fiscal policy remains as an expansionary policy instrument – the pure Keynesian case. Now we know that there is a lot that the central bank can do to run an expansionary monetary policy even when it has cut the central bank The qualification relates to the fact that some researchers, for example Clark Warburton, had emphasized this view before the publication of Friedman and Schwartz’s work. (See for example the papers reprinted in Clark Warburton, Depression, Inflation, and Monetary Policy; Selected Papers, 1945–1953, Johns Hopkins Press, 1963.) Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960, Princeton University Press, 1963, p. 30. Ben S. Bernanke, “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review, 73 (June 1983), pp. 257–76. BIS central bankers’ speeches interest rate essentially to zero – as did the Fed, the Bank of England, the Bank of Japan, and other central banks during this crisis. In the first instance there is the policy of quantitative easing – the continuation of purchases of assets by the central bank even when the central bank interest rate is zero. Although these purchases do not reduce the short-term interest rate, they do increase liquidity. Further, by operating in longer-term assets, as in QE2, the central bank can affect longerterm interest rates, which may have an additional impact on the private sector’s demand for longer-term assets, including mortgages and corporate investment. During the crisis several attempts were made to calculate how much quantitative easing was needed at a particular point in time. The calculation used a Taylor Rule to calculate what the (negative) interest rate should have been in the given circumstances, combined that with an estimate of the increase in the money supply or central bank assets that would normally be needed to reduce the interest rate by one percentage point, and thereby calculated the needed increase in central bank assets. This is a logical approach, but we should note that it extrapolates economic behavior far beyond the range of the experience on which the estimated Taylor rule is based. 4 Second, there is the approach that the Fed unsuccessfully tried to name “credit easing” – actions directed at reviving particular markets whose difficulties were creating major problems in the financial system. For instance, when the commercial paper market in the United States was collapsing, the Fed entered on a major scale as a purchaser, and succeeded in reviving the market. Similarly it played a significant role in keeping the mortgage market alive. In this regard the Fed became the market maker of last resort.5 In a well-known article, James Tobin in 19636 asked in which assets the central bank should conduct open market operations. His answer was the market for capital – namely the stock market – since that way it could have the most direct effect on the cost of capital, later known as Tobin’s q, which he saw as the main price through which the central bank could affect economic activity. Although central banks have occasionally operated in the stock market – most notably the Hong Kong Monetary Authority in 1997 – this has not yet become an accepted way of conducting monetary policy.7 Lesson 2: The critical importance of having a strong and robust financial system This is a lesson that we have all thought we understood for a long time – not least since the financial crises of the 1990s – but whose central importance has been reaffirmed by the recent global crisis. This crisis has been far worse in many of the advanced countries – among them the United States, the United Kingdom, and some other European countries – than it has been in the leading emerging market countries. This was not the situation in the financial crises of the 1990s, and it is not a situation that I expected would ever occur. The critical difference between countries that have suffered from exceptionally deep crises and those that had a more or less standard business cycle experience during this crisis Jan Hatzius, “The Specter of Deflation”, in US Economics Analyst – Goldman Sachs Global ECS Research, March 2009. This term was introduced into the literature by Willem Buiter and Anne Siebert. James Tobin, “An Essay on the Principles of Debt Management”, in his Essays in Economics, Volume I, Macroeconomics, Markham Publishers (Chicago), 1971. It is sometimes objected that such actions would require excessively detailed intervention by the central bank, since it would have to decide which companies' assets to buy. However it could simply buy very broad stock indices. BIS central bankers’ speeches traces to what happened in their financial sectors. Those countries that suffered financial sector crises had much deeper output crises. In their important book, This Time Is Different, Carmen Reinhart and Ken Rogoff8 document the fact that over many centuries, downturns that also involved a financial crisis were more severe than those that did not. This is not coincidental, for the collapse of the financial system not only reduces the efficiency of financial intermediation but also has a critical effect on the monetary transmission mechanism and thus on the ability of the central bank to mitigate the real effects of the crisis. If the financial system is intact, the standard anti-cyclical monetary policy response of cutting interest rates produces its response in the encouragement of purchases of durables, ranging from investment goods and housing to consumer durables. This happened during this crisis, in that many countries that did not suffer from a financial crisis but had cut interest rates sharply to deal with the negative effects of the global crisis returned to growth more rapidly than other countries, and soon found asset prices, particularly the price of housing, rising rapidly. Among these countries are Australia, Canada, China, Israel, Korea, Norway and Singapore. The next question is what needs to be done to maintain a strong and robust financial system. Some of the answers to this question are to be found in the blizzard of recommendations for financial sector and regulatory reform coming out of the Basel Committee – now extended to include all the G-20 countries plus a few more – and the Financial Stability Board (the FSB). In particular the recommendations relate to the capital requirements of the banks, which the Basel Committee and the FSB recommend raising sharply, including by toughening the requirements for assets to qualify as Tier 1 and Tier 2 capital. In addition, there are recommendations on the structure of incentives, on corporate governance, on the advisability of countercyclical capital requirements, on risk management, on resolution mechanisms including eventually on how to resolve a SIFI (systemically important financial institution, typically a bank with major international operations) – and much more.9 Further, there has been a focus on systemic supervision and its organization, a topic to which we will return shortly. These recommendations make sense, and the main question relating to them is whether and how they will be implemented, and whether political pressures will either prevent their implementation and/or lead to their gradual weakening. There is already cause for concern in that some of the recommendations are to be implemented only by 2019 – a period sufficiently long for everyone to forget why such drastic changes are regarded as essential, and why they are indeed essential. One element of the conflicting pressures can be seen in the concern in many countries that the banks not tighten capital requirements too fast, since an expansion in credit is needed to fuel the recovery. Lesson 3: The need for macroprudential supervision10 There is not yet an accepted definition of macroprudential policy or supervision, but the notion involves two elements: that the supervision relates to the entire financial system; and that it involves systemic interactions. Both elements were evident in the global financial Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different, Princeton University Press, 2009. For example: Financial Services Authority, The Turner Review: A Regulatory Response to the Global Banking Crisis, March 2009, Group of Thirty, Financial Reform – A Framework for Financial Stability, January 2009 and HM Treasury, A New Approach to Financial Regulation, July 2010. In this section I draw extensively on comments I made in a panel discussion at the Norges Bank at a symposium, “What is a useful central bank”, held on November 18, 2010, and due to be published in the series, Norges Bank Occasional Papers. BIS central bankers’ speeches crisis, with analyses of the crisis frequently emphasizing the role of the shadow banking system and of the global effects of the Lehman bankruptcy. Thus we are talking about regulation of the financial system at a very broad level, going beyond the banking system. We are also going beyond bank supervision in considering macroprudential policy instruments – and we are therefore also discussing an issue that requires coordination among different regulators. It is not clear whether the inclusion of a responsibility for (or contributing to) financial stability in modern central bank laws, such as those of the ECB, the Bank of England and many others, including the Bank of Israel, reflects the concerns that have led to the emphasis on macroprudential supervision, or rather primarily the traditional role of the central bank as lender of last resort. No-one who has read Bagehot on panics can think that understanding of the potential for systemic crises is a new problem. However its importance has been reinforced by the dynamics of the most recent crisis, in which a problem initially regarded as manageable – the subprime crisis – gradually developed into the worst financial crisis since the Great Depression, involving financial instruments built on mortgages, and after the Lehman bankruptcy which revealed interactions among financial institutions to be much stronger than policymakers must have thought at the time. What macroprudential policy tools do central banks have? In the first place they have their analytic capacities and their capacity to raise policymakers’ and the public’s awareness of critical issues. These are reflected in the financial stability reports that some central banks have been producing for over a decade. What about other macroprudential policy tools? Central banks have been engaged in a search for them since the financial crisis, but the search has not been especially fruitful. Some have defined countercyclical capital requirements11 as a macroprudential policy tool, presumably because they reflect a macroeconomic assessment and because they apply to the entire banking system. Nonetheless they are not particularly aimed at moderating systemic interactions, and thus it is not clear that they are the archetypical macroprudential policy tool. More generally, it seems that there are few specifically macroprudential policy tools, and that the main tools that central banks and financial supervisors will be able to deploy to deal with systemic interactions will be their standard microprudential instruments or adaptations thereof. Like other economies that did not suffer from a domestic financial crisis during the global crisis, Israel has had to deal with the threat of a housing price bubble in the wake of the global crisis. Housing prices, after falling gradually for over a decade, grew by around 40 percent in the last two years. The Bank’s housing sector model suggests that while prices in the middle of 2010 were not far above their long-run equilibrium level, a continuation of their recent rapid rates of increase would definitely put them well above the equilibrium level. Further, the atmosphere in the housing market was becoming increasingly bubble-like, with discussion of the need to buy before prices rose even further. Because the exchange rate had been appreciating rapidly, the Bank preferred if possible not to raise the central bank interest rate too rapidly. Since bank supervision is located within the Bank of Israel, policy discussions in the Bank resulted in the supervisor undertaking measures that in effect increased mortgage interest rates, without affecting other interest rates. These, together with tax and other measures undertaken by the government, along with government measures to increase the supply of land for building, appear to have begun Although these capital requirements vary procyclically, the intent is to be anticyclical in terms of their effects on the economy. Hence they are usually defined as countercyclical. BIS central bankers’ speeches to dampen the rate of increase of housing prices – though it will take some time yet to know whether that has happened. In announcing the new measures, the Bank of Israel emphasized that they were macroprudential, and that our aim was to ensure financial stability. In speeches we noted that our measures operated on the demand for housing, and that it would be preferable to undertake measures that would increase the supply – as some of the measures undertaken by the government soon afterwards were designed to do. In this case the central bank was in the fortunate position of having at its disposal policy measures that enabled it to deal directly with the potential source of financial instability. Further, the banks are the main source of housing finance, so that the Bank of Israel’s measures were unlikely to be circumvented by the responses of other institutions not supervised by the central bank. Even so, we knew there were better ways of dealing with the price rises, and that it was necessary to cooperate with the government to that end. Even within a central bank that is also the banking supervisor, questions arise about how best to coordinate macroprudential policy. In the case of the Bank of Israel, which still operates under the single decision maker model (but will shortly cease to do so as a new central bank law goes into effect), it was relatively easy to coordinate, since it was possible to include the bank supervisor in the non-statutory internal monetary policy advisory committee, and to use the enlarged committee as the advisory body on macroprudential decisions. More generally macroprudential supervision could require actions by two or more supervisory agencies, and there then arises the issue of how best to coordinate their actions. A simple model that would appeal to those who have not worked in bureaucracies would be to require the supervisors to cooperate in developing a strategy to deal with whatever problems arise. However, cooperation between equals in such an environment is difficult, which is to say inefficient, all the more so in a crisis. It is thus necessary to establish mechanisms to ensure that decisions on macroprudential policy are made sufficiently rapidly and in a way that takes systemic interactions into account. The issue of the optimal structure of supervision was discussed well before the recent crisis, with the FSA in the UK being seen as the prototype of a unitary regulator outside the central bank, the twin peaks Dutch model as another prototype, and various models of coordination and non-coordination among multiple regulators providing additional potential models. The issue of the optimal structure of supervision came into much sharper focus in the wake of the financial crisis, with the failure of the FSA to prevent a financial crisis in the United Kingdom having a critical impact on the debate. Major reforms have now been legislated in the United States, Europe, and the United Kingdom. In the Dodd-Frank bill, the responsibility for coordination is placed in a committee of regulators chaired by the secretary of the treasury. In the UK, the responsibility for virtually all financial supervision is being transferred to the Bank of England, and the responsibility will be placed with a Financial Policy Committee, chaired by the Governor. The structure and operation of the new Committee will draw on the experience of the Monetary Policy Committee, but there are likely to be important differences between the ways in which the committees will work. In other countries, including France and Australia, the coordination of financial supervision is undertaken in a committee chaired by the Governor. At this stage it is clear that there will be many different institutional structures for coordinating systemic supervision, and that we will have to learn from experience which arrangements work and which don’t – and that the results will very likely be country dependent. It is also very likely that the central bank will play a central role in financial sector supervision, particularly in its macroprudential aspects, and that there will be transfers of responsibility to the central bank in many countries. BIS central bankers’ speeches Lesson 4: Dealing with bubbles One casualty of the crisis has been the Fed doctrine that the central bank should not react to asset prices and situations that it regards as bubbles until the bubble bursts. This is known as “the mopping up approach” – which is to say, to wait for the bubble to burst, and then to mop up the mess that results. The origin of this approach may lie in the expansion and stock market boom of the 1990s. As is well known, Chairman Greenspan announced in a speech in 1996, at a point when the Dow Jones was about 6400, that the stock markets were showing “irrational exuberance”. Despite the Chairman’s authority, the markets paused for only a few days before resuming their upward climb, eventually rising above 10,000. The Fed was widely praised for allowing the boom to continue during that period, based on their conclusion that the rate of productivity growth had increased, and that the economy could grow faster than previously thought without generating inflation. When the dot-com bubble burst in 2000, the mopping up approach appeared to have been successful. The Fed cut interest rates rapidly and the recession was relatively mild. The damage seemed to have been slight. There is of course much debate about whether in the wake of the recession the Fed kept the interest rate too low for too long, thus laying the groundwork for the next – and far more serious – crisis. But even those who argue that way, do not suggest that the subsequent crisis was an inevitable result of the decision not to try to prick the bubble in the late 1990s. I believe that the mopping up discussion was misleading. The issue was generally put as “should the central bank try to prick the bubble?” with the “no” side of the debate arguing that the interest rate would have had to be raised by so much to prick the bubble that doing so would have caused a serious recession. If the question had been “should the Fed react to asset prices in setting the interest rate?”, the answer might well have been yes, though it would likely have been provided through the lens of the inflation targeting approach – that is to say, if excessively high asset prices were expected to influence future price or output levels, the central bank would be justified in taking them into account in its interest rate decision. If the same question were asked today, it would likely be answered in terms of macroprudential supervision, and with reference to the possibility that regulatory measures might be employed to supplement the effects of the interest rate on asset prices. It seems clear from the general acceptance of the need for macroprudential supervision that the mopping up doctrine is in retreat, though there could be circumstances – particularly a stock-market boom whose collapse would have no major implications for the rest of the financial system – in which the approach could be justified.12 Lesson 5: The lender of last resort, and too big to fail The view that the central bank should be the lender of last resort has a long and distinguished heritage, and central banks operated as lender of last resort in several countries in the recent crisis. The case for the central bank to be the lender of last resort is clear in the case of a liquidity crisis – one that arises from a temporary shortage of liquidity, typically in a financial panic – but less so in the case of solvency crises. The key difference is that in the case of a liquidity crisis, decisive central bank action along the lines advocated by Bagehot can resolve the situation without a long-term financial cost to This circumstance is sometimes invoked to explain why the mopping up approach was successful in the recession of 2001–02. BIS central bankers’ speeches the public sector.13 In the case where a financial institution is insolvent, intervention to restructure it may cause a long-term financial cost to the public sector – although in several crises in which the central bank and the government intervened massively to deal with a panic, the public sector ended up making a profit from the intervention.14 Given that the profits of the central bank are generally sooner or later transferred to the government, almost every financial action that the central bank takes has fiscal implications for the government. This is particularly so when the central bank is involved in actions to support financial stability, such as providing emergency liquidity to specific banks or to the financial system as a whole. In principle the distinction between liquidity and solvency problems should guide the actions of the central bank and the government in a crisis. For instance, in Israel, the law provides that the central bank can intervene on its own to deal with a liquidity problem but needs the authorization of the Treasury and the government to take over an insolvent financial institution. However in practice the distinction between a liquidity problem and a solvency problem is rarely clear-cut during a crisis, and what initially appears to be a liquidity crisis can very rapidly become an insolvency crisis. In short, judgment is needed at every stage of a financial crisis – as it is in central banking in general. The too big to fail issue and the associated issue of moral hazard have been recurrent problems in dealing with financial crises. If a financial institution has what is purely a liquidity problem, then the central bank in its financial stability role should act as lender of last resort to that institution in case of need. Special difficulties arise when the institution is “too big” or “too interconnected” to fail. That is to say, causing it to fail will significantly worsen the financial crisis, for instance – to put the issue dramatically – by turning a recession into a depression. Ideally the regulatory and legal system should have developed a resolution mechanism whereby an institution judged to be insolvent can be allowed to fail and to be wound down in an orderly process. We have not yet seen such systems in operation for large financial institutions (SIFIs), though one of the key lessons drawn from the recent crisis has been the need to develop a framework of this type. The difficulties are manifold, especially for global banks, which operate in many jurisdictions and under different sets of laws and organizational frameworks (e.g. branches versus subsidiaries). The Basel Committee and the Financial Stability Board are working on this issue, and finding it to be among the thorniest with which they have to contend. Moral hazard is usually present when governments intervene to help stabilize a financial system – or under any system of insurance. In the case of a lender of last resort, the valid concern is that the mere existence of such a lender encourages financial institutions to take more risks, since they know that in an emergency they will be bailed out, that is, they will be saved. The question here is “Who is ‘they’?” It is generally accepted – and appropriately so – that equity holders should not be saved when a financial institution goes bankrupt.15 Generally it is assumed that to preserve the payments mechanism, deposit holders up to a certain size of deposits should be saved, perhaps up to deposit insurance limits – though frequently in financial crises government extend deposit safety nets well beyond their normal limits. This leaves aside the moral hazard issue, which will be discussed shortly. It is tempting to say that a liquidity crisis can be defined as one in which the public sector makes a profit from its intervention. However the public sector’s profit depends on how its interventions are priced and structured, so that the question is more complicated. Presumably the same goes for non-financial institutions. BIS central bankers’ speeches The most difficult issue concerns bondholders. If a financial institution goes bankrupt, the bondholders will and should share in the losses. Nonetheless, governments sometimes extend guarantees to holders of non-deposit claims on banks, for instance short-term paper. Why? The answer may that in a financial crisis, governments are willing to go a long way to prevent a cascade of bankruptcies, which is likely to develop if the bondholders have an incentive to run. Or, to put it more simply, it may be difficult to draw the line between depositlike obligations of banks and equity-like claims. Further, it may be argued that once the markets realize that bonds – particularly short-term paper – are more likely to be written down in a crisis, the costs of bank financing in normal times are likely to rise. A similar issue was discussed about a decade ago, when the IMF pursued the possibility of a sovereign debt restructuring mechanism (SDRM). It was argued at the time that it should be easier to restructure sovereign bonds than it typically was in bonds issued in New York, which required unanimity among their holders to be restructured. Accordingly it was proposed that sovereign bonds should include CACs, collective action clauses, which would permit majority (or at least less than 100%) approval for restructuring. This issue was highly controversial and potential borrowers objected that its inclusion would increase their financing costs. In the event it turned out that CACs already existed in some bonds issued in London (so-called British Trust Deed instruments) and that their effects on the cost of financing appeared to be small. Since then some sovereigns, including Mexico, have included CACs in their bonds, apparently without important effects on their cost of financing. In the case of financial institutions, some banks have begun to issue contingent capital, bonds that automatically convert into equity when some objective criterion so signifies. In the last two years, both Rabobank and Lloyd’s have issues such bonds. Appealing as this approach may be, the systemic dynamics of the triggering of these bonds in a crisis remains to be tested in practice. Nonetheless: while the use of contingent capital and other forms of financing that become more equity-like in a crisis – and more generally, the development of resolution mechanisms – will all help deal with moral hazard issues, the mere existence of a lender of last resort raises moral hazard issues. That is true. But there is nothing that says that the optimal reaction to moral hazard is to stop selling insurance. Rather its existence is one factor to be taken into account in dealing with any situation in which the state provides explicit or implicit forms of insurance – just as it has to be taken into account in private sector insurance contracts, for instance the provision of fire insurance. After having had to decide how to deal with moral hazard issues in a variety of financial crises, I have arrived at the following guide to conduct: if you find yourself on the verge of imposing massive costs on an economy – that is on the people of a country or countries – by precipitating a crisis in order to prevent moral hazard, it is too late. You should not take the action that imposes those costs. Rather in thinking through how a system will operate in a crisis, you need to take into account the likelihood of facing such choices, and you need to do everything you can in designing the system to keep that likelihood very small. Lesson 6: The importance of the exchange rate for a small open economy The (real) exchange rate is one of the two most important macroeconomic variables in a small open economy, the (real) interest rate being the other. No central banker in such an economy can be indifferent to the level of the exchange rate. But there are no easy choices in exchange rate management. There is first the choice of the exchange rate system, a choice that is tied up with the question of capital controls. If capital flows can be controlled, then there may be advantages for a country in trying to fix its nominal exchange rate. Nonetheless, and without entering the long-running debate over exchange rate systems, I believe that it is better to operate with a flexible exchange rate system and with a more open capital account. BIS central bankers’ speeches “Flexible” does not mean that a country should not intervene in the foreign exchange market, or that the capital account should be completely open. Rather it means that the country should not draw an exchange rate line in the sand and declare “thus far, and no further”; countries should not commit themselves to defending a particular exchange rate. Market participants often say that the central bank cannot stand against market forces. However we need to recognize the asymmetry between defending against pressures for depreciation and appreciation of the currency. In the case of pressures for depreciation, at the existing exchange rate the market wants more foreign exchange. The central bank has a limited supply of foreign exchange, and thus cannot stand against the pressure of the market for very long – though as the recent crisis has shown, large foreign exchange reserves can help the central bank deal with market pressures, as for example in Brazil, Korea and Russia. In the case of appreciation, at the existing exchange rate the markets want more domestic currency. The central bank can produce unlimited amounts of domestic currency – that is, it can intervene to buy the foreign exchange flowing into the country. Of course to prevent inflation, it will have to sterilize the foreign exchange inflow. But that can be done, as the Bank of Israel has shown over the last three years. In the case of pressures for appreciation, the central bank has to balance the net costs of holding additional reserves against the benefits of preventing unwanted appreciation. This is a complicated calculus,16 one which has led to the development of various rules for reserve holdings: when the current account was the dominant factor in the exchange market, the rule was specified in terms of holding reserves equal to the value of X months of imports; now that the capital account is at least as important, reserve holding rules of thumb relate to capital flows, generally based on some form of the Greenspan-Guidotti rule that a country’s reserves should at least cover the economy’s short-term obligations falling due over the next year. The recent crisis has resulted in many countries deciding to hold more reserves than the previous conventions implied. In addition, country-specific factors may be relevant, for instance in the case of Israel the central bank has explicitly noted our geopolitical situation in discussing our reserve holdings. Central bankers used to say that they have only one instrument – the interest rate – and thus can have only one target – the inflation rate. That view, which is based on the Tinbergen result that there should be as many instruments as there are goals of policy, is not generally correct.17 But in any case, I see the instrument of intervention in the foreign exchange market as in effect giving the central bank an extra instrument (or at least an extra half instrument) of policy, which enables it not only to target inflation but also to have some influence on the behavior of the exchange rate. As the pressures for appreciation increase, a country may want to limit further intervention, and is likely to turn to the use of capital inflow controls. Such controls are rarely elegant, are typically difficult to administer, and are continually being undermined by private sector attempts to circumvent them. Central banks prefer to do without them. But sometimes they One complication in measuring the costs of holding reserves relates to the numeraire in which the reserves are valued. Typically and appropriately, the central bank presents its accounts in local currency terms. Any central bank that has intervened to moderate appreciation pressures is likely to show a capital loss in terms of the local currency value of the reserves. However, some of the reserves are held to enable the country to purchase foreign goods if the need arises, and in terms of the purpose for which the reserves are held, it is thus not clear that the numeraire should be the local as opposed to a foreign currency. Further, if capital flows reverse, the country may find itself intervening to prevent depreciation. One central bank colleague has remarked that his reserve holdings, at mark to market value, generally show a loss, but that whenever he has intervened in a crisis he has made a “profit”. See Stanley Fischer, “Comment” in The Reserve Bank of Australia: Fiftieth Anniversary Symposium, Christopher Kent and Michael Robson (editors), Reserve Bank of Australia (2010), pp. 38–41. BIS central bankers’ speeches are needed, as many countries faced with large short-term capital inflows – including Israel – have concluded in recent months. Exchange rate management can be difficult in a growing small open economy with a strong financial system. Capital flows are likely to be very sensitive to interest rate differentials, which leads to the exchange rate bearing more of the burden of adjustment to inflation and aggregate demand than may be optimal from the viewpoint of policymakers. In such a case, the country may be tempted to join a currency bloc. Membership of a currency bloc demands disciplined management of the domestic economy – of fiscal policy, and of the financial system. The exchange rate cannot be changed without leaving the bloc, a step with unknown but certainly major, probably massive, consequences for the economy. At this time, many expound on the constraints that membership of the Euro area impose on countries that cannot devalue. These constraints clearly matter. But it is rarely noted that when countries did have the freedom to devalue, changes in exchange rates were frequently disruptive of trade with their neighbors – and further that some countries that did have that freedom mismanaged it, and paid a significant price in terms of economic performance. Or to put it differently, whatever type of exchange rate arrangement a country has, there will be times when it wished it had a different one. I have emphasized the exchange rate problems likely to face small open economies, for that is the type of economy in which I operate. But the truth is that most of what I have said about exchange rate management in a small open economy is true of any open economy, large or small. Lesson 7: The eternal verities – lessons from the IMF While I have emphasized lessons that we central bankers have learned from the crisis, many of them lessons that our predecessors knew long ago, the crisis has also reinforced lessons we learned long ago. In particular, this crisis has reinforced the obvious belief that a country that manages itself well in normal times is likely to be better equipped to deal with the consequences of a crisis, and likely to emerge from it at lower cost. In particular, we should continue to believe in the good housekeeping rules that the IMF has tirelessly promoted. In normal times countries should maintain fiscal discipline and monetary and financial stability. At all times they should take into account the need to follow growthpromoting structural policies. And they need to have a decent regard for the welfare of all segments of society. The list is easy to make. It is more difficult to fill in the details, to decide what policies to follow in practice. And it is very difficult to implement such measures, particularly when times are good and when populist pressures are likely to be strong. But a country that does not do so is likely to pay a very high price. Lesson 8: Target inflation, flexibly How to summarize all these conclusions? Simply: flexible inflation targeting is the best way of conducting monetary policy. The tripartite set of goals of monetary policy set out in modern central bank laws provide the best current understanding of what a central bank should try to achieve. Namely, a central bank should aim: To maintain price stability To support the other goals of economic policy, particularly growth and employment, so long as medium term price stability – over the course of a year or two or even three – is preserved To support and promote the stability and efficiency of the financial system. BIS central bankers’ speeches It is noteworthy that these goals of the central bank were defined well over a decade ago, that they were in place in the ECB, the Bank of England, and other central banks before the global crisis and during it, and that there is no reason to change them now, despite the lessons we have been discussing. Rather, we have learned better ways of trying to achieve those goals. Lesson 9: In a crisis, you do not panic Consistent with the title of this lecture, all the lessons so far are reflections on the most recent crisis. Nonetheless, I would like to add a lesson I learned in an earlier crisis, the first financial crisis in whose management I was deeply involved, that of Mexico in 1994–5. At the end of January 1995, the IMF was asked to come up at very short notice – about nine hours – with an extra twenty billion dollars of loans to Mexico. The senior management of the Fund met in Managing Director Michel Camdessus’ office very early the next morning, to find a solution. The first words of the Managing Director at that meeting were: “Gentlemen: this is a crisis, and in a crisis, you do not panic.” This advice has stood the test of time and experience. Finally: Lesson 10 In a crisis, central bankers (and no doubt other policymakers) will often find themselves deciding to implement policy actions that they never thought they would have to undertake – and these are frequently policy actions that they would prefer not to have to undertake. Hence, a few final words of advice for central bankers: “Never say never” BIS central bankers’ speeches
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Summary of an address by Professor Stanley Fischer, Governor of the Bank of Israel, at a press conference on the occasion of the departure of the Bank of Israel delegation to the annual meeting of the IMF and World Bank in Washington, Bank of Israel, Jerusalem, 18 September 2011.
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Stanley Fischer: Global economic developments – implications for Israel’s economy Summary of an address by Professor Stanley Fischer, Governor of the Bank of Israel, at a press conference on the occasion of the departure of the Bank of Israel delegation to the annual meeting of the IMF and World Bank in Washington, Bank of Israel, Jerusalem, 18 September 2011. * * * This meeting is being held on the occasion of the departure of the Bank of Israel delegation to the annual meeting of the IMF and the World Bank, which will discuss global economic developments. I will therefore start with a description of the situation in that area. The global economy is experiencing a slowdown, which was a surprise mainly in the US, for which the forecasts of growth have been reduced by more than 1.5 percentage points since March. The data for the first quarter were revised downwards, so that in total the US economy grew by less than one percent in the first half of the year. The President presented a program, amounting to some 3 percent of GDP, to support economic growth, but despite that program growth is still expected to be low. The Fed may announce a program of quantitative easing, this time based on especially long-term bonds. Such a program is expected to be controversial, but the Fed does not currently have at its disposal the standard tools for coping with the slowdown. Europe is facing a serious problem of government debts, and insurance against the default of various countries has become significantly more costly – while Israel’s CDS (credit default swap) spread is 188 basis points (b.p.) (1.88 percent), Greece’s has risen above 5,000 b.p. (50 percent), and Spain’s is about 400 b.p. The slowdown in Europe so far has been relatively moderate, but the problems are expected to affect growth mainly in 2012, when growth in the eurozone is expected to be only 1 percent. Initial estimates suggest a slowdown also in world trade, with trade in goods at a standstill since March. This standstill leads to a slowdown also in Israel’s exports, which constitute one of the most important engines of growth for the economy. The above developments are taking place against the background of a very interesting process in which the center of gravity of the global economy is moving towards Asia. The scenario we are currently witnessing – with the Europeans speaking with the Chinese and with other BRIC (Brazil, Russia, India, China) countries about the support those countries will make available to help stabilize the markets in Europe – was unimaginable a mere 15 years ago. The global slowdown has implications for Israel’s economy. Interest rates in the major economies are expected to remain low for several years, and this will affect Israel’s monetary policy. The slowdown has a direct impact on the demand for Israel’s exports. The situation in Europe is likely to have a negative effect on financial stability there, and hence on global financial stability too. This concern has already been reflected in the price of bank shares in Israel. Nevertheless, Israel’s economy has reached this situation in a good condition: GDP has grown at good rates in the last several quarters, and unemployment is at its lowest level in about 30 years. The exchange rate of the shekel against the dollar has weakened in the last few months, and is expected to help exports. The trends in the current account are changing: after growing accustomed to a surplus in the last few years, we now expect the current account to be more or less balanced next year. Israel’s economy can certainly exist in the environment of a balanced current account, but it is a new situation with which we must familiarize ourselves. The interest rate in Israel is higher than those in the large advanced economies, and there is space for an interest rate cut should the need arise. BIS central bankers’ speeches Israel’s economy received a well deserved recognition for its successful achievements in the last eight years, expressed by the recent improved credit rating. In the statement accompanying the revised rating, the rating agency stressed Israel’s robust budget policy and wise monetary policy, as well as the determined supervision of the banking system. Nonetheless, the statement also emphasized the threats on the horizon, and we must continue to adhere to the correct policies that will justify the higher rating we have been afforded, and persist in supporting the economy’s strength in the future. The issues that led to the outbreak of the recent demonstrations and to the formation of the Trajtenberg Committee are serious ones, and reflect serious problems in Israel’s economy. Many of the issues relate to the high cost of living. Professor Manuel Trajtenberg is an excellent economist, and he is experienced in formulating policy recommendations. His appointment as head of the Committee was an excellent decision, as was his choice of the other members of the Committee to work with him, including, of course, the Deputy Governor of the Bank of Israel, Dr. Karnit Flug. It is premature at this stage to refer to the Committee’ recommendations, as it is due to meet several times more before it formulates its proposals and publicizes them. We do know, however, that the recommendations are expected to remain within the budget framework, and not deviate from it. In this context we must point out that for two years we have been stating in the Bank of Israel Annual Report that from 2013 the various fiscal rules are inconsistent with each other, as the planned tax reductions are not consistent with the planned path of an increase in expenditure and reduction in the deficit – growth of close to 5 percent will be needed to avoid exceeding the target deficit. The Committee for Examining and Encouraging Competition is also currently active and is expected to publish its recommendations shortly. This too is a serious and professional committee, and Karnit Flug represents the Bank of Israel on it, together with the Supervisor of Banks, David Zaken. I expect that this committee will provide a good, although not simple, solution to the problem of concentration in the economy, and will demand a lot of work from policy makers in the implementation of its recommendations. The geopolitical situation is definitely worrying, and the negative scenarios, should they occur, are liable to have negative consequences for Israel’s economy. These scenarios do not depend on the Bank of Israel’s policies, but yet we have to be prepared for the possible impact on the economy, and we hope that in the end, the negative scenarios will not unfold. What should we do, then, in the future? We must maintain the fiscal framework. It is possible that there will be an increase in the deficit as a result of the automatic stabilizers in the case of a sharp drop in GDP growth, but it would not be correct to take the initiative to increase the deficit beyond the possible activity of automatic stabilizers. Monetary policy will have to take into account developments in inflation, growth, interest rates abroad, the exchange rate, and balance of payments. Next week we will have to make an interest rate decision against the background of all these factors, and it will not be an easy decision. Likewise, we must continue our determined policy of supervision of the banking system, through cooperation with the banks. In connection with this, concerns are growing about the credit repayment ability of several companies in the economy, and we must be aware of that. Many are now asking if the current situation is worse than what happened in 2008. In some respects, there is a similarity-now, like the eve of the crisis of 2008, we are seeing negative scenarios in the global economy, but we don’t know if they will develop to the same level of severity as in 2008. In any case, we are refreshing the policy tools and the scenarios which we faced in 2008, but we must take into account that the next crisis, if it happens, will not be identical to the previous one, and we will need to adjust the policy response where necessary. I would like to raise two points in conclusion: The first point relates to the discussions regarding concentration. A lot is said about the people described as “tycoons”. It should be remembered that the “tycoons” are acting within the existing legal framework, and they have done nothing criminal. Referring to them as BIS central bankers’ speeches people who have committed a crime is populistic – a populism which is easy in the short term, but dangerous in the long term. The second point is that the economic reality in the near future will not be simple. With that, the Israeli economy is in a strong position, and we have the ability to deal with the reality which we face. It is important that we continue to take responsible policy steps as we prepare for this encounter. A happy and sweet new year! BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Interview with Professor Stanley Fischer, Governor of the Bank of Israel, and Mr Richard Quest, at the Globes Israel Business Conference, Tel Aviv, 10 December 2012.
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Stanley Fischer: Recent developments in the Israeli economy – interview with Richard Quest Interview with Professor Stanley Fischer, Governor of the Bank of Israel, and Mr Richard Quest, at the Globes Israel Business Conference, Tel Aviv, 10 December 2012. * * * Q: On the Israeli economy – we know there is a slowdown, we know it won’t necessarily be as bad as some people have forecast. But you are optimistic. A: The economy is doing well in most respects, and we’re predicting growth for next year of about 3 percent, which until the European economies started declining we thought we might do better than that, we’re not sure about that now. The things that are going well, the inflation rate is in the middle of the target range, the exchange rate is at a reasonable level, the balance of payments is in pretty good shape. Q: What’s not going well? A: Well, the next government is going to have a very large budgetary problem. The Treasury announced last week that the deficit this year will be 4.2 percent of GDP. We’re at full employment now, and that’s a large deficit to have in this situation. And it’s known that they have to cut about NIS 15 billion out of planned expenditure, and they possibly will also have to raise taxes a bit more than they have so far…that’s a huge budgetary problem. One of the reasons for the Prime Minister choosing to go to elections was that he couldn’t get a budget through the coalition – well, its going to have to be done with a new coalition. Q: As far as the growth rate of the Israeli economy – growth rate of 3 percent – are you satisfied with that level of growth, bearing in mind that it seems to be non-inflationary and therefore gives you room for further monetary activity? What will you do in the future? A: Well, the markets think that the interest rate is going to decline once more in the next twelve months. Clearly there is room if necessary to cut interest rates, we hope we won’t get there. We keep a watchful eye on the price of homes, whenever that starts showing signs of going up we have to consider what further cuts in the interest rate will do, or find other macroprudential measures. Q: Is the weakness in the Israeli economy that you are seeing primarily because of external reasons, or is there something going on within Israel? A: A large part of the weakness undoubtedly comes from the global economy and from the fact that exports are not growing as rapidly as they have in previous years. Within the economy, investment demand grew very, very rapidly in 2011 and in some part of 2012. That has slowed down significantly – that presumably means that people looking ahead are less impressed by 3 percent growth than by 5 percent growth which is what we had until 2011, for some time. So I think that’s a potential source of difficulty, and for the rest, I think there is a great deal of uncertainty – geopolitical uncertainty, and there is also governmental uncertainty, about what the next government will doQ: Let’s talk about that. What are you most worried about what the next government might or might not do? A: Well, that’s a major worry – its not going to be easy to deal with this budgetary problem, in light of the fact they were not able to pass a budget a few months ago. The major challenge is whether the next government will be able to do what was done in 2003, which was to put BIS central bankers’ speeches the economy on a very successful course of growth, based on the plan which got the budget into shape and which started liberalizing the economy. That seems to be the major challenge. What’s the concern? That instead of that, because of the political situation or whatever, there will be a budget which just scrapes by. That means that next year, in 2014, we’ll find ourselves again scrambling to get close to a budget target that is not as ambitious as it should be. The deficit for this year, which is supposed to be 2 percent, will be around 4.2 percent. One guesses that next year they’ll be aiming at 3 percent; when they said that 3 percent was the target for this year, we were arguing for something a little bit less. It’s difficult to be ambitious at the beginning; it’s much more difficult to be ambitious later, down the road, when you’ve already not done it once or twice. So that’s really a major concern. The second issue is one which is much more difficult to deal with, which is the issue of the business climate, as seen both from outside and from within. The World Bank issues a report each year called “Doing Business” which ranks countries in terms of how easy it is, or how difficult it is, to do business. In the last two years, we declined from being number 32 on that list, which is not great, to being 38 on the list, which is much less great. That reflects a general feeling that the business climate has deteriorated. It relates to bureaucracy, it relates to places where we stand out as having problems, in the construction process, in a variety of other bureaucratic processes, of registering property, in all of those things we are not doing well. We went far behind on paying taxes…these are things we have to deal with, if we want to get the economy growing again. Q: You are basically saying, the budget is not in great shape and could get worse, the economic situation is slowing down and could get worse, and the business climate which is the engine of growth is not performing as it should and could get worse. Is that what you’re saying? A: Well, it’s always good to have someone translate what I’m saying into English and I greatly appreciate that. But I can say all those things, but I can also say we’re growing at 3 percent, we don’t have a balance of payments problem, we don’t have an inflation problem, and we’re growing faster than almost any economy in the West. Q: If the next government misses its budgetary forecast, and the deficit continues to be above target, that means you, or your successor, will have to take action to rebalance, to maintain the equilibrium. A: Well it depends on the reasons for missing the budgetary targets. If the reason for missing the budgetary target is that the economy has slowed down, and tax revenues have gone down, and the government has stood by its expenditure plans, it’s not obvious that they should try to reduce the deficit at that point. If the deficit has risen because spending has gone up, or something like that, then you’re looking at a different situation. So we have to wait and see. One of the many things that the governments of Israel have fought in the last 6–7 years is to have moved from having one of the highest debt ratios in the Western world to having one of the lowest. Now we moved from 100 percent to 75 percent debt to GDP ratio. The others moved from below 75 to 100. So we have more room to run an expansionary fiscal policy if we absolutely have to do it, in a situation of unemployment and low growth. We don’t need to do that now. Q: Where do you stand in terms of tax rising or spending cuts to help balance the budget – or does it not make much difference to you and the central bank? A: Most research shows that changing expenditures – cutting spending – is more effective than raising taxes as a way of dealing with the budget deficit. But we’ve cut taxes a lot in the BIS central bankers’ speeches past years, and the Bank of Israel has argued that the cuts were a little too fast, and they have in fact been rescinded to some extent. You can’t do these things independent of asking what you are spending on. If we have to increase our defense budget, if we have to increase our education budget, then we’ll have to finance these things. Q: Do you believe there should be an increase on social spending, on education? A: Increasing the efficiency of spending in these areas would be very useful. We have a very big educational problem in this economy, and at some point we are going to have to deal with it. We have been dealing with it, we probably need to do more. Q: Whichever government takes office, there won’t be much time and there won’t be much wiggle room to get this right…If you don’t get a budget deficit under control, it can get out of control very fast. A: If you don’t get it under control in the first year, that is 2013, which will be about half a year, or a little over half a year, it will be much harder to do in the future. Putting off these problems very rarely works. Q: When you go to those meetings, at the IMF and other international forums, and you meet your European colleagues, you’re enormously respected, you’re very well known, your views count – do you ever not want to just say to the European ministers, get your act together – you’re causing mayhem and mischief? A:What are the Europeans trying to do? They’re trying to build a federation at a time of enormous difficulty – enormous economic difficulties and political difficulties. So they’re taking more than a year or two to do it. That’s very frustrating. On the other hand, if they get it done, they will have created a different Europe for the long term, and that’s what we need them to do. Q: You know as well as I do that they built that house badly to start with, and they knew they were building it badlyA: Richard, I must say that I don’t put a lot of weight on what people tell me they knew, when something happened some time ago and they forgot to mention it to me – everyone now knows that they had to get to fiscal union right away. Well, I didn’t hear that in 1994, I didn’t hear it in 1997. I think that we’re all much wiser after the fact. So I’m a little less tough on these guys who didn’t see things. Just as when an economic crisis shows up there are always at least 5 people who saw it coming, and then you say, why didn’t I pay attention to them; and there are another 50 who saw something else coming and you way thank goodness I didn’t pay attention to them. So I have to blame myself. I didn’t see it – I don’t think many people saw it. Q: What do you tell those people in the US who say – lets go over the “fiscal cliff”, because it is the only way that long term structural change will take place – when we see the pain? A: The short term argument is that all the tax reductions of the past decade, and those of this crisis, will expire on December 31 of this year. That means tax rates will have gone up, and then Obama will be in a position, when he wants to cut tax rates, and Republicans want to cut tax rates, and its argued that he will then be in a better position to reach an agreement…I don’t have a lot of faith in this “we’ll cause a lot of pain to the politicians so they’ll do the right thing”. We’ve heard that story all the time, I haven’t seen anything happen yet. I think we better rely on them trying to reach a deal right now. BIS central bankers’ speeches Q: Central bankers are often in the headlines these days. Has there been a time during recent crises when you – the major central bankers in the world – met and said, we’re doing this, we just don’t know if this is going to work? A: First, “we” does not include “me” – we are not yet members of the G7, the G10, or of the G20…there were meetings where we said something like, “this is what we have to do, we are not certain how it will work out, but this is the very best thing we can do”. Q: What happens to politicians when they get their hands on a budget? A: There’s a natural tendency to want to spend more money, because everybody asks you to spend more money, and the pressure is always people coming along and wanting money for this and for that. That’s why in some countries you need to have a very powerful Treasury, as we have in Israel. There is this spending tendency, governments prefer to run deficits. It’s very interesting that in two cases that culture changed dramatically – Canada in the 1990s and Australia in the 1980s – were chronic-deficit countries In Australia now it’s bad for the government to run a deficit, and in Canada they worry about the deficits much more. Why? Because they cut the deficits and they grew much faster in both cases, they saw the results of running a decent economic policy. Can you rely on that? Not really, it depends on each country. Q: What do you see as your responsibility when house prices, or property prices, get out of kilter? A: We have to do what we can to prevent that happening. The main problem for a central bank is that it operates on the financing side, which is to say on the demand side of the housing market. We can raise the interest rate, impose regulations on the banks, which we’ve done, that will moderate the impact of low interest rates on demand for housing. But…reducing the price of housing on the demand side does not cause more houses to be built, it causes less houses to be built. The real place that you can get action that will solve the housing problem is on the supply side…if you increase the supply of land in this country more rapidly, you will be able to get housing prices down. If you can speed up the pace at which it’s possible to get planning permission, which is the place we’re worst in the Doing Business study – If we can deal with those prices, we’ll get the supply of houses to go up, which will increase production and reduce prices. We have to do what we can because we operate on the demand side, but we don’t have the control over supply that would enable Israel to solve its housing problems. One of the reasons we’ve been growing reasonably is that housing activity has been very strong. Q: You are term-limited to 2015. If I could sign a law giving you a third term – would you want it? Would you take it? A: I believe very strongly in term limits. I have hardly seen anybody get better after ten years on a job. I believe very strongly in this ten year term limit for governors. I thought that I should stop teaching when I stopped being sick to my stomach when I went in and lectured. I lost my fear of the students, I really don’t want to lose my fear of these people and the journalists among them, by being on the job too long. It is still extremely challenging, and it’s a great privilege to have that job. Q: Will you stay in Israel after your term is up? A: I very much want to stay strongly connected with Israel, we have family in the States and we’ll have to decide what we do. But I’m not going to disappear from the local scene, that’s for sure. BIS central bankers’ speeches Q: I’m choosing my words carefully here…Do you have a desire to play a public role in Israel after you have been Governor of the Bank of Israel? A: There are a few jobs that I would prefer over this one and I don’t think any of them are available, or likely to be available. Q: What brought you to Israel? A: My wife and I, and my family, have been involved with Israel since we were young. We visited pretty regularly…spent Sabbaticals here, we knew Israel reasonably well. In 1983–85 I had the privilege of working with George Shultz when the United States and the Israeli government cooperated to stabilize the Israeli economy We’d always been close to Israel, somebody gave me the opportunity to try to contribute something to Israel, and I said well, I’d always wanted to do that, and I’ll never get another opportunity like this The current Prime Minister was very influential and persuasive, he was the finance minister at the time. We are extremely happy we did it; it’s been a wonderful experience. Q: Is it fair to say that after 2015 we will not have heard the last from you? A: I hope my voice will still be heard. 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Summary of remarks by Professor Stanley Fischer, Governor of the Bank of Israel, at the Bank of Israel Research Department's annual seminar, Jerusalem, 27 December 2012.
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Stanley Fischer: Issues of fiscal policy Summary of remarks by Professor Stanley Fischer, Governor of the Bank of Israel, at the Bank of Israel Research Department’s annual seminar, Jerusalem, 27 December 2012. * * * The area of taxation in particular, and the fiscal area in general, are in my view among the most interesting areas, and among the areas where theory can contribute the most to delineating policy. My lecture will deal more with macroeconomics, where theory is perhaps less deep but still very important. So what is the starting point for the economy heading into the upcoming period? From the standpoint of growth, we are in a relatively good position. The average growth rate over the past few years has been about 3.7 percent. Currently we are growing at a rate lower than that, if we don’t take into account the expected effect that the start of natural gas production will have on growth. The Israeli economy grew at an impressive rate in the years prior to the crisis, and the recession during the global crisis was relatively moderate. The unemployment rate is relatively low, even though we are still having difficulties interpreting the new Labour Force Survey data. Long-term interest rates are low, and the yields on ten-year government bonds are under 4 percent, and are continuing to decline despite the problems the economy is facing. In the fiscal area, there has been a continued decline in government expenditure as a percentage of GDP since the start of the program led by Prime Minister Sharon and Finance Minister Netanyahu that began in 2003. The rule that determined that expenditures shall not grow by more than 1 percent in real terms is to a large extent responsible for this trend. Another factor is the defense budget, which reached 35 percent of GDP after the Yom Kippur War, was 20 percent of GDP prior to the stabilization plan, and has been in constant decline since then, other than during the Second Intifada. We currently have a defense burden of about 6.5 percent of GDP, lower than the ratio that existed, for instance, in the United States during the Korean War. Government revenues also declined in relation to GDP in recent years, reaching 38 percent of GDP in 2011. This is mainly the result of the reduction in direct statutory tax rates, which has led to a change in the tax mix. In 2003, the deficit was slightly greater than 6 percent of GDP, but the cyclically adjusted deficit was about 3.5 percent. However, today, the deficit itself is lower than it was in 2003, although the cyclically adjusted deficit is close to 4 percent – higher than it was in 2003. Since 2007, when the actual deficit was almost zero, the deficit has grown during the crisis, declined somewhat in 2010, and since then has not declined. The result is that we have a deficit of about 4 percent in a situation of almost full employment. I feel very uneasy with this kind of deficit in the current situation, since if the economy enters a recession – a scenario which we must take into account – the deficit will grow, and it will be harder to deal with it. The debt-to-GDP ratio declined from a level of almost 300 percent of GDP prior to the stabilization plan, climbed slightly to a level of about 100 percent during the recession at the beginning of the 2000s, and continued to decline since then to a level of 74 percent today. Compared to other countries, we have greatly improved in this parameter due to an increase in the debt levels of many countries as a result of the crisis, but it is very important for the State of Israel that the debt to GDP ratio be low. We are exposed much more than other countries to geopolitical risks, and if God forbid we find ourselves one day in a conflict with our neighbors, near or far, it is important that we not come into it with this kind of debt ratio. It is very important, therefore, to continue reducing the debt to GDP ratio. In 2012, the Government adjusted the deficit path such that the deficit targets would be reduced more slowly than planned beforehand. In practice, if we grow at an average rate of BIS central bankers’ speeches 3.75 percent per year, the deficit will decline even more slowly than the path decided upon by the Government, based on the existing tax rates in the existing legislation – that is, even taking into account the increase in the VAT and direct tax rates recently enacted. According to this estimation by the Bank of Israel, the deficit in the coming year will apparently be 3.5 percent, and will reach a level of 2 percent only in the year 2020. According to this projection, debt will also decline more slowly than the Government estimated when setting the legislation. The fiscal rule which guides our actions is the result of a joint effort by the Ministry of Finance, the Prime Minister’s Office, and the Bank of Israel. It is a relatively simple rule that can be easily explained to the public. We know that the expenses planned for the coming years, according to Government decisions that have already been approved, exceed the expenses permitted as per the fiscal rule by NIS 12 billion in 2013, NIS 22 billion in 2014, and NIS 25 billion in 2015. We must remember that this is the situation after the government took the very rare step of raising VAT and direct taxes a short time before elections, and this is a very responsible step from the standpoint of the government. At the beginning of 2013, the Government will operate based on the 1/12 rule due to the fact that the budget has not yet been approved. However, the law also takes into account expenditure on debt repayments, which were very high in 2012 and are expected to be lower in 2013. Therefore, we do not expect marked restraint as a result of the 1/12 rule. Revenues are projected to be below the expenses limitation. Therefore, the Government will need to close a gap of more than NIS 12 billion in 2013. So what will the Government do? The limitation on the budget is a law, which can be changed. I hope that the Government does not change this law, since we are coming close to an expenditure level of 43.5 percent of GDP this year, and we must maintain a safety margin in case of a security crisis. The Government will therefore need to reduce the level of planned expenditure, and we obviously must remember that there will still be an increase of about 5 percent in expenses in 2013 over 2012, due to inflation adjustments. But the planned expenses are supposed to increase by 10 percent, and this is even before accounting for the ramifications of Operation “Pillar of Defense” with the Ministry of Defense. I would not want to trade places with the person who will need to explain to some of the public that “we promised, but we didn’t promise to carry it out”. But that is the work of the politicians. The Government will need to decide what to do, and it will be very difficult. If I had to choose, I would prefer that the Government meet the deficit target as well as the expenditure rule. However, if it is necessary to change the expenditure rule and to increase it, which is not desirable, I prefer that this be done through an increase in taxes and a significant reduction in the deficit, preferably even to slightly below 3 percent. It is not recommended to delay these decisions. The tensions within the Government will only increase as we move farther away from the elections, and it is preferable to make these decisions right at the beginning of the Government’s term. We must remember that there may also be security challenges, and it is the supreme responsibility of the Government to protect its citizens. BIS central bankers’ speeches
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Summary of remarks by Professor Stanley Fischer, Governor of the Bank of Israel, at Ono Academic College, Kiryat Ono, 27 February 2013.
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Stanley Fischer: Recent developments in the Israeli economy Summary of remarks by Professor Stanley Fischer, Governor of the Bank of Israel, at Ono Academic College, Kiryat Ono, 27 February 2013. * * * The Israeli economy is a very small and very open economy. It is therefore largely affected by events in the global economy. We export about 40 percent of GDP, so we are dependant on demand from global economies. Additionally, in determining monetary policy, the interest rate that we set is affected by interest rates set abroad. If we raise the interest rate in Israel sharply above global interest rates, we will be flooded by capital inflow from abroad, which will affect the appreciation of the exchange rate. As such, everything that is important in the Israeli economy is affected by what happens abroad. Therefore, any lecture that deals with the Israeli economy must begin with a description of the global economic situation. The global economy grew by 3.2 percent in 2012 – very close to the 3 percent rate that is considered the baseline of a global recession. The International Monetary Fund’s expectations are for 3.5 percent growth in 2013, and it is possible that the results of the elections in Italy will reduce these expectations to 2012 levels. In the United States, growth this year is expected to be 2 percent. In Europe, expectations are for the recession to continue, with a slow recovery in 2014. Developing and emerging markets had more rapid growth. Growth in global trade is the most important variable from the standpoint of Israeli exports. Before the global crisis, such trade grew by about 7 percent per year on average, while in 2012 it grew by less than 3 percent, which explains the difficult year experienced by Israeli exporters. The background conditions in which the Israeli economy operates, therefore, are not optimal. Between 2003 and mid-2011, the Israeli economy enjoyed average growth of 5 percent per year, despite the global recession. This is a very good growth rate for a rich and developed economy, which is what Israel is when compared internationally, even if we don’t always want to admit it. In 2012, growth was slower. I was not satisfied by the 3.2 percent growth rate in 2012, but each time I spoke with colleagues abroad, they said that they would have been thrilled if their economies had grown at such a rate. This year, the Bank of Israel expects growth of 3.8 percent, with a significant part of that – about 1 percent – expected as a result of natural gas starting to flow from the Tamar field. Unemployment in Israel has been in a continuing decline for a considerable number of years. The Central Bureau of Statistics changed its measuring framework in 2012, which makes it difficult for us to compare this year’s data to previous years. Therefore, we look at the data for the 25–64 age group, which is less affected by the change in methodology. In this group, we can see a continued decline. Unemployment in Israel is lower than in many other countries, including those that are very advanced. Toward the end of this lecture, I will enumerate a number of challenges and problems that require handling in the long term, but the macroeconomic situation in Israel is, in the final analysis, very good other than one aspect: the government budget. Beginning in 2003 there was a decline in the government deficit until 2007, when the budget was balanced and the deficit was close to zero. This was the result of the courageous and steadfast program formulated by the finance minister at the time, Binyamin Netanyahu, with the support of the prime minister. In 2008, the global growth rate began to decline, and in 2009 we returned to a budget deficit similar to what we had in 2003. This was an expected result in light of the decline in economic growth. Once the recovery began, it was expected that we would be able to restore the path that began in 2003, a path of decline in the deficit. There was a good beginning, but in 2011, it became more difficult, and in 2012 the deficit, which was planned to be 2 percent of GDP, reached 4.2 percent. BIS central bankers’ speeches Many people ask who is responsible for the deficit in 2012? The answer is that the responsibility lies mainly with growth, which was lower than expected. At the beginning of 2011, the Finance Ministry had a projection for tax receipts which, in retrospect, was too optimistic. At the Bank of Israel, we did not think that their projection was too optimistic at the beginning of 2011. We only understood this in retrospect. Following the decline in the growth rate in 2012, the government spent more than what it had planned to spend, which was another factor in increasing the deficit. Unemployment data show that the economy is very close to full employment. In this situation, tax receipts are relatively high. If the economy enters a recession, the deficit will begin at the 2012 level and will grow from there. The recession at the beginning of the last decade significantly increased the deficit, and the government was forced to ask for help from the US government through guarantees for raising debt. When we looked at the government’s commitments for 2013, we found that commitments are expected to lead to a real increase of 10 percent in government expenditure over 2012. This is a very large increase, particularly for an economy that is growing at a rate of three percent. A few years ago, the government made decisions limiting the rate of year-over-year growth in expenditure, and the limitation for 2013 according to this law is growth of about 5 percent in expenditure. It will therefore be necessary to reduce planned expenses by 5 percent. We must remember that even if the government does this, there will still be a significant increase in government expenditure for 2013. In addition, in order to meet the deficit target, we believe that it will be necessary to increase receipts by about NIS 6 billion, or about 0.6 percent of GDP. Those who will need to decide where to cut will need to make tough decisions, but in the final analysis, after all of the cuts, this will be an expansionary budget, and I feel sufficiently at ease with such a budget. The Bank of Israel’s monetary policy is successfully keeping inflation within the target range most of the time. Currently, both inflation and inflation expectations are within an easy environment, but we must not become complacent about inflation. A central bank governor who acts that way will find himself forced to deal with inflationary developments later on. We are constantly watching, with a magnifying glass, for any appearance of inflationary signs. We do not see any right now, but we must keep our finger on the pulse. Public discourse constantly deals with the question of whether the Bank of Israel should have raised interest rates in order to deal with the problem of housing prices. We must remember that the interest rate affects a variety of variables in the market: the exchange rate, the level of investment, and more. If we raise the interest rate just to deal with housing prices, it will cause an appreciation in the shekel and a slowdown in economic growth. This is the trade-off we must constantly take into consideration. We need to remember that the main factor in the increase of housing prices is the lack of supply. The increase in prices has led to the expected supply response: an increase in the number of building starts. This rate, which was 30,000 units per year, reached 44,000, which is a significant increase. However, the rate of land marketed by the State then declined, and the rate of building starts fell to 40,000 per year. According to the Israel Lands Administration, the problem is with the authorities approving building plans, without whose approvals they cannot continue marketing land. The way to handle housing prices must come from the supply side. What we cannot do is to use the interest rate, which is a policy tool that affects the entire economy, only to handle housing prices. People tell us that we took too heavy a responsibility on ourselves in terms of housing prices. This reminds me of those who argue that the Chairman of the Federal Reserve, Ben Bernanke, releases the government from its responsibility to stabilize the economy by doing everything he can to spur its growth. We do what we can, and I wouldn’t want to cause damage to the entire population in order to teach politicians how to act better. The problem of poverty in Israel is not easy to solve, since poverty is concentrated mainly in two population groups – the Ultra-Orthodox and the Arabs – although this is not to minimize the problem of poverty among the rest of the general population. However, among the ultra- BIS central bankers’ speeches Orthodox, less than half of men participate in the workforce, and among the Arabs, just 20 percent of women work. Therefore, we cannot deal with poverty by providing grants that will raise all of the poor above the poverty line due to the effect such a policy will have on employment incentives. We will need to find a solution to this complex problem. Observing both historic and expected demographic trends shows continued growth in the Arab and ultra-Orthodox segments of the population. If these labor market trends continue, we will reach a situation where half of the population belongs to sectors where labor force participation is low, while the other half finances it. This won't happen, because we cannot continue to be in such a situation, and the relevant population groups understand this. Other challenges that the economy will need to deal with over the long term include improving achievements in the educational system and reducing bureaucracy, which weights heavily on economic activity, as reflected, for instance, in the World Bank’s “Doing Business” index. All in all, the Israeli economy is a success story. If we think about the history of the economy, the security situation, the challenges that we have met, we have succeeded in building a flourishing economy. As stated, there are problems and challenges, but despite the fact that we can’t solve all of them quickly, I am certain that we will deal with the challenges and succeed in solving the problems. In response to questions from the audience: Apartment buyers who want to take out mortgage loans must take into account that the interest rate today is very low, and that when it rises, their monthly payments will rise as well. The Bank of Israel is limiting the leverage rate because when the time comes when the buyers can’t meet their mortgage payments, that’s when the problems start. These limitations mainly affect investors, and have less of an effect on those purchasing their first apartment. I like to quote the book, This Time is Different: During good time, everyone thinks the situation is good, prices are going up, and we know how to deal with problems. But in recent years, we have seen how this type of thinking led to the most serious economic crisis in many years. We will not let such a thing happen in Israel. I frequently hear the argument that “the Bank of Israel is more interested in the stability of the banks than in the customers”. We maintain bank stability in order to protect the public and the customers. We have a responsibility to the public, and we have a duty to prevent the things that we see happening in other countries. The change made in measuring unemployment data was done in order to bring the method of measurement in line with the manner accepted in the OECD. In terms of the Foreign Minister’s position, I again quote what a professor who taught me for many years told me: “The biggest mistake university graduates like you make is that they accept offers that haven’t been made to them.” BIS central bankers’ speeches
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Highlights of remarks by Professor Stanley Fischer, Governor of the Bank of Israel, at the panel "Major trends in the global economic crisis and its impact on Israel", Herzliya Conference, Herzliya, 14 March 2013.
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Stanley Fischer: Major trends in the global economic crisis and its impact on Israel Highlights of remarks by Professor Stanley Fischer, Governor of the Bank of Israel, at the panel “Major trends in the global economic crisis and its impact on Israel”, Herzliya Conference, Herzliya, 14 March 2013. * * * I have been asked to talk about the relationship between what is happening in the global economy and its impact on Israel. One has to do that, because we are a small economy, with a very small GDP, about 1.5 percent of that of the United States. We are a very open economy, we export about 40 percent of our product, the value added of exports equals about 25 percent of GDP – either way, we are very open to exports and imports, and we are even more open, possibly, to the global gap between our interest rates, which are heavily affected by what happens in the rest of the world. Our interest rates are higher relative to the United States, relative to Europe, and money comes here to take advantage of the high rates, and that created an appreciation of the shekel – that has big effects for us. We cannot allow the interest rate gaps to get too large…So this is the world in which we live. On the real side what is happening in the global economy is that the US economy is emerging from the crisis. One of the key things which differentiates the United States’s economy from the European economies is that the US very rapidly dealt with the financial system. Treasury Secretary Geithner took a big risk by subjecting the American banks to stress tests. But you better know the truth about the state your financial system is in. The US looks better now because the housing sector is recovering, it looks better because unemployment has started coming down in a serious way and it looks better because the banking sector is stronger, the automobile sector is recovering, and there is enormous change in the energy sector which is taking place extremely rapidly. There is a slowdown in East Asia, in growth rates, both in India and in China. In China, let’s say their growth has slowed from 10 percent to 8 percent, but the economy that is growing at 8 percent a year is more than double its size of ten years ago, so the 8 percent growth in today’s Chinese economy adds far more to global demand than the 10 percent growth of the Chinese economy of 10 years ago. It remains true that the center of the global economy is moving eastwards, to where it was 200 years ago, from which it was temporarily displaced by the Industrial Revolution and that’s a factor, one of many factors that we in Israel have to take account of, as we think about how the rest of the world affects us. There was a European theory that you should get 1–2 countries out of the Eurozone, so that the other countries would realize it could happen to them, but they’ve given that up for a very good reason – if you start a process like that it could really get out of hand. But they made that decision that they wanted to save the euro. Mario Draghi made the decision; he said that the European Central Bank would do what it had to do to save the euro. Well what it has to do is clear – provide some way of providing support directly to governments. Find some way of keeping the finances of governments more or less whole. We should understand that Greece in the end defaulted on its debt in a negotiated way. Not every government has to be forgiven its debt, but it has to be guaranteed support in negotiations over its problems. In any case, Europe is in a recession; over the next year we’ll probably see slightly better growth than we were expecting to have in the second half of 2013. On the capital markets side, interest rates have been low for a very long time. That situation will continue until we begin to see signs of growth or signs of inflation. In 1994 the Fed changed its monetary policy from being very expansionary, and it raised rates unexpectedly and caused a temporary slowdown in global growth, because people were simply caught BIS central bankers’ speeches unawares. That should not happen now. The Fed has been telling everybody that it’s got to be ready for a change like this. By the beginning of 2015 interest rates should possibly begin to rise. I won’t go into the argument on currency wars, or if there aren’t currency wars. It is a simple fact, whatever the motivation, that interest rates are zero, it’s a simple fact that it’s harder for us to deal with an environment in which global interest rates, in countries which account for more than half of global GDP, are essentially zero, but that’s not a fact that we’re going to change by complaining. So what do we do in the Israeli economy? At the ceremony when I got this job, in the house of the president, in May 2005, I said that this is a strong economy, they said I didn’t understand it. But this is a strong economy – it has been through more shocks, including military campaigns, the resignation of the person responsible for changing the economic strategy in 2003 – then-Finance Minister Netanyahu, in August 2005, the change of Prime Minister after the stroke of Prime Minister Sharon, Hamas winning the Palestinian elections, in July 2006 the Second Lebanon War – I can continue listing more events – but the Israeli economy faced all of them impressively and growth continued at a rapid pace. It also went through the global crisis very well. Where does all this come from? It comes from good fundamentals. Part of that is the banking system that is strong; it’s a very conservative banking system, and people mostly don’t like that, they wish the banks would take more chances, until something happens, then they wish they hadn’t taken chances. So in 2008 and 2009 our banks were heroes for having been conservative, by 2010 the heroism effect had worn off already, and the public was complaining – which is what the public does about banks around the whole world. But it is important that our banking system continues to lend, but continues to lend taking account of risks. If I can say something I’ve said more than once before, we are accused very frequently of supporting stability of the banks over stability of the consumers. The short answer is, we take care of stability of the banks because we care about consumers. In the United States, and in other countries, we have recently been witness to a banking crisis. We had such things in Israel as well in the 1980s. I am certain Israeli citizens who remember the crisis of the 1980s would not want to find themselves in such a crisis again, and that they are happy about the fact that we have not been forced to deal with such a crisis since then. That should continue to be the situation. The short run situation of the Israeli economy is very good except in one respect. I’ll give you the very good part first. Unemployment is at a 30-year low, the balance of payments essentially is balanced, inflation is a little below 2 percent, which is the center of the target range, banks are still in good shape, poverty is actually declining – though no politician gets credit for that, and increasing participation in the labor force, a larger and larger share of the population has been going out to work, which is not to say there aren’t problems in the Haredi and Arab sectors, just that more are beginning to go out to work. What is not good is the forecast for the budget. If the government sticks to its budget constraints, which are the expenditure rule, the taxes it has in place, and the deficit target of 3 percent of GDP, it will have an expansionary budget, or approximately a neutral budget. Everyone is aware of the “budgetary axe”, but that is relative to what they were promised, it is not relative to what has been passed. The promises add up to an increase of 10 percent. It will be difficult politically to cut them. However, if we don’t get the budget straightened now, it will be very difficult to do so later, and we will find ourselves doing things that are inconvenient and inefficient. It is therefore very important to stick to the budget targets and not to postpone the problem to a later stage. In the long term, we must deal with the problem of poverty and with the problem of labor force participation which is concentrated in the Arab and ultra-Orthodox sectors. We BIS central bankers’ speeches obviously have challenges in the field of education and in dealing with bureaucracy. Obviously, there is the security situation, it is very important that we reach a peace agreement with our neighbors, and I hope that all sides will be prepared for this soon. If you would have said a decade ago that the United States, and even Israel, would become energy exporters, people would have told you it was crazy. If you would have asked in 2003, is the next global crisis going to be a result of a massive financial collapse in the West, I would have said there was no chance. We have to be ready for unexpected events, and it is therefore very important to us to build up ample economic reserves. I am not just talking about foreign exchange reserves. I am also talking, for instance, about budgetary reserves. We need a budget which, if we do need to increase expenditure, does not get into immediate difficulties. We must avoid populism – when difficult decisions are put off to next year, they are generally put off the following year as well. The book “Start-Up Nation” describes, even if a little exaggeratedly, the extraordinary development of Israeli high-tech. The continuation of this development, which should be accompanied by the proper policy steps on the part of the government, will be able to lead to the success of the Israeli economy in the coming years as well. I would like to relate to the parting gift that Aharon Fogel wanted to offer me (to change the Bank of Israel law so that the growth, employment and financial stability targets would have the same level of priority as price stability). I hope that this gift does not come into being. The members of the Monetary Committee take the Law into account, as well as the way it is worded and the order of priorities among the various goals of the Bank of Israel. If we change this rule, we will have more inflationary periods and more recessionary periods. There are enough things that need to be fixed in Israel, but regarding the Bank of Israel Law, I think that the saying “If it isn’t broken, don’t fix it,” is applicable. People who preceded me spoke about the issue of government efficiency. According to international surveys, the Israeli government is not the most effective government when compared internationally. Let us look for instance at the housing market. We all want a situation where prices don’t increase but the supply of housing does. This can only happen on one side – on the supply side. It is through the supply side that it would be possible to increase the quantity while lowering prices. The government has understood this and has tried to cause this to happen. It has presented various plans, but the desired result has not come to pass. We need to think of ways to streamline government ministries. The problem in the civil service is the political incentives. The Ministry of Finance and the Ministry of Defense are apparently efficient ministries, but there are many ministries that are not. Public service workers are high-level workers. We do not have the British tradition of “Yes, Minister”. The turnover among Directors General is frequent because the political system is not stable. The current Minister of Finance has had the longest term of office since that of Pinchas Sapir, and this is the exception. The fiscal rule was formulated in order to reduce the public debt burden. The law states that it is possible to increase the growth rate in government expenditure as long as there is a decrease in the debt-to-GDP ratio. When we reach 60 percent, government expenditure will begin to grow in line with the growth in GDP according to the current formulation of the rule. However, I believe that we must strive for a lower debt than what is set out in the Maastricht rules. We are in the midst of a very complex situation, and like I said before, we must build up reserves in various areas, and among other things, we must make sure that we can raise money in the markets if it becomes necessary. When the global crisis broke out, the Australian government was able to allow itself to spend immense sums because its debt burden before the crisis was very low. If we enter a recession, the debt-to-GDP ratio will jump, and we will find ourselves in a situation where the government cannot finance the deficit at a reasonable rate of interest, like the situation in 2003. We must be in a situation where we can deal with various problems, even if we don’t know whether those problems will actually take place. BIS central bankers’ speeches If we must increase defense expenditures because it is vital to the future of the country, as some people claim, we will need to pay for it, through an increase in taxes. I don’t understand those who say, for instance, that “we have needs in education, so we must increase the deficit.” If we have such needs, then we must finance them, mainly through taxes. I don’t think that the defense budget can continue increasing at the rate it has for the past few years. Which brings me back to what I said about the importance of a peace agreement. When people say that there is no partner for a peace agreement, that is always true: you need two to tango, and it is very important to start this tango. Regarding monetary policy, the interest rate is a tool that affects the entire economy. We cannot use the interest rate in order to solve the housing problem. We must obviously take the problems in housing into account. But if there are problems in a certain area, and the central bank’s tools are not sufficient to handle these problems, someone else has to deal with it. In such a case, we are talking about increasing supply, which is currently in the realm of responsibility of the Israel Lands Administration and planning authorities. We have tried various foreign exchange regimes over the years. My experience shows that, regardless of the exchange rate regime we are in, there will always be times when we will want to have other regimes and systems. However, experience shows that it is always correct to allow the exchange rate to change based on market forces. Everyone is impressed by the success of the Swiss in strengthening the exchange rate and preventing it from falling below 1.2 Swiss francs to the euro. From the day that decision was made, they purchased foreign currency totaling about 50 percent of their GDP. We also purchased a lot of foreign currency, but we aren’t near those levels. The difference between us and them is that their interest rate is 0 percent, so holding foreign currency does not involve any financial cost on their part, as long as they aren’t forced to retreat from the exchange rate they set. Up to this point, they are enjoying a “free lunch” – until the day comes when they will need to pay. I believe that our monetary policy was, at the bottom line, successful. The alternative presented in this conference regarding the deficit, of 3.5 percent of GDP, is ambitious. It will be necessary to raise taxes, and I share the sense that we need to be cautious in this context. The median worker in Israel does not pay taxes. When taxes are raised, they want to raise them only for the rich. But there aren’t as many rich people in Israel as people think. Taxing those around the median will lead to the collection of a lot of tax since there are many people around the median. From a political standpoint, it is easier to increase taxes on the rich than on the middle and lower levels. BIS central bankers’ speeches
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Remarks by Professor Stanley Fischer, Governor of the Bank of Israel, upon taking leave of the Knesset Finance Committee, Jerusalem, 4 June 2013.
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Stanley Fischer: Challenges facing the Israeli economy Remarks by Professor Stanley Fischer, Governor of the Bank of Israel, upon taking leave of the Knesset Finance Committee, Jerusalem, 4 June 2013. * * * I would like to thank the members of the Committee for their wishes. It was an honor for me to serve as Governor of the Bank of Israel. It was not readily apparent that they would offer the position to someone who was not a citizen of Israel. But in the end, that is what happened, and my wife and I are very happy for the extraordinary opportunity that we had. Many people on the professional team at the Bank of Israel helped me during this period, contributing much to the work at the Bank during my term of office. We must not forget that I arrived in 2005, when the economy was in the midst of a period of impressive growth, and one of the reasons for the fact that we made it through the global crisis was that the economy entered the crisis in good condition: the government budget was balanced in 2007, the current account was in surplus, the banks were strong—everything required for a country to successfully get through the crisis was in place in Israel before the crisis. I would also like to thank the former Chairman of the Finance Committee, MK Rabbi Moshe Gafni, who contributed much to the system’s stability, and to the legislation of the new Bank of Israel Law, which was also helped along by former Knesset Speaker MK Reuven Rivlin. I recognize the fact that you cannot work alone—it is necessary for there to be people who agree to work with you, and in this context, I also note the Opposition Leader who is here, who was then in the coalition and who assisted with the passage of the law. If I compare the situation of the economy today to what it was in 2005, the debt-to-GDP ratio is much lower, although the government deficit is higher. We moved to a situation where the current account is balanced compared to the surplus we were in before the crisis. The unemployment rate today is very low in an historic perspective, and the employment rate is higher. The incidence of poverty remains more or less at the same level as it was. The exchange rate is more appreciated today, which to a large extent is a result of the strength of the economy—people want to live in a strong economy with a weak exchange rate, but this is a situation that generally does not happen. The foreign exchange reserves are obviously much higher than what they were when I took the position, as a result of foreign currency purchases that we have been making since 2008. The average growth rate between 2005 and 2012 was 4.3 percent, and average per capita growth during those years was 2.5 percent. The average inflation rate then as today is within the target range, such that we can say that we did not, and do not today, have an inflation problem. The last decade started with a deep recession and negative growth, and in the middle of the decade, we moved to rapid growth of 6 percent for a number of years, an exceptionally high rate for countries at the level of development of Israel. Following the financial crisis, we continued to grow at a higher rate than other developed countries, and if we continue maintaining responsible policy, we can, I hope, continue this way. The unemployment rate is very low compared internationally, since while unemployment in Israel is in decline, it has risen in many countries. Long –term inflation expectations are close to the midpoint of the target range. This means that the public believes that the economy can continue growing without inflationary outbursts, and it can plan its economic life without concern of spikes in prices. This is a very important achievement—thirty years ago, we never would have believed we would attain it. The government deficit grew in 2012 by 4.2 percent, and in order to reinstate control over the budget, the government recently decided on important measures to reduce the deficit in the coming years. These measures are also very important due to the fact that the interest burden that the government is paying is very high in international comparison, as a result of the risk premium that the financial markets include for the Israeli economy. A diplomatic BIS central bankers’ speeches process, if the markets attribute any importance to it, would reduce these costs in the final analysis, although it would take time, since the interest paid today is on debt that was issued in the past, and a reduction in the interest rate would affect new debt. There are many challenges facing the Israeli economy. The first challenge to which will relate is handling the problem of poverty. The data unsurprisingly show that the incidence of poverty is higher among large families, and lower as the percentage of wage earners increases. Furthermore, the incidence of poverty among Arabs and ultra-Orthodox Jews is very high. In this context, it is important to implement a policy that will increase the labor force participation rate of these two sectors, and we are witness to important initiatives in the area of academic education, mainly among the ultraOrthodox sector. The Israeli education system’s achievements in the international PISA tests are below average. We have recently had better achievements in TIMS tests, and I hope that they will also be reflected in the other tests. We must improve the achievements of the education system in order to achieve higher economic success. The World Bank conducts a survey of the ease of doing business in all countries each year. In 2013, we were in 38th place, a very unsatisfactory placing. We have fallen significantly in this ranking during the past decade, not because our situation has deteriorated, but because the bureaucratic burden in other countries has lessened. The bureaucracy affects not only the ease of doing business, but also the cost of living. For instance, we see its effect on the ability to adjust the supply of housing and on housing prices. The Concentration Committee made two important recommendations on the matter of breaking apart pyramids and separating financial and real holdings. In this context, I note that if we require the immediate complete separation of financial and real holdings, there would be no people who would be able to be controlling owners of banks, since they would not be able to obtain the required capital through their activities in the real industries. It is possible that in another few decades, we will reach the conclusion that controlling owners are not necessary for banks. But in the meantime, I suggest not to conduct such large experiments on the financial system. I usually don’t make comparisons to Greece, but this time I will do so: For hundreds of years, we have seen the ramifications that an unstable financial system has on the market. We have a strong banking system, which was of tremendous assistance in our ability to withstand the crisis. We must not endanger its stability, so I suggest not to limit cross-holdings of financial and real entities for now beyond what the Concentration Committee recommended when it set a benchmark of NIS 6 billion for holdings of a real company by someone who holds controlling interest in a financial entity. I understand the logic behind the other suggestions, but I think that we must first of all examine the ramifications of lowering the number of entities that can hold controlling interest before we continue advancing in this field. Labor productivity in the Israeli economy is 20 percent lower than the OECD average. While we are a wealthy economy, it is a mistake to compare ourselves to the US and Scandinavia all the time, where labor productivity is very high. It is important that we deal with all the challenges in education, the bureaucracy, infrastructure and more, in order to deal with the problem of low productivity. The Supervisor of Banks headed a team that presented important conclusions regarding reinforcing banking competitiveness. Each time I would meet a senior banker from abroad, I would try to convince him to start banking operations in Israel. I didn’t succeed, and since 2008, I have stopped trying since the crisis led banks to stop expanding their operations overseas. However, at the team’s recommendation, there are many steps whose implementation can help reinforce competitiveness in the banking system. BIS central bankers’ speeches Defense expenditures increase from year to year, although their share of GDP continues to decline and has now reached its level from the beginning of the 1960s. Still, defense expenditures are the largest component in the state budget. It is clear to all of us that we live in unsafe and uncertain surroundings. It is the government’s duty to protect its citizens, and there is therefore no alternative to large budgets for the defense establishment. This also has positive ramifications, such as the defense establishment’s contribution to the development of the high-tech industry. We do not have the luxury to think that we are Sweden and to plan our expenses without needing to allocate about 5 percent of GDP to defense. We must continue to provide ourselves with defense, but the allocation of more money to defense is not the only solution. We must also try to find other solutions, and try to achieve a peace agreement with our neighbors, including with the Palestinians. The phrase, “there is no partner for peace” is a self-fulfilling phrase. You need two for an agreement, and if we don’t want to look for a partner, we will remain in the current situation. We must look for the partners for peace. Until we reach agreements, it will cost us more since we will need to reinforce our readiness. However, in the long term, we will benefit from it, and it will have positive ramifications in various areas. We must, therefore, find a way to act more proactively in order to stop the conflict that has continued here for far too long. BIS central bankers’ speeches
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Main points of remarks by Dr Karnit Flug, Incoming Governor of the Bank of Israel, at The Prime Minister's Conference "Partnership and growth", Tel Aviv, 29 October 2013.
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Karnit Flug: Israel’s challenge to fulfil its economic growth potential Main points of remarks by Dr Karnit Flug, Incoming Governor of the Bank of Israel, at The Prime Minister’s Conference “Partnership and growth”, Tel Aviv, 29 October 2013. * * * When I decided, several weeks ago, to accept the invitation to participate in this Conference, I did not know that it would be my first lecture following my appointment as Governor of the Bank of Israel. Nonetheless, I am very happy that the hand of fate has led to my speaking here today, two days after the government’s decision to appoint me as Governor, and economic advisor to the government, because I believe that this Conference deals with one of the most important issues on the socioeconomic agenda in the State of Israel. The topic of the Conference – the Arab sector’s partnership in the economy and in growth – is a major issue in terms of the Israeli economy’s ability to fulfill its growth potential in the next few years and to reduce the scope of poverty and the gaps in Israeli society, which are among the highest in the OECD, and about which much has already been written and said. The successful integration of the Arab public into the labor market in particular, and into the economy in general, is a very important, even essential, component of the Israeli economy’s ability to continue to grow, and to support a higher standard of living for all Israelis. This Conference, which deals with various aspects of the impediments to the successful integration of the Arab population in the labor market, is therefore particularly important. I will begin with a few words about the recent state of the economy: from the macroeconomic standpoint of growth rates, the economy is in good shape, particularly compared to other developed countries. In the past decade, the economy has enjoyed significantly higher growth rates than most other advanced economies, and the global financial crisis, which was reflected in a deep and sometimes prolonged recession in many economies, was weathered by the Israeli economy with relatively minor damage. Unemployment, which jumped in many economies during the crisis and remains very high in most of them, increased relatively moderately in Israel, and resumed its decline immediately following the crisis, so that we are currently at historically low unemployment levels. The labor force participation rate, and in turn the employment rate, are increasing on a consistent basis, among other things as a result of the continuing entry to the labor market of Arabs, ultra-Orthodox Jews and women. Inflation – the main policy variable with which the Bank of Israel is entrusted – has been within the target range for a long time, which provides monetary policy the required degrees of freedom to support growth and employment in the short term, thus moderating the effects of the global slowdown which is still a restraining force on activity here as well. From a long-term view, the Israeli economy suffers from a low rate of increase in productivity (product per hour of work). The average Israeli worker produces lower output per given work hour than his peers in most OECD countries. Not only is the increase in productivity not closing the gap with the other developed countries, the gap is growing. For instance, the ratio between product per work hour in Israel and that in the US has been declining over the years. In the Bank of Israel Annual Report for 2012, the Research Department analyzed the phenomenon and noted a number of reasons for the low productivity. One major reason is a low rate of investment, which leads to lower stock of capital for production available to the Israeli worker than what is available to a worker in other OECD countries. A further issue is bureaucratic impediments, or in broader terms, the business environment, which impede accelerated development of the business sector. Returning to employment: Despite the significant improvement that has taken place in recent years, and which has led to the fact that our employment rates are no longer low when compared internationally, there are still two groups that stand out for their particularly low BIS central bankers’ speeches rates: Ultra-Orthodox Jewish men and Arab women, each with their own characteristics and specific reasons. In these two sectors, even those who are integrated into the labor market generally earn a relatively low salary, which indicates relatively low productivity. This is mainly the result of a level of education and training that does not earn a high return in the labor market. The incidence of discrimination must also not be ignored, and we know that the Arab public has difficulty integrating into certain industries, even if the appropriate training is provided. One such example is the high tech industry where, for various reasons, few Arabs successfully integrate. Since this industry has one of the highest levels of productivity and salary in the economy, that fact has far-reaching effects on the ability to fulfill economic potential with given talent such that it will be reflected in an appropriate standard of living. In the long term, demographics are expected to have far-reaching ramifications on employment, output and the standard of living. While those sectors with low levels of employment are expected to grow as a share of the population, the working age population is expected to decline as a share of the total population. If there are no changes in employment patterns, these demographic trends will reduce the annual growth rate by about 1.3 percent, every year. This is a strategic threat for the Israeli economy and for Israeli society – one that we must not ignore. Even if labor force participation increases, it is vital that we create the conditions required for workers to be absorbed in industries typified by a high level of human capital as well. Otherwise, employment growth will be able to make only a limited contribution to GDP growth, a reduction in poverty and an increase in the standard of living. The government has recognized the importance of integrating these population groups into the labor force and, in 2010, it adopted detailed employment targets to which the economy is supposed to converge in 2020. The target rates set for the Arab population in 2020 – 41 percent employment for women and 78 percent for men – are ambitious but possible. At the same time, the rate of progress toward the goals thus far is not sufficient, and much more effort is required in order to meet them on time. The government made many important decisions that delineate a policy intended to help in achieving these goals. It is very important to continue implementing this policy, which is supposed to give the appropriate weight to the relevant issues in future budget priorities. Among others, these include raising the level of education and skills relevant to the labor market, expanded early childhood care solutions, improved transit accessibility between places of residence and employment centers, methods for removing cultural obstacles to participation in the labor force, encouraging small businesses in the Arab sector in various ways, encouraging the integration of workers from the Arab sector who have the appropriate talents in industries typified by low rates from this population group, and combating discrimination. The Arab population in Israel contains immense untapped potential from the standpoint of the Israeli economy’s growth capability. Beyond the economic potential, the issue also contains highly significant social potential. The correct policy, and its correct implementation, will bear fruit both from the standpoint of the Arab sector, increasing its integration in Israeli society and improving its economic situation, and from the standpoint of the general population and the economy as a whole. Our ability to continue existing as a society that is both multi-faceted and socially cohesive depends, among other things, on how employment develops in Arab society in the next few years. If we know how to maximize the potential for increased growth and how to reduce the gaps, we will all – Jews and Arabs – be able to enjoy the fruits of this process. If we can’t manage to do this, then in my estimation, we will pay a heavy economic and social price in the years to come. Later in the conference, there will be an in-depth discussion of the details, solutions and plans on the agenda. I wish us all an interesting and productive conference. BIS central bankers’ speeches
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Main points of a speech by Dr Karnit Flug, Governor of the Bank of Israel, at the "Calcalist" Capital Markets Conference, Tel Aviv, 19 November 2013.
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Karnit Flug: The state of the Israeli economy and challenges ahead Main points of a speech by Dr Karnit Flug, Governor of the Bank of Israel, at the “Calcalist” Capital Markets Conference, Tel Aviv, 19 November 2013. * * * I will begin by presenting the state of the Israeli economy and the challenges we face in the short term, and will then provide a brief discussion of the long-term challenges as well. The Israeli market, as we know, is heavily influenced by the global environment. We are in an environment of global economic moderation, with a very moderate recovery in the advanced economies, and expectations are that this process will continue in the coming year. With that, the emerging economies are in a slowdown, and the expectation is that growth will continue to be relatively moderate for these countries. Global trade, whose influence on the Israeli economy is very large, is growing at a very moderate pace, and despite the fact that we expect its growth to accelerate in the coming year, it will still be relatively moderate. Inflation in the vast majority of advanced economies is low, and with this background, we are witnessing extremely low interest rates and very intensive monetary accommodation in the major markets. Growth in the Israeli market is higher than in the other advanced economies over the past few years, including during the crisis, however it is closely correlated to them. The data published for the third quarter point to moderate growth of 2.2 percent. This is a disappointing figure, and the main factor pulling growth downwards is exports, while consumption is what is currently pulling forward. On the assumption that world economic growth recovers as expected, we expect continued growth of 3.4 percent in 2014, but it is important to mention that excluding the effects of natural gas production, lower growth is expected, and since natural gas production does not make a significant contribution in the short term to growth in employment, we expect growth in unemployment in the coming year. An overall view of the labor market shows that it is strong, as reflected in continued growth in the employment rate, and continued decline in the unemployment rate to such low levels that we have not seen in many years. This is the aggregate picture, and it is certainly a good picture. At the same time, if we look a little closer, we see a picture that is somewhat less rosy: An assessment of the composition of the labor market shows that growth in the number of employed persons is concentrated in the public services, while employment in the business sector has been at a standstill for a long time. Another shadow is the standstill in exports. Looking at a somewhat longer period, we see that exports have not grown for two years, and have recently even contracted. This is connected first of all to moderating global demand, and also to problems specific to large companies, but exports, as we know, are also affected by the exchange rate of the shekel, which has strengthened in the past year. I should note that the aggregate sensitivity of exports to the exchange rate is not high. The estimate of exports’ sensitivity to the exchange rate is just 0.2. While the profitability of high technology companies is affected by the exchange rate, the sensitivity of low technology industries to the exchange rate is much higher. While the share of low technology and mixed-low technology manufacturing in exports is just 20 percent, these industries comprise about 60 percent of manufacturing employment. We take this fact into account as well when considering monetary policy decisions. Monetary policy is faced with a number of challenges. As we know, the shekel strengthened in the past year. There are real forces strengthening the shekel, including mainly the fact that the Israeli market is growing faster than other economies. But the forces for appreciation are also derived from the global monetary environment. Obviously, the production of natural gas in and of itself is good news – it improves the energy situation in the economy and BIS central bankers’ speeches contributes to the balance of payments. But it also obviously has an effect on the exchange rate. As I noted, interest rates in the major economies are very low. The interest rate in Europe was recently lowered to just 0.25 percent, and the major central banks are continuing to pursue quantitative easing policies. This situation has led us to the low current interest rate of 1 percent. The low interest rate environments – both domestic and global – obviously have an effect on asset prices, including home prices. The lack of investment alternatives increases the demand for homes for investment purposes, while the housing market is also affected by the low level of supply. The government is making efforts to increase the supply of homes, but in the meantime, these efforts are not leading to a moderation of prices. Monetary policy focuses on meeting the Bank of Israel’s goals: maintaining price stability, supporting economic activity, and strengthening and maintaining financial stability. For this purpose the Bank of Israel uses a number of tools. The main tool is, of course, the interest rate tool, which has reached a very low level. The Bank of Israel has for the past few years been pursuing a policy of involvement in the foreign exchange market in cases of excessive volatility in the exchange rate that is not in line with the fundamental economic conditions. The Bank also purchases foreign exchange in order to offset appreciation pressures derived from market overshooting in reaction to the production of natural gas. It is important to note that our foreign exchange policy takes the long-term economic forces into account, and we are acting to give the business sector time to adjust to the trends derived from these forces. In order to deal with the risks derived from growth in the balance of housing credit, the Bank of Israel has for a number of years been placing various limitations on the mortgage market. These are prudential tools that reduce the risk both to the financial system and to borrowers. A few words on the long term. Over time, we see very slow growth in the rate of productivity, and in parallel to growth, we were seeing growth in poverty and in inequality. The main challenge facing the Israeli economy over the long term is to succeed in creating inclusive growth. I would like to explain what I am referring to by this term. I am referring to continued, sustainable growth whose results will be divided more equally among all parts of the population, such that they will support a higher standard of living for all sectors, and a reduction of poverty and inequality in the distribution of income. Inclusive growth cannot be driven by a narrow growth engine. It must be broad based over a variety of industries, so that it can provide employment to all parts of the population over time. These include, for instance, small and medium businesses, tourism, and low technology industries – industries that can provide employment and income to workers at all skill levels. Such growth, in the center of the country and in the periphery, will ensure that the labor market is able to also absorb those who join it from the sectors with relatively low human capital or with employment levels that are still low. The challenge in creating inclusive growth is immense. It is a goal that many countries are grappling with, and it is not easy to achieve. It is important that, in formulating its strategic plan for the coming years, the government focus its policy such that we progress in this direction. Inclusive growth will contribute to strengthening the cohesiveness among various population groups and within the groups themselves. BIS central bankers’ speeches
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Address by Dr Karnit Flug, Governor of the Bank of Israel, for the Appointment Ceremony of the Governor of the Bank of Israel at the President's Residence, Tel Aviv, 13 November 2013.
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Karnit Flug: Important goals to achieve for the Israeli economy Address by Dr Karnit Flug, Governor of the Bank of Israel, for the Appointment Ceremony of the Governor of the Bank of Israel at the President’s Residence, Tel Aviv, 13 November 2013. * * * President Peres, Prime Minister Netanyahu, members of the Government, distinguished guests, and dear family: I would like to thank the President of the State of Israel who accepted the Government’s recommendation to appoint me as the ninth Governor of the Bank of Israel. I thank the Prime Minister and the Minister of Finance for their earlier remarks. I would also like to offer a special thank you to my predecessor in the position, Professor Stanley Fischer, who left a magnificent legacy at the Bank of Israel. It is a great honor and privilege for me to serve in this role, and I will make every effort to justify the confidence that the Government of Israel and the President of the State have placed in me, and to serve the Israeli economy to the best of my ability. I express my gratitude as well to the many people who have congratulated me and have wished me luck since my appointment to the position was announced. I would like to open by telling you a bit about my parents – my father, Noah Flug, of blessed memory, and my mother, Dorota, may she live and be well. They were both born in 1925 in the city of Lodz, in Poland. During World War II, they joined the youth underground in the Lodz ghetto. Later on, my father was imprisoned in Auschwitz, Gross-Rosen, and Mauthausen, while my mother was in Auschwitz, Bergen-Belsen, and Salzwedel. In 1958, when I was three, we made aliyah and moved to Israel. My father worked in the civil service for 30 years, as an economist in the Budgets Department of the Ministry of Finance, as an economic advisor to the Knesset Finance Committee, as an economic Consul in Zurich and at the Israeli Embassy in Bonn. My mother worked around the clock as a pediatrician. After retiring from government service, my father worked to protect the rights and honor of Holocaust survivors and to perpetuate the memory of the Holocaust. To the day he died, about two years ago, he served as Chairman of the Center of Organizations of Holocaust Survivors in Israel. Over the years, I heard my mother speak straightforwardly to her little patients. From my father, I learned to focus on a goal, to concentrate on what is truly important, but also to be pragmatic and reach agreements, because there is no need for unnecessary battles. I hope to bring these principles with me to the role of Governor of the Bank of Israel. There are many important goals to achieve for the economy and the Bank of Israel, which is one of the most important institutions in the economy. The new law defines the Bank’s objectives and functions clearly and unequivocally. The main objective of the Bank is to maintain price stability. In recent years, this goal has generally been achieved, though we must not take this for granted. We all remember very well the consequences of high inflation for Israel’s economy. The Bank of Israel will continue to maintain inflation within the target, and no less importantly, the public’s confidence in the Bank’s commitment to price stability. The economic literature and historical experience indicate that in the long term, price stability is a necessary condition for a growing and thriving economy. Given price stability, the law defines the additional objectives of the Bank of Israel – to support the Government’s economic policy and the stability of the financial system. These issues are at the forefront of our considerations when we decide the Bank of Israel’s policies. Just as in recent years, the Bank of Israel will continue to support the growth of the economy, while maintaining the stability of the financial system in general, and the banking system in particular. BIS central bankers’ speeches The Governor of the Bank of Israel is also, by law, the economic advisor to the government. Our Research Department leads the research on Israel’s economy, and will continue to delineate the research basis for the public discussion in areas on the agenda of economic policy makers. There are many issues, and I will attempt to focus on the most important ones: First and foremost, we must find the ways to increase the growth rate of productivity in the Israeli economy. There is tremendous potential lying within the Israeli worker, but GDP per employee does not match that of the most advanced economies, and as a result, the economy does not succeed in allowing citizens a standard of living in line with that of the most developed economies. We must find the way to increase the attractiveness of investment in the economy and to increase capital stock, to improve the competitive environment in which the business sector operates, and to reduce the bureaucratic burden. We must continue our efforts to increase the participation in employment of those population sectors which are still characterized by low employment. The expected demographic trends do not support a high rate of growth in the coming years, and we will need to act to offset the effects on growth of those trends in order to continue to grow at a satisfactory rate. High growth rates are not enough; it is very important that the fruits of growth are divided more equally by all parts of the population, so that they will support the reduction of poverty and of inequality in income distribution. We want inclusive growth, which supports the cohesion between various population groups, and within the groups themselves. Social cohesion is a prerequisite for national strength, and for forming a society in which our children, as well, will want to live and raise their children. Increasing labor force participation has an important role in this regard as well. In recent years, the cost of living has also been placed the top of the public agenda. This is partly related to the issues I already mentioned. Improvements in productivity and the rate of growth will necessarily bring with them an improvement in the purchasing power of the Israeli worker, in particular if the growth will be distributed more equally. But the cost of living is also partly related to the structure of the economy, to the level of competitiveness and the level of concentration of the economy. We must continue to strive toward an economy with a competitive environment, in which every producer can rely on its relative advantages and offer the best products and services, and in which every consumer has the access and ability to choose the cheapest and most appropriate goods and services. In recent years, we have seen important reforms in this area, and we must continue to carry out reforms which will reduce the concentration and increase competition. In the banking industry, as well, changes are occurring which increase competitiveness and the consumer’s ability to compare and choose the best and cheapest service. Alongside these changes, it is important to continue the efficiency measures in the banking system, so that competitiveness will increase while maintaining the stability of the system – stability which is a necessary condition for a growing and thriving economy. Housing prices have increased in recent years at an accelerated pace, and have also been a significant component in the rise in the cost of living. The Bank of Israel, in the framework of its economic advice to the government, assists with diagnosing the barriers and recommending the policy required to increase the supply of housing at a rate which can meet demand. Within the framework of setting monetary policy, and its responsibility for financial stability and banking system stability, the Bank of Israel deals with the consequences of a low interest rate environment, which is derived to a great extent from the monetary policy adopted in major economies worldwide. The regulatory steps taken by the Bank of Israel helped to reduce the risk to which both borrowers and the banking system are exposed. Ultimately, the solution will need to come from bringing the supply of homes in line with the basic demand for housing services, and we must hope that the steps being taken by the Government in this area will bear fruit. BIS central bankers’ speeches Israel’s agenda also includes the discussion about the size and the role of the public sector in the economy, and the structure of the tax system. After several years of reducing the share of government expenditure in GDP and reducing the tax burden, voices are heard calling for expanding the scope of services that the government provides for its citizens. The optimal size of the government cannot be calculated by one economic model or another – an economy with a small government and low tax burden can grow and thrive, as can an economy in which there is a larger government and greater tax burden. The size of government expenditure, ultimately, is the result of society’s preferences. However, we must remember that the size of government and the tax burden go hand in hand. If we choose a large government which will provide public services with high quality and quantity, will invest in infrastructure, and will be actively involved in supporting engines of growth, we will have to bear a higher tax burden. It is not a simple choice, primarily because we will not be able to allow ourselves large deficits and a growing public debt – those will endanger the financial stability of the economy, and negatively impact growth and quality of life in the long term. The global economic crisis taught us another lesson about the importance of the stability of the financial system. We learned that we must map out and understand the connections between various financial institutions, and locate possible points of failure which may influence the financial system’s stability. Supervision of the financial system in Israel is dispersed among several entities. This situation is liable to lead to cracks in the supervisory systems, and to lead to a situation in which risks which are protected against adequately in one part of the financial system are growing in another. The various regulators cooperate with each other and work professionally and collaboratively. With that, we must institutionalize the collaboration and information sharing through a Financial Stability Committee with the participation of the Ministry of Finance, the Bank of Israel, and the Israel Securities Authority. Such a committee will help to significantly reduce the probability of a threat to financial stability in Israel’s economy in the future. Dealing successfully with all these challenges requires the continued effective and productive cooperation that the Bank of Israel has with the relevant government ministries, particularly the Ministry of Finance. Alongside setting monetary policy and providing economic advice to the government, the Governor of the Bank of Israel is also charged with the responsibility of managing the Bank. I am proud that the corporate governance regime at the Bank of Israel has undergone a real revolution in the past two years. Policy decisions are not made by the Governor alone, but within the framework of the Monetary Committee. The Supervisory Council oversees important administrative decisions. Nonetheless, there are also internal challenges facing the Bank of Israel over the coming years. First and foremost, we will need to find a way to maintain the attractiveness of the Bank of Israel as a workplace which the very best will want to join. The Bank’s main asset when it comes to serve the Israeli economy is the human resource which lies within its employees. We must ensure that this resource does not erode. Bank of Israel employees come to work each day in order to serve the economy and the citizens – whether it is an employee in the Currency Department, which is charged with the regular supply of banknotes and coins to the economy, or the economist in the Market Operations Department, which carries out, in actuality, monetary policy and is charged with managing the foreign exchange reserves which are the Israeli economy’s insurance policy, or the staff of the Banking Supervision Department, whose dedication and professionalism are the guarantee that Israeli citizens’ funds which are deposited with banks are in sure hands. We all take it as a given that the check that we deposit, or the funds transfer which we carry out, always reach their destination, but this would not happen if not for the control of the Accounting, Payment and Settlement Systems Department at the Bank, and there is no substitute for the analytical talents and policy recommendations of the Research Department economists, who work constantly to try to provide answers, to both the urgent policy questions and the longer term issues in the Israeli economy. All these, with the help of the people in Statistics, IT, and various administrative units, are the human resource that the BIS central bankers’ speeches Bank of Israel places at the service of the Israeli economy. I have no doubt that the staff of the Bank of Israel will continue to serve Israel’s economy with professionalism and dedication in the coming years, and I will be proud to lead them in this effort. I would like to conclude my remarks by expressing my gratitude to my spouse, Shaul, and to my children Maya and Michael, without whose support over many years, despite their shunning of public exposure, it is doubtful I would be standing here today and taking on myself the position of Governor of the Bank of Israel. Thank you very much. BIS central bankers’ speeches
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Main points of a speech by Dr Karnit Flug, Governor of the Bank of Israel, at the Central Bureau of Statistics Conference, Jerusalem, 17 February 2014.
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Karnit Flug: Where is society headed? Main points of a speech by Dr Karnit Flug, Governor of the Bank of Israel, at the Central Bureau of Statistics Conference, Jerusalem, 17 February 2014. * * * I will begin my remarks with data from the OECD, which compared GDP per capita in its member countries with the US, broken down into factors which explain the gap between the various countries and the US. In 2011, the gap between GDP per capita in Israel and the US was close to 50 percent. The OECD also tried to project what the picture will look like in 2060, assuming that current policy trends in the various countries, and expected demographic trends, continue. The gap between Israel and the US is expected to remain more or less the same, as Israel is forecast to decline by four places in the country ranking. This is clearly a troubling picture. Economic policy is conducted under various trends and constraints, though we must obviously remember that over the long term we can affect the overall framework of the constraints as well. These trends and constraints include demographic trends, the geopolitical situation, the level of governance and efficiency in the public sector, the scope of public expenditures, taxes and the debt, and of course, the global environment in which we work is very challenging. Expected demographic trends point to two very dominant factors. A change is expected in the composition of the population, by sector, with an increase in the share of the Arab sector, and more so of the ultra-Orthodox sector, in the overall population. There is also a change expected in the age distribution – Israel’s population is relatively young, compared with advanced economies, but there is an aging trend by us as well, and the share of those 65 years and older, currently around 10 percent, is expected to reach 17 percent. In the labor market, the employment rates of ultra-Orthodox men and Arab women, as known, are low. The productivity of the people from those population segments who do participate in the labor market is low, on average. The good news is that there is improvement, albeit slow, in the employment rate of these two segments of the population. However, if we make a radical assumption, that the participation rates of those sectors will remain at current levels, demographic trends on their own are expected to reduce the employment rate by 7 percent in the long term. Thus, it is important that we continue to invest in increasing the participation and productivity of the Arab and ultra-Orthodox sectors; otherwise, not only will we not remain in place, but we will even widen the gap vis-à-vis the advanced economies. For example, in educational achievements, already today there is some gap between Israel and advanced economies, and it can be assumed that the Arab and ultra-Orthodox sectors are themselves at some gap vis-à-vis the general population in such achievements. The implication is that under current conditions, the increase in labor force participation of these sectors will be reflected in the addition of employees whose productivity is low to the workforce. The data indicate that in recent decades, the gap between Israel and advanced economies in output per hour has remained. Among the factors in this phenomenon are an unfriendly business environment, as reflected in international indices such as the Doing Business index, the problem of low competitiveness in specific industries, and a low rate of investment which leads to insufficient capital stock. Looking at per capita GDP, as well, indicates that we have not closed the gap in recent decades. Although we have seen more rapid growth of our per capita GDP in recent years, in light of the relatively moderate negative impact of the crisis on Israel’s economy compared with other advanced economies, we clearly don’t want to hope for a continued contraction of the gap between Israel and other advanced economies based on the this factor. The two demographic trends that I discussed – the decline in the share of the working age population, and the increase in the share of sectors with relatively low BIS central bankers’ speeches employment rates – are expected to deduct 1.3 percentage points from the annual growth rate. In this regard, I of course noted the improvement, which is still slow, in the employment trends in the Arab and ultra-Orthodox sectors. The aging of the population is expected to lead to a sharp decline in the ratio of number people of working age to the number of the elderly, from 5.5 today to 3 in 2050. The meaning of this is that there will be a need to increase the allocations for old age allowances, on healthcare expenditure, nursing care, and such, in order to maintain the current level of these allowances and services. Poverty is another issue with which we will need to deal. In recent years there has been a trend of increase in the poverty rate among families with workers, while the stability in the general poverty rate is the result of an increase in the share of families with one or both parents working, which is an outcome of the trend of increase in labor force participation. The picture is essentially of workers whose earning power does not allow them a respectable livelihood, and so there is an increase in the number of poor families in which there are one or two wage-earners. In this context, expanding the earned income tax credit (negative income tax) is an efficient policy tool to deal with the problem, as it focuses on the working poor, and in contrast to a policy of allowances, it does not contain negative incentives. In the long term, of course, the main key to solving the problem of poverty is continued investment in education and increasing earning power. The challenges I have presented here will require a significant increase of civilian expenditure on services such as education, healthcare, welfare, and infrastructure, even if only to maintain the current level of services, given the expected changes in composition of the population. In order to ensure that maintaining the civilian expenditure level will not negatively impact on the important effort to continue to reduce the debt burden, there will be a need to continue to increase tax revenues. This can be achieved in 3 ways, each on its own or in some combination of the three: 1. Increasing tax rates, which obviously increases the burden on activity and growth. 2. Reassessing the tax exemption system. In this regard, it should be remembered that some of the estimates of the cost of existing exemptions are biased upward, since they do not take into account the expected change in activity resulting from the cancellation of the exemption. 3. Reducing the shadow economy and enhancing collection. It is clear that from the perspective of statistics bureaus worldwide, estimating the extent of the unreported economy poses a large challenge. A very rough estimate by the World Bank, which apparently has a large margin of error, assesses that the unreported economy is about 20 percent of GDP in Israel. In this regard, there are several processes which are being discussed: definition, in legislation, of severe tax crimes as source crimes under the Prohibition on Money Laundering Law, which would allow the transfer of information between the Israel Money Laundering and Terror Financing Prohibition Authority and the Israel Tax Authority, and making punishment for tax crimes more severe; collaboration between all the enforcement entities and transfer of professional and intelligence information which will make enforcement against tax evaders more efficient; and a reduction in the use of cash and third-party checks, which is currently being considered by the Locker Committee. To the extent that we will be able to do more in increasing the efficiency of the tax exemption system and enhancing tax collection, we will be able to increase overall tax revenues without increasing tax rates. To summarize, the economy faces the challenge of supporting inclusive growth, which integrates population sectors with low participation rates, while increasing their human capital and earning capacity and increasing productivity. To that end, we must formulate a focused strategic plan, which will include integrating population sectors into employment (ultraOrthodox, Arabs, older workers), dealing with increasing human capital, dealing with the factors leading to slow growth of productivity (infrastructure, business environment, BIS central bankers’ speeches competitiveness), preparing public services systems (healthcare, nursing, etc.), and reducing the unreported economy by collaboration between all entities. The data I presented in the beginning of my remarks showed that an “automatic pilot” policy will not lead us to reducing the gaps with other advanced economies; however, there is some room for optimism, as an effective and well thought-out policy can definitely improve our situation over the long term. BIS central bankers’ speeches
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Main points of address by Dr Karnit Flug, Governor of the Bank of Israel, at the opening of the "Aharon Institute for Economic Policy" at the Herzliya Interdisciplinary Institute, Herzliya, 16 March 2014.
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Karnit Flug: A peek into the Monetary Committee room Main points of address by Dr Karnit Flug, Governor of the Bank of Israel, at the opening of the “Aharon Institute for Economic Policy” at the Herzliya Interdisciplinary Institute, Herzliya, 16 March 2014. * * * I am very happy to be participating at this event. The economic discourse on matters of policy in Israel is sometimes shallow, and there is no doubt that policy research can enrich it. That is why this institute is important. At the Bank of Israel, we certainly know how to value high-quality economic research that supports making good policy decisions. In this lecture, I will try to provide “a peek into the Monetary Policy room”. The name of the lecture was taken from an article written a few years ago by Prof. Rafi Melnick – “A peek at the Governor’s Office”. Prof. Melnick doesn’t need to peek, since he is a member within the Monetary Policy room. I will try to illustrate the economic thinking and analysis that stand behind policy decisions, thereby perhaps providing direction for the type of policy research this institute can undertake, thereby deepening and enriching the economic policy discourse, at least in this area. The Bank of Israel’s policy goals are derived from the Bank of Israel Law. The tools available to the Bank are, of course, the interest rate and the Bank’s ability to intervene in the foreign exchange market. In recent years, the Bank of Israel has also used the authority of the Supervisor of Banks to take measures in order to reduce the risks in the mortgage market. In the process of making decisions on the interest rate, we discuss the situation assessment of a number of relevant issues, in the global economy and in the domestic economy. For instance, in the most recent interest rate decision, we discussed developments in the global economy. We distinguished between the positive growth in leading indicators, mainly in the advanced economies, and some weakness and disappointment in the emerging economies. Global growth forecasts show a very gradual recovery – the entrenchment of growth in the US with continued stagnation in the European economy. A very important variable for the Israeli economy is global trade, and it is expected to recover and to support economic activity in Israel. We looked at US data, and saw weakness in the labor market data there, although the argument was raised that it is a temporary weakness due to the weather. In general, data in China and in the US indicated weakness, mainly in manufacturing, and we also saw a negative turnaround in the real estate industry in the US, which was one of the growth engines there in the recent period. In other words, the global picture is mixed – a slight improvement in the advanced economies, and a less positive picture in the emerging economies. We also look at monetary developments around the world. We saw a continued decline of inflation, and the International Monetary Fund even recently indicated concern of deflation in Europe. In the emerging markets, mainly those with a current account deficit, we saw rapid depreciations, and in some of those countries, the interest rate was raised in order to deal with these depreciations. In contrast, the tapering process in the US continued, but both the US and Europe announced that the low interest rate would remain for a prolonged period. In the domestic economy, we saw weakness in the growth rate. National Accounts data showed a slowdown in business sector product, which for the past two quarters has grown by about 1.6 percent. This is roughly the growth rate of the population, meaning that this is a weakness in terms of growth of economic activity. We saw improvement in manufacturing and in exports of the high technology industries, but weakness continues in the low technology industries, both in exports and in manufacturing for the domestic market. We saw weakness in the labor market. While the labor market aggregates seem quite positive – the historically low unemployment rate, and high employment and participation rates – we see BIS central bankers’ speeches that most of the positions were created in the public services and not in the business sector. The wags of Israeli workers alone are at a standstill, but when foreign and Palestinian workers are included, there is a slight increase in wages. Consumer confidence and business sector confidence indices also indicate weakness. So the labor market aggregates seem positive, but a deeper look at the developments in the various industries – wage and work hours data – show weakness in the labor market. Of course, we also look at inflation data. The January CPI reading showed a decline of 0.6 percent, and in general, inflation in the past year is below the target range. The core inflation indices also indicate very moderate inflation, close to the bottom of the target range, and expectations of inflation in the future are quite moderate. In other words, the inflation environment is below the center of the target range, which supports lowering the interest rate. The exchange rate is in an appreciation trend – we saw a sharp appreciation at the beginning of 2013 and moderation in the trend in recent months. Another area that we have been dealing with a lot recently is the housing market. The volume of activity, transactions and mortgages, is very high, housing prices continue to increase, and there is significant growth in the volume of building starts and building completions. Should it continue at appropriate levels, this growth is expected to lead to moderation in the volume of homes, although we still do not see this moderation. We also look at various indicators that deal with financial stability. Beyond the collection of data that I have presented here briefly, we use a macroeconomic model in order to assess the developments in the market, and to discuss the effects of various policy scenarios on activity in the market, inflation, and so forth. The framework in which we assess such scenarios is a very complex model, called the DSGE model, which is used by many central banks operating within an inflation targeting regime. This model combines the connections between the various economic units in the market and the economic variables, both nominal and real, within one coherent framework. The model enables us to make simulations and examine what the effect would be of alternative policy paths, as well as exogenous shocks, on inflation and on economic activity. We look at the various transmission channels, as reflected in the model, from the Bank of Israel interest rate and the other economic variables to the target variables – inflation and the volume of economic activity. As such, this is the conceptual framework on the basis of which we make policy decisions. If we glance at the discussions during which we made the interest rate decision for March, we looked at a decline in the inflation environment, a slowdown in GDP and business product growth, weakness in the labor market, the cumulative appreciation of the shekel, and slow and moderate recovery within a low inflation environment and monetary accommodation in the global market. All of these considerations supported monetary expansion, meaning a reduction in the interest rate. Against these considerations, there is, of course, the housing market and the continued increase in home prices. In this context, I will mention that there are other tools available to the Supervisor of Banks in order to reduce the risks in this market, and we have used these tools. So, this is the policy decision process that we employ at the Bank of Israel. We can think of various issues that studies written by the researchers at this institute can deal with, to help in making policy decisions. For instance, I mentioned the labor market and the low unemployment rate, and despite this, the sense of weakness in the labor market. We can ask to what extent the current unemployment level that we see is structural unemployment, to what extent it is frictional unemployment, and in the context of developments in the labor market, what is the correct monetary policy. BIS central bankers’ speeches
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Main points of a speech by Dr Karnit Flug, Governor of the Bank of Israel, at the Money and Technology Conference (taking place as part of Israel's National Science Day), Tel-Aviv University, Tel-Aviv, 26 March 2014.
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Karnit Flug: Money and technology – means of payment in Israel Main points of a speech by Dr Karnit Flug, Governor of the Bank of Israel, at the Money and Technology Conference (taking place as part of Israel’s National Science Day), Tel-Aviv University, Tel-Aviv, 26 March 2014. * * * In this conference, which deals with innovation and technology, I will not speak about monetary policy, fiscal policy or about the macro situation, nor will shall I speak about any challenges to the macro economic policy, but rather about part of the economy which is rarely discussed – its “plumbing”. We always take it for granted, and only speak about it when something goes wrong – when it either leaks or is clogged. This piping, which we call “payment and settlement systems”, comprises a number of levels, which include the payment systems, the means of payment – which the public uses on a daily basis – and the communications infrastructure between the system’s various components. When making a payment in one way or another, we all assume that the infrastructure (or piping) ensures that transactions are performed efficiently and swiftly. The payment and settlement system is a key element of the financial infrastructure, making sure that each and every payment or credit we make or receive arrives at its destination quickly, efficiently and securely. The Bank of Israel, through its Accounting, Payment and Settlement Systems Department, serves as its oversight entity and is responsible for its regulation, for operating some parts of it (Zahav [the Real Time Gross Settlement system] and Paper-based (checks) Clearing House), as well as for its security and efficiency. I will focus today on those parts of the system, their development in the last few years, as well as on expected developments. The means of payment include both traditional ones – paper based – such as cash, checks and vouchers, and the more advanced – electronic – ones, which include electronic debits and credits, payment cards, web-based payments and mobile payments. Each group has its advantages and disadvantages: paper-based means are characterized by ease of use, by availability to all parts of the population, by their immediacy and the finality of a transaction, as well as by being anonymous. Under certain conditions, anonymity may become a disadvantage, if used to commit offenses (such as money laundering, tax evasion, etc.) Other disadvantages of paper-based payments include the fact that transactions go undocumented, and that they are exposed to the risk of loss, theft and forgery. Electronic payment means are characterized by ease of use and availability to those who have access to them; they are efficient, quick and documented, thus contributing to a decrease in illegal activity. They are also relatively safe from loss or theft, and bridge physical distance. However, their dependency on technology exposes them to both technological and security failures – issues whose risk mitigation requires significant investments. In the past few years, the Bank of Israel has pushed a number of reforms and a number of systems have been built, which have improved the infrastructure for the use of advanced means of payment: • Development of an RTGS, an immediate and final settlement system, which allows for real time transfers and payments • Including the shekel in CLS Bank for settlement purposes, thus turning the shekel into a convertible currency which is traded freely worldwide • The enactment of the Payment Systems Law, 5768-2008, whose aim is to ensure the efficiency of Israel’s payment systems and minimize the risks embedded in them • Changes and improvements were implemented in the existing payment systems – checks, MASAV (ACH) and the security exchange’s clearing houses. BIS central bankers’ speeches The Committee for the Reduction of Paper-based Payments (the Locker Committee), which is working to reduce the use of cash and special check endorsements, will further push the development and expansion of the use of advanced means of payments. In the past decade, the use of advanced payment means has increased, both in terms of the percentage of transactions, and even more so – in terms of transaction amounts. In this context, in 2013, 56 percent of the transactions, in NIS terms, were made through the Zahav system (albeit a minor percentage of the number of transactions), with each money transfers greater than NIS 1 million being required to be made through the system. Technological advancement and innovation have not bypassed the payment means field, or even traditional means of payment: The new banknote series – the first denomination of which, NIS 50, is expected to enter the market by the end of the year – includes innovative security means, such as marks which become visible under ultraviolet light and micro lettering. Thus, for example, the leaf illustration on the bill includes tiny lettering – featuring Tchernichovsky’s poem “Oh, My Land, My Homeland” in full – which can only be discerned using a magnifying glass. As time goes by, as technology advances, electronic means of payment become more and more sophisticated: from manually swiped credit cards through magnetized cards, webbased payments, mobile payments, proximity cards, and electronic wallets, which include a variety of payment means and smart cards. Smart cards will enable customers to carry out any type of transaction currently conducted using debit cards – immediate debits, deferred debits, credit transactions and cash withdrawals, and provide them with new advantages. The use of such cards, which is expected to begin in Israel in the next few years, will require entering a code into a terminal located at the business, thus reducing the use of stolen or loss cards. Israeli innovation and creativity have not bypassed the field of payment means, which is evident from the large number of mobile payment and mobile wallet applications – some of which are becoming more popular both in Israel and abroad. Some of the electronic payment means yet to be widely used in Israel are already being developed or used in various countries, such as smart cards, proximity cards, payments using biometric identification, electronic wallets and digital checks. We are at the height of a technological revolution in means of payment, which is expected to make them more user friendly, more convenient, more widely available and safer to use. It is, of course, highly significant that this process be appropriately regulated, ensuring that its advantages are fully realized and possible risks are minimized. BIS central bankers’ speeches
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Main points of address by Dr Karnit Flug, Governor of the Bank of Israel, at TheMarker Financial Conference, Tel-Aviv, 4 March 2014.
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Karnit Flug: The macroeconomic situation and the stability of the financial system Main points of address by Dr Karnit Flug, Governor of the Bank of Israel, at TheMarker Financial Conference, Tel-Aviv, 4 March 2014. * * * Accompanying slides can be found in the Hebrew version of the speech on the Bank of Israel’s website. The macroeconomic situation The global economy is continuing to grow at a moderate pace. Growth in the US continues to take root – even though the recent data has been weak, apparently due to the harsh weather. In Europe, the very moderate and fragile recovery is continuing, with some concern of deflation. In the emerging markets, there has been some improvement, although in some of the larger countries, mainly those that have current account deficits, there have been signs of weakness and fragility in recent months. Together with the moderate recovery, global trade is also expanding. Growth in Israel moves in line with, and higher than, that of the other advanced economies, and we expect that both the correlation and the gap will continue this year as well (slide 2). However, looking at recent months, we see a further slowdown in growth in Israel, and the pace of growth declined from about 3 percent in the past year and a half to less than 2.5 percent in the past two quarters, while business output grew in those two quarters by just 1.6 percent (slide 3). Exports were the main factor in the slowdown in the third quarter, and there were signs of improvement in it in the fourth quarter., but at this stage, they are concentrated mainly in the pharmaceuticals industry and to a certain extent in the chemicals and electronics industries as well, and we have not yet seen the improvement expand to the other export industries. The labor market continues to show a mixed trend: The unemployment rate declined and is at a historic low thanks to an increase in employment rates that took place together with stabilization of the participation rate at a very high level (slide 4). Our assessment is that the decline in the unemployment rate reflects, among other things, a structural decline in the unemployment rate due to processes increasing labor market elasticity in recent years that led to a decline in the frictional and the natural unemployment rates. Furthermore, most of the growth in employment in the past two years was in the public service industries – mainly in the non-governmental portion of the public services – while the number of Israeli employees in the business sector did not grow (slide 5). The number of work hours per employee in the business sector also declined, and the rate of those who are involuntarily in part-time employment increased. These reflect a certain weakness in the labor market. Inflation in the past 12 months was 1.4 percent, and one year forward inflation expectations are anchored within the target range, below the center of the range (slide 6). Following the relatively rapid appreciation in the shekel exchange rate during the first half of 2013, there has been a moderation in the pace of appreciation (slide 7). It is important to note that the main forces acting for appreciation this year are the start of natural gas production and expectations of the effect it will have on the balance of payments in the next few years, as well as the relatively good position of the economy that is reflected in a current account surplus and in the flow of direct investments in innovative and attractive Israeli companies. All of these factors formed the basis of monetary policy this year, including the background to the most recent interest rate reduction. It is important to mention that the monetary policy goals set in the law are, first of all, maintaining price stability, meaning keeping inflation within the range of 1–3 percent, and subject to that, support of growth and employment, and of financial stability. Therefore, the decline in inflation, together with expectations of BIS central bankers’ speeches moderation in inflation, enabled and even supported the reduction of the interest rate, which is intended to support activity and growth, both by lowering the cost of credit and by its effect on the exchange rate which mainly affects the commercial sector – the export industries and alternatives to imports. As I have noted in the past, we are not indifferent to developments in the exchange rate, and we are aware of the effects it has on exports and on employment in the commercial industries. Therefore, in addition to the interest rate policy, the Bank of Israel also intervenes directly in the foreign exchange market – and we were active in the past year both in purchases to offset the effect of natural gas production on the current account of the balance of payments, and in order to moderate excess volatility in the exchange rate that is not in line with fundamental economic forces (slide 8). We must remember that the foreign exchange reserves are an important component of financial stability, and there are studies around the world that indicate that a high level of foreign exchange reserves reduce the likelihood of a financial crisis in the economy. Regarding the housing market, home prices have continued to increase at a rapid pace, increasing by about 8 percent in 2013, together with a rapid increase in the number of new mortgages taken out. The Supervisor of Banks adopted measures intended to reduce the risks inherent in mortgages and in their rapid growth. The recent measures adopted – which restrict the payment-to-income ratio and set out that at least one-third of the mortgage should be at a fixed interest rate – are acting to reduce the risk that households that took out a mortgage will have difficulty in meeting their payments, for instance in a situation where one of the household members loses his job, or if the burden of repayment increases due to an increase in the interest rate. The decline in the share of mortgages with an loan-to-value (LTV) ratio above 60 percent, and the decline in the share of mortgages with a payment-toincome (PTI) ratio above 40 percent, indicate that the measures adopted have reduced the risk inherent in mortgages (slide 9). With that, the continued rapid growth in the number of mortgages and in their weight in the bank’s credit portfolio are a risk factor, and if additional measures are required, we will not hesitate to take them. The increase in the number of building starts and completions that we witnessed in the past year, to almost 45,000 starts and more than 40,000 completions – higher than the basic demand for homes that is derived from growth in the number of households – is a positive development. If this trend continues – and we see that the government is making efforts in this direction – and if it includes areas of high demand, it will act to reduce the pressure and stabilize home prices. Financial stability The picture of the stability of the economy can be presented in multi-dimensional form by way of a radar chart that includes real data, accounting data and survey data, as well as data that show the risk philosophy of Israeli and global investors (slide 11). The diagram for the end of January 2014 indicates that the financial system and the economy are stable. The red diagram reflects the situation at the end of 2008, and shows a picture in which almost all risk indices, both global and domestic, were at record high levels at the height of the global financial crisis. The blue diagram, which shows the levels of the current risk indices, indicates relatively low levels, with most of the measured risks reflecting the global macroeconomic situation – moderate growth, high unemployment, and low indices reflecting consumer confidence and business confidence. These, of course, also have an effect on the domestic macroeconomic risk, which reflects moderate growth. In contrast, the market risk indices, both in Israel and globally, are at low levels, which creates a gap – both in Israel and abroad – between the real situation and the investors’ risk philosophy. This gap is apparently affected by the search for yields in a low interest-rate environment, but it is possible that expectations of an increase in corporate profits that will accompany the recovery also have an effect. BIS central bankers’ speeches A view of the business sector’s sources of financing indicates that the trend of a decline in the weight of bank credit and an increase in the weight of domestic nonbank credit – through corporate bonds and recently through direct loans from institutional investors as well – that we witnessed since the beginning of the century continues even after the global crisis of 2008–9 (slide 12). This is obviously a positive process, in that it increases and variegates the sources of financing to the business sector, creates competition for the banks and acts to reduce the cost of financing, thereby supporting growth. However, the process is also accompanied by the creation of risks that must be addressed. Among other things, these reflect the fact that the nonbank credit market has developed rapidly, while its regulation is developing gradually. During the global crisis, most of the negative impact to the financial system in Israel was reflected in this market: Yields in the market skyrocketed and issuances froze. In total, more than 100 companies have entered debt restructuring proceedings thus far – representing bonds totaling about NIS 40 billion. It is important to emphasize that this number does not represent the scope of the loss absorbed by investors, which will naturally be lower (slide 13). Since the global crisis, as a lesson from global developments as well as developments in Israel, in order to reduce the risks of a crisis and to reduce the damage of a crisis should one take place, many measures are being taken in the field of regulation that are intended to reinforce the durability of the financial institutions and system. Regulations have been updated in the field of corporate governance and risk management at the banks; the Basel III guidelines have been adopted in the area of capital requirements, and rules in the area of liquidity and leverage will be adopted; the use of stress tests to identify risks in institutions and in the system as a whole has been increased; the Business Concentration Law has been passed to reduce the risks derived from complex and leveraged business groups and to separate control of real corporation from financial corporations; the recommendations of the Hudak committee to strengthen control of investments by financial entities in corporate bonds have been adopted; the supervision of the payments and settlement systems has been strengthened; and the Banking Supervision Department has taken a series of measures to reduce the risks in the mortgage market (slide 14). Beyond these changes, which have already been implemented or are in the process of implementation or assessment, there is also a series of committee recommendations or recommendations that are still being formulated, that are meant to complement the improvement of regulation: the Goldschmidt committee to arrange the management of direct loans by institutions; the Andoran committee, which is handling debt restructuring proceedings in the economy. There is also a bill in advanced stages of legislation to handle a failing bank, similar to legislation enacted in this area following the crisis in other advanced countries. Even though much has been done in the field of financial regulation since the crisis, and there are steps still being taken, there remains much work to do. One of the important lessons taken out of the development of the financial crisis in various countries is the fact that while the institutions themselves were, in most cases, subject to supervision, there were parts of the system that are not supervised or are less supervised, which expanded rapidly. It also became clear that the connections between the various institutions, and the interfaces between them, which led to the rapid transfer of risks between parts of the system and increased its fragility, were neglected by regulators around the world. Therefore, the issue of an overall view of the financial system, and the issue of coordination and joint work by the various regulators is at the center of the recommendations of the various international bodies on an issue that is at the heart of the required reforms in the field of financial regulation. In terms of Israel, it is desired, as the International Monetary Fund has recommended in this regard, to establish a financial stability committee that will entrench the coordination and cooperation between all of the financial regulatory authorities, with the aim of identifying, preventing and reducing systemic risks. This committee is supposed to define, monitor and assess systemic risks; examine risks and exposures in the financial system in order to BIS central bankers’ speeches identify and assess systemic risks; promote the exchange of information among the financial regulatory authorities and between them and the stabilizing institutions (the Bank of Israel and the Ministry of Finance); improve the coordination and cooperation between the financial regulatory authorities and the stabilizers in analyzing evaluating, developing and operating tools and methods to prevent and reduce systemic risks; issue warnings when a systemic risk could become a material risk; make recommendations of measures to prevent or reduce systemic risks that are identified; and track the actions taken as a result of the warnings and the implementation of the recommendations (slide 15). It is proposed that the staff work for the committee be done by the Financial Stability Division that was recently established in the Bank of Israel Research Department, with the aim of acting to promote financial stability which, according to the new Bank of Israel Law, is one of the Bank’s goals. A stable financial environment, and a financial system in which the public places its trust, are essential for sustainable growth and a continued increase in the standard of living. I am convinced that completing the steps that are currently being taken, including the establishment of the committee as I have outlined, will contribute to the economy’s ability to withstand shocks which, by nature, will come. We have the privilege of taking these steps during a period of relative calm and stability, and it is therefore important that we complete them soon. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the 14th Herzliya Conference "Israel and the Future of the Middle East", Herzliya, 9 June 2014.
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Karnit Flug: The formulation of monetary policy in uncertain conditions Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the 14th Herzliya Conference “Israel and the Future of the Middle East”, Herzliya, 9 June 2014. * * * We have recently been dealing with a murky picture regarding the real economy, in view of the fact that various data do not always reconcile with each other, creating different pictures of the state of the economy. This situation is obviously challenging for setting policy. With this background, in the last interest rate announcement, the Monetary Committee placed a greater than usual emphasis on the uncertainty regarding the state of the economy. In view of this, I decided to concentrate today on how monetary policy decisions are made in uncertain conditions. According to the Bank of Israel Law, the objectives of monetary policy are first of all to maintain price stability over time, and subject to that, to support the government’s economic policy, and particularly growth, employment and reducing social gaps, and also to support financial stability. The Bank of Israel uses the policy tools available to it for this purpose: the Bank of Israel interest rate, intervening in the foreign exchange market according to circumstances, and prudential tools in the form of various restrictions in the mortgage market. The use of all the tools, to various extents according to circumstances, helps to achieve the various objectives and to minimize the negative effects of various tools on various other objectives. The following are the main data that we consider when making decisions. Inflation and inflation expectations are within the target range, in the lower portion of the range, and inflation is expected to decline to below the target range in the coming months. GDP growth data provide a picture of a slowdown in growth during the first quarter of 2014, with growth of 2.1 percent, and a sharp slowdown in the growth of business product (0.4 percent). It is important to emphasize that the data are obtained with a lag. The “first vintage” is obtained 6 weeks after the end of the quarter, and 2 updates are obtained in the months following, until the initial publication of data for the next quarter. In contrast, labor market data point to continued improvement. The unemployment rate declined and is at an historically low level of 5.1 percent, with an increase in the participation rate and in the employment rate. A similar picture emerges from data on wages per employee post. The development of the exchange rate affects both inflation – despite the fact that the transmission from the exchange rate to inflation is lower today than it was in the past – and economic activity, due to the exchange rate’s effect on the tradable sector. The exchange rate is obviously something we know in real time, and as opposed to other data that I will mention, it is not updated. The housing market is obviously part of the picture that we deal with in determining monetary policy, both on the inflation side – where most of the emphasis is on the rental index, which reflects the price of housing services – and on the financial stability side. We know that the volume of housing credit is constantly increasing, and that its share of total bank credit is also increasing. In this context, the increase in housing process and the rapid increase in the volume of mortgages made it necessary for the Supervisor of Banks to adopt a series of measures to reduce the risk inherent to housing loans, as part of maintaining financial stability and – first and foremost – the ability of borrowers to meet the commitments they take upon themselves. Later on, I will illustrate the uncertainty surrounding the real economic situation when making decisions. It is important to emphasize that this uncertainty is built into managing policy by the very fact that data on economic activity at any given moment are obtained with a lag and BIS central bankers’ speeches updated later. With that, there are periods, such as the current period, where various data provide a contradicting picture of the situation, leading to a particularly high level of uncertainty. The main figure that we track is obviously the National Accounts data, which outlines growth of GDP and its components. The intensity of the updates in the data is shown by the gap between the initial estimate of growth in a given quarter and the estimate published a year later. For instance, in the third quarter of 2008, the initial estimate pointed to growth of 2.3 percent, and a year later it became clear that growth was just 0.8 percent. Likewise, growth in the second quarter of 2010, according to the initial estimate, was 3.3 percent, and a year later it was 5.2 percent. With that, we can also see that the updates do not systematically tend toward one direction or another. The average of the updates is close to zero. It should also be noted that the updates in Israel are not exceptional by international comparison, and are even relatively low. As such, the challenge of dealing with uncertainty is one we share with other countries, and is not the result of poor performance by our Central Bureau of Statistics, but of the attempt to provide data that is as good as possible in real time. We can also see that the level of uncertainty is particularly high regarding estimates of the various components of GDP, such as exports, investments, and so forth, while it is lower for GDP itself. For instance, we can see that the updates in the quarterly GDP growth data in 2013 in Israel are not unusual relative to the US or the UK, and the update that was made just a few days ago in the first quarter GDP data in the US was very significant. In view of this, we also need more “rapid” data, and we use a mix of data and indicators that help us in trying to understand developments in real time, or with a relatively small lag. I note that the fact that the Labor Force Survey has become monthly is very helpful. In this context, it is worth mentioning the Composite State of the Economy Index, the Business Tendency Survey, the Google Search Index, and internal models developed by the Bank for nowcasting, which are intended to provide a clearer picture of the current situation when statistical data have not yet been published. Monetary policy is intended to affect future developments: Policy has channels of relatively rapid effect (the exchange rate), and some of the others have a slower effect (for instance, the price of credit). In any case, an important component in the formulation of policy is the forecast, since monetary policy is, of course, forward looking. It is therefore very important that the monetary policy decisions that are made each month rely on a forecast that is as upto-date as possible. Such a forecast relies on the most up-to-date information regarding the state of the Israeli economy – based on a broad set of indicators from the labor market, various indices of economic activity, consumer confidence indices and business tendency surveys – and on the most up-to-date forecast regarding the state of the global economy, and particularly global trade, which is an indicator of demand for Israeli exports. We can see that in the forecasts and estimates regarding global trade and GDP, there are also regular updates, some of which are of considerable size. Therefore, the forecast is updated on the basis of updated National Accounts data and other recent data, and on the basis of the updated global picture. Since the beginning of the Monetary Committee’s operation, the Bank of Israel has operated a framework in which the forecast is updated on a regular basis each quarter, so that policy operates on the basis of the most up-to-date picture and forecast. In retrospect, despite the need to compile the picture and forecast on the basis of partial and delayed data, policy decisions have been made in a timely manner such that they assist the economy in dealing with shocks. This was the case in the rapid response of the interest rate to the beginning of the global crisis, and this was the case with the renewal of the crisis due to the slowdown that resulted from the European debt crisis. In summation, monetary policy relies on a picture compiled on the basis of partial data, which are received with a lag, which are updated, and which change. It also relies on a global picture that is constantly changing. The challenge faced by policy makers is to formulate a BIS central bankers’ speeches picture and forecast based on these data by using models and experience and accumulated professional knowledge. The challenge in making policy decisions is the need to remain ahead of the curve in achieving balance between the effects, in view of the lags in the effect of monetary policy, and the measured response to real developments rather than the “noise” in the data. Despite the challenge in making policy decisions in conditions of uncertainty, an assessment of the policy measures in retrospect shows that the professional tools and accumulated experience make it possible for the monetary committee to formulate a picture and make decisions in real time to attain the objectives of policy for the good of the economy. BIS central bankers’ speeches
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Remarks by Dr Nadine Baudot-Trajtenberg, Deputy Governor of the Bank of Israel, at the Globes Capital Market Conference, Tel Aviv, 2 June 2014.
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Nadine Baudot-Trajtenberg: Israel’s market developments and monetary policy objectives Remarks by Dr Nadine Baudot-Trajtenberg, Deputy Governor of the Bank of Israel, at the Globes Capital Market Conference, Tel Aviv, 2 June 2014. * * * This is my first public speech as Deputy Governor, and I am pleased to be back to speak to those active in the capital market. In my remarks, I would like to look back on the Monetary Committee meeting that took place a week ago, in which we decided to leave the interest rate at its current level, and I would like to speak about what we saw, and what we did not see, in the market’s developments. I would like to re-state that the Bank of Israel has three objectives that inform our policy decisions. The first, and classic, objective, which is so relevant to the State of Israel from an historical standpoint, is obviously price stability. The second objective deals, among other things, with real developments, and the third is not a new issue, but it is one with new importance – financial stability. This means that when we look at the data, we look, obviously, at inflation, and perhaps even more importantly, at inflation expectations. Second, we assess the real developments in the economy and interpret the new data that has become available in the past month, and third, we track developments in the assets markets, and the level of leverage in the economy, which is obviously one of the most important indicators of financial stability. Let’s start with inflation. Inflation over the past 12 months is at the lower bound of the target range of 1 to 3 percent. In contrast, expectations are closer to the midpoint of the range, although they have recently declined slightly. We also look at inflation expectations over the long term, which are also within the target range. Right now, if we analyze the relatively low level of inflation that we have, we can try to understand how much of it comes from low inflation in Israel and how much is imported from abroad. We can see that inflation abroad is also low, and the case of Switzerland is prominent, as they have been coping for some time with low, and even negative, inflation, which is obviously not the situation in Israel. If we break down the Consumer Price Index and look separately at inflation in the tradable components and inflation in the nontradable components, we can see a significant gap: Inflation of tradable goods has been negative for the past few months. In the past 12 months, prices of tradable goods declined by 0.86 percent. This means that we are basically importing deflation from abroad, some of which can be attributed to the level of appreciation of the exchange rate, and some is simply the low inflation rates from abroad. In contrast, in nontradable goods, we are still seeing inflation at the mid-point of the target range – about 2 percent. As such, when discussing inflation, we find that both the expectations, and the inflation derived from domestic developments are not in the dangerous area of deflation, in contrast with many countries in which the central banks must take into consideration the concern of entering deflation. Regarding developments in the real economy, we see that growth in the Israeli economy is very much in line with growth in the advanced economies that are our major trading partners. With that, the intensity of the waves of growth and moderation is very different. Just as in looking at inflation, here too we ask ourselves to what extent developments in Israel derive from what is happening abroad, and how much of it is derived from what is happening here. In 2013, GDP grew by 3.3 percent, but if we adjust for the effect of the start of natural gas production, growth was about 2.5 percent. The Bank of Israel Research Department’s forecast for 2014 is for growth of 3.1 percent – this is the forecast from the end of March, and obviously we update the forecast on a regular basis every three months – and after adjusting for the effect of natural gas production, the forecast is for growth of 2.8 percent. In other words, after adjusting for the effect of natural gas production, the forecast is for some acceleration of growth in 2014, and not the opposite. With that, data for the first quarter of 2014 were recently published, and were disappointing. GDP grew at a rate of 2.1 percent, BIS central bankers’ speeches including a decline in private consumption, not only in the consumption of durables, but also in current consumption, which is very rare. The last time we saw negative growth in private consumption was at the height of the global financial crisis. The question arises as to whether these are really serious signals of moderation in the growth of the economy. In this context, we must remember that first quarter data in the US and Europe were also disappointing, and some of that is related to the weather in both the US and Europe. The Americans and the Europeans did not see this as a sign of future moderation, but as a one-time development, and the update of the forecasts reflected only the surprise of the first quarter, and not expectations of moderation later on. We must assume that this development also had an impact on the Israeli economy. Beyond that, the first quarter data that were published are initial data, and we know well that these data go through significant revisions for the most part. We must therefore relate to them as part of a whole of other indicators that we look at, some of which were negative and some positive. The Composite State of the Economy Index did not change in recent months, which is certainly an indicator that points to a slowdown in the rate of growth. Goods exports (excluding ships, planes and diamonds, at current prices) have not grown for a number of quarters, and we see that in the first four months of the year, there is even a decline. Exports are certainly affected by the developments abroad that I outlined, and also, obviously, by the exchange rate. It should be emphasized that in this context, I am referring to the level of the exchange rate and not the change in it. Basically, since the beginning of the year, there has not been a material change in the effective exchange rate, following the appreciation that took place mainly in the first half of 2013. However, the level of the exchange rate has a delayed effect on exports to a certain extent, and it is therefore possible that exports are currently reacting to the appreciation that took place earlier. Among the positive indicators, Bank Hapoalim’s Consumer Confidence Index is in the positive area, and is even increasing. Services exports, which account for about one-third of exports, are growing at a respectable pace, and the main component that is growing is obviously business services, and within that, software services. These industries characteristically better absorb the strengthening of the shekel, and developments abroad also apparently have less of an impact on the consumption of services that our industries excel at producing. Health tax receipts, which provide an indication of total wages in the economy, are increasing. Basically, all of the data from the labor market indicate continued growth, although we must remember that they are provided with some delay. We see continued increase in the participation rate, decline in the unemployment rate, and growth in the number of employed persons. All of these data indicate a relatively healthy labor market, which is quite different from what we see in both the US and Europe. This growth is taking place without any pressure on wages. In both the business sector and the public services sector, wages are quite stable, which says that the labor market has not yet exhausted its growth potential, and is thereby not leading to inflationary pressure. As such, overall, developments in the market do not provide a clear picture, and we can even say that they provide more of an Impressionist picture, and that anyone can interpret it any way he wishes. The data that we saw, in any case, did not lead to a clear conclusion that made it necessary to change policy in either direction. The third objective of the Bank of Israel is to support financial stability. In this context, it is of particular importance that we look at the level of leverage in the economy, and at asset prices, and ask ourselves whether we see any risks from this direction. In many places, including at this conference, and certainly at many central banks, people deal with the very complex issue of the low interest rate environment, both in Israel and abroad, and with the distortions that may be created by such a low interest rate level. This is also an issue that we discuss. When looking at early indicators of financial instability, we need to look not only at the levels, but also at the growth rates – of both prices and of levels of leverage. And here, the picture that we have in Israel is quite different from almost every other economy that we know. The overall burden of debt in the economy – the total debt of the public sector, the business sector, and households, relative to GDP – has been declining very slowly over the BIS central bankers’ speeches past few years. The government is adopting a long-term policy of reducing the debt burden, and we can see that between 2007 and 2013, the burden of debt of the public sector declined by 7.5 percentage points. In contrast, in most advanced economies, we saw very rapid growth in the public sector debt – 29 percentage points in Europe, and 40 percentage points in the US. In terms of the level, Israel’s debt-to-GDP ratio stands at 67 percent, a marked improvement compared to the past, even from the standpoint of relative position. If we look at the business sector during the same years, we can see that in Israel, there was a decline of 25 percentage points in the ratio of business sector debt to GDP, and this is also very different than any other place in the world. In the US, despite a number of years of credit crunch as a result of the crisis, there was growth of 11 percent, and growth of 14 percent in Europe. It should be noted that debt in some countries did not change a lot, and the growth in the ratio is a result of contraction of GDP. In terms of the level, we are at a relatively low level of business debt to GDP, 73 percent, compared to 85 percent in the US, and 110 percent in Europe. Among households as well, we see a very different picture than what we see in other countries. In some countries, the crisis was a result of surplus household leverage, and they needed to undergo a deleveraging process. That is beginning to happen in the US, with a decline of 10 percent, and in Ireland, and Spain as well, but there are still a number of countries in which this process has still not taken place, and we must expect that it will take place. In Israel, on the other hand, total household debt as a percentage of GDP remained quite stable during this period, despite the very rapid growth in the balance of mortgages. The level is also relatively low, 39 percent compared to 71 percent in Europe. The Americans are known to take credit more lightly, and there, the ratio is 82 percent, as stated, following a decline of 10 percentage points in recent years. To sum up the picture of credit, credit to the business sector is in a virtual standstill, and the only growth we have seen is in housing credit, which has not led to an increase in the household debt ratio, which is still at a relatively low level. The decline in credit to the business sector perhaps compensates somewhat for the relatively sharp growth we saw prior to the crisis, but to some extent, it is still a mystery. An economy that continues to grow needs credit, and we have not seen an increase in credit, either from the banking system or from non-bank sources. The rate of bond issuances has slowed recently, of which issuances in the real estate sector increased significantly this year, which is something that we are obviously continuing to look at, although the quality of credit by rating has improved this year. As such, the issue that we need to think about is that the economy is growing while there is no increase in credit to the business sector. We will try to look at the price of credit, and for this purpose, we will assess the Tel Bond spreads. If the lack of growth in credit was a result of a lack of supply, we would expect to see an increase in the price of credit. In contrast, we see a decline in the spreads, which points to a situation of a lack of demand for credit. Another interesting phenomenon is the spread between the short-term interest rate and the long-term interest rate, which is relatively high over time in Israel. In each period, there was apparently a different explanation for the relatively high spread in Israel. In 2000, the period was the beginning of large Shahar 10-year bond issuances, and there were still concerns of inflation, which could have led to higher spreads. Afterward, in 2006–07, there was an extraordinary boom period abroad, with much less here, so the spreads were perhaps greater in Israel. Even if the explanation is different for each period, it apparently reflects a higher long-term premium in Israel, meaning that despite the decline in the monetary interest rate, the long-term risk in Israel is apparently greater than in the rest of the world. There are price increases in the stock market, no different than what we see in other countries. In summation, when we look at the Bank of Israel’s three objectives, the low inflation is apparently partly due to imported inflation from abroad. The picture of real economic activity is unclear, with some negative and some positive indicators, particularly in the first quarter. In terms of leverage, there are high levels of housing credit, but we don’t see very high levels of leverage in the overall economy that could lead to a dangerous path. Summing up all of these components, the Monetary Committee decided to leave the interest rate unchanged this month. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Manufacturers' Association Conference, Eilat, 21 November 2014.
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Karnit Flug: Challenges facing manufacturing and Bank of Israel’s policy to deal with them Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Manufacturers’ Association Conference, Eilat, 21 November 2014. * * * I was asked to open my remarks by sharing with you the answer to the question, “What manufacturing means to me?” I spend a lot of time visiting manufacturing plants throughout Israel. Each time I make such a visit, I am deeply moved by the industry creativity, initiative, innovation and the ability to continue creating even during periods of missiles and sirens. Manufacturing for me is first of all an important source of employment and economic growth. Manufacturing operates in a changing world, and in order to continue succeeding, it needs to adapt to changes in the global competition environment, in the financial environment, in the regulatory environment, and also to adjust to changes in the public discourse which, in recent years, has placed a heavier emphasis on economics, consumerism, the cost of living, and other things. It is important for me to emphasize that in order for manufacturing to success, it must be profitable, since no one establishes a plant out of the goodness of their heart, and certainly not over the long-term. In order for industry to succeed, it must be competitive, and its employees must enjoy the proper fruits of that success. The success of Israeli manufacturing is the success of the Israeli economy, and the success of us all. I would like to discuss the challenges facing manufacturing in the short term in a challenging global environment, and to outline how the Bank of Israel’s policy acts to encourage growth at this time. In the longer term as well, there are significant challenges facing us, including the need to increase productivity, so that manufacturing can compete in the global world. I will also discuss what policy is required in order to deal with these challenges. The short-term challenges, and the Bank of Israel’s policy to encourage growth In recent years, growth in the Israeli economy has been slowing, in parallel with the slowdown in growth worldwide, both in advanced economies and in emerging economies. The decline in GDP during the third quarter is obviously also a result of Operation Protective Edge, and we can expect that the figures for the final quarter of the year will already show a return to the growth rates that have characterized the economy in recent years, of slightly below 3 percent. The main factor in the moderate growth is moderate global demand, which is reflected in a virtual standstill in global trade of goods – where Israel’s goods exports have been even lower than it in recent years – and a moderate increase in the global trade of services, where the Israel’s services exports have grown more rapidly than it. The global slowdown, combined with global supply factors, are reflected in a decline in global commodities prices, particularly oil, and together with the slowdown in demand, these are reflected in a sharp decline in inflation in Israel. This was also affected, until recently, by the prolonged appreciation of the shekel, which eroded the competitive ability of Israeli manufacturing. Against this background, the Bank of Israel acted both by continuously reducing the interest rate to a low level of 0.25 percent, and by intervening in the foreign exchange market, inter alia to offset the effect of natural gas production on the exchange rate. This policy, alongside the strengthening of the dollar worldwide, has generated a turnaround in the exchange rate since the last two interest rate reductions, and the shekel has since depreciated by 6.5 percent in terms of the nominal effective exchange rate, and by 12 percent against the dollar. The current exchange rate certainly makes it easier for Israeli manufacturing to compete in the challenging global environment. BIS central bankers’ speeches The long-term challenges: gaps in productivity and per captia GDP vis-à-vis the other advanced economies Per capita GDP in Israel is about 60 percent of what it is in the US, and about 87 percent of the OECD average. The gap has narrowed since the global financial crisis, since we bridged it with relative success, but over time it has remained in place. An assessment of the source of the gap shows that it is not the result of employment rates. Employment rates in Israel have constantly increased, while in most of the advanced economies, including the US, they declined, mainly following the crisis. As of today, the employment rate in Israel is higher than in the US, and higher than the average among advanced economies. In contrast, productivity in Israel, which is measured as product per hour of work, does not close the gap with the OECD countries, and the gap has even widened relative to the US. An assessment of the gap by industry indicates that export-oriented industries, which was exposed to international competition, tend to have higher productivity than their peers in other countries, while domestic-oriented industries (both in manufacturing and in other industries) have lower levels of productivity than the same industries in other advanced economies. Focusing on the manufacturing industries indicates that productivity in these industries has increased relatively rapidly – reflecting, over time, the increase in the weight of high-productivity industries that are human capital and physical capital intensive, and a decline in the share of low-technology manufacturing. Against this background, there was no long-term increase in employment in manufacturing. What are the main factors in the relatively low productivity of the business sector in Israel? The first factor is the low capital inventory per employee, which reflects a low rate of investment in product compared to other advanced economies. Here too, there is obviously a gap between various industries: In those that are technology intensive, investment grew relatively rapidly, and with it human capital and productivity, while in other industries – such as agriculture, trade and services, and low-technology manufacturing – where most of the output is intended for the domestic market, investment is relatively low, which is reflected in a slight increase in labor productivity. Productivity is obviously also affected by the amount of innovation, which relies on research and development. The national expenditure on research and development in Israel is higher than in other countries, reflecting the relatively high weight of technology-intensive industries, which are obviously also research and development intensive. However, over time, the government’s share of investment in R&D has declined, and it is lower than in other countries. There are naturally large differences between various industries in expenditure on research and development. However, we can see that internationally as well, the gaps in expenditure on innovation among the manufacturing sub-industries in Israel are particularly large. While the communications industry and the medical devices industry invest much more in R&D than their peers in the OECD (and we have also seen that productivity in these industries is higher when compared internationally), the plastics and food industries invest far less, in international comparisons as well. Alongside low investment in physical capital and in research and development, the low investment in professional training, and to a certain extent in technological education, is also prominent. Effective and focused professional training is tremendously important for the ability to provide manufacturing with the human capital it requires, and a public discourse is currently taking place regarding how to most appropriately provide this training. Another factor that negatively impacts business sector productivity is the business environment, as reflected in the World Bank’s Doing Business Index. According to this index, we fell two more places in the rankings in the past year, and since 2007, we have fallen from BIS central bankers’ speeches 26th place to 40th place in terms of the business environment. The decline in the ranking does not necessarily reflect an absolute worsening, but it certainly does reflect the fact that other countries have focused on improving their business environments, while we have remained behind. In a competitive world, the determining factor is obviously our relative position. It is also clear that wages which, in a competitive environment are consistent over the long term with labor productivity, can rise over time only if we do what is required to accelerate increased productivity and to expand it to all industries. The policy required to cope with the long-term challenges In view of the weaknesses that I have mentioned, which stand behind the fact that labor productivity in Israel is increasing slowly and that its level is still significantly far from the forefront of the advanced economies, the directions that must be taken in order to accelerate and expand the increase in productivity are clear: It is worthwhile incentivizing and supporting the adoption of advanced technologies and technological improvements, particularly in industries that are typified by low technological intensity, whether in the manufacturing industry or in the services industries. Due to the continuing decline in the Chief Scientist’s budget as a share of the state budget and of GDP, and in view of the high return on such support to the economy, it is worthwhile diverting budgets to such activity, while also involving medium and low technology manufacturing. Professional training programs must be expanded, improved, and streamlined, with an emphasis on post-secondary frameworks. It is worthwhile expanding technological-scientific studies in the secondary schools, and supporting post-secondary technological studies, including those in technological colleges. Achieving the required improvements in the business environment, while focusing on the main points of weakness, concerning bureaucracy in the fields of construction and real estate, in the legal environment, and so forth, should not be abandoned. Infrastructure reforms, including in the electricity field and in the ports, as well as connecting manufacturing to the natural gas infrastructure, should be advanced. The implementation of a policy to improve manufacturing productivity in Israel is the key for manufacturing to remain strong and to provide quality employment for all parts of the population in all parts of the country. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Pensions, Insurance and Financial Literacy Research Center, Ben-Gurion University, Beer-Sheva, 20 November 2014.
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Karnit Flug: Challenges in the field of pension savings Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Pensions, Insurance and Financial Literacy Research Center, Ben-Gurion University, Beer-Sheva, 20 November 2014. * * * Good morning, The festive opening of this institute is a very important event, and its work plan seems promising. There is tremendous importance to raising awareness and research on the matter, and action in this direction is to be welcomed. It is also important to improve the public’s ability to make an informed decision in this field as this is one of the most important financial decisions a household makes. I therefore see tremendous importance in working on financial literacy. I would like to briefly touch upon a number of facts and trends that point to the challenges in the field of pension savings, and then to present a series of questions that I believe are proper to deal with in an institute such as this. Projected demographic trends As we know, life expectancy is increasing, and if we look at the past 40 years, the life expectancy of those reaching age 65 increased from 80 years to 86 years for women, and from 79 years to 84 years for men. This fact, together with the fact that the retirement age increased by only two years, means that men are expected to live an average of 17 years after retirement and women are expected to live 24 years after retirement. This leads to the question of whether, during the working period, the public is saving enough to ensure a proper income at retirement age. Another way of looking at the demographic change is to look at what is happening to the ratio between the working-age population and the retirement-age population. The trend in Israel is similar to the trend in other countries in the world, although with some lag. As of today, there are 5 working-age people for each person over age 65 in Israel, while the ratio in 2050 is expected to narrow to 3:1. This change obviously has serious implications for the labor market, the dependency ratio, and various aspects of policy. An international comparison of retirement arrangements shows that in Israel, the retirement age for women is relatively low, and even after it is raised to 64, as is supposed to happen in 2017, it will be significantly lower than in most European countries, some of which are also in a gradual process of raising it. The retirement age for men in Israel was raised to 67, and is similar to the retirement age among European countries that have already raised it, and is at the upper threshold. The large gap between men and women in Israel is prominent, and raises a question regarding the ability of women to save enough for retirement. The more the decision on an additional increase in the retirement age for women is delayed, the more it will be necessary later on to do so more rapidly, which will be more problematic. And what is happening to long-term savings? There has been a significant increase in the volume of assets under management by longterm savings plans in the past 14 years, from about 57 percent of GDP to about 90 percent of GDP. One of the significant processes behind this increase is the enactment of the Mandatory Pension Law in 2008, which requires workers and employers to set aside a significant percentage of their income for pension. In addition, during this period, there was a gradual transition in the public sector from defined benefit pensions to defined contribution pensions, with all employees who began working in the public sector from 2004 onwards contributing to defined contribution pensions. The volume of assets increased, although it is BIS central bankers’ speeches volatile: for instance, the decline during the financial crisis, such that someone who retired at that time saw lower accumulated savings that he had expected. Looking at the distribution of main assets in the investment portfolios of the long-term savings plans, we can see a gradual and continuing decline in the share of designated bonds, together with an increase in the weight of stocks, corporate bonds and investments abroad in the portfolio, so that the share of the components that are more sensitive to developments in the financial markets is expanding over time. In terms of the composition of investment portfolios by type of plan, we see that the in plans in which more veteran members save (old pension plans and plans that ensure a yield), the weight of designated bonds is relatively high, and the weight of the assets that are sensitive to the financial markets is relatively low. In contrast, in the investment portfolios of the plans in which new members are saving (new pension funds, and profit-sharing funds), there is a much higher weight given to investments abroad, stocks, and corporate bonds, which leads to higher exposure to developments in the financial markets. These investments finance economic activity and development, but are also exposed to higher volatility. The impact of the trends on the replacement ratio In view of the trends I have presented to this point, the interesting question is what will happen to the level of the pension payout at retirement age. The commonly accepted variable to look at in this context is the replacement rate – what will the retiree’s income be compared to his pre-retirement salary. In a simulation of the net replacement rates including defined benefit pensions and old-age pensions, we focus first on women with a relatively low income of NIS 7500 a month. Women who retire at age 62, whose pension savings have generated an average real yield of 2 percent per year, and whose pension contributions are 17.5 percent of their monthly salary, will have a replacement rate of 54 percent. In contrast, if the yield is 4 percent per year and pension contributions are 19.5 percent of monthly salary, the replacement rate will be 76 percent. Men who retire at age 67 and earn NIS 7500 a month at retirement age, whose pension savings have generated an average real yield of 4 percent per year and whose pension contributions are 19.5 percent, will have a replacement of almost 100 percent. In contrast, if the average real yield is 2 percent and the contributions are 17.5 percent, the replacement rate will be just 66 percent. The replacement rate will be significantly impacted by both the retirement age and the amount of contributions to savings. This situation, which is similar among those with higher salaries, raises questions on both the individual level and the policy level. These are the issues that the institute being launched now should deal with. I will also present a number of questions, on the individual level, on the policy level, and a number of questions for research: Size of the payout: – What is a reasonable replacement rate? – How do we deal with the increase in life expectancy? – How do we deal with the ramifications of the low interest rate environment on the yields of pension savings? – How do we deal with the ramifications of high volatility on the yields of pension savings? – What are far management fees that also allow for the quality management of pension savings? BIS central bankers’ speeches The efficient allocation of public resources: – How do we use and allocate the designated bonds among the various long-term savings plans and instruments in the best possible manner? – What is a fair and efficient allocation of tax benefits? – What is the proper way to handle the population that will be retiring in the next few years without sufficient pension savings? Questions relating to the investment portfolio of the institutional investors? – What is the optimal composition of the investment portfolio in the context of the transition from classic investment channels to other channels (direct credit, real estate), and in the context of the diversification of investments abroad? – What effect does the tension between the short-term measurement method of the plans’ achievements and the need to create long-term yields and repayment abilities, which is what is relevant to the saver, have? Does the method of measurement not create short-term competition, which is not necessarily optimal? – What is the proper extent of the investment portfolio’s exposure to investments abroad and to foreign currency? Financial education: – What is the proper balance between the decisions of the individual and regulatory intervention? – What are the tools that need to be provided to the public in order for them to make informed decisions about their pension savings? Questions for research: – Can we estimate the effect of savings enforced by the Mandatory Pension Law on developments in various markets (household credit, and so forth)? – How does mandatory pension affect total savings? – How can we balance the need to direct long-term savings to support for business sector growth and the maintenance of a reasonable level of certainty for retirement age? In summation, the institute currently being launched has a great deal to do, both in the field of broad empirical research and in the field of research on questions of policy. The activity to increase the public’s financial literacy will help all of us make informed decisions regarding the question that is perhaps the most important in the area of household financial decisions. I wish the people of this institute success in your important endeavors, and I await the opportunity to learn from the fruits of your labor. BIS central bankers’ speeches
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Main points of remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Jerusalem Ultra-Orthodox Campus of Ono Academic College, Jerusalem, 1 December 2014.
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Karnit Flug: Strengths and challenges facing the Israeli economy Main points of remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Jerusalem Ultra-Orthodox Campus of Ono Academic College, Jerusalem, 1 December 2014. * * * The Israeli economy is an open economy that is greatly influenced by developments abroad, which is reflected in growth rates in the economy, which are very much connected to those around the world. The influence of activity abroad is mainly reflected in global trade, which affects demand for Israeli exports, both in goods and in services. Goods exports are in a virtual standstill, due to the standstill in global trade. They declined slightly in 2013 and recovered slightly during 2014. Services exports showed better performance than global trade in services – meaning that the state of manufacturing was more serious than the state of the services industries, which is also a result of developments in the exchange rate. The labor market is in relatively good condition, with the unemployment rate at very low levels despite the continuing trend in the labor force participation rate, and the result is a trend of increase in the employment rate. This is a different picture than what other countries are experiencing, and an indication that the labor market is showing relative robustness, as is also reflected in an international comparison of unemployment rates. Bank of Israel policy acts to achieve the Bank of Israel’s objectives as defined by law. The main objective is to attain price stability, meaning meeting the inflation target and, subject to that, supporting other economic objectives such as growth, employment, and financial stability. In recent months, the inflation rate has been below the target range, and in the past 12 months, prices have declined by 0.3 percent. The main reason for this is the decline in commodities prices abroad, reflecting stagnation in the global economy, apparently low demand abroad, and relatively moderate demand in the Israeli economy. Even though we have not seen a decline in private consumption, we have seen a decline in investments and in exports. Until a few months ago, there was also a sharp appreciation of the shekel, which also contributed to lower prices. The appreciation also made it difficult for Israeli exporters to compete in the global economy, and it therefore definitely bothered us at the Bank of Israel. Monetary policy’s response to these developments was a prolonged reduction in the interest rate, to the historically low level of 0.25 percent, and foreign exchange purchases that acted to moderate the appreciation of the shekel. In recent months, we have experienced a depreciation, which has made it easier for exporters to compete, and is also contributing to a return of inflation to the target range. The Israeli economy enjoys a number of points of strength, which stand behind the technology driven growth of the economy in recent years. Israel enjoys a very high rate of people with post-secondary education, a very high level of research and development, which is carried out mainly by the private sector, and a high percentage of high technology industries in the economy. These are the strong points upon which economic growth has relied thus far. The Israeli economy is also faced with many challenges. The level of per capita GDP is low compared to other advanced economies, so that we still have quite a way to go to reach the global frontline in terms of quality of life. The main explanation for this is that labor productivity in Israel is significantly lower than in other advanced economies, and we are not succeeding in closing the gap over time. The productivity gap is very different among the various industries and sectors. In export-oriented industries, which need to compete with the parallel industries abroad, productivity is relatively high, and in most of them, it is higher than in other advanced economies. The industries that concentrate on production for the domestic economy suffer from relatively low productivity. BIS central bankers’ speeches Israel has one of the highest levels of income inequality in the world, despite a slight improvement that has taken place in the past few years. The high poverty rates are also a significant challenge. We can see that in households with two wage earners, the rate of poverty is very low. This is not a surprising statistic. In addition, poverty among ultraOrthodox households (47 percent) and Arab households (54 percent) is much higher than among the general population (12.5 percent). These trends are very much a result of the relatively low labor force participation and education levels, as I will show. In recent years, the achievements of the Israeli education system have been lower than the OECD average, which is certainly a worrying situation, mainly for a country whose growth strategy is based on human capital. We do not have the findings of international tests for ultra-Orthodox boys, but we can see that for girls in the ultra-Orthodox sector, the marks are lower than for girls in the public and public-religious school systems. Employment rates in Israel are similar to those in other OECD countries, and the employment rate for ultra-Orthodox women is very similar to the general average. In contrast, employments rates for men are particularly low. Over time, we can see a sharp increase in employment among ultra-Orthodox women, but we cannot distinguish such a trend among ultra-Orthodox men. This is also obviously a result of education trends – the rate of higher education among the ultra-Orthodox population is particularly low, and we cannot distinguish a higher rate of those holding an academic degree among the younger population, which is certainly a worrying phenomenon. We can see that among the ultra-Orthodox students, there is a focus on professions such as business management and law, and that among women there is also a focus on therapeutic professions. Over time, we do not see growth in the rate of those with higher education among ultra-Orthodox men. There is no doubt that the way to integrate successfully in the labor market is to obtain an academic education. We can see that those holding degrees enjoy much higher rates of employment, and much higher wage levels, than those who do not hold such a degree. There is broad agreement regarding the policy measures required in order to increase education and employment rates among the ultra-Orthodox sector. These need to be implemented: • It is important that the education system provide an infrastructure that will assist in obtaining a higher education later in life. • The variety of higher education fields must be expanded so that it boosts broad and variegated integration in the labor market. • It is important to adapt the professional training program to the needs of the labor market, while relating to various population groups. Investment in professional training in Israel is relatively low, and it is important to expand it among the general population, not just in the ultra-Orthodox sector. • An expansion of the active labor market policy is required. • It is important that employers be ready to absorb employees from all sectors and population groups. Employers who are open to taking on employees from the sectors with which they are less familiar will enjoy a broader variety of manpower that is available to them. These policy tools can provide the opportunity. In the end, it is the individual that needs to take that opportunity. As such, I am very happy to say these things here, before a group of students that have chosen to obtain an academic education and make the required effort to successfully integrate in the Israeli labor market. BIS central bankers’ speeches
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Speech by Dr Karnit Flug, Governor of the Bank of Israel, at the Israel Economic Association Conference "Productivity in Israel - the key to increasing the standard of living: overview and a look ahead", Tel Aviv, 1 June 2015.
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Karnit Flug: Productivity in Israel – the key to increasing the standard of living: overview and a look ahead Speech by Dr Karnit Flug, Governor of the Bank of Israel, at the Israel Economic Association Conference “Productivity in Israel – the key to increasing the standard of living: overview and a look ahead”, Tel Aviv, 1 June 2015. * * * Highlights: • Macroeconomic policy aims to achieve the potential growth in the short term. Potential output is determined on the basis of investment in growth drivers that we first made many years earlier. We need to focus long term policy on an effort to break the productivity barrier, in order to ensure sustainable and inclusive growth, prosperity, and a suitable standard of living. • Despite the growth in labor input, the output gap between us and advanced economies isn’t closing. This is a result of low capital stock and investment, poor infrastructures, inadequate government investment in research and development, and an inefficient business environment. • Expected trends in world trade, global growth, demographics, and human capital development, will reduce the growth of Israel’s economy in the coming decades. The convergence of employment rates among the Arab and ultra-Orthodox sectors, and of the relevant educational patterns among the ultra-Orthodox, to those of the overall population will be able to reduce the extent of the negative impact on per capita GDP and support a broadening of export industries and destinations. • The economy’s relatively good macro situation enables us to focus on dealing with the longer term economic challenges. There are many, complex, challenges, but dealing with them is critical to our success, and to the benefit of the entire population in the coming years. • In order to ensure our economic and social future, we must courageously look at the current situation, and begin even now to work to ensure an increase in productivity that will allow an extended increase in the standard of living of all citizens of the country. Israel’s economy, as is known, made it through the global crisis better than most other advanced economies, and we benefit from a relatively good macroeconomic situation, among other things due to proper macroeconomic management in the years prior to the crisis, and determined management of policy during and after the crisis. Correct macroeconomic policy is obviously a very important component in ensuring growth and prosperity. However, it must be remembered that at any given time, macroeconomic policy acts within a framework of long term economic variables. Macroeconomic policy, and monetary policy in particular, leads to full utilization of potential output in the short term – but that same potential output is determined, at the end of the day, on the basis of investments in education, infrastructures, and other growth drivers that were made more than two decades earlier. In my remarks, I will focus on the issue of productivity, which has challenged us for years, and as we will see, is expected to continue to challenge us in the future in view of the global environment, as well as in light of long term processes occurring in Israel. The analysis I will present indicates that continuing the present conduct will ultimately lead us backward. We must focus policy on efforts to break the productivity barrier, in order to ensure inclusive and sustainable growth, prosperity, and a suitable standard of living, and at the same time to BIS central bankers’ speeches continue to maintain macroeconomic stability and strengthen the economy’s resilience to shocks. GDP per capita in Israel is around $32,500 in purchasing power parity dollars, compared with close to $38,000, on average, in OECD countries, or $53,000 in the US. This is a significant gap, and it can be seen that while the labor input has increased relatively rapidly since 1995, and has made a marked contribution to per capita GDP growth, GDP per hour of work, or labor productivity, nonetheless grew at a very moderate rate. The relatively rapid increase that we saw in labor input was reflected in a relatively rapid increase in the employment rate, even compared with the growth rate of employment in OECD countries, and despite our having two population groups with especially low employment rates, we have reached an employment rate that is high compared with other countries. In contrast, labor productivity is especially poor, and is about 13 percent lower than the OECD average, and more than 40 percent lower than the productivity level in the US. This is the source of the gap in GDP per capita, and thus in the standard of living, between us and other advanced economies. The fact that there is a gap would trouble us less if we would be seeing that the gap is closing. We would have expected a process of convergence – that is, a situation in which a country with relatively low productivity sees a higher rate of productivity growth. However, the rate of productivity growth in Israel is markedly lower than that derived from the low level of productivity. Clearly, that is an aggregate view, and at high resolution differences can be seen in the productivity level of different industries. In industries in which a large part of output is export oriented, and that are exposed to competition from abroad, there is a positive productivity gap – that is, their level of productivity is greater than the OECD average. In contrast, in industries that are oriented to the domestic market and are less exposed to competition from abroad, or to any competition, such as construction, electricity, water, and food, the level of productivity is lower than the OECD average. As such, I will focus on an attempt to answer the question of what has caused the output per hour of labor in Israel to grow relatively slowly and to be lower in Israel than in other advanced economies. I’ll present now a schematic diagram of the factors impacting on productivity and on GDP. GDP is affected first by factors of production – capital, human capital, and labor. These enter the production function – technology – and are affected as well by frictional factors, such as regulation, the business environment, etc. All these ultimately impact on output per hour of labor, which is the main factor in determining wages. Likewise, each one of the components in the production function is likely to be affected by policy. Thus, for example, the quantity of production factors available to the economy is impacted on by the level of investments, the labor input is impacted on by the government’s labor market policy and by the quality of education, and policy can also influence the production function itself – on the adoption of technology, and of course on the business cycle as well. Capital stock per employee in Israel is markedly lower than in advanced economies – and not only is there a gap in the stock of capital, but the gap is not closing because the rate of investment is lower than in advanced economies. The level of investment in infrastructures is also low, and in most years is around 2.5–3 percent of GDP. Extensive government investment in infrastructure is a complementary factor to investment by the business sector in productive capital. In a recent report, the International Monetary Fund found that investment in infrastructure makes a marked contribution to GDP growth. As such, the low level of investment adversely impacts labor productivity in Israel. The relatively poor investment in infrastructure is also reflected in the poor level of quite a few infrastructures in Israel, particularly in the areas of transport and shipping, and perhaps surprisingly, even the share of Internet users in Israel is low in comparison with other countries. As noted, the labor input is relatively high, and the number of work hours per employed person in Israel is also relatively high. Employees thus contribute their share to production; however, taking into account that at a given level of capital stock and infrastructures, the marginal product of labor eventually declines, the high number of work hours contributes to relatively low output per hour of labor. BIS central bankers’ speeches One of the factors impacting on productivity – technology – is the expenditure on research and development. In this parameter, Israel is among the leaders since the share of R&D in output is relatively high, as a consequence of the high share of ICT industries in Israel. Some of the knowledge acquired within the framework of these industries’ R&D eventually is expressed in production abroad, but there is no doubt that the fact that the development centers of major international companies are located in Israel has positive external effects. In any case, this is mainly private R&D. Government expenditure on R&D is relatively modest, at only one-half a percentage point of GDP, compared to 0.7 percent, on average, in the OECD, or 0.9 percent in the US. The importance of government expenditure on R&D can be important particularly for the low technology industries that are not at the forefront of technology, and for whom assistance with R&D can contribute to increasing innovation and improving competitiveness vis-à-vis foreign competitors. Policy also impacts on the environment in which the business sector works, and in this regard I will again note Israel’s not-respectable rank – 40th place – in the World Bank’s Doing Business index, which measures the bureaucratic burden in the economy. To my regret, this is a marked decline in the ranking relative to our place 7 years ago – 26th place – not because we are moving backward, but because the improvement, if any, in the bureaucratic burden for us is slower than in other countries. In view of the fact that the business sector competes with manufacturers in other countries, it is of course another disquieting finding. There are areas such as registering property, dealing with construction permits, and others, in which there are more than 100 countries that are in a better situation, in this regard, than Israel, which obviously has an impact on economic activity. Until now we have discussed the supply side, but growth in Israel is very affected by the demand abroad for Israeli products, and thus is aligned with global growth. In recent years, the connection has become even tighter, as the share of exports in GDP is increasing, and there is a high correlation between Israeli exports and world trade. Accordingly, the forecast for world trade is another factor that we need to take into account when we think about the future of Israel’s economy. Let us now examine which factors are expected to continue and affect productivity and growth in the coming years. The first factor is the development of the global economy, and it is not heartening – in recent years there has been a marked slowdown in growth of advanced economies and some slowdown in emerging markets, and the forecast is for the growth rate to increase slowly in advanced economies, and to continue to decline in emerging markets. There is broad agreement on the assessment that the rate of global growth over the next 5 years will be markedly lower than that of the decade before the crisis. Different economists use different terms in order to describe this – Summers speaks of “secular stagnation” and forecasts a marked moderation for a considerable time, while Rogoff is slightly more optimistic and speaks of a “super debt cycle”, a process in which high levels of debt are what lead to, at least in the medium term, expected moderate global growth. In any case, the moderate expected global growth will impact on Israel’s growth as well. Moreover, the assessment based on the IMF’s analysis is that the connection between global growth and world trade has weakened in recent years, and is expected to be weaker than in the past. Some countries whose past contribution to growth of world trade was very high are going through a growth reorientation process toward domestic market oriented growth, and therefore for given global growth we will see a more moderate increase in world trade. Due to the fact that global growth is translated into demand for Israeli output through world trade, this development is expected to be significant for the Israeli economy. It should be emphasized that this is a slowdown in the long term component of world trade, beyond the short term cyclical slowdown. We have thus surveyed two global trends that are expected to act adversely on growth in Israel – a slowdown in global growth, and a slowdown in world trade for a given level of growth. The estimated combined impact of both these trends is that they will reduce growth in Israel by 0.4–0.8 percentage points, relative to the growth seen in the decade prior to the crisis. BIS central bankers’ speeches A second factor, which is also behind some of the trends in the slowdown of global growth, is the demographic factor. In Israel, based on Central Bureau of Statistics projections, two intertwined trends are expected. The first is a change in the composition of the population: within 50 years, the share of non-ultra-Orthodox Jews will decline from 70 percent to around 50 percent, the share of the Arab population will increase slightly, and the share of the ultraOrthodox population will increase from 10 percent to around 27 percent. The second trend is of course the aging of the population – the share of the population over the age of 65 will increase from around 10 percent to around 17 percent. The significance is that there will be a slowdown in the rate of growth of the working age population. In addition, if there will be no change in the employment rate of the Arab and ultra-Orthodox sectors, aside from the trend of slow improvement seen in recent years, the increase in the share of these groups in the population will also lead to a decline in the participation rate and the overall employment rate. These demographic changes, which are seen already today, are also expected to impact markedly on future growth. Thus, if there won’t be a continuation of the process of rising participation rates of the Arab and ultra-Orthodox populations, the combined demographic changes are expected to reduce future annual growth by around 0.6 percentage points. In contrast, if the process that has begun – of an increase in the participation rates of these groups – will persist, the negative impact on growth can be reduced by about a third, to 0.4 percentage points per year. The third factor that impacts on growth here and worldwide is the rate of increase of the population’s human capital, as measured by years of education. After an extended process of notable increase in the population’s education level, a marked slowdown in this process is expected, because the increase in higher education attainment by most of the population is expected to reach exhaustion. Based on research by Eyal Argov of the Bank of Israel Research Department, if there is no change in the ultra-Orthodox population’s patterns of attaining education that is relevant to the labor market, the trend of slowdown in the human-capital growth rate is expected to reduce per capita GDP growth by around 0.2 percentage points per year in the coming years. If there is a change in the patterns of educational attainment among this population, so that the education attained is relevant to the labor market to an extent that is similar to the rest of the population, the change may be reduced to about half, meaning 0.1 percentage points per year. What is the significance of these trends? If we won’t affect the underlying factors that lead to our productivity being low and slowgrowing, not only will we not reach GDP per capita levels that are similar to the most advanced economies, but the demographic trends and the process of exhausting the increase in the educational attainment that we have described so far are expected to act toward a notable slowdown in the future rate of GDP per capita growth. A scenario of convergence – of both employment rates and the relevance of education – to the patterns of the general population will reduce part of the negative impact on GDP per capita. Global economic trends are also, as noted, a headwind to growth. These all sharpen the need to use all the instruments available to us in order to encourage the growth of productivity in the economy, in a manner that allows the continued rapid growth of standard of living, at a rate we have seen until now, and maybe even higher. So what needs to be done? Populations should be integrated into employment – including active labor market policy The expenditure on services supporting employment in Israel is low relative to levels generally seen in advanced economies, and thus it is even more important to formulate a policy that is effective, consistent, and focused on providing an incentive for employment. In BIS central bankers’ speeches this regard, it is important to maintain the link between the provision of services supporting employment and actual employment. For example, linking the subsidy for daycare centers to the employment of both parents is an important device for encouraging integration into the labor market; it is a mistake to abandon it. In addition, the earned income tax credit (negative income tax) – a mechanism that deals with the problem of the working poor and does not adversely impact the incentive to work – should be increased. At times, in the first stages of entering the labor market, there is actually a decline in output per worker, since usually it involves unskilled workers, and it is likely that the improvement in the economic situation is not large, or is even minimal, in view of the fact that going out to the labor market involves costs, such as childcare, etc. With time, the workers acquire the required skills, which improves their output and wages, and as a direct result, overall welfare in the economy. Furthermore, joining the labor supply has an impact on the next generation, including values, education, and more. There is further potential for increasing employment rates, among older workers. It is important to implement policy measures that support the ability of such workers to reach their full potential, and in this regard I again note the need to increase the retirement age. Human capital should be increased, with an emphasis on education and professional training • Improve the education system and the schooling infrastructure • Furnish the skills that are critical to successful integration into the labor market, such as math, science, and English, to the ultra-Orthodox population as well • Reduce the high-school drop out rate, strengthen science and technology abilities, and improve Hebrew language skills in schools in the Arab sector • There is room to markedly expand the technological professional education. At the high school level, general scientific and technological content should be provided, which will allow a choice between a professional track and an academic track at a later stage, and to concentrate the professional education primarily on focused training after military service (and not by placing students in specific tracks). In the dynamic modern labor market, professional training in school is likely to be obsolete by the end of youths’ military service. Factors supporting growth and productivity should be dealt with: • Infrastructure • Improve the business environment and reduce regulation • Competition – in those industries that are not exposed to domestic or foreign competition • Promote reforms (ports, electricity, and the energy and gas industry) • Improve and increase efficiency of public services systems – education, health (with a view to the aging population), welfare (by improving employment tests that allow increased focus of support) Expand export industries and destinations. We have seen that in export industries, the need to compete vis-à-vis abroad leads to higher productivity. • New markets: Israel’s exporting has gone a long way to gain access to new markets, and we should continue to work to expand the range, especially against the background of the low potential growth of our traditional export destinations. BIS central bankers’ speeches • New exporters: We should provide assistance to small/medium manufacturers to deal with difficulty of breaking into global markets, through already existing government mechanisms as well. • Encourage R&D not only for high technology industries, but also for low and medium technology industries in which innovation can make the difference between success or failure, and to improve the ability to export and compete abroad. Against the background of Israel’s relatively good macroeconomic situation, low unemployment, and moderate (but positive) growth, we are not required, as many other countries are, to deal with an immediate crisis. Therefore, we have the ability, but the obligation as well, to focus on dealing with the longer term challenges to the economy. As I have shown, they are many and complex, but dealing with them is critical to the success of the economy and to the welfare of the general population in the coming years. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the Knesset Economics Committee on the Gray Market, Tel Aviv, 15 July 2015.
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Karnit Flug: The credit market and its supervision in the Israeli economy Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the Knesset Economics Committee on the Gray Market, Tel Aviv, 15 July 2015. * * * Main points: • The forces of supply and demand create the gray market (a financing system that is an alternative to the institutional system) in Israel, some parts of which are a legitimate market that provides services that are complementary to the institutional system. This market can also contribute in certain aspects of competition. • The main problem in the gray market starts with the lack of regulation and supervision over activity in this market. The entities that are active in this market provide credit without any regulatory supervision in relation to this activity or at all. The lack of supervision has a negative impact on borrowers in the gray market, first of all from a basic consumer standpoint. In contrast to the banking market, there is no consumer protection system for borrowers in this market. • The risks in the gray market may spill over to the financial market, both due to regulatory arbitrage (gaps in regulatory requirements) that will lead to a decline in standards in the financial system, and from a prudential standpoint, particularly if the entities in the gray market grow and become a significant part of the credit market. • One of the reasons for the recent global financial crisis was the development of a nonbank financial system, mainly in the US, which was not sufficiently supervised. These systems grew rapidly while taking significant risks that in the end were realized in the form of a financial crisis. • It is preferable to act in this area in two directions: First, to reduce the gray market by developing alternative institutional sources of financing, and second, to regulate the legitimate activity in the gray market through legislation and regulation and to supervise activity in this market. • The Bank of Israel and the Banking Supervision Department are acting to ensure accessibility and competition that will improve the situation for households and small businesses. As part of this, we are acting to increase competition both within the banking system and through entities outside the system, including other legitimate noninstitutional entities. • Supervisory regulation of the gray market will make it possible to expand the sources of financing of the entities active in it. The proposal to enable certain entities to issue bonds and to provide credit without arranging the appropriate controls may led to serious harm to the economy. • I am aware of the desire for everything to be here and now. But we need to deal with these issues properly, with the proper regulation, even if that takes time, since the damage of promoting unregulated financial activity will exceed the benefit, and the victim, as always, will be the public. Good morning, In my remarks here today, I will present a general outline of the credit market in the Israeli economy, and relate to parts of it that are supervised by various regulators such as the Bank of Israel, and to parts that are not supervised as of today, including the gray market. I will begin with a description of the market and the various players in it, continue with a description of the gray market within the financial system and the risks that exist in the gray BIS central bankers’ speeches market in its current structure, and finish with a presentation of my position in relation to how we must handle the main failures in this market. So what is the gray market, and who are the players in it? In order to understand this and to connect it to possible solutions, I would like to start with a short description of the financial intermediation framework in Israel. By this I refer to the intermediation between the supply of sources of savings and demand for investment financing and consumption, between the supply of credit and the demand for credit. This framework can be divided into three main groups: the banking system, the nonbank financial institutions system, and the alternative financing market, which we refer to as the gray market. Traditionally, financial intermediation between savers and borrowers takes place in the banking system through the provision of loans that are financed through deposits from savers. Even now, despite the development of additional sources of credit, the banking system is the dominant system in Israel among the various financial institutions for everything to do with financial intermediation activity. By way of explanation, as of December 2014, total household debt was about NIS 433 billion. About 94 percent of that debt is to the banking system and credit card companies. Over time, and following the adoption of technological improvements and alternative instruments, additional entities began operating and specializing in various components of financial intermediation. These entities include the nonbank financial system, which provides credit through financial entities such as pension funds and insurance companies. Despite the fact that these entities are part of the institutional system and are subject to a regulatory and supervisory system, they still differ from the banks mainly in their access to liquid government sources. If we can see these first two groups – the banking system and the nonbank financial system – as institutional systems, the third group, which is the focus of this meeting today, offers an alternative financing system to the institutional system. This type of financing is referred to in Israel as the gray market. The term “gray market” has negative connotations, although it should be noted that in and of itself, credit provision activity is not necessarily contrary to the law. There are legitimate – although insufficiently supervised – actors within the gray market, and in contrast, there are also criminal elements. The way in which this market has developed in Israel is fraught with risks, including compliance risks, which I will discuss more later on. In Israel, the alternative financing system is mainly offered by currency service providers, private and public companies providing credit services, and charitable organizations. In addition, another industry is developing, thanks to technological developments, that offers a financing model that brings borrowers and lenders into direct peer-2-peer contact. When we look at this phenomenon globally, we look at the banking system and at the nonbank system opposite it, referred to by the term “shadow banking”. Perhaps this name is not so complimentary, but the vast majority of this system in the world is comprised of nonbank financial entities that are subject to various levels of supervision. There is a marked increase globally in shadow banking activity, which is made possible due to technological developments in the field, the high level of liquidity that currently exists in the markets, and against the background of increased regulatory restrictions imposed on the banks. Regarding the gray market, there are no complete data on the volume of its operations or on its customers, which is one of the problems it presents. A survey conducted for the Small and Medium Business Agency in the Ministry of the Economy in 2010 shows that many small businesses have difficulty financing their operations, but that only 0.4 percent gave a positive answer to the question of whether they use the gray market. It seems that this number is downward biased, since there is no BIS central bankers’ speeches complete information on credit provision or check clearance by currency service providers or charitable organizations. Current estimates talk about a credit market of about NIS 10–20 billion. In relation to the existing numbers in the banking system, the rates are very low. Up to now, I have outlined the financial environment in which the gray market operates in Israel. Now I will try to answer the question of who the customers are in this market. There is apparently a wide variety of customers that use the financial services of the gray market. These are mainly households and small businesses, to whom the banking system or the nonbank institutional system are inaccessible from the outset, or those that have used up their banking credit facilities. Examples of those who use the services of the gray market include restricted customers, those in bankruptcy, customers without sufficient collateral, borrowers in need of rapid and liquid money, and borrowers wishing to take out a loan under complete discretion for reasons both legitimate and illegitimate. The situation thus far is something that we recognize well from Economics 101. There are forces of supply and demand that create the gray market, and some of that market may be a legitimate market that provides services complementary to the institutional system that cannot or does not want to be part of this market. There are also advantages, including increased public access to credit. In addition, the fact that the gray market exists and is developing shows to a certain extent that it is necessary. However, there are also problems and failures in how this market has developed in Israel. The main problem in the gray market begins with the lack of regulation and supervision over activity in this market. The entities active in this market provide credit without regulatory supervision in relation to this activity or in general. The lack of supervision has a negative impact on borrowers in the gray market, first of all from a basic consumer standpoint. In contrast to the banking market, there is no consumer protection system for borrowers in this market. For instance, the banks have due disclosure obligations in relation to the terms of credit. For the most part, they are cautious in the provision of credit beyond customers’ needs and repayment abilities, and there are fixed and regulated dispute settlement mechanisms. The Banking Supervision Department also enforces consumer directives, and serves as the decider of disputes in many cases where customers have claims of improper activity on the part of the banks. Just this week, we published the activity report of the Banking Supervision Department’s Public Enquiries Unit. The Unit worked to clarify thousands of enquiries, brought about the repayment of more than NIS 3 million to customers, and was able to provide systemic handling of a number of complaints where it turned out that the complaints did not only concern those customers who enquired about them. None of this exists in the gray market. Advertisements about the terms for providing credit in the gray market often lack basic information the borrower requires, and sometimes contain misleading information. For instance, a simple search on the Internet regarding the possibility of taking out a loan results in the following information: “Immediate loans, within half an hour, for any purpose, at low interest, without guarantors.” Another aspect of the lack of regulation and supervision is the fact that there are no entry barriers to the gray market, and criminal elements working through illegitimate means – from exaggerated interest that is prohibited by the Nonbank Loan Regulation Law, to means of debt collection – are entering it. Of course the existence of criminal elements leads to additional damage in terms of the war against money laundering, the personal security of the borrowers, and the social strength of the public as a whole. In addition, since many entities in the gray market work with and within the institutional financial system, the problems and risks may also spill over into the financial system. This may be reflected in regulatory arbitrage (the gap in regulatory requirements) that may in the end lead to a decline in standards in the financial system. Should these entities grow and BIS central bankers’ speeches become a significant part of the credit market, any failure that may occur could develop into a prudential problem. One of the reasons for the recent global financial crisis was the development of a nonbank financial system, mainly in the US, which was not sufficiently supervised. These systems grew rapidly while taking significant risks that in the end were realized in the form of a financial crisis. Therefore, the International Monetary Fund in its most recent financial stability report warned of the existing risks in nonbank credit. The Federal Reserve also shone a light on these risks as part of a department that was established after the crisis and is responsible for identifying and analyzing risks in the various financial systems – not necessarily the banking systems – with a systemic, rather than individual, view. In this context, it is important to note an additional point. As I have already mentioned, there is insufficient data and information on the gray market. It is therefore difficult to estimate the prudential risks in this market. Regulation of this market will ensure proper information and data on the size and development of the market, the level of risk in the activity of the various entities in the market, and their effect on the overall financial system. For example, in view of the high growth of consumer credit in recent years, and the understand that the risks that may derive from this growth must be monitored, the Banking Supervision Department released a new reporting directive on consumer credit risk just a few days ago. How can we handle the problems created by the gray market in Israel? I think it is worthwhile acting in two directions in this area: first, to try to reduce the gray market by developing alternative institutional sources of financing, and second, to regulate the legitimate activity in the gray market through legislation and regulation to the point where it no longer justifies the term “gray market”, and to supervise activity in this market. When we talk about increasing the legitimate sources of financing for households and small businesses, first of all there is the institutional system. The banks: In recent years, bank credit to households and small business has constantly been increasing, and the banks have identified the advantages, from their standpoint, in operations vis-à-vis these customers. By the way, I note that the growth in this activity is not coming at the expense of proper risk management, and it is good that there is a regulator supervising this. The second group that could be a major factor both in terms of availability of and access to credit and in terms of price through competition with the banking system, is institutional investors. The Bank of Israel and the Banking Supervision Department are acting to ensure accessibility and competition that will improve the situation for households and small businesses. I would like to mention here the recommendations of the Interministerial Team to Examine How to Increase Competitiveness in the Banking System, led by the Supervisor of Banks, a large part of which are already in advanced stages of implementation. The recommendations related to increasing competitiveness within the banking system itself, and to increasing competitiveness through entities outside the system. Among other things, the Team saw many advantages in providing credit to households and to small businesses by nonbank financial institutions. These institutions provide a tangible potential for increasing competitiveness in the households and small businesses segments. They lead to a greater variety of credit instruments offered to the public, to an increased supply of credit to these segments, and to lower costs of such credit. Another advantage is from the standpoint of managing long-term savings, since credit to households and small businesses has characteristics that are appropriate for the public’s pension savings portfolio. It is an investment that is characterized by significant diversification and by a suitable return. The Team’s work reviewed the obstructions preventing the expansion of such activity or delaying the entry of these entities into the retail credit market, mainly the ability and cost inherent in establishing an underwriting, management and collection array for retail credit. The Team BIS central bankers’ speeches presented initial directions for removing these obstructions, and I hope that we will succeed through joint effort with the Ministry of Finance to help the entry of institutional investors into this field take form. Another measure for increasing households and small businesses’ access to credit is in line with the Team’s recommendation to increase the number of players in the banking system itself, by creating a regulatory framework for the establishment of Internet banks and credit unions. In addition, other legitimate noninstitutional entities should be able to take part in various parts of financial intermediation, such as mass financing platforms, state guaranteed credit funds for small businesses, the securitization of bank loans to these segments and their sale to institutional investors, and more. Many of these measures are already on the table, and their expansion should be considered. Some of the issues are also being discussed today by the Team to Increase Competitiveness that was recently established by myself and the Minister of Finance. To sum up this point, increasing the supply of credit by the banking and institutional systems, and increasing the availability of credit on other supervised tracks will make it less worthwhile for households and small businesses to turn to the gray market. One necessary complementary measure is the regulation of legitimate entities within the market that is currently called the gray market, and removing illegitimate entities from this market. Such entities should be put under a regulatory framework with all that that entails – in other words, a regulatory, a system of laws and directives, supervisory and enforcement authorities, and so forth. When this market is under regulatory supervision, it will be possible to talk about the sources of financing of the entities operating in it, including the proposal to enable certain entities to issue bonds and to provide credit. Expansion of such activity without the proper controls may lead to serious damage to the economy. As such, we are opposed to it. We must not be tempted by quick solutions that offer the unsupervised development of additional financial systems. We need a long-term vision in order to know how to deal with the risks that exist in the activities of the various actors in this market. A report by the Ministry of Justice has already recommended regulating the activity of these entities, and there is now a discussion on how to implement those recommendations. Beyond that, enforcement authorities must obviously deal with contraventions of the law and of public order, should any take place, and they must be given the proper tools for this both through the required legislative changes – for example, there is a proposed Fair Credit Law that sets out criminal penalties for collecting interest beyond a rate set by the law – and by making resources available. In summation, the gray market in Israel is an existing fact. There is place for a credit market beyond the banking system, mainly concerning increased access to credit. The market can also contribute in terms of competition. It is important to establish a regulatory framework to regulate, supervise and enforce the law and regulations for activity of the noninstitutional market. There are currently many processes in various committees relating to some of the problems. There is a committee in the Ministry of Finance to establish a dedicated regulator, there is a committee to increase competitiveness in the financial services, and the government is leading various efforts to assist small businesses. I am aware of the desire for everything to be here and now. But we need to deal with these issues properly, with the proper regulation, even if it takes time, since the damage of promoting unregulated financial activity will exceed the benefit, and the victim, as always, will be the public. BIS central bankers’ speeches
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Main points of remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the conference on raising the retirement age for women, Jerusalem, 1 July 2015.
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Karnit Flug: Raising the retirement age for women in Israel Main points of remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the conference on raising the retirement age for women, Jerusalem, 1 July 2015. * * * I would like to briefly address a number of facts and trends that outline the situation concerning the retirement age in Israel in general, and for women in particular. I will then present a series of recommendations and conclusions that I believe should be discussed, ideally in advance. Expected demographic trends: As we know, life expectancy is increasing. If we look at the past 40 years, the life expectancy of women who have reached age 65 increased from 80 years to 86 years, and for men it increased from 79 years to 84 years. This fact, together with the fact that the retirement age increased by only 2 years, means that men are expected to live an average of 17 years after retirement, and women are expected to live an average of 24 years after retirement. This raises the question of whether during employment, workers – and particularly women – save enough to ensure them a proper income after retirement. Another way to look at the demographic change is to examine what is happening to the relationship between the working-age population and the retirement-age population. We can see that the trend in Israel is similar to the trend in other countries, although with somewhat of a lag. As of today, there are five working-age people in Israel for every person above age 65. In 2050, that ratio is expected to narrow to 3:1. This change obviously has serious consequences for the labor market, the dependency ratio, and as a direct result, the actuarial state of National Insurance and the old pension funds. An international comparison of retirement arrangements shows that in Israel, the retirement age for women is relatively low, and even after it rises to 64, as it is supposed to do in 2017, it will still be significantly lower than in most European countries, some of which are also in the midst of gradually raising it, and all of which except for Switzerland have set out that the retirement ages for men and women will become equal in the future. Like in Israel, these countries also have wage gaps between men and women. The retirement age for men in Israel rose to 67, and is similar to the retirement age among European countries that have already raised the retirement age to the upper benchmark. The large gap between men and women in Israel is prominent, and it raises a question regarding women’s ability to save sufficiently for retirement. The longer a decision to raise the retirement age for women further is delayed, the more necessary it will be later on to do so more rapidly, and with greater problems. The effect of the trends on the replacement ratio: In view of the trends I have so far presented, a most interesting question arises: What will happen to the level of pension payments at retirement? The variable that we customarily look at in this context is the replacement rate – what will the retiree’s income be, compared to his pre-retirement wage? A simulation of the net replacement rates, including defined contribution pensions and old-age pensions, provides an illustration of income at NIS 7500 a month. If we look at women who retire at age 62, whose pension savings generate an average real yield of 4 percent per year, and who save 17.5 percent of their salaries, the replacement rate will be 71 percent. In contrast, another retiree with a deduction rate of 19.5 percent with the same yield, will have a replacement rate of 76 percent. If we look at a retiree at age 67 with a deduction of 19.5 percent, the replacement rate will be about 100 percent, which ensures the maintenance of the same lifestyle after retirement. Another possibility for BIS central bankers’ speeches reaching the same lifestyle upon retirement is to increase the monthly deduction so that women who retire at age 62 and want to reach the same replacement rate as those who retire at 67 need to increase their monthly deductions by about 8 percent. How did the increase in the retirement age in 2004 affect employment and wages? Increasing the retirement age for women from 60 to 62 increased employment and the wage path for women aged 60–61 and led, immediately after the change, to an increase of about 4.3 percentage points in the employment of salaried women aged 60–61. This is the effect immediately after the change. In the Bank of Israel Annual Report for 2013, we showed that the extended effect is even larger. The absolute majority of women (more than 80 percent) continued to work after the retirement age was raised, and there was no increase found in the unemployment rate among older women following the increase in the retirement age. In the long term, it is likely that as the retirement age rises, employment rates among older women will also increase. It is important to note that the official retirement age (age of eligibility) contributes to designing labor market norms in that it works as a signal to both workers and employers, and affects the actual retirement age, thereby contributing to their preparations for continued employment. As we can see from Labor Force Survey data, there has been a dramatic change in the labor market, which is reflected in a doubling of the rate of working women aged 60–64 from 25 percent in 2004 to 49 percent in 2013. Increasing the retirement age requires complementary policy tools in the labor market In order to make the process of raising the retirement age for women successful, complementary policy tools must be used in the labor market, such as: • Extending the period of unemployment benefits for older workers. • Incentives for employing older women. • Enforcing labor laws, particularly the prohibition against discrimination based on age. • Allocating resources for professional training while focusing on more demanding professions. In summation, increasing the retirement age is expected to significantly increase the employment rate of older women, and the retirement age should be increased in order to ensure sufficient pension savings and income upon retirement. This should be accompanied by complementary measures such as encouraging the employment of older women, for example through programs such as “Experience Required”, which was launched by the Ministry of Seniors Affairs this morning. There are obviously cases where older people have difficulty finding work, but the data show that the unemployment rate or those who despair of finding a job did not increase as a result of raising the retirement age. In view of all this, the more we promote raising the retirement age, it will be possible to do so more gradually, which will allow employers and workers to adjust and prepare for the change ahead of time, and to ensure proper employment until retirement and proper pensions for afterwards. BIS central bankers’ speeches
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Main points of a lecture by Dr Karnit Flug, Governor of the Bank of Israel, at the Supreme Court, Jerusalem, 6 August 2015.
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Karnit Flug: The Israeli economy – a macroeconomic perspective Main points of a lecture by Dr Karnit Flug, Governor of the Bank of Israel, at the Supreme Court, Jerusalem, 6 August 2015. * * * The Israeli economy is an open economy that is greatly affected by developments abroad. This is reflected in the growth rates in the economy, which are very much in line with those abroad. The effect of activity abroad is mainly reflected through international trade, which affects demand for Israeli exports, both goods and services. Goods exports are in a virtual standstill, against the background of the virtual standstill in global trade, which declined slightly in 2013 and recovered slightly during 2014. In contrast, services exports have performed better than global trade. The labor market is in good condition. The unemployment rate is very low and this, alongside the continuing trend in the labor force participation rate, with new participants finding employment, reflects an increasing trend in the employment rate. The development of real wages per employee post indicates a moderate increase in recent years, and acceleration in the past year. Monetary policy The Bank of Israel’s policy acts to achieve the Bank of Israel’s targets as set out in the law. The main target is achieving price stability, meaning meeting the inflation target, and subject to that, support for the other economic targets, chiefly growth and employment, and support for financial stability. In recent months, the inflation rate has been below the target, and in the past 12 months, prices have declined by 0.4 percent, mainly due to a decline in fuel and commodities prices. In contrast, one-year forward inflation expectations are at the lower bound of the target range – 1.0 percent. Since the beginning of the year, the shekel has appreciated, which has contributed to lower prices, following a number of months of depreciation in the last few months of 2014. The appreciation also makes it difficult for Israeli exporters to compete in the global market, and our estimation is that the shekel is appreciated relative to equilibrium levels. Against the background of these developments – which are also affected by developments in the global economy – the Bank of Israel lowered the interest rate to the historically low level of 0.1 percent, and purchased foreign exchange. The budget and the fiscal aggregates The government has recently been dealing with the finishing touches of the budget. The proposed budget for 2015 and 2016, which was approved by the government, includes deficit targets of 2.9 percent of GDP each year, which are higher than those that are appropriate for the economy in its current state, with a level of activity close to full potential, high employment rates, and low unemployment rates by historical perspective. The proposed deficit targets do not support the continued reduction of the debt to GDP ratio. An international comparison of the tax burden shows that the tax burden in Israel is lower than the OECD average, and the share of public expenditure in Israel is smaller than the OECD average. Since our defense expenditures are much higher than those of other advanced economies, and the interest expenditures on the debt are relatively high, the civilian expenditure (excluding defense and interest) obtained is very low. Israel is in next-to-last place in an international comparison of civilian expenditures. (Civilian expenditures include public services such as education, healthcare, welfare, and public security, as well as expenditures on growth engines such as investments in infrastructure that are meant, among other things, to encourage future growth.) BIS central bankers’ speeches An issue that has an effect on both the longer-term fiscal area and on the cost of living, is the outline of agreements being formulated between the interministerial team dealing with the issue of natural gas development and the gas companies. The Bank of Israel’s position is that under the circumstances created, the new outline provides a reasonable response to the needs of the economy, particularly for the purpose of speeding up the connection of an additional natural gas pipeline and the promotion of development of the Leviathan and Karish and Tanin reservoirs. By the nature of negotiations, the outline does not achieve the ideal result, but it does contain many advantages for the economy. As such, the Bank of Israel supports the main points of the outline and progress toward its implementation. The outline arranges a variety of issues related to the natural gas economy that were subject to uncertainty, thereby enabling more stable regulation of the natural gas economy, which will make it easier to advance the financing and development of the reservoirs, and will in the end enable redundancy of supply and a market structure that is more competitive than is currently the case. The outline also supports the achievement of the government’s target to enable the realization of export contracts with Egypt and Jordan for both economic and diplomatic considerations. Before final approval of the outline, it is important that milestones be set for advancement in the development of the Leviathan reservoir and connecting it to the Israeli gas economy, and that decisions be made regarding the measures that will be taken should the pace of development not be according to agreements. In particular, it is important that if a delay in development prevents the creation of a more competitive structure than is currently the case in the natural gas market, alternative steps be defined that will advance the connection of the gas reservoirs to the Israeli economy in the most rapidly possible manner, alongside a mechanism that will protect Israeli consumers from monopolistic pricing. BIS central bankers’ speeches
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Remarks by Dr Nadine Baudot-Trajtenberg, Deputy Governor of the Bank of Israel, at the institutional investors conference, Eilat, 2 December 2015.
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Nadine Baudot-Trajtenberg: Brief overview of the changing landscape of the financial market in Israel Remarks by Dr Nadine Baudot-Trajtenberg, Deputy Governor of the Bank of Israel, at the institutional investors conference, Eilat, 2 December 2015. * * * It is my pleasure to be here at the annual conference of the largest institutional investors in Israel. Today I’d like to give a brief overview of the changing landscape of the financial market in Israel, and particularly to highlight how recent legislation is expected to affect it. Particularly I’d like to discuss three central issues that are always present in any discussion of financial intermediation: the size of the system, its competitiveness and its stability and credibility. No one quite knows what the optimal size of the financial sector is for any country. What we do know is that if it is very large it is prone to crisis, and the past decade has seen a number of examples of overgrown financial markets that suddenly and often quite unexpectedly deflated rather violently and disastrously for the local economy. If the sector is too small, it will stunt economic activity and will not play its central role of channeling savings to borrowers (both to investors and to consumers) in a way that sustains economic growth. In addition it will weaken monetary policy, as it is the main avenue for the transmission mechanism to work itself and impact on economic activity. The second issue, and one which is at the forefront of public discourse in Israel, is the structure of the market, or how competitive the financial sector is. What we typically mean by competitiveness is not necessarily how concentrated that sector is, but rather whether the 3 essential characteristics of a competitive market are present: To what extent is the supply appropriate – or in other words, is access to its services too restricted? Is the pricing adequate – or in other words, do consumers get the best price for the service, the highest interest rate for savers and the lowest interest rate for borrowers of all kinds? Is the sector dynamic in that it constantly innovates new and better services for its clients? A market that is characterized by often complex products, not easily understood or compared by the consumers of those products, as well as by asymmetric information between the seller and the buyer, is a market that is unlikely to reach the “competitive market equilibrium” as delivered by the invisible hand. Last but not least, stability is an issue that is intrinsically attached to financial markets, and not to other markets where the fall and rise of companies are part of the normal course of business, because there is something about the nature of financial services that make them particularly fragile: the seductive appeal of leverage. Anyone who has tasted it can be excessively charmed by it, and when things turn sour the impact on the rest of the economy can be large and long lasting – as we have seen again recently in so many countries, including developed countries that had presumably well developed and regulated markets. The size of the financial sector relative to the economy in Israelis close to the OECD average. A few countries such as Switzerland, Ireland and the UK have become financial hubs and are exporting various financial services to other countries. In the case of Switzerland, the services exports are mostly asset management, Ireland’s are mostly back office services, and in the UK it is mostly financial intermediation. The value added of financial intermediation in Israel was 5.1% of GDP in 2013, slightly less than the 5.4% average in OECD countries. BIS central bankers’ speeches Total assets of the banking sector in Israel a share of GDP stood at 127% in 2014, well below the OECD median (243%) and average (247%). In fact, the total assets of the banking sector as a share of GDP has been contracting for the past decade from its peak of 147% in 2002. At the same time, the assets that you, the institutional investors, manage have grown over the same period from 67% of GDP in 2002 to 117% in 2014. We may not know whether the financial sector is of optimal size, but these figures show that Israel appears to be pretty much where one would expect it to be, neither very large nor very small – a reassuring figure overall. Turning now to the trickier and thornier issue of the sector’s competitiveness, we do not have all the indicators needed to make a perfect assessment of the situation, but we do note that the concentration in the banking sector is substantially higher than that of developed countries. Perhaps even more striking is the area of consumer loans, which is entirely dominated by the banks, and in particularly by the large banks in Israel. This was always the case, but as banks have receded from granting credit to large corporations, they have increased credit to consumers. Indeed during the past decade, retail credit, including mortgages, has grown much faster than any other type of credit. Over the same period, institutional investors have broadened the allocation of their assets, particularly with respect to investments abroad which have grown from 8% to 19% of their assets between 2005 and 2015. However, they have so far not taken much part in the retail credit market, either in mortgages or in consumer credit. The truth is that it is not typical for large asset managers in developed countries to enter the retail lending market. Institutional investors in Israel have entered the corporate debt market during the past decade, despite the fact that this sector shrunk as a share of GDP during that period. So we know that retail lending has been growing, but it is dominated by the banks, while corporate lending has not been growing as a share of GDP and has been the subject of competition between institutional investors and banks. What about small businesses? First, the importance of small businesses in the Israeli economy is similar to that in the other OECD countries, in fact a bit larger, constituting 42% of business sector GDP – a significant part of the economy that could be a source of economic growth. The banks increased the volume of lending to small and medium businesses from 36% of banks’ business sector credit to 44% between 2011 and 2014. An international comparison is difficult because the distribution is very wide. What about pricing? Well, the smaller the business, the higher the interest rate it pays. Does this reflect the risk involved or market power? What is clear is that profitability over the past 4 years has been much higher in the household and small business sector than for other types of credit. Even if we take into account that these years are upcycle years, and profitability is likely to be affected negatively in a downcycle, there are good reasons to believe that the higher pricing is in part due to market power. Recent legislation and regulatory changes will tackle this problem and should bring the institutional investors, to that the small business and household credit market as well. The establishment of a credit registry tackles the problem of asymmetric information, while the legislation enabling securitization will allow institutional investors to enter the retail market indirectly – as it is done in many other places in the world – by connecting institutional capital with the banks’ ability to grant credit, which will lead to an expanded supply of credit and lower financing costs. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the presentation of the Strum Committee Report to the Minister of Finance and to the Governor, Tel Aviv, 14 December 2015.
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Karnit Flug: Increasing competition in the financial system to benefit the Israeli economy Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the presentation of the Strum Committee Report to the Minister of Finance and to the Governor, Tel Aviv, 14 December 2015. * * * I would like to thank the Committee’s members and its chairperson for their comprehensive and professional work in recent months. The Bank of Israel sees extreme importance in increasing competition in the banking system in particular and in the financial system in general, and toward that end is promoting a series of processes, some in collaboration with the other regulators, in addition to the recommendations discussed here today: • Establishing a credit data register, which will reduce information asymmetries between banks and nonbank credit providers and will provide the customer with negotiating power; • Promoting a securitization market, which will allow an increase in the sources of credit and provide a bridge between the capital held by institutional investors and the credit needs of the economy; • Extended implementation of the vast majority of recommendations by the Zaken Committee to promote competition. The Bank of Israel supports every process that serves the public, and takes this principle into account in every decision it reaches. Therefore, the issues must be examined from a long term perspective, and processes whose negative impact is greater than their benefit and that are liable to pose a risk to the economy should be avoided. We will thus ensure that the reform will bring about the intended changes. There is broad agreement on the need to strengthen the competition in the credit market’s household and small businesses segment, and to make it easier for new participants to compete in the merchant acquiring and payment services sector as well. The Committee proposes ways to increase the number of participants, to create conditions that will increase competition between participants, to increase the sources available to them, and to ease the connection to the payment and settlement systems. During the formulation of these processes, there is utmost importance to ensuring the protection of financial services consumers, and the stability of new entities, which of course impacts on the stability of the entire system. We must not forget the lessons of the most severe financial crisis in our generation, which was caused by irresponsible measures and inadequate supervision. It is important to remember that in the past three years the balance of consumer credit has increased cumulatively by about 20 percent, and credit to small businesses by about 30 percent. As noted, the report contains very significant steps, which will change the state of financial system competition, and agreement has been reached regarding those steps. However, there are quite a few steps regarding which there is still disagreement, such that the discussions have not yet been exhausted and there remains much work ahead of the formulation of final recommendations. I emphasize that the issues which the Bank of Israel opposes reflect, from the Bank’s professional perspective, measures that are liable to negatively impact the public and to serve as a marked risk to the stability of the economy. The Committee’s recommendations reflect agreements that were reached on important and material issues: BIS central bankers’ speeches Separating the two credit card companies from the large banks, while providing proportionate protection to the nascent separated companies; A more lenient level of supervision over entities that do not take deposits, which will make it easier for new entities to compete with banks; Constructing technological tools for the consumer (information services and activity initiation) that will allow simple price comparison; Deposit insurance is a measure that will help small banks compete for additional customers, and strengthen our ability to deal with the next crisis; Completing regulation that will apply to nonbank financing companies (including P2P’s). Supervised companies will be able to be connected to the payment systems. Payment services regulation, in accordance with generally accepted principles worldwide with adjustment for the domestic market, and the setting of conditions for access to the controlled payment systems. Setting up a committee to monitor the implementation of the recommendations, and to recommend, as necessary, additional steps. Advancing the steps on which agreement has been reached will lead to a material change in the level of competition in the financial system, without risking its stability and without negatively impacting consumers. It is important that financial system reforms are made with agreement, as a lack of agreement will hamper the ability to implement the recommendations in practice. We must implement these steps responsibly, with a long term view of the benefit to consumers and the economy. BIS central bankers’ speeches
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Main point of remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Calcalist conference "The challenges facing short-and long-term economic policy", Tel-Aviv, 30 December 2015.
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Karnit Flug: The challenges facing short- and long-term economic policy Main point of remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Calcalist conference “The challenges facing short-and long-term economic policy”, Tel-Aviv, 30 December 2015. * * * I would like to relate in these remarks to the challenges facing macroeconomic policy: monetary policy, under the auspices of the Bank of Israel, which is focused on smoothing the short-term effect of volatility in the economy (business cycles) on inflation and on growth and employment; and fiscal and structural policy, which is focused on achieving inclusive growth that will support an increase in the standard of living of the entire population over time. Two days ago, the Bank of Israel Research Department published its macroeconomic forecast for the coming two years, from which we can assess the trends forecast for the short term. The growth forecast was revised downward, influenced by a further downward revision of global growth and global trade forecasts. The forecast projects continued moderate growth of 2.8 percent in 2016, and some acceleration in the following year. Exports are expected to grow in accordance with the global trade forecast, and private consumption is expected to moderate slightly, following a relatively sharp increase in 2015. This is the main scenario of the forecast. However, it is important to remember that there is uncertainty surrounding the forecast – as there is with any forecast – as presented graphically in the fan chart (which presents the range of projections with a likelihood of 66 percent). Some of the uncertainty regarding growth in Israel is derived from similar uncertainty that exists in relation to the global environment that will exist during that period. It is important to remember that monetary policy affects inflation and growth with a lag. In other words, it is forward-looking, and therefore, by definition, it operates under uncertainty. Another illustration of the uncertainty, as well as the dynamism, of the environment in which we are operating can be seen in the significant revisions of the forecasts made by the international organizations (in this case the IMF) in relation to global growth and – even more importantly for the Israeli economy – in relation to growth in global trade. During the past year, the forecast for global trade was revised downward by 2 percentage points for each of the years 2015 and 2016, which obviously has an impact on the forecast for Israeli exports, and therefore on the growth of the economy in general. As we know, inflation has been very low for the past two years – far below the inflation target – and is expected to remain low during the coming year as well. Despite that, it is important to note that the inflation target regime continues to enjoy trust, as shown in the medium and longer-term inflation expectations. The low inflation is to a large extent the result of commodity and energy price declines and of price reductions initiated by the government. In the past year, these factors were responsible for a 1.7 percentage point decline in the CPI, such that the CPI excluding these factors increased by 0.8 percent. In this context, it is important to emphasize that monetary policy does not aim to offset such one-off factors, but rather is forward looking, and acts to gradually return inflation to within the target range. By the way, for the coming months, the government has already made decisions to reduce prices that together come to 0.4 percentage points of the CPI. Another factor that has an impact on both activity and inflation is obviously the exchange rate. The (effective) appreciation of the shekel, which is impacted by the surplus in the current account and by the very accommodative policies of the major central banks, makes it difficult for exports to grow under conditions where demand for Israeli exports is in any case moderate, and acts to further moderate inflation. Our assessment is that at its current level, the shekel is over-appreciated relative to what is in line with the basic economic forces, and we are therefore continuing to operate in the foreign exchange market. BIS central bankers’ speeches Against this background, the Bank of Israel has used a variety of policy tools: an accommodative interest rate policy, together with a declaration that the Monetary Committee’s assessment is that policy is expected to remain accommodative for a considerable time, intervention in the foreign exchange market in order to prevent an even sharper appreciation, and a series of prudential measures to deal with the risks inherent in the housing market. Another factor taken into account in the Bank of Israel’s policy is the housing market. Home prices that have been increasing since 2007, and with them mortgage volumes, and which have also been affected by the low interest rate environment, are sources of concern to us from both the financial stability aspect of borrowers’ ability to repay, and the social aspect of affordability – the economic ability of a household to provide itself with housing services. It is therefore important to continue dealing with the problem comprehensively through a continuing increase in the supply of homes in high-demand areas. In practice, the increase in supply reacted with a large lag to the increase in demand. Government measures in this matter, and a focus of efforts on shortening the planning process together with specific programs, will contribute to change. The monetary policy tools support economic activity in a moderating global environment, and a return of inflation to within the target range. Accommodative monetary policy, which acts to moderate the cyclical effects of the global environment on the Israeli economy, can enable the government to focus its policy on the long-term challenges to achieving inclusive and sustainable growth. The long-term challenge – inclusive and sustainable growth I would now like to focus on two main challenges facing the government: increasing the growth in productivity, which will contribute to an increase in earning power and in growth; and narrowing gaps and reducing the dimensions of poverty. Productivity in Israel is lower than in other advanced economies. While countries with low per capita GDP generally grow faster and reduce the gap relative to other countries, the growth in productivity in Israel is moderate and is not narrowing the gap vis-à-vis other countries. There are various causes of this, which the Bank of Israel has already discussed at a number of opportunities. The low productivity is particularly prominent in the industries that focus on the domestic market and that are not exposed to international competition – industries in which product per work hour is low by any standard. Earlier I presented the short-term macroeconomic forecast. In preparing the long-term forecast, there is, obviously, greater uncertainty. The result of the simulation based on demographic trends is worrying. The expected trends of growth in the proportion of the population characterized by low labor force participation rates and low earning power, alongside the aging of the population and the dissipation of the contribution of the increase in education in the coming years, indicate that the “automatic pilot”, meaning the expected increase in GDP absent a change in policy, will reflect a marked slowdown in the projected rate of growth. If we add to that the widespread assessment that the growth of global trade will also be moderate in the coming years, then without a policy focused on increased productivity, the standard of living that the Israeli economy can provide to its citizens is expected to become more distant from that at the forefront of advanced economies. Beyond the low productivity and its slow growth, the Israeli economy is also characterized by high levels of inequality and poverty. Inequality in economic income – income before taxes and transfer payments – is not exceptional by international standards. But the tax and transfer payments policy is less active than in other countries in reducing inequality. Therefore, inequality in disposable income – income after direct taxes (which are progressive) and transfer payments (benefits) – is high. Inequality is not predestined. In the same way, the dimensions of poverty in economic activity are not exceptional, but the government’s policy to reduce poverty, which is relatively modest, is reflected in a particularly high poverty rate by international standards in terms of disposable income. BIS central bankers’ speeches The trends I have outlined, or a low productivity growth rate, processes that are expected to further slow future growth, together with high levels of poverty and inequality in disposable income, bring into sharper relief the need to focus government policy on encouraging productivity and reducing inequality and poverty. So what can we do? We can continue, with greater vigor, implementing (with emphasis on the term implementing) policies to include population groups in employment (the program to reduce gaps with the Arab community that was supposed to have been discussed by the government included many positive components in this area); act to increase human capital – both in the framework of the education system and through professional and technical training – in order to increase productivity an earning power; act to remove impediments to growth, through investment in infrastructure, improving the business environment, increasing competition in industries where it is insufficient, promoting reforms in essential infrastructures, and supporting R&D, including in low technology industries. There is also room to upgrade the public services, and for adjustments in the tax system through benefits – for instance by increasing the earned income tax credit (negative income tax), and more. If we act decisively to implement multi-year plans, most of which exist but are implemented sluggishly, we will be able to maximize the immense potential of the Israeli economy for the good of all its citizens. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the launch of Prof. Meir Heth s book "Reforms in Israel s Banking System", Tel Aviv, 18 February 2016.
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Karnit Flug: Reforms in Israel’s banking system Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the launch of Prof. Meir Heth’s book “Reforms in Israel’s Banking System”, Tel Aviv, 18 February 2016. * * * This event marks the publication of Meir Heth’s book, which provides a broad view of the trends and turmoil that have characterized the banking system for almost the last 50 years. His viewpoint is particularly interesting in view of the variety of positions he has held over the years: researcher in the Research Department of the Bank of Israel, the Supervisor of Banks, the chairman of one of the large banks and a professor in academia who is studying the system. One may assess that the processes and trends that the banking system will experience in coming years will be no less interesting and challenging. I will be relating to some of them. I will present the position of the Bank of Israel with regard to the reforms that in our opinion should be promoted in order to increase competition in the credit market and in the financial system and also those which in the name of “competition” are liable to adversely impact consumers and the public in general. Before we begin discussing the reforms, it is important to start with an examination of the data and the facts and only on that basis to define the problems and the ways to solve them. What are the trends in the various credit aggregates over time? How does the Israeli system compare to those in other countries? And so on. I will say already at this point and will soon expand on this point – the credit market has changed dramatically in recent years and the proposed reforms should be based on current trends and not on the approaches of the past. Using the data, we will try to get a full picture of competition, which has served as the basis for the Bank of Israel’s position on this issue. I will say already at this point, and I will illustrate later on, that the Bank of Israel is promoting competition in the financial system and its actions in recent years have proven that. I will also briefly touch on the public interest in maintaining the stability of the banking system, which is often taken for granted. The volatility that affected the global banking system, primarily in Europe, during the last two weeks, provide a reminder of the importance of maintaining the stability of the financial system. As of now, more than half of the business credit in Israel is provided from outside of the banking system, and this of course has major implications for the level of competition in this sector. From the point of view of business customers, and primarily large ones, there is an alternative to the banking system. Of course, the development of the nonbank credit market also has implications for stability. I would mention that the corporate bond market, which was less supervised than the bank credit market, was the only market in Israel that was significantly affected by the global crisis. The development of the consumer credit market and the reforms carried out to reduce concentration have also affected banks’ credit activity. The freed-up sources of capital were increasingly channeled to consumer credit, both housing and non-housing, which was provided for the most part by the banks and has been characterized by a high rate of growth in recent years. The growth in consumer credit and the fact that it was divided among all of the banks is evidence of the increasing competition between the banks in this market. As is known, the mortgage market is a particularly competitive market and the growth in the volume of mortgages began a number of years before the growth in consumer credit. It is possible, therefore, that we are in midst of a process of increasing competition in the consumer credit market. Who hasn’t recently received a text message or email with an offer of credit? Within a few years, we have arrived at a situation in which the quantity of consumer credit is equal to almost half of the quantity of housing credit and therefore we are starting to see an increase in the level of competition in the non-housing consumer credit market as well, against the BIS central bankers’ speeches background of steps taken by the Bank of Israel in recent years, even prior to the planned reforms in this sector. In view of the rapid growth in consumer credit (which is intended for current consumption, such as non-housing credit, student loans, and the like) in recent years, it is worthwhile to examine these developments relative to other countries. As a result of the rapid expansion in recent years, we have arrived at a situation in which the ratio of consumer credit to GDP in Israel is relatively high – similar to its level in the US and higher than in countries such as the UK, France, the Netherlands and Sweden. One of the sectors generally considered problematic, from the viewpoint of both prices and access to sources of financing, is the small business sector. This problem is not unique to Israel and the volume of credit to the small business sector in Israel is not low relative to other countries. The government is working to help small businesses through loan funds and it must do more in that area. The interest rate spreads are relatively high in this sector. It is reasonable to assume that part of the difference is the result of high operating costs (such as underwriting costs) of credit to small businesses relative to other sectors. In any case, there is undoubtedly a need to increase competition and access to credit and to reduce the prices in the small business sector. I expect that the transition to digital services will also lead to reduced prices in this sector. The interest rates on credit cards in Israel are relatively low in comparison to other countries and the interest rates on overdrafts and revolving credit in Israel are similar to those in other countries. (It should be noted that a report ordered by the Ministry of Finance from the McKinsey company shows that the prices of credit in Israel and the level of fees are lower than in the countries chosen as reference in that report.) Prices are also ultimately reflected in the banks’ return on assets, which is not out of line relative to the average in other countries. This situation is influenced by the fact that the banking system in Israel is characterized by a low level of efficiency relative to the global average, which apparently affects profitability; yet at the same time, the system in Israel is characterized by a lower level of risk than banking systems in other countries. In some countries, the profitability of the banking system has been very adversely affected by the realization of risks that were the result of imprudent conduct. Cautious conduct and close supervision of the banking system in Israel are also reflected in the fact that Israel did not have to rescue a single bank from failure during the global financial crisis. Such rescues in other countries were costly to their taxpayers. The fact that in Israel we did not have to rescue any of the banks contributed to Israel’s rapid exit from the global crisis with minimal effect on growth, employment and standard of living. The experience of other advanced economies illustrates the damage that we avoided thanks to the maintenance of stability in our banking system and also the extent of damage that may occur if as policy makers we will not do so in the future. Even though we in Israel did not experience the global financial crisis in the banking system, we have learned from the experience of other countries and we have aligned ourselves with global regulation. In recent years, the Banking Supervision Department at the Bank of Israel has taken numerous measures in order to strengthen the stability of the system. For example, in accordance with international standards, the capital requirements of the banks have been raised markedly, more stringent liquidity requirements have been introduced, etc. These measures, together with additional regulation that is meant to improve the management of risk in the banks and along with regulatory measures to reduce concentration in the banking system, have helped achieve a stable banking system that can deal with future crises. This is not something to be taken for granted, especially now. What can be learned from what I have so far presented with respect to competition in the financial system? BIS central bankers’ speeches • There is no doubt that the credit market for large businesses is characterized by a high level of competition. • The mortgage market is also characterized by a high level of competition, as well as wise consumption by the customers themselves who compare the options available before signing, and this is reflected in the level of prices. It is important to remember that there is a high level of competition in mortgages even under the current structure of the banking system! • The segments in which there is room to continue to increase competition, as pointed out in past Bank of Israel reports and by the committee that was headed by the former Supervisor of Banks, are the small business sector and the household sector (aside from housing credit). Even in these segments, there are processes that are leading to increased competition. Some of these originated in the banks themselves, that have identified the retail sector as a strategic objective and have been increasing their scope of activity in this sector. This can be seen, for example, in the notable increase in consumer credit. Some of these processes are external to the banking system, such as the development of non-bank entities, which has partly been made possible by technological advances. A considerable part of these processes is the result of policies promoted by the Bank of Israel to increase competition, and I will relate to them in a moment. It is important to remember in this context that numerous measures have been implemented in the last two years and their effects have not yet been fully felt. Thus, for example, the banking ID card which will be distributed shortly to all of the banks’ customers is the result of work started more than two years ago and whose full effect will only be felt in a few months. Changes in the financial system are not accomplished by declarations and headlines but rather by wise, thorough and well-thought-out long-term policies, policies that require a measure of perseverance. How then do we promote competition in the financial system in general and in the banking system in particular? How do we expand the competition in the business sector and the mortgage market to also include households and small businesses? In view of the statements made recently, I would like to stress, as unambiguously as possible, that the Bank of Israel has been working towards ensuring the interests of the public, including the promotion of competition! Competition is critical for the existence of an advanced financial sector. Without competition, our banking system will not develop, the quality of service provided to customers will be adversely impacted, the consumer will lose confidence in the system and eventually there may also be consequences for stability. Therefore, we are in favor of encouraging competition. Competition does not contradict stability. Let me repeat that in order to make sure that the message gets across – we are promoting competition in the banking system. We have done so in the past and we will do so in the future. How has the Bank of Israel worked to encourage competition? One of the barriers to competition is the difficulty in switching between banks and the entities that compete with them. The Bank of Israel is working to remove these barriers and will continue to do so. The Zaken Committee did not wait for the entry of new players and drew up a list of measures that strengthened the position of households and small businesses and increased the level of competition. The vast majority of those measures have already been implemented by the Bank of Israel. These include, among others, making it easier to switch banks and providing the possibility of implementing more bank activities on the Internet, such as opening and closing of accounts. The Banking Supervision Department recently issued an innovative directive that expands the activities that can be implemented by electronic communication, which has a huge potential for increasing competition between the banks. In general, the Bank of Israel views BIS central bankers’ speeches technology as a challenge for the banking system and also as a powerful lever for improving service to customers and lowering its price. The activity of the Bank of Israel to increase competition for the benefit of the consumer goes beyond making it easier to switch banks. Another barrier to switching banks is the fact that a customer’s current bank knows the customer better than the bank he would like to move to and as a result the customer may be apprehensive that he will not be able to obtain loans at a good interest rate from a bank that doesn’t know him as well. We have started to deal with this problem as well through the Zaken Committee and we have required that the banks issue a banking ID card to customers, which as I mentioned will be sent to bank customers in the coming days. In addition, we are promoting the creation of a central credit register at the Bank of Israel which will complement the work we have started with the banking ID card. By means of directives issued by the Banking Supervision Department, we have worked to reduce bank fees and the cost of banking services, in cases where we have found that a market failure exists. And again, it must be emphasized that the effect of some of these changes is not felt immediately. The recommendations of the Zaken Committee were implemented over the last few years and it is reasonable to assume that when their full effects are felt, we will see an increase in the level of competition. The Bank of Israel believes that these measures to increase competition between existing entities are not sufficient and therefore we have created a less stringent supervisory environment for nonbank entities, such as the separated credit card companies or companies that will provide large-scale credit against the issue of bonds. This new category will encourage the activity of these entities, in the recognition that regulation in this case can be less stringent since their activity is not financed by deposits. In other words, the supervision will be riskadjusted. This policy will facilitate the entry of new competitors into the area of credit and acquiring. Finally, as is known, the Minister of Finance and I established the Strum Committee and the Bank of Israel is taking a leading role in the work of the committee and in formulating its recommendations (and many important ones have not generated any controversy or public discussion). One of the main recommendations of the committee is the separation of two of the credit card companies from the large banks. However, it is important to understand that the credit card companies have systemic importance for the economy and therefore must continue to be supervised by the Bank of Israel, on a risk-adjusted basis. The transfer of supervision over these companies from the Bank of Israel to a regulator with a different focus and different expertise raises a real concern that the damage from separating the credit card companies will be greater than the benefit. All of the many steps to improve competition have been carried out responsibly and after a professional and comprehensive examination of the potential benefits and risks involved. It is possible to promote competition without harming stability. We have seen what happens when financial entities are allowed or even encouraged to seek profits by taking on excessive risk and at the same time imposing high risks on the general public. This occurs when regulators are unable to monitor these risks or, even worse, ignore them. Our responsibility to the public is a long-term one and requires us to prevent such a situation. We will not agree to measures that in the name of competition will enable financial entities to operate without there being a supervisory body with an overall perspective of stability and consumer welfare, which in the first stage will harm the consumer and in the second stage the general public. Many countries and millions of unemployed people all over the world are still paying the price of irresponsible financial activity. How does the Bank of Israel view the maintenance of stability? We have seen that the banking system in Israel is indeed stable and weathered the worst global crisis since the 1930s BIS central bankers’ speeches relatively unscathed. We at the Bank of Israel want to make sure that the system will also endure the next crisis, if it occurs. How are we doing so? First and foremost, it is important to understand – and this is something that is not sufficiently emphasized in public discourse – that maintaining the stability of the banking system is not meant to serve the interests of the banks or their managers and employees, but rather to serve, first and foremost, the interests of the banks’ customers, the economy as a whole – the public. Maintaining stability means that when we deposit our salaries with the bank, we can sleep at night and can feel sure that we will be able to use that money when we need to; that when we save for our children, we can be confident that those savings will be available to them when they grow up; and when a businessman or factory receives a commitment, that commitment will be honored. The lessons from the global crisis in 2008 taught us that instability in the financial system has long-term consequences on employment, growth and welfare in general. The fact that Israel weathered the crisis in 2008 relatively well emphasizes the need for professional and efficient supervision and illustrates the possible implications of not having such supervision. The responsibility for maintaining a stable financial system rests with the Bank of Israel and we will fulfill that responsibility; but it also rests with the government and other regulators. The Financial Stability Committee is an appropriate framework for coordinating activity and for the monitoring of risks and will make it easier to deal with those risks at an early stage. As we have come to realize following the series of financial crises during the last decade in many advanced economies, credit providers, which are financed through deposits or bonds issued to the public, and entities that settle most of the payments in the economy have systemic importance for financial stability and therefore we will insist that they continue to be supervised by the Bank of Israel. This is also the trend we are beginning to see worldwide, such that more and more central banks are being given responsibility for financial stability, together with the tightening of regulation of banks and nonbank entities. The Bank of Israel, like other central banks worldwide, has the necessary knowledge and expertise and is the entity most capable of supervising systemically important financial institutions. Reducing the supervisory powers of the Bank of Israel in order to ease prudential supervision will create trends that are liable to pose a risk to the stability of the economy. It is interesting that although many countries have learned the hard way how much damage a lack of stability can cause depositors and taxpayers, there is no lobby for stability. There is no public cry to “promote stability”. Therefore, it is also important that an apolitical entity, which is not measured according to its day-to-day popularity, will have responsibility for maintaining stability. We will continue to work according to these principles in the future, with determination and with the sense of purpose and responsibility that is required for this important task. Therefore, we will oppose any change in the regulatory structure that will reduce the Bank of Israel’s ability to fulfill its role in preserving stability. Our position with respect to competition and stability is also based on our position with respect to the recommendations of the Strum Committee. We are in favor of measures to strengthen competition but are opposed to measures that will negatively impact the consumer. For example: The Strum Committee recommendation to prohibit the issuing of credit cards by the banks: This will create essentially a monopoly of three companies that will be issuing credit cards as opposed to 10 today. It is easy to see that this will lead to an increase in the price of credit. For example, when the mobile telephone market was opened to competition, the existing companies were not prevented from selling devices, maintaining their customers and recruiting new ones. BIS central bankers’ speeches The Bank of Israel is opposed to separating Cal-Cartisey Ashrai LeYisrael (Israel Credit Cards) from the banks that own it. Leaving Cal-Cartisey Ashrai LeYisrael (Israel Credit Cards) in the hands of Discount Bank and First International Bank will strengthen their ability to compete with the larger banks. Encouragement of consumer credit: We have seen that the quantity of consumer credit in Israel is not low relative to that in other countries and encouraging the growth of consumer credit against pension savings may lead to a reduction in the level of pension security. In this case, the short-term perspective is clear – of course all of us are happy to increase our consumption by taking a loan, but in the long term loans have to be repaid and if they are not, it is the borrower who suffers the most, followed by the possible systemic threat to the economy and consumers in general. To sum up: Competition can be increased in the financial intermediation market without harming the stability of the financial system. The Bank of Israel will insist on maintaining its ability to continue supervising the credit providers and acquirers that have systemic importance. The Bank of Israel’s supervision will be adjusted to the supervised entity’s level of risk. Within the framework of the reforms, the consumers’ protection must be ensured, according to standards similar to those for the whole system. The Bank of Israel will adamantly oppose measures that might set the stage for the next crisis or that might adversely impact customers. The continued implementation of measures initiated by the Bank of Israel, the creation of a central credit register and the promotion of measures for which a consensus has been achieved and which reflect the long-term welfare of consumers and the economy, will achieve significant improvements in the level of competition in the financial system without endangering stability or harming the consumer. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the Knesset Economic Committee regarding the Credit Information Bill, Tel Aviv, 14 March 2016.
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Karnit Flug: Israel’s Credit Information Bill Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the Knesset Economic Committee regarding the Credit Information Bill, Tel Aviv, 14 March 2016. * * * In recent years, the Bank of Israel has been acting in various ways to increase competition in the banking system in general, and in the retail credit market in particular. An important component of increased competition in the credit market is providing a solution to the problem of asymmetric information. The banking ID card that all banking customers received a few days ago is an important measure in this area. The credit information database is expected to provide a complete solution to this issue. The database will serve as an additional tool in increasing competition and expanding access to credit while reducing the discrimination derived from a lack of information. In addition, the database and the anonymous information it will include will assist the Bank of Israel in monitoring developments in the credit market from the standpoint of financial stability. In view of this, and since the Bank of Israel has the experience and the know-how necessary to advance projects of this kind, the Bank of Israel has decided to take upon itself the challenge of establishing and operating the database, with all that this involves. To that end, the Minister of Finance and I have appointed a higher steering committee led by the Deputy Governor of the Bank of Israel and the Director General of the Ministry of Finance, and including the Director General of the Bank of Israel, the Deputy Budget Director at the Ministry of Finance, and representatives of the National Economic Council and the Ministry of Defense. We have also established professional teams at the Bank of Israel to deal with ways to handle the challenges posed by the project, including: establishing and operating the database; security of the information that will be fed into the database, found in it and provided by it; maintaining the interests of customers and protecting their privacy; and more. The higher steering committee and the work teams are working in synergy with all parties involved in the process, and with the utmost cooperation of the Ministry of Finance, the Ministry of Justice, the National Economic Council, and other entities. I would like to take this opportunity to thank the representatives of the various ministries who took part in the formulation of the bill, and particularly the representatives of the Bank of Israel in the legislative process: the Deputy Governor and the Director General of the Bank of Israel, who took upon themselves the leadership of this complex and important project, and Adv. Shirley Avner, who led the legal aspect. I would like to relate to a number of main points that arose during the discussions in this committee: 1. Protection of privacy: The Bank of Israel attributes tremendous importance to the protection of privacy, and we are aware of the responsibility placed upon the Bank in the context of establishing and operating the database. We are certain that the Supervisor of Privacy Protection, whom I will appoint in accordance with the bill, will fulfill the role in the best way possible, and will assist us in ensuring maximum protection of privacy as part of the credit database. 2. “Consumer protection”: The Bank of Israel attributes great importance to giving the proper attention to the protection of the rights of consumers regarding whom information will be held in the database. For this purpose, the bill sets out, inter alia, that I am to appoint a credit information supervisor, whose roles will include maintaining the interests of customers and ensuring the proper actions of the credit information bureaus and other entities. The supervisor will also constitute the address for clarifying and handling public enquiries regarding the activity of the credit bureaus, sources of information sent to the database, credit information users, paid representatives, and any other entity involved in the database. In addition, as part BIS central bankers’ speeches of the bill, the supervisor will be given control and supervision authorities over the activity of the credit bureaus, including concerning the statistical models, among other things. By the way, the consumer supervision standard that will be implemented regarding the database, similar to the existing standard at the Banking Supervision Department, is worthy of being implemented for customers of all financial entities, both those already existing and those that will be established. 3. The sources of information and entities that will be required to provide information for the database: In determining the scope of information to be found in the database, a balance will be struck between the various objectives of establishing and operating the database. It is important to us that the information appearing in the database will be comprehensive and broad, but at the same time, we do not want to collect information that is not relevant or that is not of sufficiently high quality. It is important to note that the value of the information in the credit database for increasing competition and improving the customer’s status will increase as the financial literacy of the public becomes deeper, because the consumer’s ability to derive benefit from the solution to the information problem I outlined depends first of all on his own financial behavior. It is therefore important that the government act to advance actions that will help increase financial literacy among the public. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the press conference marking the publication of the Bank of Israel's 2015 Annual Report, Tel Aviv, 3 April 2016.
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Karnit Flug: The conduct of economic policy, and the various functions filled by the Bank of Israel and the government in conducting the policy Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the press conference marking the publication of the Bank of Israel’s 2015 Annual Report, Tel Aviv, 3 April 2016. * * * Summary The Governor of the Bank of Israel: • Accommodative monetary policy helped the economy to deal with a moderate global environment. The reduction of the deficit as well as several other factors supported the continued decline in the share of public debt in GDP, the opposite of its trend in most advanced economies. • The success in dealing with short term challenges, and the reasonable state of the economy relative to the global environment permits an enhanced effort to reduce the gap between Israel and other advanced economies in several areas and to prepare the economic infrastructure for the future. • The trends in the global environment and the demographic trends in Israel are setting complex challenges for the future, and obligate us to act to change the trends in labor productivity, education, health, and infrastructure, so that Israel’s economy can fully utilize its potential. • It is therefore important that the government formulate a set of priorities which will allow it to focus on dealing with fundamental problems of Israel’s economy and society in the long term. • In order to deal with these, the government will have to improve the level of public services, to invest in infrastructures, and to support growth. Today we are publishing the Bank of Israel’s 2015 Annual Report. The report presents an analysis of economic activity in Israel in the past year, the economic policy that came to support it, and points of emphasis and recommendations to policy makers for future years. In my remarks today, I will focus on the conduct of economic policy, and the various functions filled by the Bank of Israel and the government in conducting the policy. It is important to distinguish between policy that acts in the short term, and is intended to moderate economic fluctuations – which economists call “the business cycle” – and policy that is geared toward achieving long terms goals. In the short term, policy makers use monetary policy and fiscal policy. Monetary policy is focused on maintaining price stability, and on supporting economic activity and employment when there are shocks that moderate them. Fiscal policy balances the need to support growth in such conditions with the need to maintain a reasonable deficit and manage the public debt burden over time to minimize the burden of interest payments in the future, and to provide the government room to act, termed the fiscal space, in times of crisis. Economic policy focused on long term targets – chief among them achieving inclusive growth over time – acts through the budget policy on its various components (size and composition of government expenditure, size and composition of taxes), as well as by promoting structural changes and reforms. The more effective monetary policy is in smoothing out the business cycles, the more it allows budgetary policy the space to act in order to focus policy on dealing with the long term challenges. BIS central bankers’ speeches Economic policy is impacted by various factors, but as we are a small and open economy, we are affected very much by the global environment. The global environment facing macroeconomic policy in the short term was moderate in 2015 as well – weak global growth which included an additional slowing in emerging markets and continued relatively low growth in the US and eurozone, very moderate growth in world trade, a sharp decline in energy and other commodity prices due both to relatively moderate demand and against the background of an increase in supply. Against the background of all these, major central banks continued, and some even enhanced, their very accommodative monetary policy. In Israel, the main developments included of course the very low inflation rate, impacted by commodity and energy prices worldwide, and by price reductions initiated by the government; the moderate growth which was impacted by the weakness of exports against the background of moderate world trade, but also by specific domestic factors and the appreciation of the shekel, the relatively strong labor market, and the rapid increase in outstanding mortgages and housing prices. Monetary policy operated against this background. The Monetary Committee adopted very accommodative monetary policy this year as well, including the reduction of the interest rate to a low of 0.1 percent in March 2015, alongside foreign exchange purchases within the framework of two programs – the program intended to offset the impact of natural gas production, and the program to moderate fluctuations that are not in line with economic fundamentals. In light of the fact that the effective exchange rate is appreciated relative to its equilibrium value according to various estimates, it continues to weigh on growth of exports and the tradable sector. Exchange rate policy acted in the past and will continue to act in the future in order to facilitate growth of exports. In order to reduce the risks in the mortgage market and to support financial stability, the series of limitations in mortgages imposed in recent years by the Banking Supervision Department remained in place. One of the main channels through which accommodative monetary policy succeeded in impacting on economic activity is credit to households. This credit increased, its cost declined, and the reduction of the interest rate thus led to a marked reduction in the price of consumer credit, and subsequently to the increase of such credit, which in the end supported the increase in private consumption by a relatively rapid prate in recent years, primarily in 2015. Private consumption, which makes up 55 percent of GDP, was the dominant factor in contributing to growth this year, and partly offset the weakness in activity that derived from the decline in exports and investments. This was also reflected in employment. Budgetary policy in 2015, which was based primarily on the interim budget, reflected a decline in the cyclically adjusted deficit – that is, the budget net of the effects of the deviation of growth from the long term rate – to 2.7 percent of GDP. As such, the policy reduced the fiscal stimulus (that is, its countercyclical effect). This is a reasonable policy given that the level of the cyclically adjusted deficit is still relatively high, and that the accommodative monetary policy supported activity. The decline in the deficit, together with a relatively rapid increase in the GDP deflator, and the erosion pf the CPI-indexed debt, supported the continuation of the decline in the share of public debt in GDP, the opposite of its trend in most advanced economies, and of their average level. The interest payment burden remains high relative to the OECD average, but is in a trend of decline, which has accelerated in the past two years. This decline derives not only from the decline in the debt ratio but also in the active policy of the Ministry of Finance Accountant General’s division, which acted to roll over the debt at today’s low rates, and also to reduce the roll over risk by extending the duration of the debt. The reduction of the debt repayment burden – from about 4.5 percent of GDP in 2010 to about 2.5 percent of GDP today frees up significant resources for other uses. The deficit ceiling that was set for the 2016 budget and the reduction of VAT and corporate taxes BIS central bankers’ speeches in response to enhanced tax collection that derived to a great extent from the strength in real estate transactions, are liable to halt the continuation of these positive developments. The success in dealing with the short term challenges, and the economy’s reasonable situation relative to the global environment, permit an increased effort to act to reduce the gap, in a range of issues, between us and advanced economies, and to set the economic infrastructure for the future. It is important that the government formulate an order of priorities in a manner that will allow it to focus on dealing over the long term with fundamental problems of Israel’s economy and society. How? The economic policy for achieving the long term targets – inclusive and sustainable growth – acts through provision of public services at an adequate level, support of the economy’s growth drivers, operation of policy instruments to reduce gaps, reforms to increase efficiency in the use of infrastructures and in public services, and increased competition in industries in which it is insufficient. What are the long-term challenges facing policy makers? A forward-looking view indicates that there are processes, some of them global and some domestic, serving as a headwind to growth – based on analysis by international institutions, the global growth rate is expected to be more moderate in coming years relative to the years prior to the global financial crisis, and the growth rate of world trade is expected to moderate even more, due to the weakening of the link between global growth and the development of world trade. Here in Israel, the combination of demographic changes (an increase in the share of populations whose employment rates are relatively low, and a slowdown in the increase of the prime working age population) alongside the exhaustion of the contribution from an increase in education, as reflected in average number of years of schooling, will act to slow the growth rate in the future. Thus, active policy to offset these trends is required. Against the background of these future trends, it is important to examine recent years’ trends in labor productivity, quality of public services and income gaps, in order to outline the directions in which policy should act in order to deal with the challenges. Labor productivity – measured as output per work hour: We are not closing the gap relative to advanced economies, and this is correct as well in the period since the global crisis. This gap, between output per worker in various industries in Israel and output per worker in those industries in advanced economies, is focused at industries producing primarily for the domestic market, and they are domestic in their characteristics, and therefore are not exposed to competition from abroad. It is important to note that these are industries that are producing the main component of GDP, and also employ a significant majority of workers in the economy. The discussion on productivity sounds very theoretical. However, for illustration, if we were to close the productivity gap vis-à-vis the OECD average, we would increase the standard of living by about a third, which is about the increase we would gain in per capita GDP. In this regard, we can look at, for example, the construction industry, which employs about 7.5 percent of those employed in the business sector – a clear domestic industry – and let’s examine the output per worker in this industry over a long period of time. Productivity in the industry declined in the 1970s and 1980s, and has remained at a virtual standstill since the 1990s, in contrast to an increase in productivity in manufacturing, which was accelerated since the exposure program in the 1990s, and the agriculture industry in which there was a moderate increase in productivity over the entire period. The construction industry, which “benefits” from the availability of foreign workers, whose salary is low relative to domestic workers with similar characteristics, suffers from a significant lag in technology. The government’s recent decision, to allow foreign contracting firms to enter into residential construction projects, if implemented at a significant scope, is likely to contribute to a turnaround in the trend of productivity in the industry – companies that will bring advanced BIS central bankers’ speeches technologies to Israel will force the local contractors to increase efficiency too, and in the long term will contribute to an increase in the wages of domestic workers in the industry. The level of public services shows a mixed picture – in industries in which adequate investment was made in recent years, whether in physical infrastructure or in an appropriate work force, we benefit from the return on the investment, in the form of high quality of level of services. Yet at the same time, in industries in which appropriate investment was not or is not made, the service level is low or is expected to be negatively impacted. It is important to emphasize that the return on public investment, or the harm from a lack of such investment, are not seen immediately. We currently benefit from past investments, and begin to feel the impact in areas in which investment was not sufficient. I will illustrate with several examples from various industries: The current level of health services is good by international comparison, as indicated by public satisfaction surveys (and as reflected as well in a relatively high life expectancy, low infant mortality, etc.). However, various indicators show that the physical and human infrastructures are very “strained” and there are already focal points of very extreme congestion. Thus, the number of hospital beds per 1,000 people is relatively low, urgent care occupancy is especially high, and the share of doctors below age 55 is nearly 50 percent – the highest among advanced economies. Without marked investments in the physical infrastructure and in training doctors and nurses, the service level will deteriorate rapidly, particularly in view of the expected aging of the population. Regarding education level, the results of years of disregard are already seen – both in terms of Israeli students’ poor results on international standardized tests, and in the large gaps between students from families at various income levels. For example, in an index examining the share of students from low socioeconomic conditions who achieve high scores on these tests, we are nearly at the bottom of the list. This index reflects the fact that affirmative action is not succeeding in improving the chances of a student from a weak economic background reaching a high attainment level. Crowded classes and a small number of computers relative to the number of children (a computer for every …fourth student) are only indicators that public expenditure per child is low, and the outcomes are in line with that. Thus it is important to note in the past two years there has been a notable increase in government expenditure on education services, including a marked increase in teachers’ wage, which will certainly be expressed over time as well in improvement in level of teachers. A positive example of the result of investment is the area of public transport. In the availability of public transportation services, which deteriorated until a decade ago, a marked improvement has been seen over the past decade due to significant government investment and the opening of the industry to competition, and together with the reduction in prices of public transportation that was recently set in law, we expect an increase in the use of public transportation, which will contribute to the public welfare, and to an improvement in the quality of the environment. In terms of inequality in the economy, the analysis presented in the report indicates that it is not a matter of fate, and that it can be reduced through increased use in policy tools that have been proven effective. It is worth noting the decline that occurred in gross income inequality (economic inequality), which today is not high in international comparison, against the background of a marked increase in labor force participation, which increased the share of families with two wage earners, and thus reduced the inequality in work hours per household. A decline in inequality in economic income occurred despite the inequality in wage per hour remaining high. This trend is supported by policy to reduce the negative incentives for employment that were incorporated in the past in the welfare system, and some increase in services supporting employment such as making the Compulsory Free Education Law effective from age 3 and expanding the subsidy of afternoon childcare and home-based prenursery facilities. As we have already shown in the report, there is a need to expand the scope of these services. In contrast, the inequality in net income, after BIS central bankers’ speeches allowances and taxation, remains especially high, and derives from a combination of relatively low contribution of the system of allowances and the progressive tax system to reducing inequality. A main tool in dealing with this issue, which the government even expanded the use of recently, is the Earned Income Tax Credit. A fair share of the results we have seen regarding the insufficient level of public services, the moderate increase in productivity reflected in moderate growth, and the high inequality in net income, are the consequences of civilian expenditure that is too low. After public expenditure that was very high in the beginning in the 2000s, there was a marked reduction in the share of public expenditure in GDP, and currently the gap in civilian expenditure between us and most advanced economies is large, and thus also the public expenditure. Government expenditure on clear growth drivers such as R&D is also low in international comparison. Broader government support can be the key to factories’ ability, not just in the high tech sector, to upgrade technology that will help them succeed in a competitive world, or active labor market policy – relevant professional training, or making services that support employment, such as subsidizing childcare, more accessible – can help in successful integration into the labor market, and to increase the entry of working families who nonetheless remain poor. An increase in the Earned Income Tax Credit will contribute to increasing the earnings of low-income working families. Steps are being taken in these directions, and there is also a decision to greatly expand professional training beginning with this year. It is important to work assiduously in these directions. So how can the government act to advance the economy’s challenges in view of the challenges we are facing, in both the short term and the long term? How is it possible to improve the quality and efficiency of services to the citizen, to improve the level of human capital and the physical infrastructure, in order to support inclusive and sustainable growth? As I illustrated in the beginning of these remarks, the accommodative monetary policy helps the economy to deal with the global business cycle, and thus allows the government to focus on policy challenges for the long term. In order to deal with these, the government must act to improve the level of public services, to invest in their increased capacity, and to support the economy’s growth drivers. If we will want to achieve these targets, it will also be necessary to increase efficiency and to markedly increase civilian expenditure, and thus, beyond the use of resources that open up from reducing the interest burden on government debt, and in order not roll over the burden of this increase on to future generations, there will be no alternative to increasing tax revenues, though canceling tax exemptions that are not justified economically, and/or to increasing tax rates. Beyond the improvement in the level of services to citizens, and to investment in infrastructure and growth drivers, it is important as well to act to promote reforms that will reduce the barriers to growth as they are reflected in, for example, our poor showing in the Doing Business index, and to increase competition in industries where it is not sufficient, including the financial sector. The long term is already here, and to the extent that we move early to adopt a strategic plan focused on the issues I have raised, we will be better able to deal with these challenges. Adopting such a plan is critical in view of the processes that I described, both in the global economy and in Israel, which obligates us to do all that is possible in order to maximize our tremendous potential. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the conference of the Israel Economic Association, Tel Aviv, 18 May 2016.
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Karnit Flug: Macroeconomic policy and the performance of the Israeli economy Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the conference of the Israel Economic Association, Tel Aviv, 18 May 2016. * * * I would like today to speak about the performance of the Israeli economy and about macroeconomic policy – both the policy adopted and the policy that is desirable in the future. It is important to distinguish between policy operating in the short-term, which is intended to moderate the economic fluctuations referred to be economists as “the business cycles”, and policy that operates in order to achieve long-term goals with the objective of leading to great achievements in the future. It is important to note that macroeconomic stability in the short term is a necessary condition for realizing long-term goals. In order to ensure macroeconomic stability, policymakers use monetary policy and fiscal policy. Monetary policy focuses on maintaining price stability, and on supporting economic activity and employment when there are shocks moderating them. Fiscal policy balances the need to support growth in such conditions and the need to maintain a reasonable deficit, manage the public debt burden over time so as to minimize the burden of interest payments in the future, and provide the government with room to operate, referred to as “fiscal space” in times of crisis. Economic policy that focuses on long-term goals – chiefly inclusive growth over time – operates through the various components of budgetary policy (size and composition of government expenditure, size and composition of taxes), and by promoting structural changes and reforms, upon which I will focus later on. The more effective the Bank of Israel’s monetary policy is in creating macroeconomic stability in view of the business cycles, the more it provides the government’s budgetary policy with the required room to operate in order to focus policy on dealing with the long-term challenges. The budget’s focus on long-term challenges becomes even more important as the term of the budget becomes longer, such as with a two-year budget. Economic policy is influenced by various factors, but due to the fact that we are a small and open economy, we are greatly affected by the global environment. The global environment in which macroeconomic policy operates was moderate in 2015 as well, with weak global growth that included a further slowdown in the emerging markets, continued relatively low growth rates in the US and the eurozone, more moderate growth in world trade, and a sharp decline in energy and commodity prices both due to relatively moderate demand, and due to increased supply. Against this background, the major central banks continued, and some of them further enhanced, their very accommodative monetary policy. From the standpoint of the Israeli economy, which is a net importer of commodities and energy, the changes in commodity prices were reflected in improved terms of trade, which led to a significant increase in the Current Account surplus. The increase in the Current Account contributed to appreciation pressure on the real exchange rate, which for its part weakened the competitive ability of the Israeli economy and contributed to the slowdown of growth in exports and of growth in general. With the decline of “surplus growth”, or the growth gap between Israel and its main trading partners, the pressure for continued real appreciation weakened. Throughout this process, the composition of growth changed, with the contribution of surplus exports declining while the contribution of private consumption to economic activity increased. BIS central bankers’ speeches These developments took place while inflation was very low, affected by global commodity and fuel prices and by government-initiated price decreases, and to a certain extent by the appreciation of the shekel. Monetary policy has operated against this background. The Monetary Committee adopted a very accommodative monetary policy this year as well, leaving the interest rate at an historic low of 0.1 percent, and announced that in its assessment the interest rate will remain low for a considerable time. In addition, the Bank of Israel continued to purchase foreign exchange as part of two programs it is running – the program intended to offset the effects of natural gas production on the Current Account, and the program to moderate fluctuations that are not consistent with the basic economic forces. In view of the fact that the effective exchange rate is appreciated relative to equilibrium according to various estimates, it continues to pose difficulties for export growth and for the tradable sector. Exchange rate policy operated in the past and will continue to operate with determination in the future in order to assist growth in exports. The Monetary Committee’s announcement of its assessment that monetary policy would remain accommodative for a considerable time, which means that the Committee’s assessment is that it would not raise the interest rate immediately after the interest rate increase in the US, which is what actually happened when the interest rate in the US was raised in December, also serves as a counterforce to the forces for appreciation. The CPI figure for April and the disappointing growth figures for the first quarter that were published this week will of course be examined by the Monetary Committee. Since those discussions will take place at the beginning of next week, I won’t go into this now. In order to minimize the risks for mortgage borrowers and to support financial stability, the series of mortgage limitations imposed by the Banking Supervision Department also remains in place. One of the main channels where the accommodative monetary policy has succeeded in influencing economic activity is in consumer credit. Credit increased, its price decreased, and the reduction of the interest rate led to significantly lower prices for consumer credit, and later to an increase of such credit, which in the end supported a more rapid increase in private consumption in recent years, and especially in 2015. Private consumption, which accounts for 55 percent of GDP, was the dominant factor contributing to economic growth in 2015, and partly offset the weakness in activity resulting from the decline in exports and in investment. This was also reflected in the labor market, increased employment in the services industry, and increased wages. Despite the increase in wages which, alongside the decline in consumer prices, led to increased purchasing power for households, employers’ cost of labor did not increase, and even declined slightly. This was mainly due to the increase in output prices, which was a result of the decline in energy prices and reduced financing costs – also a result of the low interest rate set by the Monetary Committee. This is a positive result for the economy from all standpoints. Budgetary policy in 2015, which was mainly based on a transition budget, was reflected in a decline in the cyclically-adjusted deficit – the deficit adjusted for the effect of a deviation of growth from the long-term rate – to 2.7 percent of GDP. Policy thus minimized the fiscal impulse (the anti-cyclical effect). This is a reasonable policy given that the level of the cyclicallyadjusted deficit is still relatively high, and that accommodative monetary policy supported economic activity. However, the fact that the government operated with a transition (1/12) budget for most of 2015 led to the fact that there was no discussion within the government or the Knesset regarding the targets of economic policy, and the budget therefore did not reflect the government’s set of priorities and was not focused on achieving goals to increase growth over the long term, which I will talk about later. The decline in the deficit, together with the relatively large increase in output prices and the erosion of CPI-indexed debt, supported the continued decline of public debt as a share of GDP – the opposite of the trend in most advanced economies and of the average level in those economies. The interest burden on the public debt remains high compared to the OECD BIS central bankers’ speeches average, but is in a downward trend that was accelerated in the past two years. The reduction of the interest burden, from about 4.5 percent of GDP in 2010 to about 2.5 percent of GDP today, frees up significant sources – about NIS 20 billion per year – for other uses. It is therefore important to maintain this trend. The Bank of Israel’s first assessments regarding 2017 indicate that the automatic pilot for expenditures, meaning the increase in expenditures required as a result of government commitments and expected demographic developments, is NIS 14 billion higher than the expenditure ceiling – similar to the Ministry of Finance’s estimate that was published this week. Should the government make the necessary adjustments to meet the expenditure ceiling, then according to initial forecasts of tax receipts, the government is expected to meet the deficit target of 2.5 percent of GDP. The government will need to choose between cutting expenditure, which will make it difficult to achieve the long-term goals I will detail later, and increasing tax revenue, whether through the cancellation of exemptions or through raising tax rates. Success in dealing with the short-term challenges, and the fact that the economy is in a reasonable state relative to the global environment, make it possible to increase efforts to narrow the gaps in a series of issues between us and the other advanced economies, and to lay the economic groundwork for the future. It is important for the government to formulate a set of priorities that will enable it to focus on dealing with the fundamental problems in the economy and Israeli society in the long term. How? Economic policy to achieve long-term goals – inclusive and sustainable growth – acts by providing public services at a proper level, supporting growth engines in the economy, using policy tools to narrow gaps, reforms to increase efficiency in the use of infrastructure and public services, and increased competition in industries where it is not sufficient. What are the challenges facing policy makers in the long term? A forward-looking view shows that there are processes, some global and some domestic, working as headwinds to growth: According to an analysis by international organizations, the growth rate of global GDP is expected to be more moderate in the next few years than prior to the Global Financial Crisis, and the growth rate of world trade is expected to moderate even more due to the weakening link between global growth and the development of world trade. In Israel, the combination of demographic trends (an increase in the proportion of population groups with relatively low employment rates and a slowdown in growth of the primary working age population) alongside the fact that the contribution of increased education, as reflected in the average number of years of schooling, has neared its limit, will act to slow the future growth rate. Active policy is therefore needed to offset these trends. Against the background of these future trends, it is important to examine the labor productivity trends of recent years and the directions in which policy must act in order to deal with the challenges. In terms of productivity – measured as output per work hour – we are not closing the gap with the other advanced economies, even during the period since the global crisis. This gap between output per worker in these industries in Israel and output per worker in the same industries in the other advanced economies, is focused mainly on industries that manufacture mainly for the domestic market, which are by their character domestic industries, and are therefore not exposed to competition from abroad. It is important to know that these are industries that produce most of the output, and also employ the vast majority of workers, in the economy. The discussion on productivity seems very theoretical. But to illustrate, if we would close the productivity gap vis-à-vis the OECD average, we would raise the standard of living by about one-third – about the increase that we would receive in per capita GDP. In this context, let us for example take the construction industry, which employs about 7.5 percent of those employed in the business sector – clearly a domestic industry – and BIS central bankers’ speeches examine the output per worker in the industry over a long period. Productivity in the industry declined in the 1970s and 1980s, and remained at a standstill since the 1990s, in contrast with an increase in manufacturing productivity that accelerated following the program to expose the Israeli economy to foreign manufacturing imports in the 1990s (the Exposure Program), and the agriculture industry where there was a moderate increase in productivity throughout the period. The construction industry “benefits” from the availability of foreign workers with wages lower than domestic workers with the same characteristics, and therefore suffers from a significant technological lag. The recent government decision to allow foreign construction companies to enter residential construction projects, if it is implemented to a significant extent, may contribute to a turnaround in the productivity trend in the industry. Companies that will bring advanced technologies to Israel will require domestic contractors to streamline as well, and will also contribute in the long term to an increase in the wages of domestic workers in the industry. Last year, I also spoke to this honorable forum about productivity, and I focused on a number of sources for the disappointing increase in output per work hour in most industries in the business sector in the past two decades. I focused on the low stock of capital per worker, on the low level of infrastructure, and on the low government investment in R&D. In addition, I related to a number of opportunities for improving public services through investment in physical and human infrastructure in them, as well as to reinforce the policy of narrowing gaps and integrate various population groups in the labor market. We can go back and talk about these problems and challenges, which have certainly not been solved in one year, this year as well. But this time, I would like to expand the discussion on the structural issues that have an impact on productivity picture. These mostly do not involve a marked increase in budgets, but mainly involve streamlined processes and creating changes, some of which may negatively impact the profitability of certain groups in the economy. Therefore, it is relatively difficult to make them. The updated Doing Business report by the World Bank shows that Israel fell to 53rd place in the easiness (or difficulty) of doing business here, from 26th place in 2007. This is a result of worsening bureaucratic conditions in Israel, and of the reforms in cleansing regulation that were implemented in other economies. Among all OECD countries, Israel is in 31st place out of 34 countries – fourth worse after Turkey, Greece and Luxembourg, and beneath all the others. Our weakness is particularly prominent in the areas of opening, registering and licensing businesses, building permits, tax payment processes, and barriers to international trade. Barriers and restrictions on the trade of commodities and services were also noted in the OECD report on Israel as being particularly high. By the way, our strengths are reflected in the protection of small investors, and in the relative ease of closing businesses. (It’s too bad this is not true of opening them.) In order to illustrate the types of problems that make it difficult to do business in Israel, we can focus on the “tax payment index”. An analysis of the sub-indices of this parameter shows that despite the fact that the tax rate on businesses operating in Israel is low by international comparison, the number of payments that businesses are required to pay is high, and the time required to complete procedures is also high when compared to other advanced economies. For this reason, the bureaucratic cost is high, and despite the advantage of low tax rates, Israel is ranked 103rd out of 189 countries on the index. There is a similar effect in the index that examines the ease of opening a new business. While the monetary cost imposed on the entrepreneur is low by international comparison, the number of required procedures and the time involved in them is high. We are therefore ranked 56th on this index. Another parameter where Israel’s negative position is prominent is international trade, where Israel’s low ranking is caused due to the long time and high cost imposed on importers and exporters in order to trade with their opposites abroad, compared to the leading OECD members. Israel is also negatively prominent in registering properties and building permits, which are characterized by many prolonged processes, which is widely divergent from the other advanced economies. Among other things, these reflect the problem of a lack of synchronization between the various regulatory authorities in the construction and infrastructure area (the planning authorities, the BIS central bankers’ speeches local authorities, and so forth). This is the place to note that Ministry of Finance is taking steps to shorten the length and increase the efficiency of procedures in this area. The medium rating in obtaining credit data is for the most part explained by the lack of a credit database, an issue that as we know was recently passed as legislation and the database is currently being established by the Bank of Israel. In order to examine the potential of reforms to reduce surplus regulation and to increase competition in these areas, I rely on an analysis carried out by the International Monetary Fund Research Department and presented in the most recent World Economic Outlook, and in the excelled OECD report on the Israeli economy. Areas in which Israel has a lot of room for improvement by advancing reforms include: increasing competition in the goods and services markets, including by reducing trade barriers; active labor market policy; and continued reduction of surplus regulation, particularly in industry with a “network effect”. The IMF’s assessment is that reforms, mainly through deregulation and investment in industries with a “network effect” – such as air transport networks, trains, roads, electricity and gas, and communications, can increase GDP by about 1 percent in about 4 years. This is the place to note several areas in which reforms to increase competition were carried out in Israel, generating far-reaching cost-cutting results: air shipping and cellular communications. The liberalization of air shipping (both of passengers and of cargo) by making air policy more flexible and signing an “open skies” agreement with the European Union (which replaced bilateral agreements with a number of countries) are reflected in a marked increase in the frequency of low-cost flights and the number of routes on which service is operated by 3 or more companies. These are reflected in a marked reduction of the cost of tourism and air shipping of goods. The reform in cellular communications which, among other things, disconnected the service agreements from the equipment purchase agreements, reduced interconnectivity fees, cancelled the fine for leaving a plan, and made it possible for virtual operators to enter the market, reduced the cost of service by more than 50 percent, and markedly increased the volume of activity, thereby contributing to consumer well-being. These two reforms illustrate the potential for growth and improvement of well-being from reforms that lower the barriers to competition. Investment in the volume of public transit, improved interconnectivity in public transit, and increasing competition in this area are already bearing fruit in improved and less expensive service (alongside the government-initiated price decline). However, alongside this improvement, tremendous further investment is necessary in order to come close to the accepted public transit standards in metropolitan areas around the world. A more friendly regulatory atmosphere in the goods and services markets – and particularly the removal of barriers in the goods and services trade areas and reference to the competitive supply from abroad – can contribute between 0.5 and 0.75 percent to annual growth in Israel according to the OECD’s assessment. Beyond the advancement of reforms that will lower barriers to growth, as reflected in our low ranking in the Doing Business index, and increased competition in industries where it is insufficient (including in the financial sector), it is important to also act to improve the level of public services to the citizen, including in education and training, particularly technological training, in health, welfare, active labor market policy – with particular focus on the integration of population groups with low integration levels into the labor market, inter alia by giving them the skills for the labor market. We should also not minimize the importance of investing in infrastructure and in growth engines, as I have shown at many previous opportunities. The concept that I call to adopt is that “the long range is already here”, and the more we advance to adopt a strategic plan focused on the issues that I have raised, the better we will be able to deal with these challenges. The adoption of such a program is critical in view of the BIS central bankers’ speeches processes I have described in both the global and the Israeli economy, which require us to do all we can to realize the tremendous potential we have. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the Eli Hurwitz Conference "The formulation of long-term economic policy: Strategic thinking about challenges to the economy", Tel Aviv, 25 May 2016.
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Karnit Flug: The formulation of long-term economic policy – strategic thinking about challenges to the economy Remarks by Dr Karnit Flug, Governor of the Bank of Israel, to the Eli Hurwitz Conference “The formulation of long-term economic policy: Strategic thinking about challenges to the economy”, Tel Aviv, 25 May 2016. * * * Per capital GDP in Israel is about 40 percent lower than that of the US. According to a study conducted by the OECD, in a “business as normal” scenario – relaying on the existing trends regarding the development of factors of production and productivity in Israel and around the world – the gap is not expected to be closed in the next few decades. This is the nonencouraging point of departure. Given that this is not sufficient, we need policy aimed at achieving long-term goals, based on the formulation of a strategic plan in key areas and its actual implementation. This plan must be based on an assessment of the situation at the point of departure, and of the trends and forces that the plan will need to take into account: projected demographic trends, the unpredictable geopolitical situation, and the global environment – which is expected to be far less pleasant than it was in previous decades. All of this must also be analyzed in view of the current state of the fiscal aggregates, including the level of public debt, the level and composition of public expenditure, and the tax system – rates and composition. Based on these trends and forces, we can assess the main challenges with which the strategic plan will need to deal. The demographic trends are among the fundamental factors that policy makers must take into account in formulating strategic plans in main policy areas. The combination of an aging population – the elderly population is expected to grow from 10 percent of the total population to 17 percent in the next four decades – and a significant decline in proportion of the working age population, alongside an increase in proportion of the population groups that tend not to participate as much in the labor force (there are expectations of a marked increase in proportion of the ultra-Orthodox population and a moderate increase in proportion of the Arab population), require preparation in almost all areas in which government policy operates. To illustrate, I would like to provide a brief overview of some of the implications of these trends for two key areas in which the formulation and implementation of a broad strategic plan is required – the area of healthcare and long-term care, and the area of human capital. The examples will illustrate that without the implementation of such a strategic plan, not only will we not move forward toward closing the gaps vis-à-vis the other advanced economies, the gaps vis-à-vis the countries at the forefront will widen. It is important to state at this point that in recent years, there has been significant progress in the government’s strategic planning led by the National Economic Council. A deputy directors-general forum for planning and strategy has been established, and is preparing a plan for the government’s work; seven areas in which the government has chosen to focus have been identified; interministerial cooperation has been intensified; and detailed targets have been set in a number of areas, and work has begun toward achieving them. However, the challenges are large, and the way toward formulating a work plan, and more importantly toward implementing such a plan, remains long. In the area of healthcare and long-term care, in view of the trend of aging population, we can estimate that the volume of needs for medical and long-term care services will increase sharply, and we must already prepare for this now. While the general population is expected to increase by 23 percent, the number of elderly citizens is expected to increase by more than double that – 52 percent. As a direct result, the demand for various healthcare services BIS central bankers’ speeches will also increase by about 60–70 percent, all while the overcrowding in the hospitals is already very high. In addition, about half of the physicians in the system are aged 55 or more – the highest figure in the western world – and the rate of those completing medical and nursing school is lower than in other countries, even after the increase in recent years. As such, the number of physicians per capita is expected to decline. The Israeli healthcare system is considered very high-quality by international comparison. However, given the overcrowding in the hospitals, the long wait for various procedures, and the low rate of doctors and nurses per capita, the level budgeting for the healthcare system must be adjusted to the tasks imposed on it, a significant increase in the physical infrastructure and human capital in the system, and streamlining the long-term care system, with particular attention to improving systemic coordination. These can be advanced only through a multi-year plan based on a detailed analysis of future needs. Only the formulation and implementation of such a program will be able to maintain and improve the high-quality Israeli healthcare system, in view of the trends that are expected to weigh it down even more in coming years. In terms of human capital: The increase in education over the past four decades has been a main component in economic growth during that period. Average annual per capita growth has by 1.8 percent, of which 0.8 percent is due to the increased stock of human capital. The question is whether the current trends in the creation of human capital will be reflected in a similar contribution to future growth. In order to answer this question, we must examine what level of education is expected to be relevant to the labor market in the coming years, in view of the demographic trends. A study conducted by Dr. Eyal Argov of the Bank of Israel Research Department translated actual years of schooling into years of schooling in terms of earning capacity, and indicates that while the ultra-Orthodox have an average of 17 years of schooling, these are the equivalent of just 10 years of effective schooling in terms of earning capacity. This finding, particularly against the background of the projected demographic trends, indicates that a marked slowdown in the effective schooling of the entire population is expected in the coming years – which is expected to markedly lower the contribution of increased education to per capita GDP growth. The extent of the slowdown depends on the extent to which the actual number of years of schooling is translated into effective schooling in terms of the labor market, or in other words, to what extent the learning content is in line with what is required to successfully integrate into the labor market, which will lead to increased earning capacity and a higher standard of living. I should note that in the rest of the population groups examined (ultra-Orthodox women, Arabs, and non-ultra-Orthodox Jews), no difference was found between the average actual number of years of schooling and the number of years of effective schooling for the labor market. In terms of the quality of education of the working-age population and its compatibility with the needs of the labor market, it turns out that despite the fact that the rate of workers with post-secondary degrees in Israel is relatively high by international comparison – about 30 percent – this is not reflected in labor productivity in most industries. For instance, the rate of those with higher education required according to the composition of occupations in the non-export-oriented manufacturing industry is about 3 percent. The actual rate is about 18 percent, more than in parallel industries in the OECD countries. But productivity – or output per worker – in those industries is 33 percent lower in Israel than the OECD average. We can see from this that the extra education does not translate into effective education that provides skills that contribute to high labor productivity. The quality of the education system, as reflected in international tests, is also relatively low, which does not bode well for the skills of workers that will be joining the labor market in the next few years. We do not have relative advantages compared to the rest of the world, other BIS central bankers’ speeches than human capital and our innovation and creativity. As such, these trends are worrisome in this context. Against the background of these trends, a study conducted by the OECD indicates that the future contribution of human capital to the expected growth in Israel in the next 15 years is near zero – almost the lowest among OECD countries. In view of the analysis of the trends I have presented, it is clear that in order to support sustainable and inclusive growth, which will lead to a higher standard of living, constant improvement is required in the level of human capital of the entire population. The education system, and the education required to provide the content and skills that will enable effective integration into the labor market for all parts of the population, including schooling in Mathematics, English, Hebrew, Sciences and Computers. • An increase in investment in the education system is required, with an emphasis on expanding affirmative action in all aspects of the system, and for all levels of education. • In particular, the quality of secondary and college education must be strengthened and improved, including in the post-secondary technological schools and in professional training for graduates. • The future needs of the labor market must be examined, and skills and qualifications must be adjusted to dynamic needs, including by providing cognitive skills that will provide the ability to adjust to a changing labor market. The conclusion arising from the analysis that I have briefly provided in the areas of healthcare and education is clear, and illustrates the importance of formulating and implementing a long-term policy that deals with the fundamental demographic trends and other trends and forces facing the Israeli economy in the coming years. The future is already here, and we must deal with it now. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the cabinet meeting on increasing competition in the financial system, Tel Aviv, 13 June 2016.
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Karnit Flug: Increasing competition in the financial system Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the cabinet meeting on increasing competition in the financial system, Tel Aviv, 13 June 2016. * * * I would like to express appreciation for the serious work done by the committee led by Dror Strum. The financial system is a complex system, and has unique characteristics that require indepth through regarding how reforms and changes are to be carried out. I am happy that in the end, after tremendous effort by all those involved, we have succeeded in formulating recommendations that will benefit consumers and maintain the stability of the system. The changes that we have agreed upon are very significant, particularly when taken as a whole. These changes, alongside initiatives led by the Bank of Israel and the Banking Supervision Department-such as building a credit register, promoting greater efficiency in the banking system, and promoting technology and innovation in banking-will in the coming years create an advanced banking system that is more competitive in the retail and small business areas. It is very important, and we have agreed to this with the Minister of Finance and his team, that we now focus on the implementation of the reforms, and in general avoid promoting new legislative initiatives in the field of banking or support such initiatives. The change that we are proposing here is a sizable change, joining changes that have already been made, and it is important that we manage these changes responsibly and enable the system to get accustomed to them and prepare for them. It is important to emphasize that Israel’s professional and stable banking system is an asset to the economy, and is essential in order to support the financing of the economic activity of households and small businesses. In contrast with banks in the US and Europe, the Israeli banks withstood the Global Financial Crisis very successfully, remained stable, continued to function during the crisis, and saved the Israeli economy from having to pay the high price paid by many other countries around the world in terms of loss of output, unemployment, and a heavy burden on taxpayers in rescuing failed banks. Therefore, it is important that the changes be made in an intelligent and measured manner, while maintaining the stability of the banks and the financial system. The agreement that the supervision of the credit card companies will remain at the Bank of Israel is very important, in order to prevent a regulatory gap between banks and credit card companies in the provision of credit. As the credit card companies have the potential to become a significant factor in the provision of credit to households, such a gap could have created pressure for lowering the standards for providing credit in the entire financial system. I attributed tremendous importance to the fact that alongside the implementation of the reform being presented here today, we will soon complete the legislation for establishing a financial stability committee, which will firmly establish the cooperation and coordination among the various financial system regulators. The committee will monitor, provide early identification, and handle risks to the financial system before they are realized. BIS central bankers’ speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Calcalist Forecasting Conference, Tel Aviv, 28 December 2016.
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Karnit Flug: Forecasting Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Calcalist Forecasting Conference, Tel Aviv, 28 December 2016. * * * This conference is entitled “Forecasting”. Naturally, each forecast carries with it the likelihood, sometimes high, that it will not come to pass. In economics, some of the uncertainty regarding the future comes from the fact that when preparing the forecast, we don’t always exactly know the current state of the economy or, as I will soon show, even the state of the economy in the past. I will describe how we, like other central banks, manage monetary policy given the uncertainty in terms of the environment it is supposed to influence, particularly in view of the fact that monetary policy affects the economy with some lag. Before I illustrate the limitations each forecaster in the economic environment faces, allow me to quote prof. Philip Tetlock, who has for years been researching the ability to forecast political and economic events. A book he wrote in 2006, which is based on statistics from 20 years of forecasting, became famous for its conclusion that “the average expert is about as good at predicting what the future holds as a dart-throwing chimp is at hitting the bullseye.” His new book was published in 2015, and is also based on tracking the forecasting abilities of a great number of people. In that book, he comes to a more optimistic conclusion: There are people who are better than others at forecasting, and the work of forecasting can be improved based on experience and learning. Managing economic policy is based on the ability to forecast the economic environment of the future. What can we say about forecasting ability in this area? In Israel, given that we are a small and open economy, the main input in forecasting the performance of the Israeli economy is the forecast of the global environment, particularly world trade. At the Bank of Israel, we do not pretend to forecast the main developments for the global economy on our own. Rather, we rely on forecasts from the main international organizations. For instance, the International Monetary Fund is the most professional body in preparing forecasts of the global economy, and even the forecasts it publishes are subject to frequent revisions of significant scope. At the beginning of 2016, the IMF forecast that world growth would increase by 4 percent. In October, the revised forecast estimated trade at just 2.3 percent. It is important to emphasize that world trade is the most important global economic variable from the standpoint of the Israeli economy. The economy is characterized by what economists call a serial correlation. For instance, the determination of annual GDP is not disconnected from that of the previous year. Inflation in the coming quarter is influenced by inflation in the current quarter, and so forth. Therefore, when preparing a forecast, it is necessary to assess the current activity environment (or that of the recent past). But when dealing with macroeconomic figures, it turns out that the past is still before us. Revisions are made every month in Israel’s quarterly GDP growth figures. One example of a particularly sharp revision was in the figures for the first quarter of 2016. In the first publication of those figures, GDP growth was estimated at 0.8 percent—a very low figure that was interpreted as a marked slowdown in economic activity. However, the figure was revised upward each month, and in November, the estimate for first quarter GDP growth was already 3.2 percent—meaning strong growth, and in line with the rapid growth that we saw in the labor market, which was a kind of mystery to us given the low growth figures. Essentially, the labor market figures, including figures from the Labor Force Survey, are more stable indicators than National Accounts figures, and provided an earlier indication (as it later turned out) of the positive state of the economy. 1/4 BIS central bankers' speeches The source for the exceptional upward revision in the first half of 2016 was mainly revisions in export and investment figures (especially investment in construction). It turns out that revisions in the National Accounts figures are common and substantial, but that there is no systematic deviation in either positive or negative direction (which obviously does not enable an informed assessment of the direction of the revision in advance). Parenthetically, the revisions in the GDP components, particularly the change in exports, are much higher. Are the revisions in the National Accounts data excessively large? It turns out they are not. There are significant revisions in other OECD countries as well, some of which are even larger, and the scope of our revisions is above the median in OECD countries, but below the average, which is affected by a number of countries with particularly large revisions. While we are in good company, the troubles of many in this case are not a source of even partial comfort, and do not make it easier for policy makers to manage policy in such an uncertain environment. This is perhaps the place to mention the famous statement by my colleague Janet Yelin, Chairman of the Federal Reserve, who tried to convince the markets that the policy adopted by the Fed is data dependent, meaning that it is not set in advance, but is based on currently published data. I hope that I have succeeded in illustrating how challenging it is to determine policy based on data in view of the fact that the data are subject to significant revisions. If even the past is still before us, is there a reason to try forecasting the future? Forecasting is a necessary tool for policy makers in any field, and policy makers need to examine the scenario in accordance with an assessment of the cost or damage involved in adopting a given policy path. We must assess the likelihood of the realization of various scenarios, what the result of adopting a given policy will be along various paths, and particularly, the risks against which the policy must protect. For instance: Planners in the education system need to assess how many children will live in a given locality, the margin of error of the forecast, and the damage that would occur if not enough classrooms are built against the cost of building too many classrooms. The defense establishment must assess the reference scenario for the threats we face, the damage resulting from an under-assessment, and the cost of an over-assessment. The financial supervisory authorities must assess the extent of damage from a financial crisis compared to the economic cost of security buffers that are too deep. Monetary policy makers must use the best tools available to them to assess the forces acting on the economy and what direction their effect is expected to take, and formulate a picture of the future situation based on data, models, experience and know-how in order to set the policy path. Policy management must take into account the margin of uncertainty, and decide the correct weight to attribute to various possible scenarios. In order to make monetary policy effective, a balance is required between the need to be ahead of the curve in view of the lags in the effect of monetary policy, and the need to respond immediately to real developments rather than the “noise” in the data. So after all the warnings about forecasting, the time has come to present the forecast. The Bank of Israel Research Department formulates a forecast of the economic environment every quarter, based on models, information, and forecasts of the global economy, and the data (the best that can be obtained) describing the recent developments in the domestic economy. After all of these are put together into the “oven”, the raw forecast emerges. But this is not the forecast that is presented to policy makers or the public. The economists examine the result, 2/4 BIS central bankers' speeches and exercise judgement regarding the likelihood of various variables, factors that the models do not cover, and more. The final result is the forecast that was published two days ago and is presented before you. This forecast serves as an ingredient—important though not exclusive— in the formulation of the situational assessment that forms the basis for the Monetary Committee’s decisions. The forecast indicates expected growth of 3.5 percent this year (as we said, the past is still before us), 3.2 percent in 2017 and 3.1 percent in 2018. It indicates a gradual slowdown in private consumption after an exceptional increase this year, growth in public consumption of more than 4 percent this year and 1.5 percent in the next two years, in line with the two-year budget, and a gradual acceleration of exports supported by a gradual recovery that the international organizations project in world trade. Together with the central scenario in the forecast, the Research Department also presents the uncertainty that exists in the forecast. This is illustrated by a fan chart, which shows 66 percent of the distribution of possible outcomes. The uncertainty in the forecast is derived from uncertainty in the exogenous variables inserted into the model, chiefly in relation to the global environment. By the end of 2017, the breadth of outcomes ranges from growth of slightly more than 2 percent to about 4.5 percent. Another important component in assessing the picture based on which policy is formulated is the development of the relevant exchange rate (the effective exchange rate), which has been in a trend of appreciation for the past two years. This was affected not only by basic economic forces, but also by the very accommodative policies of our main trading partners (which, according to the updated assessment of the federal funds rate, is expected to become less accommodative in the coming year). According to the forecast, inflation is expected to return to within the target range in 2017, but the range of uncertainty surrounding the timing of that return to the range is broad. In addition to the forecast regarding the macroeconomic picture, the forecast presented by the Research Department to the Committee also includes the path of the interest rate that is consistent with the macroeconomic picture emerging from the forecast and that supports its realization. Herein lies the importance of using an economic model that ensures the consistency of each component of the picture and of policy. Looking forward, based on the updated situational assessment, the Research Department’s assessment is that the interest rate is expected to begin increasing in the last quarter of 2017. Here too, the range of possible interest rate paths is very broad, and relates to a broad range of forecasts of economic activity. It is important to emphasize that this is the interest rate path assessed by the Research Department as consistent with the other components of the macroeconomic forecast, and that also serves as input for the Monetary Committee’s discussions. It is not necessarily the path that the Monetary Committee members view as the future interest rate path, and it certainly is not binding on the Monetary Committee. As part of the forecast, we also indicate the main risks to the forecast that has been formulated, and discussion of these risks serves as input in the formulation of policy. The Research Department’s assessment is that the risks to the current forecast are: Uncertainty surrounding the markets’ response, including that of the foreign exchange market, to the increase in the federal funds rate and extension of quantitative easing in Europe—the creation of a split in the direction of change in monetary policy between the two blocs. Uncertainty regarding the trend of world trade and of global growth against the background of 3/4 BIS central bankers' speeches increasing calls to raise international trade barriers. Based on the macroeconomic picture sketched out through the forecast, the additional information I mentioned, and the assessment of the various risks to its realization, as formulated during the year, the accommodative policy outlined by the Bank of Israel’s Monetary Committee has been reflected in maintaining the interest rate at the low level of 0.1 percent, and for the first time, in October 2015, the Committee published an assessment that this policy would remain in place for a considerable time. Such an announcement is referred to in central bank parlance as “forward guidance”, and has the power to affect long-term interest rates as well, beyond the effect on the short-term interest rate set by the central bank. This is in addition to intervention in the foreign exchange market, which included a component offsetting the negative effects of pressure on the exchange rate derived from natural gas production, and intervention in order to prevent too sharp a deviation from the exchange rate derived from the basic economic forces. The Monetary Committee’s policy also took into account the main risks to the economy as presented in the situational picture that was formulated, including in view of the continued decline in exports, the continued deviation of inflation from the target range, and the financial risks derived from the mortgage market. This policy has served, and continues to serve, in achieving policy targets, chiefly the return of inflation to within the target range, and support of economic activity and of employment. The macroeconomic picture that arises from the updated forecast, as well as the state of the labor market as shown by employment and wage figures, are positive, certainly when taking into account that the state of the global economy is far from one of high growth. The relatively good macroeconomic situation provides a fitting time to focus on solving fundamental problems in the Israeli economy that may have an effect on its ability to achieve inclusive and sustainable growth. Chief among those are increasing productivity, improving human capital, reducing bureaucracy, and dealing with the long-term implications of expected demographic developments. 4/4 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Knesset Reforms Committee, Tel Aviv, 14 December 2016.
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Karnit Flug: Implementing reform benefitting the public in Israel Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Knesset Reforms Committee, Tel Aviv, 14 December 2016. * * * Mr. Chairperson, Honored Members of Knesset: I have come here today, moments before the vote on the law, to say several things: Together, we have advanced a very significant and extensive reform, which was formulated through agreement after about a year of discussions. The Bank of Israel leads and will continue to lead this reform, professionally, with integrity, and focusing exclusively on the benefit of the public. The Bank of Israel has in fact already adopted very important steps to begin implementing the reform, some of them even before the Strum Committee completed its work (for example, defining the terms for control of acquirers by the entities that will buy the credit card companies), and others even before the legislative process was completed (for example, the directive to separate the boards of directors of credit card companies from those of the banks that control them). There are several reservations, not all of which were examined sufficiently deeply. For some of them, it is quite probable that their negative impact will outweigh their benefit—referring, of course, to the negative impact to the public. It is important to explain that ultimately it will be the Bank of Israel that will be charged with the responsibility to implement most parts of the reform, so it is therefore important that the Bank of Israel will lead, together with the Ministry of Finance and the Ministry of Justice, the enactment of the regulations in various areas. Specifically, with regard to the Financial Information Sharing Law, I note that several days ago we discussed the issue, in view of its complexity, and formulated an agreement—the Minister of Finance, me, Committee Chairperson Eli Cohen, and others—on the outline that we felt is responsible and appropriate. This outline is completely undone in the proposal, that I am surprised to understand the Ministry of Finance and the Committee Chairperson support, on which you are about to vote. I will explain: the addition of information on interest on credit facilities to the section dealing with the sharing of financial information is meant to serve precisely the same end that the Credit Data Law is meant to serve, which is to lead to enhanced competition in credit. It is absolutely clear that including this information adversely impacts the realization of the objective of the Credit Data Law. This negative impact was focused on yesterday by the Deputy Attorney General and the Committee’s Legislative Counsel. I emphasize that we support the sharing of information, and are already working in joint teams to promote it. However, Knesset members, you legislated the Credit Data Law a year ago, and imposed on the Bank of Israel the task of establishing the Credit Data Register. We are working intensively on that, investing huge quantities of manpower and resources. In the current legislation you are liable, with the snap of your fingers—and without allowing the professional entities even the two months (!) that we requested to examine the issue—to lead to the Credit Data Register, that will be established at tremendous effort and great expense, being a white elephant. This, of course, without any of us being able to say today if one model is preferable to another, and without adequately considering the various aspects of privacy and information security that the Economic Affairs Committee discussed over many months with regard to the Credit Data Law. The Minister of Finance and I agreed that the information to be transferred, and how it is used, will not conflict with the Credit Data law, and it was clear to us that the formulation of the details of the Bill (nature of the information, for what use, manner of transmitting the information, etc.) that will be established in amendments will be through agreement, because these are the areas of the Bank of Israel’s professional expertise, because it is the entity that is establishing the Credit Data Register, and because the entity that issues guidelines to banks is the Banking Supervision Department at the Bank of Israel and not the Minister of Finance with the approval of the Governor. Here too, the bill contradicts the agreement. 1/2 BIS central bankers' speeches The final thing that brought me here today is to refer to the manner in which some of you addressed Bank of Israel employees during the course of the discussions. Bank of Israel employees are public servants who come here to present to you their professional position as an input to the legislative process, and to contribute to the laws you are legislating being better and for the benefit of the public. Lashing out at them, when they say something you don’t want to hear, insulting and hurtful comments, raising voices—although all these did not deter them, ultimately they are liable to deter excellent professional people from arriving here and telling you their professional truth. Such a situation certainly will not improve the laws you are legislating, and is beneath the dignity of the Knesset and you. I advise you to keep this in mind. 2/2 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Press Conference presenting the Bank of Israel 2016 Annual Report, Tel Aviv, 29 March 2017.
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Karnit Flug: Recent economic and financial developments in Israel Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Press Conference presenting the Bank of Israel 2016 Annual Report, Tel Aviv, 29 March 2017. * * * In 2016, GDP grew strongly by 4 percent—higher than growth in most advanced economies. Private consumption led growth, while export growth was relatively moderate, similar to the moderate growth of world trade. The labor market is robust. The economy is close to full employment and real wages increased, supporting the increase in private consumption. Inflation remained low despite the increase in demand, and was affected by the low inflation worldwide and by the appreciation of the shekel, which were reflected in lower-priced imported goods, and by a change in consumption patterns and the transition to imports via the Internet, which led to increased competition among consumer products and reduced prices. Despite inflation remaining lower than the target range, long-term inflation expectations are anchored around the center of the target range. This means that market players continue to maintain confidence in the inflation target regime. Monetary policy remained accommodative and supported growth. The interest rate remained at 0.1 percent, and the Bank of Israel continued to purchase foreign exchange in order to reduce overappreciation. Expansionary fiscal policy also supported growth. The budget deficit was about 2 percent of GDP, similar to its level in the previous year, and lower than the ceiling. However, the cyclically-adjusted deficit increased. The debt to GDP ratio continued to decline, to 62 percent, due to the growth and the level of the deficit, and also due to transitory factors including the rapid increase of the GDP deflator alongside declining consumer prices, and an exceptional increase in tax revenues from vehicle imports and real estate transactions. Government expenditure on investment in human capital (expenditure per student) and physical capital, despite increasing in the past two years, remains low by international comparison, and the low level of basic skills and of infrastructure impairs potential growth in the economy. Economic policy measures with long-term results are necessary. A significant and efficient investment in improving education and infrastructure will make it possible to increase labor productivity and the economy’s growth potential, thereby contributing to an increase in the standard of living of all Israelis. Such investment is the key to sustainable inclusive growth. The good state of the economy is precisely the opportunity to adopt such a policy. In 2016, the economy grew strongly, by 4 percent—higher than most other advanced economies (even net of the exceptionally high purchases of vehicles). Growth was led again this year by private consumption, while export growth was relatively moderate—similar to the increase in world trade, after exports grew less than world trade in the past two years. The weakness of exports, particularly goods exports that were lower than world trade in goods, reflects the effect of the appreciation of the shekel. According to updated estimates presented in the Bank of Israel Annual Report, the pass-through from the real exchange rate to exports ranges from 0.3 to 0.6 over about 2 years. The labor market continued its solid performance this year as well, and is close to full employment, as shown by the low unemployment rate (3.7 percent among those aged 25–64), the continued increase in the employment rates to a record level of 77 percent—high both historically and by international comparison—the high job vacancy rate, and the increase in real 1/4 BIS central bankers' speeches wages—2.9 percent in the past year—which is led by the business sector. Against this background, monetary policy acted to return inflation to the target range and supported the good results seen in economic activity and employment. Inflation remained lower than the target range, even after some increase, but it is important to note that long-term (5–10 years) inflation expectations consistently remain anchored around the center of the target range, as market players maintain their confidence in the inflation target regime. It is important to examine the factors impacting on inflation: in view of the performance of the economy and the labor market, it is clear that the low inflation does not derive from moderate domestic demand. In the past 3 years there were several factors acting to reduce inflation, and some of them are near to being exhausted; in the past year factors began acting toward increasing inflation, and we assess that their continuation is expected to support an increase in inflation to within the target range. The low inflation worldwide until the past several months, and in particular in G4 countries (US, eurozone, Japan and the UK) acted to moderate inflation in Israel. At the same time, the appreciation also acted toward marked reducing prices of imported goods, as well as of goods that are produced in Israel but compete with imported goods. Thus, the price index of tradable goods declined by 1.7 percent last year after a decline of 3.3 percent in the previous year. An examination of prices, in shekels, of imports to Israel indicates a decline in the past two years, both because the composition of our imports included groups of goods that declined in price, and because a marked share of imports are from countries using the euro, which as known weakened markedly against the shekel. Another factor acting in recent years to moderate price increases is a change in Israeli consumption patterns, reflected in, for example, an increase in consumer purchases from abroad primarily via the Internet. This became stronger with the expansion of the customs exemption on personal imports in 2012 and again at the end of 2014. Beyond its direct impact, personal imports act to increase competition among domestic manufacturers and marketers of many consumer goods. Although price reductions initiated by the government diminished in 2016, they still contributed to a decline of approximately 0.2 percent in the 2016 CPI. Despite the labor market being near to full employment, in recent years the decline in inflation expectations was reflected in an only moderate increase in nominal wages, which together with the decline in the CPI essentially became an increase in real wages at a solid pace. This was reflected in a marked increase in consumers’ purchasing power, and supported the continued growth in private consumption. From the perspective of its impact on inflation, producer prices increasing while consumer prices decreased were reflected in—until recently—unit labor cost which did not increase, so that labor costs did not create pressure for increasing prices, while at the same time the increase in purchasing power as a result of the increase in real wages supported growth of private consumption. Fiscal policy In the past two years the deficit in actuality was about 2 percent of GDP, considerably lower than the deficit ceiling. With that, it is important to look at the estimate of the cyclically adjusted deficit —an estimate that takes into account the effect—on tax revenues and on some components of expenditure—of where the economy stands in the business cycle. From this viewpoint, the deficit increased in 2016, as a result of a real increase of 5.6 percent in expenditure while reducing tax rates, and it is high by international comparison. That is, budget policy also supported, alongside monetary policy, the expansion of economic activity. The share of debt in GDP continued to decline in 2016 as well, in contrast to the trend in most OECD countries, and this welcome trend acted to continue providing sources in the budget due to the decline in interest payments on the debt. In recent years, various factors acted to reduce 2/4 BIS central bankers' speeches the share of debt in GDP: along with the impact of growth and the moderate level of the deficit, the repayment of long term mortgages granted to eligible people (which reduces gross debt, even if not net debt), the large increase in the GDP deflator (which increases tax revenues) alongside very low inflation (which erodes CPI-indexed debt) in the past two years, and extraordinary tax revenues on vehicle imports and real estate in the past year. These three factors above are transitory by their nature, and thus the decline in the share of debt to GDP derived from them is near to being exhausted. The share of public expenditure in GDP has declined persistently since the beginning of the previous decade, due mainly to a decline in the share of defense expenditures and expenditures on interest on the public debt. However, the decline in these expenditures was not directed to an increase in civilian expenditure, which after declining until the middle of the previous decade, remained stable at about 30 percent of GDP, very low in international comparison. The distribution of resources among the civilian budget items has remained quite stable in the past two decades, and does not indicate material changes in priorities of various governments. The expenditure on education declined slightly in the first of those two decades and then increased slightly in the past decade. Two components in the government’s roles are particularly important to supporting the potential future growth of the economy—investments in physical and in human capital. An examination of government activity in these two areas indicates a troubling picture: Government investment in infrastructures (land transport, sea and air ports, communication, electricity/energy, and water) increased at a solid pace beginning in 2007, but declined sharply after the deficit increase in 2012, which obligated the government to markedly tighten expenditures. The need to reduce short term expenditures generally leads to a cut in investment plans, despite such cuts’ harm to future growth. In the past year there was in fact an increase in investment in infrastructure but it is still far from the level before the cut. In any case, investment in infrastructures is low in Israel compared internationally, despite that, as we have shown in previous reports, the level of infrastructures in Israel is markedly below that of most advanced economies. The low level of infrastructures also reduces the worthwhileness of private investment, and thus negatively impacts on the economy’s growth potential. In terms of human capital, the level of expenditure per student relative to expenditure per student in the OECD, for all levels of schooling, declined consistently up to recent years, reaching 70 percent in 2009. Since then, there has been some increase and the share was about 75 percent in 2013. We do not have comparative data with OECD countries for the past 3 years, and in Israel there was an increase in expenditure per student in most levels of education during those years. However, even if we make the extreme assumption that in the comparison countries the level of expenditure per student did not change at all in these years, expenditure per student would have reached 82 percent of the OECD average in 2016. Against this background, the poor results of the Israeli population on the PIAAC tests of basic skills—numeracy, literacy and writing, and problem solving in a digital environment—are not surprising (nor are the results of the PISA tests, which I have shown on other occasions). Likewise, the gaps in achievements, as measured by the Gini Index of results, are almost the highest in the entire OECD. The connection between level of workers’ wages in various countries, and the level of basic skills as measured by the PIAAC tests, are documented in the report, and present Israel in an unflattering position, with a low average score, and accordingly a low wage level. Wage inequality is also high for us, similar to the inequality in human capital level—both in the quantity of human capital as measured by years of schooling and even more so the inequality in the quality of human capital, as measured by gaps on basic skills tests. These findings with regard to the scope of civilian expenditure in Israel, particularly related to the insufficient scope of investment in physical capital and human capital, are reflected in a low level 3/4 BIS central bankers' speeches of infrastructures and of skills relevant to the 21st century labor market. Significant and efficient investment in these areas is required in order to increase the productivity of all Israeli citizens and is the key to increasing the potential growth of the economy and the standard of living of all of Israel’s citizens, and the key to sustainable and inclusive growth. The robust macroeconomic situation presents precisely the opportunity to adopt such a policy. 4/4 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Knesset Finance Committee meeting on the bill to establish a financial stability committee, Jerusalem, 16 May 2017.
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Karnit Flug: Establishing a financial stability committee in Israel Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Knesset Finance Committee meeting on the bill to establish a financial stability committee, Jerusalem, 16 May 2017. * * * I am pleased to participate in the first discussion in the Knesset Finance Committee on the issue of establishing a financial stability committee. About 5 years ago, the International Monetary Fund recommended that Israel establish a financial stability committee. It took us some time, but I am happy that the government, the financial regulators and the Bank of Israel have all reached agreements regarding the composition, aims and authorities of the committee—those that are before you, the members of the Knesset, in the text of this bill. Both in Israel and around the world, the main motivation for establishing a financial stability committee was the understanding that cooperation, the transfer of information and coordination between the various financial regulators, the Ministry of Finance and the central bank, are required in order to identify and monitor systemic risks and deal with them in a timely manner so that they don’t become risks to the financial stability of the economy. We must remember that impaired financial stability has long-term implications for employment, growth, and general well-being. The world experienced this during the Global Financial Crisis of 2008, and one of the main lessons learned was the necessity of institutionalizing cooperation and coordination between all the financial authorities in the country within a central body. Accordingly, many of the advanced economies have established financial stability committees. Such cooperation and coordination is also important due to the changes expected in the financial system in Israel, both the reforms to increase competition and the rapid technological changes that are enabling the entry of new entities into the financial system. These changes, alongside the advantages they bring with them, are naturally expected to increase the existing risks and to create new ones, both due to the increase in activity and the changes in its components, and due to the close interfaces of the new entities with the financial system. Maintaining a stable financial system is the responsibility of the government, the Bank of Israel, and the other regulators. The financial stability committee will make it possible to fulfill this responsibility. However, we must remember that the financial stability committee’s responsibility is preventive, and that the operative responsibility essentially remains that of the financial regulators or, in the case of a financial crisis, the government. The committee will enable the regular tracking and monitoring of the financial system and provide recommendations to the financial regulators and to the government that will support the stability and proper functioning of the financial system. The Bank of Israel will lead and manage the committee’s work, and for that purpose, a division was established four years ago at the Bank of Israel to deal with the area of financial stability. That division will do most of the staff work of the committee and will support its activity. The discussion of financial stability is often considered something that serves the financial entities, but this is not so. Maintaining financial stability first and foremost serves the customers of the financial entities, the economy, and the public as a whole. Maintaining financial stability means that when we deposit our salaries in the bank, we can sleep quietly and be certain that we will be able to withdraw it whenever we want. It means that when we save for retirement, those savings will be available to us. And it means that when a business or factory owner receives a commitment, it will be honored. In conclusion, this is the first significant amendment to the Bank of Israel Law in its new format 1/2 BIS central bankers' speeches since the law was legislated through this committee seven years ago, under the committee chairman of the time, who is also the committee chairman now. I am certain that the discussions will be matter-of-fact and will lead to legislation that, in the end, will serve the public in the optimal manner. Permit me to offer you, as we always do, the Bank of Israel’s professional assistance in this important legislative process. 2/2 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the annual conference of the Israel Economic Association, Tel Aviv, 6 June 2017.
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Karnit Flug: Israel's macroeconomic situation in recent years Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the annual conference of the Israel Economic Association, Tel Aviv, 6 June 2017. * * * Summary Private consumption has led growth in the economy in recent years, covered for the slowdown in exports and in investments against the background of moderate global growth, and supported a significant improvement in labor market data, with an emphasis on weaker population groups. Growth based on consumption comes with risks if it is based on factors that are not sustainable, but the main factor in increased consumption in recent years was increased income from labor. The rapid increase in consumer credit in recent years requires closer monitoring by regulators, increased caution on the part of the public and credit providers, and an informed examination of repayment capabilities when providing or taking out credit. Growth that is led by consumption generally leads to lower long-term growth. Low investment leads to a smaller increase in the stock of capital and in the adoption of technologies that accompany that investment, and lower exports lead to the economy being less able to exploit its relative advantages. The good current state of the economy, thanks partly to the rapid increase in private consumption, makes it necessary for us today to focus on dealing with the challenges we face—improving human capital and workers’ skills, improving the business activity environment, and investing in infrastructure. All these will ensure improved productivity and a better standard of living in the long term. In recent years, private consumption has become an important component of Israeli economic growth, and this has various implications. Today I would like to discuss Israel’s macroeconomic situation in recent years, and particularly the significance of the fact that growth is being led by private consumption, and the long- and short-term implications of this phenomenon. In recent years, GDP in Israel has grown by higher rates than in most other advanced economies, but the growth rate of per capita GDP is similar to that of the other advanced economies. In the past year-and-a-half, growth data have been affected by what economists call “noise” (mainly volatility in the import of vehicles), but excluding that noise, the growth of GDP has accelerated, and it currently stands at about 4 percent in annual terms. This is an impressive rate, particularly if we take into account that world trade, which reflects global demand for our exports, increased by an average of about 3 percent since the global economic crisis, compared with an average of 7.56 percent in the years preceding the crisis. Israel’s relatively good economic performance was supported by accommodative fiscal and monetary policies: low interest rates, the Bank of Israel’s foreign exchange purchases, and a relatively high cyclically adjusted deficit. All these supported activity against the background of relatively weak global economic activity. The good performance of the economy is reflected in the very strong labor data. The unemployment rate is at a low, the employment level is at a high, and it is interesting to note that these data are also reflected in the improved state of the weaker population groups. For instance, the improvement in the unemployment and employment data in the past year was 1/4 BIS central bankers' speeches particularly great among population groups with low levels of education. Wages are continuing to increase, and in the business sector, the rate of increase of real wages accelerated in the past year to about 3.5 percent. In some industries and professions, there is an apparent significant lack of workers, which weighs on the ability to continue expanding economic activity. The combination of increased wages and increased employment is reflected in the relatively sharp increase in income from labor. Against the background of these developments, private consumption increased by 4.3 percent in 2015 and 6.3 percent in 2016, and was the main factor contributing to economic growth in recent years. The rapid increase occurred in all components of private consumption—services consumption, which constitutes about one-third of private consumption, and goods consumption, where the increase in vehicle purchases was prominent. What is motivating private consumption? A series of studies conducted by the Research Department over the years examined the factors affecting private consumption in the short and long terms: - Income from labor and financial income are decisive factors in determining the level of private consumption in the short and long terms, with elasticities of about 0.3 and about 0.2 respectively. - The rapid increase in home prices in recent years also contributed to increased private consumption, through the wealth effect. - Asset prices, particularly those of financial assets, have the greatest effect on the change in private consumption in the short term. - Change in current income does not affect private consumption in the short term, other than a change in income from transfer payments. - The intensity of the replacement effect of the interest rate is not great. How have the variables affecting private consumption developed in recent years? There has been a real increase of about 6 percent per year on average in income from labor, as a result of an increase in employment and in wages. There was an increase in home prices and in the value of financial assets. Outstanding consumer credit (nonhousing credit to households) increased by 25 percent over the past three years, as interest rates declined. Together with the lower prices on imported consumer goods, against the background of the appreciation of the shekel in recent years, which led to a rapid increase in the import of consumer goods, these all supported the rapid increase in consumption. Is the growth in private consumption a phenomenon that is unique to the Israeli economy? Apparently not. Before the global economic crisis, global growth was relatively balanced, in that it was led not only by private consumption, but also by other uses, chiefly investment. In the years after the exit from the “pit” of the crisis, since 2012, in most countries growth has been led by private consumption, while investment has been stagnating. It is worth noting that the first quarter of 2017 looks to be different. In most economies, including Israel, the figures for the first quarter are unusual in the sense that investment was again a significant factor in contributing to growth. However, it is obviously too soon to determine that this quarter indicates a change in trend or a turnaround. Of course, there are positive aspects to the fact that private consumption increased relatively rapidly. Beyond the fact that it has led to an increase in the standard of living in the short term, 2/4 BIS central bankers' speeches the increase in private consumption also covered for the more moderate growth of exports and investments, which was at least partially a result of exogenous factors. With the help of macroeconomic policy, the increase in private consumption thus contributed to smoothing the business cycle. It enabled the economy to continue growing and to lead to a clear improvement in labor market data as I outlined earlier. However, the fact that growth was led by private consumption also comes with risks. Those risks mainly have to do with the question of whether such growth is sustainable, or whether it comes with a risk of a sharp turnaround. The answer to that question has to do with the sources upon which the economic growth rests. As long as growth relies to a greater extent on increased consumer credit, a sharp increase in the future debt servicing burden may put the ability to continue consuming in the future at risk. As long as the increase relies more on an increase in asset prices—the “wealth effect”—and as long as this turns out to be temporary, the turnaround in prices may lead to a turnaround in private consumption as well, and therefore in activity. A study conducted by Arnon Barak of the Bank of Israel Research Department, which was published this week, shows that in recent years, the main factor leading the increase in private consumption (according to a long-term comparison estimated in the study) is the increase in income from labor. The increase in financial asset prices and in home prices made less of a contribution than income from labor. Household debt figures show that despite the increase in outstanding mortgages and consumer debt, the debt to GDP ratio and the debt to disposable income ratio increased only moderately. At the macro level, therefore, the risk is moderate. However, the rapid increase of consumer credit in recent years requires closer monitoring on the part of regulators, extra caution on the part of the public and credit providers, and an informed examination of repayment capabilities when providing or taking out credit. The interim conclusion, therefore, is that given the relatively weak state of the global economy, the growth of private consumption contributed to maintaining a strong growth rate and a robust labor market. The fact that most of the increase in consumption relies on an increase in income from labor makes it more stable, but we must be particularly attentive to the part of the increase that is supported by increased credit and asset prices. So if the economy is growing solidly, the labor market is strong, and the engine of growth is private consumption, is there something that needs to concern us? The question is whether growth that relies mainly on private consumption in a small and open economy can persist and be strong enough to reduce the gap in the standard of living relative to the other advanced economies. In this context, it is important to remember a number of facts in relation to the two main uses that have been weak in recent years: Investment in the primary industries contributes not only to activity in the short term, but also to future production capacity, and investment in machinery and equipment means adopting the technologies inherent in that equipment, meaning that investment contributes to future growth by increasing production capacity and through its contribution to an increase in productivity. Exports make it possible for a small and open economy to exploit its relative advantages and the economy of scale. Export industries in general, and also in Israel, are therefore characterized by relatively high productivity. How have investments and exports developed in recent years? Investment as a share of GDP in Israel is low by international comparison, despite the fact that national savings is not low, as we showed in the Bank of Israel Annual Report for 2016. Therefore, not only are we not close the gap in capital per worker relative to other economies, the gap is even growing. By the way, the investments that increased in 2016 were mainly in residential construction and in the electronic components industry, but not in the other industries, such that the increase in investments made a relatively small contribution to a broad increase in 3/4 BIS central bankers' speeches production capacity. A factor that is complementary to private sector investment is government investment in infrastructure. Despite some increase in the past two years, the level of this investment remains lower than it was at the beginning of the decade. As a result, the stock of capital in the economy is lower than the average in the other advanced economies. Exports as a share of GDP also declined in recent years, affected by the weakness in world trade and the strengthening of the shekel. This fact is not harbinger of good news in terms of the dynamics of productivity. In this context, we can examine what happened to labor productivity in Israel over time. Despite its low level at the point of departure in 1995, its pace of growth was lower than what could have been expected given the fact that in general, the increase in productivity is greater in economies that begin from a lower point, if only because of their ability to adopt technologies that exist in countries at the technological forefront. The fact that the productivity gap has not been closed is particularly disappointing given that growth in productivity in the other advanced economies has also been relatively low in recent years. Other than the composition of growth and the insufficient level of infrastructure, I have discussed other reasons for the low level of productivity at various opportunities. The main reasons are unsuitable human capital, as shown by the PIAAC tests examining the cognitive skills of the adult population in Israel—such as problem solving skills in a digital environment—the problem of excessive and inefficient bureaucracy, and the fact that the economy is not sufficiently open to international competition in various aspects, such as the attitude toward competitive supply from abroad or relatively high non-tariff barriers. The question of the implications of growth led by consumption over the long term has been discussed by various international entities in recent years, and the main conclusions from their studies are similar to the analysis we have conducted. Such growth tends to be weaker, and it also generally leads to lower future growth. The reason for this is that the export industries, which tend to be an engine of innovation and productivity, are not contributing their part in pushing productivity forward, and the low level of investment contributes less to increased production capacity and to increased productivity derived from the adoption of technologies inherent in new capital. The strategy that will support more balanced growth, which for its part will contribute to stronger and more prolonged growth, must therefore include the following components: - Improved human capital and workers’ skills—Providing content and abilities that will enable successful integration in the labor market for all parts of the population, including broad technological education at various levels; - Improved business activity environment and removal of barriers that hinder competition from abroad - Investment in infrastructure—Such investment will make a particularly large contribution in Israel in view of the low level of infrastructure, particularly that of public transit. The good state of the economy, in part thanks to the rapid increase in private consumption, actually requires us now to focus on dealing with the challenges so that we can ensure continued improvement in the standard of living in the long term. 4/4 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Eli Hurvitz Conference on Economy and Society "One Society - One Economy", Tel Aviv, 19 June 2017.
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Karnit Flug: Two economies - one society Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Eli Hurvitz Conference on Economy and Society “One Society – One Economy”, Tel Aviv, 19 June 2017. * * * Private consumption has led growth in the economy in recent years, covered for the slowdown in exports and in investments against the background of moderate global growth, and supported a significant improvement in labor market data, with an emphasis on weaker population groups. Growth based on consumption comes with risks if it is based on factors that are not sustainable, but the main factor in increased consumption in recent years was increased income from labor. The rapid increase in consumer credit in recent years requires closer monitoring by regulators, increased caution on the part of the public and credit providers, and an informed examination of repayment capabilities when providing or taking out credit. Growth that is led by consumption generally leads to lower long-term growth. Low investment leads to a smaller increase in the stock of capital and in the adoption of technologies that accompany that investment, and lower exports lead to the economy being less able to exploit its relative advantages. The good current state of the economy, thanks partly to the rapid increase in private consumption, makes it necessary for us today to focus on dealing with the challenges we face—improving human capital and workers’ skills, improving the business activity environment, and investing in infrastructure. All these will ensure improved productivity and a better standard of living in the long term. In recent years, private consumption has become an important component of Israeli economic growth, and this has various implications. Today I would like to discuss Israel’s macroeconomic situation in recent years, and particularly the significance of the fact that growth is being led by private consumption, and the long- and short-term implications of this phenomenon. In recent years, GDP in Israel has grown by higher rates than in most other advanced economies, but the growth rate of per capita GDP is similar to that of the other advanced economies. In the past year-and-a-half, growth data have been affected by what economists call “noise” (mainly volatility in the import of vehicles), but excluding that noise, the growth of GDP has accelerated, and it currently stands at about 4 percent in annual terms. This is an impressive rate, particularly if we take into account that world trade, which reflects global demand for our exports, increased by an average of about 3 percent since the global economic crisis, compared with an average of 7.56 percent in the years preceding the crisis. Israel’s relatively good economic performance was supported by accommodative fiscal and monetary policies: low interest rates, the Bank of Israel’s foreign exchange purchases, and a relatively high cyclically adjusted deficit. All these supported activity against the background of relatively weak global economic activity. The good performance of the economy is reflected in the very strong labor data. The unemployment rate is at a low, the employment level is at a high, and it is interesting to note that these data are also reflected in the improved state of the weaker population groups. For instance, the improvement in the unemployment and employment data in the past year was particularly great among population groups with low levels of education. Wages are continuing to 1/4 BIS central bankers' speeches increase, and in the business sector, the rate of increase of real wages accelerated in the past year to about 3.5 percent. In some industries and professions, there is an apparent significant lack of workers, which weighs on the ability to continue expanding economic activity. The combination of increased wages and increased employment is reflected in the relatively sharp increase in income from labor. Against the background of these developments, private consumption increased by 4.3 percent in 2015 and 6.3 percent in 2016, and was the main factor contributing to economic growth in recent years. The rapid increase occurred in all components of private consumption—services consumption, which constitutes about one-third of private consumption, and goods consumption, where the increase in vehicle purchases was prominent. What is motivating private consumption? A series of studies conducted by the Research Department over the years examined the factors affecting private consumption in the short and long terms: Income from labor and financial income are decisive factors in determining the level of private consumption in the short and long terms, with elasticities of about 0.3 and about 0.2 respectively. The rapid increase in home prices in recent years also contributed to increased private consumption, through the wealth effect. Asset prices, particularly those of financial assets, have the greatest effect on the change in private consumption in the short term. Change in current income does not affect private consumption in the short term, other than a change in income from transfer payments. The intensity of the replacement effect of the interest rate is not great. How have the variables affecting private consumption developed in recent years? There has been a real increase of about 6 percent per year on average in income from labor, as a result of an increase in employment and in wages. There was an increase in home prices and in the value of financial assets. Outstanding consumer credit (nonhousing credit to households) increased by 25 percent over the past three years, as interest rates declined. Together with the lower prices on imported consumer goods, against the background of the appreciation of the shekel in recent years, which led to a rapid increase in the import of consumer goods, these all supported the rapid increase in consumption. Is the growth in private consumption a phenomenon that is unique to the Israeli economy? Apparently not. Before the global economic crisis, global growth was relatively balanced, in that it was led not only by private consumption, but also by other uses, chiefly investment. In the years after the exit from the “pit” of the crisis, since 2012, in most countries growth has been led by private consumption, while investment has been stagnating. It is worth noting that the first quarter of 2017 looks to be different. In most economies, including Israel, the figures for the first quarter are unusual in the sense that investment was again a significant factor in contributing to growth. However, it is obviously too soon to determine that this quarter indicates a change in trend or a turnaround. Of course, there are positive aspects to the fact that private consumption increased relatively rapidly. Beyond the fact that it has led to an increase in the standard of living in the short term, the increase in private consumption also covered for the more moderate growth of exports and investments, which was at least partially a result of exogenous factors. With the help of 2/4 BIS central bankers' speeches macroeconomic policy, the increase in private consumption thus contributed to smoothing the business cycle. It enabled the economy to continue growing and to lead to a clear improvement in labor market data as I outlined earlier. However, the fact that growth was led by private consumption also comes with risks. Those risks mainly have to do with the question of whether such growth is sustainable, or whether it comes with a risk of a sharp turnaround. The answer to that question has to do with the sources upon which the economic growth rests. As long as growth relies to a greater extent on increased consumer credit, a sharp increase in the future debt servicing burden may put the ability to continue consuming in the future at risk. As long as the increase relies more on an increase in asset prices—the “wealth effect”—and as long as this turns out to be temporary, the turnaround in prices may lead to a turnaround in private consumption as well, and therefore in activity. A study conducted by Arnon Barak of the Bank of Israel Research Department, which was published this week, shows that in recent years, the main factor leading the increase in private consumption (according to a long-term comparison estimated in the study) is the increase in income from labor. The increase in financial asset prices and in home prices made less of a contribution than income from labor. Household debt figures show that despite the increase in outstanding mortgages and consumer debt, the debt to GDP ratio and the debt to disposable income ratio increased only moderately. At the macro level, therefore, the risk is moderate. However, the rapid increase of consumer credit in recent years requires closer monitoring on the part of regulators, extra caution on the part of the public and credit providers, and an informed examination of repayment capabilities when providing or taking out credit. The interim conclusion, therefore, is that given the relatively weak state of the global economy, the growth of private consumption contributed to maintaining a strong growth rate and a robust labor market. The fact that most of the increase in consumption relies on an increase in income from labor makes it more stable, but we must be particularly attentive to the part of the increase that is supported by increased credit and asset prices. So if the economy is growing solidly, the labor market is strong, and the engine of growth is private consumption, is there something that needs to concern us? The question is whether growth that relies mainly on private consumption in a small and open economy can persist and be strong enough to reduce the gap in the standard of living relative to the other advanced economies. In this context, it is important to remember a number of facts in relation to the two main uses that have been weak in recent years: Investment in the primary industries contributes not only to activity in the short term, but also to future production capacity, and investment in machinery and equipment means adopting the technologies inherent in that equipment, meaning that investment contributes to future growth by increasing production capacity and through its contribution to an increase in productivity. Exports make it possible for a small and open economy to exploit its relative advantages and the economy of scale. Export industries in general, and also in Israel, are therefore characterized by relatively high productivity. How have investments and exports developed in recent years? Investment as a share of GDP in Israel is low by international comparison, despite the fact that national savings is not low, as we showed in the Bank of Israel Annual Report for 2016. Therefore, not only are we not close the gap in capital per worker relative to other economies, the gap is even growing. By the way, the investments that increased in 2016 were mainly in residential construction and in the electronic components industry, but not in the other industries, such that the increase in investments made a relatively small contribution to a broad increase in production capacity. A factor that is complementary to private sector investment is government investment in infrastructure. Despite some increase in the past two years, the level of this 3/4 BIS central bankers' speeches investment remains lower than it was at the beginning of the decade. As a result, the stock of capital in the economy is lower than the average in the other advanced economies. Exports as a share of GDP also declined in recent years, affected by the weakness in world trade and the strengthening of the shekel. This fact is not harbinger of good news in terms of the dynamics of productivity. In this context, we can examine what happened to labor productivity in Israel over time. Despite its low level at the point of departure in 1995, its pace of growth was lower than what could have been expected given the fact that in general, the increase in productivity is greater in economies that begin from a lower point, if only because of their ability to adopt technologies that exist in countries at the technological forefront. The fact that the productivity gap has not been closed is particularly disappointing given that growth in productivity in the other advanced economies has also been relatively low in recent years. Other than the composition of growth and the insufficient level of infrastructure, I have discussed other reasons for the low level of productivity at various opportunities. The main reasons are unsuitable human capital, as shown by the PIAAC tests examining the cognitive skills of the adult population in Israel—such as problem solving skills in a digital environment—the problem of excessive and inefficient bureaucracy, and the fact that the economy is not sufficiently open to international competition in various aspects, such as the attitude toward competitive supply from abroad or relatively high non-tariff barriers. The question of the implications of growth led by consumption over the long term has been discussed by various international entities in recent years, and the main conclusions from their studies are similar to the analysis we have conducted. Such growth tends to be weaker, and it also generally leads to lower future growth. The reason for this is that the export industries, which tend to be an engine of innovation and productivity, are not contributing their part in pushing productivity forward, and the low level of investment contributes less to increased production capacity and to increased productivity derived from the adoption of technologies inherent in new capital. The strategy that will support more balanced growth, which for its part will contribute to stronger and more prolonged growth, must therefore include the following components: Improved human capital and workers’ skills—Providing content and abilities that will enable successful integration in the labor market for all parts of the population, including broad technological education at various levels; Improved business activity environment and removal of barriers that hinder competition from abroad Investment in infrastructure—Such investment will make a particularly large contribution in Israel in view of the low level of infrastructure, particularly that of public transit. The good state of the economy, in part thanks to the rapid increase in private consumption, actually requires us now to focus on dealing with the challenges so that we can ensure continued improvement in the standard of living in the long term. 4/4 BIS central bankers' speeches
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Remarks by Dr Nadine Baudot-Trajtenberg, Deputy Governor of the Bank of Israel, at a conference, organized by the Bank of Canada, Ottawa, 17 September 2017.
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Nadine Baudot-Trajtenberg: Main developments and challenges in achieving the inflation target in Israel in recent years Remarks by Dr Nadine Baudot-Trajtenberg, Deputy Governor of the Bank of Israel, at a conference, organized by the Bank of Canada, Ottawa, 17 September 2017. * * * Accompanying slides "I should like to thank the organizers of the conference for inviting me to participate and share with you Israel’s experience with inflation targeting, and particularly our recent experience which is not unlike that of many other small open economies except perhaps in a more accentuated form: solid growth, rising wages, strong currency and inflation not only below its target but mostly in negative territory for 3 consecutive years. As a general background, let me recall that Israel saw a decade of hyperinflation in the 70’s and early 80’s, followed by a decade of disinflation policy that targeted a gradually diminishing inflation rate, while the present day 1%-3% range for top line inflation has been effective since 2003. Though 12 month inflation has at times variated out of this range, it did so mostly for short periods of time due to fluctuations of the exchange rate. This was the case until approximately 3 years ago, when inflation fell systematically below target for now more than 3 consecutive years. Note that medium and long term inflation expectations have continued to be well anchored within the target band, thus giving credence to monetary policy. The importance of price stability, was reiterated in the renewed Bank of Israel Law in 2010, where it states that the Bank’s first role is to maintain price stability, while supporting economic growth and financial stability. The Bank is given what appears to be ample room to attain its target, 24 months, allowing it to “look through” temporary shocks, or onetime events that are expected to have short-lived impact on inflation, thus pushing it out the range fleetingly. Or so we thought. But first, let me zoom out and give you the broad outline of macro data the MPC took in to construct its view of economic developments. Over the past few years, while many of Israel’s trading partners were faced with a financial crisis and coping with a protractedly underperforming economy, Israel’s economy was growing steadily, and is now at close to its potential growth rate, supported by a continued rise in labor rate participation (particularly of women), growth in employment across sectors, and rising real and nominal wages which have emboldened private consumption expenditures. Of course, the data underlying this picture, does not come in smoothly, and aside from the labor market data that were consistently strong, we had plenty of fluctuations, including significant revisions of quarterly national account data and despite a robust current account surplus, we faced a clearly underperforming export sector. The lull in export was in part due to the slowdown in world trade, but we were keenly aware of the continuing strengthening of the shekel, beyond what we could estimate would be the normal adjustment reflecting the relatively good performance of the Israeli economy. So unemployment was at an all-time low, wages were rising and yet inflation remained low, compelling us to dig deeper into its sources in order to disentangle its underlying “core” trend, from a series of exogenous shocks that pushed inflation down. These were many and varied, from importing “deflation” from abroad, to decreasing energy prices, to successive reduction in administered prices such as water, electricity, children daycare, a cut in VAT, to welcome structural reforms that enhanced competition in industries such as communication. These came in addition to a backdrop of social protests concerned about the cost of living that increased the public’s price awareness and changed consumer habits enhancing competition in the retail sector, particularly with the increased use of internet buying. This phenomenon is 1/2 BIS central bankers' speeches shared by other countries, but there is ample evidence that the level of prices in Israel is higher than its other advanced countries, thus leaving more space for price reductions through enhanced competition and consumer savvy. Throughout this period, of now about 3 years, all forecasts and market expectations systematically underestimated the downward forces on prices, and thus overestimated forthcoming inflation. The discussions in the MPC reflected our challenge of on the one hand allowing for a welcome reduction in the level of prices, and on the other maintaining the overall price stability environment – a hard won anchor that allows for the good functioning of the economy. We lowered the Bank of Israel’s rate as inflation was dropping, to reach 0.1% in March of 2015 when 12 month inflation reached what turned out to be its lowest point at –1%. In addition, whenever the shekel appeared to embark on what we viewed as excessive momentum not justified by fundamentals, we intervened in the FX market, and still do so, not only because of its impact on prices but also to avoid the unwarranted impact on export industries, particularly of goods which tend to be more sensitive to the exchange rate. One could look at it as the QE of small open economies. A year passed, and still the inflation rate was below target and still in negative territory and we observed that the same forces were at play, and expected to continue to be due to the global economic and monetary environment and because of our own domestic conditions. It was clear that we needed to show our patience with the price environment. We did so by introducing nonconditional forward guidance – there were clearly too many elements behind the low inflation to allow us to turn some into conditions – which we reiterated more recently, and in our view was correctly interpreted by the market. Patience has its virtue but must not be confused with inaction, the BoI has been patient with inflation to return, but quite active to ensure that the crucial broader environment of price stability remains intact. Inflation expectations of the medium and longer term are still well anchored within the target range bestowing credibility to the monetary policy. To conclude in the spirit of this forward looking conference, I would draw 3 points from the recent Israeli experience. First, protracted periods of below target inflation do not entail an automatic loss of monetary policy credibility. For the latter to be maintained, we need to better understand, and better explain, how the transmission mechanisms operate – through short term interest rates, long term rates, exchange rate and asset prices. This will lead us to use more tools and more targeted tools when available. Second, the Israeli experience does not lead to the need of changing the inflation target: an important anchor for the economy must not be amenable to easy change unless there is strong evidence that it is no longer at the appropriate level. Inflation in Israel is also strongly impacted by global inflation, and while the debate on changing the inflation target is also taking place globally, there is no reason for Israel to be a pioneer in this change, if the change takes place. Third, monetary policy must take into account financial conditions as signaled daily, if not hourly by the markets, but as upholder of a necessary and crucial nominal anchor it must be able to withstand noise and remain forward looking. This in turn requires the Central Bank to engage in discussions and better explain its interpretation of sometimes contradictory data on the one hand, and to withstand “flavor of the day” pressures. “ 2/2 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Cabinet meeting on the multi-year infrastructure development plan, Tel Aviv, 3 September 2017.
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Karnit Flug: Infrastructure development plan for Israel Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Cabinet meeting on the multiyear infrastructure development plan, Tel Aviv, 3 September 2017. * * * I attribute tremendous importance to the establishment of an interministerial team to advance, coordinate and monitor infrastructure investment projects, set standards and criteria for using PPP in infrastructure projects, and evaluate the adequateness of projects to be executed by PPP . The level of infrastructure in Israel is insufficient, particularly in the area of public transportation, and mainly in the major cities, but also in the electricity delivery system and in communication infrastructure. The volume of annual investment is low by international comparison, and we are therefore not closing the gap in the level of infrastructure compared to other advanced economies, which weighs down productivity and the growth potential of the economy. We need to define needs with a forward-looking view, in close cooperation with the ministries, and to plan years, or, in fact, decades, in advance. One of the main barriers is the long project planning duration. In view of the many needs, it is important to set priorities and to plan and execute according to them. It is important that an informed estimation of the costs be made, and that the budgetary sources be defined, in order to avoid stopping projects and sharp cutbacks in projects as has happened in the past at times of budgetary stress. The use of PPP enables the costs of the project to be spread out over time. It is important to monitor the budgetary ramifications of all projects over time. PPP can be an important tool, if the projects executed through this method are chosen wisely. The selection must be made according to criteria that rely on Israeli and international experience, as we showed in the Bank of Israel Annual Report for 2016. The large advantage of the PPP method is that the developer does not only build the project, but also plans, maintains and operates the asset over time, so that the project can benefit from the operator’s expertise and experience, and the developer has an incentive to make the investment in a way that will minimize the operating and maintenance costs over time. The main disadvantage is that the private developer’s capital cost is higher than that of the government. It is important that a government unit be established that will specialize in the management and monitoring of PPP tenders and contracts. It will require specific know-how and expertise in tenders and contracts. Even in PPP projects, it is best if the government is the one that acts to complete the statutory processes such as obtaining building permits, municipal permits, environmental quality, etc. The government has an advantage here. 1/1 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Eli Hurvitz Conference on Economy and Society, Tel Aviv, 19 June 2018.
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Karnit Flug: On the importance of strategic planning and the difficulty of implementing it in the political reality Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Eli Hurvitz Conference on Economy and Society, Tel Aviv, 19 June 2018. * * * Bank of Israel Governor Dr. Karnit Flug: In order to achieve economic and social goals over time, it is very important that there be a strategic plan. At the start of the current government’s term in 2015, it adopted a socioeconomic strategic assessment and directions of action. The test will be in its implementation over time .There is built-in and natural tension between advancing the agenda of an elected government and a policy based on a long-term vision and advancing a strategic plan. In governments with a fragile coalition that relie on many parties, the tendency to make decisions that advance short-term achievements becomes stronger. It is therefore important to strengthen the mechanisms that tie the work of government ministries to the strategic plan, and to strengthen the professional echelon in the government ministries. Background The Eli Hurwitz Conference is focusing this year on strategy: the design of policy that directs reality while looking far into the future. The conference contains various sessions in which analyses of the basic demographic and global trends are presented, and discussions are held regarding the policy required today to achieve targets in the coming decades in areas that affect the standard of living, inequality, the quality of public services, the level of infrastructure and more. It is needless to go into detail about the importance of strategic planning in this forum. There are a number of layers: setting targets; designing policy that will be consistent with the long-term planning; and no less important, avoiding policy measures that will make it difficult to attain the strategic targets in the future. The late Eli Hurwitz, for whom this conference is named, led many strategic planning efforts, and today’s conference marks a decade since the presentation of the “Israel 2028—Socioeconomic Vision and Strategy in a Global World” plan, which was formulated by a team led by Eli Hurwitz and managed by David Brodet, together with many partners. The plan was presented and discussed by the government in May 2008. A decade later, we are at an appropriate place to stop and assess: Have the governments since then acted in view of the vision presented in the plan? Have they turned it into an operative work plan in various areas? And what have we achieved in terms of the targets that were set in the plan? The plan indicated areas that required government focus, while presenting warning signs for Israeli society. It also presented the vision in quantitative terms for the level of per capita GDP, the GINI index of inequality, the labor force participation rate, and the employment level. (It is important to note that the two latter goals, which relate to employment, were achieved, and the current data are better than the targets that were set). One of the areas emphasized in the 2028 plan is the need for “a fundamental reform of education, from kindergarten through the end of secondary school and higher education”, 1/6 BIS central bankers' speeches and another was “integration of the ultra-Orthodox, Arab, and peripheral populations in economic efforts.” The plan also emphasized the risks created by the development of a dual economy, in which there is an advanced economy that leads in innovation and technology, benefits from high productivity and answers the challenges of globalization, and which employs 6 percent of the workers in the economy (today 9 percent), alongside traditional industries that are characterized by low productivity and low growth. Later on, it is noted that “the income gaps in Israel are among the highest in the advanced economies, economic polarization is dividing society and preventing the maximization of economic growth.” These issues remain a significant challenge for policy today. Government decisions and actions to formulate a strategy Despite the fact that the plan itself was not adopted as a government plan, it did provide inspiration for in-depth strategic work within the government that followed. In 2012, the government decided, based on the work done by the National Economic Council, to adopt a plan to consolidate and improve the government’s ability to formulate and manage a socioeconomic strategy (Decision 5208). The plan included: Establishing a socioeconomic strategic assessment that is to be presented to each government in the first 100 days of its term, in which the areas of action that provide a significant response to main trends and characteristics are detailed; Establishing a ministerial committee for strategic matters (in practice, this recommendation was not accepted); Establishing a strategic management team led by senior officials in the Prime Minister’s Office and the Ministry of Finance (in practice, the team held very few meetings); Establishing a forum of Depute Directors General of Planning and Strategy in the government ministries (the forum is active and holds professional discussions). In June 2015, the government adopted a socioeconomic strategic assessment, and then approved a series of government decisions to adopt directions of action in response to various issues, and to integrate them into the detailed work plans of the ministries, and into their budgets (Decision 145). The strategic issues that were defined were: cultivating and maximizing human capital, productivity and competition, financing infrastructure, housing strategy, regional economic development, preparedness for the aging of the population, and “Digital Israel”. An analysis of the performance of all items in the government decisions in the various fields, which was done by the National Economic Council in the past few months, shows a positive picture in the performance of most of the decisions. These are mainly decisions to create the frameworks and processes, such as establishing teams, presenting and formulating programs, and progress reports to various forums. Of course, the most important test will relate to the formulation and implementation of detailed plans, and achieving the targets over time. At this stage, it is too early to assess the extent to which they will be realized. Examples of issues that require a strategic plan that were included in the government decision in 2015 Human capital—As early as the Israel 2028 plan, the area of education and professional training was identified as a main component in providing the basic values and skills required in the modern labor market. This is one of the areas where the importance of a strategic plan is clear—a plan that formulates targets, defines work plans for achieving them, and allocates budgets is essential in order to achieve an education system that is tasked with providing values, abilities and skills that will enable its graduates to deal—as workers and in 2/6 BIS central bankers' speeches general as citizens—with the challenges of a changing labor world, for many years to come. The low achievements and the gaps in scholastic achievement and in the abilities relevant for the labor market are constantly being raised by the findings of PISA and PIAAC tests. Despite the increase in the average number of years of schooling, literacy, numeracy and functioning in a digital environment among the adult population in Israel—at all levels of education—are lower than those in most of the advanced economies, and the situation is no better among students. The need to deal with low abilities and skills is also shown by an analysis of labor productivity trends in Israel relative to the other advanced economies, and by productivity and wage gaps between various groups. Improvement is needed in the education system and in professional training, so that it will prepare its graduates for the labor market of the 21st century, which will require a variety of cognitive skills as well as critical thinking, creativity, teamwork ability, and more. The Ministry of Education, led by various education ministers, has set various goals, and has focused on dealing with various issues in each period. While in Gideon Sa’ar’s term, the ministry focused mainly on improving METZAV test scores, during Shai Piron’s term it focused on advancing “significant learning”. In the current term, under Naftali Bennett, the focus moved to increasing the number of students learning mathematics. During the term of the previous government, the need to provide basic skills to everyone was emphasized, and budget allocations were even supposed to be conditional on providing courses such as mathematics, English and sciences, but the current government cancelled that condition. These changes in priorities, concepts and emphases included budgetary changes and the diversion of a significant portion of the ministry’s flexible budget every time a new minister took office. The variance in philosophies, and as a direct result in the action strategy and the targets derived from it, impaired consistency and made it difficult to qualitatively implement the plans. In 2015, as part of the strategic assessment, one of the decisions made by the government was to focus on “cultivating and maximizing human capital”. Most of the activity directions proposed by the government at the time were approved and are being advanced. For instance, increasing the number of students studying 5 units in mathematics, increasing hitech manpower through various means, and reforming the technological colleges. However, it is clear that achieving a target such as increasing the number of students studying 5 units in mathematics requires consistency over time, as providing mathematical thinking skills must start at a very young age, and only based on that can we reach high proportions of children with the potential to cope with studying the highest levels of mathematics. It therefore seems that the strategic goal adopted by the government to cultivate and maximize human capital, and individual decisions derived from it, have an impact on Ministry of Education goals and work plans. However, it is too early to determine whether setting the strategic goal leads to focusing the Ministry’s efforts on achieving the goal over time, and particularly whether the required continuity is created even when there are changes in government or in ministers. Another example of an area in which it is necessary to adopt a strategic plan that will be implemented over time is housing. The need for a strategic plan in this field is due to the long time needed for policy to be implemented. Decisions made have an impact on how land is used and conceptualized, and are to a large extent irreversible. Decisions on dispersal of the population also form the 3/6 BIS central bankers' speeches basis for infrastructure planning. There is also need for a high planning inventory based on the strategic plan so that it will be possible to respond relatively quickly to changes in demand, and particularly in view of the long time required from initiation to completion of construction (about 12–15 years). In 2005, the government approved National Outline Plan 35, which was intended to define the policy of planning and the placement of localities in Israel until 2020. The main points of the plan are strengthening existing localities and avoiding suburbanization, urban renewal, and strengthening public transport. The national outline plan is intended to serve as a basis for all construction and development initiatives in Israel according to the principles upon which it is based, and set geographic dispersal targets that would increase the proportion of the population in the northern and southern regions at the expense of the proportion in the center of the country. The plan was supposed to be updated every four years. Examining the developments since then we find that the targets of the plan in the area of construction planning, both in relation to the overall volume and in relation to the dispersal of the population, did not succeed in directing demand to the housing market in the periphery (the gap between the number of residents in the periphery according to the target and the actual number is 600,000), which increased the gaps between demand and supply in the center of the country. We may assume that this also has to do with the non-use of transport development plans. In May 2017, the strategic plan for housing that was led by the Planning Administration and the National Economic Council was published. The plan set active targets for the planning system that will enable the construction of 1.5 million housing units between 2014 and 2040, in accordance with the need shown by models based on demographic trends. The plan also set targets for the future geographic dispersal of dwellings, taking into account the periphery’s absorption capabilities, the shortage of land in the center of the country, the distribution of demand, and the economy’s efficiency. This target differs substantially from the targets that were included in the previous plan. (In this context, by the way, it is worth asking whether the Housing Minister’s decision to advance the construction of 18 new localities in the Negev is consistent with this strategic plan). The importance of advancing a strategic plan in the area of housing is also derived from the certainty that it is supposed to create for the synchronization of the infrastructure required for building the dwellings and adding more residents to the localities. The Planning Administration, which led the plan, continues to implement the decision, including by mapping building cites, formulating a detailed work plan, coordinating the surface infrastructure that is required, and advancing processes in terms of employment and industry that are intended to provide a response to the employment needs of the population in places that will be built. It is entirely possible that had the strategic plan in housing been implemented at the beginning of the 2000s, it would have helped create a large planning inventory and would have enabled policy makers to deal with the rapid increase in demand for homes in 2007 in a more rapid and successful manner. And one last example that mainly indicates difficulty in the implementation of a strategic plan is in the area of transport infrastructure. One of the factors that affects both the difficulty in geographic dispersal of the population and the low level and slow growth of productivity in Israel is the low level and poor quality of the transport infrastructure, particularly public transit. In order to deal with this, the government made a number of decisions on long-term investment plans in transport infrastructure that are intended to improve and expand the road network and the public transit system, 4/6 BIS central bankers' speeches including “Netivei Yisrael”, the light rail systems in Jerusalem and tel Aviv, and the Tel AvivJerusalem train route. Monitoring the performance of these plan over time shows that they have encountered many problems in implementation and time tables. Only a fraction of the plans ever make it to execution, and most of those significantly overshoot the planned time tables for their completion, leading in the medium term to underinvestment in transport infrastructure. For instance, the gap between the 2012 expectation of budgetary expenditure on transport infrastructure in 2015 and the expectation at the beginning of 2015 was NIS 10 billion. In other words, actual expenditure was 45 percent lower than planned, even though the government did not cancel significant transport development plans. This is not a cost savings: the plans are simply being executed at a slower pace than planned. The slow progress has significance beyond the lack of transport infrastructure: The delay impairs the ability to plan residential and business locations, since the construction of residential neighborhoods requires roads and access to employment areas for future residents, and the functioning of businesses is affected by their access to transport infrastructure. Alongside areas where it seems that the government’s decision to adopt a strategic plan at least to the formulation of a working plan derived from it, there are also examples of issues that were included in a plan and are not being implemented. For instance: Establishing a financial stability committee. There is agreement over the text of the law, but it is still delayed in the Knesset Finance Committee. Gradual adjustment of the retirement age. In July 2017, the Knesset Finance Committee again stopped the automatic increase of the retirement age for women, which was supposed to gradually rise from January 1, 2017 until 2022 to the age of 64 in a number of increases. Dealing with the actuarial deficit of the National Insurance Institute. A process for solving the problem has not been formulated. A public committee (Domenicini-Nissan) submitted recommendations in 2012, which weren’t even discussed by the government and remained in a drawer. Since the decision in 2015, the issue hasn’t been discussed by the government. What all these things have in common is that the way they are being dealt with is not bearing results in the short term, and some of them even carry a public cost in the short term. No politician gets credit for an actuarial or financial crisis that does not happen. Alongside the government’s progress in creating the infrastructure for planning the strategy, there is room to strengthen this process and to assimilate it further in the government work process, similar to the budget process. This can be done in such a way that the strategic trends presented and approved by the government will constitute the vision with which fiveyear plans and annual work plans will be formulated. In particular, it is important that the annual government targets for the ministries be derived from the long-term targets of the government’s strategic plan. The existing mechanisms must be strengthened and supported by the establishment of a ministerial committee for strategy, and through the strategic management team. In summation: There is a natural built-in tension between promoting the agenda and priorities of the elected government and policy that is based on a long-term vision and the advancement of strategic plans. On one hand, planning, formulation and implementation of a strategic plan that acts to achieve targets over time are necessary conditions for progressing consistently toward 5/6 BIS central bankers' speeches the achievement of goals that affect main areas of economic and social development. On the other hand, every government elected naturally has the desire to impact policy directions and leave its mark. This desire is brought into sharper relief when the government relies on a fragile coalition in which the composite parties will be tested at the ballot box in the not-toodistant future (and at timing that is not always known). Such a government has an increased natural tendency toward making decisions that focus on short-term achievements rather than the alternative of following a strategic path that was outlined by the previous government, or the fruits of which may be harvested only by the next government. The test of the government’s strategic work will be in implementing work plans for the government ministries that are derived from the strategic plan, and the continuity of their implementation over time and during the terms of different governments. The plans must be based on an infrastructure of broad knowledge (in this context, the Bank of Israel’s role as a professional, and independent advisory body is important) and on high-quality staff work in the relevant ministries, monitored when necessary by the Budget Department. For that purposes, it is also very important to strengthen a stable professional echelon that will ensure the proper weight is given to continuity and to a long-term vision. 6/6 BIS central bankers' speeches
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Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the farewell conference marking the end of her term, Jerusalem, 4 November 2018.
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Karnit Flug: Policy dilemmas and the role of the central bank in advising government Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the farewell conference marking the end of her term, Jerusalem, 4 November 2018. * * * This conference touched upon two areas that are at the center of the BOI responsibilities: one which is unique among central banks and that is the governor of the BOI being the economic advisor to the government. The second is the core business of central banks, namely Monetary Policy making. Although the BOI has many other areas of responsibility, I would like to offer a few reflections on each of those two very important areas. In the first part of this conference, we have seen a sample of two research projects conducted by researchers from our research department, and we have heard Laurence Boone, the chief economist of the OECD covering policy issues related to inclusive growth. The two research projects give a glimpse of the type of research that tackles specific policy issues; in this case public housing policies and EITC, or income support for the working poor. The work performed at the OECD on inclusive growth has touched upon important policy dilemmas and tradeoffs, and provides some insights on what policies could be pursued in the quest for inclusive growth: The need to enhance education and promote life-long learning and acquisition of skills; enhancing access to affordable housing; and ensuring adaptation and diffusion of technologies across the board – in particular for small and young firms. These are lessens that we, as the economic advisors to the government have grappled with over the years: Some research projects conducted by BOI researchers may focus on a very specific policy question and directly help design a better policy. Others are of a more basic nature and provide a better understanding of the interaction between relevant variables; while yet others estimate and quantify these relationships or help assess the speed or extent to which a policy action may impact on relevant variables. What is common to all of this work is that it lays the foundations, and builds the infrastructure, to a more informed policymaking and thus helps design better policies. A natural question that arises in this respect is why at the Central Bank? Should the economic advisor to the government be the Governor of the Central Bank? This question was debated within the bank of Israel, among some of the people sitting here today. While we were discussing the new Bank of Israel Law, Stan was initially of the view that the role of an economic advisor to the government puts the bank in a constantly contentious position Vis a Vis the government and may undermine the banks’ independence in its core responsibility. I was the Director of the Research Department at that time, and argued in favor of maintaining the role of economic advisor in the law, which was eventually what was decided. Several years later, when I became Governor, I met Stan (in Basel, at a BIS meeting) following one of the heated debates I had with the government, and told him that now I understand and sympathize with his initial view against having the role of the economic advisor. Stan surprised me when he said that looking from the outside, he is even more convinced of the importance of this role of the Bank of Israel. This question was also posed to an independent evaluation committee which was invited to evaluate the BOI’s research department back in 2012. In their report, they said, and I quote: “We came to the Bank very skeptical of any central bank having the responsibility of being an advisor, much less the advisor, to the government on economic policy". Following a thorough discussion 1/3 BIS central bankers' speeches with many relevant stakeholders within and outside the bank, they concluded: “Absent fundamental changes in other Israeli institutions, we agree that the Bank must continue to play the critical role of advisor to the government policy" Indeed, the argument against the CB’s role in economic policy advice because it enhances the friction between the Bank and the government and thus may undermine the Bank’s independence in its core responsibilities is not unique to the role of economic advisor. In fact, this debate resembles the discussion regarding the question that is debated extensively among central bankers as to how wide should our responsibilities and mandates be defined. I have heard the argument that in some issues the decisions reflect political priorities as opposed to pure economic welfare maximization decisions, and therefore should be left to the politicians, or that they may undermine the central banks’ credibility or independence. These are valid arguments, and certainly, my tenure as governor has demonstrated that providing a wellgrounded position on some sensitive or publically debated policy issues does raise the level of friction with the government. However, when we think about designing institutions, we should not think in the abstract, and we never start from scratch. We should take the starting point into account, and asses what is the likelihood that a change will get us closer to some “ideal institutional design” (if such exists). Given that this role has been defined in the original BOI law from 1954 as one of the main responsibilities of the BOI and its Governor, the basic infrastructure of knowledge and highly professional staff, and reputation has been built at the BOI to serve this responsibility. I also believe that the credibility of the central bank is enhanced, not damaged, by the quality research and policy recommendations it provides. In that regard, it may even contribute to the public support of an independent central bank. And as to friction between the central bank and the political system, during my term it was in fact most intense around issues related to the core activity of the Bank of Israel in supporting financial stability. The quest for enhancing competition in the provision of financial services, which we all share, led to heated debate as to the scope, the speed and the specifics of the financial sector reform. It centered around our insistence on ensuring that the reform does not undermine financial stability that was sometimes taken for granted by our partners in the design of the reform. In the past, the friction was most intense regarding the disinflation process, and Jacob Frankel who sits here, can certainty testify to that. So, we’ve had frictions in the past and will probably have them in the future, and we should be able to withstand them. We should provide a quiet, behind closed doors policy advice in some cases, and contribute to a better-informed public debate on key policy questions. I believe that within the current political context, where policies tend, more than in the past, to focus more on short term benefits and ignore longer term risks and costs, it is essential that an independent well regarded institution provides solid policy analysis and advice, and helps explain this to the public. So, I believe that retaining the economic advisory role by the Central Bank in the 2010 BOI law has served the country well. In the second part of the conference, we have heard an extensive discussion of the panel of very distinguished speakers on monetary policy and Inflation Targeting in the post GFC era. Thus, I feel it will be somewhat ambitious on my part to try to add to this extensive discussion. The only thing I would like to say is that monetary policy making in Israel over the last 5 years that may have seemed boring at times to bystanders, has in fact been a fascinating journey to those involved in making it. Early on, we reduced the interest rate to 0.1%—a record low for Israel, a move that won me the title of “the most surprising governor in the world” according to one of the international news wires. Later on we had prepared to use unconventional policy tools, an option that eventually we decided not to use in light of the solid growth, healthy developments in the labor market, and the assessment that the low inflation was not reflecting weakness of demand but rather, at least in 2/3 BIS central bankers' speeches part, the result of positive processes such as the intensifying of competition. During this period we have also introduced some changes to the MP communication strategy: For example, we launched a quarterly press briefing following rate decisions, and made use of forward guidance. We have also made use of FX intervention, in times mildly, and in times intensively, according to our assessment of the nature of FX fluctuations. Each policy decision followed a very thorough and deep discussion, and although many times the debate got heated, and sometimes disagreements arose, I was always sure that every member of the MPC had only the best interest of the Israeli economy in his or her mind. Now, following almost 4 years of keeping the interest rate at 0.1 %, it seems as if the era of gradual normalization is approaching. I can already visualize the heated debates that are likely to take place within the monetary committee as to the exact pace and path that this process will take. The committee’s challenge will be to move not too fast, so as not to choke the process of entrenchment of the inflation environment within its target range; and not too slow so as not to find themselves behind the curve. I assure you I will be watching this process closely with great interest. Let me now thank the organizers Michel and Nadine, for initiating and organizing this excellent conference, and thank all the presenters from the BOI as well as our distinguished guests, who came from far away. Thank you for the very kind words you said, I am moved and honored by all of this. And thank you all for coming. 3/3 BIS central bankers' speeches
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Speech by Mr Yaron Amir, Governor of the Bank of Israel, at the Israel Economic Association Conference at the Hebrew University of Jerusalem, Jerusalem, 6 June 2019.
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Yaron Amir: Are we again taking financial stability for granted? (Or: Do we need central banks?) Speech by Mr Yaron Amir, Governor of the Bank of Israel, at the Israel Economic Association Conference at the Hebrew University of Jerusalem, Jerusalem, 6 June 2019. * * * "In recent weeks that has been an increase in uncertainty in Israel. While the financial markets have so far not been tremendously agitated by it, we cannot assume that there is no damage, and it is clear that we must deal with it and that this is a challenging period. In order to prevent harm to the economy, all policy makers and public officials must act responsibly and do all that they can in order to reinstill certainty and fiscal responsibility soon after the elections." Summary: The volatility in consumption and income may, under certain circumstances, have a significant negative impact on well-being, such that the central banks’ stabilizing policies may be very valuable. The volatility may have an impact on the path of growth, such that the stabilizing policies also have an impact on growth. There is “bad” uncertainty, because of which we must guard stability, but there is also “good” uncertainty. We must maintain stability while enabling that good uncertainty, which is reflected in innovation and technological improvements, research and development, and competition. The stabilizing policy is particularly important to prevent financial crises, since the damage from such crises is significant. Therefore, the financial stability committee becomes all the more important as a vital layer in the early identification of risks. The establishment of the committee is a very important step in view of the reforms in the financial system that are being formulated. The Bank of Israel advises the government on how to increase the long-term growth rate, and indicates main policy measures that can increase the long-term growth path: in the areas of education, infrastructure, and bureaucracy. The Bank is currently working diligently on a formal report containing the Bank’s recommendations to the government regarding the advancement of productivity in the economy and an analysis of their expected costs and benefits in the long term, which we will publish soon. *** I chose to deal today with this question, because I think that this conference is the proper platform for such a discussion, which combines economic theory, policy measures, and the current public discourse in Israel, a decade after the Global Financial Crisis. There is a model by a very famous economist behind this question, and his insights can lead us to the conclusion that the value of stabilizing policy, mainly by the central banks, is not great. But there is also widespread economic literature that proves otherwise, as well as insights that are specific to Israel. These insights have become clearer to me in recent months, since I took on the position of Bank of Israel Governor and saw how the Bank of Israel’s measures, in their various forms, have contributed to the economy’s growth and its resilience to shocks. First, let us mention the Objectives of the Bank of Israel, according to the Law: To maintain price stability, as its central goal; To support economic policy, especially growth, employment and reducing social gaps; 1/4 BIS central bankers' speeches To support the stability and orderly activity of the financial system. It is common in the economic literature to assume that one of the central bank’s roles is to moderate the volatility of the business cycle, since the widespread assumption is that this volatility is undesirable among consumers and firms. And in fact, since the mid-1980s, there has been a decline in the volatility of business cycles in the advanced economies, which has been reflected in GDP, production, employment, and more. The success in reducing the volatility is mostly attributed to the policies of the central banks, which, thanks their independence, can act in the interest of macroeconomic stability. If so, it is worth examining whether the effort to stabilize economic activity, which has in fact borne fruit in recent decades, is actually important and worthwhile. The economist Robert Lucas examined this question in 1987 by estimating the negative impact to well-being that results from volatility in consumption, assuming that potential consumption increases at a fixed rate while actual consumption is volatile. Lucas’s model shows that the consumption value that individuals will agree to pay for completely cancelling volatility—for convenience, let’s call it the “insurance premium for nonvolatile consumption"—is near zero. This means that the value to the consumer of smoothing consumption is negligible, and we can theoretically conclude that there is no tremendous value to a stabilizing policy. This leads to a similar potential interpretation regarding the importance of the central banks. Is this really true? Where does the gap between the intuitive notion that volatility should be moderated and Lucas’s conclusion come from? The answer has to do with three components that are not reflected in Lucas’s paper: 1.The single individual is exposed to greater risks than the average individual. 2.The path of growth on its own is subject to volatility and is not certain. 3.The significant impact of financial cycles on the business cycles. For now, I will expand a little on each of them. A more correct assumption for the model, which is closer to the economic reality, is that the single individual is exposed to greater risks than the average individual. Therefore, when the distribution of risk among the individuals is not uniform, aggregate data do not necessarily provide the complete picture. A more simplistic description of this assumption is used a lot in describing the statistical average, ignoring variance and volatility: “You can also drown in a pool with an average depth of 20 cm." So when examining the change in the effect of volatility on different population groups in different situations, the “consumption insurance premium” that Lucas thought was negligible becomes positive in the model and significant in “real life". For instance, during a recession, most of the public that continues to work and receive wages feels the recession only on the margins, while workers who have been laid off take a serious hit. From the point of view, a reduction in volatility would have led to a very large advantage. Another parameter that needs to be taken into account is that, as opposed to Lucas’s assumption, the path of growth actually is subject to volatility and is not certain. Economists who took this into account in their models, such as Obestfeld (194), and Dolmes (1998) actually found that the effect of shocks is prolonged. As such, if the shocks affect consumption over time, and are not limited to short-term volatility of consumption, then the value of stability—the “consumption insurance premium"—is high. Those shocks that we mentioned have an effect that is not uniform. Positive business cycles accelerate the economy, while negative business cycles moderate it asymmetrically, so that the volatility itself has a negative impact on the path of growth. A study by Yellin and Eckerloff (2004) shows that unemployment responds asymmetrically to changes in inflation, such that a stabilizing policy may increase GDP by 0.5–0.8 percent per year on average. One of the studies that helps to 2/4 BIS central bankers' speeches explain this positive outcome was done by DeLong and Summers (1988), in which they show that a stabilizing policy can have a medium-term impact because it is not necessarily symmetrical, and hence its importance. The troughs can be smoothed without “shaving” the peak periods in the business cycles. Another way of examining the cost of volatility, or alternatively the value of stability, is to examine investment in the economy, which has a large effect on GDP and on consumption. Uncertainty affects production decisions, when firms must made decisions in advance regarding the technology that they will use and the means of production they will employ. Firms may therefore inefficiently allocate their resources. Ramay and Ramay (1991) also found a statistically significant value to the “consumption insurance premium". In addition, Bar-Levy (2004) found that an increase in investment during peak periods contributes less to growth than the negative impact to growth from a reduction in investment during a recession. Therefore, a stabilizing policy is not limited to smoothing consumption volatility, but contributes to the growth rate and to improving per capita consumption. It is important to note that there is “bad” uncertainty, regarding which we must guard stability, but there is also “good” uncertainty, as shown by a study I conducted with Segal and Shaliastovich (2015). We must maintain stability while enabling that good uncertainty that is reflected in innovation and technological improvements, research and development, and competition. Until now, the discussion has been regarding volatile business cycles. But what about the significant effect of financial cycles on that volatility? "Financial cycle” is a term that is described and analyzed in the Bank of Israel’s upcoming Financial Stability Report. It is a method of identifying cyclical behavior of financial activity. The financial cycle is defined as “deviations from the long-term trend of a group of variables that are important to financial stability". The definition first requires us to choose the relevant variables, and then to choose the method of identifying deviations in the trend. In accordance with the literature, the Bank of Israel examined a number of estimations for identifying the financial cycle, including private credit, home prices, share prices, and the slope of the real yield curve. It was found that, except for private credit and home prices, the rest of the estimations that were examined vary at a different (high) rate, and therefore do not contribute to identifying the financial cycle. We can see that recessions accompanied by a downturn in the financial cycle (movement from a high point to a low point) are the deepest and most serious. This finding significantly increases the “consumption insurance premium", as shown in a study I conducted with Bansal and Kiku (2010). An examination in the forthcoming Financial Stability Report tested the effect of the intensity of the financial cycle on periods of slowdown in Israel. It shows that during downturns in the financial cycle, there was a significant negative impact to the real cycle (-3.3 percent at the beginning of the 2000s, compared with 0.2 percent in the mid-1990s and –2.0 percent during the Global Financial Crisis, when the financial cycle in Israel was in an upward path). One of the issues raised by such an analysis is the question of the need for setting anti-cyclical capital buffers: a demand that the banks hold higher levels of capital during boom periods, which can be decreased during economic downturns, thereby releasing the credit supply constraint during such periods. The use of anti-cyclical capital buffers obviously requires precise identification of the financial cycle. A number of countries, such as the UK, the Czech Republic, Hong Kong, and the Scandinavian countries, are already implementing anti-cyclical policy in setting capital buffers, in accordance with the Basel 3 guidelines. As such, we can say that volatility in consumption and in income may, in some circumstances, have a significant negative impact on well-being, such that a stabilizing policy on the part of the central banks can have tremendous value. The path of growth on its own may be affected by volatility, such that a stabilizing policy also affects growth. The stabilizing policy is particularly important for preventing financial crises since financial crises have a very strong impact. 3/4 BIS central bankers' speeches How does the Bank of Israel, in practical terms, implement the insights from these analyses and studies in order to contribute to the stability, prosperity and growth of the Israeli economy? First we examine long-term price stability, which influences many of the decisions previously discussed. We can see that the long-term inflation expectations are anchored around the midpoint of the target range, meaning that the Bank’s policy is credible and the market participants benefit from certainty regarding long-term inflation. The monetary policy that enabled this outcome was accompanied by macroprudential measures taken by the Bank, which succeeded in preventing overleverage despite the low interest rates, thereby protecting financial stability with a long-term systemic view, and enabling monetary policy to focus on achieving its main objectives. At the same time, the Bank of Israel worked to strengthen the capital buffers in the banking system in order to increase its resilience to crises, and increased the foreign exchange reserves to around 30 percent of GDP in order to strengthen the economy’s financial safety buffer. Notwithstanding these actions, there is room for advancing further measures, partly because the credit market is becoming more varied and requires a more integrated regulatory view. The volume of credit issued by nonbank entities has been expanding in recent years, partly due to the reforms in this market. Regulation of nonbank financial entities, particularly over the granting of consumer credit, is not the same as regulation over the banks. While the difference in the type of activity between the entities justifies certain differences in regulation, it is important to make sure that these differences don’t develop into regulatory arbitrage that could under certain circumstances create a systemic risk. Therefore, the Financial Stability Committee that convened for the first time in April 2019 is increasingly important, and provides an important element in reducing regulatory arbitrage and in the early identification of risks. The establishment of the committee is a very important step in view of the reforms taking place in the financial system. The multiplicity of participants in the credit market, and the division of responsibility between the various regulators require a view of the entire system and close coordination between the regulators. If we have so far discussed the Bank of Israel’s contribution to reducing volatility, I would like to mention that volatility and growth are connected to each other in certain ranges. This brings up another area under the Bank of Israel’s responsibility, where, as opposed to most other central banks, the Governor of the Bank of Israel also serves as economic advisor to the government. As such, the Bank advises the government on how it can increase the long-term growth rate. The Research Department indicates main policy measures that can increase the long-term growth path: in the areas of education, infrastructure, and bureaucracy. The Bank is currently working diligently on a formal report containing the Bank’s recommendations to the government regarding the advancement of productivity in the economy and an analysis of their expected costs and benefits in the long term, which we will publish soon. In conclusion, it is, of course, important to enable and promote innovation and competition, but as I have emphasized throughout this discussion, it is no less important to avoid taking stability for granted. There is tremendous value to overall well-being from a policy that stabilizes volatility and uncertainty in the short term, the medium term and the long term, and certainly when volatility increases to the point of a financial crisis. In recent weeks that has been an increase in uncertainty in Israel. While the financial markets have so far not been tremendously agitated by it, we cannot assume that there is no damage, and it is clear that we must deal with it and that this is a challenging period. In order to prevent harm to the economy, all policy makers and public officials must act responsibly and do all that they can in order to reinstill certainty and fiscal responsibility soon after the elections. 4/4 BIS central bankers' speeches
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Speech by Mr Yaron Amir, Governor of the Bank of Israel, at the Banking Supervision Department conference on competition in the banking system, Jerusalem, 2 April 2019.
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Yaron Amir: Competition in the banking system Speech by Mr Yaron Amir, Governor of the Bank of Israel, at the Banking Supervision Department conference on competition in the banking system, Jerusalem, 2 April 2019. * * * Summary: Some of the significant measures and reforms aimed at enhancing competition have already come to fruition, and others are in the process of coming to fruition. There are additional supporting processes that are required now, such as the development and application of financial and technological instruments, and the deepening of the capital market, which will contribute to competition in the credit market and increased consumer well-being as they advance. These processes are becoming possible mainly in view of the development and application of advanced technologies that were not available until just recently. Removing information gaps, leveraging existing information, and utilizing technological ability for informed analysis and learning in real time about the credit market will enable more correct pricing that is more in line with the risk to various layers of the credit market— households and small and medium businesses—thereby contributing to development of the market. The market must be developed while managing risks and developing proper regulation, in order to make sure that, despite the risks, the benefit from these processes will make them worthwhile. Two financial instruments that should be advanced in order to make the capital market more sophisticated and deeper, and which will contribute to the continuing increase in competition, are securitization and long-term interest rate derivatives. *** Good morning. First, I would like to congratulate the Banking Supervision Department on this conference, and welcome the honored guests. The issue of competition in the financial system is one that occupies many people in Israel and abroad. Advancing competition has been a top priority of the public and of the Bank of Israel in recent years, and for good reason. Advancing competition in the financial system, when done properly, has many positive effects on all entities in the economy, first and foremost the broad public. Today, I would like to discuss various aspects that can enhance competition in this market, thereby increasing consumer well-being and economic growth. Some of the significant measures and reforms aimed at enhancing competition have already come to fruition, and we are already enjoying the results. Others are in the process of coming to fruition. And there are additional supporting measures that are now required, such as the development and application of technological and financial instruments, and deepening the capital market. As these are advanced into the future, they will in turn contribute to market efficiency, an increase in the variety of possibilities for competition, and to increased consumer well-being. Financial markets enable a more efficient allocation of sources and create the proper mechanisms for risk-sharing. Therefore, the extent of development and sophistication of the financial markets—such as how deep they are, how liquid they are when necessary, and what mix of instruments is available to the various participants, both firms and lenders, and customers and end consumers—is very important. I will discuss these in greater detail later on, but first, to the question, “What is competition?" A common approach to defining competition is the equilibrium result where the price is equal to the 1/5 BIS central bankers' speeches marginal cost as a result of sophisticated competition. In accordance with this approach, in order to have a competitive market, a number of assumptions must be met, including the free entry and exit of firms, and public knowledge of the market possibilities. As we know, there are significant entry barriers in the credit market, some of which are natural, since the banking system is characterized by economies of scale, and there are built-in information gaps. The Bank of Israel, the Ministry of Finance, and others have dealt with these issues in recent years with the proper amount of caution, and the solutions are now coming to fruition. We will hear during the day about various processes for removing barriers, as well as the implementation of “open banking", “moving from one bank to another with one click", removing technological barriers, and the implementation of advanced technology that was not available until just recently, together with the necessary adaptation of regulation. Each of these is important on its own, and their combination makes a greater contribution than each one could when implemented separately. Together, these processes can increase competitive pressure in the coming years, and support the entry of additional participants into the market. They deal with the removal of information gaps, the leveraging of existing information, and the utilization of technological capabilities in the real-time analysis and informed learning about the credit market. These will enable more correct pricing that is more in line with risk—for various levels of the credit market, such as households and small and medium businesses, thereby contributing to the development of the market. Technology and the accompanying information contain advantages not just for the private sector, but also for the government. For instance, they enable the transition from paper-based means of payment to more advanced means of payment, enable tracking, and have the potential to reduce black-market activity in Israel. At the same time, they are leading the enhancement of competition by allowing new participants to enter the market and through the development of different business models to provide a variety of payment services and increase the customer’s ease of use. Another aspect of competition is focused on the dynamic behavior of the supply side. In other words, the market is competitive when its participants are sufficiently aggressive and a competitor has the incentive to improve in order to gain an advantage over other competitors— whether the advantages are the result of improved quality and service, lower prices, additional services, and so forth. These aspects have also undergone many changes in recent years, whether as part of a natural market process, or as a result of regulatory encouragement, in adopting technological advancement alongside significant streamlining, that will enable the creation of the required competition on the supply side. In this regard, there is an interesting simultaneous link between efficiency and competition among the banks. Streamlining enables the banks to lower prices in order to attract customers, or to provide new and higher-quality services for the same purpose. Accordingly, it is possible that increased efficiency will actually lead to increased concentration, and will therefore be interpreted as a reduction in competition, because more efficient companies will have a higher market share, which will lead to increased market concentration. Our job as regulators over this market is therefore to make sure, as the Banking Supervision Department is doing, that the fruits of streamlining actually roll over from the banks to the broad public. When dealing with efficiency, many tend to think mainly about the operational efficiency of some organization. However, a significant portion of activity in the credit market depends on the ability of the various participants to use the various capital market instruments to “offer their wares", and mainly to provide credit. The extent of this mechanism’s efficiency, for instance in its ability to allocate sources and optimally distribute risk (risk sharing), has a tremendous effect on the ability to provide products that are relevant to their customers and make them accessible, in such way that they will increase consumer well-being and support increased competition in the credit market. 2/5 BIS central bankers' speeches How can we advance this? Through continued development of the capital market, particularly by increasing the level of sophistication of the market, which will enable the informed application of financial instruments that must be developed to advance the credit market. Thanks to those instruments, it will be possible to allocate sources and share risk more efficiently, increase accessibility to sources of credit, and achieve more proper pricing in the market. In this way, we will improve the state of all participants in the credit market, particularly the end customers— firms and the broad public, which will benefit from increased competition, a greater variety of available possibilities, and more optimal decision-making capabilities. Of course, it is important that all these are done while managing risk and developing the proper regulation, in order to make sure that despite the risks, the benefits from these processes will make them worthwhile. One mechanism that enables the advancement of various financial-technological developments with the proper controls and balances is the “regulatory sandbox". This mechanism already exists abroad, and there are a number of examples that have come to fruition. For instance, England is the first country in which such a mechanism was created—back in 2016. At the end of the first year of the program’s operation, 75 percent of companies that were active in it had completed the testing they were asked to perform, and 90 percent of them had significantly expanded the market in which their product or service was offered by the end of the program. In addition, most companies that obtained a limited license as part of the program began the process of obtaining a full license once their participation was complete. The sandbox is currently being advanced in Israel, where there is a broad infrastructure of fintech and financial cyber companies. The Bank of Israel is, of course, a partner in this process. I would like today to discuss two financial instruments that I believe should be advanced in order to make the capital market more sophisticated and deep, and which will contribute to the continued enhancement of competition. The first is securitization. Naturally, institutional investors’ ability to provide credit directly to small and medium businesses is limited, due to significant operational and collection costs and because there is no developed securitization market in Israel that would allow the expansion of credit with its continued operation by the banks, who have a built-in relative advantage in this market. While the securitization market abroad is similar in size to the corporate bond market, in Israel, it is miniscule, with a value of just a few billion shekels. The advantages of a securitization market are reflected in the development of the nonbank credit market and less expensive sources of financing. It is a bridging tool between money held by institutional investors and credit consumers in the real economy. Securitization allows for the expansion of institutional investors’ investment horizons, and also makes it possible to free up capital and manage durations in the banking system, so that these sources can be allocated, inter alia, for the financing of small and medium businesses. Securitization also acts to direct sources to the Israeli economy as an alternative to investing abroad. For instance, securitization is a tool that can help finance the separated credit card companies. It is important to advance the law, with the aim of enabling the removal of barriers to the development of the securitization market in Israel, which will in turn increase competition in the credit market while maintaining financial stability. This should be done by establishing the appropriate legal, taxation, regulatory, and accounting framework for executing only traditional securitization transactions in Israel. I emphasize that the risks in this market are known, and they are addressed in the recommendations of the interministerial team that dealt with the issue. A lot of attention was paid to the lessons of the global crisis, and special emphasis was placed on the changes in regulation of the securitization market in various countries, so that we can benefit from the advantages of securitization while ensuring market transparency and a mechanism for the lenders to jointly bear the credit risk. Second, we should examine how to expand the use of interest rate derivatives, which are 3/5 BIS central bankers' speeches necessary to disperse the risks derived from the various instruments in the credit market, mainly medium- and long-term credit. The absence of these basic instruments creates unwelcome distortions in the market, whether through credit pricing that is too high, or through the allocation of financing from the outset. This may lead to an equilibrium where the quantity of credit declines, difficulties emerge for the real sector, and the rate at which the economy can grow is impaired. The Bank of Israel is acting to develop and institutionalize the Telbor interest rates as benchmarks of the real interest rate. These rates make it possible to use not only the fixed nominal or daily variable interest rates, but also a rate that varies over longer and predefined periods of time. They constitute an important and central layer in the global capital markets, because they can be used to increase the financing possibilities for the business sector. Benchmark rates also provide infrastructure for the interest rate futures market, where contracts enable businesses and the public to mitigate and even neutralize interest rate risks. In many economies around the world, there are two common types of financial products based on benchmark interest rates: (1) Deposits, loans, and mobile nominal interest bonds to various periods; and (2) interest rate derivatives. In Israel, unlike many other advanced economies, activity is currently conducted mainly in the assets themselves, and not through derivatives. It is important to note that even though activity in interest rate derivatives has grown significantly in recent years, it is still quite low compared to other countries, mainly in the longer terms. These differences indicate the underuse of financial defenses against interest rate risks in Israel, relative to what is common in other advanced economies. In order to illustrate how the development of this type of instrument would help the broad public, we can use the example of the early payment fee that is well-known to the representatives of the banking system who are here, and that is relevant to almost anyone who takes out a mortgage in Israel. It is reasonable to assume that if the banks were able to hedge the risk of early repayment of such a long-term loan and better manage their risk balance, this fee would be reduced. The banks would be able to do this by adopting a long-term IRS instrument, which replaces cash flow from fixed interest with variable interest. As a result, the customer would have a greater ability to refinance a mortgage in view of various developments—whether they are specific to that customer or they apply to the entire economy—and would improve his financial state, or what we economists refer to as “consumer well-being". In contrast with most advanced economies, where a significant proportion of interest rate derivative transactions are settled through a central clearinghouse, such infrastructure still does not exist in Israel. In a central clearinghouse, the risks of various transactions offset each other, and the remainder is transferred to one central entity that manages it through the appropriate collaterals. In order to develop the interest rate derivatives market in Israel, it is important to advance a central clearinghouse that will significantly mitigate the credit risks inherent in such transactions. There are other advisable measures that it is worth thinking about, which I will discuss at other occasions. To conclude, the Israeli economy has made many steps in recent years to advance competition in the credit market. There are additional possible stems that would complete what is necessary to advance competition in this market, some of which—particularly those that deal with the structure of the financial system—I have discussed this morning. These developments and innovations involve some risks, but they also may open the door for more efficient financial technologies for both consumers and the various supervisory bodies. As such, financial stability does not necessarily stand in contradistinction to increased competition and increased efficiency. The Bank of Israel will work to improve the efficiency and assiduously maintain the stability of the capital market and the financial system, and will work to integrate new financial technologies and instruments gradually and under careful control. 4/5 BIS central bankers' speeches I again congratulate the Banking Supervision Department on this conference, and I welcome the upcoming speakers, who contribute much to the advancements in this area and to the important professional discussion of these issues. Thank you. 5/5 BIS central bankers' speeches
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Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at the Calcalist conference, Tel Aviv, 2 September 2019.
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Yaron Amir: Bank of Israel's recommendations for increasing the standard of living while maintaining fiscal discipline Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at the Calcalist conference, Tel Aviv, 2 September 2019. * * * Good morning. I greatly appreciate the opportunity to speak here today. This is a very important time, with the election campaign drawing to a close, while millions of children are returning to school to further their education and obtain the tools necessary to lead the country into the future. I would therefore like to take the opportunity to discussion issues that involve each one of us as individuals, and all of us, particularly the Bank of Israel, at the societal level: the future of our children and further generations, and the standard of living that we want to improve for their benefit, and also of course for our benefit as a country. A few days ago, the Bank of Israel Research Department published a document that dealt entirely with the measures necessary to increase the standard of living in Israel. At the Bank of Israel, we asked ourselves how to do this, and the answer is that the focus must be on improving worker productivity in Israel. This is the “roadmap” that we created. These recommendations illustrate the Bank of Israel’s commitment to deal with the most pressing macroeconomic issues for the economy as part of my job as economic advisor to the government, and based on a professional in-depth analysis. I will expand on this in a few moments. But before that, I would like to briefly discuss the vision that I and the Bank have in dealing with, and guiding policymakers in dealing with, the issue even now. The informed decisions made by policymakers in our country from its founding until today established and strengthened the Israeli economy, its stability, and its power, and led us to a situation in which we are now ready to begin taking the necessary steps to prepare the economy for the coming decades. Israel must, and can, implement these recommendations. Implementing the Bank of Israel’s recommendations will help take Israel into the future with a higher standard of living. I say this with complete certainty. This obviously requires considerable investment. The cost of the measures that appear in the report, when fully implemented a few years from now, is not low—close to 3 percent of GDP, which is about NIS 44 billion per year in current GDP terms. The cost is high due to the large gaps that have developed in various areas over recent decades. However, the investment will be very well worth it. Our assessment of the additional GDP in the long-term from implementing the recommendations is much higher—about 20 percent of GDP per year. Or, to put it more simply, about NIS 270 billion shekels more, in current GDP terms, for our children and future generations. I emphasize that the implementation of this program will not come at the expense of the need to deal decisively with fiscal issues and the growing deficit. I have previously enumerated the measures that the government and the Knesset will have to take in order to deal with the fiscal necessities: reducing inefficient expenditures to start, cancelling tax exemptions, and apparently also raising tax rates. This does not contradict the need or the possibilities of starting to implement the recommendations right now. First and foremost, the stage of planning and building the tools to implement the reforms, which is an essential part of adopting the recommendations, will take time, and its cost is relatively negligible. In addition, there are many recommendations that can be implemented even today, since they deal with diverting existing sources, and with administrative processes. 1/4 BIS central bankers' speeches I will now briefly discuss the main points of the recommendations and the background of the report. Output per work hour in Israel, what we economists define as “labor productivity", is 24 percent lower than the OECD average, and this gap has not declined in recent decades. This gap has large implications for the standard of living in Israel. The low level of productivity compared with other advanced economies is reflected in lower wages and standard of living in Israel than in other western countries. We found that the labor productivity gap to Israel’s disadvantage is mainly due to a number of factors: the relatively low quality of education and teaching in Israel; the lag in the level of infrastructure and the quantity of business capital; and public sector regulations and bureaucracy. In the field of education: In recent years, there is a greater recognition that despite the fact that Israel is the Startup Nation that gave us the flash drive, WAZE, Mobileye, and a wealth of complex cyber solutions, most Israeli workers lack the ability to solve more basic problems. In addition to our marked lag in average skills, Israel also feature a high level of inequality in scholastic achievements, with large differences in basic labor skills among workers, large wage gaps, and large differences in productivity levels between the various industries. While the strong workers in Israel are similar in output and skills to the strong workers in other countries, the weaker workers in Israel are far weaker than their peers abroad. So how can we strengthen the “weaker” workers and raise the output per worker in Israel? There is a direct—and causal—connection between a labor force’s quality of education and productivity, with an emphasis on the importance of basic cognitive skills that enable a change in profession during one’s lifetime. Eric Hanushek of Stanford University shows this in a series of studies he conducted in recent years. It is important to state that the gaps in the quality of education in Israel exist in almost all age groups and education groups, and are not the purview of a certain segment of Israeli society. Therefore, the treatment of the problem must encompass all levels of education, and begin in preschool. In his research, Nobel prize winner James Heckman found how important the preschool starting point is for economic success during life, particularly for children from lower socioeconomic backgrounds. It is therefore important that daycare centers for children from weaker backgrounds begin the educational process at very young ages. At the same time, it is important that subsidies for the cost of daycare for weaker population groups be adjusted to increase the incentives to work for both parents. Such steps lead to a double benefit. They can materially contribute to future growth, and can contribute to reducing gaps and increase equality of opportunity. As economists, we avoid dealing with pedagogical issues. We focus on incentives that will help improvement in an area, and recommend adjusting the payment structure for teachers to the urgent needs of the system: improvement payment for those with training in subjects where there is a lag in achievements and a lack of teachers (mathematics, sciences, and English), and improving salaries for teachers to teach in schools that cater to students with weaker backgrounds. This is all on condition that there are continuous evaluations of the success of the teachers and of the schools in creating scholastic, educational, and social improvements. In addition to the investment required at young ages, there are also measures that are necessary for the older population. In Israel, too little is invested in developing human capital at older ages through professional training programs. The increasing flexibility of the labor market, and the extension of a person’s working life as life expectancy and the effective retirement age increase require significant reforms in this area, both in improving the output of technological colleges, and in adapting the content of the courses. The reform that the government recently adopted in the technological colleges is an important step in the right direction, and the recommendations that appear in this field in the draft report of the 2030 Committee appointed by the government point to additional important measures that will help Israel to better deal with the issue of professional 2/4 BIS central bankers' speeches training. In the field of business capital: The high level of variance in the Israeli economy is also reflected in the extent of innovation and the volume of investment in physical capital in different industries. In this area, the situation is good in exporting industries, particularly in software industries, but it requires improvement in the rest of the economy, compared to parallel areas in other countries. Why is this happening? First, it is reasonable to assume that some of it is a natural result of market forces. Israel developed a relative advantage in the field of high-tech, which makes successful investments and attracts select software and hardware people. However, the government’s involvement encourages these successful areas of activity directly and almost exclusively, thereby raising the costs of human and physical means of production for the other industries, which employ most of the workers in the economy. Over time, the productivity of export companies will have difficulty continuing to grow, as companies that provide them with raw materials and services remain so far behind. Therefore, a gradual change is required that will make support of the principle industries based on incentivizing the various areas of activity and industries by economic criteria that will lead the economy to higher returns on investment and government support—among exports, which can continue to benefit from it, and among domestic manufacturers. It is important to focus on running programs that support the removal of market failures that delay production and the implementation of unique knowledge, innovation, and management methods that can spill over to other companies. Such a policy, alongside the effect of streamlining and the reduction of regulation, which I will discuss later, may contribute significantly to increased stock of capital in exporting industries and in domestic industries as one. In the field of infrastructure: The rate of investment in transport infrastructure in Israel has been similar in recent years to the average rate of investment in OECD countries, but is far from what is necessary to reduce the gap in transit efficiency compared with the leading countries. This is due both to the accumulated gap and to the rapid population increase in Israel. Improving the transport system, particularly public transit, will shorten the time wasted in traffic. An example that I heard, and which illustrates the issue well is that a plumber in Gush Dan manages to get to half the amount of homes that a plumber who works in areas without large traffic jams can service. This is a situation that, obviously, creates lower output for that plumber, and raises the cost of his service to the consumer. Regulation and the business environment: Israel is ranked 29th out of the 34 OECD countries in terms of the regulatory ease of doing business. Despite the government’s recognition of the importance of the issue, actual improvement is confused and very slow. It is therefore important to accelerate the process of adopting regulations from other advanced economies, unless there are significant reasons to avoid this in individual cases. This will help to both ease the regulatory burden and to increase international competition in the economy. In addition, in order to streamline bureaucratic processes, we suggest setting targets in public sector wage agreements for the adoption of digital processes in government services to the business sector. The current fiscal situation is weighing down on the ability to finance the required investment. The government’s structural deficit has increased in recent years to more than 3.5 percent of GDP, and without a significant correction, it is expected to continue growing in 2021 and onward. The implementation of this program will not come at the expense of the need to deal with fiscal issues and the growing deficit. On the contrary: the required investments make it necessary to rapidly and decisively deal with the existing deficit. Since the large expenses due to the programs presented are expected only in a few years’ time, after the initial steps have been implemented and the plans for advancing infrastructure are fully prepared, it is important that the government prepare for early implementation in terms of the fiscal frameworks that will allow those investments that have the capability of significantly 3/4 BIS central bankers' speeches improving the standard of living in Israel. Such preparation is important, first and foremost to ensure the continued stability of the economy, but also to ensure greater ability of sources for financing the required investments. This means the early convergence of the deficit, which will ensure at least the stabilization of the public debt to GDP ratio, and maintaining this level in the coming years alongside the gradual implementation of the growth-supporting measures proposed in this program. I would like to emphasize that we do not intend to recommend financing the investments—even though their expected return will be high—through deficit spending and the accumulation of public debt to be repaid in the future. In general, there is some logic to this argument, but the question is what level of deficit is sustainable. The current deficit level is, in our assessment, too high to allow for further increase, due to the short-term marcoeconomic risks it entails. In addition, deficit financing creates risks to the quality of project selection and of a loss of control over costs. When public projects are financed without effective short-term budgetary restrictions that show the public and decision makers in real time what the cost of the sources required for the investment is, the risk of inefficient allocation of investments and excessive costs increases. In conclusion, these recommendations illustrate the material possibilities that we are presenting to policy makers to increase the standard of living in Israel. I believe that their strength is in their interconnectedness and in their being sufficiently detailed in terms of the cost of realizing each item in the report. Their concurrent implementation will maximize the chances of success of the project. The report is available for viewing, and was already presented to the various government ministries as it was being formulated. Thank you. 4/4 BIS central bankers' speeches
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Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at the opening of the Globes newspaper's "Governors' Conference", Tel Aviv, 1 September 2019.
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Yaron Amir: Setting goals and embracing innovation to meet the challenges of a changing environment Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at the opening of the Globes newspaper’s “Governors’ Conference”, Tel Aviv, 1 September 2019. * * * Good evening. I am very happy to have the opportunity to sit here today with three of my predecessors and to discuss core central banking issues—I cannot think of a more appropriate group with whom to hold such a discussion. There is no need for me to introduce the previous governors, but nonetheless, it is important not to take for granted their achievements, which placed the Bank of Israel at the forefront of economic activity in Israel and in central banking worldwide, and strengthened the Israeli economy, its stability and its robustness. They led us to the situation in which we can today take the steps necessary to prepare the economy for the challenges of the future. Prof. Jacob Frenkel was the stabilizing Governor, who drove forward the foreign exchange market liberalization. When he took office, there were those who thought that after we had succeeded in eliminating the hyperinflation of the 1980s, a further decline from the level of 20 percent to a lower level was not worth the cost involved. Jacob led an extended, persistent and committed process, at the end of which Israel reached low inflation, and the economy benefited from stability and certainty for many years in that area. As you know, today we are dealing with inflation that is slightly lower than the target (perhaps it would have been better to work just a drop less, Jacob). Today it is clear to all that this effort was worth it in the long run. Jacob conducted the liberalization process in the foreign exchange market and in the balance of payments, and thanks to him, the overall economy benefits from full openness of the foreign exchange market and from the free flow of funds between the domestic economy and abroad. Prof. Stanley Fischer is the Governor who successfully withstood the global crisis. Under his leadership, and while the global economy trembled, the Bank of Israel was an island of stability, judgment, original thinking, and brave actions, which instilled confidence in market participants, companies, and the general public, and was one of the factors in Israel’s economy being among those that suffered less from the global crisis. Stan determinedly led the legislation of the new Bank of Israel Law, in the framework of which, in contrast to human nature, he led the process of cutting the powers of the Governor, who until that change was almost all-powerful. Due to him, monetary policy decisions today are reached by a committee, which enhances the public legitimacy and the independence of the Bank of Israel in reaching decisions. The Bank also operates, from an administrative perspective, under the watchful eye and guidance of the Supervisory Council. These and other changes did not make the lives of the Governors who succeeded him easier (and I’m not complaining, Stanley—not yet), but they improved and strengthened the functioning of the Bank of Israel. Prof. Karnit Flug was the Governor who grabbed the bull by the horns and dealt with the fundamental problems of the Israeli economy. Karnit put on the table, clearly, the problem of the Israeli economy’s low productivity—maybe the factor that will have the most impact on the welfare of Israel’s citizens in the coming decades. Due to a series of research studies and analyses carried out during her term in office, today everyone is able to point to the problem. Karnit’s term was characterized by a significant reform in the financial system. Under her leadership, the Bank took on itself the establishment of the Credit Data System, which we launched five months ago; the Bank collaborated with the Ministry of Finance and other entities in designing, legislating, and carrying out the reform to enhance the competition in banking. With the clear recognition of the importance of financial stability, Karnit insisted on promoting the 1/4 BIS central bankers' speeches legislation of the Financial Stability Committee, which is an important infrastructure in reducing risks if and when a crisis occurs. So immense thanks to you, my predecessors, and of course thank you as well to Globes for the distinguished platform you have gathered here. I will take this opportunity to tell my predecessors, and the public, about what has been going on at the Bank of Israel since I took office, and about our plans for the future. The economic world as we knew it is undergoing great changes. In order to continue to function in a changing environment, and to know how to optimally advance in the face of potential crises, we have to speak, think, and breathe technological, financial, and research-related innovation. In the first months of my term, we completed several processes that had begun in previous years. As I noted, we went live with the Credit Data System, which is operating satisfactorily. A large number of financial entities, including those not obligated by law, joined the system and began reporting to it and receiving data from it. We also set out the separation of two credit card companies, while ensuring that the parameters of the separation support the goals of the reform. I am also happy to update that the Financial Stability Committee has already met several times and is making progress with the formulation of its tools and work procedures. We presented to the government an extensive and clear analysis on the need to carry out fiscal adjustments. In parallel, we presented a plan to improve the standard of living and productivity in the economy— with an emphasis on operative policy proposals. We are not blind to the housing issue, and its impact on the young generation. Therefore, I asked the Research Department to begin formulating operative recommendations in the housing area, in order to help the new government identify the order of priorities and to act to remove obstacles that weigh on increasing the supply of homes. In a joint initiative with the IMF, we are developing a new macroeconomic model, which takes into account two sectors that to date have not been included in the common models—the housing market and the financial system. Recall that these two were among the main factors in the 2008 crisis. The model will serve us in macro assessments but will also contribute to the work of the Financial Stability Committee. In another joint initiative with the IMF, we are working on an international conference on cyber risk in the financial and banking system, with the understanding that looking forward, this is one of the main risks to financial stability. Given the changes in the global economy, and with eyes to the future, I initiated a strategic process to define the Bank’s goals for the coming years. The entire management has been enlisted in this process, which is being conducted by the Director General of the Bank, Hezi Kalo. It is not straightforward to carry out such a process in the midst of the ongoing work that is always very intensive, but it was clear to me that we must look beyond the immediate issues. Therefore, we added a slogan to the process—“Working today, thinking about tomorrow”. I asked the members of management to think outside the box, and to try to identify the important challenges that the Bank of Israel and the Israeli economy will deal with in the coming years. To that end, we set up several teams, with the participation of tens of staff and managers, in all the relevant areas: The first deals with monetary policy in the modern era, and asks the big questions. In view of the changes in the global and domestic economies, and in view of the changes that are likely to occur in the structure of money in the modern age, it is crucial to understand how monetary policy should be conducted and what is the toolbox required to do so. Thus, already in the coming year we intend to carry out a process of rethinking the monetary policy framework, and we have already invited senior officials from central banks around the world to come to Israel and participate in a conference we plan to hold on the issue. It is certainly 2/4 BIS central bankers' speeches possible that at the end of the process we will reach the conclusion that the current regime is the correct one and there is no need to change it, but we must challenge that thinking from all sides before reaching that conclusion. Another team is dealing with the financial system of the future, and how to prepare for the changes expected in it. The team is formulating a strategy, the goal of which is to maintain financial stability while aligning the financial and regulatory system to the changing environment, enhancing competition, and implementing innovation. The technological developments that are changing the financial system were at the core of the team’s work, as were the challenges deriving from the growth in the number of type of participants in the system, alongside questions raised regarding the role of the Bank of Israel as a main factor in the financial system and in the capital market overall. The third team is having a ball. It is focused on advanced technologies in the digital era. The team thought about the effects of the digital era on financial infrastructures—open banking, blockchain, digital currencies, and the need to update the payment systems in the economy to an immediate and fast payment system—an area in which Israel lags behind the global frontier. They discussed the contribution of the fintech industry to the Israeli economy, how innovation can be promoted in the financial system and in the economy overall, as well as how to change the Bank itself into a digital and innovative organization. Anyone who knows me knows that I live and breathe research and data. The fourth team that we established deals with that. I’m afraid that since I took office I have caused more than a few white hairs among the excellent people in the Bank’s Research Department and the Information and Statistics Department, with the requirements and requests I set for them. The statistical data are among the main building blocks in a central bank’s work. Looking ahead, there will be a need to collect new data of various types from new sources. Big data, visual data, audio-visual, geographic data, artificial intelligence—these are all areas that are being developed at a rapid pace and the Bank will have to examine how to derive the maximum from them in order to fulfill its various functions, and how to make the data accessible to the public in the most efficient and convenient manner. We are also looking inward—to the human resource—the most important asset a central bank has. We are comprehensively examining our operational setup, what strategy will ensure the adequate inputs for carrying out the Bank’s functions over time; and our communication with the public—whether, and how, to adjust how we explain ourselves to the public in view of the sharp changes occurring in the world in communication in general, and in how central banks communicate with the public in particular. This process is complex and comprehensive. Our goal is to question every convention, and to leave no stone unturned. And obviously, our test will be in the implementation. In view of how the entire bank was enlisted into this process, I am sure that ultimately the Bank will be better prepared to fulfill its objectives optimally, in view of our upcoming challenges over the coming years. And from these lofty ideas, let’s move for a moment to some current issues. As you know, last week the Monetary Committee decided to keep the interest rate unchanged, though it conveyed a different message than the one we conveyed in recent months. The message was changed because the data changed—in central banking jargon that is called data dependency. Within a relatively short period of time, we saw a decline in inflation, a change in the direction of monetary policy worldwide, a worsening of the risks to the global economy, and a relatively sharp appreciation of the shekel. We noted with satisfaction that the domestic economy is in a good situation—and indeed, when looking beyond the technical volatility, we see that the economy is growing at a solid pace, the labor market remains tight, and it appears that to date the slowdown in the global economy is not trickling down to the Israeli economy, not even to exports, which continue to grow, particularly due to services exports. 3/4 BIS central bankers' speeches If the economy is in a good state, why did we note that if necessary we will take steps to make monetary policy more accommodative? First, because the trend of inflation changed. It is not clear to us at this point if it is noise in the data—loud noise, to be sure, but noise—or a fundamental decline in inflation. However, it is clear to us that we have to continue to strive and raise the inflation rate toward the midpoint of the target range. Second, the risks have intensified. Should the risks be realized, we will want to act in a timely manner, in order to prevent to the extent possible a slowdown in economic activity. How will we do that? We have a range of tools, and they are all on the table. There are the standard tools, and we are refreshing the toolbox regarding tools that have not been tried here, or have not been used for a very long time. And one more comment on monetary tools—in recent weeks the issue of the foreign exchange market has been in the headlines. Therefore, maybe this is the time to clarify—I did declare that in principle I would prefer that the exchange rate would be set by market equilibrium, and that was the also the Bank’s approach before I took office. Practically, there is a window of exchange rates that we view as consistent with price stability and economic activity, when we take into account all the factors and variables in the economy. The window is dynamic, and depends on parameters that change all the time, which naturally should not be disclosed. From this perspective, the Bank of Israel policy on this issue could be called “constructive ambiguity", which is the appropriate policy for a small economy such as Israel; and therefore, if and when the Bank of Israel will assess that the exchange rate has materially deviated from the window that we defined, we may very well intervene in the market—and no one will receive a warning letter from us beforehand. Thank you! 4/4 BIS central bankers' speeches
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Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at a Bank of Israel Research Department conference "Competition and structural changes", virtual, 17 December 2020.
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Yaron Amir: Competition and structural changes Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at a Bank of Israel Research Department conference “Competition and structural changes”, virtual, 17 December 2020. * * * Good morning. I would like to welcome all the attendees of the conference. The topic of the conference is “Competition and Structural Changes”, an issue the importance of which is quite clear. The guest lecture will be given by Prof. Thomas Philippon. Thomas has contributed much in his academic work to the interface of finance and macroeconomics. His many papers are characterized by original and creative thinking. In addition, I would like to thank the Research Department and its Director, Prof. Michel Strawczynski, for organizing this important conference. Holding the conference at this time, in spite of the pandemic, is very important. I have said in the past, and reiterate, that the coronavirus crisis is also a key to many structural changes, of the kind that will help promote financial technology and accelerate growth and productivity. Holding this conference on line for the first time is one of many confirmations of the new age into which we have entered. This is actually not new technology that has just been developed, but technologies that have existed for years. However, the reality of the coronavirus has forced us to leave our comfort zone in which we all were and has made it possible for the acceleration of technology to merge into our daily lives. In the future, when these days are studied and examined, I assume that this period will be able to be pointed to as the turning point, after which the economy changed, similar to other significant events that have occurred throughout human history. In this regard, I have chosen to speak today about a very important area that is undergoing profound change: financial innovation. The changing economic environment, together with the entry of technology companies into the financial services areas (fintech), is changing the existing market conditions, the manner in which financial services are provided and consumed, and the business models according to which the existing financial entities operate. The research literature deals a lot with the connection between innovation and financial performance. In my view, innovation is like a brush in the painter’s hand, contributing to creation and execution of positive changes in our lives. Innovation is the ability to achieve better solutions in information systems, communication, technology, and marketing methods. Innovation is considered a generator of competitiveness and it is important not only for large companies but also for small and medium sized enterprises (SME), which have a significant share in the area of innovation. The increasing number of innovative companies operating in financial areas and the rapid pace of developments in this areas, are already reaching into areas of activity that until recently were the exclusive domain of the traditional financial entities, and are undermining their status. However, it should be remembered that innovation and technology are also an opening to many diverse challenges, and we should take care to mange risks in a controlled manner. In Israel, we can find leadership of certain elements of innovation. For example, in fintech, Israel is among the world leaders—today there are more than 500 fintech startups in Israel, and they have grown rapidly in recent years and have generated a lot of interest among foreign investors. Thus, in 2019, investments in Israeli fintech companies reached $1.8 billion, making up approximately 5 percent of total investment in fintech worldwide. Israel leads research and development areas in high-tech, and in fintech in particular, and a large part of investment in the economy is dedicated to that. 1/4 BIS central bankers' speeches The Bank of Israel also promotes innovation in its areas of activity, and we set it at the top of the strategic plan we formulated. Leadership in innovation in our areas of activity is a central target from the Bank’s perspective, we are continuing to integrate and enable innovation in banking and payment services, development of the capital market and credit market and their integration into the changing environment: As such, the Bank of Israel has been working a lot to update the existing payment system in Israel. The switch to a world of advanced and modern payments is a necessity. Payment systems that are convenient, efficient, secure, and stable are an important component of every advanced economy. The Israeli economy lags compared with other economies in the world in terms of integration of advanced means of payment and the steps we are promoting will help to bridge over part of this gap. For example, implementing the EMV standard—the first stage in companies switching to it was last week—is an initial step for the entry of advanced payment technologies and of other players, both domestic and global. The process will expand the range of possibilities available to businesses and consumers, such as executing smart transactions, contactless transactions, transactions via mobile phones, and it will accelerate the integration of electronic wallets and advanced payment applications. The Bank of Israel supports the development of a Faster Payment infrastructure that will make it possible to expand the range of payment possibilities in the payment system and to carry out, among other things, direct payments from a customers’ account, conveniently and efficiently 24 hours a day, every day. Promoting a Faster Payment system will reduce transaction costs, allow cross-border settlement, increase businesses’ liquidity, and will reduce the use of cash. In addition, the Bank of Israel is examining additional steps to promote innovation and efficiency of the payment system in general, and of faster payment in particular. This is with an emphasis on the following issues: cross-broder payments, integration of electronic wallet payments, regulation of the execution of payments at businesses, and more. Another project that the Bank is promoting is Open Finance I would like to emphasize that from my perspective, its “Open Finance” and not “Open Banking”. The idea is to take away the control of customers’ information and financial activities from the traditional financial entities and not just from banks, and to transfer the power to the customers themselves. We support promoting an “open financial world” which will include all the creators of all financial products. Behind the scenes there will be a uniform API standard, which the Bank is now promoting energetically, and that will allow a secure way to transfer customers’ data from the customer’s service provider to a third party—such as another bank, a nonbank entity, a fintech company, etc. The advantages of this process are: strengthening the customer’s control over information about him or her, enhancing competition in the area of financial services, comparing costs, providing financial value proposals and financial intermediation, consulting on financial conduct, initiating financial activities, and more. In this regard, it is important for there to be access to all the financial players—to all the required information, as is generally accepted worldwide. These entities will be able to provide information and to offer advanced services. An additional issue that we are promoting is securitization A securitization transaction is one in which a corporation issues bonds whose maturity is secured by expected cash flows. While around the world the securitization market is about as 2/4 BIS central bankers' speeches large as the corporate bond market, in Israel this market is tiny and its value is only several billion shekels. This is, among other things, due to the lack of an appropriate regulatory infrastructure. The ability of the various entities to extend credit directly is limited, due to the significant operating and collection costs and because Israel does not have a developed securitization market, which would allow the expansion of credit while continuing its operation by banks, who have a structural comparative advantage in this market. By using the securitization tool, credit providers who are not necessarily financial companies will be able to sell credit portfolios that have already been extended and to use the compensation in order to extend new credit. The securitization market will thus help in reducing the costs of sources of financing and in dispersing the risks in the economy. This is a tool that bridges between the money that is held by the various entities and the credit consumers in the economy. Securitization allows the expansion of institutional investors’ investment horizons, and allows the freeing up of capital and the managing of duration in the banking system. As I noted, developing the securitization market will lead to a broader dispersion of the risks in financial markets, and to an increase in the accessibility to sources of financing for entities that are not “classic” credit providers. Thus, for example, it will be possible to securitize a range of asset-backed flows—such as commercial loan payments, debts from credit card transactions, municipal taxes, leasing, etc. As such, securitization is an extremely important tool for the development of the capital market in Israel, particularly in the current period of crisis, and the development of the economy on the day after. In order to advance this, an appropriate legal, tax, regulatory, and accounting infrastructure for carrying out securitization transactions in Israel needs to be set up. As I have mentioned in the past, another area in which the Bank of Israel is working to develop and institutionalize is the Telbor interest rates as benchmark rates for shekel interest. These interest rates allow the use of not only a fixed nominal interest rate or daily variable rate, but also an interest rate that changes over longer and predefined periods of time. They make up an important and central pillar in capital markets around the world, and with their help it will be possible to increase the financing possibilities for the business sector. Benchmark interest rates also serve as an infrastructure for forward interest-rate contracts, contracts that make it possible for companies and the public to reduce interest rate risks. It is reasonable to assume that within the framework of an efficient Telbor market, financial companies will have the opportunity to hedge and better manage their balance of risks. They will be able to do this by adopting the long-term IRS instrument, which is an instrument for exchanging cash flows between a fixed interest rate and a variable interest rate, which ultimately will lower costs for the end consumer as well. We are examining the best platform for implementing the activity of this market—against the background of the major challenges in those markets. In view of the lack of conditions for developing an interbank market, the development of a repo market looks like the most significant alternative for developing benchmark interest rates in the market. The various tools that I have mentioned today have already existed in the world for some time, some of which, as noted, are being implemented and promoted now in Israel. Their implementation in the domestic market, in an integrative manner, will accelerate the financial innovation processes in Israel and will contribute to the promotion of competition in the financial market in Israel. In conclusion, remember that together with financial innovation come numerous challenges and risks, with an emphasis on cyber and information protection. To promote innovation we 3/4 BIS central bankers' speeches understand that we have to take risks—in our terms: we have to define a “risk appetite”. At the same time, when a risk is realized we have to confirm that it does not have macroprudential ramifications. This has to be reflected at the country level as well, by financial regulators as well as the participants themselves. I wish you all a continued productive and informative conference. 4/4 BIS central bankers' speeches
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Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at the Eli Hurvitz Conference on Economy and Society 2020, virtual, 14 December 2020.
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Yaron Amir: Remarks - Eli Hurvitz Conference on Economy and Society 2020 Remarks by Mr Yaron Amir, Governor of the Bank of Israel, at the Eli Hurvitz Conference on Economy and Society 2020, virtual, 14 December 2020. * * * Hello to all those watching the conference—I am pleased to be here today taking part in this important professional discussion, which the Eli Hurvitz conference provides each year. The past year was characterized by a health crisis that led to an economic crisis of historic proportions, one that crossed borders and continents. The lockdowns imposed in response to the broad outbreak of infection led to a sharp decline in economic activity. We are pleased that the recovery from the second lockdown has been more rapid than the recovery from the first one, and thus it may be concluded that it is important to continue and open the economy and to maximize economic activity, but in a responsible manner. The crisis also caused a strong negative impact on the labor market—an impact that included all population levels and geographic areas. The government’s role in the handling of and exit from the crisis is extensive and incredibly important, and hence there is great importance to the 2021 budget, which is the economic work plan of the government. I will expand on the importance further on in my remarks. Monetary policy has also had an important role in the crisis so far, and through it the Bank of Israel worked in a range of ways to minimize as much as possible the negative impact on Israel’s economy, and we are working all the time on steps and programs that will lead the economy back to a path of growth, employment and productivity, through utilizing the opportunities inherent in the crisis. I will begin with a short survey of the Israeli economy as it headed into the crisis. It should be recalled that Israel entered the crisis in a relatively good state: solid growth, a tight labor market, a current account surplus, and a debt to GDP ratio that had declined to approximately 60 percent, due as well to the responsible budgetary conduct by Israeli governments in most years—a fact I’ve defined in the past as a strategic asset. Israel was adversely impacted by the crisis relatively less than other economies worldwide. The outbreak of the crisis and the imposing of limitations led to a negative economic impact, but compared internationally the adverse impact to GDP was lower. The data throughout the summer were better than we had thought, and show that there should be a continuation of a policy to minimize the adverse impact on businesses that drive growth and employment, and to open the economy in a responsible manner alongside maintaining low morbidity. We are seeing that the adverse impact from the second lockdown to date has been lower than the first lockdown, and the economic recovery from it has been relatively rapid. The Bank of Israel Research Department presents a forecast with two macroeconomic scenarios, depending on the development of the infection rate in Israel. These were built based on information that we had in October. One scenario is the “control scenario”, which includes the second lockdown with exit paths as we currently see them—gradually, without further significant limitations through the second quarter of 2021. The “low control” scenario refers to a longer and more severe lockdown as well as additional waves of morbidity around December–January and even another around March. The gap between the scenarios is very wide, with the differences between the two scenarios mostly being reflected in 2021. 1/6 BIS central bankers' speeches In order to understand the meaning of the control scenario relative to the point we should have been if not for the coronavirus, under the control scenario there is a GDP gap of 5 percent and under the low control scenario the gap is almost 10 percent. These are tremendous differences —GDP of billions of shekels that is not being achieved by the Israeli economy. Obviously, we also have some good news—not only regarding third quarter activity but also the expected arrival of the vaccine. However, we have to understand that even with the vaccine and if everything occurs as it should, we will be with the coronavirus until at least the end of the first quarter of 2021, if not into the second quarter of 2021. Therefore, the two scenarios in the forecast are still relevant. When we examine the forecasts regarding unemployment and the labor market, we can see evidence that the labor market will take quite some time to return to its strength, and that is also when the economy will recover. Unemployment rates are very high. In the low control scenario, the broad unemployment rate is liable to stabilize around 14 percent, while under the control scenario the broad unemployment rate could decline to around 8 percent. I would like to focus on two main subjects—the labor market and the activity of small and micro businesses. The labor market and the activity of small and micro businesses are particularly relevant to economic recovery—economic activity returned to rapid activity after the second lockdown, but the labor market is recovering more slowly. We can look at 3 concepts – standard unemployment, which represents the unemployed; the unemployed and those on unpaid leave; and the unemployed, those on unpaid leave, and those who’ve reported that they’ve already stopped seeking work due to the coronavirus. This is the definition of the concept of broad unemployment. The trend line in the past month is slower than the trend of return to work in the first lockdown, it gets stronger gradually and more slowly and stabilizes in the middle of November at an unemployment rate of approximately 14.5 percent. This raises the question, do we have here the signs of structural unemployment? Reasons for this can be that businesses that closed or were suspended during the crisis will not reopen, or alternatively employers found ways to increase efficiency in their labor force. Alternatively, it could be that the uncertainty creates a temporary concern among employers to recruit workers at this time. An additional marker for the concern of structural unemployment is the stabilization in the number of those unemployed for four months already at around 200,000 people. These data raise the concern that for those unemployed people it will be particularly difficult to return to the employment circle. It is important to remember that the longer workers are detached from work, their human capital erodes, and the ability to find work becomes more difficult. We can also see an adverse impact on employment relative to wages. Decision makers, supported by the Bank of Israel, minimized the lockdowns’ limitations in industries in which the risk of infection is low and the contribution to GDP and employment are high. Thus, the fact that they continued to work reduced the adverse impact on the economy overall. This reflects the world of high tech, finance, and areas that are amenable to technology, digitization. In contrast, the cost of this is that inequality increased. The strong got stronger and the weak became weaker. We can see that low wage earners were more negatively impacted by the crisis. Entire areas of business, in which wages are not high to begin with, such as culture, art, leisure, trade and micro businesses, were the most negatively impacted. 2/6 BIS central bankers' speeches We have to take care that the first-mentioned industries continue to grow, but at the same time we have to assist those areas that I noted in order to allow economic recovery and broad employment. The increase in inequality will create a notable adverse impact on the resilience of Israeli society, which has negative influences on the economy, and certainly on society. I see and hear publications that those with the main adverse impacts are youth and students. In actuality, the reality is more complicated. The coronavirus of unemployment negatively impacted the entire economy! It did so without distinguishing between age, geographic location, the self-employed, wage earners, women, men, Arabs, ultraOrthodox, and essentially everyone. I see in this a very important issue, from the economic as well as the social perspectives. Let me give 2 examples on which to focus: The population aged 55 and older still have 10–15 years of work ahead, and a considerable percentage of them have not yet returned to the labor market. It should be remembered that this is a population for whom it is often the peak of their lives and the peak of their careers. There is a real concern that without government assistance in training they will not be able to return to the labor market in the years remaining in their career. We are liable to lose here 15 years of work and productivity of tens of thousands of workers. Another point worth remembering is that unemployment has reached the center of the country, and can be seen today from Hadera to Gadera, an area that was less exposed to unemployment—the middle of the country, which contains 41 percent of Israel’s population, today contains 55 percent of the unemployed in Israel. Therefore it is important to us, that beyond holding training, we should increase the flexibility of the ability to return to the labor market. The mechanism for that exists today, and it should be maintained and even developed further. Thus, for example, an employee who wants to, and can, return to work on a part-time basis will be able to collect partial unemployment benefits. The worker’s economic status will improve and the burden on the government and the budget will decline. It is clear to us that there are more than a few employers who will not immediately return to 100 percent activity and these abilities to increase flexibility are very important. In addition, it is also important to stick to a model of maintaining employment, which has already been discussed a lot, and with it to increase the ability to incentivize employers to retain employees. There is a concern that even after the vaccine we will remain for some time with a considerable amount of uncertainty in the labor market, and it is not impossible that demand for workers will still be low. The range of these steps and the focus on the populations that need assistance will help to reduce that uncertainty and the “new normal” that will be created in the labor market after the coronavirus event will contain as little as possible structural unemployment. Further to this, I would like to shine the spotlight on the business owners, those who of course reflect the demand for workers. There are 2 real time surveys by the Central Bureau of Statistics in August and October, in which businesses of various sizes were asked, “How long can you continue activities if the current situation continues”? The business owners estimate that should the limitations be expanded, such as the possibility of entering a third lockdown, the adverse impact they expect will increase. Thus, for example, we can see that in August, 80 percent of large businesses claimed that they can exist more than half a year, while in October the figure declined to 54 percent. Due to the second lockdown, business owners became more pessimistic regarding their ability to survive. 3/6 BIS central bankers' speeches I will now expand on fiscal policy, the government debt, the importance of the 2021 budget and the utilization of the crisis to increase the level of productivity and to develop the financial world. I want to go back and spend some time on the issue of the deficit and the debt to GDP ratio, and the importance of keeping them at a controllable level. The fact is that the Israeli economy went into the crisis with the deficit and the debt to GDP ratio relatively low. Now as well these figures are low in international comparison, which is an important asset for Israel’s economy. The reason for this is that financial markets and international institutions have confidence in the Israeli economy, as rating agency S&P noted when it confirmed Israel’s credit rating, and as IMF economists wrote in their recent survey. However, the decline the debt to GDP ratio in the past 20 years derived not only from fiscal restraint steps but also from other factors that there is no guarantee will be on our side in the future when we want to lower the debt to GDP ratio. These factors include the fact that over those years, the GDP deflator increased faster than the CPI used to calculate the debt, export prices increased more than import prices, and there was a big redemption of public debt to the government. The combination of these factors helped “pull” the debt to GDP ratio downward, and as they are not permanent, they may even balance upward over the long term. However, it is very important to understand that the rating is not a given, and we should take note of the points raised in that S&P report, in which they point out that there is a possibility that Israel’s good rating will decrease should the economic crisis extend longer than expected, or if there is a lack of fiscal convergence in the medium term and instability to a debt to GDP ratio around 80 percent. I would like to emphasize the importance of maintaining the credit rating. The economic significance is that the State of Israel can issue debt at more convenient prices, and the government’s interest expenditures are smaller, so that more resources can be allocated to growth drivers and assistance to citizens. As there is considerable uncertainty regarding the macroeconomic environment, we can see a large difference between the forecast for the deficit and the debt to GDP ratio under scenarios in which there is a lot or a little control of morbidity. Therefore, in order to reduce the uncertainty, a reduction is required in the expenditure side, “the numerator”, which can be controlled more effectively than the denominator side—the size of GDP. We can see the change in the debt to GDP ratio under the 2 scenarios of control and low control over morbidity. As noted, it is very important that this ratio doesn’t run wild. This will require tight fiscal restraint. We should also note that there won’t be a rapid convergence to even a structural-deficit target of 2.5 percent. In contrast, this ratio will decline to the extent that we will be able to improve productivity and growth of GDP—something that naturally will improve the standard of living in the economy. Therefore, we need to put into the 2021 budget already growth accelerators to exit the crisis, and to invest in issues that support productivity, such as human capital, decreasing bureaucracy and regulation and increasing the efficiency in the public sector, in physical capital and infrastructures —details on the implementation of these items can be found in the Bank of Israel’s Productivity Report. 4/6 BIS central bankers' speeches It is very important to approve the budget for 2021 very soon, it is the government’s economic work plan. The interim budget through which the government is currently operating is causing the government to operate under a budget based on the budget for 2019, which was approved during 2018, and that is about 5.5 percent lower, in real terms, than the situation in which budgets would be approved based on the expenditure limitation. This is liable to lead to fiscal restraint for reasons that are not wanted and at a time that is not appropriate. This impacts on the activities of government ministries as well as on a range of entities and organizations. An approved budget enables them to act with a work plan based on a budget that provides a response to the needs of the population. In addition, since the 2019 budget was passed, the economy has gone through many fluctuations, and the budget needs to be aligned with needs that have changed, and a renewed allocation of part of the budget by shifting budget sources among various goals and programs of the government. A rapid contraction of the structural deficit and the debt to GDP ratio, through increasing tax rates and moderating expenditures, is likely to impact adversely the Israeli economy’s exit from the crisis. Therefore, it is recommended to approve the budget for 2021 very soon, while converging to the multiyear fiscal frameworks that will stabilize the debt to GDP ratio and at the same time will allow flexibility due to the considerable uncertainty. To that end the following principles should be adopted: 1. Regular expenditures in 2021 will be based on the amount of total expenditure, and will be separated from the direct expenditures deriving from dealing with the coronavirus. 2. Due to the high uncertainty, for 2021 the deficit will be consequential but the tax rate will not be reduced without a parallel decrease in expenditures. 3. Adjustments will not be made for the coming years, but decisions that increase them will be blocked. 4. The multiyear budget framework for years after 2021 will be determined when approving the 2022 budget. 5. Instead of the existing expenditure limitation, the 2022 budget will anchor an outline for reducing the debt via an “adjusted expenditure” ceiling. Let’s switch now to speak about the foreign exchange market, which in recent weeks has been at the core of the economic discourse, and I will try to review it at this opportunity. I will speak now about the reasons that led to the strengthening of the shekel, the steps that the Bank has taken so far, and what the policy terms are, looking ahead. The dollar weakness is a global phenomenon, and the dollar has weakened against most countries worldwide. The shekel hasn’t particularly stood out in its strength against the dollar, among other things due to the Bank of Israel’s policy in the foreign exchange market. Accordingly, the strength of the effective exchange rate, and of the shekel vis-à-vis the euro, are more moderate than against the dollar. There are additional reasons for the strength of the shekel. The current account surplus grew this year, due to transitory reasons related to the crisis—the marked contraction in the quantity of imports and a decline in energy prices. The reasons that led to the strength of the shekel are mostly good ones—years of current account surplus, and the capital flows into the economy are extensive investments by the leading technology companies in the world in the Israeli economy, 5/6 BIS central bankers' speeches and large institutional investors around the world increased the scope of their holdings in Israeli government bonds due to Israel joining the WGBI index. In addition, the coronavirus adversely impacted imports, while exports continued to grow, which combined with the effect of the balance of trade in recent years. Excluding the item for tourism services, which due to the circumstances of the crisis particularly adversely impacted it. Export performance throughout the crisis has been notably good, relative to private consumption and investments, and especially in view of the decline in world trade. Despite the good cumulative performance of exports to date, a rapid appreciation is liable to negatively impact performance of exports and subsequently of industries that produce import substitutes, and to weigh on the economy’s recovery from the crisis. This concern becomes stronger in view of the state of world trade and the growth in the percentage of companies that are reporting a shortage in orders for imports. Foreign exchange purchases by the Bank of Israel, which were $17 billion through November of this year, acted against the foreign currency flows noted above, moderated the pace of appreciation, so that the exchange rate has not markedly strengthened beyond what is in line with the dynamic window derived from fundamental forces. Under the current circumstance, the level of foreign exchange reserves is not a limitation on the policy of purchasing foreign exchange. The Bank of Israel intends to continue the policy in the foreign exchange market in 2021 as well and to purchase foreign exchange at quantities required in order to prevent the continued appreciation of the shekel beyond what is derived from the economy’s fundamental data. The foreign exchange purchase policy is one pillar in the Bank of Israel’s monetary policy, and joins a broad set of steps taken in the crisis. These include ensuring a low interest rate, government and corporate bond purchases, and the special program to increase the supply of credit to small businesses and the deferral of loans. All these together provide broad support to the business sector with all its facets and we will continue to do so to the extent necessary. Thank you! 6/6 BIS central bankers' speeches
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Remarks (virtual) by Prof Yaron Amir, Governor of the Bank of Israel, at the Payments Conference "A Look at the Future World of Payments: Trends, the Market, and Regulation", Jerusalem, 20 June 2022.
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Remarks by the Governor of the Bank of Israel, Professor Amir Yaron, at the Payments Conference held today 20/06/2022 Speeches by the Governor A conference is being held today on the issue of “A Look at the Future World of Payments: Trends, the Market, and Regulation”. Following are the Governor’s remarks at the Conference: “Good morning and welcome to the Bank of Israel conference, which will focus on the world of payments. Thank you to the organizers and to all who took part in preparing this event, to our important guests from abroad and to all those who are addressing the conference, our partners in government, private market participants, and all the participants in the sessions that will be held over the course of the day. Before we dive into a discussion on the activity of payment—transferring money from one person or business to another—I would like to open with a more general question, maybe even semi-philosophical: What, essentially, is money? Every Economics graduate will remember the three main functions of money: means of payment, unit of measurement, and a store of value. These are the functions of money, but I would like to deal on a more basic level—what is the value, the economic essence of this product, money? It is not a regular product in economics. For example, when economists formulate models of a choice between one product or another, the money is not considered a “product”—it does not appear in the utility functions that are at the basis of the models. An excellent article written by well-known economist Narayana R. Kocherlakota, my colleague in Chicago, “Money is Memory”, elegantly presents the claim that money is a substitute for “sophisticated” memory; the memory of all the economic transactions and interactions between every two agents in the economy. Kocherlakota, a past president of the Federal Reserve Bank of Minnesota, shows that for each one of the accepted monetary theories, if we replace money with the “memory” of the economic activity of every agent in the past—that is, instead of money we would manage some recording notebook—ultimately we would receive the same result: the economic activity will be exactly the activity that we would have received in a world with money. By the way, the opposite is not correct—in a model in which there is only the same “memory”, there could be economic results that would not be obtained in an equilibrium in which there is money in place. The almost unavoidable conclusion, possibly even somewhat prophetic, is that money is liable to become extraneous when participants in an economy have access to historical documentation of all the activities carried out in the past by the other participants. That is, the use of money is not ideal, and more sophisticated “memory substitutes” could lead to better economic results. Skipping to today, the technological advances, with an emphasis on the worlds of DLT and blockchain, enable us to consider seriously—although we are far from its possible implementation—the idea of a balance, or full “memory” of past transactions in digital format. DLT and blockchain make it possible to store vast quantities of knowledge, and to “remember” huge numbers of transactions made over time—in digital and secure format. Thus they may call into question to some extent the way we think about money, and the government monopoly on owning it, and if we return to Narayana, “the government's monopoly on seignorage might be in some jeopardy as information access and storage costs decline”. The events of recent days teach us that we are very far from fully adopting the digital system as a “regular” product in economics, and we are very far from the day in which money will disappear from our lives, if ever, but there is no doubt that the accelerated technological progress challenges our thinking as economists on many conventions. After this semi-philosophical opening, I want to switch and discuss the active aspect of recent technological changes: the payments market, crypto, smart contracts, virtual currencies, and CBDC. When I arrived at the Bank of Israel, the state of the payments market in Israel was different than it is today. One of my central goals was to develop the payments market in Israel and to have it among those of the leading countries. Therefore, it was also one of the main anchors in the strategic plan we formulated at the Bank when I took on the position. In recent years, we took a series of steps to promote innovation, efficiency, and competition in the payments market for the benefit of the overall population in Israel. These steps even helped us to endure the COVID-19 crisis better, as they allowed a rapid and efficient switch to contactless payment, and they will continue to help in developing the economy even long after the crisis. The State of Israel is a start-up and fintech nation, and the exhibit outside this room, with the collaboration of the government fintech community, is a small example of the abilities. However, a big part of the technological developments that Israeli companies implement worldwide does not come from the Israeli market. There are structural reasons for that, such as Israel being a small economy, and more. However, there are also barriers related to regulation and the incentive structure, and we can deal with those. The Israeli technology in the payments world does not have to be only aimed at abroad, and we certainly have to encourage the various companies to implement in Israel as well the cutting edge of technology they are developing. It is important to us to hear the industry and the fintech community, to understand from them what the barriers are, and to try to resolve them. Today, you will be presented with several plans to improve the regulation of the fintech sector, so that it will contribute to enhancing and expanding its activity here in Israel as well. In the world of economic and business, the phrase Time is Money is often heard. The world of payments illustrates this fantastically. Several years ago, we began to drive significant changes in the payments market, we made great strides in recent years to reduce the gaps vis-à-vis the rest of the world, and this is the time to continue looking forward. We have to set down the required infrastructure so that Israel will be among the leaders in the payments market, and thus allow here a more developed financial market and a base for promoting the economy and the ability to conduct business, mainly for the smaller ones, and even to reduce the costs to the customer. In recent years, the Bank of Israel has promoted the open banking reform. We expect to be one of the first countries that requires, via regulation, the possibility of transferring information between financial entities, beyond current accounts and credit, and includes customers’ deposits, savings, loans and securities—all in order to strengthen customers’ control over their information. It is important to me to note that we advocate the promotion of an “open financial world” that will include all the producers of all financial products, and not just the banking system. In this regard, it is important that there will be access for all the financial players to all the information required, as accepted worldwide. These entities will be able to provide information and with that to offer advanced services. In the past year, the use of digital wallets in Israel has increased markedly. Much of the development of innovation in this world is based in steps that we took in order to push the payment card system to a more advanced standard, EMV, with the understanding that the entry of new players and new services into the payments sphere will necessarily create additional innovation and enhance the value to the customer. A few words about digital currencies. It is important to make a clear distinction between the two types of digital currencies: stable and not. A stable currency is a currency, the value of which approaches being fully linked to the value of another currency. It can be a fiat currency, meaning like that issued by a government, such as the US dollar, it can be a financial asset like a government bond, or it can be a real asset, like gold. The uniqueness of stable currencies over other digital currencies is that they promise—they don’t always keep, as I will explain—the holder the same value as the currency to which it is linked. One of the main reasons for the marked increase that we saw in the value of stablecoins—until recently—is that they are essentially a gateway from the “regular” financial world to the crypto worlds. It is almost impossible to conduct activities in the Defi worlds with “regular” money, so the first stage will generally be to convert it into a stablecoin. Accordingly, when one wants to redeem profits made in Defi activities, the conversion back to regular money will be done via stablecoins. Although there is a “payment” aspect here, if this process seems familiar to you, you aren’t wrong—the process is similar to depositing a deposit in a “regular” commercial bank. This parallel, between a stablecoin to money and banking, sharpens the difference between currencies that are stable and those that are not. Currencies that are not stable, such as Bitcoin and similar ones, although they do seem similar to stablecoins at first glance—both are “virtual”, based on crypto technology, and traded on similar platforms—are significantly different than them: Bitcoin is a speculative asset: its price can soar, fall, or remain steady, but in contrast to the optimistic, or even utopian, forecasts, that accompanied the issuance of crypto than a decade ago—it does not serve any of the fundamental functions of money. It is not a means of payment, not a unit of measurement (has someone recently been in a supermarket where prices are denominated in Bitcoins?), and in view of the high volatility we see in its price—it certainly does not retain value. Stablecoins, in contrast, could approach the worlds of money and banking. To the extent that the stablecoin is in fact linked to the value of a fiat currency, it can serve as a “store of value” like that same currency, and possibly serve as a real means of payment. Alongside the features of the stablecoins that I noted, which force us to think of them more as “money”, and distinguish them from currencies that are not stable, we also have to pay attention to the challenges that may arise in using those currencies. For example, when stablecoins represent a significant market share of all the assets backing them, the trade in those assets, which is made in order to protect the value of the stablecoin, could impact on the stability of the financial system. To illustrate, the sale of a large quantity of government bonds owned by the issuer of stablecoins who is facing a liquidity crisis as a result of a mass abandonment of the stablecoin, could challenge the stability of the bond market. In this regard, it is worth noting a simple fact: when they are not supervised as required, stablecoins are, in fact, not necessarily stable. Only recently, an ostensibly stable currency, Tera USD, one of the biggest currencies in terms of the scope of its market value, collapsed and lost its value in several days. Given that this occurred, it is good that it occurred at a fairly early stage of development of this world, when it is still worth billions, and not trillions, of dollars, which could have impacted the entire monetary system. Therefore, I am of the opinion that we as a central bank have to be charged with the supervision and regulation of stablecoins, to the extent that we will assess that it is required for maintaining economic stability. This is in contrast to currencies that are not stable, where the supervision has to focus on consumer aspects such as transparency, proper management, etc. In recent years an additional, interesting, historic development is starting, which could completely change the rules of the game in the worlds of payments in particular and the financial system in general. I am referring, of course, to central bank digital currencies—CBDC, or what we in Israel tend to refer to as a digital shekel, or its nickname of “Shaked”. CBDC is a digital means of payment that serves as a liability of the central bank vis-à-vis its holder. It is a type of combination of two types of money that I noted—“digital cash”. In addition, through CBDC, it will be possible to “enjoy” the advantages of a digital currency, while reducing the risk inherent in it. For example, CBDC will be able to serve as a gateway to the worlds of Defi in place of the private stablecoins. CBDC could also allow faster and more efficient cross-border payments. While the existing payments system has reached a relatively high level of efficiency in all that is related to local payments, with customers in many countries able to make fast, inexpensive, and reliable payments, cross-border transactions remain complex, very expensive, and inefficient. To the extent that there will be interoperability between CBDC systems of various countries, cross-border payments could become inexpensive, efficient, and faster. It should be noted that such interoperability is also liable to create challenges for small economies, whose monetary policy will become more limited in its force compared to larger economies. About a year and a half ago, I decided that we have to begin examining the issue, in an operative manner, by us as well. It is too early to tell if ultimately we will decide to put this plan into action or not, but I do know two things: If the Bank of Israel will decide to issue a digital shekel, it will be a tremendous change, and it makes sense that we should prepare for it. And if we decide not to, all the information we are building up in the digital shekel project will serve us as well in terms of other reforms in the world of payments. In this regard, we announced at the end of last week that the Bank of Israel, the BIS Innovation Hub, and the Hong Kong Monetary Authority will collaborate on a special experiment in which the preparedness of CBDC will be examined, including cyber protection. The project is planned to begin in the third quarter of 2022, and its findings are planned to be published by the end of the year. The integration of Israel in this international project indicates the standing we are accorded in the world, and the progress we have made on the issue. In conclusion, we will continue to work, alongside our partners in the public sector, the private sector, central banks and international organizations, to design the future financial system in a way that will enlist technologies in the service of the entire public. The world of payments, for a long time already, is not just a “plumbing” system, but an integral part of the financial world. I promise that over the course of the day we will see, learn, and hear about developments in the worlds of payments, that have changed, are changing, and will change the payment experience of all of us, and will make it more convenient, effective, secure, and accessible. Thank you for attending this conference, and I wish all of us a productive and beneficial conference.
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bank of israel
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Remarks by Mr Andrew Abir, Deputy Governor of the Bank of Israel, at the Bank of Israel's Payment Systems Conference, Tel Aviv, 16 November 2022.
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Andrew Abir: Remarks - Bank of Israel's Payment Systems Conference Remarks by Mr Andrew Abir, Deputy Governor of the Bank of Israel, at the Bank of Israel's Payment Systems Conference, Tel Aviv, 16 November 2022. *** Good morning. I am pleased to be here with you at a conference that will deal with the planning of the new world of payments. It is also important to me to emphasize the extent to which we see the development of an innovative payments system in Israel as a strategic goal of the Bank of Israel. The central bank's money stands at the center of each country's payments system, and that is what forms the foundation of the public's trust in the system. There are currently two types of central bank currency. The first is one you are all familiar with cash. Historically, trust in the banking system was based on the public's understanding that it could always withdraw money from its accounts at a commercial bank and ask for central bank currency. Normally, no one even thinks about this. But it becomes relevant for many people during emergencies. We make sure to routinely maintain an efficient cash distribution system, embed advanced security features so that it will be very difficult to impossible to counterfeit banknotes, and maintain the public's trust in cash. But technology is changing, and in view of the decline in the use of cash, we are considering the launch of a central bank digital currency so that even in the digital era, central bank currency will remain at the center of the retail payments system. The second type of central bank money is in the wholesale system - the banking system's accounts with the Bank of Israel. These accounts also increase the public's trust in the banking system. We have seen during crises that banks may prefer increasing their balances at the central bank to enable them to pay each other with central bank currency. What essentially connects wholesale money with the retail payments system is the local RTGS system, called ZAHAV. And just like it is important to use to increase the efficiency and dependability of the cash supply system, it is also important to use to ensure the efficiency, dependability, innovation, and readiness for the future of this system. ZAHAV is a national network for all financial transactions in the economy. Its stability and availability is a precondition for management of an advanced economy, and the basis for conducting monetary policy. Therefore, RTGS systems around the world are managed by the central banks. The new ZAHAV system has interfaces with other payment systems in the economy, which enables it to create synergy in the world of payments. In addition, by replacing it, we can upgrade the system's protocol to the new ISO 20022 global standard, which will bring additional advantages to the entire economy, mainly by increasing the supply and variety of financial services available to the public. 1/2 BIS - Central bankers' speeches The ZAHAV upgrade is consistent with one of the Bank of Israel's main strategic principles: positioning Israel at the technological forefront with regard to the world of payments. Obviously, there remains a long road ahead of us, but together with the implementation of the EMV standard, the implementation of faster payments, the development of an infrastructure for digital checks, the removal of barriers to fintech firms, and other actions, we are definitely on the right track. As I noted, the upgrade of the system's protocol to ISO20022 provides an opportunity with immense potential - for advancing it, improving the consumer's user experience for both business and private customers, adding an immense amount of tremendously valuable - and no less important, structured-information with every financial transaction. We believe that with the cooperation of the entire financial ecosystem in Israel, we will properly implement the standard in a way that the changes and business advantages will be significant. 2/2 BIS - Central bankers' speeches
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bank of israel
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Remarks by Mr Julian W Francis, Governor of the Central Bank of The Bahamas, at the 13th Annual Bahamas Business Outlook, Nassau, 20 January 2004.
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Julian W Francis: The Bahamas economy - critical strategic issues Remarks by Mr Julian W Francis, Governor of the Central Bank of The Bahamas, at the 13th Annual Bahamas Business Outlook, Nassau, 20 January 2004. * * * An attempt to form a view on the short-to-mediumterm Business Outlook must necessarily seek to identify the principal challenges facing us and assess our readiness to confront them. What then are the challenges? These are not new; for years there has been general agreement on the list; what is changing is how the Bahamas economy is being shaped and affected over time by these challenges, especially in those areas where we have not been able to implement appropriate policy to address and cope with these external forces. The Bahamas has generally been able to hold its own and to perform well in the two major economic components of its economy: tourism and financial services. This ability to compete in these two industries can be explained largely by the related comparative advantage held by our country, vis-à-vis those who in fact can compete against us in those industries, given mainly geographic considerations. But, it is the result, also, of a long-standing significant openness in the broad policies governing the operation of those activities in this environment; there is virtually no restriction on investments by credible and acceptable parties in either sector - with the exception of the domestic retail banking sector where, for a long time, some level of restriction on entry has applied. With respect to the labor policy applicable to these two major sectors, it has generally facilitated the management and technical - including infrastructural development - needs of these sectors and, I believe, would be considered by those operating in the sectors as reasonably flexible. – The Bahamas government has consistently sought to provide necessary fiscal and administrative support to these sectors; the Hotel Encouragement Act, for example, and the incentives which it provides, has been critically important in attracting many hotel projects to the Bahamas. In financial services, we need consider only the recent establishment of a Government ministry to focus on issues related to that sector to have clear evidence of Government’s commitment to support this industry. The policy of openness, and determination to be competitive in these two industries, its no doubt the result of the realization that despite the comparative advantage enjoyed in each instance, because these are global industries which cannot be easily controlled by individual countries acting alone, and this is especially true of the smaller countries such as The Bahamas, one has to play by the rules of the broader global environment or not play at all. Indeed this is the reality which has been lost, recently, on many who still pine for the old days of financial services; they do not fully understand, or agree, that The Bahamas, alone, cannot cause this industry to behave as we might wish. A most interesting, even intriguing, paradox is that while the Bahamas has thrived and built its successful economy largely through the embrace of these two global industries, which have demanded and have largely received exemption from a more closed, inward-looking investment policy generally, a large segment of our economy has not been spared the reflex of protectionism and administrative control, which in many instances probably should have been left behind when we closed the doors on the decade of the sixties. To fully reinforce this point, let me ask you to consider for only a second what the respective size and economic contribution of our tourism and financial services sectors would be, had these been restricted to a Bahamian-only- policy. It is probably not an exaggeration to assume that they would be considerably smaller, far more costly in their operation, and would consequently speak for only a fraction of the contribution the actual industries make to our economy. I think its important to point-out, that I do not wish to suggest an inherent inefficiency in domestic business, although this is often the experience, but rather to point to: (a) the resource availability advantage of a non-restrictive policy, and (b) the fact that in an open economic environment, domestic resources are, like those from abroad, forced to be efficient, competitive participants, or they will dissipate, not benefiting from the protection of public policy. The domestic economy, and whatever opportunity there may be for the economy to develop, will benefit from the significantly higher levels of resources available and competitive efficiencies. Some of the principal areas of administrativeeconomic control include: – The Exchange Control Policy; – The Investment Policy, which restricts entry by non-Bahamians into certain areas of the economy; – The Public sector official virtual monopoly over provisions of electrically and telecommunications services; – The monopoly over provisions of legal services, held by the Bahamas Bar Association; and – The Immigration Policy, which appears to be premised on the principle that work permits should be available only for positions which cannot be filled by Bahamians. While I don’t propose to examine each of these in great detail, I feel a few comments could be useful: Exchange Controls: the need for these is, of course, rooted in the country’s decision, almost forty years ago, to adopt its own currency at values which have always been fixed and not permitted to float on the currency markets. Had the decision been taken at the beginning or early on to adopt the U.S. Dollar (for example) as the currency, or to allow the B. Dollar to float, exchange controls would not have been necessary. I would argue that we are too far down the path of having pursued the fixed exchange rate arrangement to make a sudden complete reversal. It is therefore, in my view, necessary to pursue the measured liberalization path which has been followed for more than ten years now, the ultimate objective being complete removal of controls in the future. I have said on a number of occasions before, and sincerely believe, that The Bahamas will at some point during the next ten or so years decide to become a member of a larger currency arrangement. The main implication of such a step would be the loss of the Government’s ability to borrow from the Central Bank. The most important theoretical benefit to the economy of the eventual removal of exchange controls is the removal on restrictions to the movement of capital. I believe that The Bahamas would be a considerable beneficiary of such a development when it eventually is possible, but wish to emphasize that it would probably not be possible in the very short term. Investments: National security, environmental, and reputational concerns dictate that there should be some level of approval with respect to proposed investments into the economy. However, I am not certain that the strict reservation of certain activities for Bahamians can be maintained if our economy is to achieve the level of competitiveness needed in the current and developing environment. The policy requires review in the context of what is happening around us. Public Utilities: unless we move quickly to commercialize the benefit of the diminishing monopoly, we will completely lose the stock of value developed in the national telephone company over the years. As in the tourism and financial services industries, and numerous others, telecommunications has become one of those industries which is driven by global forces. In the same way that communist China found that they could not control it, and particularly its internet applications, The Bahamas needs to embrace international telecommunications industry fully, and allow business and the community generally to realize the tremendous benefits it provides. I realize that there is an understanding of this reality at the policy-making level, but as in other domains we do have to appreciate that developments will not wait for us. Equally, in the provisions of electric power to our economy, particularly in the more developed centers of The Bahamas, we should not be driven by protectionism, but should seek to offer to the Bahamas economy the very latest and most developed technology by way of commercial arrangements which allow our consumers to enjoy terms as similar as possible to those available anywhere else. Those who would have us believe that this has anything to do with our birthright or national pride are wrong! The best long term interest of Bahamians in a globalized environment is served by policies which embrace all opportunities available to us, and which force us to be challenged by the highest standards practiced anywhere. Legal Services: there is, I think, an increasing realization that the maintenance of a strict legal monopoly in favour of members of the Bahamas Bar, certainly as it affects the delivery of international financial services, is highly counter-productive. The best that one can say for this anachronism is that it fails to appreciate to what extent legal services have become synonymous with this industry; some feel that like some of our labour union leaders, legal practitioners who refuse to contemplate any compromise in this regard are simply pursuing naked self interest. If the policy-makers refuse to takeon the Bar in a meaningful way on this issue, this is a matter which should be put to the Bahamian people to decide. It is simply too important to the future of a potentially more vibrant and dynamic financial services industry to leave it as it currently stands. Immigration: There is a view that there needs to be a separation of border protection from immigration issues related to the development of those business sectors which The Bahamas most favour if our economy is to compete globally. While, as I suggested earlier, Tourism and Financial Services have probably not been significantly disadvantaged in this regard, especially during the last ten to fifteen years or so, there is room for considerable reform in this area, to provide the flexibility and efficiency which business should enjoy. The Bahamas needs to overcome the underlying unwillingness to accept the meaningful and equal participation in our economy by persons from elsewhere. This, I admit, will probably change more quickly, when more Bahamians, themselves, venture to invest and pursue business beyond our borders. Again, though, if we have to wait for this type of “organic” acceptance to occur before we can reform the way our economy works, we risk missing-out on the positioning phase of this new global economic order. We should consider most carefully if we are to take such a risk. With regard to labor issues more generally, our country is clearly faced with a crisis of unreasonableness in the expectations which labor has been made to understand it should have vis-àvis what the economy can and should, given competitive realities, afford to labor. This, I think, is one of the largest issues challenging the orderly development of the Bahamians economy. The time, I think, has come for tow things in particular to happen: There needs to be careful reflections on the operation of labor unions, to ensue the they do not continue to capriciously hold the economy at ransom; and, The institutionalization of a meaningful forum for dialogue between labor, industry and government, as employer, needs to be pursued, to a) develop a better appreciation by labor of its appropriate place in the economy, and b) provide for a long-term stable framework within which orderly negotiation and determination of labor contracts, and other issues of importance between these groupings, could be pursued. I would argue that the influence of labor leaders - as distinct from the union membership - is currently far in excess of what it should be given what they represent in the entire process. One can wonder whether they have not been allowed to direct the administration of labor far too much in their individual interest. Is The Bahamas ready for these types of reform? Certainly not for the most part. There is a pervasive Bahamian desire to resist change and to assume that our country can continue to enjoy the fruits of our traditional good fortune without any particular effort on our part. Of course this is a badly mistaken view which in any event does not seem to recognize that we ourselves demand an ever increasing improved standard and quality of life. Unless we are willing to embrace these types of reforms in the way we pursue development, the improvements which we have known for three half decades of development will become increasingly difficult to realize. A development vision for The Bahamas over the next decade must be based on the principle of openness.
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central bank of the bahamas
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Remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the Bahamas Business Outlook 2018, Nassau, 18 January 2018.
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The Path to Exchange Control Liberalisation: Completing the Journey in One Piece Remarks by John A Rolle, Governor Bahamas Business Outlook 2018 18 January, 2018 Introduction A special thanks to the Counsellors for inviting me to make this presentation on exchange control liberalisation. I intend to keep the focus narrowed to issues related to capital and investment flows, as these are the areas where policies and administrative practices have the most substantive impact. Rather than argue that The Bahamas should resist liberalisation, I would instead like to convince you that we should make more credible preparations to do so—but in a stable fashion. I would also like to convince you that some of the roadblocks to liberalisation are matters related to our national investment policy regime, which defines the limits of property rights enforcements for those who might otherwise, already be able to circumvent the exchange control regulations. Finally, there is the question of dollarization, and whether this option would allow The Bahamas to speed up the process of liberalisation. Purpose and Scope of Exchange Controls The system of exchange controls, and the monetary policy tools available to the Central Bank are to ensure that The Bahamas is able to maintain the fixed exchange rate, with B$1.00 = US1.00. The parity with the US currency provides a necessary convenience for tourism, which is mostly transacted in US dollars and mostly with US clientele. The fixed exchange rate has also provided a stable anchor for domestic inflation, which has closely mirrored the inflation rate in the United States. This is an achievement almost unrivalled in independent countries in Latin America and the Caribbean, or in most developing countries. 1|Page It should also not be so quickly discounted given the importance of stable inflation expectations in the medium and long-term decision making processes of the private sector-whether it is about investments, savings or wage negotiations.1 Our exchange controls have been effective, not because they are fool proof, but because they provide safeguards around very liquid and mobile financial flows, which if shifted rapidly could destabilise the exchange rate. Given enough time, people do manage to evade controls but the short-term fallout from such movements is not felt. Meanwhile, the national investment policy provides a check on restricted categories of inflows, because it determines the ease of forming legally binding commercial contracts with non-residents. The downside, however, is that protection can reduce the incentives for expedited structural reforms that would have longer-term benefits. More liberal capital flows do expose policies and policy makers to greater market scrutiny and accountability. It is to our advantage to subject ourselves to such discipline, and to push for reforms that positively reinforce good policies. The exchange rate peg has only survived because the Central Bank, with the help of exchange controls, has consistently been able to assure a supply of foreign currency to the public at the official rate. The system also allows excess inflows from tourism and other export activities to accumulate in the external reserves until they are needed.2 In accommodating foreign exchange demand, the system then distinguishes between international transactions that are current in scope, versus those of a capital or financial in nature. Current transactions, most commonly cover goods and services (including travel), interest and profits on investments and remittances such as expatriate workers’ income or The benefits of the fixed exchange rate and the longstanding ability to maintain the currency peg is an achievement on which The Bahamas receives repeated commendation from the IMF, in the Fund’s Article IV Consultation Reports on the country. See for example the 2015 Assessment by the IMF’s Executive Board: http://www.imf.org/en/Publications/CR/Issues/2016/12/31/The-Bahamas-Staff-Report-for-the-2015-ArticleIV-Consultation-43125. Except where the policies have been relaxed, the law requires that exporters and those permitted to raise funds in foreign currency must sell the proceeds to the Commercial Banks. Beyond the amounts required for immediate use by their customers for external payments, commercial banks must sell the excess to the Central Bank. 2|Page transfers. Capital transactions cover both portfolio and direct investment flows, and the contracted liabilities of individuals, financial institutions and businesses. The use of foreign exchange is permitted freely to pay for current transactions. In this area, there has been significant delegation of authority to commercial banks to approve payments without prior reference to the Central Bank. A forthcoming round of delegation will provide additional flexibility to banks to approve commercial payments, and particularly benefit medium and larger businesses. For individuals, small businesses and most mediumsize businesses, there is already virtually no direct contact with exchange controls for these trade related transactions. There is, however, a more selective approach in dealing with private financial transactions. Policies have always embraced private direct investment inflows in the foreign exchange earning sectors, but paced slower to accommodate outflows by Bahamians. The ability of Bahamians to make outward direct investments that were not assessed an investment currency premium, only started to be embraced as a policy in 2006, and is now accommodated up to a limit of $10 million, per investment, every three years. The approval process considers whether such investments would produce returns that would be repatriated to The Bahamas.3 In 2017, access by Bahamians to financing in foreign currency for domestic ventures was also strategically relaxed,4 with a limit of up to $5 million per business firm every 5 years.5 This is available for businesses operating in sectors generating positive net foreign exchange impact or where expressed national development goals have been articulated. On portfolio or potentially liquid investments, the approach has been one-sided. Inflows are still not very much embraced. However, since 2006, Bahamians have been able to invest abroad without paying the investment currency premium, once they purchased instruments marketed through local broker dealers and traded on the local stock exchange (BISX). The This covers the ability to establish ownership in international financial institutions operating in The Bahamas, which have to be capitalised in foreign currency. The relaxed measures are published in the following report on the Central Bank’s website: http://www.centralbankbahamas.com/download/013616000.pdf Borrowing from the private sector arms of the IDB or World Bank are not subject to any limit. 3|Page collective annual accommodation limit for these vehicles is now $35 million. Other portfolio transactions still incur an investment currency premium. The premium used to be at 25 percent, but was reduced to 12.5 percent in 2006 and will be reduced further to 5 percent in 2018. That said, the Investment Currency Market exists primarily to limit speculative pressures that could deplete the supply of foreign exchange and render the exchange rate unsustainable. Figure 1: Bahamas Utilisation of Investment Currency and Stock Exchange (BISX) Linked Facilities Note: Cumulative capital outflows for selected vehicles area as follows:- ICM: more than $50 million; BISX vehicles: $150 million; NIB: $109 million. Source: Central Bank of the Bahamas Another reform that has already been foreshadowed is that greater access is being opened up for residents and businesses to maintain foreign deposits accounts, but with built in protections for the exchange rate regime. In particular, business will be able to retain a portion of their foreign currency revenues to meet ongoing trade payments. Also, Bahamians who have accumulated foreign currency assets abroad will be permitted to repatriate these and, if they desire, maintain the deposits in foreign currency. The holders of these facilities will not be able to fund them with foreign exchange that is purchased on the local market. This ensures that inflows of foreign exchange remain for the most part available for the private sector’s current account needs. 4|Page A Stable, Sustainable Path to Further Liberalisation It is the continued liberalisation of the capital account to which we should aspire in The Bahamas, to the extent that it is able to stimulate higher rates of national savings and investment and provide more diversification opportunities for local investors. The proviso is that the flows, whether inward or outward, ought to be sustainable. We ought also to be able to maintain relative exchange rate and financial stability. The Bahamas must be prepared to move in this direction only as fast as we are able to erect the appropriate safeguards around highly liquid capital flows. At the same time, we should strive to put such frameworks in place. Compared to the present environment, the outcome for liberalisation could include the following: The ability of Bahamians to invest outside The Bahamas in foreign currency, absent the investment currency market premium; and the ability of non-residents to invest more freely inside The Bahamas in both long-term and short-term capital. The ability of residents to hold foreign currency deposits in local banks and for nonresidents to maintain deposits in local currency. The ability for residents to borrow in foreign currency and for non-residents to borrow in local currency, irrespective of source. These would, of course imply, no restrictions on converting into and out of Bahamian dollars. To be sustainable, net capital inflows must be able to pay for themselves. That is, their deployment should generate enough foreign currency returns to repay both the initial inflows and the required returns on those flows. Otherwise, they could become a net drain or burden on a country’s stock of foreign reserves. Now, when the decision is left to banks, there should be less of a concern about whether financing of a particular currency 5|Page denomination should be given to a firm, because from a best practices or regulatory point of view, banks would be required to match their lending to the currency in which the revenues of the business are denominated. Outside of banks and similarly regulated entities, policy makers would have to orchestrate this sustainable outcome at a national level through direct incentives or disincentives to the sectors of strategic concern. If the government lacked tools such as tax policy to influence financing behaviour, it would continue to have to rely on direct, though less efficient intervention to influence external financing patterns. This is the positon in which The Bahamas still finds itself, and will likely have to focus if we are to further optimise external financing inflows to locally owned businesses over the medium-term. As to stability, The Bahamas must still be able to accommodate the volume and speed of capital flows, without losing control of the exchange rate or the solvency of financial institutions. Funds that move through capital markets or sit in liquid bank deposits are examples of flows that can relocate swiftly. Again, from a regulatory point of view, the risk of bank insolvencies can be suppressed, by requiring that banks do not rely on short-term foreign currency deposits inflows to finance long-term lending. Reserve requirements can also be placed on banks to reduce such tendencies and to provide some insurance against sudden outflows. That said, there could also be vulnerability to sudden outflows if, en masse, residents are allowed to shift out very liquid funds they hold in local currency. Faced with such developments, the exchange rate could be allowed to depreciate—that is, the price of foreign exchange could be allowed to increase. Such an outcome would not be desirable for The Bahamas.6 Therefore, we should be striving for an outcome, where other than for diversification residents are indifferent between holding deposits in local or foreign currency. This would be an outcome where portfolio decisions are not materially driven by speculative movements to outrace expected depreciations in the exchange rate. Among other factors, Given high import reliance, a fluctuating exchange rate would affect prices but little else, as it would not confer any competitive advantages to the economy. Instead in tourism, for example, depreciation would be offset by higher local currency costs on imported inputs, and in negotiated wages which would also respond to exchange rate generated increases in the cost of consumed goods. 6|Page speculations about whether the currency would maintain its value would depend on whether it is believed that the government was doing a credible enough job of keeping its finances in order; whether it is believed that public sector debt dynamics would be kept within a comfortable zone, or whether misaligned finances were viewed as having a credible chance of being remedied. The monetary authority is also part of the fiscal picture. Failed public finance dynamics can show up in unchecked borrowing from the central bank and in growing gaps between local currency liabilities of the monetary authority and foreign reserves, which are held to support the currency. Central bank lending to the government can also be a source of accumulated bank liquidity, of the sort that might seek to flee the jurisdiction, if they are allowed to become mobile. The confidence boost that a financial system would need, before opening itself unchecked to short-term financial flows would be, in a case where deficits and debts are a concern, to quiet such concerns. Deficits or debt burden need not disappear at the outset, but there has to be an anchored belief that such reduction would occur within a comfortable time frame. At the Central Bank, we are focused on gradually reducing the amount of outstanding credit provided to the government. It will also achieve, as a side benefit, some important reduction in surplus liquidity within the banking system. Over the medium-term it is also expected that a new Central Bank Act would put stronger governance arrangements in place to continue to reduce lending to government. At the same time the public finances will have to support some of the liquidity reduction in the medium-term through direct slowdown and eventual reduction in the debt burden.7 Aside from exchange control, liberalisation also has to be considered in the context of the national investment policy. If certain sectors are constrained from foreign participation, then Bahamians operating in those sectors would also be constrained in how they A costly option that many countries have taken is to have the central bank issue its own securities to soak up liquidity. However, if done aggressively the institution could incur losses. 7|Page collateralise access to foreign currency financing. If majority ownership in a venture must be Bahamian, then the majority financing source, unless it is domestic would not be permissible in foreign currency.8 Also, to the extent that restrictions apply to how nonresidents acquire real estate in The Bahamas, use of such assets as security for mortgages would be subject to a layer of processing and approval that is independent of any EC rules. Figure 2: Central Bank Financing to Government As the government debt burden increased, reliance on central bank financing, especially over the last decade, has also increased…. The balance sheet impact for the Central Bank has been that the coverage provided by external reserves for B$ currency liabilities has declined. Note: The Reserves to demand liabilities coverage spiked in 2009 because of the Bahamas’ share of the Special Drawing Rights allocation that the IMF provided to its membership during global financial crisis. Source: Central Bank of the Bahamas The Central Bank had to take this into account in how the 2017 liberalisation measures were framed. 8|Page The question will still come up as to how far The Bahamas should go with liberalisation, both for direct investments and portfolio transactions. The extensive work that the IMF has done has been to advise that countries should sequence liberalisation at least one step after the upgrade to institutional and policy arrangements has been made, which allow the country to optimally manage the transformed environment.9 At the extreme, the IMF’s view is that a flexible exchange rate would be ideal to allow a country to absorb the effects of large movements in short-term capital. This assumes that a country has well developed and functioning financial markets, and that the regulatory frameworks exist to ensure that financial institutions operate in a sound fashion. Adequate fiscal policy tools should also exist to incentivise the right course for the private sector. This would also mean less reliance on administrative measures, in favour of tools that affect a wider cross-section of the markets directly.10 Being able to pre-empt adverse outcomes, which is critical, also means that sufficient capacity must exist to collect timely data to monitor private sector activities. The Central Bank and policies affecting the banking sector are a subset of the elements in this required stronger framework. Indeed there is already progress in on the banking side. Our local banking system is sound, with the required regulatory framework, and high frequency reporting requirements to ensure safety and soundness, even if the composition of balance sheet flows were to change or become more fluid. Moreover, the Central Bank is developing expanded frameworks to monitor economy-wide indicators of financial soundness. With modernisation of the government securities market, the Bank will also have a more flexible set of tools to manage financial sector liquidity. That’s said, we have to continue to improve data quality and coverage for activities outside of the banking sector.11 Consideration also has to be given to harmonised policies that influence other parts of the financial sector. This means progressing to a legal framework for financial stability that See The Liberalization and Management of Capital Flows - An Institutional View (IMF, 2012). http://www.imf.org/en/publications/policy-papers/issues/2016/12/31/the-liberalization-and-management-ofcapital-flows-an-institutional-view-pp4720 For example interest rates and tax policy. The Bahamas now aspires to meet the Special Data Dissemination Standards (SDDS) of the IMF. (See link here). This would impose more rigor on statistical systems, with more frequent and broader coverage of private sector activities. 9|Page draws in all of the other financial sector regulators, so that prudential measures, when required, have a uniform impact. Alternatively, The Bahamas needs to move to consolidate the supervision of the financial sector, at a minimum, along prudential lines. The operating frameworks in the government sector also need more evolution, to be able to intervene in capital flows in a non-administrative fashion. As it stands, the system is still skewed towards consumption taxes. Moreover, for well into the medium-term the government’s flexibility will be constrained by the necessary emphasis on fiscal consolidation. Is Dollarisation an Option? The working assumption is still that The Bahamas would want to avoid the nuisance of exchange rate flexibility. Reliance on other fiscal and monetary policy tools therefore becomes more important. Many have suggested that dollarisation would be an option. Giving up the B$ entirely and adopting the US currency by default would eliminate the exchange rate concern.12 It is true that the government would no longer be able to borrow from the central bank, but it would not alter much else of what would be required in policies and frameworks to ensure stable and sustainable capital flow trends. It would not, for example, make a financial stability framework less relevant or relieve the government of the need when necessary to use fiscal policies to maintain macro-economic stability. Indeed, this outcome, if we aspire to such, would increase the imperative for good and sound fiscal frameworks. Going the route of dollarisation also does not shorten the time required to get to a more liberalised state. The B$ currency liabilities of the central bank would still have to be extinguished at the promised rate of one-to-one. The process of deficit reduction and debt reduction therefore has to run its course. The outstanding balance of central bank lending to government would still need to be eliminated and the government entirely reliant on the A case for dollarisation could be advanced on the basis of the high structural linkages between The Bahamas on the US economy. Forgone monetary policy independence would not be a strong reason for dissuasion, however the need for policy independence could increase if the Bahamian economy were to diversify in ways that were less dependent on the US. 10 | P a g e market and on market pricing to finance its shortfall. In fact, the government has to go much further than just eliminating its debt to the central bank. Much of the attractiveness to the private sector of holding government debt rest on the ease at which it can be sold to the Central Bank. Reliance on the central bank as the “buyer of last resort” for government debt will also have to diminish, maintaining the overall focus therefore on comprehensive debt reduction. Even a persistent balance budget rule would not outweigh expenditure prudence and efficiency. Uncompetitive high rates of taxes as a percentage of GDP would still be a recipe for capital flight. Conclusion To conclude, there are justifiable economic reasons to push for increased capital account liberalisation for The Bahamas. Where this process could end is much further than where the economy sits at present. However, there is no shortcut to the pre-requisite reforms to develop stronger institutions and policy frameworks, and healthier economic fundamentals. Added to how the central banking framework is strengthened, a more consolidated view of the financial sector regulations would support this outcome. Improved public finances and stronger fiscal management systems underscore the central role that the government must also play in any transformation. Finally, the speed at which we are able to reform will determine the stable and sustainable pace at which we tackle our capital controls. 11 | P a g e
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Remarks by Mr John A Rolle, Governor of the Central Bank of the Bahamas, at the Seminar on Exchange Control Liberalisation and Future Developments, Nassau, 5 February 2018.
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Welcome Remarks Governor John Rolle Seminar on Exchange Control Liberalisation and Future Developments 5 February, 2017 The Central Bank is pleased to welcome participants to today’s seminar on the administration of Exchange Controls (EC) in The Bahamas. This event is being held to provide more information on the recent liberalisation measures. We seek to promote better awareness of the distinction between exchange controls current account or traderelated transactions versus those on capital and financial flows. This has a bearing on how discussions about liberalisation of international financial flows could be approached. We also expect to receive constructive feedback on how the various administrative processes can be further improved. Over time the Bank expects that our focus will narrow to just those issues related to capital and financial flows and how these can be managed for the benefit of the economy. The Bank anticipates a further rapid shift in delegated responsibility to commercial banks to process foreign currency applications for trade-related payments. This will leave more space on our work agenda to explore and prepare for relaxation of capital flows. It should be stressed though that The Bahamas is not presently in the position to make a large leap to more liberalised, unfiltered financial flows, such that the stability of our exchange rate would be preserved. This is especially so considering the very liquid nature of flows to which some stakeholder groups aspire. Preparation is still required to strengthen our institutional capacity to function in a transformed environment, and to improve the structural health of the economy. Some of our important stakeholder groups do not yet fully acknowledge the trade-offs that could be involved between the extent of liberalisation introduced, and difficulty it would pose to preserve the fixed exchange rate. Also, The Bahamas has not built the sufficiently informed national consensus on what the final state should look for either liquid flows or direct investments. “Informed consensus” means that the positions adopted should be based on proficient understanding of how the economy is structured; the nuts and bolts of how the economy works; how foreign exchange gets from where it is earned to where it is needed; and how, in the absence of capital controls, pricing mechanisms could dictate how foreign exchange gets allocated. As prepared for delivery. But the messaging seems clear: we want less administrative involvement of the public sector in the commercial activities of the private sector, balanced with the objective of keeping the outcomes stable. How does the central bank fit into this process? In our Strategic Plan for 2016-2020 the Bank mapped out goals to pursue a constructive approach with both internal and external stakeholders to improve the administrative processes for Exchange Controls. This includes a focus on promoting more informed dialogue on capital and financial flows and on how these relate to an understanding of the way our economy works. Our Financial Literacy program will support this process. We also believe that literacy will encourage more transparency and accountability on policies and fundamentals over which we have control. It will better equip the private sector to ask pointed, relevant questions of policy makers. Our dialogue has to draw out the importance of holding policy makers accountable to inspire confidence through the outcomes that they produce. In this regard, the degree of success achieved with liberalisation ought to be gauged by the extent to which private sector decisions around the deployment of capital is based on genuine pursuit of higher productive returns rather than a fear of erosion of wealth from real or perceived risks of domestic economic ruin. Fear is still too prominent in the discussion for wanting to go outside. As such the private sector’s decisions could be underweighting the returns that their capital would generate in productive investments inside The Bahamas. This point should not be downplayed given already significant liquid resources that lay idle in local banks. These resources and others are in need of greater deployment in the enterprise sector. New private sector mechanisms ought to be developed to deploy these resources. The Central Bank does believe that more benefits can be obtained from liberalisation. Prudent reforms should continue to be advanced to put these advantages within the reach of the economy. The Bank has stressed though that liberalisation should be gradual. After all, the process of developing the systems and capacity to manage a transformed economy is itself gradual. With these points in mind, the Bank trusts that you will find today’s seminar useful. We look forward to your constructive input. Thank you.
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Remarks by Mr John A Rolle, Governor of the Central Bank of the Bahamas, at the Launch of the Get Money Smart Bahamas Financial Literacy Campaign Launch, Nassau, 1 May 2018.
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John A Rolle: "Get Money Smart Bahamas" Remarks by Mr John A Rolle, Governor of the Central Bank of the Bahamas, at the Launch of the Get Money Smart Bahamas Financial Literacy Campaign Launch, Nassau, 1 May 2018. * * * The Central Bank of The Bahamas is pleased to announce the launch of its national financial literacy campaign, “Get Money Smart Bahamas,” with the participation of the Clearing Banks Association of The Bahamas. After a competitive search, we engaged the partnership of Colina Financial Advisors (CFAL) Ltd and Blue Orchids to help with the formulation and execution of the campaign. CFAL brings its financial management expertise and literacy promotion experience to the campaign. Blue Orchid Bahamas is providing creative direction and strategic communications support. The Central Bank recognizes the need to educate consumers more on personal finances, financial products and the economy, especially in the context of increasingly vocal concerns about the cost of banking services, and the ease of access to banking services. The Bank believes that literacy is an empowering and critical line of defense for consumer financial protection. We want the users of financial products and services to ask the right questions about the services that they receive, to understand their legal rights, to be empowered to make responsible choices around savings and borrowing and to conduct their affairs safely and securely in a digital world. Since this campaign was conceived, we have benefited from the results on domestic financial literacy from a national survey, which the Bank sponsored through Public Domain. Some of the highlights that are soon to be published are as follows: Although many Bahamians have access to savings accounts, most persons are not using them to accumulate funds; rather, they are just serving the basic purpose of storing money that would be spent almost immediately. More consumer education is needed around how interest rates aid our ability to build up savings over the longer-term; and Much more education is needed around personal debt management. The goal of this campaign is to equip Bahamians of all ages and socio-economic backgrounds with the knowledge and confidence they need to make sound financial decisions. We especially want to encourage a strong culture of personal savings and reinvesting. This ties into the shared national goal of keeping the value of the Bahamian dollar on par with the US dollar, because it translates into more prudent use of the foreign currency that The Bahamas earns. This campaign will have a special segment on banking products and services to help the public learn more about how to borrow and use credit wisely. We will also provide education on how to conduct transactions in safer and more secure fashions, especially given the increasing importance of electronic commerce, online banking and electronic money. This pushes along the desired path of being less dependent on physical cash in our daily transactions. We are pleased to be partnering with the Clearing Banks’ Association with this campaign. We will also be working with several industry stakeholders throughout the year to ensure that the campaign is well-rounded, relevant, and can reach as many people as possible. We encourage the public to visit the campaign website www.getmoneysmartbahamas.com/, for 1/2 BIS central bankers' speeches information that will be updated at regular intervals throughout the year. We also encourage the public to follow Get Money Smart Bahamas on Facebook and Twitter and to join the conversation online using the hashtag #getmoneysmartbahamas. 2/2 BIS central bankers' speeches
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Remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at The Bahamas Anti-Money Laundering and Countering the Financing of Terrorism Risk Management Conference, Nassau, Bahamas, 17 September 2018.
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How the Bahamian Financial System Serves Bahamian Society: Why Our AML/CFT Reputation Is Important Remarks by John A Rolle Governor The Bahamas Anti-Money Laundering and Countering the Financing of Terrorism Risk Management Conference Baha Mar Resort Nassau Bahamas 17 September, 2018 *As Prepared for Delivery How the Bahamian Financial System Serves Bahamian Society: Why Our AML/CFT Reputation Is Important1 Remarks by John A Rolle, Governor, Central Bank of The Bahamas at The Bahamas Anti-Money Laundering and Countering the Financing of Terrorism Risk Management Conference, Nassau, Bahamas, 17 September, 2018. Introduction Good morning. I propose to review the ways in which the Bahamian financial services industry serves Bahamian society, and also touch upon a few ways in which this can be and will be improved. I will then outline why the Bahamian jurisdiction’s AML/CFT reputation is a critical determinant of our financial services industry’s ability to prosper and grow, and summarise our current international standing, as represented in various league tables. The take away from this that we must transform the domestic financial sector in ways that promote more internally self-sustaining growth; fortify the international sector in ways that protect and expand upon its direct economic contribution; and that we must exploit and amplify the positive feedback from the direction of enhanced AML/CFT frameworks in favour of increased economic resilience, and from the direction of targeted financial sector development, access and inclusion in favour of increased AML/CFT effectiveness. Why We Care about the Financial Services Sector - the Domestic Story The Bahamian domestic financial system provides all the benefits typical to a country of our size and economic development. We have direct financial intermediation of savings— across a wide range of sectors and activities. We have risk pooling, and we have specialist services such as payments processing. In particular: - The banking sector provides a safe place to store liquid funds, allocate credit, and process payments; - The insurance sector provides risk pooling and investment products; and - The securities and pensions sector provide investment products as an extension of the savings process. A well-functioning domestic financial sector serves society by making us safer, wealthier, more resilient to financial distress; and better able to manage the risks and returns in the real economy. It should also distinguish itself by converting savings into investments, or into uses that generate net positive, longterm benefits. As prepared for delivery. How does the Bahamian financial sector stack up against these criteria? In some ways well, in other ways not so well. The Bahamian Economy It will be helpful for this discussion for us all to be reminded of the following facts. First, the Bahamian resident population is less than 400,000, so in population terms we are quite a small country. We are also significantly small in terms of our weight in the global economy, and in terms of how sensitive we are to fluctuations of a policy or economic nature that radiate in our direction from the outside world. On the other hand, The Bahamas enjoys a fairly high average per capita income, even though this position has not improved in some years. $27.8 $27.6 $27.4 $27.2 $27.0 $26.8 $26.6 $26.4 $26.2 $26.0 $25.8 2.0 1.40 1.5 1.0 1.00 0.5 0.0 (0.10) (0.40) -0.5 Per cent $ Thousands Chart 1: The Bahamian Economy -1.0 -1.5 (1.70) GDP/Capita ($‘000) -2.0 Real GDP Growth (%) Source: Department of Statistics After the 2007 to 2010 global financial crisis, the Bahamian economy suffered through an extended period of challenges, including falls in asset values, and on average near-zero income growth. The recovery is only now becoming entrenched, but at levels of potential growth that are still unsatisfactory. How do we then achieve more substantial and sustainable economic growth? Part of the answer is that we must foster a domestic financial system that better supports such growth and in more instances, can seed such growth. I wish to emphasise, however, that the financial system cannot manufacture economic growth out of thin air. As it now stands, our financial system does best at supporting the growth potential that is created in the economy. Most of the enterprises that attract domestic bank credit are in sectors that do not earn foreign exchange. Their prospects are linked to the second round effects of thriving foreign exchange earning sectors such as tourism. This is what economist would term as a “pro-cyclical” dependence. It can only be reduced if more of the credit provided by banks helps to expand those local enterprises that are either direct earners of foreign exchange or those that help conserve on our foreign exchange dependency. It is also important to remember that the financial system is the second largest industry in The Bahamas, comprising 15 to 20 per cent of GDP depending upon the definitions used. A growing financial industry generates jobs, and they tend to be well-paying jobs. The Bahamian public and private sectors have identified a great many reforms necessary to improve the underlying growth potential in our economy. As these reforms are delivered, the financial system will help translate potential growth into actual growth. Domestic Banking Sector Our domestic banking system is soundly capitalized and nowadays solidly profitable. However, it is not sufficiently incentivized to allocate or provide credit in ways that would better serve the economy. Chart 2: Domestic Banking - Private Sector Lending $6.55 $6.17 $ Billions $6.0 $5.95 $5.0 $4.0 $3.0 $2.0 $1.0 $0.0 Per cent $7.0 Enterprises ($Bn) Total Private Credit ($Bn) Mar-18 Jun-18 Households ($Bn) Private Cedit/GDP (%) Source: Central Bank of The Bahamas In the five years from 2013 to 2018, domestic private credit shrank from $6.5 billion to under $6 billion. Even more so remarkably, commercial loans fell to well under $1 billion, and well under 10 per cent of GDP. Unfortunately it speaks to the pro-cyclical constraints on credit just mentioned; to the low-quality information environment surrounding borrower risks and to a reward structure most favoring consumer lending over other forms of credit. It is not simply reversible by lowering interest rates, because the credit stimulus—skewed to consumer financing—would exhaust rather than sustain the support we value for the fixed exchange rate. To give a sense of perspective on this level of lending, the Bahamian private credit to GDP ratio is currently about 55 percent. The same ratio among the large and developed economies in the G20 ranges from around 150 to over 200 percent. Currently, Canada has the highest ratio at 267 percent. We are in the curious situation where the carrying or sustainable capacity for credit in Canada is several multiples greater than is being sustained in The Bahamas, where we are both serviced by the same leading institutions—and arguably, technology and capital are not the hurdles to be surmounted. I am not advocating an expansion in Bahamian private sector credit to these much higher levels. But in comparison to other countries, Bahamian bank lending could stand to be larger, and still be prudent. That is, particularly, if we incentivise more lending of the right mix, to fund more counter-cyclical business and investment growth. In the process, the economy could also be sustainably larger and more prosperous. The transformation needed is to decrease the number of cents out each dollar of income earned that must be spent on imports. There are five conditions precedent for confident bank lending: - Sufficient capital Sufficient liquidity Sufficient information about borrowers A clear ability to collect on problem loans Confidence in the general prospects for the economy Bahamian banks at this point have plenty of capital and liquidity. What they lack is borrower information, and perhaps confidence in collecting problem loans, and/or confidence in the business prospects for The Bahamas. The Central Bank is already progressing several initiatives that will improve bank confidence to lend. This includes a program of reducing the industry’s aggregate non-performing loans, establishing a Bahamian credit reporting bureau, and commencing a program to move more domestic transactions from cash to electronic methods. Just in 2017, the Central Bank relaxed capital controls on access to financing in foreign currency for enterprises, that would make our credit policies more countercyclical, and therefore of a more sustained impact on stronger growth. Two issues are highly relevant in the AML/CFT context. First, “sufficient information” about a customer extends beyond the customer’s financial standing, to the customer’s potential to ensnare the bank in a financial crime matter. The Central Bank, the Bahamian government, and the public sector overall have undertaken a great many reforms, in this area that you will hear about during this conference. One benefit from these reforms is that Bahamian banks and other financial institutions will be able to deal with their customers with greater confidence regarding the customer’s non-involvement in financial crime. Furthermore, through its regulation and supervision, the Central Bank will be able to demonstrate to interested stakeholders that the Bahamian banking system is reasonably well insulated against AML/CFT risks. Our colleagues at the other Bahamian financial regulators have taken or are taking similar steps to lift public and private confidence in the AML/CFT robustness of their regulated entities. We can never guarantee that no customer will ever put tainted money into a Bahamian financial institution. We are, however, approaching the day when we can undertake that no Bahamian financial institution has a substantial or systemic exposure to laundered money or terrorist financing. The second AML/CFT confidence issue is more macro than customer-focused. The Bahamas, in common with many other small countries, still faces a material threat from diminished or cut-off access to international correspondent banking or “de-risking”. We face the actual consequences of more difficulty in undertaking cross-border transactions. This difficulty extends beyond the financial system to all businesses. Faced with de-risking threats, domestic banks may validly conclude that the Bahamian economy is more vulnerable to correspondent banking abandonment than they find comfortable. Our work on lifting AML/CFT risk management, and all the other regulator work, will over time reduce this risk. It’s worth noting that moving the bulk of Bahamian payments from cash to electronic will generate a great many benefits for our society and economy. Among these benefits, commercial borrowers will be able to document their receipts and expenses more credibly, and over time this must help in obtaining bank loans. The International Banking Sector Moving to the international banking and trust sector, I will show you two hopefully interesting slides. Chart 3: International Banking Assets $558 $511 $409 $ Billions On-Balance Sheet Assets Fiduciary Assets Jun-18 Total Assets Source: Central Bank of The Bahamas Funds held by the sector in The Bahamas have decreased in the past several years. In broad terms, The Bahamas is no longer in the business of hiding money from international tax authorities. We have seen a considerable return of now-compliant clients to their home jurisdictions, or alternatively to the United States. Chart 4: International Banks: Employment Home supervised Host supervised Source: Central Bank of The Bahamas Nevertheless, employment in the sector has remained more or less constant over the past several years. So jobs are holding up, despite the decrease in funds under management. The Central Bank’s interpretation of this is that the remaining international clients are receiving value-adding trustee, advice, and management services. Those services make for “stickier” clients, and they also require more staff per client. We also observe that home-supervised institutions, which have no overseas parent, have been growing their staff relative to host-supervised institutions. In 2012, about a quarter of the industry worked for Bahamian-owned or headquartered firms, and this proportion has increased to a third. We expect to see the Bahamian-owned international banking sector continue to increase in proportion to the offshore-owned sector. Where does this leave the international banking and trust sector? Clearly, smaller than it was a few years ago in balance sheet terms, but still substantial. The average wage for the jobs in this sector exceeds $100,000 per year. Furthermore, the sector supports a great many service jobs in areas such as accounting, law, and consulting. The Central Bank expects that the number of international banks and trust companies will decrease some more, as several small entities have indicated their intent to exit The Bahamas. This does not necessarily mean that funds in the system, or employment, will materially fall. We are hopeful that the sector is finding a base from which it can grow. If we are not in the money-hiding business, what business is this sector pursuing? In a few cases our licensees have highly specific business strategies, but the more general approach is preserving private wealth, increasingly focused on Latin American clients. This suggests that if The Bahamas wishes to preserve and grow its international banking and trust sector—and we do—both the public and private sectors will need to consider how best to become and retain the Western Hemisphere’s jurisdiction of choice for private wealth preservation. In following this strategy, we will need to continue grappling with AML and to a lesser extent CFT issues. It is obviously the case that there is dirty money in Latin America. But it is equally obvious that there are clean businesses and investors in Latin America, and in most cases they would be well-advised to keep some of their family wealth offshore. The Bahamas needs to be the natural place where clean money from clean clients finds a home. Maintaining a substantial international banking and trust industry in The Bahamas materially complicates our efforts to improve our jurisdiction’s international reputation for AML/CFT risk management. Those who arbitrate such matters globally consider that private banking in small population centres such as Nassau is an automatically high risk business. We are increasingly forming the view, contrary to this conventional wisdom, that properly regulated and supervised international banking and trust business need not be high risk in AML terms. As our jurisdiction has dispensed with money in hiding, and concentrated on money needing more active services, what has become clear to us is the following: a) First, that supervised financial institutions know their remaining customers closely; b) Second, that not only customers but funds and transactions are scrutinized at the individual level; and c) Finally, that the typical client is performing around one transaction per month, so this is not a high volume proposition. At this point we are still in transition, and our supervisors and examiners have identified a considerable list of improvements necessary in the industry. But nothing about this list and our other supervisory findings suggest that the Bahamian international sector is irremediably high risk. We are rather more of the view that, given another one to two years of newly intense supervision, under considerably improved regulation, this sector will become solidly medium risk. We look forward to industry’s cooperation in achieving this outcome, and in helping to demonstrate this outcome to the world’s AML risk arbiters. Sovereign AML Ratings Agencies Speaking of AML risk arbiters, the Central Bank has identified six providers of AML sovereign risk ratings. The first and most extensive of these is the Financial Action Task Force and its nine regional affiliates— most relevantly in our case the Caribbean Financial Action Task Force. Second and most accidentally, we have the U.S. State Department’s INCSR Volume II, which is an annual list of so-called high-risk jurisdictions. In spots three to six, we have four subscription based services, which operate on very similar weighted index approaches. The Central Bank’s AML Analytics team maintains a watching brief on all six of these ratings, particularly as regards The Bahamas. We are normally rated towards the high risk end of the spectrum, but in this space there is a strong bias towards high risk weightings. Let’s look at each ratings provider. First, the FATF, which helpfully provides comparisons for all countries it has assessed through mutual evaluation reports. There are in fact two ratings: a compliance rating based upon 40 technical assessments, and an effectiveness rating based upon 11 judgement categories. All 51 of these sub-ratings are based upon a four step scale. There is no official method to convert these 51 ratings into one or two aggregate ratings, but it is easy and common for interested parties to perform this conversion themselves. The current position of The Bahamas against about 50 other recently FATF-rated countries is show on the next slide. The horizontal axis gives our position on technical compliance, and the vertical axis our position on effectiveness. In these ratings small numbers are better than big numbers, and it can be seen see that The Bahamas is in the middling group, but at the less good end of that group, particularly on the effectiveness rating. Chart 5: FATF Fourth Round Evaluation Rankings Source: FATF Nearly all of you would be aware that the CFATF issued the Bahamian ratings in 2017, but another exercise is in progress now, with a new assessment scheduled to be published in a couple of months. We expect that the re-rating will appreciably improve the Bahamian position on this map of relative AML/CFT strength, as reflected through the FATF ratings universe. Regardless of how one feels about the FATF in general and the Bahamian assessment in particular, it is clearly the case that the FATF approach is: - Credible; Fully documented; Reasonably consistent in global application; and Represents a great deal of work by experienced AML professionals. Only the first of these characteristics applies to the next rating source, the US State Department’s International Narcotics Control Strategy Report (INCSR). In the absence of a credible competitor to the FATF assessments, many around the world have launched on to this list as the second major source of sovereign AML risk information. The problem with this approach is that the INCSR is not any sort of rating model. It is simply a list prepared through the relevant American embassies and coordinated in Washington. The underlying analytic support for this list, we understand, is a single page questionnaire, which is filled out locally, not necessarily by an AML professional. Our intent is not to criticise the State Department. They have never claimed that the INCSR is any sort of AML ratings tool, but it is simply a statutory requirement under relevant American legislation. At any rate, in the INCSR universe, The Bahamas is on the list, as are 75 percent of the countries considered by the State Department. Now we move to the four subscription services: Thomson-Reuters, about which you will hear more later today; IBM; the Basel Governance Institute; and KnowYourCountry.com. All four of these providers deploy a weighted average approach to risk scoring, within which the FATF and State Department assessments are typically the two largest inputs. Other inputs include items such as global transparency, rule of law, and economic league tables. The Bahamas tends to rate somewhere in the medium to high risk range with these four subscription services. KnowYourCountry, for example, has us as medium risk and rated 139th out of 219 jurisdictions. The Basel Governance ratings has us as high risk, and in the ninth out of ten deciles of countries. Chart 6: Distribution of FATF Effectiveness Ratings Frequency Low Moderate Substantial High Immediate Outcome Rating Why are AML sovereign ratings important? Because, singly and in aggregate they often form a material input into the risk considerations of correspondent banks and others who deal with The Bahamas. The effect is similar to debt ratings agencies: If Moody’s and Standard & Poor’s lists a country as subinvestment grade, it becomes much harder and more expensive to raise funds. If the AML ratings agencies list a country as high AML risk, it becomes harder for that country and its institutions to operate effectively in the global financial markets. Financial inclusion Now, let’s talk about financial inclusion. “Financial inclusion” is something of a buzz phrase globally, but that hardly detracts from its importance. It is easy to conclude that Bahamian financial inclusion is not nearly as complete as it needs to be. Our populace is still not fully banked on either the deposit/transaction or the credit side of the balance sheet. Our insurance penetration, investments, and pension participation are a long way from what might be optimal. Our capital markets are neither large nor liquid in global terms. Then there is the geographic issue that inclusion in the Family Islands is in some cases markedly less than in New Providence. Neither the Central Bank nor any other agency can fix this on their own, but collectively we can do quite a lot to create a more inclusive Bahamian financial system. We look forward to providing advice to the government on this point. Financial inclusion is not mainly about AML, but it does generate two distinct AML advantages. The first is that cash intensity in the economy will drop, in favor of electronic transactions. This makes our society and economy safer and more efficient, and it makes large and possibly suspect cash transactions easier to identify. The second advantage flows indirectly from the increased data intensity of the financial system. It will become harder for financial criminals to hide in the undocumented recesses of a non-inclusive system. The Central Bank and other agencies are already progressing a number of financial inclusion initiatives. In our case, these include joining the Alliance for Financial Inclusion, or AFI, and adopting that body’s Maya Declaration. The AFI has already helpfully created a number of national inclusion benchmarks which we can adapt for Bahamian use. The AFI also provides many case studies, research reports, and other information, which will help us generate ideas for Bahamian financial inclusion. The Central Bank’s digital currency initiative, for which we received expressions of interest through September 15th, is a financial inclusion, AML and economic efficiency prospect. The returns against these metrics will crystallize at varying pace over time. It would be fair to say though that the future of retail payments appears to be centered on mobile phones rather than cards, and much more so than inbranch bank transactions. The Central Bank’s promotion of a credit bureau, as already noted, should assist in financial inclusion, as Bahamian lenders will become more confident that they understand their prospective lending customers. We are shortlisting potential operators of the bureau this month, and plan to complete the licensing process for the successful bidder before the end of 2018. Finally, the Central Bank recently released updated Guidelines for AML/CFT risk management. Among a great many other items, these Guidelines have substantially streamlined the documentation requirements to open a simple B$ bank account. This will make banking easier for all Bahamians, and also make banking available to some of our residents who previously couldn’t open a bank account. Where to from Here? In forecasting the future, it’s important to remember that we know, but can’t predict the timing or incidence, of some major negative shocks. These include hurricanes, global recessions, and sudden panics in the international financial and banking markets. What we can assert, however, is that The Bahamas is not yet as well positioned for these shocks as we would like to be, or as we intend to be. Most obviously in the context of this conference, The Bahamas has become, and will continue to become, a more robust jurisdiction in managing AML/CFT risks. This has direct benefits in discouraging criminality, corruption, and terrorism, and large indirect benefits in giving the world’s major financial markets and institutions the confidence to deal with us on good terms. Improved financial inclusion will also lead to improved resilience. Our banking system will become bigger and safer. There is the prospect for our insurance, funds management, and pension industries to grow, which creates better risk pooling and a larger pool of long term investable funds for The Bahamas. Outside the sphere of this conference, we see the Bahamian Government and associated parties undertaking many initiatives to reduce societal risk. We are a small country facing a somewhat uncertain future. Provided we manage our risks sensibly and proactively, however, I am confident that The Bahamas can aspire to a great future. Part of that great future involves a Bahamian jurisdiction that both is and is accepted as sound in managing its AML and CFT risks. Thank you for your attention today.
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Special address by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the 13th ASBA-BCBS-FSI High-Level Meeting on Global and Regional Supervisory Priorities, Nassau, 30 October 2018.
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SMALL COUNTRY INTERFACES WITH THE WORLD’S FINANCIAL RULE-MAKERS John Rolle Governor, Central Bank of The Bahamas 30 October 2018 Special Address to the 13th ASBA-BCBS-FSI High-Level Meeting on Global and Regional Supervisory Priorities Introduction The Central Bank of The Bahamas is pleased and honoured to be able to co-host this gathering of eminent persons from Latin America, the Caribbean, the Basel Committee on Banking Supervision (BCBS), the Financial Stability Institute (FSI), and the Bank for International Settlements (BIS). My topic tonight is: “How Small Nations Interact with the International Financial Rule-Making Architecture”. The core elements in this architecture include: - - Multilateral agencies, among which the IMF is probably the most impactful for small countries, and the BIS the most impactful for the world’s central banks; Rule-making bodies, among which the Basel Committee is probably the most prominent, but including the international Association of Insurance Supervisors (IAIS), the International Organisation of Securities Commissions (IOSCO), and similar groups, with the Financial Stability Board (FSB) assuming prominence in recent years; The ever-growing architecture on financial crime suppression, centred on the Financial Action Task Force (FATF); and A range of public, quasi-public, and private groups that create, impose, and/or enforce standards in international finance, among which leading examples include the ratings agencies, SWIFT1, ISDA2, LCH3 and many others. The small country experience in general What has been the experience of small countries in dealing with these groups? In a few words: generally positive, but mixed. From a small country perspective, the ideal engagement with an international rules-making body would feature four key elements: - - The body explicitly considers small countries when making and enforcing rules; The body provides, directly or through its membership, reasonable assistance to help small countries adopt and maintain the relevant rule set; The body’s governance arrangements allow for small country representation, and for staff from small countries to engage on working groups, task forces, secretariats, and the like; and When conducting compliance assessments and similar engagements, the body’s evaluation process gives small countries a fair chance to demonstrate compliance, in the context of each country’s economy and society. Society for Worldwide Interbank Financial Telecommunications. International Swaps and Derivatives Association. LCH is a London and European based clearing house for trades in financial instruments. My experience, both directly and through engagement in the Caribbean and elsewhere, is that most international rules-making bodies lack comprehensive policies in the above areas, but there is generally sincere goodwill expressed by these bodies. Put another way, few international rules-making bodies are set up to disadvantage small countries, but several of them can bruise us inadvertently, and we would like to see international practice improve to reduce this bruising. The challenge in part relates to focus on rules making to affect outcomes of a globally systemic importance; outcomes which are less likely to be the case for economic events and economic actors in small countries. As such, conceding to small country concerns is often a question of quantifying and recognizing the unintended or spillover consequences of international standards; and determining how or sometimes whether to act to offset adverse externalities. Small countries often have difficulty interfacing with the major international rule-making bodies, and it is clearly not the case that every such body should be expected to engage individually with about 200 countries. This is where regional groups shine, and among these groups, ASBA has been particularly helpful for Latin American and Caribbean small countries. We thank ASBA for their past, present, and doubtless future good work. The FSB has also made good progress by convening non-members through its regional consultative grouping. I can also acknowledge positive strides at the IMF and World Bank. Some of the recent sensitivity take a more micro-state view that narrows the universe to just most countries in the Caribbean, other Pacific Isles and parts of Africa. It has helped in tailoring policy prescriptions in the Fund’s surveillance framework, for us, particularly around capital flow management and exchange rate policies. Let me clarify that from my perspective, “small countries” are usually small in population, though they could be large in financial terms, with say New Zealand or thereabouts the cutoff between large and small. This is clearly a flexible definition, perhaps closer to the economic definition of small. The experience with the Basel Committee Now let’s consider how the Basel Committee, with strong input from the FSI, measures up on my nominated criteria for ideal small country engagement. 3.1 Consideration of small countries in rules making and enforcement First, how well does the BCBS consider small country issues when making and enforcing rules? I commend you on two issues, and suggest a reconsideration regarding one other matter. The first commendation flows from past years of reasonable receptivity to small country issues, albeit secondary to large country and large bank issues, at the Basel Committee. There are clearly routes through which a well-prepared small country can inject its views into the Basel processes, often via regional consultation formats. The second commendation, and it is difficult to overstate its value, is the Basel Committee’s and FSI’s more recent and explicit adoption of proportionality as an accepted and important part of the framework. This allows small countries to adopt the Basel rules texts in ways that are fully compliant with the texts, but very much simpler and cheaper to supervise and comply with. To take a topical example, The Bahamas is currently consulting on a Basel III implementation that will require perhaps 10 per cent of the complexity of the full Basel rules text. Much of this simplification revolves around avoiding model-based approaches, but even the new Standardised Approaches give a great deal more freedom for small countries to adopt simpler but robust rules. Please continue with proportionality, and encourage the IMF to support this approach as they conduct FSAP reviews. The matter I would ask you to reconsider is the increasingly fragile assertion that the Basel Committee is only making rules for large, internationally active banks. That may be the Basel position, but it is not the IMF position when it comes to FSAPs. This applies to the Basel Core Principles and the capital and liquidity frameworks. I certainly don’t suggest that you move away from making rules for internationally active banks, but please try to remember, ideally not just around the margins, that a great many non-member countries will strive to adopt the Basel rules, both for international and domestic banks. 3.2 Assistance with rules adoption The second question is, does the Basel Committee and FSI assist small countries in adopting new and almost always more challenging international rules? Your record on this is particularly good, in our experience. That’s the whole point of the FSI. We are also grateful that the Basel Committee, relative to some other international rule-making bodies, allows considerable time for consultation and for implementation of new rules. This conference is an obvious example of part of the extensive assistance given to non-member countries, as is the biennial ICBS event. So please keep up the good work. 3.3 Opportunities to engage Third, what about governance and use of staff? The BCBS and FSI secretariats and working groups naturally feature staff from member countries, but it is also the case that staff from non-member countries get opportunities from time to time. We would like to see this practice continue, and ideally expand. I acknowledge that there are a great many non-member countries for the Basel Committee to potentially engage with, but on the other hand, engaging a single high quality person from such countries can have a disproportionately positive effect in transferring best practices. I note again the ICBS, and the regional consultation groups, as indications of good practice. 3.4 Getting a fair chance to demonstrate compliance Finally, what about a fair chance to demonstrate compliance? In the BCBS case, RCAPs are only relevant to member countries, and small countries generally deal with Basel rules text compliance through the IMF/World Bank and FSAP processes. Our experience has been that we do get a fair chance to demonstrate compliance on the core principles, and aspects of the rules texts as they come up. On the other hand, I must observe that small countries are often subject to regulatory and supervisory fads that emanate from the large countries that constitute the bulk of your membership. Current examples include stress testing and resolvability of domestic systemically important banks (DSIBs). On the stress testing front, North American and European banks are spending billions of dollars a year on financial stress testing. That is their business. It should not be our business. To again refer to the Bahamian example, our banking system has a Common Equity Tier 1 (CET1) ratio exceeding 30 per cent. Recession-type stresses generate reductions in that ratio, but nothing remotely large enough to approach international minimum capital levels. But what about our obvious stress, which in common with many small countries revolves around a natural disaster? Most hurricanes which hit The Bahamas have not presented a financial system threat. But a Category 4 or 5 hurricane passing to the close north of this island could hurt us very badly. How badly? We don’t know. Why don’t we know? In part because it’s a very complex question requiring coordination across a great many agencies plus the private sector. But also because the relevant staff are working on financial stress tests that in all honesty are more for FSAP consumption than our own use. Plus, there is a huge amount of work for a great many international agencies on a great many topics, not all of which are locally helpful. On the DSIB resolution front: we have a minimal equity and nearly no debt capital market, and deposits handily fund loans. So why would we do total loss absorption capacity (TLAC)? And what sort of resolution plan is possible when recapitalization from markets is most unlikely? We can’t afford to close a DSIB, and we have no capital markets providers to take the failure risk. This is far from unusual in small countries—so why are we putting a lot of time into Internal Capital Adequacy Assessment Processes (ICAAPs), recovery plans, resolution plans, and the like? Because that is the international expectation. It would be better to develop a supersimplified but pragmatic approach that minimizes but does not eliminate the potential for public sector bailouts of DSIBs. Conclusion To sum up: the Bahamian experience, and from what we have seen of other small country experience with the Basel Committee, has generally been positive. We are also deeply grateful for the work of the FSI, which is an extraordinarily helpful group. The same applies to the technical assistance on offer directly from Basel Committee member agencies and their associated national assistance bodies, plus the international multilateral development bodies. There are a few areas where we would like to see more consideration given to small country issues, but the bottom line is that the BCBS works for us, even though we aren’t a member and are unlikely ever to become a member. We are not yet in a position to say that about all international rule-making bodies, but that is a conversation for another day. I will conclude by thanking you personally and your agencies for your good work, and for the assistance and consideration you have shown The Bahamas and other small nations over the years, and the assistance and consideration to come in the future.
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Remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the Forum on the Past, Present and Future of Monetary and Fiscal Policy, Nassau, 20 November 2018.
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The Foreign Exchange Constraint on Monetary Policy: The Bahamian Context Remarks by Governor John A Rolle1 Forum on the Past, Present and Future of Monetary and Fiscal Policy The Government and Policy Institute University of The Bahamas Harry C Moore Library 20 November 2018. Good evening. It is a pleasure for me to bring opening remarks for this distinguished panel of past Central Bank Governors, all of whom I know and have worked with in some professional capacity.2 The common theme in these professional encounters was the appreciation of the scope for which monetary policy could be effective in either a Bahamian or Caribbean setting; what contributed to making policy effective; and the understanding of what constrained policy makers. In The Bahamas, we have a commitment to maintain a fixed exchange rate, at one to one against the US dollar. The exchange rate peg is supported by the foreign reserves of the Central Bank. By law, the currency liabilities of the Bank must be matched, at all times, by at least half the equivalent amount of foreign reserves. At present, the Central Bank tries to target this coverage in the range of 90% to 100%. As prepared for delivery. I was introduced to Sir William Allen in 1988 in my first tour as a summer intern at the Central Bank of The Bahamas. After Governor James Smith joined the Bank, I remember detailed comments he provided on a policy paper I wrote about options for monetary integration in the Caribbean. Those comments are still relevant today. During Governor Julian Francis’ tenure, I interacted on many occasions with him about adjustments to exchange controls and monetary policy, including policies which we embraced in the immediate aftermath of the September 11, 2001, terrorist attacks on the US. In fact, Governor Francis’ queries motivated most of my research on dollarisation and exchange control liberalisation. Governor Wendy Craigg and I have had the longest relationship of all, as she managed the Research Department, where my central bank career began, and we both attended regional conferences, where I present papers on the pressing monetary policy themes facing the Caribbean. For the peg to be credible, the Bank must always be able to supply foreign exchange at the guaranteed rate. Under our exchange control regime, this guarantee is binding for all trade and current account transactions.3 To ensure credible access to foreign exchange, the Bank seeks to balance inflows, principally from export earnings against demand stimulated outflows from income, drawdown of savings and domestic credit financed activities. The lever most controlled by the Bank is domestic credit. It is focused not on whether credit can stimulate economic activity, but on whether the credit generated can be sustained, given the first imperative to maintain adequate external reserves. In the aftermath of the September 2001 attack on the US, the optimal policy response was to freeze the supply of domestic credit, and to tighten lending standards. This was a contractionary or procyclical policy response. When the foreign exchange inflows improved, credit conditions were relaxed, also in a procyclical fashion. This episode illustrated, what is generally the case for The Bahamas-- protecting the value of the Bahamian Dollar, leaves little sustainable space for monetary policy to be growth enhancing in the short-run. Developments in the fiscal domain also affect the monetary policy space. As a general proposition it is neither advisable nor sustainable in a fixed exchange rate regime to have unchecked deficit financing by the monetary authority. These can perpetuate currency base expansion without the corresponding increase in foreign reserves that provide the coverage for the currency.4 Fiscal deficits can also can fuel increased imports, which drawdown on foreign reserves. At the instance of a deficit, monetary policy is therefore most concerned about how the deficits will be financed. The reference point is not the amount of domestic liquidity against which the government might borrow, but the amount of foreign exchange that the economy would require to pay for the resulting increase import demand. Given this consideration, the Central Bank’s advice is usually that deficits must be financed with some amount of foreign borrowing. Otherwise, the effect would be a drawdown in foreign reserves and undermined support for the currency. The preventive measure is limiting the occurrence of deficits, in the first instance, as often the choice of how the deficit will be financed is an artificial one. There is nevertheless a medium-term concern about the level of liquidity in the Bahamian financial system. To address this, the Central Bank’s forward looking strategy is to gradually reduce the outstanding lending to the government. This would absorb any excess liquidity that had its origin in accumulated past central bank financing of the government.5 Where does all of this leave us in terms of improving the environment for monetary policy, and making it less procyclical? First, over the medium and longer term, the economy has to do a better job of retaining the foreign exchange that it earns. More bank lending has to reach productive enterprise activities that forge Over time, liberalisation of the regime has also allowed greater access to foreign exchange to support more outlets for savings and investments that expand the country’s longer-range capacity to earn foreign currency. The other instances that drive expansion in the currency base are purchases of foreign exchange from public and private sector activities. These produce a one to one growth in the reserves and create no tension in the external reserve backing for the domestic currency. Liquidity is also created when the private sector takes in more foreign exchange than it uses. Such excesses flow from commercial banks to the central bank. In the process, the central bank issues new domestic currency liabilities. This is liquidity that can support demand and credit growth without unease about the cover for exchange rate stability. linkages with tourism, provide competitive substitutes for imports and expand our export reach. The Central Bank’s targeted liberalisation of capital controls, has also allowed such categories of enterprises direct access to financing in foreign exchange. We believe that it is a strategy that will bear fruit over the medium-term. Second, the fiscal policy framework has to bolster support for the currency. Deficits, when they arise, should anchor public investments with positive net returns to economic growth, and have a positive foreign exchange bias. More fundamentally, for our present circumstances, deficit reduction and eventually budget surpluses should become the order, with more public investments sustained from savings on recurrent expenditures. Fiscal deficits and debt accumulation, can make it difficult to wean the government off borrowing from the monetary authority; and in parallel, can expand foreign currency debt in ways that cannot be easily repaid. Better foreign exchange retention and confidence engendered by fiscal policy, takes us to the topic of exchange controls. Some rebranding is necessary to make this more of a conversation about capital controls and capital flow management. This is essentially where our policies are more binding, but where scope for very gradual targeted easing is possible over the medium-term. The limit though is to understand that liberalisation cannot happen out of a sequence of first having in place lasting policy and accountability frameworks that bolster investor confidence. Where these frameworks are missing or nascent, liberalisation must impose a distinction between how we deal with direct investments versus very liquid, and highly sensitive portfolio flows. If the end goal is to have fully liberalised capital flows, then we must accept that it would come with a floating Bahamian dollar. If we float, we should want to avoid the exchange rate volatility that arises when investors become jittery. If we dollarise to eliminate currency volatility concerns, then fiscal and private sector savings will remain important to provide the buffers needed to make our economy resilient. Dollarisation will not provide a shortcut out of reforms that are needed--in terms of utilising less direct means of influencing credit and investment behaviour to safeguard financial stability; having more comprehensive realtime data on economic activity, including fiscal indicators; having a larger stock of foreign reserves to cushion against shocks, and the like. Dollarisation would still be premised on a target value for the exchange rate at the time of the domestic currency’s abandonment. This again raises the question of whether such an outcome could be achieved absent an effective capital flow management regime. There is much more than can be said on this topic and on other dimensions of the Central Bank’s role, beyond the protection of the currency. The Bank has been working tirelessly in all of those dimensions: strengthening the quality of our regime for supervised financial institutions; accelerating the modernisation of the domestic payments system; laying foundations for use of more indirect monetary policy instruments and building more capacity for macro-prudential supervision. We realise that it is only through lasting structural reforms that there would be progress in making the monetary and financial system a stable, more resilient and a less procyclical component of our growth and development. It is fitting therefore to have this esteemed panel assembled, and I look forward to hearing their views on this important topic.
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Speech by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the Central Bank of The Bahamas Blockchain Seminar, Nassau, 18 March 2019.
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The Bahamian Payment System Modernisation: Advancing Financial Inclusion Initiatives By John A Rolle* Governor *As prepared for delivery. Central Bank of The Bahamas Blockchain Seminar 18 March 2019 Introduction Inclusive of a digital version of the Bahamian dollar, the Central Bank of The Bahamas has defined several evolved objectives for the Bahamian payments systems. On some levels The Bahamas is positioned to use new technology to accelerate this transformation. It brings into focus the need for new policies and regulatory reforms to address best practices in the digital supply of financial services, consumer protection in its multifaceted forms, cyber security, and more. There are multiple, complementary objectives within our digitisation and reform initiatives. These include: Making the payments system more efficient. Using technology to achieve more inclusive, cost affordable, even access to financial services, across all islands of The Bahamas; providing access that avoids discrimination on the basis of immigration or residency status. Strengthening national defenses against uses of the financial services infrastructure for money laundering and other illicit ends; including activities that thrive more easily in cash intensive environments. Selected Payments System Indicators By international standards, The Bahamas has a very developed financial system. However, the averages obscure gaps in who have access to services over our disperse geography, and the 1|Page inefficiencies that constrain services delivery.12 Banking presence is sporadic on the Family Islands, and absent altogether in a few cases.3 At the national level, trends point to increasing use of electronic payments (see Box 1), but anecdotally the costs of settling transactions is a drag on the speed of change.4 Cost aside, accelerated change could be also encouraged through increased comfort around accepting and making digital payments; and placing these capabilities universally within the reach of more consumers.5 In 2018, the Central Bank conducted a baseline survey on financial literacy and garnered metrics that speak to financial inclusion, along the lines of templates used for the OECD countries (Table1). Although this survey does not capture what is happening among undocumented persons, it indicates a high degree of awareness and high degree of access to basic deposit facilities in The Bahamas. Just above 90 percent of the respondents had knowledge of savings accounts and debit cards. Yet, only about 80 percent of such persons had use of a savings account.6 Only about 70 percent of these individuals used a debit card; and fewer than half possessed a credit card. Improvements must be sought in all of these estimates, along with much higher rates of access and usage for personal investment products. Fintech Driven Financial Inclusion The payment system modernisation initiative (PSMI) is to provide both the incentives and the means to spur more widespread adoption of electronic payments, and to enable greater general access to financial services over digital platforms. Ultimately this means approaching 100% access to digital services; universal access to banking services of a deposit maintenance nature; and fully enabled electronic payments capabilities. Reducing the size of legitimate but unrecorded economic activities will also be necessary, admitting particularly micro, small and medium-sized businesses into the digital space. In 2013 estimates, Svirydzenka (2016) ranked The Bahamas at 40th out of 183 countries in terms of overall financial development but at 15th in comparative access to financial institutions—which took account of the density of the physical banking infrastructure. The relatively lower development index compared to access was due among other reasons to lower ranking on all other metrics including the efficiency of financial institutions (44th out of 183) access to financial markets (54th out of 183) and the efficiency of financial markets (in the lowest quartile). See: Katsiaryna Svirydzenka (2016), “Introducing A New Broad-based Index of Financial Development,” IMF Working Paper (WP/16/5). On a per capita basis, for 2017 there are 26 bank branches for each 100,000 persons in The Bahamas, the 35th highest in the world (see IMF Financial Access survey for 2018 at http://data.imf.org/?sk=E5DCAB7E-A5CA-4892A6EA-598B5463A34C), even though for efficiency reason this estimates is lower than the 35 to 40 branches per 100,000 persons averaged during 2007-2014. There has also been growth in the number of ATM available, near 155 per 100,000 persons the 15th highest concentration in the world, according to the IMF’s (2018) data. Berry Island, Mayguana, Acklyns, Crooked Island. The Bahamian data reveal an increasing volume of transactions occurring outside of the physical branches at ATMs (which is still cash unfortunately), increasing use of credit and debit cards for electronic payments, and declining reliance on check writing. Anecdotally, wire transfer costs have also slowed the transition from out of the use of checks for payroll processing for some firms. Also, the merchant fee for accepting credit and debit card payments which can average between 2% and 5% of the transactions value, can act as a disincentive for firms that might cling exclusively to cash receipts. See The Bahamas Financial Literacy Results 2018 (https://www.centralbankbahamas.com/news.php?id=16402&cmd=view). 2|Page For what needs to be accomplished, how results are measured and how The Bahamas progresses in comparison to other countries, we will be guided by established international frameworks and standards; and we will take full advantage of technical assistance from the network of like-minded peers and supportive agencies. In this regard the Central Bank’s 2018 membership in the global Alliance for Financial Inclusion (AFI), will yield returns in terms of how we build capacity to regulate and create more enabling frameworks to spur beneficial developments in the Fintech space. Recent Bahamian Policy Reforms In The Bahamas, we have already made some progress on financial inclusion initiatives, but with much more to be accomplished. Throughout recent regulatory reforms, the Central Bank was guided by the principle that access to payment services should not discriminate between whether the products originate from banks or from other regulated entities; and that the range of access that users of cash currently enjoy in services should also persist when the products are digitised. Also, irrespective of whether consumers avail themselves of mobile payment services or traditional bank deposits, the ease of access and risk tailored customer due-diligence should be similar. One of the early outcomes was that the Central Bank was able to establish regulations to license nonbanks to provide electronic money services to the public. There are already two firms that have either provisionally or fully met the requirements for licensing. In addition, several existing money transmission businesses are in the process of developing digital payment solutions. On ease of access, streamlined customer due diligence standards were introduced in 2018 under revised AML Guidelines7 which simplify the identification and address verification requirements to establish deposit accounts and to access other services from financial institutions. It shifts more emphasis to the important transactions monitoring process after the accounts are established. Further, it limits enhanced due diligence processes to relationships which banks assess to be higher risk. For very low-value stored products the identification process need not be invoked.8 In this regard, forthcoming clarification to be issued to banks will also suppress practices that mandate proof of employment as a pre-requisite to open an account. Not all banks have converged to these new standards, but we are actively pursuing this transition. The next easing, which the Central Bank undertook was to remove Exchange Control restrictions from non-resident access to Bahamian dollar (B$) deposit facilities. Irrespective of their immigration or work permit status these persons can open and maintain B$ deposit accounts with balances of up to $50,000 without approval from the Central Bank. As part of the Get Money Smart financial literacy program, and working with commercial banks we are formulating a new public education campaign focused on these changes. The literacy campaign The guidelines (see: https://www.centralbankbahamas.com/legal_policies.php?cmd=view&id=16883 ), which apply to entities supervised by the Central Bank: banks, credit unions, MTBs and payment services providers. These have been issued under provision in the amended Financial Transactions Reporting Act 2018. In the AML Guidance Notes these would be accounts that carry $500 or less and for which the monthly reload capacity is $300 or less. Monitoring of transactions for AML purposes, still applies for all accounts which financial institutions maintain. Where higher risks are assessed supervised institutions may also invoked processes that go beyond identification, such as verification of sources of income or wealth. 3|Page will also provide more education on cyber security, to increase public comfort and acceptance around the use of digital financial products. Near-Term Priorities There are necessary further reforms that the Central Bank will target in the near-term. Under the Payment System Act, the Bank will propose new regulations to strengthen consumer protection, along evolving best international standards. These would apply to savings and checking accounts; debit and credit cards, and to stored value products, where the common thread is the actual or potential use of such facilities to effect payments. The Central Bank will also promote direct participation of credit unions and non-bank payment services providers in the payments and settlement system. This would apply to the retail clearing house (the ACH) and to the wholesale RTGS.9 The draft new Central Bank Bill provides that all of these entities would be allowed to maintain settlement accounts with the Central Bank to clear payments. As the largest originators and recipients of payments, the Public Treasury and the National Insurance Board are being invited to become direct participants in the RTGS and ACH systems. Mechanisms will also be explored to determine how international banks might participate directly in Bahamian dollar payments and settlements, to facilitate their own local needs or those of clients who maintain a nexus to the local economy. Project Sand Dollar Highlights Through Project Sand Dollar, the Central Bank will develop and pilot a general purpose, digital version of the Bahamian dollar—that is, with both wholesale and retail applications. As the draft Central Bank Bill anticipates, the Bank would have statutory authority to issue currency in digital form and to develop regulations to govern the instrument. The pilot would allow the Bank to enhance the digital system before it is deployed nationally. To stay focused on the challenges that an archipelago poses, and to tackle gaps in access to services in remote communities, Exuma has been identified as the pilot community. The Bank will also explore how to enlist other selected islands that have suppressed or no banking presence. The digital representation of the B$ will be identical to, and not a separate version of the currency. It will align with all of the statutory rules that govern existing liabilities of the Central Bank; always exchanged at one for one with existing notes, coins and balances. The design will also incorporate best international practices around AML and CFT risks. Anonymity is not a feature. This framework will rely intimately on the national identify infrastructure, when permitting users to hold and exchange digital money. A t the onset, it will use KYC and identity features incorporated into the system design, and adopt the wider public identity system as it becomes available. A blockchain infrastructure has been proposed for the digital currency, with performance capabilities that would adequately satisfy the Central Bank’s requirements for swift processing of payments. This would not impose any change on the current ownership of the ACH, which is by the commercial banks. 4|Page There will be an extensive public education process for all stakeholders potentially impacted by this transformation. Also, from the outset, this project will engage with banks and other payment services providers, so that interoperability standards can be perfected. Design Features of a Digital Currency There are important design features of a digital B$ that are intended to reflect the Central Bank’s role as a sponsor of financial sector development. This is essentially a public good that is being provided. Geographic fragmentation cannot assure that the private sector, acting alone, would achieve the level of inclusion and access which all communities in The Bahamas deserve.10 This instrument is intended to complement and not replace existing banking services. Its use will be optimised when persons in remote communities are able to deploy it to establish and maintain deposit accounts and other services at banks. Those who use central bank sponsored digital wallets would not see their funds treated as interest bearing deposits.11 However, the Central Bank will explore future innovations that would allow mobile wallets holders to invest in Government securities. While it would be possible to maintain mobile wallets independent of a bank account, the Central Bank intends to impose a ceiling on how much digital currency could be maintained in mobile wallets. High volume use will require a passthrough flow of funds to personal bank accounts. Business accounts would always fit this profile. The wallet’s integration with commercial banks or other licensed entities would be required in order for account holders to have access to foreign exchange services. The interoperability feature means that the digital B$ would be available for use across all payment platforms and within existing or proposed wallets of private services providers and financial institutions. Although the consumer public would have the default option of establishing a wallet account with the Central Bank, they would be enabled to use the currency within any product developed by regulated private wallet providers. Over time, it is expected that the Central Bank would play a diminished role in providing front-end solutions and be left to focus on maintaining the digital ledger for the currency. At the policy level, the Central Bank is also putting emphasis on a system that would allow for effective maintenance of monetary and financial stability, safeguards to ensure aggregate stability in the deposit base of commercial banks; data privacy and data sovereignty for consumers and an aggressive cyber security posture. A Bank for International Settlements Publication (2018) by the Committee on Payments and Markets Infrastructures indicates that central bank digital currencies (CBDCs) are being widely explored around the world, but mostly for limited wholesale use in interbank markets. (BIS (January 2019), “Proceeding with Caution - A Survey on Central Bank Digital Currency”, https://www.bis.org/publ/bppdf/bispap101.htm). In many cases this reflects the wide availability of private e-money solutions that leave little value-added for central banks to operate in this space. Presumably, other policy complexities, and technical and operating risks, also explored by the BIS, limit many central banks’ interest in maintaining retail accounts for users of digital currency. (see BIS, March 2018), “Central Bank Digital Currencies”, https://www.bis.org/cpmi/publ/d174.htm). This preserves the level playing field that prevents payment services providers from paying interest on stored value products. It also avoids any expanded mandate for the Central Bank to intermediate savings at direct costs to the Bank or in competition with other financial institutions. 5|Page Conclusion and the Way Forward The near-term actions for the Central Bank is to complete the contractual on-boarding of our technology solutions provider, and then to deepen the preparation and outreach process for the pilot. The government is a lead stakeholder and critical sponsor of national initiatives that will help transform the domestic financial services sector and the payments system. The Central Bank will stay actively engaged with the Government to ensure that the legal framework evolves in step with payments system needs; that The Bahamas achieves the financial inclusion outcomes that are desirable for our archipelago and to ensure that the commercial sector benefits from a more efficient and secure infrastructure. The other key stakeholders, with whom engagement and outreach will intensify over the remainder of this year are the local financial institutions and public and private enterprises of all sizes. There will be much more to reveal about project Sand Dollar. 6|Page Appendix of Tables and Boxes. Box 1: Profile of The Bahamian Payments System The Bahamian payment system is continually evolving, showing shifts towards greater use of electronic transactions, and out of branch access to banking services. Both consumers and business firms are using these electronic options in increasing numbers. In 2017, 56.8% of commercial banking branches were located in the capital, while the remaining 43.2% were in found in Grand Bahamas and the Family Islands. This was still a shrunken access from as many as 88 branches in 2008 to 74 outlets at the end of 2017. As to access to ATM terminals, 71.5% were in New Providence, 13.8% in Grand Bahama and the remaining 14.6% were in the Family Islands. Under electronic payments, between 2013 and 2017, payment card usage rose by 138% and 203.2%l respectively, with equally impressive growth in the number of merchant terminals able to process such payments. There has also been a significant increase in the use of online banking by both consumers and businesses. Selected Payment Systems Data New Providence Grand Bahama Family Islands Total Debit Cards 1,352,857 1,196,012 2,013,084 2,771,071 3,221,699 Credit Cards 275,855 206,521 396,367 751,279 836,461 Stored Value Cards 15,355 23,524 64,597 60,957 105,010 1,693,448 1,511,097 2,505,138 3,678,007 4,249,520 Volume of Transactions 347,235 396,229 452,947 550,389 564,302 Value of Transactions (B$’000) 1,610,093 1,947,990 1,656,074 3,336,894 3,210,946 5,377 4,908 8,853 9,146 11,306 29,252 Business Users NA NA 2,613 Total NA NA 66,224 74,505 89,335 Volume 4,759,159 3,535,739 4,858,373 6,712,163 7,066,865 Value (B$’000) 4,971,567 4,625,916 5,191,732 7,424,147 7,687,696 A) ATM/ABMS (Number by Islands) B) Payments Volume by Card Type Total C) Direct Credits/Credit Transfers D) Number of Merchant Terminal Accounts Total E) Electronic Banking Users Residential Users Memo: Cashless Instrument Transactions Source: Central Bank of The Bahamas 7|Page Table 1: Bahamas—Selected Financial Access Measures Surveyed Knowledge and Use of Products Product or service i. ii. iii. iv. v. vi. vii. viii. ix. x. xi. xii. xiii. xiv. xv. Savings Account Debit card Checking Account Insurance policy Pension Fund Mortgage Credit card Mobile Phone banking “Asue” “Numbers” Account Bonds Stocks and shares Investment Account Mutual Funds Equity Funds % of respondent answering “yes” Heard of & Own Want to learn jointly or more personally Source: Central Bank of The Bahamas, Bahamas Financial Literacy Survey 2018. 8|Page Box 2: Using Global Standards and Peer Support to Guide Bahamian Guide Financial Inclusion Initiatives In August 2018, the Central Bank joined the Global Alliance for Financial Inclusion (AFI), an international network of central banks and financial sector regulators across from more than 90 emerging market and developing economies (EMDEs). The goal of AFI is to assist members to improve financial inclusion in an environment supported by peer feedback, technical assistance and training as needed. In keeping with the high-level commitments of the AFI membership the Central Bank of The Bahamas has adopted the MAYA declaration12 that required the Bank to identify measurable goals to promote national financial inclusion.13 The Bahamas has identified seven broad goals, which include development of the digital version of the currency, advancing financial literacy, consumer education and empowerment, contributing to a national financial inclusion strategy (which takes a wider perspective than just banking services), and promoting the development of national digital identify infrastructure. The Bank also has an obligation to improve compilation of data on financial inclusion. AFI has recognised that Fintech innovations offer opportunities to accelerate financial inclusion progress. In 2018, the Sochi Accord14 was adopted to heighten this focus. The Accord speaks, among other things, to building capacity to understand and promote Fintech developments, using Fintech solutions to help bridge gender divides in financial access, and ensuring that and official infrastructure is developed to support Fintech applications. The case studies that emerge from AFI member countries particularly highlight the role of a digital ID infrastructure, and there is a recognition of the potential to develop electronic KYC on-boarding solution for banks. Just on the heels of the Sochi Accord, the IMF and the World Bank promoted the Bali Fintech Agenda listing high-level principles that align with the AFI approach, again stressing the supportive public framework of reform that could allow EMDEs take advantage of Fintech to promote inclusion and and other financial development results. The adoption of best practices is also urged to manage the multi-faceted risks of technology, and thwart the use of Fintech for illicit means. A recurring thread in both the IMF and AFI’s work is for EMDEs to encourage and explore Fintech solutions that would solve or reduce the de-risking threats around threatened access to correspondent banking relationships. The Maya Declaration was endorsed by AFI in 2011 at the Global Policy Forum (GPF) in Riveria Maya, Mexico. It requires AFI members to make measurable commitments in four broad areas: (i) create an enabling environment to harness new technology that increases access and lowers the cost of financial services; (ii) implement a proportional framework that advances synergies in financial inclusion, integrity, and stability; (iii) integrate consumer protection and empowerment as a key pillar of financial inclusion; and (iii) use data for informed policymaking and tracking results. See link at https://www.afiglobal.org/sites/default/files/publications/2018-08/MAYA_FS_18_AW_digital.pdf See Press Release: The Central Bank of The Bahamas Joins The Alliance For Financial Inclusion & Commits To The Maya Declaration, https://www.centralbankbahamas.com/news.php?id=16452&cmd=view The Sochi Accord: Fintech for Financial Inclusion (https://www.afiglobal.org/publications/2851/Sochi-Accord-FinTech-for-Financial-Inclusion) 9|Page Box 3: Central Bank of The Bahamas Commitments under the Maya Declaration Under the Maya Declaration of the Alliance for Financial Inclusion the Central Bank has committed to: i) Support the development of a National Financial Inclusion Strategy by 2020. ii) Increase access to banking and payment services by reinforcing our newly revised Customer Due Diligence (CDD) requirements. iii) Introduce a digital version of the Bahamian currency by 2020, to ensure minimum levels of access to banking and payments services in geographically remote parts of The Bahamas. iv) Collaborate with the government on improved national identity infrastructure to enhance the Know Your Customer (KYC) procedures in our supervised financial institutions (SFIs). v) Conclude the development and start-up of a credit bureau in The Bahamas by 2020 to foster trust and accountability between our SFIs and their customers. vi) In partnership with relevant stakeholders, pursue the creation of the Office of the Financial Services Ombudsman (OFSO) by 2020. vii) Promote public awareness of consumer rights and responsibilities through our recently deployed financial literacy program, Get Money Smart Bahamas. 10 | P a g e
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Welcome remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the Alliance for Financial Inclusion (AFI) Convergent Meetings of the Digital Financial Services Working Group and the Consumer Empowerment and Market Conduct Working Group, Nassau, 26 March 2019.
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John A Rolle: The importance of financial inclusion in mending social and economic disparities Welcome remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the Alliance for Financial Inclusion (AFI) Convergent Meetings of the Digital Financial Services Working Group and the Consumer Empowerment and Market Conduct Working Group, Nassau, 26 March 2019. * * * Welcome to The Bahamas. We are pleased to host both the Digital Financial Services Working Group and the Consumer Empowerment and Market Conduct Working Group meeting in The Bahamas this week. The Central Bank of The Bahamas joined AFI less than one year ago, in order to benefit from a structured approach to promoting financial inclusion goals, and to learn first-hand from countries that are actively pursuing such ideals. The range of countries that make up this alliance illustrate aptly that financial inclusion is intended to mend social and economic disparities that are often obscured in average measures of economic wellbeing and income. The Bahamian experience draws this out. On a per capita basis, The Bahamas has the third highest GDP in the Western Hemisphere. Our financial sector is highly developed, when considered in terms of the size of the deposit base and outstanding credit of the domestic banking system, relative to GDP; and in terms of the share of the population that has access to basic banking services. Moreover, relative to the size of the population we enjoy the 35th highest density of bank branches in the world and the 15th highest density of automated banking machines in the world.1 From an identity perspective, members of the population do not have extreme difficulties acquiring birth certificates or primary documentation needed to apply for identity documents. But financial access is very uneven. On many of our rural island communities basic banking services are not available, or only available in very constrained conditions. The rising costs of providing banking through traditional physical channels have further scaled-back this access. Also, high concentrations See the IMF’s 2018 Financial Access Survey Database: data.imf.org/?sk=388DFA60–1D26– 4ADE-B505-A05A558D9A42. of undocumented immigrants are excluded from access to financial services, even when these services are available in the same spaces for documented persons. Equally problematic for countries like The Bahamas, there has been a dilution of access from the disproportionate application of global anti-money laundering and counter financing of terrorism standards, on low-risk, retail segments of our financial community. We are now attempting to reverse this through more proportionate risk-based systems. Beyond banking, affordability of access is more constrained in property insurance markets, where financial vulnerability is heightened because of the increasing frequency and intensity of hurricanes, which can in a single season push households into ruin. Finally, relevant to the themes of consumer empowerment, we recognise the scope for improved literacy and conduct regulations to improve financial welfare. 1/2 BIS central bankers' speeches As it should be, political pressures to address financial inclusion deficits are mounting in The Bahamas, and there has to be comprehensive constructive responses. In the strategies that the Bahamian Central Bank is formulating, we understand that the private sector will not optimally achieve all of the outcomes that we desire. We recognise that an enabling environment that embraces the aspirations of the Maya Declaration, with a focus on Fintech, to promote digital inclusion is critical. This is defining very critical elements of our approach. However, we also have to identify those elements of both the policy space and technology infrastructure that ought to be supplied by the public sector. For example, the Central Bank of The Bahamas is engaged in the creation and promotion of a digital version of the national currency which is expected to close vital payments system gaps for The Bahamas that many countries are able to leave up to the private sector to resolve. At the same time, the Bank has volunteered to coordinate development of a national financial inclusion strategy that would enlist all relevant stakeholders, and focus on more than just payments and banking. We are already seeing the benefits of our membership in the AFI, in bringing sharper focus to our financial inclusion initiatives. In that spirit, we look forward to a continued build out of this network of peers, capturing all of the accessible knowledge and experiences that you have to offer. Coming into these working group meetings I expect that we have broadly similar goals, and expectations; and that there will be mutual gains from our exchanges over the next four days. Indeed, we have two very stimulating agendas. As we have received you as our guests, we hope too that you will find time to experience a sampling of our culture and the beauty of our people and country. Welcome again and my best wishes for a productive week! 2/2 BIS central bankers' speeches
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Welcome remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the launch of the Association of Certified Anti-Money Laundering Specialists (ACAMS) Bahamas Chapter, Nassau, 24 May 2019.
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John A Rolle: Fostering training to enhance the effectiveness of anti-money laundering and counter financing of terrorism outcomes Welcome remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the launch of the Association of Certified Anti-Money Laundering Specialists (ACAMS) Bahamas Chapter, Nassau, 24 May 2019. * * * It is a pleasure to be here at the launch of The Bahamas Chapter of the ACAMS network. We all appreciate the importance of having skilled professionals to manage the money laundering and related risks posed to the financial system. We also appreciate that The Bahamas must demonstrate increasingly greater effectiveness in countering attempts to exploit its financial system for illicit purposes. To this end, ensuring a critical mass of skills and certifications across our industry is essential. Perception wise, it signals to the outside world that our jurisdiction is not a haven for, nor does it intend to be known as a haven for illicit financial flows. My expectation is that as the critical mass of skills in the industry increases, The Bahamas will demonstrate more in practice, and in the experience of customers, that it is applying risk-based principles, which do not undermine the quality of services on supply. I believe we still have gaps in how risk-based outcomes are being achieved. The pressure persists for regulatory guidance to be overly prescriptive and check-list based, with the result that the retail customer experience is still too degraded. We will only arrest this trend through—in addition to all of our other interventions—strengthening competence around the application of AML/CFT safeguards. I expect that we will make more progress in this regard, thanks to AML certifications of this nature. My own position, which is not yet the institutional view of the Central Bank of The Bahamas, but which I will work to become the institutional view, is that the Money Laundering Reporting Officers (MLROs) and Compliance Officers ought to be subjected to an ongoing certification process to satisfy the regulatory requirements for holding their posts. Some of the recent initiatives of the Bahamian regulators and the Government were to identify that our compliance culture was not sufficiently risk-based. The result was that financial inclusion and access was hindered for those on the margins of the system. Thanks to the provisions of the Financial Transactions Reporting Act (FTRA), the Central Bank has been able to provide guidance that streamlines “know your customer"(KYC) requirements for access to retail domestic banking services. For low-risk customers, a passport is adequate documentation in itself for account opening. In the absence of the passport, a list of other government issued identity documents is acceptable. Verification of address by proof of a utility bill has given way to establishing proof that the client can be contacted by electronic or other means. The Central Bank of The Bahamas has also made it clear that high risk does not mean than an extra burden should be imposed to identify oneself—rather more due diligence should be exerted around the other dimensions of how a relationship is established and monitored. Also, for low-risk retail prospects, the Central Bank has gone on record to state that the potential customer does not have to offer proof of employment in order to open a bank account. The Central Bank of The Bahamas has already placed its support behind this ACAMS training initiative. It will allow The Bahamas to make more necessary, qualitative process in perfecting its national AML/CFT regime. For all of the Bahamian financial sector regulators, and the rest of the financial services industry, this provides more concentrated opportunities for in country training. 1/2 BIS central bankers' speeches I congratulate the founding Steering Committee and the Executive Board of the ACAMS Bahamas Chapter and assure you of the Central Bank’s sustained support. Thank you. 2/2 BIS central bankers' speeches
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Remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the 2019 AML/CFT Risk Management Seminar of The Bahamas Group of Financial Services Regulators, Nassau, 26 June 2019.
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The Evolving Landscape of AML/CFT in The Bahamas Remarks by Governor John A Rolle, Central Bank of The Bahamas (as prepared for delivery) at the 2019 AML/CFT Risk Management Seminar of The Bahamas Group of Financial Services Regulators, 26 June, 2019. Introduction Good morning Ladies and Gentlemen. Once more, on behalf of the Group of Financial Services Regulators, it is a pleasure to welcome you to today’s anti-money laundering and countering the financing of terrorism risk management seminar. We are grateful to have the support of the Honourable Attorney General, and both the Minister of Finance and the Minister of Financial Services for this important event. We are setting the standard for continuous engagement with financial sector stakeholders, with the expectation that, as practitioners, we will collectively strengthen and maintain national defenses against the use of Bahamian financial services for illicit purposes. If we have learnt anything in getting to this point, it has been that we have to do a thorough job in quantifying, rather than just speculating, about the risk posed by illicit activities; and that we have to make measurable progress in managing both our actual and perceived risks. Today, I will touch upon three topics related to these themes: - Where the Central Bank is seeing material money laundering risks in the Bahamian economy, and what the responsible authorities are doing about these risks; Summarising recent progress on AML/CFT risk management among supervised financial entities (SFIs) licensed by the Central Bank; and The Central Bank’s plans to improve both the reality and the reputation of Bahamian AML/CFT risk management. Money laundering risks in the domestic economy Money laundering arises when illicit funds are converted to, apparently, illicit assets usually through the financial system. In the Bahamian case, we need to consider both the domestic economy and our international financial firms. Let’s look first at the domestic banking system. The Central Bank has just released a study of domestic deposit inflows across 17 sectors that have been identified globally as potential money laundering or terrorism financing problem areas. The bottom line from this work is that with limited exceptions, headed by real estate, there is no evidence that any element of the domestic banking industry or that industry’s clients is facilitating material money laundering. In 2018, Bahamian domestic banks accepted $52 billion in deposited funds, mainly from commercial customers. Table 1: Domestic Deposit Inflows in 2018 (Rounded $Millions) Deposited Funds BSD Non-BSD Total 37.6 13.9 51.6 7.6 30.0 0.7 13.3 8.3 43.3 5.7 31.2 0.5 13.4 6.2 44.6 of which Retail Commerc'l/Other of which Cash Non-Cash Source: Central Bank of The Bahamas Chart 1: Domestic Deposit Inflows in 2018 ($Billions) Source: Central Bank of The Bahamas Table 2: Canadian Banks’ Share of Domestic Deposit Inflows, 2018 (%) Deposited Funds BSD Non-BSD Total 82% 98% 87% 68% 86% 96% 98% 70% 90% of which Retail Commerc'l/Other of which Cash Non-Cash 85% 84% 96% 98% 86% 88% We can see that the three Canadian banking groups accounted for 90 per cent of the funds placed in commercial deposit accounts, and nearly all non-Bahamian dollar gross deposits. On the commercial and, particularly, the cross-border side, the standard of AML/CFT risk management in these operations in Nassau or Freeport would be the same as in Toronto or Winnipeg. Bahamian-owned banks are less engaged in commercial banking, but have about 30% of the deposits placed by individuals. Let’s now look at the 17 individual categories where global experience suggests we should be looking hardest for money laundering. Source: Central Bank of The Bahamas The aggregate 2018 deposits in each segment can be viewed from several perspectives: by Bahamian dollars versus foreign currency accounts, and split by cash versus non-cash deposits. Broadly speaking, cash carries more AML risk than non-cash deposit. That said, only about 10 per cent of the funds deposited in Bahamian banks in 2018 fell into these 17 sector categories, with the remainder in less potentially troublesome areas. There are several lessons apparent from the data. First, many segments which the international community and standards setting bodies flag as susceptible are simply too small in The Bahamas to constitute a material money laundering risk in the domestic economy. Examples include diplomatic establishments, pawnshops, and wholesale jewellery stores. The domestic banks have yet to commence taking deposits from crypto-asset sources, but this may change in the future. Second, nearly all segments are dominated by non-cash deposits. When looking at retail jewellery stores, auto dealers, and maritime sectors, for example, very low cash flows were evident, with electronic payments such as credit and debit cards, and other traceable instruments settled through the wholesale and retail clearing houses more notable. Third, adding up the real-estate relevant sectors, which include the legal industry holding settlement funds, identifies over half of the gross funds deposited across the 17 sectors. Meanwhile, the material sources of cash deposits are in limited sectors: - Gaming Money transmission Religious organisations Insurance On the gaming front, the Gaming Board has already published a paper1 which demonstrates that retail gaming through web shops gives no indication of material money laundering activity. The Central Bank agrees with this assessment. Casinos are the only material source of foreign currency inflows in the domestic banking industry. The Gaming Board regulates casinos to the same standards held in, for example, Las Vegas. I will discuss about money transmission businesses in the next segment of this presentation. As for religious organisations, most, if not all us have been experienced the churches’ weekly collection take up, which is heavily cash-based, but hardly risky for money laundering. In addition to this deposit survey, the Central Bank has been gathering data from its own and other Bahamian public sector resources. Examples include commencing publication2 of information on Bahamian dollar denominated and US dollar denominated currency notes moving through the economy. Without going into details today, the US dollar currency flows are substantial but highly consistent with tourism activities rather than money laundering. The median note value is https://www.centralbankbahamas.com/download/056332100.pdf, page 13 https://www.centralbankbahamas.com/download/056332100.pdf, page 35 $10, and there are 40 times more $1 bills collected than $100 bills. This contrasts with global experience, where the United States has3 issued more $100 bills than $1 bills. As for Bahamian dollar cash, again the median note is $10, which limits any material capacity for cash-based money laundering. The Central Bank also analysed vehicle import data provided by the Customs Department, which reveals that the total and average value of vehicles imported into The Bahamas show little if any evidence of vehicle-based money laundering. This is also consistent with our auto dealer deposit data, which reveals a heavy non-cash industry. In summary, it is the case and, doubtless, will remain the case that some Bahamian criminals will use the domestic financial system to launder some funds. The police and the courts deal with a reasonable number of such cases per year. But, more importantly, it is generally the case that the domestic banking system provides no evidence that it is being used in any material way for money laundering. Money laundering in the international financial sector When the rest of the world looks at The Bahamas for AML/CFT risk, in a risk-based sense, they really should focus on the international banking, trust, funds management, and international business company segments. The Bahamian international financial sector, by balance sheet, measures around twenty times larger than the domestic banking sector. Domestic banks, for example, have about $20 billion in assets, while international banks and trust companies control close to $400 billion in assets. While, as mentioned, domestic bank had gross deposit receipts of $52 billion in 2018, SWIFT data reveal that gross cross-border funds movement amounted to several trillion US dollars. There are four large and essentially permanent sources of AML/CFT risk in the international sector. Our national strategy is not to remove the underlying risks, but, instead, to control them such that the sector is overwhelmingly focused on clean business. The four relevant sectors are: - International banking/trust/funds management, for which the Central Bank and the Securities Commission are the lead regulators; Cross-border real estate; International business companies; and Money transmission businesses. From January 2018, the Central Bank has moved to continuous supervision of AML risks, in the same way that we continuously supervise financial failure risks. Our current assessment is that all our substantial licensees are at least tolerably well placed for AML/CFT risks, with the typical entity not displaying any critical deficiencies, but also exhibiting a number of areas needing improvement. See for example the Harvard Kennedy School paper from Sands et al: Making it harder for the bad guys: the case for eliminating high denomination notes, February 2016. Most hearteningly, our industry has converted from a business model which historically included a large element of hiding money from foreign authorities, to one in which hiding money is no longer possible or desired. Instead, The Bahamas offer what is intended to become and remain the western hemisphere’s jurisdiction of choice for legitimate private wealth preservation. As for real estate, the Bahamian public sector’s challenge is that we have many data sources on cross-border and luxury real estate purchases, but these have not yet been fully integrated. Data directly available to the Central Bank, notably our Exchange Control approvals for foreigners purchasing real estate, reveal nothing worrisome. At this point, however, we lack a comprehensive database of all property in The Bahamas. The Department of Inland Revenue and the Ministry of Finance have commenced a major project to remedy this data shortage. As a substantial side benefit of this work, we expect that a full registry of Bahamian property ownership would facilitate a universal approach to preventing real estatebased money laundering. In the interim, the Central Bank will work with several other agencies to better coordinate real estate-relevant data. I am hopeful that within three years, The Bahamas can demonstrate that we have a world-leading and fully data-driven approach to preventing real estate-based money laundering. The international business company or IBC story is somewhat similar. The Attorney-General’s Office is the responsible authority for introducing and administering the 2018 register of beneficial ownership legislation. During the second half of 2019 and into 2020, The Bahamas will make rapid progress in demonstrating good global practice for monitoring AML risk for cross border legal entities. Money transmission businesses are negligible in balance sheet terms but generate appreciable cross border cash flows, which are, in turn, mainly driven by currency notes in the underlying transactions. Table 3: October through December 2018 MTB Cross-Border Payments -- Selected Statistics Transaction Number (000s) Transaction Value ($million) Largest Transaction ($000) Average Transaction ($Actual) Main Countries USA, Haiti, Jamaica Source: Central Bank of The Bahamas As these statistics demonstrate, the MTB transaction flow is dominated by payments averaging a few hundred dollars, with no payments over $50,000. The main source and destination countries are consistent with Bahamian economic engagement with the United States and our Caribbean neighbours. The Central Bank is the regulatory authority for MTBs. As we have ramped up our AML supervisory focus since January 2018, we have discovered a number of areas for necessary improvement in MTB risk management. This work is in progress, and we expect it will require a year or two to reach a fully satisfactory outcome. So, to summarise the international sector: - The biggest segment, banking, trusts, and funds management, is in reasonable shape but still requires improvement; The current extensive controls on foreign real estate purchases seem to be effective, but we are probably two to three years away from being able to definitively prove this; The IBC sector’s data infrastructure will improve over the next year or so to a point where we can demonstrate world-class surveillance of legal persons; and The MTB sector needs to improve its controls, and this work is in progress. Current supervisory focus In the Central Bank’s supervisory arrangements, the word “requirement” has special meaning, referring to a deficiency which the Central Bank is prepared to deploy statutory force if needed to correct. The ebb and flow of requirements, and particularly the quick and comprehensive clearance of outstanding Requirements, is an essential element in effective supervision. The Bank has formally measured progress on requirements since the end of 2017. Table 4: Supervisory AML Requirements by Sector December 2017 March 2018 Sept 2018 March 2019 Domestic Banks Domestic Other International Home International Host Source: Central Bank of The Bahamas Unsurprisingly, the volume of new requirements over this period has increased, as the Central Bank has intensified its AML supervision. Gratifyingly, the industry has, in general, lifted its focus on these issues, and is clearing Requirements, more or less, as fast as we are identifying them. This pattern, plus other information, suggests that Central Bank regulated entities are in reasonable shape for AML/CFT risks, but with material areas where they could get better, and they are in fact getting better. On the other hand, in the domestic sector, there is a disproportionate concentration of requirements among the nonbank sector, comprising credit unions and MTBs. Over the past 18 months, the Central Bank has concentrated heavily on lifting the AML performance of banks and trusts companies, which account for over 99 per cent of the relevant industry assets. From late 2019, we will deploy more supervisory attention on the smaller domestic licensees. In the international sector, the Central Bank has identified relatively more requirements among home-supervised rather than host-supervised institutions. This is, to some extent, an artefact of our 2018 and 2019 onsite examination schedule, which has focused more on Bahamian-owned vs. foreign-owned banks and trust companies. In summary, the Central Bank is working with generally cooperative and competent SFIs to rapidly improve the quality of Bahamian AML/CFT risk management from acceptable to good. The national AML/CFT risk management reality From the Central Bank’s perspective, the reality of Bahamian AML/CFT risk management is as follows: - We have, as a nation, made tremendous progress on world class legislation and regulation, but much of this needs bedding down through experience; Our domestic sector is keenly aware of the relevant issues, and over all is not a material AML risk; Our international sector will always be a material potential risk, but we have at least acceptable and increasingly sound controls in place; There are material data issues in the cross border real estate and IBC areas, which are being addressed at the moment; and In general terms, larger and foreign-owned financial institutions are somewhat ahead of smaller and Bahamian-owned institutions in AML risk management. Above all, as an industry and as a society, we are definitively out of the money-hiding business. Given that many jurisdictions cannot make this claim, the world’s dirty money managers are on notice that they should take their business elsewhere. From what we can see, which vision is not yet as perfect as we would like, the world’s dirty money managers are heeding this message. What about reputation? On the reputation front, we are dealing with an essential and possibly existential global fallacy. That fallacy is that in the field of dirty money, small countries with large international financial sectors are the problem. Now it is true that countries such as The Bahamas have in the past been part of the problem, hence, our massive reforms since 2000 and more recently. The other fallacy we are struggling with is that financial crime is an impossibly intractable problem, so, there is no point trying to empirically study the issue. These two fallacies combine to create an environment in which it is very hard for jurisdictions such as The Bahamas to reap the reputational benefits from becoming highly resistant to money laundering and other financial crimes. It is obvious to informed observers that: - The world has been unable to appreciably intercept the flow of dirty money, which could be in the trillions annually and tens of trillions in embedded asset terms. This - compares with illicit asset recoveries, which could be generously measured in the low tens of billions. The world’s large countries, starting with the United States, Great Britain, and the EU, are both the sources and the destinations for the great bulk of the world’s dirty money4; although one of the lessons from the outside should be in how our jurisdiction mobilises its enforcement resources. Put simply, life isn’t fair when you are a small country daring to compete in international financial services. So what do we do about this? The Central Bank and the rest of the Bahamian public sector have adopted two obvious strategies. First, there is no point in even continuing this conversation unless we can demonstrate that our financial services industry and economy are under close control for AML/CFT purposes. We have made very large strides in this area—but the fact that we have had to make very large strides indicates that we started from a weak position. In any event, our current actual position is reasonably good, and in two to three years will be world-leading. The Bahamas must now be able to encourage the world’s relevant opinion-makers, such as the FATF, U.S. authorities, EU, OECD, and correspondent banks, to give us fair credit for our actual position. There is no easy and cheap answer to this challenge. The Central Bank and the rest of the public sector are buckled down for a long, hard slog. The Central Bank’s activities in this space include the following: - - - With other Bahamian regulators and government agencies, we are publishing an annual report on Bahamian AML/CFT matters.5 We will shortly commence regular direct communications with all correspondent bankers to Bahamian banks. We have sponsored the annual Bahamian AML conference, of which todays is the second edition. We intend to sponsor, every two years a major international and regional conference on AML risk management. Many of you attended the inaugural event in September 2018. We are co-sponsoring the 2020 version with CARICOM Secretariat and a very good international cast of speakers, anticipated in May 2020. We are introducing annual letters on financial strength and AML/CFT risk management to our supervised financial institutions, which are explicitly meant to be shared with current and potential correspondent bankers. From January 2020, the Central Bank will host the world’s leading research conference on empirical approaches to AML and financial crime suppression. This will become an important tool to encourage data-driven as opposed to opinion-driven approaches to assessing national financial crime risks, and will usefully lift the Bahamian reputation See for example Oliver Bullough’s 2018 book Moneyland https://www.centralbankbahamas.com/download/056332100.pdf as a jurisdiction that is part of the solution rather than the problems of global AML/CFT management. Conclusion The Central Bank and our public sector colleagues are doing quite a lot to improve both the reality and the reputation of The Bahamas as a high probity, low risk regime for AML and financial crime. We need industry’s continued competence and cooperation so that we can collectively achieve the reality and the reputation we all want. Thank you for your attention.
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Remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the 45th Anniversary Celebration of the Central Bank of The Bahamas, Nassau, 5 July 2019.
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John A Rolle: 45th Anniversary of the Central Bank of The Bahamas Remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the 45th Anniversary Celebration of the Central Bank of The Bahamas, Nassau, 5 July 2019. * * * Acting Prime Minister and Minister of Finance, Governors, representatives of the Clearing Banks Association, representatives of the Association of International Banks and Trust Companies, former central bank employees, other guests: good afternoon. On behalf of the Board of Directors, Management and staff of the Central Bank, thank you all for being here with us this afternoon to celebrate the 45th Anniversary of the Central Bank of The Bahamas. Today, we are particularly pleased to honour all of our past Governors and to thank them for their service to the Bank and to The Bahamas. As part of our civic responsibility, the Central Bank has taken a strong interest in promoting the development of Bahamian art. On display today is a sample of our collection from throughout the years, including a cross-section of celebrated talent, some of whom made their successful debut in a Central Bank exhibition. Through art we tell stories of our culture and values. We also etch these treasures in the narratives we relate on our currency: the beauty of the physical environment, our treasured natural resources; the nostalgia surrounding the commerce and ways of the past; about Junkanoo, Family Island regattas, bonefishing, pineapple growing, hand crafted straw work, the horse and carriage, tourism, and so on. When we reflect on the mission of the Central Bank, and strip away the technical terms that often entrap us, our mission is simply put, to accomplish within the financial sector space all that is within our legal authority, to preserve and improve upon this Bahamian way of life. That applies equally as well to the outcomes we promote for residents in Elbow Cay, Alice Town, McCleans Town, Spring Point, Old Bight, Barretarre, Majors, Sandy Port, or any settlement we choose to name. It is a mission that you Governors took on successfully. You worked to ensure that the last thing any resident had to worry about was how much imported goods or services they could purchase with their Bahamian dollars, or about whether the dollars they deposited in a bank would be safe in such bank. You worked to ensure that the average citizen could set such worries aside and concentrate on being productive and engaged with the other fulfilling aspects of their lives. As a Central Bank today, we want to promote the equal access of all persons within our country to the conveniences of this nature that the financial sector provides. It comes across, for example, in the ways that we endeavour promote modernised delivery channels for services that do not impose the same product constraints as a physical banking network. It also comes across in simplified regulations to make it easier for all persons inside our borders to have access to legitimate banking services—whether they are employed or not; and whether they are Bahamians or not. Also, recognising that a focus, rightly, is to keep illicit activities from infiltrating our financial services it comes across in being more attentive to those who could pose such risk, rather than treating all users and their transactions with suspicion. We will continue to do more work in this area. Exchange Controls have always been synonymous with the important tools we deploy to preserve the one-to-one value of the Bahamian dollar against the American currency. 1/3 BIS central bankers' speeches Successive Central Bank governors have led reforms to liberalise these administrative processes. The constraint that you constantly faced on the speed of change was how swiftly the financial management practices and reforms on the Government’s end materialised, to leave open a stable path for permanent change. Another constraint was the speed at which the Central Banks’ own capacity increased to manage foreign reserves usage through less administrate channels. We have made more progress in these areas than is even realised or acknowledged.The Exchange Control Department has gone from being the largest operating units in the Bank to one of the smallest. It is transforming more and more to data gathering and intelligence operation. Today, firms in the private sector that have a positive nexus to foreign exchange earnings activities or those that promote strategic national development priorities enjoy direct access to capital raising in foreign currency. They operate within limits that would rarely constrain the small and medium-sized operations that should be engines of growth in any economy. Now, the entrepreneurial set also has expanded access to establish businesses outside The Bahamas, or to use such access to establish firms in international financial services sector. The examples of those who have taken advantage of these facilities is increasing, although not as fast as we would like. Going forward, the key word for the Central Bank is being “progressive". We are open to reforms in our policies and administrative processes and to advocating when necessary, for pre-requisite reforms elsewhere in the economy that would make our initiatives sustainable. Indeed there are already areas in Exchange Control administration for example, in our payments system initiatives and in our financial sector development push, where the Government has committed to supportive reforms, not just in the legal system, but also in the Government’s own administrative processes. In the spirit of progressiveness, we also want the engagement with stakeholders to be constructive. This means that together, we are able to identify and propose how beneficial change can happen in ways that can be sustained. For the Central Bank, the energetic focus on financial literacy is one of the ways that we hope to ensure constructive input and enduring embrace of change. We still need to build lasting capacity to deliver on our mandates. The Bank will therefore intensify its effort to recruit, train and retain competent professionals. We have offered and stand ready to work with the University of The Bahamas to develop graduate level programs that produce the next generation of economists and policy analysts, and we are reprioritising our internal resources to build out more specialist training in core central banking competencies. As of this year, a more calculated approach is also being taken to recruit new talent for the Bank. Starting this summer, and as part of an annually timed exercise, the Central Bank will recruit a select number of bright college graduates who will be taken through a two to three-year structured preparation for long-term carers in central banking. Having little or no experience is actually a prerequisite to apply. For those just completing a Bachelor’s degree, and who have both the aptitude and aspiration to purse graduate studies, we will invite them to apply to our Central Bank Apprentice Programme. For new graduates with Master’s Degree, our Executive Professional Program will be open to admission. Today, we have every right to celebrate the Central Bank’s accomplishment. Again, I want to congratulate each of our past Governors for the foundations laid and built upon: from Governor Donaldson to Sir. William; and onwards to Governors Smith, Francis and Craigg. Thank you for allowing us to honour you with these bronze busts. Sequentially and imminently this display will be completed, with a bust of Governor Craigg also going on display. We are equally excited about what is ahead of us. As Governors and former Ministers of Finance, you know well that the job required that you always stayed prepared to respond 2/3 BIS central bankers' speeches effectively to the unexpected. My colleagues in the Central Bank look forward to this continuing challenge and to perfecting our responses to the unexpected. Also we look forward to being proactive and innovative in how we inspire reforms for the benefit of The Bahamas. 3/3 BIS central bankers' speeches
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Remarks by Mr John A Rolle, Governor of the Central Bank of The Bahamas, at the Exuma Business Outlook, Exuma, 24 October 2019.
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Bahamian Financial Resilience Post-Natural Disasters John Rolle Governor* *As prepared for Delivery. Exuma Business Outlook Sandals Resort, Exuma, Bahamas 24th October 2019 Introduction It is always a pleasure to speak at the Exuma Business Outlook. This is happening at a time of incredible change within our economy. We are paying more attention to the immediate and long-term needs for planning and development around financial and economic resiliency; and on leveling the playing field of access for commercial goods and services. Post-Hurricane Dorian we are now more focused on strategies for financial resiliency for households, businesses and the public sector; and we are preoccupied with business continuity and recovery at the national level for critical financial services. The take away from my presentation is that alongside the interventions which the Central Bank intends to make to increase the preparedness of the banking and payments system, serious interventions will also be needed from a policy and cultural perspective to tackle the household sector’s financial vulnerability. Critical evolution is also required in our tourism product model to make this leading foreign exchange earner more resilient. The Central Bank will continue to take a progressive approach to identifying and promoting legal and regulatory reforms to accommodate financial sector transformation in the direction of greater resilience. General Impact of Natural Disasters For the better part of the last two decades, The Bahamas has been experiencing the direct impacts of climate change, particularly as it relates to the passage of tropical cyclones (hurricanes). They have increased in both frequency and intensity. Since 1999, there have been at least eleven named storms that had a notable impact on some part of the archipelago. These storms have had the foreseeable impact of disrupting economic activity in both the immediate and medium-term, as shown in reduced output, rise in unemployment; and in placing great strain on government’s finances.1 Before Dorian, Hurricane Matthew (2016) exacted most recent high toll, even posing an obstacle to the government’s then articulated medium-term fiscal consolidation plan. The impact from Hurricane Dorian is projected to be greater than Matthew’s. In the monetary and financial sector, setbacks include the disruption in banking and payment services; and a potential deterioration in banks’ credit quality indicators as borrowers in the impacted zones encounter a lengthy period of reduced or eliminated incomes. Policy Responses & Preliminary Estimates of the Impact of Hurricane Dorian on the Banking Sector Immediately following the storm, the Central Bank – consistent with actions taken after other severe encounters – relaxed lending guidelines for domestic banks on a temporary basis. Specifically, in relation to hurricane relief facilities, the 15% equity or down payment contribution and the 40%-45% debt service ratio (for directly impacted borrowers) were waived in order to facilitate easier, flexible access to credit. Disaster response for the Government normally included major expenditures on infrastructure rebuilding, social and humanitarian assistance, subsidies to un-insured and underinsured households and tax concessions on private sector recovery expenditures. At the same time, base of remaining taxable commercial activities decreases. Additionally, the Bank endorsed temporarily relaxed due diligence procedures for money transmission businesses (MTBs), given the loss of vital documents for customers in the impacted areas.2 For their part, commercial banks suspended loan repayments for borrowers in the affected areas for a period of up to 6 months. In addition, with the absence of bank branches, the customary fees on ATM usage were voluntarily suspended on Abaco and Grand Bahama. Our commercial banks are not under any unmanageable financial stress because of the Grand Bahama and Abaco outages. These institutions have comfortable levels of capital to absorb any losses that might materialize, and they are still collectively in a position where their capital levels will need to be reduced over the medium-term. Most of banks’ credit exposures are to New Providence, where economic activities remain intact. The Central Bank’s stress testing simulations show that in a very severe, major hurricane, that might be the case if damages were concentrated in New Providence, banks could face significant loan losses, but would still be able to withstand the setback generally, from their existing capital buffers.3 Where this picture could evolve in an unsettling fashion however, is changing expectations on the frequency of major shocks, since the system would need sufficient time to recover between events. This takes us back to the issue of having overall macroeconomic resilience, to contain the extent of losses for any major or successive storms. In terms of financial sector exposure, commercial banks’ credit portfolio for Grand Bahama and Abaco totaled approximately $830 million over the July-September 2019 reporting period, which accounted for around 14.8% of total private sector credit. Collectively just over half of the exposures were mortgages. Moreover, Grand Bahama represented about four-fifths of the total credit—which is good in the context It should be emphasized, however, that MTBs were made aware of the continued expectation to exercise due care and attention to prevent the occurrence of fraudulent activities in order to safeguard the integrity of the financial sector. These simulations were refined in close collaboration with the IMF, during the recent Financial Sector Assessment Program (FSAP) mission. of the faster pace at which this sub-economy is expected to recover.4 At the outset, the non-performing loans rate was higher in these northern islands. As we consider the impact and recovery from Dorian, the general outlook for the Bahamian economy is for some setback in the near-term, with the revised growth projection still positive for 2019, but at less than the levels forecasted prior to the storm’s passage. In 2020, the outcome could be flat to negative, with a return to positive territory in 2021. The recovery path in both of the affected islands will initially be dominated by extensive rebuilding activities, which will heighten the demand for construction-related skills and services. This should partially offset the contraction in activities other economic sectors. The private sector component of the rebuilding activity will be partly financed by external reinsurance proceeds. The Government will also rely on foreign currency resources.5 This hints at an important element in our resilience to natural disasters: that rebuilding relies on imports that must be financed with foreign exchange, at the same timing as when the tourism earnings are disrupted. Resiliency amounts to being able to withstand such shocks without putting the survivability of the Bahamian dollar exchange rate into question. Reinsurance payments inflows will offer a cushion of at least $0.5 billion to foreign exchange needs. These will be the largest such inflows levels ever received (see chart). In reliving these experiences in the future our national savings must also stay present in the form of the external reserves of the Central Bank. As The Bahamas is able to build up these buffers, we would create space to use more local currency resources to rebuild. On the projected recovery path, our foreign reserves will experience a boost initially from the re-insurance receipts and proceeds from government financing. These are expected to be consumed in full next year, with the expectations that The Bahamas could end 2020 with slightly lower foreign reserves than at the end of 2018. Credit exposures to Grand Bahama and Abaco totalled $658.8 million and $170.8 million, respectively. Moreover, residential mortgages represented 54.8% of the aggregate portfolio ($343.9 million in Grand Bahama and $111.0 million in Abaco). This is a debt management strategy collectively agreed between the Central Bank and the Ministry of Finance, in order to offset any balance of payment strain from import financing around rebuilding activities. The ability to see some return to activity in Grand Bahama in 2020, favors the onset of the recovery of tourism earnings. Having the Abaco tourism plant substantially back in production by 2021 would help to normalize return to the still positive mediumterm outlook for reserves. Until then, the tourism marketing strategy has to succeed in attracting some of the displaced business from the northern islands to undamaged facilities elsewhere in The Bahamas. Resilience Post-Natural Disasters At this point, I would like to delve deeper into the topic of resilience. Drawing on the work of the IMF, the World Bank and others, a framework for building resilience would consider three major elements: the physical or structural infrastructure, financial factors and the social, post-disaster resilience. I will keep the focus today on financial resilience.6 That said, both social and infrastructural vulnerabilities still reduce to financial costs that ought to be addressed in policies that build buffers and provide ample insurance for both public sector interests and private households. Financial Resilience For the public sector, the World Bank and IMF inspired multi-layered approach to managing the fiscal and macroeconomic risks of natural disasters focus on four areas. They include: 1. Fiscal buffers (as a means of self-insurance) 2. Securing direct insurance (through risk-pooling mechanisms) 3. Pre-arranging emergency access to credit (for rapid response) 4. Securing access to international financial and humanitarian assistance Physical resilience encompasses structural measures aimed at mitigating the impacts of natural disasters. It includes investment in infrastructure including new structures, upgrades to existing ones; and developing and fine tuning policies related to zoning, building codes, land use, early warning systems and “risk maps”. The social resilience element comes into play post-disaster. It involves the response of the government, wider community and relevant organizations to the various humanitarian needs that exist following the occurrence of a natural disaster. The relevant authorities must be able to ensure minimal interruption in national security, emergency medical care services and essential utilities. Additionally, the established frameworks must ensure that aid to the adversely affected population is efficiently distributed without undue delays and abuses. The Bahamas has made particular recent progress in the second and third areas, with access to the Caribbean Catastrophe Risk Insurance Facility (CCRIF) and through a pre-arranged line of credit with the Inter-American Development Bank (IDB).7 Selfinsurance will likely have a greater impact on resilience over the longer-term, as evidenced by our ability to generate annual budgetary savings, and to reduce the public debt burden. This would make it possible take on extra debt if necessary—and without concern—after natural disasters. Fiscal savings could also purchase larger amounts of insurance in the market and finance larger natural disaster funds, both of which are debt avoiding strategies. Further, buffers accumulate in terms of how infrastructure is rebuilt and in some cases relocated, at greater upfront cost, to resist extensive future damages from major hurricanes and sea level rise.8,9 Financial Resilience for Private Sector/Households Another major consideration for the post-disaster phase is the exposure of private sector agents (households and businesses) to losses. In particular, a significant number of uninsured or under-insured homes exist in the damaged zones, which is a snapshot of a greater national prevalence of the same, particularly among lower income homeowners who find it financially challenging to purchase insurance coverage. This presents a significant financial risk to the Government! Fiscal costs mount when these exposed interests require some subsidized level of recovery. For inadequately insured middle and upper middle-income families, or small businesses, public subsides are not likely to provide either timely or full restoration of their former circumstances; and some losses may become permanent. This is a vulnerably that still has to be meaningfully addressed, through households and businesses taking on more In April 2019, the Government secured access to a contingent loan from the IADB for natural disasters in the amount of $100 million. Access following the passage of Hurricane Dorian will finance disaster recovery expenses, including on infrastructure repair and social and humanitarian assistance. The Bahamas will also be able to continue to leverage support from the international community, of which it is a part and to which the country also contributes when others face tragedies. It includes invaluable access to technical assistance, specialized skills that permit accelerated the rebuilding, and generous financial donations. After the Hurricane, technical assistance materialized from within the regional multiple disaster response agencies within CARICOM, the various United Nations bodies, the IMF, IDB and the World Bank. Technical assistance weighted heavily in all responses. active responsibility for it, and through intentional public policy to reduce the financial risk to the government. A philosophy which stresses that Bahamian households should prudently manage their finances over a life time perspective is important—especially with mounting climate change vulnerabilities. Just as in the case of the government, the household’s approach to savings should allow families to insure better against the setbacks from natural disasters. Insurance has to factor into the cost of housing, just as should tax and other maintenance obligations. A part of the solution is accepting downsized housing, for which families can more fully afford the insurance. We must also be able to afford more resilient physical dwellings. Aside, from being cautious about the coastline, it could mean more acceptance of multi-family condominium style structures, built more elevated and able to withstand higher winds forces than singlefamily housing. Accepting the premise that some families are not going to be voluntarily disciplined then public policy would have to cause the insurance to be secured. This speaks to taxpayer funding on some direct level. Having savings buffers also means that our families have to be more conservative about their debt levels in ordinary times. Even with the relaxed position that local lending institutions are now taking to accommodate borrowers after the recent storm, there will be some families who are be unable to take on more debt to finance necessary home repairs or to replace lost assets. Again, this means more scrutiny of the expenditure levels that families take on in ordinary times. The policy intervention from the Central Bank side would lean towards tighter lending standards for households that are not yet in distress. At the national level, regulation on lending standards will also need to reflect uniformity across entities that are not supervised by the Central Bank. It is a macroprudential concern—meaning that it could undermine the stability of the financial system in a general sense, if left untreated. In the extreme, it could affect how the economy in the aggregate is able bounce back from natural disasters. The Central Bank’s medium-term approach will be to also explore how the incidences of under-insurance on mortgaged properties could be suppressed. The financial distress from underinsurance can be particularly acute when debt survives that has to be repaid, despite major loss of the physical assets. For the business sector, affordable bridge financing will also have to be in greater abundance post-natural disasters. The Central Bank is already committed to studying this issue of how even larger volumes of resources can be accumulated for such purposes. Again, the outcome is likely to target savings in funds that are only accessible for lower cost financing after natural disasters. Enhancing Financial Resilience Through Technology Moving from households to financial institutions, technology will have to feature more prominently in our resilience and recovery plan. Indeed the recovery of access to financial services is vital to restarting commercial activities. Payments services have to be present for businesses to operate; for the government and aid agencies to effectively dispense financial assistance, and even to make use of early payouts from insurance policies. At present, there is still too much dependence on cash handling services and therefore commerce is only able recover clumsily, when the physical support that banks provide is missing or hampered. Fully accessible and enabled digital mobile payments would resolve many logistical challenges at once. Project Sand Dollar has the potential to deliver this longer-term resilience. It would permit wireless restoration of payments connectively, avoiding the cash shipment and cash handling frustrations. It would permit electronic dispersing of aid; and allow families to recapture personal dignity, by restoring the flexibility to prioritise the elements of personal need that they prefer to satisfy postdisasters. One of the impacts of the recent hurricane on the country’s banking sector was the significant damage to physical structures in Abaco and Grand Bahama, which also shut down operations on those islands. Critical to restoring a sense of commerce is the timely resumption of banking and payments systems. For this reason, the Central Bank is exploring an early entry of Project Sand Dollar into Abaco. It will allow the Bank to test aspects of the emergency wireless communications features that would enable rapid financial services recovery; and to connect with many retail businesses early in their recovery process. The Sand Dollar infrastructure is being designed to connect with bank accounts, so that remote access to these facilities is also quickly re-enabled for deposits and withdrawals. Tourism Sector Resilience for the Fixed-Exchange Rate Regime I started to touch on the stability of our fixed exchange rate regime and the value of the Bahamian Dollar earlier. For the medium and longer-term this amounts to making the foreign exchange earning assets more resilient. Hotels and other onshore accommodations are The Bahamas’ most valuable and most exposed assets. Damages to Abaco are most summarized by the extent to which these assets have been taken offline. In 2016, Hurricane Matthew similarly resulted in the loss of much of Grand Bahama’s room inventory, compounding the decline in the island’s tourism output which had already been entrenched. If the Bahamas is to cope better with more frequent and intense tropical cyclones, it needs to be able to keep more of its income producing resources out of harm’s way. One way to do this is through direct ownership over more mobile infrastructure. The cruise industry does this already, and such capacity exists to a great extent with smaller pleasure crafts. This ties in with taking more advantage of the blue economy, yachting and ecotourism. Achieving increased direct ownership and direct employment in the sector would expand the associated retention of economic benefits. The Bahamian exchange control regime has already been reformed to permit Bahamians to attract capital in foreign currency to acquire ownership in the maritime sector. However, it is a strategy to which heightened entrepreneurial focus is now required, and potentially public policy that would provide the same tax incentives for maritime assets as is done for onshore tourism assets. Concluding Remarks In conclusion, Hurricane Dorian served as a reminder of the ongoing challenges facing The Bahamas, given our geographic and economic makeup, set against the reality of global warming, rising sea levels and more frequent, intense storms. We must apply economic policies and frameworks for financial resilience that mitigate the risks associated with this new reality. For its part, Central Bank is in the process of developing a financial sector disaster recovery plan that will serve to enhance the sector’s preparedness and resilience to shocks, inclusive of the timely resumption of banking and payments services. To these interventions The Bahamas must also secure higher insurance coverage in the household sector; and the savings philosophy which the government is pursuing must also come across strongly within households and in the accumulated foreign exchange holdings. Whether the ills of climate change are of our own making or not, The Bahamas cannot ignore either reality or the urgency of protecting itself better; and accepting that certain economic and financial priorities have to be adjusted. Appendix of Figures and Charts Figure 1: Recent Hurricane Impact on Stopover Tourist Trends Source: Bahamas Ministry of Tourism Data Figure 2: Recent Fiscal Balances Trends vs Hurricane Occurrences Source: Central Bank of The Bahamas Figure 3: Hurricane Induced Re-insurance Inflows Source: Central Bank of the Bahamas and preliminary feedback from insurance industry. Figure 4: Commercial Banks — Selected Credit Exposure Indicators 4A:Credit Shares by Island 4B: Non-Performing Loans (NPL) Rate Source: Central Bank of The Bahamas survey.
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Welcome and opening remarks by Mr Benno Ndulu, Governor of the Bank of Tanzania, at the official launch of the National Financial Inclusion Framework, Dar Es Salaam, 12 December 2013.
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Benno Ndulu: Addressing the challenges of financial inclusion in Tanzania Welcome and opening remarks by Mr Benno Ndulu, Governor of the Bank of Tanzania, at the official launch of the National Financial Inclusion Framework, Dar Es Salaam, 12 December 2013. * * * Your Excellency, Dr. Mohamed Gharib Bilal, Vice President of the United Republic of Tanzania; Your Majesty, Queen Máxima of the Netherlands; Honorable Ministers of Agriculture Eng. Christopher Chiza and Minister for Finance Ms. Saada Mkuya, Your Excellency Ambassador of Netherlands to Tanzania; Ms. Ertharin Cousin, Executive Director, World Food Program (WFP), Maria Helena Semodo, Deputy Director General, FAO Mr. Adolfo Brizzi, Director, Policy and Technical Assistance, IFAD Dr. Alfred Hannig, Executive Director Alliance for Financial Inclusion, Heads of the UN Agencies Members of the Diplomatic Corps; Permanent Secretaries; Deputy Governors; Chief Executive Officers; Distinguished Guests Ladies and Gentlemen: I am greatly pleased to welcome you all to this important event to officially launch the Tanzania National Financial Inclusion Framework. Please accept my profound appreciation for accepting our invitation to attend this event. In particular, I would like to thank your Excellency, Dr. Mohamed Gharib Bilal, the Vice President of the United Republic of Tanzania, for finding the time to grace and open this occasion. Special gratitute to your Majesty, Queen Maxima of the Netherlands who is the UN Secretary General’s Special Advocate for Financial Inclusion for accepting to be the guest of honor to this event. I wish to recognize a great friend of financial inclusion Dr. Alfred Hannig, the Executive Director of Alliance for Financial Inclusion who has helped to establish and grow an initiative that has enabled to engender not only global peer learning but also peer pressure to achieve ambitious targets. Also for special recognition are the three guests, Executive Director of World Food Program (WFP), Ms. Ertharin Cousin, Deputy Director General, Ms. Maria Helena Semedo Food and Agriculture Organization (FAO) and Director, Policy and Technical Advisory Division of International Fund for Agriculture Development (IFAD) Mr. Adolfo Brizzi. Your Excellency, Your Majesty, Ladies and Gentlemen: The Framework has been developed through an elaborate process that involved all key financial inclusion stakeholders in the country with special support from Financial Sector Deepening Trust (FSDT); I thank FSDT for extended cooperation and assistance. We have together as stakeholders identified barriers to financial inclusion and their corresponding core enablers that will be implemented in a coordinated manner to overcome the BIS central bankers’ speeches barriers. These have been put together in the document that you will today witness its launch. Financial stakeholders realized that financial inclusion couldn’t be achieved with everyone working in silos. Rather it requires a concerted cooperative approach that will be used to address the challenges of financial inclusion in Tanzania systematically and in a coordinated manner. Ladies and Gentlemen: Financial inclusion is important to the economy, it enables improving the welfare of the poor, – contribute to financial stability; and to growth of micro-business that ultimately stimulate growth of other sectors in the economy. Tanzania has made significant strides to enhance the proportion of adult population who are formally included (adults with accounts in formal financial institutions). In 2006 the proportion stood at 9%, 12% in 2009 and in 2012 it was 17%, or 22% formal inclusion if we include SACCOS. Cognizance of this low rate of formal financial inclusion, we identified a number of barriers that account for such state of affairs. These include: supply side barriers ranging from, high interest rates, services that don’t meet demand side needs, costs, to inefficiencies of service delivery. Demand side barriers include, information asymmetry, irregular income patterns, and financial literacy. Structural and regulatory barriers include, stringent or lack of proportionate requirements for client on-boarding, lack of regulatory framework for broad based micro-finance services, lack of centralized national identification system to mention but a few. Ladies and Gentlemen: In order to build impetus and push for acceleration of financial inclusion we made an international commitment under the AFI auspices (the Maya Declaration) to increase formal access of financial services to 50% by 2015. The AFI network, that has more than 100 countries’ regulators and policy makers as its members, has enabled us to gain knowledge in financial inclusion through peer-learning and peer-pressure. It has also enabled us to host international forums for the establishment of Africa Mobile Phone Financial Service Policy Initiative (AMPI) in February 2013 in Zanzibar. AMPI has been instrumental as a platform to share experiences on how countries in Africa may scale up the use of mobile money for financial inclusion. Tanzania has been used as one of the success stories in using mobile telephony to deliver financial services. And we have already hosted some central banks in attachments to learn from our experiences of taking advantage of leveraging on the use of this mobile technology as a platform to facilitate payment services to the majority of the population far and wide, including those that were hitherto underserved or unbanked. The mobile financial services operated by non-banks and banks has now enabled by September 2013, 90% of the adult population in Tanzania to have access to a mobile money accounts with 43% (or 9.8 Million) adults being active users. Most of these, however, are still unbanked. Although mobile telephony financial service has its limitations as it is still widely used for payment based services only, current initiatives are being deployed to expand its use as a platform to deliver other financial products from mainstream banking. Ladies and Gentlemen: Overall, the level of access to formal financial inclusion in Tanzania is relatively low. According to 2012 World Bank survey 24% of adults in Africa have an account at a formal financial institution as of 2012. As pointed out earlier, in Tanzania 17% of adults have accounts with a formal financial institution. In 2006 this proportion was significantly lower at 9%. Including SACCOS this proportion in Tanzania rises to 22%. The provision of SME and Agribusiness finance likewise has been lower than necessary to support significant growth in this important sector of the economy. Based on National Baseline Survey Report (2012) only 10.6 % of MSMEs have access to finance from BIS central bankers’ speeches formal institutions. And based on AgFims Tanzania Headline Findings (2011) 32.4% of agri-businesses have access to formal credit. We believe that strategies to address challenges behind these low levels of financial inclusion are articulated in the National Financial Inclusion Framework that will be launched today. In preparing this framework we have the advice and challenges that His Excellency Dr. Jakaya Mrisho Kikwete, the President of United Republic of Tanzania raised in Arusha in November 2012 in the Conference for Financial Institutions and in Dar es Salaam in July 2013 at the Smart Partnership Global Dialogue. In both events, financial inclusion was the central theme; and the President challenged us to increase the level of financial inclusion within the shortest time possible. This Framework is the results of that advice and we are pleased that Her Majesty and His Excellency the Vice President are here to witness its launch. Your Excellency, Your Majesty; Ladies and Gentlemen: The Framework is a commitment voice from financial inclusion stakeholders in Tanzania from the private and public sector, who are here present today. They have documented the barriers and key core enablers to be implemented with the objective of spurringfinancial inclusion in Tanzania. An Action Plan that articulates key priority areas will be implemented by each stakeholder. The priorities areas for implementation include: • Proximity: Enhancing and implementing access channels, such as Agent banking, mobile telephony financial services, point of sales, stand alone ATMs, POS and a regulatory framework that creates conducive environment for growth of financial inclusion; • Robust Electronic Platforms: Improving, developing ICT payment platforms that facilitate cost effective and secure access to financial services; • Robust information and easy client on-boarding: Implementing, monitoring and enhancing use of credit bureaus, proportionate Know Your Customer requirements and improved ID system that is linked to financial systems; and • Informed customers and consumer protection: Implement financial consumer protection mechanism and national financial education framework. Your Excellency, Your Majesty; Ladies and Gentlemen: In order to ensure that we achieve results, the Framework has set targets for financial access of 50% by 2016, echoing our international commitment that we made in Riviera Maya, Mexico in 2011 under the AFI initiative-Maya Declaration. Specific targets are also made for specific core enablers that stakeholders are required to implement and achieve within a span of 3 years from today. It is worth noting that some barriers are planned to be addressed within six months from the launch of the Framework, while others are being addressed as I speak for example the regulatory frameworks for the cyber laws and national payment systems law. The Framework also provides an elaborate measurement mechanism that will be used in the assessment of the level of financial inclusion in Tanzania. Based on an all encompassing working definition of financial inclusion key indicators that include usage of financial services have been developed. This is important to ensure that the efforts that stakeholders are making towards implementing the Action Plan have an impact on the ground. Your Majesty, Your Excellencies, Ladies and Gentlemen: A coordinating structure is also established to oversee and supervise the implementation process; where an apex organ: the Financial Inclusion National Council comprising eleven member institutions, from various ministries at Permanent Secretary level and heads of other financial regulatory authorities. This National Council has responsibilities of BIS central bankers’ speeches ensuring that stakeholders implement the Action Plan as articulated in the Framework. The coordinating structure upholds accountability and applies tools such as periodic reporting and assessments. An Impact Assessment will also be conducted after the 3 years target: mid- term review shall be conducted to assess impact of the interventions of the financial inclusion initiatives included in the Framework and inform the National Council on the appropriate directives to issue to the key stakeholders for implementation. Your Excellency, Your Majesty; Ladies and Gentlemen: Development of the Framework has been a very fruitful process; we have witnessed, from the members of the Council and other national technical committees, great enthusiasm, commitment, energy and desire to increase the level of financial inclusion in Tanzania. We therefore expect that the official launch of the Framework shall build more impetus to fulfill our objective of improving the level of financial inclusion in Tanzania. With this remarks, I now have the honor to welcome Honorable, Ms. Saada Mkuya, Acting Minister for Finance to deliver her remarks and welcome His Excellency, Dr. Mohamed Gharib Bilal, the Vice President of the United Republic of Tanzania, to deliver his opening speech and thereafter welcome the guest of honor her Majesty Queen Máxima of the Netherlands to deliver the keynote address. Honorable Minister; Ms. Saada Mkuya, welcome. BIS central bankers’ speeches
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Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the Canterbury Employers' Chamber of Commerce in Christchurch on 23/1/97.
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Dr. Brash explains the Reserve Bank of New Zealand’s new inflation target, and New Zealander’s expectations about inflation and growth Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the Canterbury Employers’ Chamber of Commerce in Christchurch on 23/1/97. Introduction As perhaps you know, this is the fourth time on which I have been invited to address the Canterbury Employers’ Chamber of Commerce at your first luncheon meeting of the New Year and I want to use the occasion to talk about two issues. First, I want to talk about the new Policy Targets Agreement, amending the inflation target from 0 to 2 percent to 0 to 3 percent, signed last month. And secondly, I want to talk about the expectations which we New Zealanders have about both inflation and economic growth. In some important respects, I believe that those expectations are quite unrealistic. The new inflation target First, the new Policy Targets Agreement. There have been two changes made in the new PTA, but I suspect that to the general public the only difference between the new Agreement and all of the earlier ones is that the new Agreement has changed the ‘definition’ of price stability from 0 to 2 percent to 0 to 3 percent, while making it clear that delivering that price stability remains the single objective of monetary policy and constitutes the best way in which the Reserve Bank can contribute to New Zealand’s economic development. Some will ask in anger why the inflation target is still so low, and why the Bank will continue to focus monetary policy on delivering that target, when there are other objectives - such as economic growth, employment, and export competitiveness - which are at least as important and in many respects more so. Others will feel betrayed that the ceiling of the inflation target has been raised from 2 to 3 percent, or that the mid-point of the target has been raised from 1 percent to 1.5 percent, particularly given the fact that the two largest parties in Parliament were both strong advocates of a mid-point of 1 percent during the last election campaign. I want to try to respond to both groups of critics. In many ways the easiest critics to respond to are those who feel that the inflation target is still too low, or that, given the extent to which the economy has been slowing in recent months and the extent of the pressures on the export sector, the Bank’s objectives should have been widened to include those other objectives. For there is in fact no evidence that monetary policy can, by tolerating a little more inflation, engineer a sustainably higher rate of growth, or a sustainably higher level of employment, or a sustainable improvement in export competitiveness. To be sure, monetary policy can engineer faster growth, higher employment and improved exporter competitiveness in the short term - by tolerating a bit more inflation right now, there is not much doubt that growth and employment would be a little higher in 1997 than otherwise, and that exporters would enjoy the benefits of a lower exchange rate. Most of that faster growth and higher employment would be bought at the cost of tricking working New Zealanders into accepting a reduction in their real wages, as prices rose ahead of wages. However, it would not last. Before too long, people would recognise the deception and would demand compensation in the form of higher wages and salaries. Within a very short time, inflation would be rising, growth would be back to its previous, lower, level and we would be left contemplating the cost of reducing inflation again - and nobody should forget the very substantial one-off costs, in terms of unemployment and lost output, incurred in reducing inflation from levels above 15 percent in the mid-1980s to our current situation of price stability in the early and mid-1990s. Not only is there no evidence that tolerating more inflation can engineer sustainably faster real growth, there is now overwhelming evidence that high inflation positively damages the way in which the economy works - reduces the capacity for sustainable growth and higher employment, and of course also does huge social damage, through the arbitrary redistribution of income and wealth which it creates. There is also very considerable evidence that even quite low rates of inflation do damage to growth and employment, and virtually no evidence that inflation actually helps those objectives. This is why the second of the two changes in the Policy Targets Agreement makes clear that it is precisely in order to enable monetary policy to make its maximum contribution to sustainable ‘growth, employment and development opportunities’ that the Bank is directed to focus on maintaining a stable general level of prices. But isn’t there some concern, fostered in the popular media by the American economist Paul Krugman, that if inflation is too low it may actually damage growth? In other words, even if we accept that high or even moderate inflation is damaging, isn’t it possible that central banks which are excessively obsessive about achieving no inflation might actually be harming the economy and the society they claim to be helping? This brings me to the second group of critics, who are concerned that in changing from 0 to 2 percent to 0 to 3 percent we have betrayed the intention of the Reserve Bank Act, requiring that monetary policy focus exclusively on delivering ‘stability in the general level of prices’. There is quite intense debate going on at the moment around the world among central bankers and academic economists about what the best specification of a low inflation target should be. There are two broad schools. The first school accepts that monetary policy should be focused on delivering predictably low inflation but argues that for several reasons that target is best expressed as inflation in a range of 1 to 3 percent. The best known advocate of this ‘low positive inflation’ school is probably Stanley Fischer, formerly of MIT and now Senior Deputy Managing Director of the International Monetary Fund. He is visiting New Zealand next month, and it is likely that his views will receive appropriately wide media coverage at that time. He argues for this ‘low positive’ inflation target for various reasons, of which three are particularly important: The way in which inflation is measured results in quite a significant over-statement of actual inflation. Estimates of this over-statement in the United States have suggested that, in that country, the ‘bias’ in the measurement of inflation is between 0.7 and 2.0 percent, with bias of 1.1 percent very recently estimated by a group chaired by Michael Boskin on behalf of the United States Senate Finance Committee. For this reason, central banks should target measured inflation of at least 1 percent, because to target anything lower than that would be to target de facto deflation. Because at some stage in the cycles through which all economies go it may be necessary in the interests of maintaining a high level of employment for there to be some reduction in inflation-adjusted (or real) wages, having a low positive level of inflation is more desirable than having absolutely no inflation. This is because, with some inflation, real wages can be slightly reduced by simply giving no increase in nominal wages, whereas with no inflation reducing real wages involves having to actually reduce nominal wages. Real wages can still be reduced, even with no inflation, but only at the expense of higher unemployment. Similarly, it is argued that at some stage in the economic cycle it may be desirable for inflation-adjusted interest rates to fall below zero to provide a strong stimulus to demand and, since it is not generally practical for nominal interest rates to fall below zero, it is helpful if inflation is some low positive number to make negative real interest rates possible. The second school of thought argues for a lower inflation target, often characterised by 0 to 2 percent but sometimes expressed as the level of average prices remaining stable over time. Those who favour this view discount the arguments advanced by the ‘low positive’ school. They acknowledge that there is an upward bias in the way in which inflation is measured, but argue that in most countries outside the United States that bias is almost certainly less than 1 percent and certainly could not justify a target with a mid-point of 2 percent. (The New Zealand Government Statistician is strongly convinced that there is less bias in the measurement of the New Zealand CPI than there is in the measurement of the US CPI.) They acknowledge that it has not been easy to adjust nominal wages downwards in recent years, but argue that in substantial part that is a result of the persistently high inflation most countries have experienced in recent decades, so that that should be no more than a transitional problem. Moreover, even though it may be difficult to reduce the wages of an individual employee, that does not prevent a significant reduction in unit labour costs as a result both of unchanged wages and positive productivity, and of natural turnover in the labour force. Critics of the ‘low positive’ school challenge the assertion that monetary policy occasionally needs to reduce real interest rates below zero, and note other ways in which monetary policy can stimulate demand, particularly in very open economies where movements in the exchange rate play an important role in influencing aggregate demand in the short term. Those favouring very low inflation (0 to 2 percent) argue that not only are there no advantages in tolerating a ‘low positive’ rate of inflation there are also significant disadvantages of even quite low rates of inflation. Thus for example Martin Feldstein of Harvard University (and current president of the National Bureau of Economic Research in the US) argues strongly that even very low levels of inflation significantly exacerbate the biases in the tax system which encourage consumption, discourage saving, and encourage excessive investment in residential property. In a recent paper he argued that reducing measured inflation from 3 percent to 1 percent in the United States would result in a permanent increase in the level of US GDP of 1 percent, a very large gain in economic well-being even if there is some temporary loss of output required to reduce inflation to that level. Others have also argued that the interaction between inflation on the one hand and tax and financial reporting systems geared to historical cost accounting on the other creates a significant bias against capital-intensive investment projects and all investment with a long pay-back period, and a bias in favour of highly-geared companies and investments with a short pay-back period. This debate is by no means concluded. At a major conference I attended last August in the United States, it seemed to me that a majority of those who expressed an opinion favoured a 0 to 2 percent target, and that has been my own clear predilection. But given that there are very experienced central bankers and monetary economists in both schools, it is at this stage quite inappropriate to be dogmatic, and in my own view a target which involves doing our utmost to keep measured inflation between 0 and 3 percent is certainly consistent with the intention of the legislation within which monetary policy is operated. Indeed, irrespective of where the mid-point of the target range should be, there may be some advantage in having a slightly wider inflation target than the original 0 to 2 percent target. A number of observers have suggested that a target with a width of only 2 percentage points requires an excessive degree of activism on the part of the central bank, and that a slightly wider band, whatever its mid-point, would be sensible. This has been argued, for example, by David Turner, an OECD economist. The tension is between, on the one hand, choosing a target range which effectively anchors inflation expectations at a low level but which is so narrow that it provokes excessive policy activism and risks loss of credibility by being frequently exceeded; and on the other, a target range which does a less effective job of anchoring inflation expectations, but which requires less policy activism and protects credibility by being rarely breached. A 0 to 3 percent range seems a reasonable compromise. But whether there is any benefit at all from a wider target band depends significantly on how a wider band, with a higher ‘ceiling’, affects the public’s expectations of future inflation. If people understand the new target as meaning that the Bank, under Government instructions, is now willing to accept 1 percent more inflation than previously, then nothing positive will have been achieved at all - and indeed there will almost certainly be net cost involved in the change. This is because any increase in inflationary expectations would tend to feed into slightly higher pricing decisions, slightly higher wage settlements, slightly greater eagerness to borrow, slightly less enthusiasm for saving. If the Bank were willing to accept this behaviour, ‘accommodate’ it in the jargon, we would end up with somewhat higher inflation but no other result (though of course the higher inflation would have all the negative consequences for the real economy referred to earlier). If the Bank were in fact not prepared to accommodate this increase in inflationary expectations - which it would not be I hasten to emphasise - then the end result of increased inflationary expectations would simply be higher real interest rates, somewhat lower economic growth, and somewhat higher unemployment. If that were the end result, the widening of the inflation target would not only provide no benefit it would be positively damaging. So I think it is crucially important that nobody misunderstand what the Reserve Bank is doing. Let me be absolutely clear. The Reserve Bank has not gone soft on inflation. We will not be targeting an inflation rate of 3 percent, or even an inflation rate close to 3 percent. The Reserve Bank will be striving to keep inflation well inside the 0 to 3 percent range, and we best do that by trying to have inflation as close to the middle part of the range as possible. That does not mean, of course, that we will always hit the target, any more than we always hit 0 to 2 percent. But it does mean that we will be constantly implementing monetary policy with the intention of having inflation as defined around the middle part of the target. If we do this, the number of occasions on which we miss the target should be minimised. Indeed, given the wider target range, there should be fewer breaches than in the past. Inflation and growth expectations And this leads naturally into the second major theme of my address today, about New Zealanders’ expectations about inflation and growth. It is my contention that expectations about both need to become a lot more realistic. First, let’s look at expectations of inflation. Yes, there are some encouraging signs that New Zealanders’ expectations of future inflation have fallen substantially over the last decade as actual inflation has fallen. Surveys of inflation expectations currently suggest that, on average, householders now expect year-ahead inflation to be around 3.9 percent, well down on the levels of the late 1980s (year-ahead inflation expectations were 12.5 percent on average towards the end of 1987, and were still 8.3 percent near the end of 1989), while 10 year bond yields are slightly lower than 10 year bond yields in Australia and less than 1 percent higher than 10 year yields in the US. Wage settlements in recent years have also been one of the areas where inflation expectations seem to have been subdued, with a great many wage settlements concluded at levels which have, until recently at least, put little upward pressure on prices. However, other indications are not nearly as encouraging and suggest that New Zealanders’ inflation expectations are still showing the effects of the two decades of high inflation we endured in the 1970s and 1980s. Look at New Zealanders’ saving behaviour for example. Among those with financial assets, how many are locking in the high real interest rates they purport to see by investing in long-term fixed interest instruments, such as term bank deposits or government bonds? The short answer is ‘very few’. To be sure, our bond yields are now comparable to international bond yields, and I used to deduce from that that the new monetary policy framework had produced a profound reduction in inflationary expectations. I now believe that I was unjustifiably optimistic, because it is foreign savers who have bought our bonds in huge volumes, thereby reducing bond yields to international levels. More than half the New Zealand government bonds on issue are now held overseas, and the proportion of some of the longer-dated bonds held overseas is even higher. (In recent months, for example, more than 70 percent of the longest-dated nominal bond held by the market has been held by overseas investors.) If we look at the term structure of the New Zealandsourced deposits of any major bank, we will see that overwhelmingly New Zealanders are holding their cash and fixed interest investments at very short term, the great bulk with a maturity of less than 12 months. Indeed, most banks have close to 90 percent of their total deposits maturing within six months, and very few have more than 5 percent of their deposits maturing beyond 12 months. By and large, most New Zealanders do not invest their savings in long-term fixed interest securities at all, despite what are, on the face of it, very attractive inflation-adjusted interest rates. What are we doing with our savings? Though the data on saving behaviour in New Zealand is not very good, anecdotal evidence strongly suggests that New Zealanders invest any available saving in some form of equity investment, most typically property: a bigger house to live in, another house to rent out, a bigger farm, another piece of farmland, perhaps a block of flats, a beach-side section, an industrial property, a commercial building, perhaps a forest block, anything which, the best-selling books and advertisements constantly tell us, will protect us against inflation. Protect us against inflation? But we’ve hardly had any inflation for the last six years and, despite the biggest change in New Zealand’s constitutional arrangements this century, we have just had the new Coalition Government re-affirm the strong commitment to price stability. True, but we’ve certainly had two decades of high inflation in the memory of all adult New Zealanders and we all know of people who lost most of their life’s savings over that period by ‘making the mistake’ of investing in ‘secure’ fixed-interest investments. I’ve told the true story of my uncle so many times that I am almost embarrassed to tell it again, but in my view it contains the explanation of much of the current approach to saving in New Zealand, so I will tell it again. After a life-time of orcharding in the Nelson area, he sold his orchard in 1971 and invested the sale proceeds ‘safely’ to provide income and security for his retirement. To be absolutely safe, he invested the entire proceeds in 18-year government stock, at the then-interest rate of 5.4 percent. Perhaps fortunately, he did not live until those bonds matured in 1989, but if he had done the $30,000 he received from selling his orchard in 1971 and which matured in 1989 would have bought him by that time just one Toyota Corolla car (with a little change). In 1971, $30,000 would have bought him 11 Toyota Corollas. In the space of just 18 years, he had lost some 90 percent of his retirement nest egg, all by making the mistake of assuming that inflation would stay at the relatively low level of 1971. As I say, most adult New Zealanders know stories similar to that one. Or they know stories which tell the same message in another way. Stories about people who bought a property with borrowed money in the early 1970s and watched the price of the house increase perhaps eight- or tenfold over the next 20 years, with the value of the equity actually invested in the house (after allowing for the money borrowed to help finance the purchase) increasing perhaps 30 times. Perhaps we have had an experience like that ourselves. Even if we have not, we are assailed by books and advertisements on all sides which assure us that property investment is the best way of ‘protecting you against inflation’, to say nothing of making the most effective use of the tax system. Even if we are not familiar with the detail of the statistics, we know that in recent years residential property prices have risen hugely in much of the country, most obviously in Auckland. According to REINZ data, the median price of house sales in the Auckland district rose by 53 percent over the three years to December 1996, by 36 percent in the Southland district (including Queenstown), and by 29 percent in the Waikato/Bay of Plenty district. Even rural land prices, which have come back markedly in some areas in recent months, rose by 45 percent over the three years to the first half of 1996, according to Valuation New Zealand data. Is it any wonder therefore that New Zealanders who claim to believe that consumer price inflation is more or less under control continue to borrow money enthusiastically at 9, 10, and 11 percent to acquire property? Lest there be any misunderstanding, I am assuredly not against investing in property, let alone against home ownership. I own a home and a small amount of other property myself. I am merely saying that inflationary expectations are alive and well in the minds of most New Zealanders and that, until that situation changes, we will inevitably be looking at interest rates which look high in comparison to current consumer price inflation. Conversely, of course, as inflationary expectations abate, and particularly as expectations of property price inflation abate, the overall level of interest rates will tend to be lower also. Alan Greenspan, chairman of the US central bank, has on several occasions suggested that price stability obtains when economic agents - businesses and private individuals - no longer take account of the prospective change in the general price level in their economic decision-making. It is clear that we still have a little way to go. What about New Zealanders’ expectations for economic growth? Are these too quite unrealistic? I believe that they are, at least based on current policies and attitudes. In the early 1990s, New Zealand achieved real economic growth of more than 5 percent per annum for two years in succession. We were told that we were growing faster than any other OECD economy, and at growth rates comparable to those achieved by the East Asian ‘tiger’ economies. We began to believe that, as a result of the economic reforms of the last decade, we too were capable of 5 or 6 percent growth indefinitely and all of us wanted to believe that. Sadly, we can not, or at least there is no evidence yet that we can. The very fast growth of 1993 and 1994 was the result in part of the one-off productivity gains resulting from the micro-economic reforms of the late 1980s and early 1990s, and in a greater part of the economy having available a large number of unemployed and underemployed people, and unutilised industrial capacity, as a result of the recession of 1991 and early 1992. As these people and this capacity were brought back into productive work, the rate of growth of real output jumped well above its sustainable rate. The rate of unemployment fell very sharply from almost 11 percent to just over 6 percent in little more than three years and, while everybody hopes that unemployment falls further, it is clearly impossible to reduce the rate of unemployment by 5 percentage points every three years indefinitely. As I told the members of the Auckland Chamber last year, economic growth depends primarily not on monetary policy but on real factors - on how fast the labour force is growing, on how skilled the labour force is, on how much capital that labour force has to work with, on the technology embodied in the capital, on the efficiency of the price system in signalling where capital can be most productively invested, on the nature of regulations and restrictions which inhibit the effective working of the price system, and a host of other factors. Prices which are, on average, stable assist the pricing system to work effectively, and thereby help to ensure that investment takes place in the most economically sensible places. Prices which are, on average, stable tend to encourage saving, and thereby help to finance additional investment. But stable prices won’t make the labour force grow more quickly, or make the labour force more skilled, or improve the technology embodied in the capital equipment which the labour force uses, let alone make public sector enterprises more efficient; or improve the quality of the education system; or move resources out of highly protected sectors into those which can be competitive on international markets; or improve the marketing of commodity exports; or even give us East-Asian-type savings rates. I would argue strongly that price stability has been helpful to the improved performance of the New Zealand economy in recent years, but I have never claimed for a moment that price stability has been the sole reason for our better performance, nor that price stability guarantees us strong growth in the future. In addition to our ability to bring back into productive work people and capital equipment that had become unemployed during the recession, our very much improved growth performance in recent years has been the result of a whole range of policy changes - of reduced protection and regulation in the private sector, of corporatisation and privatisation of many formerly inefficient public sector enterprises, of a vastly less distorting tax structure, of port reform, of labour market reform, and all the rest. If we want to build on that achievement in the years ahead, we must constantly be seeking areas where productivity can be further improved. At this stage, the aggregate numbers for the economy as a whole have led the Reserve Bank to base its economic projections on trend labour productivity growth of no more than 1.25 percent per annum. If that turns out to be the case (and 1.25 percent is close to productivity growth in other mature economies, such as the United States1 and Australia), total growth in GDP could well be around 3 percent per annum because of growth in the labour force. But growth in real income per head, which must surely be the real objective of economic policy, will not exceed 1.25 percent annually. If we want faster growth in spending than that, we can in the short term borrow to supplement our income but, as we learned in the 1970s and 1980s, that is ultimately futile. In the longer term, higher incomes per head, and the higher spending that that can bring, can only come from finding ways to accelerate productivity growth. And how do we do that? Certainly not by debasing the currency through tolerating inflation. The very rapid growth of the countries of East Asia is in part simply the result of their being able to pick up ‘off the shelf’ modern technologies, which have taken decades to develop elsewhere. In other words, there is a substantial element of ‘catch-up’ in the fast growth of East Asia. But the growth which has occasioned so much envy on the part of some New Zealanders has also been achieved in a particular cultural environment - a cultural environment which places enormous emphasis on family self-reliance, which abjures reliance on the state, which as a consequence generates a savings rate roughly double the New Zealand rate, which pursues education and training with a passion, which regards material affluence as a highly desirable goal. New Zealanders have, implicitly at least, chosen a slower growth path, by placing little emphasis on saving, by placing a more modest value on education and training, by valuing other goals more highly than affluence. I recall seeing a television programme three or four years ago about Asian students in our schools. The programme included comments from two New Zealand children that they resented the fact that the Asian children worked much harder than they did. I don’t think New Zealand children should be forced to work as hard as Asian children do, but I think it is important for our children to realise that they live in a world where those who work hard will end up with higher incomes and more wealth than those who choose to work less hard. If we are only prepared to pay for beer, we won’t be drinking a lot of champagne. The sooner we acknowledge that reality the better for all concerned. By not doing so, the risk is not only that private spending will constantly be running up against income constraints, but also that successive governments will be under considerable and unreasonable pressure to satisfy demands for increased public expenditure. Both will have serious implications for our ability to finance development from our own savings. Indeed, over the period from the fourth quarter of 1992 to the second quarter of 1996 overall business sector productivity in the United States grew by only 0.3 percent per annum. Conclusion Mr. Chairman, let me conclude by summarising my main points. First, I am confident that the new inflation target set me by Government is consistent with the legislation under which the Bank operates and consistent with monetary policy continuing to make the best contribution of which it is capable to New Zealand society and the development of the New Zealand economy. Secondly, whether the slightly wider target band enables the economy to operate with slightly less central bank activism depends heavily on how the change affects the expectations which people have of future inflation. If people assume that, on average, inflation will be 1 percent higher than they assumed previously, there is a real danger that, far from providing additional flexibility, the wider target will actually harm the way in which the economy works. Let it be clearly understood, therefore, that the Bank will be implementing monetary policy with the intention of having inflation as defined in my agreement with the Minister around the middle part of the 0 to 3 percent target. If we do this, the number of occasions on which we miss the target should be minimised. It would clearly be very damaging if the impression were created that we might be content with inflation outcomes near the top of the target. Thirdly, we still have some work to do in convincing New Zealanders that our money is a predictably safe store of value for the relevant future. Until that is achieved, the interest rate at which the willingness to save in the form of financial assets is matched by the willingness to borrow will continue to look high by international standards, and our companies will continue to seek unrealistically high rates of return on investment projects. That will tend to mean that investment is lower than it might otherwise be, and that the exchange rate will be higher than otherwise. Fourthly, it is important that, while constantly aspiring to improve our national growth performance, we all have realistic expectations about the speed at which the New Zealand economy can actually grow. Recent reforms have undoubtedly increased our sustainable growth rate above that which was possible in the past: after several decades of growing much more slowly than other developed economies, we now seem capable of growth comparable to, and probably a little higher than, growth in many other mature economies, such as the United States and the United Kingdom. But we will probably never be able to equal the growth rates achieved recently by the ‘catch-up economies’, while growing faster than we currently can will depend not on the central bank being a little more tolerant of inflation but on continuing improvement in many other policy areas and on sustained productivity growth. The Reserve Bank makes its greatest contribution to New Zealand society by achieving and maintaining public confidence in the stability of the unit of value, predictably, dependably, reliably.
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reserve bank of new zealand
| 1,997 | 3 |
Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the IMF conference on banking soundness and monetary policy in a world of global capital markets held in Washington on 30/1/97.
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Dr. Brash looks at banking soundness and the role of the market with respect to New Zealand's banking industry Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the IMF conference on banking soundness and monetary policy in a world of global capital markets held in Washington on 30/1/97. My address this morning is on “Banking Soundness and the Role of the Market”. As most of you will already know, this is a subject of particular relevance to New Zealand, given that we have adopted a banking supervision approach which places considerable emphasis on the role of the market in promoting a sound financial system. In my speech today I will be outlining the key features of our new approach to banking supervision and the reasons why we have gone in this direction. Although much of my address will focus on the New Zealand experience, I will attempt to draw some general conclusions about the role market disciplines can play in promoting a sound and efficient financial system - conclusions that may have relevance for the design of banking supervision arrangements in other countries. Before I outline the new approach to banking supervision in New Zealand, I think it would be useful to give you a little background on the supervisory structure which operated at the time that the Reserve Bank of New Zealand conducted its review of banking supervision. Background to New Zealand’s Banking Supervision Arrangements New Zealand first adopted a formalised approach to banking supervision in 1987. For most of the period from then until the end of 1995 New Zealand’s approach to banking supervision was relatively orthodox. It involved: minimum capital requirements (based on the Basle Capital Accord); limits on the amount which banks could lend to individual customers and related parties; a limit on banks’ open foreign exchange positions; off-site monitoring of banks, using information provided privately to the Reserve Bank; annual consultations with the senior management of banks; and a range of powers to enable the Reserve Bank to respond to bank distress or failure. However, the former system of banking supervision differed in some important respects from the approaches adopted in many other countries. In particular, New Zealand’s supervisory framework: did not involve the licensing or supervision of deposit-taking or the business of banking - only those entities wishing to use the word “bank” in their name were subject to supervision; did not feature deposit insurance; did not seek to protect depositors per se - instead, it sought to protect the financial system as a whole; and did not involve any form of on-site examination of banks. These distinguishing features continue to apply under the new supervisory framework. In late 1991 we commenced a major review of our banking supervision arrangements. The review was motivated by a number of concerns. Probably the main reason for commencing the review was a concern that conventional approaches to banking supervision generally make insufficient use of market disciplines as a means of promoting a sound and efficient financial system. We believed that there was considerable scope to use market disciplines to promote systemic stability. In particular, we wished to provide the market with a greater capacity to hold the directors and management to account for the sound management of their bank. And we wanted to improve the market’s ability to make well informed decisions as to which banks they would do business with. As I note later in this address, we concluded that the introduction of a well focused and comprehensive disclosure regime would go a long way towards achieving these objectives. Another factor which led us to review our banking supervision arrangements was a concern at the compliance costs and regulatory distortions which can be associated with conventional approaches to banking supervision. This concern reflects our view that banking supervisors tend to have strong incentives to promote a stable financial system, without always having appropriate regard to the compliance costs and regulatory distortions to which supervision and prudential regulation can give rise. We were also concerned at the taxpayer risk involved in the traditional approach to banking supervision. Although this risk is present regardless of the form banking supervision takes, it is likely to be greater where the banking supervisor, and only the banking supervisor, has regular access to financial information on a bank. It is also likely to be greater the more intensive the supervision process is. We wanted to explore ways of reducing the risk of the government being called upon to rescue a bank in distress. Finally, we recognised that conventional banking supervision can only go so far in promoting a sound banking system. There are inherent limitations in the extent to which prudential regulation and supervision, even supervision which includes on-site examinations, can minimise the incidence of bank distress and failure. This is evidenced by the fact that countries with intensive supervisory regimes have not been immune from serious episodes of financial distress. Indeed, we were concerned that banking supervision could even be increasing the risk of bank failure or distress, by potentially reducing the incentives for bank directors and managers to make their own considered judgements about what constitutes prudent behaviour. The New Approach to Banking Supervision in New Zealand In the light of these concerns, and following a lengthy period of review, we concluded that the concerns we had identified could be substantially addressed by placing greater reliance on market disciplines through public disclosure by banks, increasing the accountability of bank directors and management, and reducing the extent of prudential regulation. The new banking supervision arrangements, which came into force on 1 January 1996, reflect these conclusions. The new approach differs from the former regime in two main areas. First, a new disclosure regime applicable to all banks operating in New Zealand has been introduced. The disclosure regime is designed to substantially strengthen the market disciplines on banks and sharpen the incentives for the directors and management of banks to manage their banks’ affairs in a sound and responsible manner. I will outline the main features of the disclosure arrangements shortly. The second major change involved a reduction in the extent of prudential regulation of banks. The main changes included: the removal of the former limit on the amount which banks may lend to their customers; the removal of the limit on banks’ open foreign exchange exposures; the removal of the Reserve Bank’s guidelines on internal controls and the associated audit requirements; and the removal of the need for banks to privately report their financial position and risk exposures to the Reserve Bank. We were satisfied that the introduction of the new disclosure regime obviated the need for many of the former prudential controls on banks. Undoubtedly the feature of the new approach that has attracted most attention is the disclosure regime. Let me briefly outline its main features. Under the new arrangements, all banks operating in New Zealand must publish a disclosure statement each quarter. The disclosure statements are in two forms: a brief Key Information Summary, which is aimed at the ordinary depositor; and a more comprehensive General Disclosure Statement, which is aimed principally at the professional analyst. The Key Information Summary contains a short summary of key information on a bank, including: the bank’s credit rating (or a statement that the bank has no credit rating); the bank’s capital ratios, measured using the Basle framework; and information on peak exposure concentration, peak exposures to related parties, asset quality, shareholder guarantees (if any) and profitability. The Key Information Summary must be displayed prominently in, and be available on demand from, every bank branch. The General Disclosure Statement contains wider-ranging and much more detailed information on a bank and its banking group, including: corporate information and some information on parent banks (where applicable); comprehensive financial statements (including a five year summary of key financial data); credit rating information (including any changes to the rating in the two years preceding a bank’s most recent disclosure statement balance date); detailed information on capital adequacy, asset quality and various risk exposures (including exposure concentration and related party exposures); information on funds management and securitisation activities, risk management systems, and a summary of the prudential regulations imposed on the bank in question by the Reserve Bank of New Zealand; information on the bank’s exposure to market risk, both peak and end of period (and in respect of the full banking book). The disclosure statements issued by banks are subject to full external audit at the end of year and a limited scope audit review at the half year. Disclosure statements issued at the other quarters in the year are not required to be audited. One of the most important features of the disclosure framework is the role it accords bank directors. Each director is required to sign their bank’s disclosure statements (or authorise someone to sign on his or her behalf) and to make certain attestations in the disclosure statements, including: whether the bank is complying with the prudential requirements imposed on it by the Reserve Bank; whether the bank has systems in place to adequately monitor and control its banking risks and whether those systems are being properly applied; whether the bank’s exposure to related parties is contrary to the interests of the bank; and whether the disclosure statement contains all the required disclosures and is not false or misleading. Directors face severe criminal and civil penalties (including up to three years’ jail and personal liability for creditors’ losses) if a disclosure statement is held to be false or misleading. The disclosure arrangements are expected to bring a number of important benefits to the New Zealand financial system: We are confident that the disclosure arrangements are playing an important role in strengthening market disciplines on banks. Under the new arrangements the market has considerably greater information on a bank’s financial performance and risk positions than was previously the case. And the information is available more frequently and in a more timely manner. The market therefore has greater scope to react to developments affecting a bank’s financial condition - rewarding those banks which are well managed and penalising those which appear to be less well managed. The strongest banks are likely to benefit from that strength by operating at lower costs; weaker banks are likely to be under pressure to strengthen their position. Over the longer term we believe that stronger market disciplines will make a major contribution to the soundness of New Zealand’s financial system. Another benefit which we expect to see from the disclosure regime is a growing emphasis on the important role which bank directors play in overseeing the prudent management of their banks. The disclosure framework reinforces and provides a sharper focus on the duties of bank directors. In particular, it sharpens the focus on directors’ duties to ensure that their bank has the necessary systems in place to identify, monitor and manage adequately the bank’s various business risks, and to ensure that those systems are being properly applied at all times. The disclosure requirements are also likely to increase the accountability of bank directors and, indirectly, the accountability of various levels of management within the banks. As a result of the disclosure arrangements, we would expect to see directors taking greater care than might otherwise have been the case to ensure that they are adequately discharging their obligations. In so doing, it is likely that directors will take steps to ensure that there are appropriate accountability mechanisms within the management hierarchy. Over time, we expect that the increased accountability of bank directors will lead to an improvement in the quality of bank boards. Shareholders now face stronger incentives to ensure that the directors of their banks have the appropriate skills, experience, integrity and judgement to fulfil the duties expected of them. Another important benefit which we hope will flow from the disclosure regime is a reduction in the risk that the taxpayer will be called upon to rescue a bank. As a result of the disclosure arrangements we hope that there will be a stronger public perception that the management and directors of a bank have the sole responsibility for the management of their bank’s affairs. Moreover, the public now has access to much the same information on banks as does the Reserve Bank, thereby eliminating the monopoly of information which supervisors generally tend to have in respect of a bank’s financial condition. Both of these factors should assist in enabling future governments to resist the inevitable pressures to rescue a bank in distress or to insulate creditors from losses - at least to some extent. Although the new supervisory framework places great emphasis on the role that market disciplines can play in promoting systemic stability, it is important to note that the Reserve Bank of New Zealand has not abandoned its responsibilities for the financial system. We recognise that, for the time being at least, systemic stability is best served by a combination of market disciplines and banking supervision. In particular, we see value in: retaining some control over which entities may call themselves banks in New Zealand; the Reserve Bank maintaining a sound understanding of the state of the financial system; and the Reserve Bank retaining a capacity to respond to financial distress or bank failure, where this threatens financial system stability. In this context, a number of the Reserve Bank’s core functions have been retained. The Reserve Bank continues to have responsibility for registering new banks. Banks continue to be subject to minimum capital requirements (in line with the Basle Capital Accord) and a limit on lending to related parties. Although we believe that disclosure alone would ensure that banks would maintain capital at least equivalent to the 8% minimum, we consider that retention of the minimum capital requirements reinforces the credibility of the new supervisory framework, at no additional cost to banks. The Reserve Bank continues to monitor banks on a quarterly basis. However, monitoring is now conducted principally using banks’ public disclosure statements, in contrast to the former system of monitoring on the basis of information provided privately to the Reserve Bank. In most respects, banks’ disclosure statements contain information which is more comprehensive and more reliable than the information previously provided privately to the Reserve Bank. The Reserve Bank also continues to consult with the senior management of banks. Formal prudential consultations are held annually, and generally focus on the strategic direction of the banks, major changes in their operations and other high level issues. In addition, as Governor of the Reserve Bank of New Zealand, I meet with the chief executives of the larger banks on a regular basis to discuss a broad range of issues, including issues relating to the banking industry and to the wider economy. And, importantly, the Reserve Bank retains a wide-ranging capacity to respond to financial distress or bank failure where a bank’s financial condition poses a serious threat to the stability of the banking system. As with the former supervision arrangements, the objective underlying the above responsibilities is the promotion of a sound and efficient financial system. Depositor protection does not feature in the Reserve Bank’s objectives. Reactions to the New Approach to Banking Supervision All in all, I believe that the new approach has been relatively well accepted. But it has taken time for that acceptance to be achieved. It is fair to say that, during the review process, reservations about the new approach were expressed from a number of quarters, both at home and abroad. I think it would be useful to mention some of these. One of the observations made has been that New Zealand is “free riding” on the efforts of the home supervisors. We firmly reject this notion. We believe that the new supervisory framework is at least as effective at promoting prudent banking practices as are the more traditional approaches to banking supervision. And we are satisfied that the new framework enables the Reserve Bank of New Zealand to fulfil its duties as a host supervisor within the terms of the Basle Concordat. In that regard, under the new approach to banking supervision, the Reserve Bank of New Zealand remains well informed about the activities and financial condition of all banks operating in New Zealand, and well placed to respond to incipient financial distress where appropriate. Indeed, as I have already noted, the disclosure regime provides the Reserve Bank (and the public) with information which is generally more comprehensive than the information previously received by the Reserve Bank. But it is certainly true that any host supervisor will - inevitably - rely to some extent on the global supervision of the home supervisor. After all, this is an intrinsic part of the Basle Concordat. The most a host supervisor can realistically achieve is to promote prudent banking practices in the local operations of the banks within its jurisdiction. In the context of the above point, some commentators have suggested that the Reserve Bank of New Zealand is not well placed to anticipate emerging financial distress in the absence of conducting on-site examinations of banks or otherwise obtaining private information from banks. Although I acknowledge that on-site examinations do increase the information available to banking supervisors, I am not at all convinced that the information obtained from such examinations enables the supervisors to reliably anticipate incipient financial distress. In modern banking, risk positions can and do change rapidly. A week in politics might be a long time, but in banking it is a very long time indeed! This is becoming increasingly the case. The information obtained from on-site examinations, or from any other sources for that matter, can only provide a snapshot of a bank’s risk positions at a particular point in time, and even then generally only in respect of a subset of the bank’s business. For these reasons I believe any such information is of limited usefulness in assessing the dynamics of a bank’s risk positions or in anticipating financial distress. I acknowledge, of course, that publicly disclosed information also has these limitations. But at least public disclosure brings with it the incentives for the sound management of banking risks. I am not at all sure that the private disclosure of information to a banking supervisor - whether on-site or off-site - creates these types of incentives. A further concern we have with on-site examinations or the off-site collection of detailed private information on banks, at least in the New Zealand context, is the risk that these approaches can blur the lines of responsibility for the management of banks. If the banking supervisor has responsibility for regular on-site examinations, it presumably follows that the supervisor also has responsibility for encouraging or requiring a bank to modify its risk positions or make other adjustments to its balance sheet where the supervisor has concerns in relation to the bank’s risk profile. This has the potential to erode the incentives for the directors and management of banks to take ultimate responsibility for the management of banking risks, effectively passing some of this responsibility to the banking supervisor. It also has the potential to create public perceptions that the responsibility for managing banking risks is effectively shared between a bank’s directors and the banking supervisors. In turn, this makes it very difficult indeed for a government to eschew responsibility for rescuing a bank in difficulty. I acknowledge that any system of banking supervision - even one that relies principally on public disclosure - will inevitably create public expectations that the supervisory authority takes some responsibility for the management of banking risks. And I acknowledge that any system of banking supervision creates a risk for the taxpayer in the event that a bank gets into difficulty. However, in order to minimise these risks, the Reserve Bank of New Zealand prefers to keep the spotlight clearly focused on the directors and management of a bank, rather than risk a further blurring of their accountability. We believe that the avoidance of having an on-site examination role or otherwise regularly obtaining private information from banks assists in this regard and reinforces market disciplines on banks. Another observation frequently made is that New Zealand would not have adopted the new framework had a substantial part of its banking system been domestically owned. It is my firmly-held conviction that we would have adopted this approach even if all or most of our banks had been locally-owned. I say this because we believe that the regime is actually more likely to promote prudent banking behaviour than do the more traditional approaches, but with a lower likelihood of moral hazard and regulatory distortion. In this context, I should note that, at the time we commenced our review of banking supervision, in late 1991, a significant part of the New Zealand banking system was still domestically owned. Indeed, as I see it, many of the changes we have implemented in New Zealand would be of equal relevance to those jurisdictions in which the core of the banking system is domestically owned. Another criticism made of the New Zealand approach is that comprehensive and frequent disclosure can, in some circumstances, exacerbate financial system distress, rather than promote systemic stability. I acknowledge that, in some circumstances, disclosure could exacerbate a bank’s difficulties. For example, where a bank is required to disclose a loss or a severe deterioration in asset quality, this could lead to a sharp adverse reaction by the market, possibly causing the bank in question to come under liquidity pressure. Of course, this possibility exists with even the barest disclosure requirements - such as with the release of an annual report or a six monthly interim disclosure. And the risks of adverse market reaction are present even in the absence of disclosure requirements - for example, as a result of market speculation as to a bank’s financial condition. Indeed, in some circumstances the disclosure of comprehensive information might actually reduce the risk of the market reacting adversely to misinformation or to an absence of information. In any case, where a bank knows in advance that it will be making adverse disclosures, it would generally have the opportunity to take steps to reduce the risk of an adverse market reaction. These steps would include the disclosure of the remedial measures being taken to address the bank’s difficulties. Of course, the risk of a severe market reaction to an adverse disclosure creates the very incentives for banks to ensure that they manage their affairs in such a way that there will be no adverse developments to disclose. In the longer term, therefore, the risk of adverse market reaction could be expected to promote a sounder financial system. One of the criticisms often made of public disclosure by banks is that the vast majority of depositors will not read banks’ disclosure statements. On this assumption, some observers suggest that disclosure is of very limited effectiveness. We do not agree. It is certainly true that most depositors are unlikely to read the disclosure statements. But the disclosure regime in New Zealand is not predicated on the assumption of wide readership by the ordinary depositor. The source of market disciplines does not lie in wide public readership. Rather, the efficacy of the disclosure regime rests on the assumption that the disclosure statements will be read by the agents of depositors, such as the financial news media, financial analysts and investment advisers, and by wholesale creditors and fellow bankers. It is the risk of adverse reactions by these types of disclosure users that creates the incentives for bank directors and management to manage their banks’ affairs in such a way as to avoid the need to make adverse disclosures. Although the disclosure regime does not rely on the mass readership of disclosure statements by depositors, the Reserve Bank of New Zealand is encouraging depositors to take a greater interest in their banks’ disclosures. Over much of last year we actively promoted publicity about the new disclosure arrangements. And we prepared a “user’s guide” to assist depositors (and their agents) to understand the disclosures being made by banks. The user’s guide is now available in every bank branch in the country. While it is unlikely to be a “best seller”, it is encouraging to note that there has, in fact, been a surprising degree of interest in it from the public. We hope that, over time, an increasing proportion of depositors will take a keener interest in their banks’ financial condition. Another observation made about the new framework is that our approach places an excessive emphasis on the role of bank directors - that we are asking too much of them. To illustrate this point, during the review process, I had a visit from the chief executive of one major international bank with an operation in New Zealand. He had come to protest strongly at the requirement that bank directors would have to sign the disclosure statements every quarter and attest to the appropriateness of their risk management systems. When I asked why, he said “... bank directors understand absolutely nothing about banking...”. This comment is quite unfair about many bank directors, of course, but there is an uncomfortable element of truth in it in some cases. The blame for this situation almost certainly lies, in part, on a supervision regime which had assumed too much of the responsibility for the viability of banks. We very much hope that a regime which will continue to have some key regulations, but which is based primarily on market disclosure and director attestations, will improve that situation. Early Indications of the Effects of the Disclosure Regime Although it is far too early to make conclusive assessments of the success or otherwise of the new supervisory approach, there have been some encouraging signs that the disclosure requirements are meeting a number of their objectives. I will briefly highlight a few of these. We have been encouraged by the fact that the financial news media in New Zealand have taken a close interest in the new bank disclosure regime. The quarterly disclosure statements have received quite detailed scrutiny from the news media, resulting in greater and more focused public exposure of banks’ financial results and risk positions. We hope that this type of media attention will sharpen the incentives for banks’ directors and management to manage their banks’ affairs prudently. A good example of the news media’s interest in banks’ disclosure statements was the media’s interest in one bank’s disclosure of its non-compliance with a Reserve Bank prudential requirement. We were surprised at the intensity of the media’s interest in this disclosure - as, I suspect, were the management and directors of the bank in question. Hopefully, this type of media attention, and the attendant adverse publicity to which it inevitably gives rise, will encourage banks to ensure that they comply with Reserve Bank requirements in the future. I am inclined to think that the threat of adverse publicity is likely to be a more effective discipline on banks than are many of the standard supervisory sanctions for breaches of regulatory requirements. Interestingly, the disclosure regime seems to be strengthening the extent to which banks scrutinise each other’s financial performance and risk positions. We are aware that banks are making considerable use of the disclosure statements to monitor each other. The additional and more frequent information now available could be expected to assist banks in managing their inter-bank exposure positions and in assessing the extent and nature of the business they conduct with each other. We believe that the banking industry itself is one of the most potent sources of market disciplines on individual banks. Anecdotal feedback suggests that the obligations now placed on bank directors are causing the directors of some banks to exercise greater scrutiny of their banks’ risk positions. In turn, this seems to be focusing greater attention on the systems they have in place for identifying and managing risks. Moreover, it seems that some banks are taking steps to increase the accountability of various levels of management within their banks. We are also aware that some banks have engaged external consultants to review aspects of their risk management systems. It seems that part of the motivation for conducting these reviews lies in the disclosure requirements - particularly the director attestation as to the adequacy of a bank’s risk management systems. These are all pleasing developments. We hope that they auger well for the success of the new arrangements. I am confident they will. But we are under no illusion that the new arrangements provide guarantees of financial system stability. Of course they do not. No system of banking supervision can do that. The most we are entitled to believe is that the disclosure regime will significantly reduce the likelihood of financial system instability in the future - at lower regulatory, compliance and taxpayer costs than other supervisory options might be expected to achieve. - 10 - General Observations on Incorporating Market Disciplines into Banking Supervision Before I conclude this address, I should probably make some comments about the extent to which market disciplines could be better incorporated into the supervisory frameworks in other countries. I should first of all make it clear that the Reserve Bank of New Zealand is not promoting the New Zealand supervisory model as the ideal model for other countries to adopt. We make no such claims. The model we have adopted meets our particular needs, but it might not necessarily be suitable for other countries. Clearly, each country needs to make its own judgement as to what type of supervisory framework is best suited to its unique requirements. That judgement will inevitably depend on many considerations, including: the objectives which banking supervision is expected to meet, and whether those objectives include depositor protection; the existence or otherwise of deposit insurance arrangements; the structure of the banking system; and the infrastructure within which banking operates, such as banking law and accounting standards. Having said this, I do believe that market disciplines can play a substantial role in most financial systems. In particular, I think policy makers in many countries could usefully give careful thought to the merits of introducing comprehensive and well focused disclosure requirements for banks. Similarly, I believe there would be much to gain from the adoption of policies designed to strengthen the responsibilities of bank directors, so that the ultimate responsibility for the management of banking risks lies squarely in the boardroom, rather than being awkwardly balanced between the banking supervisor and the bank director. But it is fair to say that the effectiveness of market disciplines will much depend on the structure of the regulatory arrangements in place and the nature of the infrastructure within which the banking system operates. In particular, the following factors would seem to play an important role in determining the effectiveness of using disclosure as a mechanism for promoting systemic stability. Market disciplines are more likely to be effective where governments do not insulate depositors from losses - whether explicitly in the form of deposit insurance or through implicit depositor protection. Understandably, depositors and other creditors are less likely to take an interest in a bank’s financial condition where they know, or have good cause to surmise, that they will be insulated from losses should a bank get into difficulty. In such circumstances, banks which are performing poorly are less likely to face adverse market reaction than in an environment where creditors operate under the expectation that they are likely to lose money in the event of a bank failure. In part, this is why, in New Zealand, we have eschewed deposit insurance or depositor protection, and have sought to make it clear to depositors, among others, that they should not expect the government to insulate them from losses in the event of a bank failure. It is also fair to say that market disciplines are more likely to be effective where the supervisory requirements applied to banks are kept to a minimum. I say this for two reasons. - 11 - First, the greater the supervisory requirements, the more likely it is that the market will perceive that the government is underwriting individual banks. And second, the greater the supervisory requirements, the less likely it is that bank directors and management will view themselves as having ultimate responsibility for the management of their banks. The effectiveness of market disciplines will also depend on the structure of the financial system. In particular, it seems likely that market disciplines would be more effective where a bank is domestically owned - that is, where no other bank stands behind it. Where a bank is owned by another bank, the market would naturally have regard to the financial condition of the parent bank when assessing how it should react to disclosures made by the local bank. Market disciplines might therefore be somewhat more subdued in a financial system characterised by foreign ownership than in one dominated by locally owned banks. Having said this, I am fully satisfied that even in a financial system which is largely foreign owned, such as in the New Zealand financial system, there is very considerable scope to use market disciplines to promote improved risk management by the subsidiaries and branches of foreign banks. Indeed, it is possible that New Zealand’s disclosure regime might well be adding to the incentives on overseas parent banks to more vigilantly supervise their New Zealand operations and to give greater attention to their own financial condition. The extent of government ownership of the banking system is also likely to influence the effectiveness of market disciplines. I think we would all agree that the market is less likely to impose meaningful disciplines on a bank which is state owned than would be the case with a privately owned bank - assuming, of course, that the market has faith in the financial soundness and political stability of the government in question. However, even where a bank is state owned, a robust disclosure regime might well strengthen the accountability of the directors and management of the bank, leading to improved risk management within the bank. It will come as no surprise to you that I believe that market disciplines are more likely to be effective where banks are required to make comprehensive disclosures on a frequent and timely basis. The disclosure requirements should focus on the key aspects of a bank’s financial performance and risk profile, and should be made with sufficient frequency and timeliness as to provide the market with a meaningful basis for assessing a bank’s financial condition and comparing one bank with another. Disclosure is likely to be more meaningful and effective if it is supported by robust accounting standards which have the force of law. Certainly, in the case of New Zealand, we have found that our disclosure regime has been assisted greatly by the introduction of legally binding and more rigorously drafted accounting standards. Moreover, disclosure requirements should ideally be coupled with an appropriate legal framework governing bank directors - a framework designed to focus directors’ attention on their duties to manage the affairs of their bank in a sound manner, and to hold them to account for any breaches of those duties. However, as they say, there is a time and a place for everything. And so it is with disclosure. I think we would all agree that it would not be helpful to introduce new disclosure requirements at a time when the banking system is in a fragile state. Doing so could well exacerbate the situation. That is why, in New Zealand, we introduced the disclosure regime at a time when the financial system was in a strong position and therefore when disclosure would assist in maintaining confidence in the banking system, rather than detracting from it. Finally, the effectiveness of market disciplines through public disclosure will obviously be influenced by the infrastructure within which banking operates. By “infrastructure”, I refer to such matters as: the nature and adequacy of corporate law; the - 12 - adequacy of accounting standards and auditing requirements; the sophistication and integrity of the accounting profession; and the adequacy of the financial news media and financial professionals. All else being equal, the more well developed the infrastructure, the more likely it is that market disciplines will be effective. This suggests that, in the case of some developing countries, where perhaps the infrastructure is not well developed, the scope for using disclosure to promote market disciplines is somewhat more limited than would otherwise be the case. But even in such cases, I would not dismiss the potential merits of developing relatively simple disclosure requirements, drawing on international accounting and auditing standards as appropriate, as a means of promoting some rudimentary market disciplines. Conclusion Let me conclude by reiterating my view that market disciplines can play a powerful role in promoting systemic stability, in conjunction with some degree of banking supervision. I think there is considerable scope for policy makers to give further thought to how market disciplines could be better used to reinforce the efforts of banking supervisors in the quest for systemic stability. However, in giving thought to this matter, it may well be necessary for policy makers to re-assess some fundamental aspects of the conventional approaches to banking supervision and their relationship to the promotion of market disciplines. These include such issues as depositor protection, deposit insurance, the extent of prudential regulation of banks, and the intensity with which banking supervision is conducted. These are all substantial issues of course, and I have little doubt that there will be continuing international debate as to where the appropriate balance should lie. I very much hope that the approach which we in New Zealand have adopted will assist in promoting international debate on supervisory options.
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reserve bank of new zealand
| 1,997 | 3 |
Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Counties Kiwifruit Growers Association in Pukekohe on 22/8/97.
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Mr. Brash discusses fluctuations and long-term trends in exchange rates and their effects on export commodities and comments on the Reserve Bank’s Monetary Conditions Index Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Counties Kiwifruit Growers Association in Pukekohe on 22/8/97. Mr Chairman, I am delighted to be back in Pukekohe, though I must admit I’d rather be next door in my orchard instead of in here, explaining the impact of monetary policy on the fruit-growing industry! Two months ago, when you asked me to speak this afternoon, you asked me to focus on exchange rates. In particular, you suggested I speak about ‘fluctuations and long term trends in exchange rates and their effects on export commodity pricing’. I am happy to do that, but I also want to make a few comments on the Reserve Bank’s Monetary Conditions Index, both because it is relevant to the subject you have asked me to address and because the MCI has become the subject of a good deal of public discussion and debate over the last month or two. Indeed, some claim it is only the Reserve Bank’s obsession with the MCI that has seen exchange rate and interest rates pushed around in a rather volatile manner over the last couple of months. The exchange rate First let me talk a little about the exchange rate. Here the concerns seem to be partly about fluctuations in the exchange rate and partly about the long-term trends, as your suggested subject for my speech indicates. I have to say that I do not have a great deal of sympathy for those who complain about the fluctuations in the exchange rate, and that for two quite different reasons. First, and most obviously, there is now a very well-developed market in forward foreign exchange contracts, so that it is readily possible for exporters to fix the exchange rate at which they sell their products long before they actually want to repatriate the proceeds to New Zealand. Exporters may, of course, choose not to use that market and instead gamble that they might get a more favourable exchange rate at some stage in the future. They should be free to make that choice. But it is important to recognise that they are deliberately taking on foreign exchange risk in the hope of getting something better in the future. They are not obliged to gamble in this way. This point is perhaps particularly relevant at the moment, when a number of farmers are lamenting the fact that, while the exchange rate is now much more attractive, that doesn’t help farmers because few have stock to sell at the moment. But there is nothing at all stopping farmers who have no stock to sell, or meat companies on their behalf, from buying foreign exchange forward at the currently prevailing rates, and locking in current exchange rates. By doing that, they eliminate the risk that the exchange rate may rise before their stock is ready for sale, but of course they also pass up the additional benefit they might get if the exchange rate were to fall further. Secondly, although the New Zealand dollar has been subject to quite marked fluctuations over the last few months, by and large the New Zealand dollar is not a volatile currency by the standards of other floating rate currencies. Certainly measured on a tradeweighted basis, the New Zealand dollar has in recent years been less volatile on a week-to-week basis than, say, the Australian dollar, the US dollar, the pound sterling, or the Japanese yen. What about the longer-term trends? Since at least the beginning of the seventies, the trade-weighted measure of the New Zealand dollar has tended to move to reflect differences between inflation in New Zealand and inflation in our trading partners (graph 1). Graph 1: Relative Consumer Prices and Nominal TWI (1970 - June 1997 average equals 100) Index Index Nominal TWI Foreign/Domestic price level In other words, when inflation was higher than in our trading partners, the New Zealand dollar had a tendency to depreciate. When inflation was lower than in our trading partners, the New Zealand dollar had a tendency to appreciate. Occasionally, the exchange rate Graph 2: Nominal and 'Real' Trade Weighted Exchange Rate (1970 - June 1997 average equals 100) Index Index Nominal TWI Foreign/Domestic price level 'Real' exchange rate would depreciate a little faster than seemed warranted by a relatively poor inflation performance in New Zealand, and exporters enjoyed the experience. Occasionally, as in the period from early 1993 to early 1997, the exchange rate appreciated faster than seemed warranted by a relatively good inflation performance, and exporters found the experience anything but enjoyable (graph 2). If historical relationships hold, one would expect the New Zealand dollar to move broadly in line with inflation differentials over the longer term, and a few months ago this led a number of commentators to suggest that, at that time, the New Zealand dollar was clearly over-valued. Last December I also expressed the view that, at that time, the New Zealand dollar did indeed seem somewhat over-valued on that basis, though it should be noted that, to the extent that productivity growth is higher in New Zealand than in our trading partners, one would expect to see the exchange rate rise somewhat faster than inflation differentials alone would suggest. I have no difficulty at all in acknowledging the fact that the appreciation in the New Zealand dollar from its floor of around 53 (on a trade-weighted basis) in January 1993 to 69.3 in March 1997, an increase of some 30 percent over just four years, put significant pressure on a great many exporters. But four points need to be made in qualification. First, it is very likely that an exchange rate of 53 on a trade-weighted basis was as unsustainable as an exchange rate of 69.3. Neither represents an ‘equilibrium’ level of the exchange rate, so to measure exchange rate appreciation from that artificially low level risks creating quite a false impression. Secondly, while acknowledging the pressure which the rising exchange rate from 1993 to early 1997 placed on exporters, I am bound to express a degree of cynicism about the way in which some producer boards have described this impact. To hear some tell it, the impact of the rising exchange rate on the gross incomes of farmers and orchardists is the same as the impact of the exchange rate on their net incomes, and of course that it not correct. Granted, our land-based export industries are not heavy users of imports, but they do use diesel, they do use tractors, they do use fertilisers, and they are heavily affected by the costs of transport to and from the farm-gate. And from their net incomes they still spend money on petrol for the family car, they still buy clothes, they still buy other goods which are imported. The New Zealand dollar price of all these items would have been significantly higher over the last few years had it not been for the appreciation of the currency. Indeed, it is very likely that wage increases would also have been significantly higher if there had been no currency appreciation. So while the increase in the New Zealand dollar in recent years has undoubtedly had a severe impact on gross farm incomes, the impact on farmers’ living standards was rather less severe. Thirdly, while the exchange rate appreciation has clearly made matters worse, the basic problem facing our land-based exporters is that the inflation-adjusted, or real, price of many of the items which they produce has been declining, and that for a long period. The New Zealand Meat and Wool Boards’ Economic Service tells me that between 1948 (prior to the Korean War boom) and 1996, the inflation-adjusted price of lamb fell by 45 percent in the US market; the price of dairy products fell by 55 percent; the price of beef fell by 69 percent; and the price of wool fell by 79 percent. I don’t know that anybody was noticing the price of kiwifruit in the US market in 1948, but I can still recall that in 1982, just 15 years ago, the orchard-gate price of New Zealand kiwifruit was $11 per tray. Nobody yet knows what we will realise in 1997, but if the orchard-gate price for this year’s crop is, say, $4.30 per tray, that will be an inflation-adjusted fall in the orchard-gate price of some 85 percent in just 15 years - and that over a period during which the New Zealand dollar has fallen quite substantially against the currencies of virtually all our trading partners, and especially against the Japanese yen and the German mark, the two currencies of most direct relevance to kiwifruit exports. The basic reality is that the market price of kiwifruit has fallen substantially over that time. And in case New Zealand exporters feel hard done by by this reality, remember that very substantial falls in inflation-adjusted prices are common for most commodities, and indeed for a great many other goods and services as well. Productivity improves, and international competition often ensures that the benefit of that improvement is passed on to consumers, rather than retained by producers. Reflect on the huge fall in the real price of computers - a fall which dwarfs the falls suffered by New Zealand land-based exporters - or the price of television sets, or of motor vehicles, or of international air travel, or of long-distance telephone calls. Large price falls are by no means unique to the products which New Zealand exports. To remain viable, all producers must be constantly seeking new ways to improve productivity or add value, and if they do that successfully, they can maintain profitability despite a trend decline in prices. Finally, apart altogether from the tendency for the prices of many commodities to decline in the long term, commodity prices tend to be volatile and in recent years this volatility has tended to swamp the impact of exchange rate trends. The best illustration is the experience of beef farmers in the three years to the middle of 1996: of the fall in the farm-gate price of bull beef over that period, more than three-quarters was caused by a fall in overseas market prices, and less than one-quarter by the rise in the exchange rate. In other words, the fall in the market price of bull beef was substantially greater in its impact on farmers than the effect of the increase in the exchange rate. Our land-based exporters operate in inherently volatile markets, and would face major swings in prices even if, in some way, the New Zealand dollar could be held absolutely stable. This should influence what can sensibly be paid for farming and orcharding assets. So yes, monetary policy does have an impact on the exchange rate, but that in turn has much less impact on exporters’ net incomes than on gross incomes, and has been of very much less significance to land-based exporters than the fluctuations in international commodity prices and the long-term decline in the real prices of many of the commodities which New Zealand exports. The Monetary Conditions Index But what of the Reserve Bank’s Monetary Conditions Index? Is the MCI, as some have suggested, really to blame for much of the current economic slowdown, or at very least for the sharp increase in interest rates recently? Before answering those questions, it is worth recalling briefly that, once every three months, the Reserve Bank does a comprehensive projection of the New Zealand economy and of inflation for a period of two or three years. That projection takes into account all the information available to the Bank at that time - the official statistics covering GDP, prices, wages, employment, imports, exports, and all the rest; the data collected by the Bank itself on the money and credit aggregates, and the path of interest and exchange rates; the survey data covering business and consumer confidence; the views expressed to us, formally and informally, about individual businesses and the economy; and much more. At the end of that process, we reach a view on how firm monetary conditions need to be to keep inflation moving towards the middle part of the 0 to 3 percent inflation target we have agreed with Government. But of course neither we nor any other central bank can control the mix of monetary conditions. In other words, we can tighten monetary conditions, but we can not determine whether that tightening takes the form of an increase in interest rates with little or no increase in the exchange rate; or an increase in the exchange rate with little or no increase in interest rates; or an increase in the exchange rate with a decrease in interest rates; or an increase in interest rates and a fall in the exchange rate. The mix depends on the perceptions and reactions of a great many people, here and abroad, and indeed on what other central banks are doing or are expected to do. What to do? In a small open economy like New Zealand, it is impossible to ignore the fact that monetary policy affects inflation through both interest rates and the exchange rate, and for a number of years we have factored that into our policy setting. What the Monetary Conditions Index seeks to do is to give the public and financial markets a broad indication of how we see the relative impact of interest rates and the exchange rate on medium-term inflation with a ‘rule of thumb’ combining both. Nobody can be dogmatic about the precise nature of this relative impact - it clearly differs between economies depending on the importance of international trade, and almost certainly varies depending on the stage of the economic cycle. On the basis of research to date we believe it is reasonable to suggest that a 1 percent increase in 90 day interest rates has roughly the same effect on inflation, in the medium-term, as a 2 percent increase in the (trade-weighted) exchange rate. This ratio is particularly helpful in helping us to assess how the overall degree of monetary restraint is evolving when interest rates and the exchange rate are moving in opposite directions, as has often been the case over the last year. In June this year, we expressed this relationship in numerical form, called it the Monetary Conditions Index, and indicated that our projected inflation track was based on monetary conditions being at 825 on that Index through the September quarter. Has this increased openness been constructive or destructive? On balance, I have no doubt that it has been constructive. Financial markets now know explicitly what in the past they could only guess at, namely how we ‘translated’ movements in exchange rates into movements in interest rates in assessing their effect on inflation. In the last few months, we have experienced the sharpest decline in the New Zealand dollar since late 1991 without any kind of drama or crisis. Interest rates have adjusted upwards to offset the effect of that depreciation on the medium-term inflation rate, and that with only a couple of brief comments from the Reserve Bank. Of course, a sharp fall in the exchange rate is almost inevitably going to be associated with rising interest rates, since the fall is likely to prompt many investors to want to withdraw funds from New Zealand investments, and this inevitably leads to higher interest rates. But the fact that interest rates moved to keep the MCI broadly unchanged - certainly over the sharpest movements in the exchange rate - suggests that the system has worked well. For the record, I think the MCI is working at least as well as other approaches - better in some respects - and I am in no hurry to change it. Let me put this another way. I’m sure that if the Reserve Bank had not published an MCI actual monetary conditions would have evolved in a broadly similar way, but probably with more anguish. Without the early interest rate reaction, the exchange rate fall would have left monetary conditions very much looser than we wanted. We would then have had to move to recover the lost ground by tightening policy, probably requiring specific policy actions. In other words, the MCI is only an indicator. It isn’t driving events in a substantive way, so people blaming the MCI are misdirecting their complaints. Give me stick, if you want, for misreading inflationary pressures out there, but ‘don’t shoot the messenger’, for that’s all the MCI is. What of criticism that the Bank has been operating the MCI mechanistically, or robotically, and thus causing excessive volatility in financial markets? Should the Bank have been more willing than it has been to allow actual monetary conditions to diverge from its announced ‘desired’ conditions of 825, or, alternatively, should we have adjusted policy instruments to ensure that actual conditions kept within the plus or minus 50 points of 825 announced as ‘desired’ on 27 June? It is perhaps worth recalling what I said on 27 June, in releasing our latest Monetary Policy Statement: ‘It is clear that deviations from desired monetary conditions can be very large indeed without threatening either edge of our inflation target if those deviations are of relatively short duration. This suggests that the Bank should be relatively tolerant of quite large deviations from desired. On the other hand, large deviations, even for relatively short periods, may raise doubts - either about the Bank’s determination to achieve the inflation goals we have been set or about the possibility that the Bank, in accepting those large deviations, may have changed its view of desired conditions. These doubts can create uncertainty, and that uncertainty has real costs, both short-term and long-term. We already allow monetary conditions to move within a range, without reaction from the Bank, which is at least as wide as that allowed in other developed countries. I am reluctant to be too precise about how much deviation we are willing to accept and for how long. Much will depend on the circumstances in which the deviation occurs. We may, for example, be more tolerant of deviations which appear to arise out of sharp movements in overseas exchange rates, where local interest rates or exchange rates may take a brief period to adjust. We may be more tolerant of deviations during the weeks immediately preceding our next quarterly inflation projection, since it is at that time when our last comprehensive review of desired conditions is, by definition, getting most dated. We are likely to be less tolerant if monetary conditions change very rapidly, and appear to be building some momentum, without any obvious explanation in terms of overseas exchange rates or changed prospects for inflation. As a very approximate guideline, we would expect actual monetary conditions to be within a range of plus or minus 50 MCI points from desired in the weeks immediately following a comprehensive inflation projection. As more data comes to hand over the ensuing three months, and as our last comprehensive inflation projection recedes into history, we may be rather more tolerant. But this is not, repeat not, a binding rule which the market can expect us to follow under all circumstances, and those expecting us to do so are likely to be disappointed.’ That is what I said on 27 June, and looking back with the wisdom of hindsight I think the comments have stood the test of time rather well. Did we signal a tight band of plus or minus 50 points around ‘desired’? Hardly. On the contrary, we made it clear that we would judge monetary conditions in the light of emerging data, and the factors we believed were driving conditions. Should we therefore leap to change the target for settlement cash as soon as conditions stray by more than 50 points from the designated level? Absolutely not, and nobody should expect us to do so. My only regret is that I did not mention, as one reason for being tolerant of deviation of actual monetary conditions from desired monetary conditions, the complication created by a sharp change in the mix of conditions. Clearly, the Index is based on the assumption that a 1 percent movement in interest rates is equivalent, in medium-term effect, to a 2 percent change in the exchange rate, and that is our best estimate at this stage. But it is only an estimate, and we recognise that the relationship may well change over time and in response to very sharp movements in either interest or exchange rates. In the jargon, the relationship may not be linear. It is partly for this reason that we have been willing to accept quite a marked divergence between actual and desired conditions in recent weeks. It is important also to recall that, as indicated a moment ago, we can not control the mix of monetary conditions. This was very clearly indicated between September 1996 and March 1997. Over that period, 90 day interest rates fell from around 10 percent to around 7.5 percent, while the exchange rate rose from around 66 on the Trade-Weighted Index to over 69. On the face of it, this period of rising exchange rate and falling interest rates was the very reverse of what might have been desirable - given that there was already little or no inflation in the export and import-competing sectors of the economy, and plenty of inflation in the domestic sectors - and I expressed my unhappiness about this mix on several occasions, all to no avail. For a whole host of reasons - perceptions of the likely trend of monetary policy in New Zealand and overseas, perhaps concerns about the balance of payments deficit, perhaps general concern about currencies in this part of the world - the mix has changed quite sharply in the last few months, with an increase in interest rates, which has taken them about half way back to where they were last September, and a sharp fall in the exchange rate. Overall, conditions have eased considerably, and I am sure that there won’t be an exporter in the country who is not a good deal happier with the present mix than with the one we had three or four months ago. But aren’t monetary conditions still too tight, given the low level of business and consumer confidence, the general flatness of the economy, and the fact that, on the Reserve Bank’s own figures, we will have inflation at or slightly below 1 percent by the end of this year and into 1998? In less than a month, the Bank will be publishing its next comprehensive inflation projection, so I don’t want to give a substantive answer to that at this stage. But let me just remind you of a couple of relevant points. It is hardly surprising, or a matter for regret, that our June Monetary Policy Statement projected that inflation would fall to 1 percent by the end of this year: through all of last year, until 10 December, we were targeting inflation at between 0 and 2 percent, with a mid-point of 1 percent, because that’s what our Policy Targets Agreement with the Government required at that time. We were battling to reduce inflation, which had been somewhat above the top of that range throughout 1996. Given that it takes a minimum of 12 months for monetary policy to have its impact on inflation, it would be surprising if inflation were not projected to be moving towards 1 percent at the end of this year. The inflation projection which the Bank published at the end of June was not only based on monetary conditions being around 825 on the MCI during the September 1997 quarter, it was also based on a particular combination of interest rates and exchange rate. We assumed that, during the September quarter, the trade-weighted exchange rate would average around 67.3, and 90 day interest rates would average around 7 percent. We also explicitly recognised that if the mix of conditions changed, the short-term track of inflation could be different. With the exchange rate in fact significantly lower than assumed in the June Monetary Policy Statement, and interest rates significantly higher than assumed, it is possible that the immediate inflation track may be a little higher than projected in June because of the impact which the lower New Zealand dollar may have on the prices of goods like television sets, cars, and other imports. In other words, a lower dollar may increase inflation more quickly than higher interest rates will reduce it. Although there are many people who feel that monetary conditions are inappropriately tight, and some who just feel that the combined wisdom of financial markets is more likely to be right than is the Reserve Bank, it is worth recalling that for the first four months of 1997, until the very end of April, financial markets kept monetary conditions appreciably tighter than the Bank had indicated was necessary or appropriate, despite our saying that we would be happier if conditions were somewhat easier. In other words, financial markets are not infallible. It is interesting that in the latest Consensus survey of New Zealand forecasters, representing views in mid-July 1997, 39 percent felt that conditions were unduly firm, but 54 percent felt that they were about right - and conditions have eased somewhat since that survey was conducted. Monetary conditions have eased substantially over the last six or eight months from an average of 1000 on the MCI in the December 1996 quarter to an average during the first half of August of 730. Put in more familiar terms, conditions have eased by the equivalent of a 2.7 percent fall in interest rates with unchanged exchange rate; or by the equivalent of a 5.4 percent fall in the exchange rate, with unchanged interest rates. This is a considerable easing in monetary conditions, which will not have its main effect on activity and inflation until well into 1998 - at about the time the economy is also experiencing a strong stimulus from reduced tax rates and increased government expenditure. In other words, the suggestion that the Reserve Bank has been braking the economy in recent months is factually wrong. In fact, over recent months the opposite is true. We will, of course, be weighing all these factors and more in reaching our judgement for the appropriate level of monetary conditions in the December quarter. We will publish our considered judgement on 18 September. Unfortunately, given the long lags between actions taken by the Reserve Bank today and the impact of those actions on inflation, nobody will know until at least the second half of next year whether we should have eased rather more in June 1997, or indeed whether we should have kept things a little firmer. Of one thing you can be certain. We will do everything in our power to keep inflation within the target which has been agreed with the Government. That will not guarantee you a profit in fruit-growing, or in exporting more generally. It will, however, be the best contribution which the Reserve Bank can make to the creation of an environment where you and others can make rational investment decisions, to the ultimate benefit of all New Zealanders.
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Speaking notes of Mr. Donald Brash, Governor of the Reserve Bank of New Zealand, on the release of the September, 1997 Economic Projections in Wellington on 17/9/97.
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Mr. Brash looks at economic developments and their bearing on inflationary trends Speaking notes of Mr. Donald Brash, Governor of the Reserve Bank of New Zealand, on the release of the September, 1997 Economic Projections in Wellington on 17/9/97. Introduction Good morning, and welcome to this briefing on the Reserve Bank’s September 1997 Economic Projections. You will recall that, in contrast to our June and December Monetary Policy Statements, which the Bank is obliged to produce by statute, the Economic Projections which we release each March and September are more in the nature of ‘self-initiated’ documents. Their primary purpose is to assist us in assessing economic developments that have a bearing on inflation trends, and thereby to assist us in forming judgements on how monetary policy should evolve. In publishing our Projections, we take the opportunity to inform financial markets and the public generally on what is driving our day-to-day policy decisions. Typically, you can expect to see in our Economic Projections more discussion of matters such as investment behaviour, labour market trends, the balance of payments and so on than is to be found in our Monetary Policy Statements, which concentrate more on assessments of past and future financial market conditions, and the stance of monetary policy. However, both documents require us to produce a comprehensive view of the future trends in the New Zealand economy, and to test our previously articulated views against the stream of emerging data and opinion. A key ingredient in that process is our new forecasting and policy system (FPS) -- the system of models we now utilise in developing our Projections. One important change which that new system of models has made possible was introduced with our June Monetary Policy Statement. Whereas we had previously projected inflation on the basis of an assumed track for interest rates and the exchange rate, in June we shifted to a structure that constrains our Projections of inflation to converge on the mid-part of the 0 to 3 percent inflation target, while allowing the track of monetary conditions to vary as necessary to produce that outcome. You can see that process at work again in these Projections . One point made in relation to FPS when it was first introduced bears repeating. While it is an important tool which helps shape our view of the economy and its likely future path, it is not a ‘black box’. FPS provides a coherent framework for thinking about the economy, but considerable judgement is still required to arrive at a final projection. There are clearly a number of different paths through which the economy can evolve to essentially the same point. What is portrayed in this document is just one of those paths, but one that we feel is both realistic and sound as a base for our policy judgements. The real economy Shortly after our June Monetary Policy Statement was published, the release of March quarter GDP data seemed to suggest that the economy was significantly weaker than we had allowed for. Our subsequent analysis indicated that there were particular factors (notably that Easter, unusually, fell into the March quarter) which explained much of the small decline in GDP in that quarter. Since then, the emerging data have suggested that the economy is a little weaker than we had portrayed in June, but that it is also resuming a robust growth path. Whereas we were projecting an annualised growth rate through the first half of calendar 1997 of a little over 1 percent, the estimate incorporated in these Projections is closer to 0.5 percent. Having said that, data released since we completed the Projections are, if anything, suggestive of stronger rather than weaker outcomes for June quarter GDP. In any event, we remain of the view expressed in June that activity will pick up in the second half of the year. Over the year to March 1998, we expect the economy to expand by around 2.5 percent, accelerating further to 4.6 percent growth in the year to March 1999. The factors driving that expansion include a robust global economy, gradually increasing household expenditures, improved productivity, stronger exports (partly the result of a lower exchange rate), business investment and an expansionary fiscal policy -- both from increased government spending under the Coalition Agreement and from the tax cuts scheduled for July 1998. Easier monetary conditions since earlier this year are also supportive of stronger growth. It seems clear that, in the middle of this decade, the New Zealand economy became somewhat over-stretched in terms of its ability to support the pace of spending. It seems equally clear that the economy has entered a period in which there is some spare capacity. Given the current and imminent expansionary forces that I have described, the spare-capacity phase should be short-lived, but long enough to take the pressure off inflation, and long enough to make it unlikely that we will experience the kind of destructive crunch that has so often brought past cycles to a shuddering halt. In this sense, we are describing a growth profile that reflects the steadying influence of maintaining low inflation, which in turn should contribute to New Zealand’s future growth potential. We expect continued job creation throughout the period to March 2000, continued growth in real disposable household income (averaging over 3 percent per annum through the projection period), continuing modest fiscal surpluses, further declines in the government’s debt-to-GDP ratio, and an improvement in the current account deficit from nearly 6 percent of GDP to around 4 percent of GDP. Inflation As I mentioned earlier, our new Projections framework takes as given that inflation should converge on the mid-part of our target range, and derives the monetary conditions that are needed to achieve that outcome. In that sense there is no particular news in the fact that we expect underlying inflation to be close to the middle of the target over the projection period. But there are some aspects of the inflation track that require comment. In particular, we now expect inflation outcomes over the next two quarters to be rather higher than was the case in June. There are two principal sources of that upward revision. First, the last few months have seen a 6 or 7 percent depreciation of the trade-weighted exchange rate. The increased inflation now expected over the next two quarters is, in part, a direct consequence of that depreciation. Secondly, domestic inflation continues to be strongly influenced by the policy decisions of the Government. We now estimate that, over the next two quarters, policy-related increases in Housing New Zealand rentals and tertiary education fees could well exceed the materiality threshold which is applied in determining our measure of underlying inflation. In that event, underlying inflation would be slightly lower than the estimates given in these Projections. Policy Implications We now view an MCI level of 725 as being appropriate for the next quarter. This is 100 basis points lower than the desired MCI level which has applied for the last quarter, but roughly equivalent to actual monetary conditions over recent weeks. You will recall that a 100 point reduction in the MCI is equivalent to a 1 percentage point decline in 90 day bill rates, a 2 percent decline in the TWI, or some equivalent combination. You may also recall that the average MCI for the December 1996 quarter was 1000. The extent of easing over the past nine months has clearly been significant, although certainly off a high base. Our Projections point to further, but quite small, easings in the first two quarters of 1998 before emerging inflationary pressures lead us to expect monetary conditions to enter another tightening phase. However, as we make clear in our policy assessment section, whether those further easings eventuate in 1998 is very much dependent on how the economy develops over the next few months. Financial market participants eager to bring forward the small, and conditional, easings shown in these Projections clearly do so at their own risk! On the face of it, with inflation over the next two years, and especially over the next two quarters, being a little higher than we thought likely back in June, easing now by more than we foreshadowed in June may seem surprising. The explanation is straightforward, and relates to the lags inherent in the operation of monetary policy. While inflation is a little higher in the short term than we had previously expected, it is still well within our target range, and has been boosted by factors which should be essentially transitory, such as the impact of moving Housing NZ rentals to market. Of more relevance to the outlook in 18 months to two years’ time is the margin of spare capacity in the economy. That now looks somewhat larger than it did previously, and warrants somewhat easier monetary conditions. Although activity will be accelerating through 1998, it is not until 1999 that the inflation pressures associated with strong growth begin to emerge. A gradual tightening of monetary conditions from mid-1998 fits with that profile. There are, of course, alternative paths for monetary policy that could deliver inflation within our target range. As was discussed in June, one alternative path would involve more aggressive easing now, followed by earlier and more aggressive tightening next year. Another path would involve holding conditions relatively flat at about current levels until the latter part of 1998 before beginning a somewhat gentler tightening beyond that date. Inevitably, there is rather more art than science in selecting the best of these alternatives. What we have chosen reflects the risks that we see around us at present, and also reflects the benefits we see in providing a relatively smooth path for monetary conditions over time. The mix of monetary conditions On numerous occasions over the past year or two, I have indicated that the particular mix of monetary conditions was unhelpful -- that the exchange rate was too high, putting excessive pressure on exporters, and that interest rates remained too low to discourage borrowing for housing purposes, or to encourage increased domestic savings. The past quarter has seen a substantial, and welcome, shift in the mix of monetary conditions in the direction we believed appropriate. The fall in the exchange rate will boost the incomes of exporters and those competing with imports, and will ultimately increase export volumes. The projected improvement in the current account balance reflects that. The increase in interest rates is also helpful, given the continuing pressures we have seen in the domestic or non-tradeables sector of the economy, and especially in real estate markets. There is no benefit to New Zealand in seeing real estate prices increase to a point where they become vulnerable to a sudden, and damaging, correction. (Anyone who has been observing events in South-East Asia over the past couple of months will be conscious of the enormous damage that can be inflicted in those circumstances. Our own experience post-1987 is also instructive in that regard.) The shift in the mix of conditions, while substantial, has occurred in a manner which is fully consistent with our inflation target, and fully consistent with our use of an MCI in assessing the overall stance of monetary policy. It is certainly the case that the sharp decline of the exchange rate will boost inflation to some degree in the short term. That is already apparent in our Projections. But even with that increase, projected inflation remains well within our target range. And the increase in interest rates that has accompanied the exchange rate fall will work in the opposite direction, dampening inflation in the longer-term. The MCI At the time when the exchange rate was declining, and interest rates were rising, we heard a good deal of criticism of our MCI. It was, it was claimed, too rigid; it was forcing up interest rates at a time when the economy was already in recession; it was based on a relationship between interest rates and the exchange rate which was no longer valid; and so on. As I made clear in my speech to the Counties Kiwifruit Growers Association on 22 August, I regard those criticisms as ill-founded. I think the MCI structure has performed admirably over the past three months. In making that assessment, I think it is important to reflect on just how volatile international exchange rates have been over that period. Any of the alternative monetary policy arrangements we could have adopted in place of the MCI would also have been subject to a good deal of stress. I certainly see no reason to change the MCI approach at this point. Likewise, the description I offered in June of how the Bank might react to deviations in actual market conditions from the central or ‘desired’ MCI track appears to us to have weathered the tests of the past quarter rather well. I see no reason to modify that description now, and our response to evolving market conditions over the next three months will be consistent with my comments of June.
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Address by the Governor of the Reserve Bank of New Zealand, Mr. Donald T. Brash, to the Rotary Club in Auckland, on 6/10/97.
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Mr. Brash asks how fast the New Zealand economy can grow Address by the Governor of the Reserve Bank of New Zealand, Mr. Donald T. Brash, to the Rotary Club in Auckland, on 6/10/97. Introduction: economic growth is important Ladies and gentlemen, I am delighted to be addressing the Auckland Rotary Club today. Just 15 years ago I was a member of this Club, and I look back to that time with very warm memories. When I was invited to speak to you, I was given a clean slate: I was essentially allowed to choose my own subject. And I want to use that freedom to go beyond my usual territory, of monetary policy, interest rates, exchanges rates, MCIs and all the rest, to talk about a broader issue, namely New Zealand’s future economic growth -- what it may be, what is constraining it, and how it can be enhanced. And I want to do that for two reasons. First, because economic growth is the ultimate objective of much public policy, and that in turn because it is economic growth which gives us choices -- the ability to enjoy better quality housing, the ability to have better health care, the option of choosing more leisure, the ability to invest in environmentally-friendly production techniques, the freedom to choose between an array of options denied to those where economic growth is low or non-existent. And secondly I want to talk about economic growth because there is still a great deal of public misunderstanding about the role of the Reserve Bank and monetary policy in encouraging or discouraging economic growth. There is still quite a widespread view that the Reserve Bank’s exclusive focus on delivering predictably low inflation involves a cost in economic growth, and that if only the Bank were not so obsessive about its inflation objective the New Zealand economy could grow much more quickly. People look back to the 5, 6 and 7 percent growth rates achieved just a few years ago, and wonder why we can’t return to those growth rates. They look at our Asian neighbours expanding with breathtaking speed, and wonder why we can’t emulate them. They reflect on the painful restructuring that the New Zealand economy underwent from 1984, and ask if it was all worthwhile. Some people suspect that perhaps the Reserve Bank has denied us the benefits which should have been available. So today I want to discuss the issue of economic growth in the broadest terms. My aim is to provide a framework for thinking about what is a reasonable expectation for New Zealand’s growth, to identify some of the factors that will determine whether we are able to achieve that potential, and to discuss the linkage between growth and the Reserve Bank’s interest, namely inflation. Running the economy is like running a marathon Let me start by reminding you of the challenge facing a marathon runner. The objective is to go as fast as possible over the full distance. It makes no sense to sprint, ‘hit the wall’, and simply not finish the race, or spend much of the time on hands and knees recovering from that initial bout of excessive enthusiasm. Nor does it make any sense to walk most of the way, finishing the race with unused reserves of energy. Neither approach is likely to lead to running the race in a personal best time. And that is why experienced athletes constantly check their pace, making sure it is neither too fast nor too slow. In terms of an economy, going too fast also leads to ‘hitting the wall’, with symptoms typically being a burst of inflation, a deterioration in the balance of payments position, perhaps an asset price boom, signs of difficulty in finding skilled employees, and very often a sense of euphoria (‘look how fast I’m going and I still feel good!’). The results of hitting the wall are typically a sharp recession -- sharper still if overcooked asset prices are collapsing. To complete the analogy, in any long distance race you will find several runners who have paced themselves correctly, but who complete the race in very different times. Each may have done a personal best time, but those personal bests will be very different. So it is with economies. Some economies will be able to sustain a much faster pace than others without running into the too-fast danger territory; some will naturally grow more slowly than others, without leaving large amounts of unused energy or potential. And it is not necessarily a question of one economy being better than another; it’s just a question of being different. If that thought surprises, I’d simply note that the ‘best’, most highly productive, economy in the world -- the United States -- is also one of the slower growing economies, and has been now for some decades. What is it that determines why some economies can achieve sustainably faster growth than others? Potential growth ultimately depends on two things: quantity and quality. The quantity of people and capital, in the form of factories, forests, trucks, roads, and all the rest. And the quality of those same things. Countries that have faster potential growth rates have faster trend growth in the quantity of people and capital at work in the economy, and/or faster trend growth in the quality or productivity of those things. New Zealand’s sustainable growth now about 3 percent annually So how fast can New Zealand grow in a sustainable, or ‘long-term average’, sense? Looking forward, we estimate New Zealand’s potential growth rate currently to be around 3 percent annually -- a result of trend growth in the working age population of 1.5 percent and trend growth in output per person also of about 1.5 percent. That growth in real output per person comes from a combination of growth in the quantity of capital, and growth in the quality of that capital and the way we use it. In other words, we should expect our growth rate to average about 3 percent annually over the course of our usual economic cycles, with outcomes for any given year ranging from about 1 percent at the trough to, perhaps, 4 or 5 percent at the peak. If a 3 percent average growth rate does not sound very exciting, let’s put that into a broader context. Sustained growth of 3 percent is clearly well ahead of our experience in the seventies and eighties. Indeed, between 1975 and 1990, growth averaged less than 1 percent annually. Of course occasionally we grew more quickly than that, but those periods of faster growth were typically short-lived, and associated with unsustainably large fiscal and balance of payments deficits and rapidly increasing inflationary pressures. And the difference between a 1 percent average growth rate and a 3 percent average growth rate adds up to an enormous difference in the volume of goods and services available to New Zealanders if the difference is sustained for, say, 10 years. Today, our economy is producing goods and services totalling about $100 billion each year. If that total grows by only 1 percent a year for a decade, in 10 years’ time we will be producing goods and services of $110 billion. If the total grows at an average of 3 percent a year, in 10 years’ time we will be producing goods and services of $134 billion. The difference of $24 billion annually is a lot of additional hospital operations, or tertiary education, or restaurant meals, or overseas holidays. But what about the much more rapid growth of the 1993 to 1995 period, during which at one point growth exceeded 7 percent? Surely that shows that we are capable of much faster growth than 3 percent? Clearly we can grow faster than 3 percent at times, and we are likely to do so, just as the marathon runner can occasionally sprint. Equally clearly, however, growing at 5, 6, or 7 percent for a brief period tells us nothing about how fast we can grow on average over a longer period of time. The rapid growth which we experienced for a brief period in the 1993 to 1995 period was the result in part of adding more capital and of improving productivity, but was fundamentally the result of being able to bring back into employment the large number of people who had become unemployed during the recession of the late eighties and early nineties. You will recall that unemployment reached 11 percent of the labour force in the early nineties, and fell to 6 percent by the mid-nineties. Everybody hopes that unemployment falls below its present level, of almost 7 percent of the labour force. Growth rates aside, lower unemployment implies a huge improvement in well-being, both for the individuals concerned and for society as a whole. It is conceivable, although unlikely during the next two or three years, that we could reduce unemployment by 5 percent of the labour force again. But it is clearly inconceivable that we can do that repeatedly, since that would quickly imply negative unemployment. To the extent that the very rapid growth of the mid-nineties was a result of being able to ‘mine’ the unemployment rolls for additional workers, it is not something which can be repeated indefinitely. 3 percent growth looks good by the standards of other developed countries If we look at other countries, we find that, by the standards of the developed world, our 3 percent looks reasonably attractive. For example, the United States is generally estimated to have a growth potential of a little over 2 percent, being 1 percent labour force growth, and 1 percent annual productivity gain. Over recent months, some US commentators have wondered whether the US productivity trend has lifted -- largely as a consequence of the impact of new computer technology -- but the jury is still out on this question. Certainly the fact that US unemployment has recently been falling markedly, and now stands at 4.9 percent, its lowest level in nearly a quarter of a century, strongly suggests that recent US growth has also been dependent on ‘mining’ the unemployment rolls for additional workers, and is likely to slow as finding additional workers becomes increasingly difficult. It is also interesting to recall that, while some people have questioned why New Zealand can not achieve US growth rates, over the six years to March 1997 New Zealand grew at an average rate of 3.1 percent annually, slightly faster than the US economy grew over the same period (2.7 percent). Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, noted in a recent speech that, between June 1991 and December 1996, both New Zealand and Australia had enjoyed economic growth of 3.6 percent, and that that growth had been faster than growth in any of the other 16 developed countries against which he compared us, with the exception of Norway and Ireland. (Speech to the Australia-Israel Chamber of Commerce in Melbourne on 15 May 1997.) In other words, although it is too early to be dogmatic -- given the influence of cyclical factors on growth rates measured over relatively short periods -- New Zealand does appear to have made a significant gain in its growth potential in recent years, and to have lifted its performance from near the bottom of the class to somewhere rather closer to the top of the class of developed countries. Why do the Asian Tigers seem so much more successful? So where do the Asian Tigers fit in -- countries that have been routinely achieving growth rates of 8 to 10 percent per annum -- and why can’t New Zealand be more like them? That’s a question that has challenged economists around the world for some time. It would be misleading to claim that any sort of consensus has been arrived at -- indeed, the debate on the sources of these extraordinary growth rates still rages. But it seems likely that the very rapid growth achieved by the Asian Tiger economies, and by China, can be explained very readily in conventional terms, by looking at growth in the inputs of labour and capital, and at productivity improvements. Thus demographics and migration trends are obviously important in determining how fast a labour force will grow. And Asian economies have experienced very rapid increases in their effective labour forces in recent years. Singapore, for example, almost doubled the proportion of its population engaged in the formal labour force between 1960 and 1990. That increase accounts for close to one-third of Singapore’s remarkable average growth rate of 8.5 percent over that period. Similarly, a few decades ago many Asian economies operated with little in the way of modern tools and machinery. In recent years, the growth in the quantity of capital has been huge. Annual investment in Singapore has consistently exceeded 30 percent of GDP, and rose to almost 50 percent at times during the seventies. Those very high rates of investment, and the ability of traditionally poor, often agricultural, economies to pick up, off the shelf, very much more productive technologies from other countries have in turn made it possible to achieve extremely rapid improvements in labour productivity. Thus for example, taking a peasant farmer employing a water buffalo and a wooden plough and giving him either a modern tractor and a plough, or a modern computerised lathe, is likely to see an extremely large increase in output per person. It seems clear that if a country has available some under-utilised labour, large amounts of capital and an ability to adopt the latest technology, perhaps through being open to foreign direct investment, it is possible to grow very quickly indeed during a ‘catch-up’ phase. But once a country reaches the developed country norms in terms of labour force participation rates, standards of education, and available technology, growth rates will also tend to slow to match the developed country norms. Japan seems to have undergone that transformation in recent years. After growing at a very rapid pace that enabled it to transform itself over the post-war period from a rather poor and war-devastated country to one having per capita incomes amongst the highest in the world, Japan’s growth rate over the past few years has been much closer to that of the ‘more established’ developed economies. Lessons for New Zealand: immigration policy, benefit policies, and education policy are all important What can we learn from this survey of growth in other countries that is relevant to New Zealand today? The most important lesson is that if we wish to lift our long term growth rate -- our sustainable average growth rate -- we have to look to those factors that are important determinants of long term growth, namely the quantity and quality of the labour force, the quantity and quality of investment, and the other factors which determine the productivity with which labour and capital are combined. The supply of labour is largely determined by population growth and the proportion of the population which is engaged in employment. We can influence population growth to some extent, by our policy on immigration. The experience of Australia, Canada and the United States -- indeed of New Zealand -- suggests that a well-considered immigration policy can have a significantly beneficial effect on an economy’s long-term growth rate not only by increasing the labour force but by bringing skills, market knowledge and capital. The proportion of the population engaged in formal employment (the participation rate) can be influenced by policy even more substantively. For example, pension and entitlement rules which impose very high effective tax rates on low income people contemplating staying in, or re-entering, the work force tend to reduce participation rates. This makes the current discussion about reforming the benefit system of direct relevance to potential growth. With an ageing population and sensible policies on retirement income, we can expect a greater proportion of the population to remain in work beyond the current retirement age and, with some evidence that people remain healthier, both physically and mentally, when they are employed, that is almost certainly something to be welcomed for reasons going well beyond potential growth rates. Moreover, we can probably expect the trend towards higher participation rates for women to continue, and this too will mean that the labour force is likely to grow rather more quickly in the years ahead than does the population generally. The quality of our labour force can also be influenced through public policy choices, but only slowly. It is abundantly clear that the process of economic development and growth goes hand in hand with enhanced educational standards. We in New Zealand once routinely listed ‘a well-educated labour force’ as one of the clearly identifiable strengths of our economy. We can no longer be so confident on that front. The capacity of today’s high school graduates to write grammatical English seems to be disappointing to a great many employers, while international studies comparing the ability of New Zealand students in mathematics and science with that of students in other countries suggest that we no longer have anything of which to be terribly proud. In the Third International Maths and Science study, New Zealand ranked 22nd out of 41 countries in science and 24th in maths. By contrast, the top four countries in maths were Singapore, South Korea, Japan, and Hong Kong, with Singapore, South Korea and Japan also occupying three of the top four positions in science. As a general proposition, those economies which have been out-performing us in terms of per capita growth have typically also been out-performing us in educational effort. Whether that is because those countries have better educational structures, or just have people who are more convinced of the crucial importance of a good education, I do not know. But the result is that the quality of their labour force is rapidly improving, whereas ours is improving rather more slowly. For the longer term, it may well be that the most important policy area relevant to improving our sustainable growth rate is education policy. The quality of management also matters, and in this regard I have no doubt that the opening up of the New Zealand economy during the last decade or so has been a catalyst for improved business management in New Zealand. Certainly poor management is no longer sheltered by regulations and tariffs which keep competitors at bay. Similarly, economies that grow strongly typically have good industrial relations. Here too we have made progress in recent years. The less centralised structures we now have for negotiating pay and conditions have been beneficial from the standpoint of encouraging both employers and employees to focus on their mutual stake in staying up with, if not ahead of, the competition. At the very least, nobody seems to want to go back to the very highly centralised industrial relations structures we had in the seventies and eighties. And the number of ‘days lost’ as the result of strikes is well down on what used to be regarded as normal. These things are all helping our growth performance. Lessons for New Zealand: policies which distort investment decisions damage our growth prospects Additional investment, so that each person employed is teamed with a greater amount of physical capital, is also crucial to our growth performance. But in some ways the quality of additional investment is even more important than its quantity. When we look at New Zealand’s slow growth period -- through the seventies and eighties -- we find that the ratio of investment to GDP was quite respectable by comparison with other developed countries. What was impeding growth was not so much an inadequate level of investment as a persistent tendency to direct capital into low-yielding activities. Perhaps the best-known examples of low-yielding investment were the ‘Think Big’ projects of the late seventies and early eighties, but a great many could also be found in the private sector. Partly because of the distortions caused by inflation, much investment was channelled into real estate investment, sometimes well ahead of demand. Partly because of subsidies, capital was invested in the production of sheepmeat for which there was no market. Largely because of quantitative import restrictions and high tariffs, a great deal of capital was invested in activities which, while profitable to the investors, added little or nothing to output valued at international prices. Worse, in some highly protected industries, when measured at international prices the value of output was actually negative. In other words, the cost of inputs, at world prices, exceeded the value of outputs at world prices. It is with those considerations in mind that countries seeking to boost their growth performance look to micro-economic reforms -- to reduced protection, to deregulation, to flatter and broader tax structures, and to increased market flexibility -- to encourage available resources of labour and capital to move into those activities where private financial returns and national economic returns are similarly high. With that, of course, goes the requirement that those same resources are permitted to move away from activities in which the returns are low. Allowing industries which depend for their continued existence on protection from imports to continue operating indefinitely may be doing a favour to the subsidised few, but it certainly does not help our growth potential. (It surprises me that we still hear, occasionally, a manufacturer argue that we should not reduce tariffs in New Zealand because other countries use tariffs to protect the internationally uncompetitive parts of their economies. Since tariffs are essentially a tax on exports, and our export industries are almost by definition those which are the most efficient in international terms, why we should tax such industries just because other countries tax their export industries is frankly beyond me.) Lessons for New Zealand: growth affected by high taxation? Attention is also increasingly focusing on the role which the total size of government plays in influencing an economy’s growth rate. In recent months, a series of studies commissioned by the Inland Revenue Department has reached the conclusion that when a government’s total tax revenue exceeds about 20 percent of GDP the impact on growth is negative. Another study commissioned by the Treasury has cast some doubt on the methodology used in the studies commissioned by the IRD, but suggests that the optimum level of taxation, relative to GDP and from a growth point of view, is probably below 20 percent. Why? Presumably because with low tax rates fewer resources are squandered in trying to minimise tax obligations, and the disincentive effects of taxation on effort and risk-taking are reduced. I myself do not know why countries with relatively low tax burdens appear to grow more quickly than those with relatively high tax burdens, or indeed whether there is any causal relationship between low tax levels and high growth. But it does seem clear that the East Asian countries where economic growth has recently been most rapid are also countries where the ratio of tax revenue to GDP is very much lower than it is in New Zealand or other developed economies. Lessons for New Zealand: growth remains heavily dependent on foreign savings One other issue deserves mention. Before a country can invest it must have access to savings -- either its own domestically-generated savings, or the savings of other countries. New Zealand has a long record of relying on the savings of others. That was hardly surprising when, as a colonial outpost, we drew on the capital of Britain to fund our development. We also relied on a flow of migrants to boost the available labour force. Together, those imported resources were combined to generate growth and wealth at a rate that was probably similar to that achieved by the Asian Tigers in the last decade or so. While the flow of migrants is generally rather smaller in modern New Zealand than was the case during the late nineteenth century, we’ve never fully weaned ourselves from a relatively heavy dependence on the savings of others. We appear to see nothing unusual, let alone undesirable, in continuing to do so indefinitely. It is not at all obvious that we would invest more, or would invest more efficiently, if we generated more savings domestically. But it seems to me, as someone who believes that our being open to international capital markets has been hugely beneficial to our economy and to our society, that we would probably face a more stable and perhaps more secure future if our dependence on the savings of others were reduced. At the very least, we need to recognise that there is little point in decrying the degree of foreign ownership of New Zealand businesses and assets if we are not also ready to decry the paucity of New Zealand savings. Growth and monetary policy So where does monetary policy fit into this growth story? It may surprise you to hear me contend that, as a determinant of long term growth potential, monetary policy has a relatively modest and indirect influence. I say that because, as I have explained, long term growth is a product of labour and capital, and how productively those two factors work together. The things which I have described as being crucial here are essentially ‘supply-side’ matters -- the rate of growth of the labour force, the quality of the education system, the extent to which government policies distort the allocation of investment, and all the rest. These are the crucial determinants of our sustainable growth rate. But monetary policy can help in two ways. First, by keeping inflation stable it can, as a by-product, assist in moderating economic cycles -- restraining demand when it threatens to exceed the economy’s capacity to supply and encouraging demand to increase when it threatens to fall short of capacity. In other words, successful monetary policy aimed at keeping inflation stable also keeps the economy’s pace as close to the optimum as possible. In the marathon analogy, successful monetary policy avoids the economy ‘hitting the wall’, but also avoids it ‘running too slowly’, with unused reserves of labour and capital. Secondly, there is now strong evidence that high inflation positively damages sustainable growth, and growing evidence that there is some damage caused even by quite low rates of inflation. Nobody argues that price stability will create a major improvement in an economy’s sustainable growth rate -- that growth rate depends primarily, as indicated, on all the real factors I have already discussed. But it now seems beyond reasonable doubt that keeping the general price level stable is the best contribution which monetary policy can make to the way in which the economy operates, and therefore the best contribution to the economy’s sustainable growth rate. In an inflation-free environment, investors and the public generally get their best shot at reading accurately the signals that markets are delivering -- which goods and services represent best value, where the best returns on investment may be found, how much to consume and how much to save. Price stability is not a sufficient condition for strong growth. It is not even a necessary condition for strong growth. It is just the best contribution which monetary policy can make.
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Address by the Deputy Governor of the Reserve Bank of New Zealand, Mr. Murray Sherwin, to the Annual Conference of the New Zealand Forest Owners Association in Auckland on 12/11/97.
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Mr. Sherwin considers growth, productivity and monetary policy: the longer-term perspective Address by the Deputy Governor of the Reserve Bank of New Zealand, Mr. Murray Sherwin, to the Annual Conference of the New Zealand Forest Owners Association in Auckland on 12/11/97. Introduction: competitiveness and productivity I have been asked to discuss the New Zealand economy in a medium-term context, with particular reference to the place of forestry. I am conscious also of the overall theme of this conference -- The Competition Gap. I applaud the Association for choosing to focus on that theme, because while that is clearly a very relevant issue for the forestry sector to be debating, it is equally relevant to the broader economy. We all wish to raise living standards in New Zealand. The reform effort of the past 13 years has been focused on precisely that goal. To achieve it, we require a sustained lift in productivity, across the New Zealand economy. Improved productivity and “meeting the competition gap” are one and the same thing. It is not my intention to provide a substantive projection of New Zealand’s economic prospects over the growth cycle of a GF17 pine tree. Nor do I intend to discuss the likely prospects of the forestry sector. Rather, I will try to lay out a few of the very broad factors that will shape the development of the New Zealand economy over the medium term, and to reflect a little on the factors that influence interest rates and exchange rates over longer time horizons. The determinants of economic growth Last month, Governor Don Brash delivered a speech to the Auckland Rotary Club under the topic “How Fast Can the New Zealand Economy Grow?” The key theme of that speech was that our growth potential is determined ultimately by quantities and quality. The quantity of people and the quantity of capital -- in the form of factories, forests, trucks, roads, computers and all the tools of a modern economy. And the quality of those same inputs -- how well they work, and how efficiently they are deployed. As Dr. Brash went on to say, the Reserve Bank believes that New Zealand’s longer-term growth potential is probably of the order of 3 percent annually at present -- a result of a trend growth in the working age population of around 1.5 percent and trend growth in output per person, or productivity, also of around 1.5 percent. Lifting that growth potential requires bigger quantities or better qualities -- of people, attitudes, and equipment. On the quantities side, we can’t do a great deal in the short term about the size of the working age population. After centuries of diligent practice, it still takes around 9 months to produce a new Kiwi and, only a little quicker than Pinus Radiata -- around 20 years -- to get that new Kiwi into the work force. Of course, we can import new workers “ready built up”. But even then, as we have discovered in recent years, there are limitations on how quickly new immigrants can be absorbed. In any event, while increasing the size of the labour force may enable us to boost overall economic growth, what really matters for living standards is per capita growth. And that means we need to focus on output per person, or the productivity of our work force, not just its raw quantity. In the longer term, and at the risk of doing some violence to the wealth of economic research on the subject, productivity is heavily dependent on one key factor -- the quality of our human resources. Living standards rise on the back of overall educational attainment and attitudes. That implies a continuing need to raise the quality of our general educational effort. It means raising the numbers participating in higher education. It means improved on-the-job training. It means better-trained managers able to make smarter decisions and provide improved management of our work force -- in the forest, on the factory floor, in the research laboratories, within both the public and private sectors. And it means smarter governance from within the nation’s boardrooms. The role of capital investment Intertwined with the quality of our work force and how well it is managed is the issue of the quality and quantity of physical capital available to each person. By teaming better-trained people with better technology and working with more and better physical capital we can provide a recipe for making serious progress in raising productivity. And through that, we can make serious advances in our living standards. New Zealand’s history provides some useful insights into the role of capital investment. During our slow growth phase -- through the 1970s and 1980s -- our investment levels were quite respectable by the standards of other developed economies -- somewhere around 25 percent of GDP per annum. What was impeding growth was not so much an inadequate quantity of investment, but poor quality investment -- a persistent tendency to direct capital into low-yielding activities. The sources of that misdirection of capital are not hard to find. They lie with government-led investment decisions -- for example, “Think Big” projects -- and with investment encouraged into sectors or activities sheltered by protections of various kinds. It is those protections -- the import quotas, licensing arrangements, or tax incentives -- that produce situations in which the returns to private investors become disconnected from the underlying market realities. The individual investor may be profiting as a consequence of those protections, but only at the cost of overall national efficiency and income. Raising productivity means allowing change It is with those considerations in mind that countries seeking to boost their growth performance look to micro-economic reforms -- to reduced protection, to deregulation, to flatter and broader tax structures, to increased market flexibility -- in order to encourage available resources of labour and capital to move into those areas where private financial returns and national economic returns are similarly high. Of course, encouraging the flow of resources into higher-yielding activities also implies that those same resources, labour and capital, are permitted to move away from activities in which returns are low. So when we see sheep and beef farms being converted into either dairy units, on the one hand, or pine forests on the other, we need to check if there are particular regulatory or taxation reasons encouraging that shift. If there are none, we are entitled to conclude that rational investors are making a judgement that the future returns on investment in dairying or forestry are likely to be superior to the future returns on sheep and beef farming. Moreover, we are entitled to presume that, as a result of that changed land use, our national growth potential will be higher. The efficiency of our capital stock will have increased. Of course, rational investors may be wrong in their judgements. Only time will tell. But so long as those investors are risking their own money, in an efficient regulatory and tax environment, we stand the best possible chance of maximising the performance of the economy overall. One message should be very clear. We cannot lift our economic performance by locking land, labour or capital into low-yielding activities. Lifting our growth performance will inevitably mean continuing change, including the decline of some sectors, in order to free resources for movement to expanding, higher-yielding activities. And in a world of ever-faster innovation, the high performance economies are likely to be the more flexible ones -- the ones most able to quickly take up emerging technologies and production processes and to encourage the shift of resources from one industry or production technique to another. Monetary policy has a background role in facilitating faster growth You will note that so far I have managed to avoid any mention of monetary policy or the role of the Reserve Bank in all of this. Interest rates and exchange rates haven’t entered the equation. That’s because monetary policy and the Reserve Bank have an important, but essentially “background”, role in allowing the economy to achieve its longer-term growth potential. A couple of points are relevant here. What I have discussed so far are the “real” contributors to economic growth -- the quantity and quality of inputs. These are the “supply side” factors. Monetary policy and the Reserve Bank operate on the demand side. The task of monetary policy is to maintain price stability. That involves ensuring that demand in the economy grows roughly in line with the capacity of the economy to meet that demand. The Reserve Bank’s Policy Targets Agreement (PTA), signed by the Minister of Finance and the Governor, sets a 0 to 3 percent inflation target as the Governor’s sole objective. The PTA establishes that single objective of price stability “... so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy”. The rationale for that position is quite straightforward, and is particularly relevant to a sector such as forestry, which involves such long investment horizons. In an inflation-free environment, investors and the public generally get their best shot at reading accurately the signals that markets are delivering -- which goods and services represent best value, where the best returns on investment may be found, how much to consume and how much to save. Simply adopting an easy monetary policy does nothing to increase the supply of labour or its skill level. It does nothing to improve the availability of better technologies. But most importantly, an easy monetary policy that gives rise to a risk of future inflation is likely to divert investment and the flow of resources away from sectors with longer-term investment horizons -- such as forestry -- towards quick-return real estate and similar investments that exploit the tax and other distortions which emerge in an inflationary environment. Once price stability has been achieved, monetary policy is essentially an exercise in smoothing economic cycles -- slowing the economy when it looks likely to overheat, stimulating it as activity slows. That is not a straightforward exercise. Even if we get it right, (and we won’t always) there will still be economic cycles. But we should be able to avoid the boom/bust cycles of old. If our longer-term growth potential is around 3 percent, it is probably the case that growth outturns in the 1 percent to 5 percent range will be the norm. Occasional external shocks and surprises -- climate, international events, and so on -- may take us outside that range. But surprises of that sort should be rare. However, a sustained growth performance within a range of that sort would represent a substantial step up from our experience through the 1960s and 1970s, and would place us somewhere near the top end of the OECD growth league. Interest rates are determined by international conditions and local risk factors So what does that mean for interest rates and exchange rates in New Zealand over the longer term? Essentially, in our world of open capital markets, interest rates in New Zealand will tend to settle at some margin above or below a benchmark set in US financial markets. How large that margin is (and whether it is positive or negative) will depend on the risks and returns that savers, both domestic and foreign, associate with New Zealand. There are, of course, many different risks that enter that assessment. But a key one is the risk of future inflation. A firm commitment to the maintenance of price stability is already resulting in substantially lower interest rates in New Zealand. The rate paid by the New Zealand Government on its New Zealand dollar 10-year bonds has fallen from around 10 percentage points above that paid by the US Government on 10-year US dollar bonds in the mid 1980s, to little more than half of one percent above the US rate. Our shorter-term interest rates have also fallen sharply relative to those in other countries over the past decade or so, but they remain high by OECD standards, and high in real terms. That will remain the case so long as the strong demand for borrowing that we have seen over the past several years continues. On that note, it is worth reminding ourselves that the route to consistently lower interest rates lies in allowing both savers and borrowers to become confident that the risk of future inflation is slight. We can’t look to the exchange rate to boost international competitiveness A conference examining competitiveness may find it tempting to look to the exchange rate for salvation at some point. Don’t bother. The forestry industry, like every other export industry in New Zealand, is going to have to live with an exchange rate that varies. There is nothing you can do about that, and there is nothing the government or the Reserve Bank can do about that. We live in a world of floating exchange rates. While it is conceivable that we could fix our exchange rate to the US dollar, or the Australian dollar, or even the TWI (as we once did) we can’t fix to all simultaneously. Inevitably we have to learn to cope with exchange rate variability. In fact, on measures of shorter-term exchange rate volatility, the New Zealand dollar is a surprisingly good performer. Day-to-day volatility of our currency is modest when measured alongside the experience of other developed countries -- even those much larger than New Zealand. To assess the impact of longer-term exchange rate trends, we need to look to measures of the “real” or inflation-adjusted exchange rate -- because that is what matters for exporters. On that basis, we find that the New Zealand dollar moves through the inevitable cycles, but will typically be found within about 15 percent to 20 percent of its longer-term average. Our recent experience has been consistent with that. The real TWI was around 10 percent below its long-term average at its last trough in 1992. At its recent peak, in April of this year, it was around 17 percent above that same longer-term average. While cycles in the real exchange rate of that amplitude can certainly create discomfort for exporters, it is clear that they are well within the range experienced by other currencies. In essence, exporters should be factoring cycles of that sort into their business planning. It is clearly relevant to the variability of their future earnings stream, and therefore, to the value of their assets and to the nature of the capital structure they require to stay in business. Of course, it is also relevant to their balance sheet management and to risk-hedging strategies they may need to adopt. The best contribution that governments and central banks can make to moderating real exchange rate cycles is to embrace policy consistency and transparency -- in monetary policy, fiscal policy, and in tax and regulatory policies. The decline in exchange rate volatility in recent years provides some evidence to support that. One point we should all be clear on. There is no future in thinking we can pursue competitiveness, in forestry or any other sector, through attempts to use monetary policy to engineer a weaker exchange rate. I say that for several reasons: • Competitiveness and the productivity improvements that ensure competitiveness are products of “real” advances in efficiency, technology and management. Lowering the exchange rate makes no one more efficient. • The focus of monetary policy on the single objective of price stability is key to convincing savers and investors that, in taking their decisions, they do not need to factor in a large inflation risk. It is only in that way that we can get sustainably lower interest rates. • As our own history well demonstrates, any short-term gains that may be available to exporters as a result of a one-off depreciation of the exchange rate are quickly eroded as future inflation increases. As a fix for competitiveness problems, exchange rate depreciations are both addictive and ultimately destructive. • Central banks do not determine real exchange rates in the long term. Markets and relative economic efficiency/productivity trends determine real exchange rates. What of the balance of payments deficit? Let me touch on one other issue that is relevant to the longer-term behaviour of the New Zealand dollar and New Zealand interest rates -- the balance of payments. We are currently running a current account deficit of the order of 6 percent of GDP. That puts us amongst the largest external deficits in the OECD. Note also that New Zealand’s net foreign debt currently amounts to around 80 percent of GDP -- which puts us at the top end of international experience. To prevent that external debt ratio from increasing further, it is necessary for the current account deficit to decrease to less than the annual growth of GDP -- ie, to something less than about 3 percent. The key issue here is domestic savings behaviour. To the extent that domestic savings are insufficient to fund the nation’s investment needs, we must rely on foreign savings. And if we are reliant on foreign savings, we must, by definition, continue to run a current account deficit. That is a simple accounting identity. I note with interest the estimates of some commentators who suggest that the forestry industry alone will require substantial volumes of foreign investment over the next few years. They may be correct in their estimates of investment needs. But if those needs are met from foreign investment, we must accept that that is equivalent to saying that New Zealand must continue to run a current account deficit. Will New Zealand generally, and the forestry sector in particular, have difficulty attracting the investment capital it requires? Probably not. So long as investors have confidence in the quality of our industries, the reliability of future earning streams, and the quality of our future macro and micro economic policies, it is unlikely that we will have difficulty in attracting the necessary investment. We compete in a global market to sell our products. Equally, we compete in a global market to attract savings for investment. The pool of savings available globally is enormous, and New Zealand’s needs represent just a minute fraction of that available. New Zealand need not, therefore, regard itself as investment constrained. But to the extent that our domestic savings fall short of the levels required to fund our investment needs, our external debt ratios continue to rise, then the risks perceived by potential investors will also rise. With higher risks come increased interest rate margins. It is probably also the case that those high external debt ratios leave New Zealand a little more vulnerable to shifts in international market sentiment, which may reveal themselves in sharp and sometimes disruptive movements in interest rates and exchange rates. For those reasons, it is our belief that New Zealand would face a more secure future if our dependence on the savings of others were reduced.
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Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Single Financial Services Market Conference in Wellington, on 19/11/97.
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Mr. Brash looks at the implications of the global financial marketplace for New Zealand Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Single Financial Services Market Conference in Wellington, on 19/11/97. Introduction It’s a great pleasure to be here today to share some thoughts with you on the global financial marketplace, and its implications for New Zealand. We have recently had a dramatic example of how events in one country can spread rapidly. The recent share market collapse that began in Hong Kong and spread to equity markets around the world, including New Zealand, illustrates just how integrated global financial markets have become. Designing and implementing an effective financial policy in pursuit of national goals, in a world of highly integrated capital markets, is one of the most topical and challenging tasks in central banking today. To keep my presentation today within manageable bounds, and reflecting my professional interest, I will constrain my comments to one of the important functions of a central bank, namely, the preservation of stability in the financial system. Our focus at the Reserve Bank is on promoting the maintenance of a sound and efficient financial system in New Zealand. This focus involves establishing a policy environment to counteract the possibility of contagious spread of financial distress, and in particular is aimed at encouraging prudent bank behaviour. I will begin by sketching out some of the key trends in global finance, and will then describe the international regulatory response to these developments. Along the way, I will tease out the implications for New Zealand, and test our approach to banking supervision against these global developments. I will conclude with some crystal ball gazing. Trends in the global financial marketplace Let me begin then with some observations on the rapidly changing global financial marketplace. It is now a commonplace that barriers between countries and financial markets, at least in developed countries, have largely disappeared, and this fact, together with new technologies, new financial instruments and new funding techniques, means that financial intermediation is increasingly global. Fundamental to this trend has been the way in which advances in computer and communications technology have reduced the costs of cross-border transactions by lowering the costs of collecting and analysing data, undertaking transactions, clearing and settling payments and monitoring financial flows. And the cost reductions have been very dramatic. A recent article in The Economist noted that “the cost of a three-minute telephone call between London and New York has fallen from US$300 (in 1996 dollars) in 1930 to US$1 today”. The same article stated that “the cost of computer processing power has been falling by an average of 30 percent a year in real terms over the past couple of decades”. Such trends allow both the users of financial services and financial institutions themselves to look to global solutions to meet their financial needs. Funds can now be raised and invested, currencies exchanged, and financial risk positions changed around the world at almost anytime. Contributing to the globalisation of finance has been the rapid trend towards financial market liberalisation. This has seen country after country freeing up their financial system. In that process, exchange controls (that had been intended to isolate domestic markets from global influences) have been dismantled. In the increasingly integrated global capital market that has resulted, global financial firms with often complex financial and corporate structures have emerged as dominant players. These firms are to be found operating around the globe -- relatively low transaction costs and the application of new technologies allow such firms to be active players in whichever of the world’s financial markets they want to participate in. Distinctions between different types of financial institutions are breaking down as a result of the growth of these conglomerate structures, the relaxation in regulatory constraints, and the way in which derivatives can be used to transform the risk characteristics of institutions’ portfolios. A related development is that the risk management practices of global financial firms are becoming increasingly centralised as competitive pressures drive financial organisations seeking the highest risk-adjusted returns for shareholders. With the processing power of modern computers, it is now possible for the risk and return characteristics of large and complex portfolios to be managed centrally and, if not real time, at least on an intra-day basis. Virtually all large bank holding companies are now operated and managed as integrated units. This trend towards centralised risk management raises some fundamental policy issues as to how best to regulate and supervise such large and complex banking organisations. Product innovation has gone hand in hand with liberalisation. One of the more significant developments has been the emergence of derivatives such as financial futures, swaps and options. The total risk of more traditional financial products has been broken into component parts and repackaged into synthetic products that have risk profiles similar to other financial instruments. The synthetic products can then be sold to those domestic and global investors willing and able to bear the associated risks. Such products are now used extensively throughout the world to help firms manage the exposure to interest rate and exchange rate movements that occur in liberalised financial markets. And innovation is ongoing, as is evident with the increasing application of derivatives to credit risk. The rapid globalisation of finance is well illustrated by the phenomenal growth in cross-border financial activity. An April 1995 survey by the Bank for International Settlements estimated that an average of US$1.2 trillion flowed through the world’s foreign exchange markets each day, up 45% on three years earlier. Estimated turnover of over-the-counter derivatives on an average day was US$880 billion, 70% of which involved transactions with counterparties in different countries. An article in Institutional Investor in August 1997 provides another illustration of the magnitude of cross-border finance -- “nearly US$150 billion of net new private capital poured into the main Latin American and Asian economies in 1996, almost double the 1995 level”. These numbers are enormous however you want to look at them. New sources of systemic risk The globalisation of finance, the liberalisation of financial markets and rapid technological change have opened up new opportunities in commerce for achieving economies of scale, and facilitating the international rationalisation of production and distribution. The resulting benefits include productivity growth and improving living standards. Innovations like derivatives improve the efficiency of financial markets. New technology allows sophisticated management information and control systems, and the application of complex analytical models to help institutions manage risks more effectively. But while considerable benefits flow from such developments, they also inevitably bring with them new risks. One of the most important from a central banker’s perspective is the introduction of new sources of risk to the stability of the financial system: • Liberalisation and globalisation bring competition, which squeezes out the rents created by previously protected markets. This produces efficiency gains but it also means that financial institutions in the new environment have less of a buffer of protected profits and are therefore more vulnerable to distress caused by either mismanagement or misfortune. • Derivatives bring new risks in that they can expose financial institutions to greater leverage, thereby allowing for shocks to be amplified. In addition, they increase the linkages between national financial markets, which means that adverse events are quickly transmitted from one market to another. • Furthermore, market participants can now react very rapidly to a problem in a particular country, or even a perceived problem. Capital can move rapidly and in large volumes. Again, a disturbance in one country can now flow rapidly to other countries with the result that other countries’ financial systems, and the international financial system more generally, are arguably more exposed to disturbance than before globalisation. In the light of these increased risks, it is worth recalling that there have been relatively frequent episodes of national financial instability over the past couple of decades. Since 1980, over two-thirds of IMF member countries have experienced at least one serious banking-sector difficulty. And, in more than 65 emerging country cases, bank losses nearly or completely exhausted the banking system’s capital. In more than a dozen countries in the emerging markets of Asia, Latin America and Eastern Europe, financial collapses have required budgetary expenditure of more than 10% of GDP to resolve. Some industrial countries have also experienced major financial problems over the same period. The list includes the United States, Japan, France, Sweden, Finland, Norway and Spain. In Sweden, for example, 18% of bank loans were lost between 1990 and 1993 with two of the largest banks being bailed out by the state. These and more recent episodes of bank distress, such as Mexico and Thailand, suggest that there is no evidence that financial sector fragility is reducing with time. While New Zealand has not experienced bank problems of the magnitude that I have just described, there have nevertheless been occasions of serious bank distress. In 1989-90, the Bank of New Zealand (which was government-owned at the time) had to be re-capitalised twice by the Government, at a total cost of about 3% of government expenditure. NZI Bank would certainly have failed had it not been re-capitalised by its parent in Scotland. A very significant non-bank financial institution, the DFC, was placed in statutory management in 1989 when it became insolvent. A national financial crisis can not only have a severely adverse impact on the economy of the country directly concerned, it may also threaten the stability of the international financial system. A recent example was Mexico in early 1995. A build up of short-term US dollar-linked debt, combined with the devaluation of the peso and a sharp rise in interest rates, undermined the solvency of most of the Mexican banking system and resulted in a liquidity crisis. International investors shifted their claims away not just from Mexico, but also from other countries where similar weaknesses were suspected. Instability in the international financial system can arise not only from the transmission of a national problem but also from a breakdown in the normal functioning of critical financial interconnections between countries. What I have in mind here are the payments and settlements processes that link national financial systems. This is not a new source of risk, and the best known illustration of the problem was the failure of Bankhaus Herstatt in 1974. This small German bank was active in the foreign exchange market. It defaulted after receiving Deutsche Marks from international banks but before the matching US dollar leg was processed later in the day. This left its counterparties exposed to the full value of the Deutsche Marks delivered. This event severely disrupted CHIPS, the main clearing system for US dollars, led to a collapse in trading in the US dollar/Deutsche Mark market and even resulted in disorder in the inter-bank money markets. The circumstance that led to Herstatt risk is still present today, namely the time lapse between the payment and receipt of currencies in foreign exchange transactions. What is different now is the exponential growth that has occurred in foreign exchange transactions since 1974. In the late 1990s, if a major international bank were unable to meet its obligations in settling an average day’s foreign exchange transactions, it would have serious ramifications for the stability of the international financial system, as well for domestic financial markets. Globalisation of finance to date has been most marked in wholesale business. But technology in the form of the Internet is now beginning to allow for retail products to be advertised and sold from anywhere in the world, and paid for electronically by anyone in any other country. There seems little doubt that, when our next conference on financial services is held, this trend to the globalisation of retail financial services will be an important theme. In any event, there is no doubt that finance is now global. Nor is there any doubt that new sources of systemic risk have emerged from the liberalisation of financial markets, from the increased size and greater complexity of institutions, from the greater complexity of some of the new financial instruments, from the greater volume and speed of transactions, and from the increased involvement in the global financial system of national banking systems which are themselves suffering considerable strains. It is probably fair to conclude that, while the threat of serious disruption to the international financial system remains relatively small, should serious disruption occur it could have disastrous consequences for living standards around the world. Regulatory response Faced with these new sources of risk, the objective of safeguarding the soundness of financial systems has become a top policy priority both nationally and internationally. Most obviously, the trend towards large and complex global financial institutions, centralised risk management and the blurring of boundaries between different types of financial institutions is leading to a change in regulatory structures. Generalising somewhat, the traditional approach to regulating the financial industry was for there to be a bank regulator, a securities industry regulator, an insurance industry regulator and so on. This decentralised approach to regulation was seen as being appropriate when institutions were clearly delineated and decision-making was decentralised. However, in today’s world of conglomerate financial institutions where decision-making and risk management are centralised, the traditional regulatory approach is seen as being inadequate by many countries. Exposure of a bank to potential risk, for instance, cannot be evaluated independently of the condition and management policies of any conglomerate to which the bank belongs. Whereas efforts have been made in some countries to co-ordinate and exchange information between different kinds of supervisors, in other countries the supervisory structure has been changed so that all financial institutions are supervised by one “umbrella-type” supervisory body. Recent developments in this direction have been seen in Australia, with the Australian Government adopting the recommendations of the Wallis Inquiry. This will see the establishment of the Australian Prudential Regulation Authority to oversee all financial institutions in Australia. Similarly, the new United Kingdom Government has decided to establish a new “super-regulator” that will bring together nine financial regulators in one organisation. New Zealand’s regulatory approach Given that the banking industry in New Zealand has always been dominated by foreign-owned banks, particularly from Australia and the United Kingdom, any development that makes supervision of the parent bank more effective is welcomed by us. From the Reserve Bank’s perspective, though, we have not seen a pressing need to change our regulatory structures in a similar way. The reasons for this are two-fold. First, we take a rather different approach to promoting financial system stability, an approach which relies less on direct regulation and more on the use of market disciplines and the internal incentives for banks to behave prudently (I will return to this shortly). Secondly, we see our present regulatory structure as being effective. Over recent years, our regulatory structure has been closely aligned to a public policy approach that recognises that open and competitive financial markets are desirable. Within this, all of the key areas where private sector failure may occur have been covered in a way that meets our circumstances. Hence, the Reserve Bank is responsible for the maintenance of the financial system’s soundness and efficiency, with our attention focused on the banking sector, where any systemic problems, if they were to occur, would arise. The Commerce Commission has responsibility for protecting the consumer against exploitation and unfair trading. And the Securities Commission is focused on improving the efficiency and fairness of the markets for securities (widely defined) of entities that raise funds in New Zealand. This approach recognises that in New Zealand systemic issues are central in the supervision of banks, whereas in non-bank financial services consumer-protection issues are more important. There has been a strong presumption in economic policy development in New Zealand over the last decade or so that market forces generally produce better outcomes than those arising from bureaucratic rules and regulations. Our approach to banking supervision reflects this. We start with the presumption that financial markets contain powerful and flexible disciplinary mechanisms for rewarding good bank performance and penalising imprudent bank behaviour. Given the widespread public belief in most countries that “governments never allow banks to fail”, we do not argue that market forces alone will do the job, but we do see the disciplines of the market as being the dominant and most effective means for promoting a robust financial system. There are three key elements in our market-based approach to banking supervision. • The first is to ensure that the marketplace has sufficient and reliable information on banks on which to base financial assessments and decisions. This is achieved through a public disclosure regime which requires banks to publish a comprehensive range of financial, corporate and risk-related information for the bank and its banking group at quarterly intervals. • The second important element is to promote market discipline by ensuring that government policy supports, or at least does not impede, the development of active inter-bank markets, the diversification of funding instruments and sources, the development of institutional investors and the entry of sophisticated foreign players to the financial market. The rationale is that professional players are the market’s strongest disciplinary force. • The third key element has been to strengthen the incentives for the directors and management of banks to manage their banks’ affairs in a sound and responsible manner. An important aspect of this is a requirement for the directors of banks to attest to the accuracy of the information in the quarterly disclosure statements, to the fact that their banks have satisfactory risk management policies and to the fact that these are being properly applied. This approach, of harnessing market forces and using improved internal governance to promote financial system soundness, is gaining some support in the international supervisory community, and among academics. This can be highlighted by recent comments from three prominent and highly respected individuals. • “As financial transactions become increasingly rapid and complex, I believe we have no choice but to harness market forces, as best we can, to reinforce our supervisory objectives. The appeal of market-led discipline lies not only in its cost effectiveness and flexibility, but also in its limited intrusiveness and its greater adaptability to changing financial environments. Measures to enhance market discipline involve providing private investors the incentives and the means to reward good bank performance and penalise poor performance. Expanded risk management disclosures by financial institutions is a significant step in this direction.” Alan Greenspan, May 1997.1 • “For major banks in industrial countries ..... there needs to be a shift of emphasis towards the re-inforcement of internal managerial risk-control mechanisms, and a recasting of the nature and functions of external regulation, away from generalised rule-setting and towards establishing incentives/sanctions which reinforce such internal control mechanisms.” Charles Goodhart, June 1997.2 • “Much recent thinking has focused on incentive-compatible regulation -- using the market’s own internal forces -- as the promising next step for strengthening the financial system. It is 1 Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr Alan Greenspan, at the Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on 1 May 1997. 2 From “Financial Regulation: Why, How and Where Now?” Charles A.E. Goodhart et al, 6 June 1997. (Charles Goodhart was for many years at the Bank of England and is now Deputy Director and Norman Sosnow Professor of Banking and Finance at the London School of Economics.) banks’ shareholders and management that have the strongest interest to measure risk accurately.” Andrew Crockett, September 1997.3 To illustrate the evolution that is taking place in supervision, let me cite one example. In a recent initiative by the Basle Committee on Banking Supervision to amend the Capital Accord to include market risk, a greater role has been given to banks’ own internal models in the measurement of market risk. This reflects a move away from regulation that relies on detailed rules to an approach that places more emphasis on the adequacy of internal risk control mechanisms. Such an approach recognises that it is bank directors and management that have the strongest interest and ability to measure risk accurately, and that an internally-generated measure of risk should be better than one derived from that imposed by supervisors. The ongoing challenge to regulators is to ensure that incentive structures are conducive to this outcome. My own perspective is that a paradigm shift in supervision towards harnessing market forces will make a more significant contribution to promoting sound and efficient financial systems than simply changing regulatory structures within the same external regulation paradigm. Although it is far too early to make conclusive assessments of the success or otherwise of our new supervisory approach (which has now been in operation for nearly two years), I am satisfied that it is encouraging prudent behaviour by banks in New Zealand, and thereby is reducing the likelihood of financial system instability in the future. Moreover, I am confident that it is doing this at lower efficiency, compliance and taxpayer costs than other supervisory options might be expected to achieve. Payments system reform So far, I have discussed the regulatory response to the globalisation of finance in terms of the health of the individual institutions that make up the financial system. Of equal significance to financial stability in this new environment is how resilient payment and settlement systems are, both domestically and internationally. In common with most central banks around the world, we have been devoting considerable attention to payments system reform. Our main focus to date has been developing a real time gross settlement system for large-value transactions between banks. Until quite recently, the standard form of settlement was end-of-day net settlement: all payments and receipts between banks were allowed to accumulate during the day, to be settled by transfer of the very much smaller net amount at the end of the day. The risk of this form of settlement is that it usually requires participants to grant unsecured and unlimited credit to other participants during the period until final settlement occurs. Credit extended to a single counterparty can in some cases exceed a bank’s entire capital. One important solution which has been implemented in some countries, and which we have as a high priority to implement within the next few months in New Zealand, is the replacement of this traditional end-of-day settlement arrangement with an RTGS system. Individual transactions under RTGS are settled one-by-one during the day rather than being allowed to accumulate, thereby removing the very large exposures that can 3 Speech by the General Manager of the Bank for International Settlements, Mr Andrew Crockett, at the Money, Macro and Finance Conference held in Durham on 11 September 1997. build up between banks. Once implemented, RTGS will be a significant milestone in the reduction of domestic payment system risks. Another important initiative that we are promoting to reduce systemic risk is to make bilateral and multilateral netting arrangements for certain transactions legally binding. With legally enforceable netting arrangements in place, the various “gross” obligations to make payments can be offset against one another, and it is only the net amounts due which are called into question in the event of a bank failure. Our attention is also being actively focused on dealing with settlement risk in cross-border foreign exchange transactions. As already noted, the value of foreign exchange deals that are now being settled is so substantial that the resulting settlement risks can be of a size to cause systemic concern for both national and international financial systems. This risk, mentioned earlier in my presentation, is often referred to as Herstatt risk. As in New Zealand, much international attention is currently being focused on this problem. Co-operation amongst supervisors My final comments on the response of regulators to global financial trends concern the co-operation among supervisors and international agencies to address the potential for systemic disruption. These efforts have gained momentum over the last decade as the inherent tension between nationally-based regulatory structures and an increasingly globalised financial sector has become apparent. Co-operation among bank supervisors under the auspices of the Basle Committee on Banking Supervision has produced a number of important agreements on the supervision of banks, including minimum capital standards and minimum standards governing the supervision of banks’ cross-border establishments. Similarly other supervisors, such as the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), have pursued co-operation in their areas of responsibility. And in the early 1990s, in recognition of the emergence and growth of financial conglomerates, banking, securities and insurance supervisors from G-10 countries began to work together to identify problems that conglomerates can cause and to consider ways to overcome them. The Mexican crisis in 1995 in particular, and the widespread incidence and high cost of banking problems more generally, have prompted calls for concerted international action to promote the soundness of financial systems. These calls have strengthened over the last couple of years with the G-7 countries calling for “the adoption of strong prudential standards in emerging countries” and encouraging the international financial institutions to “increase their efforts to promote effective supervisory structures in these economies”. The Basle Committee on Banking Supervision has been at the forefront of this effort over the past year with the release of its Core Principles for Effective Banking Supervision. These principles have quickly become the focal point for the increased efforts to strengthen financial sectors around the world. Also aiming at more effective bank supervision, the IMF is making the evaluation of financial supervision and regulation part of its annual country reviews, and the World Bank is emphasising the strengthening of financial infrastructure as an important part of its structural assistance programmes. A comment on the international supervisory response While the international regulatory response has many positive elements, to me it has not always been appropriately focused. Often following a crisis, there are calls to “strengthen supervision”. For various reasons, I feel that these calls, or the ways in which they have been answered, have not always been well directed. Let me briefly elaborate on why I think this. At both the national and the international levels, the nature of the policy response to a crisis needs to be based on a careful analysis of the “problem”. It is certainly clear from the record that there have been significant weaknesses in some countries’ banking systems, and that these weaknesses have both contributed to the emergence and severity of financial crises and complicated the task of resolving them. However, I am somewhat sceptical of the general proposition that “poor supervision” has been the primary cause of these weaknesses. There has been a tendency to give supervision the “blame” for problems which have originated elsewhere, and/or to seek supervisory remedies for problems which might well be better solved in other ways. I would note further that “supervision” (in its general sense) has sometimes been part of the “problem” rather than part of the “solution” -- particularly when it has involved excessive forbearance by the regulatory authorities, and/or excessive reliance on the public safety net. I think it important that we supervisors should be appropriately modest about what we can achieve, and supervision should not be seen as an assured remedy for all potential problems. Establishing price stability and a sustainable fiscal position are also critical elements in the pursuit of sound financial systems. While weakness in the financial system can have macroeconomic implications, the reverse is also undoubtedly true -- unsound macroeconomic policies can have long-lasting effects that lead to weakness in financial systems. Excessive credit creation and inflation are obvious examples. Some observers have suggested that virtually every major financial system problem in the last two or three decades was caused, directly or indirectly, by unsound macroeconomic policies. Some of the international regulatory responses also do not sufficiently recognise that the objectives of bank supervision, and the infrastructure within which supervision takes place (for example, the quality of company law, accounting standards, and external auditors), are not the same in all countries. To have any chance of being successful, international initiatives will need to be flexible enough to suit this wide variety of national circumstances. For emerging countries where the banking infrastructure may not be well developed, it may well be sensible to actively pursue financial stability through improving the quality of prescriptive rules. In this regard, the initiative by the Basle Committee to establish an international standard of core principles for effective supervision may be helpful. But regulators in many developed countries are finding that the complexity of banking, the blurring of functional dividing lines amongst financial institutions, globalisation, and the speed of portfolio adjustment are making external regulation based on standard rules less effective and less feasible. This is resulting in an increasing emphasis being placed on internal risk management processes and in harnessing market disciplines to promote prudent banking behaviour. What this suggests to me is that the regulatory approach followed by a particular country will need to fully reflect its own circumstances. Attempting to apply a “one-size-fits-all” approach to all countries is likely to be ineffective, and may even be counterproductive. - 10 - The Future So, what do I see as being the likely issues of the future? What is certain is that the future will surprise us! But some things seem likely. Innovation in the financial sector will continue, as will the integration of the world’s financial markets. Using market disciplines to strengthen the financial system also seems likely to grow in relative importance. New Zealand’s approach to promoting financial system stability is entirely consistent with the global trends that I have described and, in particular, with the “incentive-compatible” approach to regulation. It seems absolutely appropriate for our circumstances. There will inevitably need to be refinements made to our regulatory approach from time to time, but I believe that the principles on which it has been established, and its basic design, are soundly based and will remain so for the foreseeable future. At some point in the future the “special” status of banks in the New Zealand supervisory approach may need to be reassessed. This might be prompted by the continued gradual breaking down of the traditional distinction between banks and non-banks in financial intermediation, or perhaps by banking services being provided in New Zealand by institutions not physically located here. It may also be prompted by a risk-proofing of payments and settlements systems that effectively prevents the problems of one bank contagiously spreading to others. Concerns about financial system stability might ultimately be best addressed by designing a supervisory framework that is focused on those systems themselves rather than on the main institutions. For the foreseeable future, though, concerns about financial system soundness in New Zealand are likely to continue to be focused on the banking system, as it is here that systemic risks are likely to remain concentrated.
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Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the Canterbury Employers' Chamber of Commerce in Christchurch on 30/1/98.
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Mr. Brash addresses the concern about New Zealand’s balance-of-payments deficit Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the Canterbury Employers’ Chamber of Commerce in Christchurch on 30/1/98. Introduction I am delighted to be addressing you once again, on the last Friday of January. If my memory is correct, this is the fifth year in which I have done this, and I appreciate your tolerance in inviting me back each year. On previous occasions, I have addressed a range of issues, often relating to the exchange rate and to the question of whether monetary policy was too tight or too loose. Today, I want to focus on one particular subject. Over the last few weeks, there has been heightened public concern about New Zealand’s balance-of-payments deficit, triggered at least in part by media reports of comments made by the International Monetary Fund in the context of their recent review of the New Zealand economy. And this public concern is hardly surprising: at 6.4 per cent of GDP in the year to September 1997, New Zealand’s current account deficit is already one of the highest in the world. The Reserve Bank’s latest projections have that deficit increasing further to nearly 8 per cent of GDP in the year to March 1998, a level comparable with that in the crisis year of 1984, and closely similar to the deficit in Thailand’s balance of payments before its mid-1997 difficulties. Moreover, our current account deficit is adding to a net stock of external liabilities which, at some 80 per cent of GDP, is already probably the highest of any developed country. So the questions I want to address today are, first, do large current account deficits matter? And secondly, if they do matter, what should policy-makers seek to do about them? Do large current account deficits really matter? There are a number of well-respected economists who argue that large balance-of-payments deficits are not something for policy-makers to be concerned about. They argue that a current account deficit is simply an indication that investment being undertaken in New Zealand exceeds the savings of New Zealanders and that, since the public sector is running a surplus, this excess of investment over savings simply reflects the decisions of countless individual New Zealanders in the private sector to borrow (or raise equity capital) to finance investment. In the longer term, this process will be self-correcting as either New Zealanders decide not to take on additional debt or foreigners decide not to extend additional credit. This view, in which the balance of payments is expected to adjust relatively smoothly, without the involvement of governments or central banks, is taken by such eminent economists as Max Corden and John Pitchford in Australia and Milton Friedman in the United States. Even economists who do not take quite such a sanguine view of current account deficits as that concede that deficits are of much less concern today, with a floating exchange rate and the virtually complete abolition of the distortions which previously affected the allocation of investment, than was the case, say, prior to 1984. At that time, deficits were often the result of substantial fiscal deficits and had to be covered by government borrowing overseas in foreign currency. Today, of course, the government’s accounts are in surplus. So what causes the sort of current account deficits that have recently provoked so much comment? It is probably fair to say that today’s deficit is in part the result of the enthusiasm which foreigners have had for investing in New Zealand. Not, I should stress, because foreign investment creates a current account deficit over the full life of the investment. On the contrary, I believe it can be shown that, after taking all the direct and indirect effects into account, most foreign investment in New Zealand actually tends to have a beneficial effect on the balance of payments. Rather what I am saying is that, as foreign capital flows into New Zealand, it is matched by a current account deficit. In other words, if there is a net inflow of capital, there must of necessity be a current account deficit. Because that is what a current account deficit actually means - it means there is a net inflow of capital. If the current account were in balance, there would be no net capital inflow. If the current account was in surplus, it would mean that there would be a net capital outflow. (Those who say, and many do, that New Zealand needs an inflow of capital to finance its future development are in effect saying that New Zealand must continue to have a current account deficit.) So in that sense, part of the reason for our current account deficit is simply a reflection of the enthusiasm which foreign institutions, companies, and indeed individuals have had for investing in New Zealand in recent years. Some of this foreign investment has been in the form of so-called direct investment, involving a foreign company establishing a controlling interest in a New Zealand operation. As you know, there has been a very large amount of investment of this kind going back over many years - in banks, insurance companies, and manufacturing - while in recent years the rate of foreign direct investment has, if anything, increased - in telecommunications, food processing, hotels, forestry, commercial property, and transport. In addition, there has been an increasing flow of so-called portfolio investment from overseas - non-controlling investment in New Zealand equities, a huge investment in New Zealand dollar government securities, and most recently a very large investment in New Zealand dollar securities issued by overseas corporations and governments, the Eurokiwi and Samurai bond issues. These Eurokiwi and Samurai issues have, through the swap market, provided New Zealand banks with attractively priced fixed-term funding, keeping longer-term interest rates lower than they would otherwise have been and making possible the recent rapid growth in the fixed interest rate home mortgage market. New Zealanders’ enthusiasm for borrowing But if this desire to invest in New Zealand on the part of foreigners had been the whole story, we might have expected to see interest rates in New Zealand at levels equal to or even below interest rates abroad, and asset prices - share prices in particular - at high levels by world standards as the impact of the abundant overseas capital swamped our small economy and readily met New Zealanders’ demand for funds. Instead, while New Zealand interest rates have been very much lower in recent years than would have been the case had there been no capital inflow, they have tended to be higher than those in major capital markets, whether measured in nominal terms or in inflation-adjusted terms. The prices of shares and commercial property have tended to increase more slowly than those in many overseas countries. This suggests that, while foreign investors have been happy to provide capital, many have done so because New Zealand has offered unusually attractive yields. What is striking is the willingness of New Zealanders to pay those yields. At least part of the reason must lie in a strong demand for additional funds within New Zealand. To some extent this demand has reflected strong investment activity in the corporate sector, as recent reforms have opened up profitable investment opportunities or have obliged companies to invest in cost-reducing facilities to improve their competitiveness. There has also been a strong cyclical recovery in investment spending after the 1991 recession. Strong investment spending widens the current account deficit in the short-term, but as long as that investment turns out to be profitable, any foreign capital tapped to finance it - whether in the form of debt, new equity, or retained earnings - will create no problems. In fact, corporate balance sheets in New Zealand have generally remained healthy after the stresses of the late 1980s and early 1990s. But much of the demand for borrowed funds in recent years has come from the household sector, and has been secured by that favourite New Zealand financial instrument, the house mortgage. This borrowing has taken the ratio of household debt to household disposable income from a relatively low 42 per cent as recently as mid-1990 to almost 90 per cent currently (Graph 1) - from a level which was relatively low by international standards to around the levels of indebtedness seen in places like the United States. It has also taken the share of loans extended to the household sector from 31 per cent of total bank loans to 52 per cent of the total over the same period, an increase in the dollar amount from $16 billion to $50 billion in just seven years. As Graph 2 illustrates, lending by major financial institutions to the household sector has been growing markedly more quickly than nominal GDP throughout most of this decade. Some of the borrowing by the household sector has been undertaken as a relatively cheap and efficient way of funding small businesses owned by the household sector, and to that degree is ‘mislabelled’ as household sector borrowing. But for the most part, the rapid growth in household indebtedness appears to have helped make possible the rapid rise in house prices seen in much of the country in recent years and, as employment, incomes, and wealth have risen, strong consumption growth. Obviously, this sort of strong growth in lending to households cannot continue indefinitely, but while it does there is likely to be pressure on our external accounts. Credit, after all, is designed to allow us to increase our investment without sacrificing current consumption, or alternatively to increase consumption now in the expectation of higher income in the future. Both of these mean enjoying now a level of consumption beyond what is produced locally: and in simplified terms, that is what a current account deficit is. Other things being equal, a strong demand to borrow tends to push up interest rates. It is those pressures which then draw in foreign capital. The capital inflow in turn tends to check the extent to which interest rates rise in response to the strong borrowing demand. The willingness of foreign investors to provide capital allows us, as a nation, much greater flexibility in making our own spending and investment decisions. But of course, the foreign investors expect to earn a return on the funds that they invest in New Zealand, and by using those foreign funds we are taking on an obligation to pay interest or dividends on the capital used, just as we do when we use funds from a domestic source. If we use the capital unwisely, then we compromise our future prospects, and that is no different when talking about four million people as a group than it is when we talk about people individually. The lessons of Asia The key issue at the moment is whether a current account deficit approaching 8 per cent of GDP, well above the 5 percent of GDP sometimes regarded as being dangerous, should be of concern. And the answer appears to be ‘not necessarily’. Singapore ran a current account deficit averaging 10 per cent of GDP for 20 years from 1965 to 1985, while Canada ran a deficit which exceeded 5 per cent of GDP for most of the 43 years from 1870 to 1913. But what about the recent lessons of Asia? What about the risk that foreign capital might suddenly flow out again, with disastrous consequences for New Zealand banks, New Zealand corporates, and the New Zealand dollar? Indeed, hasn’t the New Zealand dollar already been dragged down because of foreign concerns about our links with Asia? Let me correct one misapprehension at once. Yes, as of the middle of this week, the New Zealand dollar had declined by some 17 per cent against the US dollar since 1 January 1997, but this is closely similar to the extent to which the Australian dollar had declined against the US dollar over the same period (15 per cent), and was from levels at which the New Zealand dollar was widely regarded as being significantly over-valued. In fact, virtually all currencies have depreciated against the US dollar over the last year or so. This is simply another way of saying that the US dollar has itself appreciated against virtually all currencies. By comparison to the 10 to 20 per cent depreciation of most currencies, including the New Zealand dollar, against the US dollar, the currencies of many East Asian countries have fallen very much more sharply - by 44 per cent in the case of Malaysia, by 50 per cent in the case of South Korea, by 52 per cent in the case of Thailand, and by 84 per cent in the case of Indonesia. Neither New Zealand nor Australia has had an experience even remotely similar. It is worth looking briefly at some of the factors which have provoked recent problems in Asia because understanding these factors helps in understanding why the sorts of vicious corrections we have witnessed in Asia are not likely to happen here. There appear to have been three factors in particular which caused what seemed initially like a localised currency crisis in Thailand to spread so quickly to embrace many parts of Asia: * * * First, a serious lack of transparency in many Asian countries and markets, which made it difficult for investors to assess and understand the risks they were assuming, and which contributed to the speed at which confidence collapsed as soon as bad news began to appear. Second, fairly widespread evidence of poor credit evaluation by banks and other intermediaries, perhaps in part a result of the often-close connections between governments, banks, and big business, and in part a result of over-confidence and carelessness borne of decades of strong economic growth. (Paul Krugman has suggested that the willingness of banks to take on high credit risks was in large part the result of the perception that the liabilities of banks were effectively government-guaranteed, and that the moral hazard created by this perception was itself the cause of grossly inadequate credit evaluation.) Third, the widespread maintenance of pegged exchange rates, which compromised the ability of the countries concerned to maintain adequate monetary control when faced with very large capital inflows, and which seriously complicated financial management when problems began to emerge. New Zealand different from Asia in several crucial respects Of course, capital could flow out of New Zealand, and it would be a brave (or foolhardy) central banker these days who would claim ‘it can’t happen here’. Foreign investors could decide to sell-up and leave New Zealand, and indeed New Zealand investors could do likewise, in the absence of any controls preventing them from doing so. But I don’t think we are afflicted by any of the particular Asian problems I have just mentioned. To begin with, a rapid outflow of capital is very unlikely if the policy framework remains sound and transparent and if those who are the recipients of the foreign capital inflow remain creditworthy. In that regard, there is no sign of the policy framework here being changed. Almost all political parties are committed to the retention of the current transparent and independent monetary policy framework, established without dissentient vote in Parliament in 1989. Almost all political parties recognise the importance of continuing to run fiscal surpluses at this stage of the demographic cycle, and the high level of fiscal transparency is simply not a political issue at all. Almost all political parties are committed to an internationally open and competitive economy. And as far as creditworthiness is concerned, one of the major ‘borrowers’ - to the extent that foreign investors have bought New Zealand dollar government securities on the New Zealand market - is the government itself. The government has become markedly more creditworthy in recent years, as the ratio of net public sector debt has declined from around 52 per cent of GDP in the early 1990s to some 27 per cent currently. In the private sector, banks have on average strengthened their total capital position since the beginning of the decade, and all registered banks comfortably exceeded both the tier 1 and total capital ratios prescribed by international agreement as at the last date for which we have complete data (30 September 1997). All but two of the banks are rated by one or more of the international credit rating agencies, with the four largest banks all enjoying an S&P rating of AA- or better. In addition, of course, almost all the banks operating in New Zealand have the backing of financially strong overseas parent banks. Among corporates, balance sheets are probably as strong as they have been at any time in the last two decades. It is in the household sector that balance sheets are probably becoming most extended, after seven or eight years of strong borrowing, but international creditors are protected from potential bad debt problems in that sector by the fact that the foreign capital which has, in effect, been lent to ordinary household borrowers has been channelled through the banking system, and, as indicated, our banks are in robust condition. So there seems little reason for any sudden loss of confidence leading to capital flight. Secondly, even if there were to be a sudden flight, leading to a sharp depreciation in the New Zealand dollar, the result would be very different in one important respect from what we have seen in some Asian countries in recent months. In those Asian countries currency weakness led to very serious problems because, previously, as I have noted, currencies had been actually or virtually pegged to the US dollar. This led borrowers to take on large unhedged US dollar liabilities these looked very cheap at the time and, with the explicit or implicit guarantee that there would be no currency depreciation, devoid of currency risk. When as so often happens the countries concerned were forced to abandon their peg to the US dollar and the currencies fell sharply as a consequence, the losses which both banks and corporates sustained were often huge, threatening many of them with insolvency and collapse. (Indeed, the losses were magnified because, with sharply increased liabilities expressed in local currencies, borrowers rushed to sell assets, which tended to push down asset prices sharply as well.) These large losses in turn tended to further reduce investor confidence, and accelerate the capital outflow. By contrast, much of the foreign capital inflow into New Zealand has been either in the form of equity investments, with no currency risk borne by the company receiving the capital, or in the form of New Zealand dollar borrowings, by government and banks. The quarterly disclosure statements published by New Zealand banks show that they have little in the way of unhedged foreign exchange positions and, although I do not have detailed information on which to make a dogmatic assertion, I would be fairly confident that the unhedged foreign exchange liabilities of New Zealand corporates are very small. They have been operating for too long in a freely floating exchange rate environment to be unaware of the risks, and indeed some still recall the losses they sustained by borrowing in low interest foreign currencies in the 1970s and 1980s when the New Zealand dollar itself was pegged. A third point to note is that, if a capital outflow did occur, interest rates would rise sharply as a result and it is very likely that the combination of sharply lower exchange rate and markedly higher interest rates would quite quickly reduce the current account deficit. The Reserve Bank might well be blamed for the sharp rise in interest rates, and to be sure we would not be at all opposed to such an increase since if the exchange rate fell sharply a marked increase in interest rates would be needed to keep inflation under control. But it is also true that, unless the Bank moved to pump money into the economy aggressively, any sharp outflow of capital, whether owned by foreigners or owned by New Zealanders, would necessarily result in a sharp increase in interest rates, since those selling New Zealand securities and other assets would be forced to increase the yields offered on those assets in order to encourage others to buy them. In other words, with a floating exchange rate, investors (whether foreign or local) wishing to sell out of New Zealand assets or the New Zealand dollar need to find private sector buyers to sell to. The central bank is not going to be supporting the price of the New Zealand dollar, or of New Zealand bonds, or of New Zealand shares. And of course, although capital outflow can alter the price of assets, foreign corporate owners can not take the land and buildings which they own with them. Those assets would remain in New Zealand, with their ownership changing from foreign to local. Whether or not an outflow of capital was ‘painful’ and disruptive would depend very much on the magnitude and speed of the outflow. If, as seems quite unlikely, it happened on a large scale and over a short period, the adjustment could involve markedly higher interest rates. Companies exposed to interest rates and not benefiting from the fall in the exchange rate would be put under pressure, and some might well collapse, notwithstanding their currently-strong balance sheets. This would be part of the process of reducing the current account deficit, as resources were displaced from domestic or non-tradeable parts of the economy and enticed back into exporting and import-replacement industries. Household borrowers, especially those with variable rate mortgages, could also face some very sharp adjustments to their spending patterns. So the deficit is not a matter for alarm, but we should not be complacent. So in answer to my first question, namely, whether our large current account deficit matters, my answer is that it isn’t a matter for great alarm at present. The deficit in part reflects international enthusiasm for investing in New Zealand, and in part a judgement by many thousands of New Zealanders that there are attractive investment opportunities in New Zealand which are worth pursuing with borrowed funds (especially in the housing sector) and perhaps a judgement that future incomes will rise sufficiently rapidly to support a higher level of consumption spending now. There are market mechanisms which generally succeed in reconciling the intentions of individual households and firms with the interests of the nation as a whole. Some other countries have experienced similarly large deficits for years on end without ill effect, although it is not common to sustain for too many years a large current account deficit, in a floating exchange rate regime, without particularly high GDP growth rates. Moreover, we are well placed to weather any capital outflow which might eventuate. While a current account deficit of about the present size was associated with a foreign exchange crisis in 1984, that situation was one where the Government was trying to maintain a fixed exchange rate against a widespread belief that the exchange rate was over-valued. Today, with the exchange rate freely floating and able to adjust, month to month and hour to hour, to reflect changes in demand and supply, the situation is fundamentally different. But we should not be complacent. The size of our accumulated external liabilities does, as the IMF has suggested, make us somewhat vulnerable to unpredictable external shocks, or to a sudden loss of confidence for whatever reason. It puts a premium on maintaining the confidence of markets that New Zealand remains a safe place in which to invest, and means that the quality and transparency of economic and financial sector policies are crucial. In a situation where much of the capital inflow has, in effect, found its way into financing consumption, higher house prices, and residential investment, rather than into much higher investment in directly growth-enhancing sectors, we would be unwise to assume that we can sustain a deficit at around current levels indefinitely. Much will depend on the rates of economic growth we are able to sustain: the results in recent years have been encouraging, but to adopt a cricketing analogy, the innings is really just getting underway. If we want to reduce the deficit, what needs to be done? If as a country we want to reduce our vulnerability to external shocks by reducing first our current account deficit and then, over time, our high ratio of net external liabilities to GDP, how could this be done? The first point to reiterate perhaps is the one which the Corden/Pitchford/Friedman school would probably make, and that is that, because the public sector is in surplus, our current account deficit reflects decisions being made in the private sector to take on more liabilities. This will not continue indefinitely, since at some point we are likely to find either borrowers deciding that they have taken on enough debt or lenders making that decision for them! New Zealand has already seen a very strong increase in the ratio of household debt to household disposable income, as already noted. This has seemed prudent to thousands of New Zealanders, partly because house prices have increased strongly in recent years. And while to some extent it does make sense to anticipate future income growth, the ratio of house prices to incomes is currently at historically high levels - the sort of levels reached in the mid-1970s, just before the very sharp fall in real house prices in the second half of that decade, or in the United Kingdom before the savage correction in the late 1980s and early 1990s. If New Zealand house prices were to falter, even more if they were to fall back somewhat over the next year or two, as several commentators are now suggesting is very likely, we could quite quickly see a rapid slow-down in the growth of household sector borrowing followed by a down-turn in investment in housing and a rather broader slowdown in consumer spending. This would in turn quite quickly produce a reasonably rapid reduction in the current account deficit, both as the demand for imports fell away and as the profitability of foreign companies operating in New Zealand dropped. Any policy issue would disappear. But supposing this does not happen in the near future. Are there measures which policy-makers should be considering to reduce the deficit? We know from long and bitter past experience that imposing direct controls on imports is no solution. Unless matched by measures to reduce domestic spending power, consumers initially spend on items other than controlled imports in such a way that exports tend to be reduced and other imports increased. The balance of payments is not helped. Moreover, in time New Zealand producers invest in the production of the items subject to import controls, and since these items are almost by the nature of the case expensive to make in New Zealand, productivity suffers and efficient exporters are severely hindered. There is no solution in trying to license or control imports. The key challenge: how to increase national savings Since at root a balance-of-payments deficit is an excess of investment over saving, any attempt to reduce the deficit must either look to reduce investment or to increase saving. I will assume that reducing investment is hardly an attractive policy option given the constant pressure for a higher standard of living and more jobs, which leaves us with the question of how to increase savings in New Zealand. And I can’t stress too strongly that, fundamentally, reducing the current account deficit is ultimately about how we might increase total national savings relative to national investment. For a great many years, the public sector was a net dis-saver in New Zealand, as indeed it still is in most countries in the world. This was reflected in a considerable build-up in net public sector debt, to a peak of some 52 per cent of GDP in the early 1990s, as I have already mentioned. Partly as a result of the sale of government assets but mainly, since 1993/94, as a result of running budget surpluses, debt has been roughly halved in relation to GDP and at the present time the public sector is making a contribution of some 1.5 per cent of GDP to our total national saving effort. This is a very much better performance than that of virtually any other developed country (the exception, as to so much else, is Singapore), but it is a markedly smaller contribution to national saving than the public sector was making in, say, 1995/96. In that year public sector saving amounted to 3.7 per cent of GDP. So in the last couple of years the trend in public sector saving has been unhelpful in terms of the balance-of-payments deficit, a reflection of a strong increase in public sector spending over the last two years and a reduction in tax rates. One way of reducing the balance-of-payments deficit might be to increase the public sector surplus again, although nobody should under-estimate the difficulties of doing that in a country where pressure to increase government expenditure is relentless. New Zealand’s record of household sector savings seems to have been relatively poor for many years. There have doubtless been many reasons for this. In the high inflation 1970s and early 1980s, when many interest rates were controlled at artificially low levels, the after-tax real return on savings invested in fixed interest securities was strongly negative, creating a strong disincentive to save. This situation changed markedly in the mid-1980s, with positive after-tax real interest rates, but at about the same time financial sector liberalisation greatly increased the ability of many households to borrow; this too almost certainly discouraged net saving. And of course for most of the last half century New Zealanders have been encouraged to believe that the things for which people save up in many other countries - education, medical care, and retirement - would largely be taken care of by government. We were effectively told: you don’t need to save and, by the way, if you do, you’re a fool, because government-sourced inflation will steal a large chunk of what you save anyway. I’m frankly not sure how this culture of low household-sector saving can be changed. Clearly there is a significant section of the community that has no surplus income at all. To suggest that a solo parent living on benefit has scope for increased saving is absurd, and would be presumptuous in the extreme coming from me. But it is also true that too many New Zealanders on higher incomes still have attitudes to their personal finances that only made sense in the high inflation 1970s and early-1980s. The mind-set was that only a fool had personal savings, and the quick and the clever were in debt up to their eyeballs. Indeed, those attitudes were sensible from an individual’s point of view, with negative real interest rates and rising asset prices. Those attitudes no longer make sense. Part of the problem in recent years may have been the less-than-ideal mix of monetary conditions, with interest rates too low to encourage saving or discourage borrowing and with the exchange rate too high to allow the export and import-competing sectors to grow. This mix of monetary conditions was particularly unhelpful when most of the inflation pressures were in the domestic parts of the economy, especially the housing sector, and not in the export and import-competing sectors. The Reserve Bank began to tighten monetary policy early in 1994 to head off the inflationary pressures which we projected at that time. By the end of that year, 90 day interest rates had risen from around 4.5 per cent in January to close to 10 per cent, while the exchange rate had increased from 57 on the trade-weighted index (TWI) to 60. Through the next nine quarters, to the end of March 1997, interest rates never went much above 10 per cent, but the exchange rate continued to increase until the TWI reached 69. As a consequence, lending by major financial institutions to the private sector continued growing at rates more than double that of nominal GDP growth. In other words, although the exchange rate was putting great pressure on the exposed parts of the economy, interest rates were not nearly high enough to restrain a huge surge in private sector borrowing. But hold on, you may be saying. Don’t we have some of the highest inflation-adjusted interest rates in the developed world? And so we do, if one compares interest rates with inflation in the CPI. But of course few of us borrow to buy the goods and services in the CPI basket. Rather, most of us borrow to buy assets, and particularly real estate. And when our interest rates are compared with changes in an index of house prices, as shown in Graph 3, it can be seen that our - 10 - mortgage interest rates adjusted by house price inflation have been very low in recent years, and well below those in Australia. For whatever reason, our real interest rates have not been seen as particularly high by New Zealanders - despite all the protests to the contrary. If they had seemed high, we would not have been increasing our borrowings by 10 to 15 per cent per annum, and we would have been increasing our saving. As noted earlier, the ratio of household debt to household disposable income has more than doubled over the last seven years, and most of this increase has had nothing to do with buying food and other necessities. However, central banks have very limited ability to influence the mix of monetary conditions. This is ultimately determined by the decisions of countless thousands of individual investors here and abroad, and by the actions and expected actions of other central banks. As I have acknowledged previously, we gave some consideration when the exchange rate was at its peak in early 1997 to undertaking some form of so-called sterilised intervention in an attempt to reduce the exchange rate and increase interest rates - without risk to the inflation objective - since most of the inflationary pressures were coming from sectors relatively immune from exchange rate pressure but more susceptible, we believed, to interest rate pressure. But most of the international evidence suggests that such sterilised intervention has little lasting effect unless it is simply a precursor to an easing of overall monetary policy. I believe that the introduction of the Monetary Conditions Index in December 1996 may have helped to change the mix of monetary conditions to some extent by eliminating the impression which had grown up that we had an exchange rate target as well as an inflation target, but even this is by no means certain. If the central bank can not do much to improve our national saving performance, could the Government do more? I have already mentioned the importance of the Government itself continuing to run fiscal surpluses. There are almost certainly other policies which would have an effect on private sector saving performance. - 11 - For example, there may be some scope to further reduce our relatively heavy dependence on raising government revenue from the taxation of income, in favour of relatively greater reliance on taxes on expenditure, thus increasing the incentive to produce and save. Unfortunately, there is very little evidence that specific tax incentives for saving would increase overall private sector saving (as distinct from changing its form), and some evidence that national saving would actually be diminished by such incentives, because of the cost to public sector savings of providing the tax incentives. There is probably an on-going need to encourage New Zealanders to take more responsibility for their own future, though how this can be done after so many decades of encouraging them to believe that doing so is entirely unnecessary is a political challenge of mammoth proportions. At very least there is a pressing need for a multi-party consensus both to reassure New Zealanders that future governments will be able to provide a basic safety net for all in retirement, and to make it clear that those wanting a more comfortable lifestyle in retirement need to start saving now. There is also the superficially attractive option of attempting to widen the gap between New Zealand interest rates and those overseas through some direct policy measures. If this could be achieved, the argument runs, New Zealand interest rates could be driven up to the point where New Zealanders were encouraged to kick the borrowing habit without provoking a huge inflow of foreign capital and the related increase in the current account deficit. This is a route which Chile, for example, has followed, requiring a part of all monies borrowed overseas to be deposited for one year in a non-interest-bearing account with the central bank. Others have noted the possibility of reintroducing a withholding tax on interest payments to foreigners. Such proposals should be treated very cautiously. Not only would there be significant administrative problems in ensuring compliance with such measures but the longer-term costs of undermining investor confidence in New Zealand’s commitment to free and open capital markets would weigh heavily against any possible shorter-term adjustment gains. Alas, none of the possible policy changes to encourage private sector saving - or reduce private sector borrowing - is politically easy. But then living beyond our means carries risks as well. I myself do not think that these risks are terribly large at present, but the longer we continue living beyond our means, the greater those risks become. New Zealand is relatively prosperous, is well-endowed with educated people, and has natural resources which many others would give their eye teeth for. It is not obvious to me that we should be content to be a heavy user of the savings of others indefinitely, especially when a significant part of those foreign savings is being used not to generate faster economic growth but simply to buy ourselves larger houses.
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Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Asian Pacific Bankers Club Annual Conference in Auckland on 13/3/98.
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Mr. Brash asks how central banks can best help banking systems remain strong in a world of open capital markets Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Asian Pacific Bankers Club Annual Conference in Auckland on 13/3/98. Introduction I appreciate your invitation to address you this morning and I join with others in welcoming you all to New Zealand. This country can not be regarded as truly Asian, but we are increasingly integrated into the Asian region, through trade, through immigration, through political and diplomatic linkages, through cultural exchanges, and in my own case through marriage! Whereas when I went through school almost the only foreign language learnt in New Zealand schools was French, now more New Zealand students learn Japanese than learn any other foreign language, with many students also studying Mandarin and Indonesian. Whereas when I went through school the United Kingdom took roughly half of New Zealand’s exports, now the British market takes only some 7 per cent of our exports, with Japan taking 16 per cent, China/Hong Kong taking 6 per cent, and Korea (in 1997) taking 5 per cent. Seven of our largest 10 export markets are now in this region. Whereas when I went through school almost all immigrants to New Zealand came from the United Kingdom, Australia or the Pacific Islands, in the last few years a great many immigrants have come from East Asia - especially from China/Hong Kong, Taiwan, and Korea. And New Zealand has gained enormously from these immigrants, who have tended to be hard-working, thrifty, enthusiastic about education, and enterprising. They have enriched our culture and helped our economy. Whereas when I went to school New Zealanders seeking international experience inevitably travelled to the United Kingdom and Europe, typically by means of a ship which travelled via the Panama Canal and lots and lots of ocean, today many New Zealanders seek overseas experience in the countries of Asia and, even when travelling to Europe, travel via several Asian countries. This year and next, the Reserve Bank of New Zealand holds the Chair of SEANZA, a grouping of 20 central banks in the Asian region originally formed in the mid-1950s, and we were a founding member of EMEAP, an 11-country group of East Asian central banks. (Indeed, we hosted two of the three EMEAP working groups in New Zealand last month.) And of course next year New Zealand will host the APEC Leaders’ meeting here in Auckland. So we are increasingly a part of the Asian region, and have a vital stake in the prosperity of the region. And in that regard, everybody in this room, and indeed almost everybody in this country, is very much aware of the stresses and strains which several of the countries in the region have been going through in the last few months. Even countries which have not experienced severe turbulence in their currency markets in some cases face very considerable pressures on their banking systems, so that it is no exaggeration to say that most of the people in the region live in countries where banking systems are under real strain. Oceans of ink have been spilt in analysing the causes of these strains, and this analysis will no doubt continue for a long time to come. Most detached observers seem to agree that the underlying problems had nothing to do with the real or imagined activities of foreign speculators but a great deal to do with more fundamental factors, factors which clearly varied from country to country, but which included politically-directed lending by banks, the end of a real estate bubble, sharply increased real exchange rates in a pegged exchange rate situation, a lack of transparency in financial markets, and, dare I say it to this audience, some poor quality credit analysis by some of the banks and other financial institutions. I do not propose to offer my own analysis of the causes of ‘the Asian crisis’ this morning. I was originally invited to speak about ‘the role of central banks, the New Zealand experience’. But instead I want to tailor my remarks more specifically to the theme of your conference, ‘Open Markets - the implication for Banks in the Asian Pacific Region’. So for this reason I want to focus this morning on a question, namely ‘In a world of open capital markets, how can central banks best help banking systems remain strong?’ Not surprisingly, my remarks will be heavily conditioned by our own experience in New Zealand. While we are all conscious of the strains currently besetting the banking systems in many Asian countries, not all of you will be aware that we in New Zealand had our own banking system problems less than 10 years ago. As a result of these problems, our largest bank would almost certainly have failed had the government, as majority shareholder, not been willing on two occasions to provide a substantial capital injection. One very major financial institution (not a bank, but certainly a quasi-bank, and an institution which was in the process of applying for a banking licence) did fail, one of the largest failures in New Zealand’s history. Another bank would have failed had its private sector shareholder not been in a position to inject very large amounts of additional capital, and even after that was done the institution was eventually wound up. At no point did it look likely that the whole banking system might fail, but we certainly had major problems with some of the largest participants in the system. What lessons did we learn from that experience? There were of course a whole host of factors which caused these difficulties. One important factor was the sheer inexperience of many of our bankers: they had been accustomed to a highly protected environment, and were ill-prepared to deal with the demands of a deregulated environment. Nevertheless, I think there were four important lessons. While every country has to make judgements and decisions in the light of its own particular circumstances - and certainly no two countries are exactly alike - some of the things we learnt may have relevance to other countries also. Lessons from New Zealand: encourage banks to behave prudently First, it is important that banks are given every incentive to behave prudently. This may seem a self-evident statement, but it is astonishing how frequently the importance of this principle is ignored. In New Zealand’s case, we diminished this incentive to behave prudently by allowing the view to go unchallenged that banks were effectively ‘sovereign risk’, or at least ‘too big to fail’. This meant that bank creditors felt little need to assess the creditworthiness of the banks with which they deposited funds - banks were, it was widely believed, effectively guaranteed by government. Bank boards and managements may have felt similarly protected against the possibility of failure, and made loans with a disregard for risk which was, in some cases, breath-taking. This so-called ‘moral hazard problem’ may have been particularly severe in the case of two of the three institutions which got into serious difficulties in the late 1980s, both of them owned wholly or in part by government. There was little or no direction of their lending by government, but the management of both institutions certainly embarked upon lending transactions in the newly liberalised environment which rapidly got them into serious difficulties. In some Asian countries, it is possible that the incentive for banks to behave prudently was seriously eroded not only by the impression that most large financial institutions would not be allowed to fail but also by the extent to which governments directed the lending activities of the banks themselves. After all, if governments are going to become extensively involved in directing where banks should and should not lend, it is not unreasonable if the banks and their creditors assume that governments will ‘see them right’ if things go wrong. Bank management certainly has little incentive to carefully assess credit risk if, at the end of the day, the decision on whether or not to lend will be made by the bank’s board under the influence or direction of higher political authority. At the moment, there is a great deal of international attention focused on how this problem of poor credit decisions in the banking sector can be dealt with. Most of the attention is on how official banking supervision and banking regulation can be improved, and made more independent of political influence. Certainly, freeing banks from political interference in their credit decisions is very desirable, and better banking supervision is one possible way to reduce the risks of future problems in the banking system. But as some of you perhaps know, we in New Zealand are not persuaded that improving the quality of official banking supervision is the only way to proceed, or indeed even necessarily the best way to proceed in all circumstances. When we reviewed what we were doing in banking supervision in the early 1990s, we became concerned. At that time, we were conducting banking supervision along conventional Basle Committee lines. We were gathering very large amounts of confidential information from banks on a quarterly (sometimes a monthly) basis. We were laying down a large number of rules and limits designed to ensure that banks behaved prudently. Several things prompted us to review that approach, and one of them was a worry about the risks which we were incurring on behalf of taxpayers. What would happen if, despite our banking supervision, a bank were to get into difficulties? Might depositors argue that they wanted full compensation, since while they had had no knowledge of the bank’s financial condition we in the Reserve Bank were not only fully aware of that condition but were also responsible for laying down the rules and limits by which the bank had been obliged to operate? We consoled ourselves with the thought that our banking supervision was so good that no banks would fail under our watchful eye. But then we looked abroad - at the United States, at Japan, at Scandinavia, at the United Kingdom, at Australia, and indeed even at New Zealand itself. We found banks going down in significant numbers, despite some extremely professional and politically-independent banking supervision. We could not be confident that traditional banking supervision would prevent bank failure, and we could be confident that, by being the sole recipient of detailed financial information on banks and the main arbiter of what constituted prudent banking behaviour, there was a major risk that we would be held liable, politically and morally if not legally, for any losses incurred by depositors. Then we became aware of anecdotal evidence that our banking supervision was reducing the incentive for bank directors to make their own decisions about crucial aspects of their bank’s operations. In other words, because the Reserve Bank was laying down maximum individual credit limits, and limits on open foreign exchange positions, and guidelines for internal controls, some bank directors were assuming that they were necessarily behaving prudently provided they were operating within those limits and guidelines. They stopped addressing the risks which their own banks were facing and simply complied with the general limits and guidelines. To the extent that that was true - and as I say we found some evidence that it was true in some banks - we concluded that our banking supervision might actually be increasing the risk of bank failure, by reducing the incentive for bank directors and bank managers to make their own careful assessment of risk. So we retain a system of official banking supervision, and we take it very seriously. But we retain only a few absolute rules within that framework, principally that all banks must at least meet the Basle capital adequacy rules, and rely mainly on a requirement that banks disclose to the public a substantial amount of financial information quarterly. In addition, all bank directors must sign off these quarterly statements, at the same time attesting to the fact that the internal controls of their banks are appropriate to the nature of their banking business, and that those controls are being properly applied. We in the Reserve Bank do not attempt to tell banks what those controls should look like, but directors signing those quarterly statements without making a careful assessment of the adequacy of internal controls are exposing themselves to very considerable legal risk in the event that their bank gets into difficulty. We have also gone out of our way on a number of occasions to make it clear to the public that neither the Reserve Bank nor the government of New Zealand is guaranteeing individual banks, and we published a booklet designed to assist the general public to interpret banks’ financial information. None of these actions is a guarantee against imprudent bank behaviour, but we believe that we have gone a considerable distance towards ensuring that banks face strong incentives to behave prudently. No bank operating in New Zealand is now owned by government, none is guaranteed by government, none is obliged to lend to particular sectors or companies, and our supervision is based heavily on mandatory public disclosure and director attestations. As Alan Greenspan said last year, ‘Regulation by government unavoidably involves some element of perverse incentives. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish.’1 We have tried to minimise those perverse incentives. Of course, to some extent this approach only works where there is a clear framework of company law which makes it clear that company directors and managers have unambiguous responsibilities. Having agreed accounting rules is important. Having a vigorous media, with probing financial journalists, is also of great value, so that when a bank is forced to disclose to the public a deteriorating financial position, or a breach of one of the few rules we retain, there is at least a reasonable chance of that being picked up and sensibly analysed by the media. Not all countries are so lucky. So far at least, we are well satisfied by the way in which the new system is working. (A few months after the new system first came into operation, at the beginning of 1996, one bank was obliged to disclose the fact that it had had a credit exposure to its shareholder bank which considerably exceeded the limit which we had stipulated for such 1 Remarks by the Chairman of the Board of the US Federal Reserve System, Dr Alan Greenspan, at the annual conference of the Association of Private Enterprise Education, in Arlington, Virginia, on 12 April 1997. exposure. The attention focused on this issue by the media, and indeed by other banks, created strong incentives for the bank never to repeat that mistake - quite probably stronger incentives than any threat of central bank sanction could have created.) Lessons from New Zealand: beware of government ownership of banks The second lesson from the New Zealand experience in the late 1980s is that the ownership of banks is an important issue. For us, the issue was in part government ownership of banks and in part foreign ownership of banks. The government-owned financial institutions almost without exception suffered various degrees of financial difficulty - sometimes because their managers had undertaken imprudent lending, and sometimes because they had been obliged to invest in large amounts of government securities at sub-market interest rates. The large foreign-owned banks suffered to a much more limited extent from the bad debts and losses which the government-owned banks experienced. There have been various reasons given for this difference, but the most plausible is that the large foreign-owned banks were under the watchful eye of experienced parent banks, and were therefore much less able to stray into some of the riskier propositions which tempted the government-owned institutions, especially in the years immediately after the banking sector was liberalised in the mid-eighties. (The newly-arrived foreign-owned banks, however, often did succumb to the temptation of lending on risky propositions, perhaps because, being quite small both in absolute terms and in relation to their overseas parents, they were subject to much less intensive parental scrutiny.) More recently, New Zealand has been running a very large balance of payments deficit, probably amounting to more than 7 per cent of GDP at the present time. As in some Asian countries, this balance of payments deficit has been experienced at a time when the government itself is running a fiscal surplus. In other words, it has been the private sector which has been borrowing heavily from overseas, not the public sector. And while some of this borrowing has been done by the corporate sector directly, much of it has been done by the banking sector. Comparable levels of overseas borrowing by some Asian banks have been sufficient to make foreign lenders very nervous, and yet similar nervousness has not been at all evident in New Zealand. Why? I can only conclude that the foreign lenders take considerable comfort from the fact that most of the banks operating in New Zealand now are in fact wholly-owned by foreign banks, or are indeed branches of foreign banks. Those parents are seen as being financially strong, and fully able to back the operations of their New Zealand subsidiaries or branches. (It may also be relevant that, overwhelmingly, the overseas borrowing being undertaken by New Zealand banks carries no foreign exchange risk for the banks themselves.) In some countries, there is political reluctance to allow foreign institutions unrestricted entry into local banking sectors. I would have to say that, as a country where all but one of our 19 banks are owned and controlled overseas, we have seen absolutely no disadvantages from this situation, and many advantages. We have a financially stable banking sector, with vigorously competing and highly innovative banks, all of them subject to the monetary policy influence of the central bank. I have no doubt at all that the banking sector is considerably more stable than would have been the case had all the banks been domestically-owned, whether in the private sector or in the public sector. Lessons from New Zealand: keep prices stable The third lesson from our experience has been the crucial importance of keeping prices stable. By the late 1980s, New Zealand had experienced nearly 20 years during which inflation had been above 10 per cent almost without a break. Interest rates after adjustment for tax and inflation were often strongly negative, and there was as a consequence a strong incentive to invest in real estate and shares, using as much borrowed money as could be obtained. This was undoubtedly an important contributor to the severe difficulties which both the corporate sector and some parts of the banking sector experienced when monetary policy was tightened in order to reduce inflation. Interest rates went up and asset prices went down, and several banks incurred very large losses as a consequence. Asian countries have an enviable record of combining very rapid rates of economic growth with rates of inflation which, by the standards of many other countries, have been low or moderate. But it is also true that in many Asian countries relatively low consumer price inflation has been accompanied by a huge escalation in asset prices. There is no single explanation for this phenomenon and, as New Zealand has itself discovered over recent years, with quite a strong increase in the price of both residential and rural property, it is often extraordinarily difficult to restrain asset price inflation even when inflation in consumer prices is low. But it is at least possible that asset price inflation in Japan in the late 1980s - the reversal of which has done so much damage to bank balance sheets in that country - was a consequence of monetary policy being kept too easy for too long, whether to appease the United States after the Plaza Accord or for some other reason I know not. Similarly, it may well be that if central banks in some other Asian countries had not been so preoccupied with trying to avoid the appreciation of their currencies against the US dollar as capital flowed into these economies in recent years, their interest rates would have been higher and asset price inflation commensurately reduced. And of course if asset price inflation had been less, the over-investment in certain kinds of real estate would presumably have been less and, with that, the subsequent fall in asset prices would have been less also. Lessons from New Zealand: avoid pegging the exchange rate And that brings me on rather naturally to the final lesson from New Zealand experience, and that is the danger of pegging the exchange rate unless you are prepared to go all the way to a currency board, as Hong Kong has done, and have the political and banking sector strength to endure the economic, political, and social pain which is inevitably associated with a currency board arrangement from time to time. In New Zealand, we had a pegged exchange rate until March 1985. Prior to that date, it was not uncommon for companies to borrow overseas, often at interest rates which were very much lower than those within the high inflation New Zealand economy. Some companies made rather spectacular losses when the New Zealand dollar was devalued from time to time, or when, even when pegged, the New Zealand dollar depreciated against the currency in which the loan was denominated. (Borrowing in Swiss francs was particularly popular, and particularly painful, for some companies.) But the losses were probably fairly moderate in comparison to the loss which the government itself incurred on behalf of taxpayers in 1984. In that year, the New Zealand dollar was devalued by 20 per cent after a foreign exchange crisis which had certain similarities to some of those in Asia more recently and the government, which had written very large volumes of forward exchange contracts with companies trying to protect their positions, incurred losses of many hundreds of millions of dollars. Since March 1985, the New Zealand dollar has been freely floating, and indeed I suspect we may be the only central bank that can claim not to have intervened directly in the foreign exchange market for more than 13 years. (I say ‘directly’ because from time to time we did adjust monetary policy when we felt that movements in the exchange rate seemed likely to threaten our single goal of low inflation.) One of the benefits of this has been that, though many companies and banks have borrowed overseas, none of this borrowing was undertaken in the belief that there was no currency risk involved. Overseas interest rates were frequently much lower than those in New Zealand, but after factoring in the exchange rate risk, the incentive to borrow offshore in foreign currency was substantially reduced. As a consequence, when, after a period of strong New Zealand dollar appreciation between early 1993 and early 1997, the New Zealand dollar fell by some 18 per cent against the US dollar, there were very few companies unhappy about that fall - and indeed plenty of exporters who were delighted. Even fewer of our banks were caught out by the depreciation, and to the best of my knowledge none incurred losses as a consequence of the move. Because they knew that the New Zealand dollar was freely floating, they were careful to avoid taking on unhedged positions in foreign currency. Conclusion In conclusion, in a world of open capital markets, the challenges facing banks are very considerable. Central banks can not prevent all banks from getting into trouble, and nor should they try to do so. But central banks do have a responsibility in all our countries to promote the stability of the banking sector. In my own view, they can best do that by creating strong incentives for banks to behave prudently; by discouraging government ownership of banks, and removing barriers to the foreign ownership of banks; by keeping the focus of monetary policy on price stability; and by not creating the impression that borrowing in foreign currency is a riskless activity. We learnt those lessons the hard way.
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reserve bank of new zealand
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Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the Foresight in New Zealand Agriculture Summit in Wellington on 2/4/98.
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Mr. Brash addresses the topic “living with low inflation: farming for profit” in New Zealand Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the Foresight in New Zealand Agriculture Summit in Wellington on 2/4/98. Introduction Thank you very much for that kind welcome. I must, however, immediately ask your forgiveness, in that I am going to change the topic of my address from that which is printed in the very elegant programme which you have before you. When I came to prepare this address I went back to the title suggested for me - “Business performance and investment; redefining the industry” - and I could see the thrust of what was being asked for, but my heart dropped. You see, I could regale you with old war stories about when I tried to assist in the marketing of kiwifruit. I could give you my frank assessment of the performance of the producer board with which I have most personal contact, the Kiwifruit Marketing Board, or whatever it is now called. I could tell you I am still successfully losing money as an absentee kiwifruit grower. I could talk about added-value. I could chant the mantras - which you all know - saying there’s no future in selling undifferentiated commodities. I could say we all need to be in the business of building top-of-the-line brands. I could claim that, if we did that, then, regardless of the exchange rate or the state of the world economy, all would be well. I could say the rich and the famous would then want to buy our products - top-of-the-line, nuclear-free, greener-than-green, designer foodstuffs and natural fibres, all sanctioned by Xena the Warrior Princess and Peter Blake. I could say all that, and it would all be true, but from me it would just be rhetoric, in that I am not in the marketing business, except perhaps of price stability. As a central banker, I think I should talk about the things I know best, under the title “Living with low inflation: farming for profit.” Moreover, I suspect that what I’m going to say is germane to what this summit is trying to achieve. The exchange rate In the last two or three years, the Reserve Bank has been acutely aware that its policies have been causing, or appearing to cause, the nation’s export farmers a whole lot of distress. Often, in despair, farmers would tell us that the rising dollar was driving them into the ground, and for some it was. Between the low point in early 1993 and the high point in early 1997, the New Zealand dollar rose against the US dollar by nearly 40 per cent, while even on a trade-weighted basis the increase was some 30 per cent, big increases by any standards. Having acknowledged that, I must also say that sometimes farmers, and unfortunately some of their representatives, blamed the exchange rate when the real villain was low world prices over which monetary policy could have no influence. As I have noted on other occasions, for example, roughly three-quarters of the fall in the farm-gate price of bull-beef over the three years to June 1996 was a result of the fall in US beef prices, with only one-quarter of the fall explained by the rise in the New Zealand dollar. Moreover, while I would not deny for a moment that the rise in the exchange rate between early 1993 and early 1997 put huge pressure on many farmers, it is important to recall, for what I am going to say in a moment, that that rise had at least some offsetting advantages: the price of fuel was lower than it would have been otherwise, as was the price of tractors, the cost of off-farm transport, and quite probably the cost of farm and off-farm labour as ˝ well. I’ve sometimes felt that, for some marketing agencies at least, the Reserve Bank has been a convenient whipping boy, or a way to pass the buck - pardon the pun. Now export farmers are feeling much better, or at least those who have escaped the impact of the drought are feeling better. The exchange rate has fallen sharply, and some observers feel it will fall further yet. Hopefully, as a result, the New Zealand dollar incomes of export farmers will rise. I’m sure many farmers are now saying it’s time to reinvest in their farms. If that’s the case, I’m delighted. But I want to sound a warning note to farmers. Yes, everything else being equal, your end of the court is now favoured, just as it was back in the early 90s. But it is important to remember that exchange rates go both up and down, and you should not assume that, just because the kiwi dollar has fallen sharply over the last six to nine months it will stay down at these levels permanently. Indeed, if our economy prospers, we should expect to see a gradual appreciation of the exchange rate over the long-term. Perhaps farmers need to think about the exchange rate the way Canterbury farmers think about rain. Sooner or later, droughts are going to happen. Consider what we call “the real exchange rate”. The real exchange rate is New Zealand’s nominal exchange rate, adjusted by the difference between inflation in New Zealand and inflation in our trading partners. This is more relevant to exporters than simply looking at the nominal exchange rate: clearly, if inflation within New Zealand is markedly higher than that in our trading partners, even a falling exchange rate is of little help to exporters, while if our inflation is markedly lower than that in our trading partners, exporters can cope with an appreciating exchange rate. When the real exchange rate rises, or in other words when the nominal exchange rate rises by more than the difference between our inflation rate and that of our trading partners, exporters are put under real pressure. And vice versa. Now have a look at Graph 1. Graph 1 Nominal and ’Real’ Trade Weighted Exchange Rate (1970 - March 1998 average equals 100) Index Index Nominal TWI Foreign/Domestic price level ’Real’ exchange rate ˝ The solid line is the nominal Trade Weighted Index, in other words the nominal exchange rate. The dotted line shows the difference between inflation in New Zealand and inflation in our trading partners. As you can see, over long periods of time, the nominal exchange rate tends to reflect the difference between our inflation rate and that of our trading partners: when our inflation was relatively high, our exchange rate tended to depreciate; when our inflation was relatively low, our exchange rate tended to appreciate. Of course, there have been divergences between the two lines, sometimes for periods of three or four years at a time, and that is illustrated by the dashed line, or real exchange rate. But over the whole period shown, nearly 30 years, there has been no persistent tendency for the real exchange rate to rise or fall, and that is true despite the fact that through the first half of the period the exchange rate was essentially pegged to the US dollar (with periodic devaluations) while for the last 13 years the currency has been floating. The dashed line - the real exchange rate - has fluctuated around a pretty flat trend-line. Back in the late 1980s, farmers were in despair, and part of the reason for that was that the real exchange rate was at a peak in 1987/88. In the early 1990s, by contrast, it was relatively low, and farmers were feeling much better. In the mid 1990s, it was up again, and now its coming down again. Note how enduring this cycle is, irrespective of the exchange rate regime. Farmers need to remember this, when judging what investments are worthwhile. A good Canterbury farmer knows that droughts are inevitable, and plans accordingly. Likewise, a good exporter knows that fluctuations in the real exchange rate are also inevitable, and plans accordingly. I would like to be able to say that the Reserve Bank can reduce the amplitude of these fluctuations, but since fluctuations in the real exchange rate have been of broadly similar magnitude in, for example, the United States, Japan, Australia and the United Kingdom in recent years, I can give you no confidence at all in this regard. Interest rates My staff tells me that 12 months back they were often fielding calls from angry farmers, wanting to vent their spleen about the exchange rate. Those calls have dried up. Now the calls of distress are often coming from Auckland - people upset that interest rates aren’t lower. A few days ago an Auckland talkback host was telling me in no uncertain terms what he thought about me and monetary policy because he couldn’t sell his house. Out in the vast hinterlands of Auckland talkback radio, I’m becoming a bit of a villain again. I’m consoled by the comment of a wise American central banker who once said that an unpopular central bank governor is not necessarily a good central bank governor, but a popular central bank governor is almost certainly a bad one. So maybe farmers are a bit happier, for a while at least. However, too often, I’m afraid, farmers do have something in common with that Auckland talkback host. And this leads me to the amended title of my address. At the beginning of this year my staff and I were wrestling with that old faithful: “Why does New Zealand have such high interest rates relative to other countries?” Now the conventional explanation is: “The New Zealand economy has been more buoyant than others, pushed along by a fiscal loosening, strong immigration and so on. As a result, until recently we had to have monetary policy tighter than elsewhere and that meant higher interest rates than elsewhere.” That is fine as an explanation, as far as it goes. But a key part of the story has also been that insatiable desire to borrow that still afflicts us New Zealanders, so that, as soon as money is available at under 10 per cent, we rush down to the bank saying: “Give us more”, forcing the Reserve Bank to tighten monetary conditions to contain inflation. Why is that? Are New Zealanders irrational? I doubt that. But hold on - we’ve had price stability since 1991. Yet, clearly, if you look at our willingness to borrow ever-increasing ˝ amounts at apparently high rates of interest, it’s taking a long time for that lesson to sink in, and in the meantime, monetary policy has had to be pretty tight. What’s been happening? Well, one young economist in our Economics Department recently came up with an interesting graph. She compared our real estate inflation with Australia’s. She then offset that against the mortgage rates in the two countries and something very telling emerged. People don’t borrow to buy the basket of goods and services that go into the Consumers Price Index. Mostly they borrow to buy property. Measured against property inflation, our real interest rates have been much lower than theirs have, at least until recently (Graph 2). That’s to say, our mortgage rate minus our residential property inflation has, until recently, been much lower than Australia’s mortgage rate minus their property inflation. So, in the mid 1990s, it made more sense to borrow to the hilt to buy property in New Zealand than in Australia. New Zealanders weren’t being irrational. They were reacting perfectly sensibly to the incentives that property inflation was giving them, though, I have to add, it has come to an end now, and I fear there may be tears, as happens whenever a fall in property prices affects people who have borrowed heavily in the expectation that prices will continue to rise indefinitely. Graph 2 Real mortgage interest rate (Mortgage interest rate less ex-post house price inflation) % % NZ Australia -2 -2 -4 -4 -6 -6 Living with low inflation Let’s peel this back further. Why did property inflation continue in the 1990s? We achieved price stability measured by the CPI in 1991. Those representing both sides of wage negotiations quickly understood what that meant. I well recall Ken Douglas saying - and I hope Ken will forgive me if I report this a bit roughly - that he didn’t support this new Reserve Bank obsession with price stability, but if that was going to be the fact of the matter, then double digit pay rises were a thing of the past. Likewise, retailers and the providers of services quickly surrendered the traditional cost-plus attitude of the 1970s and early 1980s. However, strangely, we have been far less successful with property ownership, and, I have to say, this applies both in town and in the countryside, as Graph 3 illustrates: for most of the ˝ last decade, both house prices and farm prices have risen markedly more quickly than the general rate of CPI inflation. Far too many people still see getting heavily into debt to buy a second property as the best way they can save for their retirement, even though, in my view, they will be disappointed. Graph 3 House prices and rural land prices (indexes rebased to a March 1988 value of 100) Index Index Auckland house prices Other NZ house prices Farm land prices CPIX 1990 1991 1994 1995 Source VNZ. ’Other NZ’ series is derived by RBNZ from VNZ data. Lest I be misquoted yet again, I’m not criticising home ownership. Owning your own place is normally a good thing to do because it provides a secure home. It also provides an asset for people, particularly in their retirement, assuming it is financed rationally. I own a home myself, and have done so for most of my adult life, for all the normal reasons that apply to most New Zealanders. However, my concern is that - forgive me pinching a great line - New Zealanders’ “irrational exuberance” for getting into debt, in the hope of making money out of now non-existent inflation, is still distorting the New Zealand economy. So, the question remains, why that passion for debt to finance speculative real estate? Why have people, when it comes to their personal finances, failed to learn the lessons of low inflation that they have learnt very well indeed in the work place? One of my staff has come up with an interesting proposition. He says it’s all the Reserve Bank’s fault. Maybe we’ve sold the message wrongly. Maybe our advocacy has been at fault. Certainly, I’ve given innumerable speeches about the worth of price stability, but always as a public good or as a benefit that applies to society as a whole. I’ve talked about how economies perform better if people making investments have a stable currency by which to measure the value of commercial decisions over time. I’ve talked about social justice, and the way inflation harms the poor and benefits the rich, and so on. Maybe what we, the Reserve Bank, have failed to do is talk about the value of price stability as a private good. More specifically, maybe we’ve failed to take the lead in saying: “All right, low inflation is here to stay. This is what you need to think about in personally managing your affairs given that fact.” ˝ As we bounced this idea about, another staff member said: “Yes, just this weekend, my father - he’s got a few properties - said: ‘Back when there was inflation I knew how to make money - but now I don’t’.” At the moment we are investigating some media strategies to start talking about this. I don’t know if anything will come of it, but I do think there is an important point here. The virtue of price stability as a private good is a case that hasn’t been won yet, or at very least we have failed to explain the implications of low inflation at the individual level. For example, people need to think about questions like: “Does that second property make sense if, over time, its value will increase at little more than the average rate of inflation, indeed for some properties at less than the average rate of inflation? Given the extent to which property prices have risen faster than incomes over the last few years, is there a risk of a substantial fall in property prices over the next few years? Would I be better investing in financial assets that earn interest? Does putting that deck on the house make sense given low inflation, or will I be over-capitalised? This mortgage is stretching my finances to the limit, so can I endure it, given that my debt won’t be wiped out by inflation in five years’ time?” Am I just seeking to re-educate townies doing up old villas in Grey Lynn, not because they want to live in them, but because they plan to sell next year? Well, no. When farmers were in distress about non-tradable inflation and the “blunt instrument of monetary policy”, I and one or two others on the receiving end, said: “Hold on, what about the runaway prices for farm land? They’ve been going up just as fast or faster that property in town.” “Not fair,” replied various farmers’ representatives. “That’s a cost of production we have to face, not a price we control,” they said. Well maybe. But for the most part farmers sell land to and buy land from other farmers. It seems to me that many farmers are like people in the cities when it comes to their private finances. Too many still haven’t internalised the lesson that, by hook or by crook, price stability is here to stay. This is part of why, to put it bluntly, the price of farm land is still very high - certainly irrationally high, if one is assessing the business of farming in terms of the annual profits being earned on the investment. The Meat and Wool Board’s Economic Service reports that the rate of return on the market value of farm assets used in farming sheep and beef averaged just 0.8 per cent in 1995/96, and 1.7 per cent in 1996/97. Indeed, that rate of return has not reached 6 per cent in any year since 1979/80. And this in an industry where the trend of world market prices has been inexorably downwards since the Second World War. Why, on that basis, would anybody invest in farming? Of course, the answer, in part, is that farming people have non-commercial reasons for wanting to be in this business, as well as commercial reasons, and that’s perfectly legitimate. Lots of other people make similar decisions. I recognise also that, in part, the reasons for the low rates of return on sheep and beef properties in the years cited were related to temporary factors, such as the strong demand for land suitable for planting in forestry and, on the other end of the spectrum, for land suitable for conversion to dairying. However, also, I suspect that too many farmers are still farming for capital gain. Too many farmers still think, okay, my life will be pretty basic during my working career, but the life-style is good, and I will have a gold-plated retirement when I sell. Here I come right back to the wider theme of this summit. I don’t think farming for capital gain does farming any good at all. I think it is based on delusion, in that from here on the capital gains won’t be there, because inflation has been contained even for farm land prices (indeed, Graph 3 indicates as much over the last couple of years, while many observers are predicting some fall in land prices from current levels). However, in the meantime, the entry costs of getting into farming are still too high, which excludes fresh blood and innovation. For example, why would anybody take seriously advice to improve the market acceptability of the meat they produce, or the wool they produce, if the real crop is selling the ˝ property to the next guy? Why would the pursuit of excellence, that this summit is promoting, have any relevance, if the primary goal is property speculation? The answer, ladies and gentlemen, is no reason at all. My worry is that, as the profitability of producing meat, and wool, and milk is gradually restored with a lower exchange rate, farmers will quickly capitalise that increased profitability into the price of land once more. If that happens, the profitability of farming will remain low indefinitely: farm-owners may have substantial wealth, but the rate of return on that wealth will remain very low. Eventually, this process only ends when people refuse to invest in an industry where the rate of return is so low and the risks - of weather, disease, and markets - are so considerable, and put their money in the bank instead. Farming doesn’t come to an end at that point: land prices fall to the point where the rate of return on farming seems attractive relative to the risk. ˝
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reserve bank of new zealand
| 1,998 | 4 |
Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, before the Auckland Chamber of Commerce, in Auckland, on 20/4/98.
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Mr. Brash speaks on monetary policy in New Zealand Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, before the Auckland Chamber of Commerce, in Auckland, on 20/4/98. I very much appreciate this opportunity to address such an important Auckland audience at this time. We all know that, on 18 March, the Reserve Bank announced a further easing of monetary policy, an easing which was rather larger than most people had been expecting. Since then, the exchange rate has fallen and interest rates have risen (especially at the short end of the yield curve). These developments have led to a great deal of puzzlement and some anger. What kind of easing is it which leads to an increase in interest rates? Hasn’t Don Brash become just like Rob Muldoon, interfering in the market and manipulating first this lever and then that - perhaps initially focused on keeping inflation low but now, worried by the balance of payments deficit, pushing down the exchange rate to help reduce that deficit and pushing up interest rates to punish Auckland house buyers? Why do we need the Reserve Bank interfering in financial markets at all, now that we have a largely deregulated economy? Surely the easing was totally ‘botched’? This morning I want to answer those charges. (I will not be making any comments on the current level of the MCI, or about what the Bank might or might not do about it.) Central banks are an ‘intervention’, but the RBNZ is not ‘Muldoonist’ Let me begin by stating at the outset that central banks are an intervention in the economy. The Reserve Bank of New Zealand probably has less direct control over financial market prices than any other central bank in the world - we haven’t intervened in the foreign exchange market for 13 years, for example, and don’t fix any single interest rate - but I do not deny for a moment that we intervene to influence overall monetary conditions. I do not want to be side-tracked into a long debate about the virtues of having a central bank, beyond simply observing that for all practical purposes we either have our own central bank, as the great majority of countries do, or we abandon our own currency and use the services of some other central bank, such as Hong Kong and Argentina effectively do (they use the services of the US central bank of course). As long as we want to retain our own money, we need to have a monetary policy, and some institutional structure with which to implement that monetary policy. The key issue is what that institution, typically a central bank, should try to achieve with its powers. I presume that those who accuse us of having become ‘Muldoonist’ believe that we have given up our single-minded pursuit of price stability and have instead started using monetary policy to achieve other objectives, perhaps trying to help to reduce the balance of payments deficit or trying to deflate property prices. Some people have of course welcomed this ‘more pragmatic approach’. I don’t think even our worst critics have accused us of manipulating monetary policy for political purposes, which of course was one of the accusations levelled against Rob Muldoon. So let me say it again: monetary policy has been exclusively focused on delivering low inflation in accordance with the target agreed with Government (initially 0 to 2 per cent, now 0 to 3 per cent) since at least the time I was appointed Governor, now almost 10 years ago. Monetary policy remains focused exclusively on that objective. Indeed, any other focus for monetary policy would be inconsistent with the legislation under which the Reserve Bank operates, passed without dissent in 1989. But it is important to recall that price stability was not chosen as the single objective of monetary policy because Parliament thought that other objectives were unimportant. Rather, by the late eighties it had become increasingly recognised here and abroad that the best contribution which monetary policy could make to those other objectives - social justice, growth in employment, growth in output - was to deliver predictably stable prices. And indeed, this point is now recognised quite explicitly in the wording of the Policy Targets Agreement between the Treasurer and myself. Monetary policy aimed at stable prices assists social justice by avoiding the kind of capricious transfers of income and wealth which are the inevitable result of inflation. Monetary policy aimed at stable prices assists growth in output and jobs by helping the price system, which is at the heart of the market economy, work more effectively. And monetary policy aimed at stable prices assists the economy by helping to smooth business cycles. Ah, you say, he admits it: the Reserve Bank is using monetary policy to try to smooth the business cycle. No, I am not saying that at all. What I am saying is that when monetary policy is aimed at delivering stable prices it has the ancillary benefit that the business cycle may be smoothed to some degree also. Why? Because the situations where inflationary pressures are increasing are by their nature usually situations where demand in the economy is running ahead of the economy’s long-term capacity to supply, so that monetary policy aimed at restraining those inflationary pressures inevitably tends to dampen down booms. And conversely, those situations where demand falls short of the economy’s long-term capacity to supply are usually situations where inflationary pressures are falling towards zero, so that monetary policy aimed at preventing inflation falling below zero (as required by my agreement with the Treasurer) inevitably tends to work to mitigate those downturns. In determining the stance of monetary policy, we are inevitably trying to assess what future inflation pressures will be. That means we are always trying to assess how demand pressures will evolve relative to the economy’s ability to supply. Are we primarily trying to smooth business cycles? No, we are trying to maintain consistently low inflation within the target we have agreed with Government, but one of the corollaries, one of the ancillary benefits, is that, if we get it right, the business cycle will be somewhat moderated also - less vigorous booms and less recessionary busts. As one of America’s leading monetary policy economists, Larry Ball of Johns Hopkins University, has recently argued, even if you were mainly concerned to smooth output and employment cycles, focusing monetary policy on delivering predictably low inflation would be the most sensible way of running monetary policy. So let’s make this abundantly clear. The Reserve Bank has not had some sort of road-to-Damascus experience. We have not decided that inflation matters less and that we have to ‘go for growth’. We have not decided to fix the current account. We have not decided to get the farmers back in the black. And we have certainly not, as columnist Chris Trotter put it, anticipated ‘the National Government’s political needs’. The easing process that is now underway is absolutely intrinsic to, and an inevitable result of, the monetary policy framework that has applied in New Zealand since the passage of the 1989 Reserve Bank Act. More precisely, it is the inevitable result of an inflation target which has an upper and a lower limit. Recent events are therefore just ‘business as usual’. Recent changes in interest rates and the exchange rate But, you ask, hasn’t the Reserve Bank just deliberately knocked down the exchange rate and increased interest rates? Doesn’t that suggest that the Bank has taken its eye off the price stability ball, and is now trying to manipulate conditions in order to reduce the balance of payments deficit? That is certainly a widespread perception, but it is totally wrong. For a very long time, the Bank has argued that, while we can tighten monetary policy or we can ease monetary policy, we can not control the way in which these policy adjustments affect monetary conditions. Put another way, the mix of monetary conditions is determined by the decisions and perceptions of countless thousands of individuals, borrowers and savers, both within New Zealand and overseas. Let me illustrate that point first by looking not at the events of the last few weeks and months but rather at the period during which monetary policy was being tightened to head off emerging inflationary pressures from early 1994. Graph 1 shows how overall monetary conditions tightened from the beginning of 1994 through to late 1996. In 1994, that tightening took the form of both an increase in interest rates and an increase in the exchange rate, as shown in Graph 2. But through 1995 and 1996, as exporters and those competing with imports know only too well, interest rates fluctuated through quite a narrow band while the exchange rate continued to increase strongly. Indeed, at times the overall firming of conditions took the form of an actual fall in interest rates, more than offset, in terms of the effect on inflationary pressures, by a strong increase in the exchange rate. GRAPH 1 Nominal Monetary Conditions Index January 1994 - April 1998 Index Index 11 Mar 98 -400 11 Dec 97 -400 12 Sep 97 -200 14 Jun 97 -200 16 Mar 97 16 Dec 96 17 Sep 96 19 Jun 96 21 Mar 96 22 Dec 95 23 Sep 95 25 Jun 95 27 Mar 95 27 Dec 94 28 Sep 94 30 Jun 94 1 Apr 94 1 Jan 94 GRAPH 2 TWI & 90 Day Bank Bill Rate January 1994 - December 1996 Index 70.0 % 67.5 65.0 62.5 60.0 TWI (LHS) 90 Day Bank Bill Rate (RHS) 57.5 16 Nov 96 27 Sep 96 8 Aug 96 19 Jun 96 30 Apr 96 11 Mar 96 21 Jan 96 2 Dec 95 13 Oct 95 24 Aug 95 5 Jul 95 16 May 95 27 Mar 95 5 Feb 95 17 Dec 94 28 Oct 94 8 Sep 94 20 Jul 94 31 May 94 11 Apr 94 20 Feb 94 1 Jan 94 55.0 Were overall monetary conditions firming through that period, even though interest rates were stable and sometimes falling? In my view they were, and I suspect that most exporters and those competing with imports are in full agreement. Was the situation ideal? In my view it was not. From our point of view in the central bank, it meant that interest rates stayed too low to restrain the very strong growth in borrowing which occurred through that period, which in turn meant that there was insufficient disinflationary pressure on those domestic sectors of the economy which were the source of so much of the inflation in those years. Conversely, the strong increase in the exchange rate was putting more and more disinflationary pressure on those sectors of the economy in competition with the rest of the world, even though inflation in those sectors was very low. I occasionally expressed my unhappiness with that particular mix of monetary conditions, but I recognised that I was not able to change it. Over the last year or so of course the process has been substantially reversed. The Bank has been progressively willing to ease overall monetary conditions, and the extent of this easing since the end of 1996 is also shown in Graph 1. But as can be seen in Graph 3, all of the easing, indeed more than all of the easing, has taken the form of a fall in the exchange rate, offset in part by some increase in interest rates. Is this new mix of monetary conditions surprising? Not really, given the widespread perception that New Zealand’s balance of payments deficit has reached a high level and given the still-strong demand by New Zealanders to borrow. In other words, our strong demand to borrow and our reluctance to save require us to attract the savings of foreigners. Since those foreign savers have seen an increasing risk that the New Zealand dollar might depreciate, we have had to pay increasing interest rates to offset that perceived risk of currency depreciation. GRAPH 3 TWI & 90 Day Bank Bill Rate January 1997 - April 1998 Index % 70.0 67.5 65.0 62.5 60.0 TWI (LHS) 90 Day Bank Bill Rate (RHS) 57.5 6 Apr 98 17 Mar 98 25 Feb 98 5 Feb 98 16 Jan 98 27 Dec 97 7 Dec 97 17 Nov 97 28 Oct 97 8 Oct 97 18 Sep 97 29 Aug 97 9 Aug 97 20 Jul 97 30 Jun 97 10 Jun 97 21 May 97 1 May 97 11 Apr 97 22 Mar 97 2 Mar 97 10 Feb 97 21 Jan 97 1 Jan 97 55.0 Is the new mix of monetary conditions in some sense undesirable? I am sure it must seem so to many indebted companies and households. On the other hand, I am equally confident that there are a great number of people in the export sector, and in companies competing with imports, who are absolutely delighted by the change in the mix of monetary conditions. So also are those people who derive income from their savings. Predictably, most of them are not issuing press statements expressing their delight, so the overall impression created is that the whole country is miserable about the change. In my own view, the change in the mix of monetary conditions which we have seen over the last year or so has been a positive development for the economy’s medium-term development. It should certainly assist in reducing the currently large balance of payments deficit. Having said that, however, the balance of payments is not an objective of monetary policy - and that’s just as well because, as I have noted already, monetary policy has no ability to influence the mix of monetary conditions. But didn’t the Reserve Bank deliberately change the mix, by projecting a weaker exchange rate and higher interest rates in its quarterly inflation projections? Certainly, we did project an easing in overall monetary conditions over the next year or so and, because we have to make some assumption about how that easing will be reflected in interest rates and the exchange rate in order to complete our inflation projection, we did indicate that we expected that easing to take the form of a somewhat reduced exchange rate and broadly unchanged interest rates (at least through 1998). But we have routinely disclosed the interest and exchange rate assumptions underlying our inflation projections, and financial markets have understood that these are not assumptions which we necessarily expect to see realised, let alone assumptions which we can in some way enforce on financial markets. In December 1997, for example, we projected that the exchange rate would remain broadly unchanged at 64.2 on the Trade-Weighted Index and the 90 day interest rate would stay at around 7.6 per cent through the first half of 1998. Well before our March projections were published, the exchange rate had fallen well below 64.2 and interest rates had risen above 7.6 per cent. Neither in December 1997 nor in March 1998 were our assumptions about the path of interest and exchange rates intended to direct financial markets to particular outcomes. But hasn’t the Reserve Bank’s easing been ‘botched’ in some way? Has there really been an easing at all? On those questions I have not the slightest doubt. One can debate whether the Bank’s Monetary Conditions Index is correctly calibrated, whether a 2 per cent fall in the exchange rate is equivalent to a 100 basis point movement in 90 day interest rates. One can debate whether the Bank’s Trade-Weighted Index correctly measures movements in the New Zealand dollar. One can debate whether the 90-day interest rate correctly measures movements in New Zealand interest rates. And I am familiar with all of that debate. (We dealt with several of these issues in the March 1998 Economic Projections, and in my speaking notes for journalists in releasing that document.) But if we accept, as I believe we must, that in a small, open economy monetary policy works to affect the real economy and, in that way, inflation through both interest rates and the exchange rate, then I don’t have the slightest doubt that overall monetary conditions have eased in New Zealand in recent months, and indeed have eased quite considerably. That easing has taken the form of a sharp fall in the exchange rate which has been partly offset by an increase in short-term interest rates (the increase in longer-term interest rates has been much more moderate). I have often conceded that the MCI is not a perfect measure of monetary conditions. We will continue to seek ways to improve it. But as a rule-of-thumb to guide financial markets between quarterly projections it has proven enormously useful. It has assisted us through a very major rebalancing of monetary conditions at a time of great turbulence in financial markets internationally, with an absolute minimum of drama. Yes, interest rates have gone up, but given our balance of payments deficit - or in other words, our huge appetite for borrowing and our national aversion to saving - that should not be a matter for surprise or regret. If as a nation we become less enthusiastic about borrowing or more enthusiastic about saving, we can expect interest rates to decline to the levels which would seem to be justified by our low inflation. In conclusion, I think it is important that we all look at recent events objectively. Right now, the New Zealand economy is having to adapt to a complex set of circumstances, including an increase in government expenditure, a reduction in taxation, a changing housing market, and, coming rapidly over the horizon, the negative implications of the Asian financial crisis. Yet what we see is adjustment to these new circumstances, taking place within existing structures, without great drama. Monetary policy, with its single focus on price stability and its total transparency, has reacted as it must, smoothly and objectively. The markets too are dealing with changed circumstances and creating a context within which New Zealand can be more internationally competitive. This is ‘business as usual’.
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reserve bank of new zealand
| 1,998 | 5 |
Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Construction Liaison Group in Wellington on 26/6/98.
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Mr. Brash points out some positive aspects of New Zealand’s situation in the world economy Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald Brash, to the Construction Liaison Group in Wellington on 26/6/98. Introduction Over recent months, there has been a great deal of negative economic news. In countries as diverse as Italy and Japan, GDP data for the March quarter have been released suggesting economic activity is slowing down. Growth in industrial production in the 14 countries which we monitor most closely in preparing our own economic forecasts was projected to be just 0.1 per cent in 1998 in the June Consensus Forecasts, a significant fall from the increase of 3.8 per cent expected last November, and even a fall from the 1.0 per cent increase expected as recently as last month. Financial markets have been extremely turbulent, with particularly volatile trading in the foreign exchange market and some equity markets. Where is the world economy going, and how will New Zealand be affected? It is always risky being too definitive in answer to questions of this kind, because in reality nobody can know the answers with any confidence. But it is particularly dangerous to give answers at this time. If one suggests that the world economy is in for a very rough ride, and New Zealand with it, one is accused of undermining confidence and making the situation worse. If one points out some of the positive aspects of New Zealand’s situation, one is accused of being hopelessly unrealistic. Today I will try to be totally realistic. You may not agree with me, but I will not gild the lily. The implications of the situation in Asia are serious for New Zealand In our December 1997 Monetary Policy Statement, we estimated that growth in our trading partners would average 1 per cent less than otherwise over 1998/99 due to the events in Asia, and in releasing that document I commented that the most obvious risk to our economic projection was that the difficulties in Asia would turn out to be even more serious than we assumed at that time. In the intervening six months, the situation has indeed become markedly worse. Whereas in November 1997, the Consensus Forecasts projected Japan’s industrial production to grow by 1.6 per cent in 1998, the comparable estimate in June 1998 is minus 4.0 per cent. Whereas in November 1997, the Consensus Forecasts projected Korea’s industrial production to grow by 8.2 percent in 1998, the comparable estimate in June 1998 is minus 7.8 per cent. Whereas in November 1997, the Consensus Forecasts projected Indonesia’s industrial production to grow by 6.9 per cent in 1998, the comparable estimate in June 1998 is minus 13.3 per cent. Japan’s banking system is under severe strain, and this is hampering the recovery of that economy. The same is true in many of the other countries of Asia. A number - potentially a large number - of banks will fail unless the governments of the countries concerned are willing and able to support them. Even those countries which have strong banking systems, such as Hong Kong and Singapore, face very sharp slowdowns in economic activity and possibly recession in 1998. So the economic situation in Asia has deteriorated significantly in recent months and could get much worse yet. With the exception of Japan, Korea and Australia, New Zealand has a bigger exposure to Asian markets than does any other OECD country. In 1997, some 36 per cent of our total exports went to the countries of East Asia. In that year, Japan was our second largest export market, and Korea our fifth largest market. Of our 10 largest export markets, six were in the East Asian area last year, or seven if Australia is included. And Australia itself has a huge exposure to the markets of Asia, which means that we have a further indirect exposure to those markets through that country, now easily our largest single market. Of the tourists who visited New Zealand in 1997, over 30 per cent came from East Asia. This substantial involvement in the markets of Asia has been of great benefit to New Zealand in the past, and will be of great benefit to us in the future. But right now, their pain is also our headache. In the three months to April, for example, our exports to Korea were down 48 per cent compared with the same three months in 1997, while exports to Indonesia were down 69 per cent. Some commodity exports, such as logs and deer velvet, have been particularly hard hit. This has had a severe impact on some industries and some regions. Moreover, there are other risks. If the Japanese economy moves deeper into recession, and the Japanese yen resumes its fall, there could be further downward pressure on other currencies in the region, as well as political pressures to build protectionist barriers around other markets. Or, because of Asian difficulties or for some other reason, the US equity market could turn down sharply, triggering an abrupt slowdown in the United States economy. As I said in releasing our May Monetary Policy Statement, it is not at all difficult to envisage circumstances where the New Zealand economy grows more slowly than projected. Indeed, it is possible to imagine scenarios where the world economy at least is quite weak. The external environment is not good, and could get markedly worse. To complicate matters still further, New Zealand enters this period of international turbulence with a balance of payments deficit exceeding 7 per cent of GDP, and a negative net international investment position (overseas assets less liabilities to foreigners) of some 80 per cent of GDP, both high figures by international standards. But we have many strengths So we face serious challenges. But having established that I am fully aware of that fact, allow me also to note some of the advantages we have in dealing with those challenges. First, while a little over one-third of our exports go to East Asia, almost two-thirds do not. And many of those other markets continue to grow strongly at this stage. In the three months to April, New Zealand’s exports increased by nearly 30 per cent to the United States (our third largest market) as compared with the same three months in 1997, while those to Belgium and Italy increased by more than 50 per cent. Even exports to some parts of East Asia increased during that period - to Hong Kong by 29 per cent and to Singapore by 27 per cent. While tourist arrivals from Korea in the month of May were down 89 per cent as compared with the year earlier level, and from Thailand by 64 per cent, overall visitor numbers were down only 7 per cent as a result of increases in tourists from the US, Britain and Australia. Our exporters and tourist operators are showing considerable ability to switch from weak markets to more buoyant markets. The decline in the New Zealand dollar against the currencies of the United States and Europe has greatly helped in this re-orientation of our markets. Secondly, we go into this period of international turbulence without the grossly over-inflated asset prices which have been such a serious problem in many of the countries of Asia, and which were such a serious problem in Japan in the late eighties and early nineties. It is the pricking of these asset price bubbles which has often done so much damage to banking sectors and, as a consequence, to the real economies of the countries affected. Yes, I have at times lamented the high prices paid for both houses and rural land in New Zealand. I remain convinced that some of these prices reflected unrealistic expectations of future income growth. But the extent to which these prices got out of line with long-term trends was relatively minor compared with the inflation in asset prices in some of the countries of Asia. We are quite unlikely to see the 60 to 80 per cent fall in such prices which have been common elsewhere in the Asian region. And we have not (in the last few years) seen ‘price bubbles’ in either commercial property or equities. Of course, in part, the absence of significant asset price bubbles in New Zealand is a direct result of the fact that monetary policy here was leaning hard against inflationary pressures throughout the middle part of the decade. While that attracted a great deal of criticism at the time, it now means that we don’t face the painful adjustments which inevitably follow when asset price bubbles burst. Thirdly, and related in part to the substantial absence of asset price bubbles, we have a banking sector which is arguably as strong and as competitive as at any time in New Zealand’s history. This is in marked contrast to the situation in all of the troubled countries of Asia. Indeed, the troubled countries of Asia are in an important sense defined as those where the banking sectors are in serious trouble. Fourthly, we go into this period of turbulence with a ratio of net public sector debt to GDP of only some 25 per cent, less than half the level as recently as 1992. This ratio is one of the lowest in the OECD. While the Government does owe some of this debt to foreigners, the foreign currency component of the public sector debt is exactly matched by foreign currency assets, so that the Crown has no net foreign currency debt at all. As everybody knows, Government has been running fiscal surpluses for the last five financial years, and is budgeting to continue doing so for the next three years. This clearly gives the country considerably more room to manoeuvre than if we were already running substantial fiscal deficits. And perhaps most important of all, New Zealand has a floating exchange rate regime, and has had since March 1985. This has two hugely important implications. First it means that the value of the New Zealand dollar adjusts day by day and month by month as supply and demand change. This in turn means that, if there is a perception that New Zealand is in a difficult period, for whatever reason, the New Zealand dollar tends to fall in value (and vice versa). This tends to offset some of the impact of a weaker international environment. And this is precisely what has happened over the last year or so, with the New Zealand dollar down from its peak by some 28 per cent against the US dollar and by 17 per cent against the Trade-Weighted Index (TWI). As a result, though the average world price of the commodities that New Zealand exporters sell declined by 10.8 per cent over the last year, the New Zealand price of those exports actually rose by 9.3 per cent over the same period. Furthermore, having a floating exchange rate regime - one where everybody understands that neither the Government nor the central bank will interfere in the foreign exchange market to prop up the value of the dollar - strongly discourages banks and corporates from taking on unhedged foreign exchange liabilities. This means that when the New Zealand dollar moves substantially, as it has done over the last year or so, neither banks nor corporates incur the huge losses which have been commonplace in countries which have been forced to abandon fixed exchange rate regimes.1 To the best of my knowledge, there has been nothing which could be called a foreign exchange crisis in any country with a floating exchange rate regime since 1945. In a recent editorial, the Christchurch Press suggested that ‘New Zealand is a child out in the economic storm this week - out in the storm without a hat or coat and with gumboots leaking’.2 Certainly, the weather is getting rough, and may get rougher. But in my own view, we have good wet-weather gear and a sturdy four-wheel-drive vehicle. Should policies be changed? Are there things which Government should be doing to further assist the country weather the storm? Clearly, one of the issues being focused on currently is the desirability of Government’s cutting back on some of its planned increase in expenditure because of the risk that, with slower economic growth a possibility, the projected operating surplus may turn into a deficit. To the economist, cutting government expenditure in a growth slowdown seems counter-intuitive. Better, surely, to allow the ‘automatic stabilisers’ to work, with the Government’s operating position moving into a small deficit when the economy is in the trough of the cycle and into a surplus at the peak. Moreover, there is quite a strong case for allowing longer-term considerations to determine fiscal decisions, in the light of considered judgements about the appropriate size of the public sector in the context of Government’s economic and social objectives. On the other hand, it must be acknowledged that the Government’s determination to run fiscal surpluses throughout the cycle, and to achieve further reductions in net public sector debt, has been one of the important reasons why foreign investors have been willing to finance New Zealanders’ insatiable appetite for borrowing in recent years. Should there be no Government fiscal response to the present situation, and should a fiscal deficit subsequently emerge, the confidence of foreign investors could be somewhat undermined - with resultant upward pressure on interest rates and downward pressure on the exchange rate. Last week, the Government Statistician announced that the gross overseas debt of New Zealand banks and corporates had risen by $20.1 billion during the year to 31 March 1998, to reach a total of $79.0 billion. Of this increase, it was stated that $6.2 billion was on account of the increase in the New Zealand dollar value of foreign currency debt. It was also noted, however, that the figures took no account of ‘hedging or other financial derivatives used by companies to offset potential foreign currency risk.’ The significance of this note has almost certainly been missed by many commentators, because it is quite clear that all banks, and I suspect most corporates, hedge their foreign-currency denominated liabilities in full or in substantial part. Certainly at 31 March 1998, the four largest banks, which have been heavy borrowers of foreign funds in recent years, carried almost no foreign exchange risk on that borrowing. This means that the increase in the New Zealand dollar equivalent of the gross overseas liabilities of the banking system as a result of the depreciation in the New Zealand dollar, included in the debt figures published by the Government Statistician, will have been almost exactly matched by gains on the banks’ currency hedges. The Press, 23 June 1998. Moreover, in recent years it has been possible to argue that New Zealand’s balance of payments deficit has been a result of investment exceeding saving in the private sector; the public sector was more than funding its own investment activities through its operating surplus. In 1998/99, the budgeted operating surplus looks likely to be broadly similar to public sector investment. If the operating surplus turns out to be less than now budgeted, perhaps because economic growth turns out to be slower than projected, it is possible that public sector investment will exceed the operating surplus. In other words, if the operating surplus turns out to be less than now budgeted, the public sector will be contributing to the balance of payments deficit in 1998/99 for the first time in several years. If Government were to cut back on its own spending, this would further dampen demand in the domestic (non-tradeable) part of the economy. This would in turn permit some further easing in monetary conditions without putting price stability at risk, leading to stronger investment in export and import-competing sectors of the economy. The economic benefit would be faster reduction in the balance of payments deficit. The economic cost would be slower growth in the domestic (non-tradeable) part of the economy. To the best of my knowledge, all commentators project a gradual reduction in the balance of payments deficit over the next few years on present policy. My own hunch is that the deficit will in fact reduce somewhat more quickly than any of the official projections (including that of the Reserve Bank) now suggest, as a result of the substantial fall in the real exchange rate over the last 12 months and a decline in imports which may follow an increase in household sector saving, in turn a result of a decline in house prices. It is already evident that growth in bank lending to the household sector has slowed markedly in recent months. Offsetting that, of course, is the risk of further reductions in export volumes as a result of the prolonged drought, and the weakness in some of our export markets. At the end of the day, this decision about the trade-off between the speed of balance of payments adjustment and the strength of the domestic part of the economy must, of course, be a political judgement. Whatever Government chooses to do with fiscal policy, it is obviously important to continue with the programme of microeconomic reform, which can play such an important role in building on the competitiveness of New Zealand producers in world markets. What about monetary policy? It is my absolute conviction that monetary policy targeted at maintaining price stability has a crucial role to play in the uncertain environment in which we now find ourselves. Just as policy aimed at price stability must tighten monetary conditions as inflationary pressures increase, so policy aimed at price stability must ease monetary conditions as inflationary pressures abate. And that is what the Reserve Bank has been doing for the last 18 months. For much of 1997, before the Asian crisis became a present reality, we eased gradually from a level of 1000 on our Monetary Conditions Index (MCI) in the December quarter of 1996 to around 650 in the December quarter of 1997. As it became obvious that the international environment was deteriorating, we allowed conditions to ease substantially faster, to around 250 over the last month. The MCI seeks to measure the effect of both interest rates and the exchange rate on the real economy, and so on inflation. Perhaps not surprisingly, given New Zealand’s balance of payments deficit and the uncertain international environment, the easing in monetary conditions over the last year or so has been entirely in the form of a fall in the exchange rate. Indeed, 90-day interest rates have actually risen somewhat over that period. But overall the easing which has taken place over the last 18 months is equivalent to a fall in 90 day interest rates of over 7 per cent with unchanged exchange rate, a substantial easing in any language. Just as it was the export sector which bore much of the brunt of policy tightening between early 1994 and late 1996, so it has been the export sector which has received all of the benefit, so far, of the easing. Ten days ago I attended an interesting conference in Stockholm on the best ways of conducting monetary policy. One of the papers at that conference3 argued that, when the Swedish central bank became the first central bank to use monetary policy to try to maintain a stable price level in Sweden in the ‘thirties, it had the important benefit that Swedish output and employment were also maintained at markedly higher levels than was the case in other countries at that time. We in New Zealand do not target a price level but we have been charged with the responsibility of keeping inflation tightly constrained below 3 per cent and above 0 per cent. This does not imply that we can eliminate the economic cycle. The world is far too uncertain for that, and the lags between taking a monetary policy action and the effects of that action are both too long and too variable. (This means, incidentally, that there is nothing which monetary policy can do at this stage to affect the growth in GDP in the June quarter, which indeed is virtually over. There is virtually nothing which monetary policy can do at this stage to affect the growth in GDP in the September and December quarters. As far as monetary policy is concerned, those quarters are already substantially beyond influence. Whether they are quarters of strong growth or of weak growth will be determined by a range of domestic and international factors, one of which is monetary policy in 1997.) But, provided we take our responsibility to keep inflation above zero as seriously as we take our responsibility to keep it below 3 per cent, monetary policy should be able to protect the economy from any prolonged deflation and the loss of output and employment which that would entail. We have spent much of this decade fighting to keep inflation below the top of the target agreed with Government. It is at least possible that, over the next year or two, we will be working to prevent it from going through the bottom of that target. We will be as singleminded in that objective as we were in the earlier challenge. Indeed, we have been easing monetary conditions for more than a year with exactly that objective in view. Having said that, we also need to be mindful of the risks in ignoring the long lags with which monetary policy works. If we ignore those lags, we run the risk of making economic cycles worse. Alan Blinder, former vice-chairman of the Federal Reserve Board, sometimes uses the analogy of the thermostat. Who has not checked into a hotel room and turned up the heating because the room is too cold? Then, after having a shower, turned the heating up some more ‘Pioneering price level targeting: the Swedish experience 1931-1937’, by Claes Berg and Lars Jonung. because the room is still cold. And finally woken up two hours later in a sweat, with the room like an oven. It takes time for central heating to warm up a room. It takes time for an easing in monetary policy to offset a sharp increase in deflationary pressures. If we keep easing until activity actually starts picking up strongly, we run the risk that in a year or two we will need to be slamming on the brakes. As we have sanctioned very substantial easing over the last year, we have been conscious of this risk. We have been conscious also that, with the sharp fall in the exchange rate which has taken place, import prices may be pushed up, with a risk that this might spill over into more generalised inflationary pressures. We recognise that, even now, with confidence quite low among both businesses and households, there is a strong increase in activity in some parts of the economy, particularly in those parts of the manufacturing sector which have benefited most from the fall in the exchange rate. In short, while we can not eliminate cycles in economic activity, we believe that monetary policy aimed at price stability can smooth economic cycles to some degree. This means that when inflationary pressures increase, we can be relied upon to tighten. It means that when inflationary pressures fall away, perhaps because of a sharp deterioration in the international environment, we can be relied upon to ease. It certainly does not mean, as some commentators have asserted, that we operate in some kind of strait-jacket which requires us to suppress economic activity at every opportunity. Monetary policy aimed at delivering predictably low inflation enables the economy to maximise sustainable growth and employment opportunities. Conclusion The sharp downturn in many of our major export markets may well turn out to be the most serious shock to hit the New Zealand economy since the oil shocks of the ‘seventies. If so, the benefits of recent economic reforms, in reducing public sector debt and improving the flexibility and adaptability of the economy as a whole, will be evident for all to see. A monetary policy aimed firmly at price stability is of enormous benefit in weathering the storm. * * * NB This BIS Review is available on the BIS World Wide Web site (http://www.bis.org). _____________________________
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reserve bank of new zealand
| 1,998 | 7 |
Address by the Deputy Governor of the Reserve Bank of New Zealand, Mr. Murray Sherwin, to the New Zealand Institute of International Affairs in Wellington on 15/10/98.
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Mr. Sherwin reviews economic prospects and challenges for Asia and the Pacific region Address by the Deputy Governor of the Reserve Bank of New Zealand, Mr. Murray Sherwin, to the New Zealand Institute of International Affairs in Wellington on 15/10/98. I was asked to discuss the economic prospects for Asia and the Pacific. I’m going to take a fairly liberal interpretation of the topic. You will not be surprised that my comments are framed within a high degree of uncertainty about the direction of the global economy. Events of the past year or more have been dominated by a growing sense of contagion spreading from the initial Thai problems, and now affecting most parts of the world. Even over the last couple of months, we have seen Russia and Latin America faltering, and a substantial re-rating of corporate profit prospects in the USA and Europe. As we look forward to 1999 and 2000, we can do no better than guess at when these downward influences will run their course, and when robust, sustainable, recovery will commence within the Asian region. However, I will offer a few guesses on Asia’s prospects. I will also offer some observations on the nature of the adjustments and transitions now being worked through in Asia, especially within the financial sectors of the affected countries. The Asian Growth Story The Asian growth story, over three decades or more, has been extraordinary, with sustained annual expansions of the order of 7 to 10 percent. That is more than just a statistical nicety. Not only has Asian economic success supported growth in the rest of the world, it has been the driving force in the most profound process of poverty alleviation in human history. By World Bank estimates, where 60 percent of East Asians lived in absolute poverty (i.e. less than US$1 per day) in 1975, 20 percent were living in absolute poverty in 1995. The numbers living in poverty have declined, the severity of poverty has declined, life expectancy has climbed, infant mortality rates and literacy indicators have all improved in tandem with economic growth. Growth created jobs for the poor, and provided opportunities to expand their productivity. The Asian miracle was real and tangible. Of course, Paul Krugman made himself famous, and unpopular in some parts, by arguing that while Asia had generated extraordinary growth over an extended period, there was no magic formula that the rest of us could borrow in order to imitate that growth performance. To use Krugman’s now-famous line, perspiration, rather than inspiration, was the Asian secret. In tolerably well-organised economies, simply adding more inputs will lead to more outputs. Certainly, lots of Asians became wealthier, and were able to enjoy rapidly improving material well-being. But there was, in Krugman’s view, no miracle. There was no productivity steroid. The last year or so has generally given strength to Krugman’s analysis. In crude, and rather simplistic terms, the Asian formula worked so long as those new inputs were directed into areas where the real value added, at the micro level, was sufficient to support real growth at the macro level. Asia was able to generate high savings rates, and to maintain similarly high levels of investment. But as investment increased, to 30 or 40 percent of GDP in many cases, the quality of that investment began to deteriorate. Returns on investment were driven below the cost of capital. The legacy is a huge amount of surplus, and essentially redundant, capital stock. Inevitably, that surplus capacity has been repriced. The internationally tradable capacity has been repriced by way of local currency depreciations in most cases. As currencies fall, output becomes more competitive in foreign currency terms. The non-tradable component, largely surplus real estate investment, emerges in the form of sharply reduced asset prices, and in an enormous stock of bad debts. The Asian crisis has so far appeared largely as a financial crisis, at least in the eyes of casual observers from abroad. The volatility in financial asset prices - exchange rates, interest rates, equity prices - has been spectacular, and it is not surprising that attention has been attracted in that direction. Perhaps less visible, and certainly less reported, is the still emerging ‘real’ impact. Industries throughout the region now face declining markets, after years of unrelenting rapid growth. As already noted, the surplus capacity in many industries implies that asset values must decline. Companies will fail, or will if they are allowed to. Unemployment is rising, and will rise further. Poverty levels will rise again, and the welfare of, quite literally, hundreds of millions of people will deteriorate. Many will return to the absolute poverty that, a year ago, was a rapidly fading memory. That will not be a permanent deterioration. But the next couple of years promise to be harsh. Prospects In the longer term, I have no doubt that the region will return to robust growth almost certainly not as rapid as has been experienced in the past two or three decades, but still the sorts of growth rates that the rest of the world envies. As a guess, and it is no more than that, I would suggest a future of something closer to 4 to 6 percent annual growth rather than the 7 to 10 percent rates of old. Lower debt levels, and closer attention to risk, will likely feature in this slower growing Asia, and desirably so. What gives me confidence of resumed growth? Firstly, one of the largest investments, and without doubt the most important, made in Asia in recent decades has been in human capital. The Asian commitment to education has been immense, and the benefits of that will be durable. To put it crudely, the wheels may have fallen off the Asian economy for now, but the engine and chassis are still there, willing and able to move again. It is the human capital base that will provide the engine for recovery. Secondly, despite the vast strides made in the past, Asia still has some ‘catch-up’ to do. Average per capita incomes remain well below OECD levels in most of non-Japan Asia, and there remains scope for technology transfer into the region. Macro-economic management is likely to remain sound, and that provides the basis for believing that the process of catch-up can resume. But the short-term economic prospects are more difficult. At the Reserve Bank, we do not undertake independent forecasts of the economies of our trading partners. Rather, we look to the local experts, and rely on Consensus Forecasts - which are essentially a survey of local forecasters’ views for each country. Table 1 summarises the Consensus view of industrial production for the region’s economies. For 1998, I have included the results of the latest Consensus survey (September 1998) along with the corresponding forecasts of a year earlier. For 1999, the table shows the latest numbers, plus the results of the first survey of 1999, which was taken in January of this year. Table 1 Consensus forecasts of industrial production annual average Calendar Country Australia United States Japan TWI Weighted South Korea Taiwan Hong Kong* China Indonesia Malaysia Thailand 14 countries Export Weighted Calendar Share of NZ Exports 19.3 11.0 14.4 53.5 3.9 2.6 2.8 2.8 1.3 2.2 1.2 71.7 Forecast as at: Sep-97 Sep-98 4.3 2.9 2.8 3.3 2.4 -6.4 3.2 0.7 7.9 -8.1 6.4 4.6 5.4 -4.7 15.1 9.4 9.8 -16.2 10.1 -5.1 4.8 -13.1 4.4 -0.5 Forecast as at: Jan-98 Sep-98 3.3 2.4 2.2 2.4 1.6 -1.9 2.6 1.3 4.3 1.6 6.0 4.7 4.0 -2.8 12.8 9.9 5.9 -0.3 7.1 0.5 3.0 0.3 3.4 1.4 * GDP Two points are striking. Firstly, the extent and pervasiveness of the reduction in expected output over the course of the last year are enormous. By any historical standards, the region has suffered a very serious growth shock. Secondly, the current Consensus view for 1999 does not envisage any substantive recovery for the region. At best, it is suggestive of stabilisation at the new, lower, levels of activity. Note that the track of the past year or so has been one in which the Consensus growth forecasts have been repeatedly revised downward as they incorporated emerging news and data. There is no clear sense yet that that process has run its course. Note also that the latest growth outlook still assumes a fairly benign, and frankly implausibly optimistic, growth path for China, the USA and Europe. As noted earlier, it is impossible to get a firm grip on the near-term prospects while the contagion unleashed in Thailand in July of 1998 is still working its way around the globe. All going well, China, the USA and Europe will be able to sustain their positive growth paths, and will provide the pillars around which the affected countries can resume their growth. I think that is still the most likely scenario. But other, realistic, and much less comforting, scenarios can be conjured up with disturbing ease. Developments in financial markets over the past couple of weeks tip the balance even more in the direction of the pessimists. Even the scenario of continued modest growth involves some very harsh transitions for Asia. I will focus on primarily one aspect of that transition - namely the enormous damage that has been wrought to balance sheets in the region and what will be required to remedy that. Financial Sector Adjustments What has been highlighted by the Asian crash is the extent to which Asian growth has been debt fuelled and has proceeded on structures that were inherently risky. Assumptions were made about the ability of Asian governments to shelter entrepreneurs from those risks. Those assumptions proved ill-founded. Deals that involved borrowing in low-interest foreign currency terms to invest in rapidly inflating domestic property assets, for example, were premised on exchange rates remaining fixed, and property prices continuing to inflate. Other investments in manufacturing capacity were based around assumptions of continued rapid growth in demand, continued access to loan funding, plus stable interest and exchange rates. It was a good formula while it lasted, but it could not last. Estimates of the extent of balance sheet damage done in the Asian collapse carry wide margins of error, largely because asset prices remain uncertain and accounting and auditing conventions do not always provide reliable guidance as to the health of entities. However, even in accepting those wide margins of error, it seems plausible that, within the region’s financial sectors alone, losses have been incurred which are equivalent to something of the order of 25 to 50 percent of GDP. Even for Japan, non-performing assets of the banking system (not all of which will become ‘losses’) are estimated by one of the credit rating agencies at 30 percent of GDP. The USA Treasury estimates for total non-performing assets of Japan’s banks run to a more modest 20 percent of GDP. By comparison, the USA savings and loan problems of the early 1990’s involved losses of around 3 percent of USA GDP, and the Scandinavian financial sector collapses of the same period ran closer to 6 to 8 percent of GDP. To find anything comparable to what has happened to Asia, we have to look to the Argentinian crisis of the early 1980’s which led to loan losses of the order of 50 percent of GDP. It is difficult to see how robust growth can resume in Asia before these equity holes are filled. The obvious question is how to achieve that. Specifically, where will the money come from? First, we need to recognise that not all such losses need to be ‘replaced’. The financial sectors in much of Asia were almost certainly rather larger than needed and therefore don’t need to be fully ‘replaced’. Indonesia, for example, had something like 240 banks servicing an economy which, at its peak, was little more than three times the size of New Zealand’s. As in other parts of the region, most of those banks are insolvent. But it will not be necessary to rebuild the capital base of each to BIS standards. Without wishing to diminish the magnitude of the task, many, if not most, of those banks can probably be allowed to disappear, through mergers or closures, without impairing the effective functioning of the economy. Indeed, the priority throughout the region is to quickly resurrect functioning and trustworthy financial systems around a small core of robust institutions. Even that will require enormous equity injections. Where will that equity be found? The options are reasonably clear cut: • • • • • shareholders of banks creditors (i.e. depositors) of banks the public purse domestic investors foreign investors But those options are somewhat constrained. In essence, existing shareholders have, to use the vernacular, ‘lost their shirts’. Some private shareholders may be able to contribute additional capital, but most will not. For the most part, the depositors of banks in the region have already received public guarantees on their deposits. There seems little prospect that they will be obliged or allowed to share directly in the losses accrued. The public purse is the mostly likely source of substantial, and early, new equity. Most countries in the region went into this crash with relatively light public debt loads. Most could probably absorb an additional debt burden of, say, 10 to 20 percent of GDP equivalent in order to recapitalise banks and deal, at least in part, with the bad debts. In so doing, they would, in effect, socialise the losses, and spread the impact of the economic collapse over the next decade or two. Of course, as conditions improve, and perceptions grow that the worst of the shock is over, private investors will be increasingly willing and able to reinvest, enabling the governments to withdraw from direct ownership and retire at least some of that debt. Whatever view one takes of the desirability of public investment in financial institutions, it is difficult to see how this particular option can be avoided given the magnitude of the problems that have emerged, and the profound lack of confidence on the part of private investors which now exists. Indeed, this process of public capital injections is already well under way in Korea, Thailand and Indonesia. Japan, it seems, is still struggling with the concept. Asia’s domestic private investors, for the most part, have taken such an enormous hit to net worth that it is difficult to imagine them being an early or substantial source of new capital for banks. In any event, the need for new equity extends well into the non-financial business sector also, and even with Asia’s renowned savings capacity, the short-term need for private savings well exceeds the local capacity to supply. That leaves only foreign investment in Asian financial systems and industry as a substantial and available avenue for prompt recapitalisation and rapid economic recovery. Foreign investment would bring more than just capital. The region needs skills, experience, risk management systems, accounting and auditing systems, diversification of ownership risk and, perhaps beyond all else, high reputation and confidence in creditworthiness. Foreign investors can provide all of that. Certainly, foreign investment in the region’s financial systems is already occurring. However, my impression is that it is not always openly welcomed. I am well aware of all of the national reservations about foreign investment, and I don’t approach this issue with a strongly ideological view of the subject. But it does seem that without a more liberal and welcoming approach to foreign investment, the recovery will be slower because the region’s equity needs far exceed the capacity of domestic sources - public and private - to provide. Before private investors, of either domestic or foreign origin, are enticed into recapitalising the region’s banks, there will have to be substantial progress on issues of accounting standards, audit standards, transparency, and legal underpinning of bankruptcy proceedings and commercial law more generally. Investors will not invest unless reasonably confident that they understand the risks they are accepting (which, as recent events prove, isn’t the same as saying that investors will assess those risks accurately). Reducing those risks is one of the most productive activities that governments in the region can now engage themselves in. Concluding Comments Asia has suffered a shock which, by any historical comparison, is severe. Recovery from that shock will take time and perhaps the most useful thing that can come from the experience now is to extract the available lessons and try to ensure that recovery is sound, durable and less susceptible to such crises in future. Asia 2000 Executive Director Philip Gibson in a recent speech pointed to the fundamental strengths of Asian countries, in terms of their cohesiveness, willingness to save and invest, commitment to improvement, especially through education, and commitment to recovery. All of those qualities are evident, and all will be necessary over the next couple of years as recovery takes root. To my mind, there are two key lessons emerging from the Asian experience, and these are now being reinforced by events elsewhere around the world. • The crucial importance of a strong, well-capitalised financial sector, with robust systems for recognising and managing risk. The experience is showing us again just how financial system stress can amplify difficulties in the rest of the economy. • Asset price booms may be enjoyable on the way up, but are terribly destructive when the bubble finally pops. If those two lessons are well-learnt, and applied in future policy making, Asia’s future will be even more robust and durable than its past.
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reserve bank of new zealand
| 1,998 | 10 |
Address by the Governor of the Reserve Bank of New Zealand, Mr. Donald T. Brash, to The New Zealand Society of Actuaries inWaitangi on 21/10/98.
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Mr. Brash gives an address on ‘Reserve Bank forecasting: should we feel guilty?’ Address by the Governor of the Reserve Bank of New Zealand, Mr. Donald T. Brash, to The New Zealand Society of Actuaries inWaitangi on 21/10/98. Introduction Thank you for the invitation to address you today. I last addressed the Society in April 1995 on why I was strongly in favour of the Government’s issuing inflation-indexed bonds. Notwithstanding some concerns about the tax treatment of those bonds, and their inaccessibility to small investors, I believe that the issue of the bonds has been successful, and I am very glad that the Government proceeded to issue them. Today, I want to talk on quite a different matter. You, as actuaries, spend a lot of your time assessing the viability of pension schemes, and in doing that you need to make assumptions about the rate of inflation, the rate of return on investments, and a host of other things. And of course sometimes your assumptions turn out to be wrong, because the one thing you can all be absolutely certain of is that the future will never turn out to be quite the same as you assume it will be. Well, I have a great deal of sympathy for you. Like you, I as a central banker spend a great deal of my time trying to make an assessment of the future. And like you, I rarely get it absolutely right. Recently, the Reserve Bank has been severely criticized by a number of people for having misread the economy in recent months, and in particular for failing to head off the two quarters of negative growth which New Zealand experienced in the first half of this year. One major newspaper has gone so far as to suggest that our forecasting record is ‘abysmal’. In recent days, with the New Zealand dollar up sharply against the US dollar, we have also been criticized for allowing this to happen. I believe the critics are wrong. The accuracy of Reserve Bank projections The Reserve Bank devotes very considerable effort to its projections. We study a very wide range of data from New Zealand sources on production, prices, wages, money supply, bank credit, business and household confidence, and much more. We have developed a series of so-called indicator models, which help us to assess what is happening in the economy at the present time, before we have the official GDP figures available to us. We have developed a sophisticated model of the whole economy to help us with medium-term forecasting, after looking carefully at the work done in other similar countries, particularly in Canada and Scandinavia. Before each quarterly projection, a group of Reserve Bank staff fans out across the country and talks to upwards of 40 businesses and business organisations to get an up-to-the-minute impression of what a small number of - hopefully - representative firms are experiencing. We have, for example, talked with 54 companies and business organisations throughout the country in the last few weeks, in preparation for our November Monetary Policy Statement. We get information from the non-executive Directors of the Bank itself, and from a large number of informal sources, such as letters, phone calls, and the meetings which I myself have throughout the country. We talk to Statistics New Zealand to try to get an understanding of what lies behind some of the statistics. We talk to the producer boards to get an understanding of what is happening in the agricultural sector. As a result, we go into each quarterly projection ‘round’ armed with a very great deal of information on the New Zealand economy. We do not ourselves make forecasts of the international economy, but instead use the monthly Consensus Forecasts, produced by Consensus Economics Inc. in London. These reflect the assessment of a group of forecasters in each of the major countries to which New Zealand exports, and historically the average of these forecasts has tended to outperform the forecasting performance of any single forecaster. We certainly have no reason to believe that we could produce better forecasts for our overseas markets than can the forecasters ‘on the ground’ in the countries concerned. But despite all this effort, we often end up wishing, with the benefit of hindsight, that we had run monetary policy slightly differently. Unfortunately, it is inherent in the way in which monetary policy works that at times we will wish we had done things a little differently. Why? Because monetary policy has its effect on the real economy with a considerable lag, and its effect on inflation with an even longer lag. To make matters worse, the lags are not even stable. This means that to avoid making errors we would have to have perfect foresight, and of course I am not embarrassed to admit that we have nothing of the kind. Indeed, the situation is even worse than that. Not only can we not see into the future with perfect foresight, we do not even know precisely where the economy is at present. To be sure, we receive lots of anecdotes, and some of the data we analyse may only be a few weeks out of date. But the most comprehensive measure of output in the economy, the estimate for Gross Domestic Product, is not available for almost three months after the end of the quarter to which it refers - and then for the next year or so that figure is subject to revision, often to very substantial revision. Thus for example, the first estimate made by Statistics New Zealand for GDP in the March quarter of 1996 indicated that the economy was growing at an annualised rate of some 1.5 per cent. A year later, Statistics New Zealand estimated that the annualised growth rate for the March quarter of 1996 was actually some 4.2 per cent. The policy implications of those two numbers are radically different. Cynics have suggested that God made economic forecasters to make weather forecasters look good. But at least weather forecasters can look out the window, and with reasonable accuracy know what the weather is at the present time. Economic forecasters do not have that advantage. If monetary policy works well, it can help the economy adjust to the unforeseen shocks which will inevitably hit us from time to time, whether these be sudden changes in export prices, sudden changes in import prices, or whatever. This should have a tendency to smooth fluctuations in output to some extent. But it is quite unrealistic to expect that monetary policy can eliminate the business cycle completely, and we have never claimed that we can do so. No matter how prescient the Reserve Bank had been, the sudden collapse of the Korean economy was always going to have a hugely negative impact on the New Zealand forestry industry, and on parts of the New Zealand tourist industry. We should not, and do not, feel embarrassed about being unable to fully offset events such as that. In years past, some economists, recognising the very great practical problems involved in forecasting over the period relevant to monetary policy, suggested that as a substitute for economic forecasting central banks should simply concentrate on keeping some measure of money supply growing at a rate consistent with the inflation target. Alas, central banks around the world found that keeping money supply growing at a stable rate was not only very difficult to do in practice but it also provided rather poor control over inflation. As a result, virtually all central banks admit to having abandoned such a monetarist approach to monetary policy, and even those central banks which continue to base policy on money supply numbers to some degree often find it necessary to depart from a strict adherence to those targets. Other monetary policy ‘rules’ have been devised, the most famous of these perhaps being that named after Professor John Taylor of Stanford University. The Taylor rule involves setting interest rates in response to deviations in the rate of inflation and the level of output from their targeted levels. But all of these rules involve a simple rule of thumb as a guide to policy in a situation where the central bank must of necessity set policy for an economic situation which is 18 to 24 months into the future, and therefore can not be foreseen with any certainty whatsoever. The only way the Reserve Bank could avoid the embarrassment of being wrong about the future at least as often as being right would be to stop publishing our projections. Indeed, most central banks do not publish detailed projections for either the economy or for inflation. The Bank of England does, as does the Swedish central bank. But the Reserve Bank of Australia does not, the Bank of Canada does not, the Federal Reserve Board in the United States does not, and the Bundesbank does not. We still believe that publishing our projections is helpful to an understanding of what the Reserve Bank is doing, but life would certainly be rather more comfortable for us if we did not. What of the present situation? How seriously have we misread the situation? The first point to note I think is that the Bank’s primary responsibility is to keep the inflation rate within the target which has been agreed with Government. That is the measure against which the Bank should be held accountable. The inflation target was originally 0 to 2 per cent, but has been 0 to 3 per cent since December 1996. We first entered that inflation target in 1991 and, with the exception of the year to June 1995 (when we exceeded the target by 0.2 per cent, in part as a result of a very sharp increase in vegetable prices two months before the end of the year), and 1996 (when we were slightly above the target throughout the year), the inflation rate has been within the agreed target throughout that period. For all of 1997 and for 1998 to date, we have not only been within the target, but have been close to the middle of the target. At no point since first entering the target band in 1991 have we driven inflation below the bottom of the band, and indeed at no point has inflation gone below the mid-point of the band which applied at the time. This hardly suggests an abysmal forecasting record, nor that the Bank has operated policy excessively firmly. On the contrary: overall, it suggests that the Reserve Bank has done its job well. As an aside, I don’t propose to comment in detail here on why we have had to have policy rather tighter in New Zealand in recent years than has been necessary in Australia. That matter has been dealt with in a good article in the Bank’s quarterly Bulletin not long ago. The key point is that we clearly experienced a conjunction of inflationary pressures, including quite strong increases in housing prices, in the mid-1990s, whereas Australia had a rather different experience. If inflationary pressures in the two countries converge, I have no doubt that in due course we will find that monetary conditions in the two countries will converge also. Indeed, that seems to have happened to a considerable extent in recent months. But is it fair to suggest that the Bank was slow to ease policy in response to the Asian crisis, or to the drought? It is worth recalling that the present easing cycle began when our Monetary Policy Statement was issued in December 1996. At that time, an easing, even the relatively moderate one which we indicated was appropriate, seemed a fairly bold move. Inflation had been outside the top of the target band all year, the Government had announced a major increase in government spending for the next three years, and a major reduction in income taxes, although deferred by a year, was within the period relevant to monetary policy. Moreover, financial markets were much less confident than we were that inflation was trending down, and kept monetary conditions tighter than we felt was necessary almost constantly for more than the next four months. Nobody, in New Zealand or elsewhere, was predicting the Asian crisis at that time, though it was at that time that monetary conditions relevant to economic activity in the first part of 1998 were determined. Nobody, in New Zealand or elsewhere, was predicting the drought at that time. Throughout 1997, the Reserve Bank continued to ease monetary conditions gradually. During the first months of 1997, most of the easing took the form of lower interest rates. Through the balance of the year, the easing took the form of a lower exchange rate, with interest rates somewhat firmer. But in interest-rate-equivalent terms, we sanctioned an easing of some 3 percentage points between December 1996 and 1997. And how reasonable was the assessment in the Monetary Policy Statement we issued in December 1997? In October that year, the World Economic Outlook published by the IMF projected that world economic growth would continue at above 4 per cent per annum for the balance of the decade. This projection was made in the knowledge of the emerging problems in Asia, but in the expectation that relatively robust growth would continue in the United States and Europe. A few weeks later, the South Korean economy was clearly in serious difficulty, but the mean of the November Consensus Forecasts projected that industrial production in Korea would grow by almost 8 per cent in 1998. Industrial production in Japan was projected to grow at what seemed like a very modest 2 per cent this year. We were suspicious that perhaps the Consensus Forecasts were not picking up the seriousness of the deterioration in the world situation. For the first time, we deliberately departed from our traditional use of the mean of the Consensus Forecasts, and instead used a pessimistic sub-set of those forecasts. We had a hunch that the situation could turn out even worse than these numbers suggested but, with the overwhelming majority of international forecasters continuing to project strong growth in key markets such as Australia, the United States, and Europe, we stayed with that pessimistic sub-set. Even though, with the wisdom of hindsight, it is clear that the growth we projected for the New Zealand economy in 1998 was too optimistic, that is not the same as saying that monetary policy itself was flawed. Every quarter, the Bank produces a new quarterly projection, and adjusts its position in the light of new data. Perhaps of even greater importance, the Bank allows financial markets very considerable leeway to adjust monetary conditions in the light of new data between those quarterly projections. The real issue is not whether the Bank’s projections were absolutely correct; they will never be. Rather the issue is whether the Bank allowed monetary conditions to evolve appropriately in the light of new information, and I believe that we did. Over the 10 months since December 1997, the easing of monetary conditions has accelerated so that today monetary conditions are the equivalent of almost 10 percentage points easier than they were in December 1997, and more than 9 percentage points easier than they were projected to be now, back in December 1997. Of course, not all of that easing has been through reduced interest rates: the exchange rate has fallen substantially also. But 90-day interest rates today are at levels last seen in early 1994, and indeed, apart from that brief period in early 1994, New Zealand has not seen lower 90-day rates, or lower floating rate mortgages, since the very early 1970s! Part of that easing has come about as the Bank has announced its new quarterly projection, but most has occurred as the market has interpreted the new data to mean that inflationary pressures are continuing to abate even more rapidly than the Bank’s forecasts envisaged. And while we have from time to time sought to rein in the speed of the market easing, for the most part we have sanctioned it because we too could see that the emerging data justified easing beyond that envisaged when our projections were completed. Remember that when market conditions change and the Bank sanctions that change by its silence, the Bank has effectively taken an action. Each Wednesday morning at 9.00 a.m. when the Bank says nothing, that silence contains deliberate meaning, which the markets understand very well. In my business, silence does not mean abdication. Certainly, both the March and June quarter GDP figures were weaker than we had envisaged when we did our projections. But it is inappropriate to compare our published projection, completed six weeks or so prior to the publication of the GDP estimates, with the estimates of market economists immediately prior to the release of those estimates if by that comparison something meaningful is implied. All of us revise our estimates as new pieces of the jigsaw emerge, and the fact that we have been revising down our own internal estimates is amply illustrated by the extent to which we have been willing to accept conditions very much weaker than envisaged in our projections. The last few months illustrate the point rather well. In our August Monetary Policy Statement, we estimated that the June quarter GDP figure would, when released, show that GDP had contracted by 0.2 per cent. On that basis, we estimated that the economy would have a certain level of unused capacity, resulting in weak inflation pressures. On that basis, we indicated that the appropriate level of monetary conditions, on the MCI, would be around zero during the following three months. By 25 September, when Statistics New Zealand released their first estimate of June quarter GDP, it was clear that inflationary pressures were abating much more quickly than we had expected in early August as we completed the Monetary Policy Statement, that GDP had probably reduced by rather more than 0.2 per cent, and that easier monetary conditions would be appropriate. And in fact monetary conditions just prior to the release of the June quarter GDP numbers on 25 September were not zero but -290. We issued a ‘that’s about far enough for the moment’ statement on 7 October, by which time conditions had reached -370. To repeat, the real issue is not whether our quarterly projections were correct, but rather whether those projections were reasonable in the light of the data available to us at that time, and whether our response in terms of sanctioning easier monetary conditions was appropriate as new data emerged. Certainly, monetary conditions have eased very substantially over the last 18 months and, as we see it at the moment, that has been appropriate. Do we feel in some sense ‘guilty’ that we did not ease earlier? Even looking back, the decisions, which we took, seem reasonable in the light of the information available at that time. So, no, we don’t feel ‘guilty’. As President Harry Truman once said, ‘Any schoolboy’s hindsight is better than the President’s foresight’. In summary, I have no doubt about the professional excellence of my staff, or about the rigor they bring to our projections four times a year. Inherent in the criticism, which has been made of the Bank in recent weeks, is the view that we have unnecessarily constrained the economy by failing to allow monetary conditions to evolve as the emerging data have suggested was warranted. If that’s true, we will see inflation go near to, or below, zero. Well, the latest annual inflation number was 1.7 per cent, above the mid-point of the inflation target agreed with the Government, and slightly above market expectations. I don’t know of too many commentators who are projecting inflation to go anywhere close to zero over the next year or two. Our projections are not an end in themselves; they are merely a guide to the markets as to how the Reserve Bank is thinking given current data. Nobody who is informed expects them to come precisely true, because the world is always changing. That’s why we constantly allow the markets to adjust monetary conditions as new data emerge. Why, then, all the criticism? Partly it is that people always want someone to blame when times are tough, and the Reserve Bank is an easy target for a cheap shot. Also, I think people instinctively want certainty, even when it is not to be had. In that sense, the Reserve Bank will continue to disappoint those who want everything to be black-or-white for as long as the Bank continues to be open and honest. What about the rising exchange rate? The only other point I would like to touch on briefly relates to the sudden strengthening of the New Zealand dollar over the last few weeks. Since 23 September, when the New Zealand dollar reached 0.492 against the US dollar, the kiwi has strengthened against the US dollar by nearly 9 per cent (as of late 19 October). This is pretty dramatic stuff, and the appreciation has clearly worried some exporters who fear it may be the beginning of a new period of strong exchange rate appreciation. Indeed, the Meat and Wool Economic Service of New Zealand has estimated, presumably on the assumption that no forward exchange cover has been taken at lower exchange rates and that the appreciation is not soon reversed, that a 10 per cent rise in the exchange rate would see farmers’ returns on lamb drop by 17 per cent, on beef by 14 per cent, and on wool by 12 per cent. I am bound to say that the present mix of monetary conditions is not one, which makes me terribly enthusiastic. Given the propensity of us New Zealanders to borrow as soon as cash-flow constraints allow I worry that at present levels interest rates have become undesirably low. I certainly don’t see much evidence that, at these lower interest rates, New Zealanders will be rushing to increase their savings in order to fund our on-going appetite for borrowing. Even at the higher interest rates which prevailed earlier in the year - allegedly the highest real interest rates in the developed world - New Zealanders were enthusiastic borrowers and reluctant savers, at least in fixed-interest form, suggesting that, whatever the arithmetical calculation implied about real interest rates, most New Zealanders did not perceive interest rates as particularly high in real terms. Certainly, our real interest rates are not out of line with those in similar countries today. In any case, I have long ago had to face the fact that central banks have very limited ability to affect the mix of monetary conditions. To be sure, we could push up interest rates, but only at the cost of putting still further upward pressure on the exchange rate. I know of no way in which the Reserve Bank can both reduce the exchange rate and increase interest rates. (Of course, we could ease monetary policy further, thereby reducing both interest rates and, presumably, the exchange rate, but the appropriate level of monetary conditions is something which we have to judge in the light of the overall inflationary pressures, or lack of them.) What we do know is that international foreign exchange markets have been through a period of quite extraordinary turbulence in recent weeks. During one 24-hour period, the US dollar depreciated by 10 per cent against the Japanese yen in the biggest one-day movement in that exchange rate since most currencies were floated in 1973. Over a three-day period, the dollar fell by almost 20 per cent against the Japanese yen, again an unprecedented movement. In fact, most of the apparent recent strength in the New Zealand dollar has been simply a reflection of the decline in the US dollar. Against the German mark we had, as of 19 October, appreciated by less than 5 per cent; against the Australian dollar we were almost exactly unchanged; and against the Japanese yen, we had depreciated by 8 per cent. The Trade-Weighted Index had appreciated by little more than 1 per cent (all comparisons with rates on 23 September). Throughout this recent period of extreme turbulence in international financial markets, the New Zealand dollar has barely been outside a narrow range of 55 to 57 on the Trade-Weighted Index. Moreover, it is also clear that the New Zealand dollar has fallen a very long way since its peak in April 1997, at 69.1 on the TWI. There seems not the slightest risk of our approaching these levels again in the near future. Indeed, there is some evidence to suggest that the current ‘bounce’ in the New Zealand dollar has a great deal to do with turmoil among the hedge funds in New York. Certainly, market gossip suggests that some of these funds have been selling out of so-called short kiwi positions in recent weeks, causing upward pressure on the New Zealand dollar as a result. But before you rush to denounce these funds for putting upward pressure on our currency, keep in mind that they were instrumental in putting some downward pressure on our currency in the process of establishing the short-kiwi positions which they now appear to have been unwinding. When these short positions have been closed out, the upward pressure on the currency could well dissipate quite quickly. Having said that, neither I nor anybody else I know has a dogmatic view about the appropriate, ‘fair’, or equilibrium exchange rate for the New Zealand dollar. My own guess is that it is somewhat stronger than the present exchange rate. Certainly, on an inflation-adjusted basis, the long-term average trade-weighted exchange rate is a little higher than the present level. But just as the exchange rate almost certainly overshot during the period of almost four years in which it was appreciating, so it may overshoot ‘on the other side’. Given New Zealand’s large current account deficit, and still-heavy dependence on world commodity markets, some further weakness in the currency in the short-term would not be at all surprising. One thing we know with confidence, and that is that if financial markets feel disinclined to continue investing in New Zealand in large amounts at current low interest rates, either interest rates will rise somewhat or the exchange rate will fall somewhat. The Reserve Bank’s responsibility is to ensure that, whatever the mix of monetary conditions, we continue to deliver price stability. Conclusion On 26 June this year, I gave a speech entitled, Monetary Policy in a Dangerous World. Though delivered about two hours after the release of the weak March quarter GDP numbers, it was, of course, written several days before that release. In it, I warned that we could well be facing ‘the most serious shock to hit the New Zealand economy since the oil shocks of the 1970s’. But I also said that the reforms of the last 15 years, including a monetary policy committed to delivering on-going price stability, put us in a good position to weather the storm. Nothing that has happened since 26 June has changed my mind, either about the seriousness of the shock or about our ability to weather the storm.
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reserve bank of new zealand
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Address by the Governor of the Reserve Bank of New Zealand, Dr Donald T Brash, to the Canterbury Employers' Chamber of Commerce in Christchurch on 29/1/99.
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Mr Brash addresses the subject of the New Zealand dollar and the recent business cycle Address by the Governor of the Reserve Bank of New Zealand, Dr Donald T. Brash, to the Canterbury Employers’ Chamber of Commerce in Christchurch on 29/1/99. Introduction Mr Chairman, Ladies and gentlemen, I am delighted to be addressing you once again, on your first meeting of the New Year. If my memory is correct, this is the sixth occasion on which I have done this, and I appreciate your courtesy and tolerance in inviting me back each year. Last year, I addressed the subject of New Zealand’s balance of payments deficit. Today, I want to talk a little about a related issue, the exchange rate and its behaviour in recent years, because I recognise that, in an export-oriented economy like that of Christchurch, the exchange rate has a substantial impact on the viability of many businesses. I feel relatively safe in Christchurch today, with the trade-weighted measure of the New Zealand dollar around 57, but I felt distinctly less secure when I was here just two years ago, with the TWI up around 69! And certainly the appreciation from around 53 in early 1993 to 69 in early 1997, or an appreciation of some 30 per cent in four years, made life very difficult for many businesses. Eleven years have passed since the Minister of Finance first gave the Reserve Bank of New Zealand an explicit, quantitative, inflation target, and we have now experienced one full business cycle under that inflation targeting regime, from recession in 1991 to recession in the first half of 1998. For this reason, it seemed like an opportune time for us in the Bank to review that experience to see what we could learn. Accordingly, over much of the last year, we have been doing a careful study of the evolution of the New Zealand economy during the nineties. And to me at least, the results of that review are intensely interesting. Some of them were published just prior to Christmas in the December 1998 issue of the Reserve Bank’s quarterly Bulletin, while others will be published in the March Bulletin. I can’t even begin to summarise all of these results, but I want to record a few of them, as they relate to the appreciation of the New Zealand dollar between early 1993 and early 1997. In particular I want to address four questions: • Why did the appreciation take place? • Was the appreciation in some sense abnormal or unusual? • What part did the Reserve Bank play in the appreciation? • Can large appreciations be avoided in the future? First, why did the appreciation take place? When we look back over the last business cycle, from the recession in 1991 to the recession in the first half of 1998, one of the dominant impressions is that the New Zealand economy grew for longer than in either of the two previous business expansions. An even stronger impression is of an economy growing at quite a fast pace, certainly in comparison to growth in most other developed countries. Indeed, in 1993 GDP growth peaked at 7.1 per cent and, while growth slowed from that point on, the slow-down was quite mild by historical standards. The result was –2– that economic growth in New Zealand exceeded the average growth among 18 OECD countries from 1992 to late 1996. By the December quarter of 1997, the New Zealand economy was 25 per cent larger in real terms than it had been at the trough of the recession in 1991. (See Figure 1.) Figure 1 Real GDP growth: New Zealand and selected OECD countries (Sources: Statistics New Zealand, International Financial Statistics, RBNZ calculation) At the same time as we were enjoying that relatively rapid growth, inflation (as measured by the CPI excluding interest rates) was both low and stable, fluctuating between a minimum of 1.1 per cent and a maximum of 2.7 per cent between 1991 and the present. In the early part of that period, inflation was slightly below the average for these OECD countries, while in the later part of the period, New Zealand’s inflation rate was virtually identical to the OECD average. (See Figure 2.) But although actual inflation was subdued, inflationary pressures were, for several years at least, intense. The New Zealand economy initially expanded more rapidly than several of its major trading partners, fuelled at the outset by rapid export growth but sustained by strong growth in investment and consumption, and, later, by strong inward migration and an expansive fiscal stance. The prices of goods and services not exposed to international competition rose significantly faster than the average increase in all prices. There can be little doubt that our inflation rate would have been appreciably higher – that is, more typical of the seventies and eighties – had monetary policy not been leaning hard against those inflationary pressures. –3– Figure 2 Annual inflation rates: New Zealand and selected OECD countries (Sources: Statistics New Zealand, International Financial Statistics, RBNZ calculation) And of course ‘leaning hard against inflationary pressures’ is a euphemism for pushing up real (inflation-adjusted) short-term interest rates. In 1992, our real short-term interest rates were actually lower than the OECD average; in 1993, they were very close to the average; but from 1994 until some six months ago they were well above the OECD average. (See Figure 3.) Figure 3 Short-term real interest rates: New Zealand and selected OECD countries (Sources: RBNZ, International Financial Statistics, RBNZ calculation) –4– While various factors help to explain why the New Zealand dollar appreciated from early 1993 to early 1997, our research suggests that the dominant explanation is the obvious one, namely the relative strength of the domestic economy and the resulting inflation pressures. Those inflationary pressures necessitated significant monetary restraint, as reflected in the rise in New Zealand’s short-term interest rates relative to those in our trading partners. Higher interest rates in New Zealand than elsewhere ensured plenty of demand for New Zealand dollar assets, which is another way of saying that there was upward pressure on the exchange rate. In other words, the strong appreciation of the mid-nineties was the direct result of demand growing to the point where inflationary pressures would have pushed up measured inflation markedly had it not been for firm monetary policy. It was not until the domestic inflation pressures had clearly dissipated that the TWI began to depreciate, around May 1997. Secondly, was the appreciation in some sense abnormal or unusual? It is helpful in answering this question to look not at the movement in the nominal exchange rate but at the movement in the real (inflation-adjusted) exchange rate. Figure 4 shows the real exchange rate measured on a trade-weighted basis. What the graph shows is that the real exchange rate rose between early 1993 and April 1997 by 29 per cent, compared with an increase of 36 per cent between late 1984 and mid 1988. So the most recent appreciation was slightly smaller than the one experienced in the mid- to late eighties. Figure 4 New Zealand trade-weighted real exchange rate (Source: RBNZ) Another important point can be seen in the graph, and that is that, although some exporters are particularly prone to measuring exchange rate appreciations from the very bottom of an exchange rate cycle, it is as unrealistic to imply that the bottom of the cycle is in some way the norm as it would be to imply that the top of the cycle is the norm. The real exchange rate goes through –5– cycles, sometimes appreciating above its long-run average and sometimes depreciating below its long-run average. In early 1993, it is quite clear that the New Zealand dollar was significantly below its long-run average, and no exporter should have been expecting that the exchange rate would continue indefinitely at those levels. In early 1997, it is equally clear that the New Zealand dollar was significantly above its long-run average, indeed above its long-run average to almost exactly the same extent as had been the case in the middle of 1988 (almost 12 per cent). Today, the real exchange rate again seems to be somewhat below its long-term average level. Given New Zealand’s relatively low short-term interest rates, and the size of our current account deficit, I do not myself expect any rapid change in that situation. Indeed, any strong appreciation of the New Zealand dollar at this stage would be surprising. But on the other hand it is no more reasonable to expect the exchange rate to remain below its long-term average indefinitely than it is to expect it to remain above that level for a lengthy period. But, I am often asked, why do we have to endure these big appreciations at all? Surely other countries have managed their affairs without suffering from such strong appreciations? Well, some may have done so, but it is not at all difficult to find other countries which have experienced similarly strong real appreciations in the recent past, including Japan (an appreciation of 62 per cent from 1990 to 1995), the United Kingdom (an appreciation of 31 per cent from 1995 to mid-1998), Germany (an appreciation of 25 per cent from 1991 to 1995), and the United States (an appreciation of 24 per cent from 1995 to mid-1998). Indeed, Japan’s real appreciation was very substantially greater than New Zealand’s, while Britain’s was somewhat greater and over an even shorter period. And of course none of these countries is small or particularly prone to being buffeted by international shocks. (See Figure 5.) Figure 5 Recent episodes of exchange rate appreciation (Sources: RBNZ, International Financial Statistics) –6– But what about Australia? Surely Australian exporters have not been so badly affected by movements in their real exchange rate as New Zealand exporters were? To be sure, the Australian real exchange rate appreciated rather less strongly than the New Zealand dollar did in the mid-nineties but, as Figure 6 shows, over the whole period since 1980 it is not immediately obvious that the Australian real exchange rate has behaved in ways which have been kinder to exporters than the New Zealand dollar has. Indeed, looking at the volatility of real exchange rates, while the Australian dollar has clearly been through a more subdued cycle than has the New Zealand dollar over the last five years, taking the eighties and nineties together the volatility of the Australian dollar (in real terms) has been somewhat greater than has that of the New Zealand dollar. Figure 6 Trade-weighted real exchange rates: Australia and New Zealand (Sources: RBNZ, International Financial Statistics) There are various reasons why the Australian dollar appreciated more modestly than did the New Zealand dollar during the most recent business cycle: Australia’s commodity prices were weaker than were New Zealand’s at various times during the nineties, and more generally Australia had more subdued inflationary pressures, requiring less firm monetary conditions, than New Zealand did. My point is simply that it would be unwise to assume, on the basis of one cycle, that Australia has found some enduringly relevant way of avoiding strong exchange rate appreciations. A comparison of New Zealand with Singapore and Hong Kong is also interesting perhaps, since they are two small, very open, economies, one of them operating a managed float and the other a currency board peg to the United States dollar. Both economies are often held out as models of economic management, and certainly are economies which have, over many years, achieved strong export growth. If we consider the period of maximum New Zealand dollar real appreciation, from late 1992 to April 1997, we see that the New Zealand dollar appreciated by rather more than did either the Hong Kong dollar or the Singapore dollar over the same period. But if we consider the whole of the nineties, from January 1990 to late 1998, we find that over –7– that longer period the New Zealand dollar ended up at almost exactly the same point as it started in real terms, whereas the Singapore dollar appreciated by some 12 per cent, and the Hong Kong dollar, pegged though it was to the US dollar, appreciated by a very substantial 39 per cent. (Figure 7.) Figure 7 Real exchange rates: New Zealand, Singapore and Hong Kong (Source: JP Morgan) The conclusion we reached from all this analysis is that the appreciation of the New Zealand dollar in the mid-nineties was not unusual, either internationally or in terms of our own history. Thirdly, what part did the Reserve Bank play in the appreciation? This may seem a very odd question, since I have already acknowledged that the main factor driving up the exchange rate in the mid-nineties was the need to tighten monetary policy to head off the inflationary pressures caused by demand growing faster than the potential of the New Zealand economy to meet that demand. This pushed up not only the nominal exchange rate, but also the real (inflation-adjusted) exchange rate. But suppose the Reserve Bank had acted differently. Would matters have been much different? The answer is ‘almost certainly not’. Suppose the Bank had not tightened monetary policy. At some point, the rise in the price of houses and other goods and services in the non-tradeable sector of the economy would have begun to spill over into the general price level. Wages and other costs would have started to rise. Other things the same, exporters would have found themselves squeezed by these rising costs. In other words, they would have been squeezed by a rise in the inflation-adjusted exchange rate. So no matter what policy the Bank had pursued, the real exchange rate would have appreciated considerably, and exporters would have been put under pressure. The only issue is whether the real exchange rate appreciation took place alongside low inflation within New Zealand or whether it took place through an inflation blowout within New Zealand. –8– It is fair to acknowledge, however, that the way in which the Reserve Bank sees the exchange rate in the implementation of monetary policy has evolved over the years. In the first years of the fight against inflation, the Bank paid very little attention to the exchange rate. In the years immediately following deregulation, both interest rates and the exchange rate were very volatile. We had very little sense of what ‘normal’ levels for these prices were, and hence put little weight on movements in them when we were thinking about monetary policy and the outlook for inflation. Instead, we paid particular attention to keeping the quantity of ‘primary liquidity’ stable. By the time I became Governor of the Bank in 1988, we had come to recognise that the very short-term volatility in interest and exchange rates was largely unnecessary, and might well have real costs – if only in obscuring the price signals facing investors and producers in the real economy. As inflation targeting became more formalised, we tended to implement monetary policy by making a careful assessment of all the factors relevant to inflationary pressures, and then working out some internal ‘comfort zones’ for the key financial prices. These were not targets in the sense that we were totally dedicated to maintaining interest or exchange rates within these ranges. But they were designed to shape our own thinking, and to guide us in deciding when it made sense to take some action to limit movements in interest or exchange rates between the periodic reassessments of the inflation outlook. Over time, the exchange rate band became increasingly prominent. This was partly because we had little formal sense of the linkage between interest rates and inflation, whereas we did have statistical estimates of the direct effect, other things being equal, of a movement in the exchange rate on prices – in other words, the effect of a movement in the exchange rate on the New Zealand dollar price of imports and things like meat and milk which were also exported. Largely because the inflation outlook was still so uncertain during the disinflation period, but also because we thought we had a reasonable handle on the direct price effects of changes in the exchange rate, monetary policy often tended to be focused principally on the inflation outlook over the following 12 months or so. By the mid-nineties, this approach was becoming increasingly less relevant. Our confidence that a 1 per cent movement in the trade-weighted exchange rate would produce a change in consumer price inflation of about 0.3 per cent within about 12 months began to wane, as first the depreciation of 1991 and then the appreciation of 1993-97 produced a much smaller impact on inflation than previous research had suggested. Indeed, by the end of 1995 reference to ‘exchange rate comfort zones’ had largely disappeared from our monetary policy implementation lexicon. The impact of interest rates on inflation was becoming more evident, and in particular it became clear that the low interest rates of 1992 and 1993 were, with a lag of more than a year, encouraging strong credit growth, rapidly increasing house prices, and inflationary pressures in the domestic sectors of the economy. More importantly, with inflation having been within the agreed target for 1991, 1992, 1993, and 1994, there was also gradually increasing confidence, within financial markets and, to a lesser extent, in the general public, that the commitment to low inflation was credible. This increased credibility meant that we could afford to be less concerned about the one-off direct price effects of exchange rate movements. Even if we had had a lot of confidence in our estimates of the size and timing of these effects, the risk that they would spill over into higher inflation expectations, creating ongoing problems, was much diminished. While mindful that a change in the exchange rate might in itself be telling us that monetary policy had become inappropriate, we could afford to focus mainly on the medium-term channels by which interest and exchange rates affect the –9– ongoing rate of inflation. In recent years this has meant trying to focus more on the inflation outlook 18 to 24 months ahead. Keeping that medium-term focus means recognising that monetary policy mistakes take time to correct – that even if we could turn our monetary policy super-tanker very quickly it might not be sensible to do so. To illustrate, in April 1996, when the Minister of Finance requested an explanation of inflation falling outside the agreed target by 0.1 per cent, I advised him that indications at that time were that inflation might remain outside the target for two or three more quarters. Despite this, I advised him that we did not intend to tighten policy sufficiently to avoid those further breaches since the only way that that could have been achieved would have been through a very aggressive tightening of policy that would have both created a risk of going below the inflation target the following year and considerably exacerbated the exchange rate and interest rate cycle. What we were implicitly recognising is that, while monetary policy can not be used to engineer a sustainably faster growth rate in the long-term, there can be a trade-off between the variability of inflation and the variability of monetary conditions in the short-term. In late 1996, of course, the inflation target was amended from 0 to 2 per cent to 0 to 3 per cent and, though not requested by the Reserve Bank, this increased the scope for flexibility when faced with the many lags and uncertainties in setting monetary policy. All of these factors drove us in the direction of being less concerned about the direct price effects of exchange rate movements and more concerned about the medium-term effects of interest rates and the exchange rate. Our focus lengthened from a primary interest in the next 12 months to an 18 to 24 month view. So in short, over the decade we have moved from a primary focus on the relatively short-term direct price effects of exchange rate movements as a way of reducing inflation, when there was an urgent need to reduce inflation quickly and where the credibility of policy was very low, to a focus on the medium-term effects of interest and exchange rates on the real economy, and therefore on inflation. In large part this change has been made possible by the increased confidence within the community that the Reserve Bank will continue to deliver stable prices, the result in turn of eight years of low and stable inflation. Finally, can large appreciations be avoided in the future? Let me say first that a gradually appreciating exchange rate is something to which all countries should aspire. A trend appreciation in the real exchange rate is usually the direct result of a country’s relatively superior record of productivity improvement, and that is obviously something to aspire to. A trend appreciation in the nominal exchange rate may arise from that superior record of productivity improvement or it may arise from a superior record of keeping inflation under control. And I think most New Zealanders, including most exporters, would welcome an appreciation which arises from one or both of those factors. But what we are talking about here is the kind of appreciation which raises the New Zealand dollar by close to 30 per cent over three or four years, faster than any plausible increase in relative productivity or inflation performance. Can that be avoided? Can we even reduce the amplitude of the swings around the long-run average from, say, plus or minus 12 per cent to, say, plus or minus 5 per cent? If I could assure you that the Reserve Bank is confident that it can operate monetary policy without the risk of such large fluctuations in future, I would leave here a – 10 – much more popular man, and you would leave here feeling very much happier too. Unfortunately, I can give you no such assurance. In principle, the ways in which large and rapid appreciations might be avoided are of four kinds. First, to the extent that large appreciations are a function of firm monetary policy, one option might be to resist inflationary pressures less vigorously. Alas, all the evidence from our own and international experience suggests that allowing inflationary pressures to become more embedded in the economy makes the subsequent job of eliminating inflation much more difficult. In other words, when inflationary expectations become more deeply embedded in society, eliminating inflation requires more pressure from monetary policy, higher real interest rates and a higher real exchange rate, not the reverse. And in any event, as already indicated, failing to resist an increase in inflation still leaves exporters facing a loss of competitiveness because of the increase in the domestic costs which they face. The United States, the United Kingdom, Germany, and Japan all approach keeping inflation low in rather different ways, but all have experienced periods of sharp exchange rate appreciation this decade. The second way in which we might avoid strong appreciations in the future is to avoid, or at least to minimise, the situations where a strong tightening of monetary policy is required. In part, this is a Reserve Bank responsibility, and involves our being quick to spot situations where demand looks likely, 18 to 24 months ahead, to exceed the economy’s sustainable capacity to deliver. We are doing a great deal of work to assist us in forecasting but, as I have remarked on several occasions before, no matter how good our research, no matter how good the statistical data on which we make decisions, no matter how good our formal and informal information networks, no matter how good our models, by the nature of the case the future will often turn out very differently to our expectations. Neither we nor any other central bank has a perfect crystal ball. This means that there is simply no guarantee that we will be able to avoid vigorous tightening of monetary policy in the future. Some have suggested that monetary policy would not have needed to tighten so aggressively in the mid-nineties if fiscal policy – government taxation and spending policy – had not been so expansionary. It is certainly true that, after acting to dampen aggregate demand in the early nineties, fiscal policy became rather more expansionary in the mid-nineties, and this required monetary policy to be tighter than would otherwise have been necessary at that time. To that degree, the stimulatory fiscal policy of 1996 and 1997 must bear some of the blame for the strong appreciation of the exchange rate. Moreover, there can be little doubt that, if strong appreciations are to be avoided in the future, a full recognition of the monetary policy implications of changes in fiscal policy will be imperative. But it has to be acknowledged that it is not always easy to adjust fiscal policy to take account of cyclical pressures, for reasons which are sometimes technical and sometimes political. Indeed, some would argue that the Fiscal Responsibility Act is based on the premise that adjusting fiscal policy in response to cyclical pressures is neither necessary nor appropriate. New Zealand’s experience in 1996 and 1997 illustrates some of the technical problems well. In late 1995, the Government publicly announced that they would proceed with a reduction in income tax rates in mid-1996 only if the Reserve Bank were satisfied that the tax cuts could take place without putting undue pressure on monetary conditions. We were formally asked if the tax cuts could proceed without creating such upward pressure on monetary conditions, and after careful consideration we formally advised Government that we believed the tax cuts would not create any undue upward pressure on monetary conditions. As Reserve Bank watchers may – 11 – recall, this was close to the time when we reached the judgement, in October 1995, that inflationary pressures were abating and that some easing in monetary conditions might be appropriate. We in the Bank, others in the Treasury, and many private sector forecasters all felt that the economy would slow down markedly in 1996, and that the proposed fiscal stimulus would not create undue pressure on monetary conditions. In retrospect, our judgement was incorrect: inflationary pressures in the economy had not eased by as much as we thought at the time and, as it turned out, a firm monetary policy had to be maintained for a further year. And of course, by the time we thought that the outlook was sufficiently subdued that monetary restraint could be eased without inflation becoming a problem, the Asian crisis was about to break. This course of events serves to underscore just how difficult it is to fine tune monetary policy, and why I am reluctant to claim that swings in the exchange rate are a thing of the past. There may also be difficult political obstacles in using fiscal policy to carry some of the load otherwise carried by monetary policy. In late 1995, the New Zealand public sector was in very substantial operating surplus and, in the absence of tax cuts or increases in government spending, that surplus looked likely to continue indefinitely. Even leaving aside the fact that both the Reserve Bank and other forecasters mis-read what was likely to happen to the economy in 1996, it could well have been difficult to persuade any Parliament in those circumstances to forego tax cuts or increases in government spending. In the end we got both, and part of the price may well have been a continuation of strong exchange rate appreciation for longer than anybody in the export sector enjoyed. Thirdly, measures might be taken to drive a wedge between New Zealand interest rates and foreign interest rates, so that when monetary policy is tightened in New Zealand to head off inflationary pressures this does not result in an appreciation of the exchange rate, or at least results in a rather smaller appreciation than otherwise. Various countries try to do this. Some, for example, have tried to cut themselves off from international capital markets by instituting comprehensive controls on capital flowing into and out of the country, of the kind that New Zealand used to have. Few would seek a return to this kind of regime in New Zealand and indeed, even in the countries of Asia which have been most affected by recent turbulence, few have seen the benefits of such controls as likely to exceed their very substantial costs. Those who advocate such controls usually do so only for countries which have not yet got their macro-economic policies in order, or which have serious weaknesses in their financial systems. In other words, controls of this kind are often seen as a temporary or transitional measure, while more fundamental weaknesses are addressed. Other countries have tried to drive a wedge between domestic and foreign interest rates by instituting a tax on interest income accruing to foreigners, a non-resident withholding tax. In principle, this has considerable appeal because it means domestic interest rates can be pushed up to a level appropriate to the restraint of domestic inflationary pressures while not encouraging a strong capital inflow which would push up the exchange rate. But New Zealand’s own experience suggests that it is in fact quite difficult to make such taxes work effectively, since there are lots of ways in which foreign investors, working in conjunction with locals, can find ways around that tax. Some academic economists have suggested that countries institute a small tax on all foreign exchange transactions, a so-called Tobin tax after the economist who first proposed it, in order to discourage speculative capital flows. But very few policy-makers give such a tax any chance of – 12 – being implemented and, if implemented, of actually working as intended. To be effective, it would need to be applied in all countries at the same rate, lest foreign exchange transactions simply migrate to a country where the tax is not applied. And if this substantial hurdle could be overcome, most observers believe that the effect of the tax would be to substantially diminish liquidity in financial markets, so that large ‘beneficial’ transactions would produce very large movements in the exchange rate. Worse still, there seems little prospect of such a tax deterring large-scale capital flight: who will resent paying, say, a 0.1 per cent Tobin tax if he fears a 30 per cent devaluation? The only serious contender on the international stage at present as a way to drive a wedge between domestic and foreign interest rates is the so-called Chilean approach. In principle, that involves no restrictions on capital outflow and no restrictions on incoming foreign direct investment, but a requirement that a proportion (initially 30 per cent but later reduced to 10 per cent) of incoming portfolio investment be deposited with the central bank at zero interest for a period of one year. The intention of this measure was to discourage short-term capital inflow while creating no barriers to other forms of capital movement. Whether such a measure would work in the relatively sophisticated financial markets which we now have in New Zealand is at this stage an open question. Indeed, there is intense debate internationally whether the policy has even had a beneficial effect in Chile itself, and Chile has recently reduced the proportion of incoming portfolio investment which must be deposited with the central bank to zero. As I noted in my speech on the balance of payments deficit last year, there would clearly be some real risks in introducing such a policy in New Zealand, not least the longer-term costs of undermining investor confidence in New Zealand’s commitment to free and open markets. A fourth idea for avoiding strong exchange rate appreciations has recently been gaining some media play, namely the idea that New Zealand should irrevocably peg to some larger currency, or even form a currency union with some larger country or group of countries. The New Zealand dollar is simply too small and insignificant to float alone in the turbulent ocean of world financial markets, it is argued, and would be better securely linked to a bigger vessel. Many countries contemplating this possibility see a link to the United States dollar as having huge appeal, while in the past the German mark has also had a number of adherents. No doubt in the future the euro will also attract its strong adherents. In the New Zealand situation, it is not surprising that most of those who advocate New Zealand becoming a part of a larger currency area argue for a currency union with Australia (although in reality, given the relative size of our two economies, a currency union between New Zealand and Australia would be more akin to New Zealand pegging to Australia than a genuine currency union in the European sense). Australia is our largest trading partner, and there is essentially free mobility of labour and capital between the two countries. This means that two of the key criteria for an optimal currency area would be at least partly met in the case of an Australian/New Zealand currency union. But while Australia may well be the most logical country for New Zealand to form a currency union with, and this idea may well be worth further exploration for a whole raft of economic and political reasons, it is quite misleading to imply that forming a currency union, with Australia or anybody else, would avoid the problem of strong currency appreciation in the future. As I have already indicated, most of the world’s largest economies have within the last decade seen appreciations of a size similar to that experienced by New Zealand in the mid-nineties. The Hong Kong dollar, effectively tied to the United States dollar since the early eighties, saw a huge real appreciation during the nineties in part as a result. Australia did not have such a strong – 13 – appreciation during the nineties but, as also indicated, the Australian dollar has had rather more volatility over the last 20 years than the New Zealand dollar has. It is not very long ago that the most common complaint made to me in areas of the country outside Auckland related to the fact that non-Aucklanders were facing real interest and exchange rates which were quite inappropriate to the inflationary pressures in areas outside Auckland. Why, I was often asked, do we have to pay these high real interest rates, and suffer the penalties of the high real exchange rate, when the only inflationary problem is in Auckland? Of course, inflationary pressures were far more widespread than this question implied, but my answer always included the point that, in a single currency area (New Zealand), there can only be one set of interest rates and one exchange rate. Sometimes those monetary conditions will be too loose for some parts of the country and too tight for other parts of the country. But that is the nature of the beast: it simply isn’t feasible to have a different set of monetary conditions in different parts of the same currency area. This means that if we were part of a currency union with Australia and the Australian economy were very buoyant, perhaps because of booming exports of iron ore, gold, and wheat, it is quite possible that New Zealand exporters would be facing a rising (common) exchange rate and all of us would be facing relatively high real interest rates at a time when the New Zealand economy was quite subdued. New Zealand exporters who were concerned about an exchange rate dominated by Auckland conditions can hardly feel confident that Sydney or Melbourne economic conditions will always be more relevant to them. But surely, if it makes sense for 11 European countries to form the Economic and Monetary Union, with a common currency throughout those 11 countries, it must make sense for New Zealand to link with Australia (or somebody else) also? Not necessarily. Although 23 per cent of our total merchandise trade is with Australia, that is a relatively small part of our trade in comparison to the proportion of trade between members of the new European monetary union. Thus, for example, 45 per cent of France’s total trade was with EMU members in 1997, 46 per cent of Germany’s, and 57 per cent of Holland’s. While Australia is our largest trading partner, and joining a currency union with Australia might well make life easier for those companies trading primarily with Australia, it would not solve any of the problems caused by currency variability for those conducting the other 77 per cent of our international trade. Indeed, I can imagine New Zealand beef exporters might argue for a link to the US dollar, dairy exporters might argue for a link to the euro, and fruit and vegetable exporters might argue for a link to the yen! – 14 – Conclusion So where does that leave us? It has sometimes been argued that developments in monetary conditions in New Zealand were abnormal or unusual in the nineties. Without a doubt, the rise in interest rates and the appreciation of the currency were large. But this tells us little about whether they were, in some sense, too large or inexplicable. I have suggested that monetary conditions were not dramatically out of line with past experience here and abroad, and were broadly what we should have expected given the length and strength of the business cycle. I also believe that the policy framework has coped well through these testing times. For the first time in many years, we have been through a business cycle without an explosion in inflation expectations and without a large structural fiscal deficit. We have weathered the Asian crisis with our banks in good stead, and we remain well positioned to take advantage of the next international upswing. Given the circumstances, we have also experienced a remarkably orderly shift in the mix of monetary conditions, to one more reflective of the current realities facing the economy. But clearly it would be a mistake to believe that this is the last time the framework will be tested. What we have learnt from our study is that we need to view these developments in the context of our own business cycle pressures, developments in international capital markets, and the business cycle and inflationary pressures of our major trading partners. Looking ahead, another business cycle upswing will occur at some point, and monetary conditions will again need to be tightened in order to constrain inflation. The extent to which that is reflected in upward pressure on the exchange rate will depend on the strength of the inflationary pressures and the level of interest rates both here and abroad. Alas, there is no magic bullet which can avoid this situation. Ongoing changes at the Reserve Bank in the way in which we operate policy may, at the margin, slightly reduce exchange rate fluctuations. These changes have included a more flexible approach to inflation targeting by shifting the policy horizon out to 18 to 24 months, assisted in part by a wider inflation band of 0 to 3 per cent. Over recent years, I think that the Reserve Bank may have slightly reduced the risks of strong exchange rate appreciation by making it unambiguously clear that we have no secret exchange rate floor in the back of our mind. We have an inflation target, not an exchange rate target. For this reason, those buying New Zealand dollar assets with foreign currency always face the possibility that they might lose on their investment. There is no one-way bet in buying New Zealand dollars. We in the Reserve Bank are committed to doing our utmost to avoid situations where monetary policy has to be tightened aggressively. In other words, we will do our best to tighten in a timely way, so that the tightening can be gradual and moderate. And I hope you will be loud in your support of the Reserve Bank next time we begin such a gradual tightening! But with the best will in the world, it will be necessary to tighten aggressively from time to time to deal with unexpected events. The message I want all exporters – and indeed those competing with imports – to take from this speech is this. You should assume in your business planning that the current relatively low dollar is not the norm, and will not last indefinitely. As already indicated, I myself do not expect an early appreciation in the New Zealand dollar, given our relatively low interest rates and large current account deficit. Indeed, the New Zealand dollar could well depreciate further. But in – 15 – deciding how to run your business, especially in a strategic sense, you should look at the historical record, and note that the exchange rate cycle experienced over the last decade was not exceptional, either for New Zealand or by international standards. Exchange rate fluctuations of that magnitude are just part of the rough and tumble of an economy such as New Zealand’s. They will happen again. My plea to you therefore is this: just because the currency is low now, don’t sit on your hands and enjoy it. Invest in quality; keep costs under tight control; reduce your vulnerability to exchange-rate-driven price fluctuations; don’t pay too much for land (especially relevant to farmer exporters); develop brands that are less price sensitive. As I’ve said before, a good Canterbury farmer knows that droughts are inevitable from time to time, and plans accordingly. Likewise a good exporter knows that fluctuations in the real exchange rate are inevitable, and plans accordingly. You should be doing this now. * * *
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Address by Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Northern Club, Auckland on 25 March 1999.
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Mr Brash addresses the question: What can New Zealanders expect of monetary policy in the long term? Address by Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Northern Club, Auckland on 25 March 1999. Introduction Mr Chairman Too often, both in the Reserve Bank and, I suspect, in financial markets, we are inclined to lose sight of the longer-term, or strategic, issues of relevance to monetary policy. We get preoccupied with whether the Official Cash Rate should really have been set at 4.50 per cent rather than at 4.25 per cent, as if this detail had any enduring significance for the real economy and the lives of ordinary New Zealanders. I don’t want to imply that the short-term tactics are irrelevant – far from it – but they are very much less relevant than the longer-term issues, particularly when the Official Cash Rate itself is explicitly up for review on a regular basis. So today I want to address the question, What can New Zealanders expect of monetary policy in the long term? The monetary policy framework is profoundly democratic The first point to note in answering that question is that the answer depends on what Parliament wants monetary policy to deliver. It is sometimes suggested that the Reserve Bank seems to be a law unto itself, and that Don Brash seems to run the country. Nothing could be further from the truth. In New Zealand, the Reserve Bank is subject to an Act of Parliament, and Parliament can change that legislation by simple majority. This is also true in Australia, the United Kingdom, the United States and many other countries, of course, but it is not now true in much of Europe (where the European Central Bank is a creature of the Maastricht Treaty) or in those countries where the central bank has been given essentially unlimited independence under the constitution. Moreover, that Act of Parliament requires that, within the general directive prescribed by the Act, the Governor of the Bank must sign a written agreement with the Treasurer setting out quite explicitly what the Governor must achieve during his or her term of office, the so-called Policy Targets Agreement. That Agreement can be changed by mutual agreement at any time during the Governor’s term of office, and can be overridden by Order-in-Council if the Government wants a change and the Governor does not. So what monetary policy will deliver in the years ahead is essentially a matter for the public, through Parliament, to determine. The Reserve Bank and I as the Bank’s Governor are held accountable for our performance in delivering the objectives which Government and Parliament have chosen, through a requirement to produce regular Monetary Policy Statements and to appear regularly before the Finance and Expenditure Committee of Parliament. Having said that, as long as the present Act remains in place at least, the Government can not change the objective laid down for monetary policy without telling the public. In other words, any change in the objective must be totally transparent and, given that inflation is essentially a form of theft, that seems entirely appropriate. All this seems profoundly democratic, and makes it clear that the Reserve Bank and Don Brash are servants of Parliament. Since 1989, the Reserve Bank Act has made it clear that monetary policy must be used to achieve and maintain ‘stability in the general level of prices’, with the meaning of this defined in the Policy Targets Agreement. The present Agreement, signed when I was reappointed Governor at the end of 1997, defines ‘stability in the general level of prices’ as meaning that monetary policy should be aimed at keeping inflation as measured by the CPI excluding credit charges, or CPIX, between 0 and 3 per cent over each 12-monthly period, though the Agreement also recognises that there will be some circumstances where inflation may legitimately be allowed to fall outside that range. But what, I am often asked, happens after the election? Fundamentally, that depends on what the next Parliament decides. It is not inevitable that anything (related to monetary policy) will change after the election. Almost all political parties are on record as supporting the present legislation, and indeed supporting the present 0 to 3 per cent target. While the Policy Targets Agreement could be changed by agreement between Governor and any new Treasurer, there should be no presumption that that will occur. Consistency and continuity are attractive in monetary policy as elsewhere, and I shall certainly not be promoting a change. It is perhaps worth noting that other central banks with a price stability objective and a quantitative inflation target all have targets that fall within the 0 to 3 per cent range – and to the best of my knowledge, there are none that fall outside it. But, to repeat, it is for Parliament to decide in the final analysis. The present Policy Targets Agreement What does the present Policy Targets Agreement imply about the way in which the Reserve Bank will formulate monetary policy in the years ahead? Without going into great detail, it means that we will be aiming to keep CPIX inflation close to the midpoint of the 0 to 3 per cent target one to two years ahead. We aim close to the midpoint because we recognise that, in an uncertain and fast-changing world, aiming at the midpoint maximises the chance that we will be able to keep inflation in the target range. Aiming near either edge of the target would run too high a risk that unexpected shocks would throw us outside the target. And we aim to keep inflation near the midpoint not this quarter or next, but in one to two years’ time, because we recognise that monetary policy has most of its impact on trend inflation over this kind of time horizon. It follows that in implementing policy we would in principle be willing to accept the prospect of inflation outcomes close to the edges of the target, and conceivably even outside the target, in the next few quarters if we were reasonably confident that inflation would be back near the centre of the target within one to two years. Clearly, we will not lightly sanction breaches of the agreed target – indeed, we will do our utmost to avoid such breaches, of either side of the target – but to pretend that we can at all times and in all circumstances keep inflation within the target would be to promise more than we can deliver. Indeed, we learnt that in the mid-nineties. As an aside, we are reasonably certain that headline inflation, the CPI including interest rates, will fall below zero for several quarters this year. In the 12 months to December 1998, headline inflation was only 0.4 per cent, the lowest level for several decades. We expect the 12 months ‘increase’ to be negative very shortly. But it is important that nobody misunderstands the significance of this. Having the headline inflation figure go below zero is not a breach of the Policy Targets Agreement, any more than it was a breach when the headline figure rose to 4.6 per cent in mid-1995. The inflation target in the Policy Targets Agreement is explicitly defined in terms of the CPI excluding interest rates, for the very good reason that an interest-inclusive CPI target would quickly have the Reserve Bank chasing its own tail, tightening monetary policy (increasing interest rates) in response to an increase in measured inflation which was itself caused by increasing interest rates earlier in the year, and vice versa. Both the negative headline inflation figure we now project and the high figure experienced in the mid-nineties are simply the result of the inclusion in New Zealand’s headline inflation figure of interest rates. Most economists are agreed that interest rates should not be in the inflation figure and many major countries already exclude them. The Government Statistician has agreed to remove them from the official CPI from later this year. Thankfully, this will end the potential for public confusion inherent in the present situation. But in the meantime we ignore the interest-inclusive headline figure, as we have done all decade. Of course, we could prevent the headline inflation figure turning negative very easily – by aggressively increasing interest rates! I don’t think anybody is strongly arguing for this! Growth and inflation Why not add a growth objective for monetary policy? Surely, the most important objective for all economic policy must be to encourage growth, so why isn’t the same true for monetary policy? In a fundamental sense, it is. It’s just that we now realise that the most constructive thing that monetary policy can do to encourage growth is to deliver price stability, so that businesses planning what products to produce can distinguish relative price movements from the noise of general inflation, so that savers can sensibly plan how to invest their savings, so that the gross distortions created by the interaction of inflation and a tax system geared to historical cost accounting can be avoided, and all the rest. We now know that inflation damages economic growth, to say nothing of the social damage it also does through the capricious redistribution of income and wealth which it produces. It is for this reason that the present Policy Targets Agreement makes it clear that the Reserve Bank is to deliver price stability ‘so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy’. In other words, price stability is not simply an end in itself but a means to an end, and that end is better growth, better employment, and indeed a more just society. The Governor of the Reserve Bank of Australia, Mr Ian Macfarlane, expressed it well late in 1996 when he said that ‘the other way of expressing an inflation target is to say that monetary policy is set in a way which lets the economy grow as fast as possible without breaking the inflation objective, but no faster.’1 The Governor of the Bank of England, Mr Eddie George, also put it very clearly in a speech last month: ‘We’re often described as a lot of “inflation nutters”, or even as “pointy-headed industrial hooligans” who don’t care at all about real economic activity or jobs … That view … is profoundly and fundamentally wrong. ‘The implication, of those who take that view, is that they think there is a trade-off between inflation and the rate of economic growth; they think that if only we would let up a bit on controlling inflation then we could all enjoy higher activity and lower unemployment and rising Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the CEDA annual general meeting dinner, Melbourne, 28 November 1996. living standards, which are, of course, the really good things of economic life. At the very least, they say, if you were a bit less manic in your pursuit of low inflation, we could avoid some of the worst damage that is currently being inflicted upon agriculture, upon large parts of manufacturing, and even some service sectors. ‘And that might even be true for a time. The trouble is that, in anything other than the short term, it would be likely to mean more rather than less economic damage, and lower rather than higher growth and employment … ‘We are every bit as concerned with growth and employment as we are about price stability – as anyone in their right mind must be. Permanently low inflation is a necessary means of achieving growth and employment sustained into the medium and long term.’2 I totally agree. The control of inflation, and output variability Most of us now accept that monetary policy can not, by tolerating a little more inflation, buy sustainably faster growth. In other words, keeping inflation low is the best contribution which monetary policy can make to growth in the longer term. But it is also widely accepted that there may be a trade-off between the variability of inflation and the variability of output. In other words, it may be that attempting to keep inflation at precisely 1.5 per cent at all times might lead the Bank to throw interest and exchange rates around quite vigorously – and output around quite vigorously as a result. In recent years, the distinction between ‘strict’ inflation targeting and ‘flexible’ inflation targeting has grown up in the economic literature, with ‘strict’ inflation targeters being those who aim to keep inflation very close to a narrow target at all times, and ‘flexible’ targeters being those who are willing to accept a little more variability in inflation outcomes for the sake of reducing the variability of interest and exchange rates, and of economic output.3 I am not sure that any central banks are in fact ‘strict’ inflation targeters, but the distinction is useful in highlighting why all central banks are more or less ‘flexible’ inflation targeters. The Reserve Bank of New Zealand has never been a ‘strict’ inflation targeter. From the very first Policy Targets Agreement, reasons why actual inflation might legitimately fall outside the target band – the so-called caveats – were recognised. At no stage have we treated the centre of the inflation target band as a fetish. Early in 1996, after inflation fell outside the then 0 to 2 per cent target by 0.1 per cent in the year to March 1996, I wrote to the Minister of Finance and explained that, although we were confident that inflation would be back within range by the following year, I was not confident that further breaches of the target could be avoided in the immediate future without a very aggressive further tightening of monetary policy. I noted that under all the circumstances I could not recommend such an aggressive further tightening, and indeed noted that tightening to the extent which would have been needed to reduce the risk of further breaches of the top of the inflation target in the Speech by Mr E A J George, Governor of the Bank of England, at Hertfordshire University, 18 February 1999. See Lars Svensson, ‘Inflation targeting in an open economy: strict or flexible inflation targeting?’, Reserve Bank of New Zealand Discussion Paper, G97/8. immediate future ran the risk of throwing the inflation rate through the bottom of the inflation target further into the future.4 So there is plenty of evidence that we have been ‘flexible’ inflation targeters from the beginning. But I suspect that we may be even more willing to be ‘flexible’ inflation targeters now than we were in the late eighties and early nineties, when we were at the beginning of our inflation targeting experience. This is a direct result of the fact that inflation and inflation expectations are now much more firmly anchored at a low level than was the case a decade ago. At that time, we were coming out of a period of nearly two decades of high and variable inflation, a period during which governments had repeatedly promised to reduce inflation and had repeatedly broken those promises. It was hardly surprising that, initially at least, the public greeted the news of one more approach to delivering low inflation with a high degree of scepticism. Today, by contrast, even those who criticised the commitment to low inflation initially are persuaded that low inflation is likely to be around for a considerable time to come. Businesses no longer assume that they will be able to increase prices more or less automatically each year. Consumers no longer assume that they must buy this month because next month prices will be higher. Those negotiating wage and salary increases strike agreements consistent with stable prices. Long-term interest rates are nearly back to their levels in the sixties. Even home-buyers are beginning to realise that house prices go down as well as up. As a consequence of these more firmly-anchored inflation expectations, the Bank can afford to respond rather more moderately to the prospect of small changes in the inflation rate, confident that, even if inflation does temporarily depart from the midpoint of the target, this is not likely to produce any damaging longer-term changes in pricing and wage-setting behaviour. We live in an uncertain world This anchoring of inflation expectations is of considerable assistance in the way monetary policy operates, and should mean that interest rates may not need to move around as strongly as at times in the past. But does that mean that the Bank will be able to formulate policy with perfect foresight, and without controversy, in the future? Of course not. Inevitably, sometimes things turn out differently than expected. For example, 90 day interest rates rose from an average of 4.6 per cent in February 1994 to 9.5 per cent in December that year. At the time, that increase in rates seemed to be ample to contain inflationary pressures. But with the wisdom of hindsight it is probable that we should have tightened policy earlier and more aggressively than we did; had we done so, we might have nipped inflationary pressures in the bud at an earlier stage, and it may have been possible to ease policy earlier than was in fact the case. Not many people complained, in 1993, that we were not tightening policy sufficiently quickly. Late in 1995, we thought we could see inflationary pressures abating in 1996, and so advised the Government that there seemed no reason from a monetary policy perspective to abandon the tax reductions proposed for mid-1996; in retrospect, we were rather too optimistic, and inflationary pressures continued throughout that year, with the tax cuts and, later, additional government spending adding to those pressures. Again, not many people complained at the time. Letter to the Minister of Finance dated 19 April 1996, published in Monetary Policy Statement, June 1996. As President Harry Truman once said, ‘Any schoolboy’s hindsight is better than the President’s foresight.’ You would be disappointed if I did not mention the introduction of the Monetary Conditions Index with ‘bands’ at the end of June 1997 as another innovation which, with the benefit of experience, has proved less useful than we had hoped. In the extreme test provided by the Asian crisis, we believe that the MCI with ‘bands’ produced unnecessary volatility in short-term interest rates in the 12 months or so after it was first introduced (that volatility began to diminish in the second half of 1998 as we more explicitly relaxed the ‘bands’ around desired conditions), so in that sense we believe that the MCI was not as helpful in the implementation of policy as we believe the Official Cash Rate will be. But we have not abandoned the MCI as an indicator of monetary conditions, and we intend to continue using it to illustrate how we see monetary conditions evolving over the period covered by our projections. Moreover, we do not accept that the MCI ‘caused’ the brief recession in the first half of 1998. The monetary conditions relevant to the level of activity in the first half of 1998 were those in 1996 and early 1997, not those in the second half of 1997. If monetary policy carries any part of the blame for that early 1998 recession, it was monetary policy in 1996 and the first part of 1997 which was to blame; the MCI was introduced at the end of June 1997. In 1996, notwithstanding that inflation was slightly above the then 0 to 2 per cent target and notwithstanding the tax cuts and increased government expenditure, we were projecting inflationary pressures to abate over 1997 and 1998, with a period of positive but below-trend growth. In other words, we were projecting the proverbial soft landing. On this basis, we began easing, in December 1996. What turned a soft landing into something much harsher was the Asian crisis and the drought, both unpredicted and unpredictable in 1996. In fact, judging from the inflation outcomes it is not at all obvious that monetary policy in 1996 was too tight. CPIX inflation has been close to the middle of the inflation target since the June quarter of 1997, and indeed, had it not been for the widening of the target from 0 to 2 per cent to 0 to 3 per cent at the very end of 1996, inflation outcomes in much of 1998 would have been rather uncomfortably close to the top of the band. On this basis, it is certainly hard to argue that policy in 1996 was too tight. But there have been mistakes in the past, as I have indicated. And there will be mistakes in the future. Without a crystal ball, this is quite inevitable, given the huge amount of uncertainty which surrounds the way in which policy must of necessity be implemented, namely looking forward one to two years. There is uncertainty about where the economy is when we begin each projection. The projection which we published last week was finalised on 1 March, and yet the latest comprehensive data we have on economic activity is for a quarter which finished five months earlier, and we know that data for that quarter may be revised, and revised again, for many quarters to come. Of course, we try hard to offset this problem by studying a very large number of more up-to-date statistical series, by talking to scores of businesses all over the country, by talking to audiences in many parts of the country, by assessing the implications of several surveys of business and consumer confidence, and by asking our seven non-executive Directors for their assessment of the economy. As I remarked on a previous occasion, I sometimes suspect that God made economic forecasters to make weather forecasters look good, but at least weather forecasters can look out the window and see what the weather is like today! Economic forecasters do not have that luxury. There is also a great deal of uncertainty about ‘how the economy works’, in other words about how people and businesses react to circumstances. For example, our latest projections assume that household expenditure will grow more slowly as the economy grows out of the early 1998 recession than it did as we grew out of the recession of 1991/92. We made that assumption because people now carry a great deal more debt, relative to their incomes, than was the case a decade ago. We are assuming that they will take on rather less additional debt over the next few years. That seems an entirely reasonable assumption, but of course nobody can know that with certainty, particularly given that low interest rates of the kind now prevailing have not been experienced in New Zealand for many years. There is perhaps even more uncertainty about ‘what lies around the corner’. Will the US share market continue rising over the next year or two, stabilise at present levels, or fall substantially? The answer to that question, on which we all have views no doubt, will almost certainly have a material bearing on the growth of US consumer spending and potentially therefore on world economic growth. But should we formulate monetary policy on the basis that the US share market will correct downwards, or will not? Similarly for developments in the Japanese economy. Even within New Zealand, there may be all kinds of totally unpredictable events. Another drought perhaps? Unlikely surely, but certainly not impossible. All these sources of uncertainty mean that, when we look back on the way in which monetary policy was formulated in March 1999 from the vantage point of, say, 2002, what seemed like well-founded decisions as we finalised our decision on the Official Cash Rate last week may seem hard to justify. Because of the delay between monetary policy action and the effects of that action on the real economy and, through those effects, on inflation, we have no alternative than to formulate policy in full recognition of this inherent uncertainty. This has several implications, and this is not the place to spell out all of them. But one of the ways in which we try to reduce the risks associated with the inherent uncertainty of monetary policy formulation is by publishing our quarterly projections and the key assumptions on which they are based. (Indeed, we have published considerable information about the model on which our projections are based.) This helps markets to interpret new information as it emerges, and to adjust monetary conditions even before we adjust the Official Cash Rate. Of course this only works because financial market participants understand the objective of monetary policy in New Zealand and, on the basis of our track record over the last decade and more, understand also that we are committed to delivering that objective. What this means in practice will no doubt be illustrated tomorrow. In our Monetary Policy Statement last week, we indicated that when we finalised our projection on 1 March we expected that GDP would have increased by 0.6 per cent in the December 1998 quarter (seasonally adjusted). It is possible that, when the figure for December 1998 quarter GDP is released by the Government Statistician tomorrow, it will show growth of exactly 0.6 per cent. Possible, but unlikely. But in an important sense that doesn’t really matter. Not only is there ample time for us to adjust policy long before any mis-assessment has the slightest relevance to inflation in the second half of next year, but financial markets themselves may adjust conditions within minutes of the announcement. Thus if the December quarter GDP figure turns out to be appreciably stronger than the Bank projected, and if this is seen by markets as being relevant to the inflation outlook, monetary conditions might well tighten quickly. And vice versa. This is precisely what happened, for example, on the announcement of the GDP figures for the March quarter of 1998 at the end of June, for the June quarter at the end of September, and for the September quarter near the end of December. In each case, monetary conditions moved in a broadly appropriate direction. Conclusion At the beginning of my address I asked what New Zealanders can expect of monetary policy in the long term. I would hope that they can expect monetary policy to become so totally predictable as to be boring – stable average prices year after year after year – because that is the best environment for growth in output and employment. Interest rates will still move up and down to some degree of course, reflecting changes in the balance between savers and borrowers. But the week-to-week volatility of short-term interest rates should be diminished by our move to implement monetary policy through an Official Cash Rate, and our progressively longer track record of low inflation should make it unnecessary ever to push interest rates to the levels seen in the early stages of disinflation in the mid-eighties. The New Zealand dollar will also fluctuate of course, certainly against individual currencies and even against the trade-weighted index. As I discussed in a speech to the Canterbury Employers’ Chamber of Commerce at the end of January, that appears to be a fact of life which nobody has yet found a way of avoiding. So I suppose that, with interest rates and the exchange rate still moving up and down, monetary policy will never seem totally boring. But with luck monetary policy will at least come to be seen for what it is when it is formulated with skill, namely a useful contributor to a prosperous society, but not nearly as important as a whole host of other matters – policies on education, policies on the labour market, policies on taxation, our access to international markets, the quality of our managers, and all the rest. Those are the things which will really determine our longer-term prosperity.
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Text of the sixth L K Jha Memorial Lecture given by the Governor of the Reserve Bank of New Zealand, Dr Donald T Brash, in Mumbai on 17 June 1999.
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Mr Brash addresses the question of inflation targeting: is New Zealand’s experience relevant to developing countries? Text of the sixth L K Jha Memorial Lecture given by the Governor of the Reserve Bank of New Zealand, Dr Donald T Brash, in Mumbai on 17 June 1999. Introduction Mr Governor, Ladies and Gentlemen, I am deeply honoured to have been invited to give this sixth Memorial Lecture in memory of Shri L K Jha. I never had the privilege of meeting L K Jha, although I did visit India in the late 1960s when he was Governor of the Reserve Bank of India and I was a staff member of the Commission on International Development – better known as the Pearson Commission. But from all that I have read of him he was one of India’s most distinguished sons – an economist of distinction, a Governor of the Reserve Bank of India, a distinguished diplomat, a respected leader in the Indian Civil Service, the Deputy Chairman of the Brandt Commission, Chairman of the General Agreement on Tariffs and Trade in the late 1950s, Governor of Jammu and Kashmir, and so much more. He was, too, an ardent supporter of liberalisation, and had no doubt that, in the long run, it would improve the competitiveness of the Indian economy to the benefit of the Indian people. He would, I am sure, have been an enthusiastic supporter of many of the changes in India’s economy in recent years, while no doubt urging a still faster rate of progress. I am also honoured to have been invited to give this Lecture by my good friend, Dr Bimal Jalan. I mentioned a moment ago that, in the late 1960s, when L K Jha was Governor of the Reserve Bank of India, I was a staff member of the Pearson Commission. Dr Bimal Jalan was also a staff member of the Commission at that time. And since there were only 13 of us on the staff in total, Dr Jalan and I got to know each other very well. I developed a very healthy respect for him, and indeed a strong friendship with him, at that time. Our paths have diverged in the years since then, and it is for this reason a particular pleasure to be here in Mumbai at a time when he has assumed the enormous responsibility of guiding India’s central bank. The Governor has suggested that I talk today about inflation targeting in New Zealand, and in particular comment on whether New Zealand’s experience with inflation targeting might be of relevance to developing countries. I am delighted to do that. But let me say at the very beginning that, while New Zealand’s experience with inflation targeting has, I believe, been a positive one, I do not want to lecture you, or developing countries more generally, about what is best for you or other developing countries. Every country has circumstances and traditions which are a little different and, while I believe that inflation targeting is an approach to monetary policy formulation which deserves serious consideration, the ultimate decision about how best to run monetary policy must obviously be made by each country in the light of their circumstances and traditions. The background to New Zealand’s move to explicit inflation targeting To understand why we in New Zealand moved to inflation targeting, it is worth recalling some of the history. It has some similarities to the experiences of other countries recently. Prior to the mid-1980s, the Reserve Bank of New Zealand was closely modelled on the Bank of England. We provided advice to the Minister of Finance, but the day-to-day decisions on monetary policy were made by him. The legislation under which we operated required us, in formulating our advice, to have regard for the inflation rate, employment, growth, and a range of other good things. And the result? We never experienced hyper-inflation, but we did have one of the worst inflation rates among OECD countries (above 10 per cent per annum for more than a decade). Importantly for the subsequent political recognition that such inflation did not enable us to grow any faster, our growth rate was the lowest in the OECD. Monetary policy followed a cycle which looked suspiciously like the three-yearly election cycle. And in 1984, the whole business culminated in a foreign exchange crisis which looks in retrospect remarkably like some of those experienced in East Asia in recent times - where the previously-pegged exchange rate came under huge pressure and eventually gave way. The economic damage inflicted by that crisis on the balance sheets of banks and corporates was relatively mild compared with the damage which has been sustained in, say, Thailand or Indonesia, but that was partly because the Government itself had, through the Reserve Bank, sold a lot of forward exchange contracts. Honouring those contracts was very expensive for New Zealand taxpayers. So what to do then? Initially, we devalued and began freeing up the financial sector. In March 1985, we floated the New Zealand dollar with the explicit objective of enabling monetary policy to focus on the single objective of reducing inflation, without having that objective complicated by concerns for maintaining a fixed exchange rate. While still formally simply advisers to the Minister of Finance, the Reserve Bank was given clear instructions by the Minister that we now had the single objective of achieving price stability, and that he had no interest in knowing the mechanics of how we achieved it. We were given de facto independence. Not long afterwards, the Minister asked the Bank to suggest ways in which it might be possible to change the legislative framework in order to prevent the cynical manipulation of monetary policy for short-term political objectives by any future government. So we set about studying the literature on central banking, and examining the relationship between governments and central banks in other parts of the world. The 1989 Act What emerged from this study was the Reserve Bank of New Zealand Act 1989, which became law on 1 February 1990. It was based on six principles: • Monetary policy does affect the inflation rate, but can not successfully be used to engineer a sustainably higher rate of economic growth or a sustainably higher level of employment. This principle was absolutely fundamental, and of course was totally at variance with the assumption underlying previous legislation. It was at variance also with much of the post-war orthodoxy, which assumed that there was an enduring trade-off between inflation on the one hand and employment and growth on the other, that countries could choose to have low inflation with high unemployment or, more likely, could choose to have a bit more inflation in the interests of getting a bit more growth. (This view had been deeply entrenched in New Zealand, perhaps because the economist whose name is often, unfairly, associated with this belief, Bill Phillips, was New Zealand’s best known economist.) But it was clear well before our legislation was passed that there is no such enduring trade-off, that, in the jargon, the long-run Phillips curve is vertical. Our own experience prior to 1984 - of high inflation and very poor growth - demonstrated the point conclusively. • Secondly, in these circumstances, where there is no enduring trade-off between inflation and growth, the most sensible inflation rate for monetary policy to target is price stability. By 1989, quite a lot of empirical work had already been done in a variety of countries which suggested that high inflation was damaging to economic performance, and that low inflation, or price stability, was beneficial. We did not have the benefit of some of the recent studies of course, debating the relative merits of price stability and ‘low but positive’ inflation rates (often associated with the names of economists such as Paul Krugman, and Akerlof, Dickens, and Perry). But price stability in some sense seemed the appropriate goal, and the 1989 Act makes the Bank responsible for using monetary policy for the single objective of ‘achieving and maintaining stability in the general level of prices’. • Thirdly, in a democratic society, it is appropriate that the elected government have an explicit role in defining what ‘price stability’ means, and the speed at which it should be achieved. This seemed to follow from the fact that, while there is no long-term trade-off between inflation and growth, there is clearly a trade-off in the short-term. Hence, the 1989 Act required there to be a written agreement, a Policy Targets Agreement, between the Minister of Finance and the Governor of the Bank, signed on the appointment or re-appointment of the Governor, giving specific content to ‘stability in the general level of prices’. This gave government an explicit role in defining the objective of monetary policy, subject to the need to have that objective consistent with some reasonable interpretation of the statutory objective of ‘stability in the general level of prices’. Moreover, the Act provided that the Policy Targets Agreement could be changed during the course of a Governor’s term of office by mutual agreement of the Minister and the Governor. Indeed, where Minister and Governor can not agree, the Act provides for an ‘over-ride’ whereby, if the government feels circumstances warrant the complete abandonment of the price stability objective, the Policy Targets Agreement can be set aside, by the unilateral decision of the government, for a period of 12 months. The first Policy Targets Agreement defined our target as inflation of between 0 and 2 per cent annually, as measured by the CPI, achieved before the end of 1992.1 • The fourth principle on which the 1989 Act was built was based on the observed fact that, internationally, central banks which are independent of political control seem to do a very much better job of keeping inflation low than do central banks which are subject to political direction. So the Act provides that, once the Policy Targets Agreement between Minister and Governor has been signed, the Governor should be entirely independent in the formulation and implementation of monetary policy. The Governor has absolutely no obligation to consult with the Minister, with the Treasury, or indeed with the Board of the Bank. Note that the combination of these two principles - of political involvement in the definition of the objective of monetary policy but complete independence on how that objective is achieved made the New Zealand approach internationally unique at that time. We were neither to enjoy the complete independence of the Federal Reserve or the Bundesbank nor to suffer the complete political subservience of the Bank of England (at that time) or of our own history. A clear distinction was made between goal independence and instrument independence - we had the latter but not the former. • But, fifthly, it was taken as axiomatic that, with total instrument independence should go accountability, and the 1989 Act required that in two main ways. First, the Governor was required to provide a comprehensive report to Parliament at least six-monthly, explaining how he saw the inflation situation and how monetary policy would be conducted to ensure that It is not entirely clear where our original target of 0 to 2 per cent annual inflation came from. It has been said that its source was a capricious remark by the Minister of Finance who, when confronted by journalists wanting to know whether he was ‘finally satisfied’ that price stability had been achieved when the CPI first fell below 10 per cent, responded that ‘No, I’m aiming at genuine price stability – you know, something like 0 to 2 per cent’. That may or may not be true, but it is certainly clear that well before the 1989 legislation was passed, in early 1988, the Minister was publicly espousing a target of 0 to 2 per cent inflation as the Reserve Bank’s only monetary policy objective. By 1989, the Bank’s Annual Report referred to our objective of achieving such an inflation rate no later than the end of 1992. By then, the target was not the capricious observation of the Minister of Finance but a welljustified definition of price stability in a situation where we suspected measurement bias in the CPI of about 1 per cent; in other words, 0 to 2 per cent was regarded as ‘genuine price stability plus or minus 1 per cent’. price stability was maintained. (We now produce these so-called Monetary Policy Statements four times a year, and I am examined on them on almost every occasion by the Finance and Expenditure Committee of Parliament.) Secondly, the Act provided that the Governor can be dismissed for all the usual reasons (bankruptcy, criminal conviction, insanity, and so on) and for ‘inadequate performance’ in meeting the terms of the Policy Targets Agreement. The Act does not provide that I am dismissed automatically for the slightest breach of the inflation target, but the threat of dismissal for breaching the target certainly focuses the mind! (Incidentally, as already mentioned, the Policy Targets Agreement is between the Minister and the Governor, not between the Minister and the Bank, and it is the Governor who has decision-making freedom not, technically, the Bank. And that was quite deliberate. When I questioned the Minister on this when the legislation was being drafted, he replied ‘We can’t fire the Bank. We can’t even realistically fire the whole Board. But we sure as hell can fire you!’) • Finally, the 1989 Act mandated a very high level of transparency. The Act transparently requires that monetary policy be focused on the single objective of achieving and maintaining stability in the general level of prices. The Act transparently requires that the Minister and Governor agree a Policy Targets Agreement, and that that Agreement immediately be made public. The Act transparently requires that any change to the Policy Targets Agreement be made public immediately, whether agreed by Minister and Governor or arising from the ‘over-ride provision’. The Act transparently requires the Governor to report to Parliament on a regular basis. And it is almost impossible to overstate the importance of this transparency. It is this above all which prevents the cynical manipulation of monetary policy for political ends. The Act explicitly allows the inflation target to be modified provided the government is willing to tell the public that that is being done. The obligation to tell the public about any change in the target effectively means that monetary policy can not be used for political ends, because monetary policy achieves short-term increases in economic activity largely by producing surprise inflation. It is hard to see what political gain would be achieved by a government which announced, in an election year, that the inflation target was to be increased to, say, 5 to 8 per cent. The effect on interest rates and the exchange rate would not be conducive to winning votes! The results So that was the framework established by the 1989 Act, and we have now completed more than one full business cycle within that framework. Looking back from the experience of a decade, I believe it has served us very well. It clearly makes sense to focus monetary policy on delivering price stability. It clearly makes sense in my view to give the elected government a say in defining what price stability should mean during the Governor’s term of office. It makes sense to make the Governor or the Bank independent to make the technical judgements on how to deliver the agreed objective. It makes sense to hold the Bank or the Governor accountable for the outcomes. And it certainly makes sense that both the objectives and the modus operandi of policy are clearly understood by the public and financial markets. It is not possible, of course, to be dogmatic about the contribution which this framework has made to the reduction of inflation in New Zealand. Many other countries have also maintained inflation at very low levels during the 1990s. Nobody can be sure how inflation would have evolved in New Zealand without the framework established by that Act. Some academic commentators have pointed out that inflation was already falling quite strongly before the 1989 Act was enacted. But in my own view, the framework was of major benefit in the New Zealand context, where we had had two decades of very poor inflation performance. Yes, inflation was falling quite strongly prior to the 1989 Act becoming law on 1 February 1990, but of course the Bank had been acting under instructions from the Minister to focus exclusively on reducing inflation since at least 1985, and to focus on achieving a 0 to 2 per cent target since April 1988. We had also enjoyed complete operational independence since the mid-1980s. Little wonder, then, that inflation was falling: de facto, we had had an explicit inflation-targeting regime several years before the 1989 law was passed in December of that year. As Figure 1 above illustrates, inflation as measured by the CPI (excluding the estimated impact of our Goods and Services Tax and of interest rates, which in New Zealand are still included in the CPI) fell steadily in the late 1980s, and reached the inflation target by the end of 1991. The graph also shows what until late 1997 we referred to as ‘underlying inflation’, which was short-hand for the measure of inflation consistent with the intention of the Policy Targets Agreement (which permits us to disregard price shocks arising from certain changes in indirect taxation, significant changes in the terms of trade, changes in mortgage rates, and so on). That measure of inflation remained consistently within the then 0 to 2 per cent target from 1991 until June 1995, despite economic growth in 1993-95 which, by New Zealand standards, was exceptionally high. We exceeded the inflation target by 0.2 per cent in the year to June 1995, in part because of a very sharp spike in the prices of fruit and vegetables, returned to the target for the next six months, and then exceeded the target by a small margin throughout 1996. Our target was changed, by mutual agreement, to 0 to 3 per cent in December 1996, and in the year to March 1999 CPI inflation excluding interest rates was slightly below the middle of our target (at 1.0 per cent). So for more than eight years consumer price inflation has been within a range of 0 to 3 per cent, and for most of that time it has in fact been below 2 per cent. I believe that the framework established by the 1989 Act has also played a useful role in reducing inflationary expectations in New Zealand. Again, it is difficult to prove this point because nobody knows how inflationary expectations would have evolved in the absence of the Act. But I believe it helped increase the credibility of the Bank’s commitment to low inflation that it was widely understood that I ran a serious risk of losing my job if inflation fell outside the agreed and publiclyrecognised inflation target. On each of the occasions in 1995 and 1996 when inflation slightly exceeded the 0 to 2 per cent target (and at its highest the excess was only 0.4 per cent), the Minister of Finance formally wrote to the non-executive Directors of the Bank asking them whether they felt my performance under the terms of the Policy Targets Agreement had been adequate. Both the letters from the Minister and the replies from the Directors of the Bank were made public, and everybody understood what was at stake. In late 1990, not many months after the 1989 Act became law, the head of the New Zealand Council of Trade Unions wrote an article which appeared in one of the major newspapers2. The article argued The Dominion, 31 October 1990. that the Reserve Bank was focused on an undesirably narrow inflation objective, but that, as long as that was the case, unions would need to moderate wage demands to avoid increases in unemployment. In the weeks which followed, he actively, and with very considerable courage, campaigned for moderate wage settlements as a way of reducing unemployment. I myself have little doubt that the Reserve Bank Act played a part in encouraging employers and unions to adjust their wage settlements to levels which were quite quickly consistent with the inflation target. The same sort of effect on inflationary expectations was visible in financial markets. As Figure 2 shows, in early 1986 the yield on New Zealand government New Zealand dollar 10 year bonds was roughly 1000 basis points above the yield on US Treasuries. By early 1990, that margin had contracted to about 400 basis points. By early 1994, the yield on the New Zealand government securities was marginally below that on US Treasuries. In the last few years, the yield on New Zealand 10 year bonds has typically been a little higher than on US Treasuries, but the margin looks trivial in relation to that in the mid-1980s. Another of the interesting by-products of the inflation-targeting regime has, I believe, been some stabilisation of the New Zealand dollar exchange rate. I don’t want to overstate this: the New Zealand dollar has been through some pretty big swings in recent years. Against the US dollar, we appreciated by nearly 40 per cent between the beginning of 1993 and the beginning of 1997; and then we lost all of that appreciation (which means that we declined in percentage terms by nearly 30 per cent) over the next 18 months. But on a day-to-day and week-to-week basis, fluctuations in the New Zealand exchange rate have been rather less than those experienced by many other floating currencies - and this in a situation where the Reserve Bank has not intervened in the foreign exchange market for more than 14 years (since we floated in March 1985). Why is this? I think it is because financial markets understand that, with a very explicit inflation target, there is a limit to how much movement we will accept in the exchange rate before we look to see some offsetting change in interest rates. No, we do not have an exchange rate target. We have an inflation target. But in a small open economy such as ours, no central bank with a commitment to low inflation can be indifferent to major movements in the exchange rate. This is because the exchange rate has important direct and indirect influence over prices. Most importantly, a change in the exchange rate alters the demand for locally-produced goods and services, thereby altering domestic inflation pressures. Of course, the difficulty for a central bank is to know exactly why the exchange rate changes. This has important implications for the appropriate monetary policy response. Thus, if a sharp movement in the exchange rate seems to be related to, say, an adverse development in our external markets, as has been the case over much of the last two years, then we may judge that the adverse external development will have sufficient disinflationary impact on the economy to offset the inflationary impact of an exchange rate depreciation, so that no offsetting increase in interest rates is necessary. Conversely, if the exchange rate change simply reflects some shift in investor preferences, with no justification in the real economy, then inflation pressures will have changed, and some adjustment in monetary policy will normally be appropriate. A fourth contribution of the framework established by the 1989 Act was, I think it is fair to say, an improvement in fiscal policy. Again, I don’t want to overstate this point: there were a number of factors driving an improvement in New Zealand’s previously rather poor record of fiscal performance, including some very determined Ministers of Finance. But the monetary policy framework played a useful part. This first became apparent in 1990 when the then-Government introduced an expansionary Budget not long before the general election that year. We judged that that degree of fiscal stimulus would require us to tighten monetary policy somewhat if inflation (then running at over 5 per cent) was to be brought down to the 0 to 2 per cent target by 1992; so we did. Immediately, an editorial in New Zealand’s largest daily paper noted that the Budget had ‘rekindled inflationary expectations. The (Reserve Bank) was bound to lift interest rates…. Electors are frequently bribed to their ultimate cost. This time the independence of responsible monetary control quickly exposes a fiscal fraud.’3 The main Opposition party campaigned in the election on a commitment to get interest rates reduced, not by leaning on the central bank but by ‘giving monetary policy some mates’ through tighter fiscal policy and deregulation of the labour market. Five years later, with several years of fiscal surplus behind it, the Government undertook to reduce income taxes subject to several conditions, one of which was that the Reserve Bank was satisfied that such tax cuts would not require a significant tightening of monetary policy. To me, this is a good illustration of the benefit of having the precise specification of the objective of monetary policy a matter for formal and public agreement between Government and Bank. The Government makes a public commitment to the agreed inflation objective. It implicitly accepts that, if its fiscal policy increases inflationary pressures, the Bank will need to tighten monetary policy to ensure that the agreed objective is met. The Bank is protected from political pressure to ease monetary policy as long as the inflation rate is, and looks likely to remain, above the bottom of the inflation target range. In contrast to these positive benefits from the 1989 Act, some people have noted that in the early 1990s New Zealand also saw quite a strong increase in unemployment and a downturn in output, and have suggested that the Reserve Bank must accept the blame for that. I know of no cases internationally where inflation has been reduced from a relatively high level to a very low level without some temporary adverse impact on employment and output, and New Zealand’s experience was no different. Indeed, I have often acknowledged that the process of reducing inflation from a high level to a low level almost certainly had the effect of temporarily reducing employment and output. But I certainly am not willing to accept that the process of reducing inflation was the only factor in reducing employment and output in New Zealand in the early 1990s, since a great many other policies had also been changed at about that time. While most of those other policy changes were highly desirable in the interests of the long-term growth of the New Zealand economy - reductions in protection against imports, reductions in subsidies for exports, privatisation and rationalisation of many heavily over-staffed government trading operations, for example - many of them also had adverse short-term impacts on employment and output. For this reason, attempts to New Zealand Herald editorial, 3 August 1990. calculate the ‘sacrifice ratio’ involved in reducing inflation in New Zealand are almost inevitably doomed to failure. What we know is that employment and output both fell at the beginning of the 1990s. What we acknowledge is that the process of reducing inflation was a part of the reason for that. What we do not accept is that monetary policy was the only factor in that outcome. Moreover, as theory suggested would be the case, once wage- and price-setting behaviour adjusted to the new, low, level of inflation, employment and output both recovered quite quickly, with unemployment declining from almost 11 per cent in 1991 to 6 per cent in 1996. In other words, the increase in unemployment was a result of the process of reducing inflation from a high level to a low level, not a result of maintaining inflation at a low level. While unemployment has recently risen to over 7 per cent of the work-force, it remains well below its 1992 peak, and well below that in most of the countries of Europe, notwithstanding the impact on production and exports of the Asian crisis and two successive years of drought. We are confident that, provided inflation expectations remain broadly consistent with the inflation target, low inflation can be maintained without any ongoing cost in terms of employment or output. Interestingly, a recent paper produced by the IMF4 suggests that inflation-targeting countries as a group have recently improved their rate of economic growth compared to countries which are not inflation-targeters. Certainly, New Zealand’s growth performance relative to other OECD countries has been markedly better in the 1990s than in the previous two decades, although given all the other economic reforms which took place in New Zealand in the late 1980s and early 1990s it would certainly be inappropriate to attribute that improved growth performance primarily to the inflation targeting regime. As an aside, it is perhaps worth stressing what has come as something of a surprise to some people in New Zealand and that is that our inflation range has both a top and a bottom. One of our central banking colleagues once said to me that he thought that any fool could get inflation below 2 per cent by simply keeping monetary policy tight at all times. I agreed. But that is assuredly not the way we see inflation targeting, and of course it is not the way our inflation target is specified. Our obligation, currently, is to keep inflation below 3 per cent and above zero. I would not expect to be dismissed the instant inflation fell below zero, any more than I was dismissed when there was a small breach of the top of the target. Indeed, the Policy Targets Agreement recognises that there may be quite legitimate reasons why inflation may, on occasions, move outside the 0 to 3 per cent target range. But there would certainly be questions asked if inflation fell below zero, and I would need to have a good explanation of that outcome. We began easing monetary policy in December 1996 – and eased aggressively throughout 1998 - precisely because we take the bottom of the target as seriously as we take the top. Brooks, Ray, ‘Inflation and Monetary Policy Reform’, in Australia: Benefiting from Economic Reform, 1998. The formulation of monetary policy Let me talk briefly about the actual achievement of the agreed inflation target, about the formulation of monetary policy. Does an inflation-targeting framework help in the actual delivery of price stability? I think it does, in three ways. First, having an explicit inflation target is useful in anchoring inflation expectations and thus affecting wage- and price-setting behaviour. I have already mentioned that in the discussion of the results of the adoption of the new framework. We in the Reserve Bank devote a very considerable amount of energy to explaining what we are doing and why, not just to the financial markets but to the public more widely - groups of farmers, manufacturers, Rotarians, teachers, lawyers, anybody who will listen. I myself do more than 100 speeches all over the country in an average year, and my colleagues do a great many also. Perhaps six or eight of these speeches will be on-the-record, and these we will post to an extensive mailing list of Parliamentarians, business executives, school teachers, and so on. We produce our quarterly Monetary Policy Statements, and a series of brochures and pamphlets, many of them written in question-and-answer format, designed to deal with the monetary policy issues of greatest concern to the public. We have an Internet site, quite comprehensive and regularly updated, receiving over 20,000 hits per week at this stage. All of this communications work is designed to strengthen the credibility of the inflation target and thus both to increase the likelihood of achieving the target and to minimise any social cost in doing so. Secondly, having an explicit inflation target provides a very useful discipline on the Reserve Bank itself, and helps considerably in keeping our deliberations focused. I have been at the Bank for little more than 10 years, during all of which time we have had an inflation target. But I am told by those of my colleagues who remember the days before we had an explicit inflation target that prior to the introduction of that target monetary policy discussions, and decisions, were very much more difficult. Those making the decisions and expressing the opinions often had a range of spoken and unspoken objectives in mind, some of them consistent and some of them inconsistent. Dr Mervyn King, Deputy Governor of the Bank of England, has reported the same change in discussions at the Bank of England. With a clear directive from the British Government to keep inflation as close as possible to 2.5 per cent, the members of the Bank of England’s Monetary Policy Committee focus on that objective. It matters not whether the Committee members are ‘doves’ or ‘hawks’. Indeed, the terms have no meaning in the context of an inflation target agreed with government. The central bank decision-makers are being asked to use their expertise and judgement to deliver an agreed target, not to express a view about whether the target should be higher or lower. Thirdly, having an explicit inflation target often goes hand in hand with public inflation forecasting, and does so in our case. This has led Dr Lars Svensson of Sweden to suggest that central banks which do this are effectively making their inflation forecasts into a kind of instrument of monetary policy5. This certainly seems to be a fair characterisation of the role of our own inflation projections. Because financial markets know that we will, if need be, adjust our Official Cash Rate whenever we judge that monetary conditions are no longer consistent with maintaining the price stability target, markets are constantly weighing new economic data trying to assess its implications for the inflation target, with the exchange rate and interest rates adjusting on a real-time basis with the inflation objective constantly in view. But alas, inflation targeting does not guarantee that a central bank practising it will be able to deliver consistently low inflation. All the debates about how to formulate monetary policy in order to deliver the best outcomes are still relevant. Should we use monetary aggregates? Should we use Taylor rules? Svensson, Lars E.O., ‘Inflation forecast targeting: Implementing and monitoring inflation targets’, European Economic Review, Vol. 41, 1997, pp.1111-1146. Should we simply adjust interest rates so that the exchange rate moves in such a way that the direct price effects of the change in the exchange rate produce the desired effect on the domestic price level? In our own case, we used to be rather strongly focused on the direct price effects of changes in the exchange rate. This was early on in the disinflation process, at a time when inflation was high and there was no ambiguity about the need to reduce it, at a time when we thought we could see a clear relationship between movements in the exchange rate and domestic prices, and at a time when, by contrast, we found it very difficult to measure the effects of interest rate changes on the inflation rate. This did not mean that we had an exchange rate target in the conventional sense, but rather that, after making our best estimate of all the factors affecting prices in the domestic economy, we ‘solved’ for the exchange rate which would keep inflation within the target range. So, for example, when inflationary pressures were strong we judged that there was a need for the exchange rate to appreciate somewhat in order to reduce the prices of imports and exportables. And vice versa. The financial markets understood this approach, and as a result the exchange rate tended to move very much in line with the need to keep inflation on target. In the early 1990s, this primary focus on the direct price effects of exchange rate movements got us into some difficulty. Interest rates were allowed to fall to very low levels, in part because, as indicated, we did not take interest rates as seriously as we took the exchange rate in the price formation process. At least in part as a consequence, the economy accelerated somewhat above a sustainable level, and inflation pushed to, and eventually slightly above, the top of the inflation target. We recognised that we had to pay more attention to the impact of interest rates, and this in turn caused us to start looking rather further into the future, in formulating policy, than had been necessary when we were primarily focused on the direct price effects of exchange rate movements (most of which came through into consumer prices within two to four quarters). In recent years, we have developed what we believe to be a sophisticated model of the New Zealand economy which seeks to answer one question: given all we know about the structure of the economy, about the present state of the economy (and in particular the gap between actual and potential output), about the stance of fiscal policy, about wage behaviour, about prospects for the international economy (clearly of huge importance for a small country like New Zealand), and so on, what are the monetary conditions required to deliver inflation to somewhere close to the middle part of our inflation target in six to eight quarters’ time? Nobody pretends that that is an easy question to answer, or that our model is flawless, but it seems to us that that is the right question. Note that I referred to the ‘monetary conditions required to deliver inflation to somewhere close to the middle part of our inflation target in six to eight quarters’ time’. The reference to monetary conditions rather than to interest rates is a recognition that, in a small open economy, as I have already mentioned, a central bank committed to delivering price stability has to be concerned with what is happening to the exchange rate, and not just what is happening to interest rates, since both affect inflation. (Unfortunately, too much of the academic literature on monetary policy has been written by economists in the United States, an economy where, because of the relatively small share of international trade, the exchange rate can be, and has been, largely ignored in thinking about monetary policy issues.) But the reference to delivering inflation to ‘somewhere close to the middle part of our inflation target in six to eight quarters’ time’ is a recognition that what we should be mainly concerned about is not the direct price effects of movements in the exchange rate but rather the longer term effects which arise out of the way in which changes in the exchange rate affect the demand for goods and services produced locally. Thus, for example, a depreciation in the exchange rate will have two kinds of effects on local prices. First, it will tend to push up prices for imports and exportables as the local currency equivalent of unchanged international prices increases. In New Zealand, these price effects tend to come through into consumer prices within about a year. We can not entirely ignore these price effects because of the risk that they spill over into inflationary expectations and thus into wage- and price-setting behaviour. But the more enduring impact of an exchange rate depreciation is its second effect. The depreciation makes domestically-produced goods cheaper relative to internationally-produced goods, as already noted. As a result, local residents tend to buy domestically-produced goods in preference to imports. Foreigners tend to buy more of our exports. Both factors increase the demand for our output and increase local production relative to the economy’s sustainable capacity to supply. This in turn has medium-term implications for the inflation rate. Clearly, this approach does not guarantee that we will make no mistakes. No approach can do that for the obvious reason that monetary policy works with ‘long and variable lags’ and the future is inherently unknowable. But in a world where controlling inflation by targeting monetary aggregates has been abandoned as unworkable by many central banks - and by targeting exchange rates has been abandoned as too dangerous by most of the rest - we believe that the direct and explicit targeting of inflation has a great deal of merit. That does not mean, of course, that we pay no attention to monetary aggregates, and it certainly does not mean that we pay no attention to the exchange rate. It does mean, however, that we look at monetary aggregates and movements in the exchange rate as two of many important influences on the inflation rate. How relevant is all this to developing countries? Let me turn finally to a consideration of whether inflation targeting is relevant to developing countries. I have heard a number of people argue that it is not. First, it is sometimes suggested that inflation targeting is inappropriate in a situation of so-called ‘fiscal dominance’, a situation, in other words, where the central bank is primarily concerned with assisting the government meet its need for revenue. Often this is a situation where government’s revenue base is very poor, and as a result the government has a heavy dependence on the ‘inflation tax’ represented by seigniorage income, or on central bank credit. Certainly, in many developing countries governments do depend on seigniorage income to a much greater extent than is true in developed countries. A recent study found that seigniorage income averaged between 1.4 per cent and 3.0 per cent of GDP in developing countries, compared to less than 1 per cent in developed countries6. In New Zealand’s case, seigniorage amounts to less than 0.1 per cent of GDP. I think it must be conceded that having a high dependence on central bank credit, or on seigniorage income, is a real constraint on the introduction of an inflation targeting regime, or indeed on the introduction of any other rational monetary policy regime. Having said that, several countries have successfully introduced inflation targeting when their central banks were still in a position of ‘fiscal dominance’, at least where that is measured by the size of seigniorage income (Chile and the Czech Republic are good examples). So while it may be more difficult to focus monetary policy on keeping inflation low where government has a high dependence on the ‘inflation tax’, it clearly is not impossible. Of course, to the extent that monetary policy is successful in eliminating inflation, the ‘inflation tax’ is commensurately reduced, and government needs to find alternative sources of revenue. Secondly, it is sometimes suggested that in developing countries monetary policy should be used not just to attain a specified inflation rate but to encourage real economic growth and to maintain a competitive real exchange rate. There is obviously not the slightest debate that encouraging real economic growth and maintaining a competitive real exchange rate are crucially important objectives Debelle, G., Masson, P., Savastano. M., and Sharma, S., “Inflation targeting as a framework for monetary policy”, IMF Economic Issues 15, 1998. in most, probably in all, developing countries, indeed, probably in all countries, whether developing or developed. And it is accepted that monetary policy can sometimes stimulate demand and so encourage real economic activity in the short-term. Monetary policy can also influence the real exchange rate in the short-term. But there is absolutely no evidence that I am aware of that monetary policy is able to foster a higher rate of real economic growth in the long-term except by delivering predictably stable prices, or that monetary policy is able to have any sustainable effect on the real exchange rate. While most of the evidence for the inability of monetary policy to produce a sustainably faster rate of economic growth, or a sustainably more competitive real exchange rate, relates to the experience of developed countries, that evidence is so overwhelming that those who argue that monetary policy can improve real growth in the long term, or maintain a competitive real exchange rate in the long term, in developing countries need to have some pretty cogent arguments to support their claims. I have not myself seen those arguments. Thirdly, it is sometimes suggested that inflation targeting is unsuitable for developing countries because it requires a sophisticated inflation forecasting ability in the central bank, or a sophisticated financial system, or a sophisticated measure of inflation. Certainly, a good ability to forecast inflation, a sophisticated financial system, and a robust measure of inflation are all desirable things to have. But when New Zealand began inflation targeting in the 1980s, we had none of those things. Far-reaching economic restructuring meant that our econometric models were of little use. The financial system had just been freed from an extensive network of direct controls and was anything but sophisticated. Our best-known measure of inflation included interest rates and house prices, and indeed it still does. Poor tools make any monetary policy approach problematic, but it is not obvious that inflation targeting is more difficult than the available alternatives. And in any event, what are the alternatives? At a conference hosted by the Swedish central bank in Stockholm last year, papers explored three main approaches which the European Central Bank might take to monetary policy – money aggregate targeting, exchange rate targeting, and inflation targeting. Most people at the conference felt that the relationship between the growth in money aggregates and inflation was so unstable, at least over policy-relevant periods, that for central banks to focus exclusively on such aggregates was likely to produce a very unstable inflation rate. It was also argued that virtually no central banks today (the Swiss National Bank being a possible exception) do focus exclusively on money aggregates, for precisely this reason. Most of those at the conference also accepted that using monetary policy to maintain a nominal exchange rate peg, or even a nominal exchange rate ‘zone’, was fraught with danger. Yes, exchange rate targeting has its advantages, perhaps the most important being the ability of a country with limited monetary policy credibility to borrow the credibility of the central bank of the country whose currency is ‘targeted’. In certain circumstances, and with strong institutional and political commitment, that may be an optimal policy. But as the countries of East Asia have recently discovered, and the United Kingdom and Sweden discovered earlier in the decade, the risks are substantial. Pegged exchange rates seem to attract speculation like bees to honey – with often disastrous consequences. Pegged exchange rates seem to encourage banks and corporates to borrow overseas in foreign currency in the belief that that is a prudent and relatively inexpensive borrowing option – with often disastrous consequences. Most of those at the Stockholm conference appeared to feel that inflation targeting, while in no sense a panacea, was the most sensible policy option for the European Central Bank. Conclusion And that is my conclusion for developing countries also. Clearly, inflation targeting is no panacea. It is no silver bullet. It is certainly no guarantee against monetary policy error. In many respects, it is a mistake to think of inflation targeting as some kind of new approach to monetary policy. Rather, the formal and public adoption of an explicit inflation target is a frank recognition of what monetary policy can and can not do; in other words, it can influence the inflation rate. Inflation targeting is a way of helping to anchor inflation expectations, and thus both to assist in the achievement of the inflation target and to minimise the inevitable social and economic cost of achieving it. Through the transparency which is an essential element of an inflation targeting regime, inflation targeting helps to ensure that central bankers and governments are held to account for their use of one of the most misused powers developed in the 20th century. It is hardly surprising, therefore, that an increasing number of countries, developed and developing alike, have adopted inflation targeting over the last decade. The developed country inflation targeters are well known – New Zealand, Australia, Canada, the United Kingdom, Sweden, and, until they joined EMU, Finland and Spain. But there are now a host of developing and transitional economies which have also adopted inflation targeting, including Albania, Botswana, Brazil, Chile, the Czech Republic, Israel, Jamaica, Mexico, Mongolia, and Poland. Several countries in East Asia are giving serious consideration to the adoption of an inflation targeting approach to monetary policy. While the optimal approach to monetary policy will clearly depend to some degree on the traditions and constitutional structure of individual countries, I believe that explicit inflation targeting is an approach which is worthy of serious consideration.
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Speech by Mr Murray Sherwin, a Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Association of Economists Conference in Rotorua, New Zealand on 1 July 1999.
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Mr Sherwin discusses the origins of New Zealand’s inflation targeting regime and its evolution over the past decade Speech by Mr Murray Sherwin, a Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Association of Economists Conference in Rotorua, New Zealand on 1 July 1999. A decade ago, during the course of 1989, the New Zealand Parliament devoted considerable time and intellectual energy to the consideration of the Reserve Bank of New Zealand Bill, later to become the Reserve Bank of New Zealand Act 1989. That Act completely re-wrote the RBNZ’s charter. The bulk of the Act – indeed almost half of its 192 clauses - relates to prudential supervision. While the prudential material is interesting in its own right, I won’t be dwelling on it in this address. Rather, I will concentrate on the origins of our inflation targeting regime, its evolution, and an assessment of our experience with it over the past decade. The origins of the 1989 Act lay primarily with Roger Douglas. Around the middle of 1986, with memories of the 1984 election debacle still deeply etched in his mind, Douglas initiated a discussion on means by which monetary policy could be made less susceptible to manipulation for short-term political ends. Officials were asked to explore options that might have that effect. Not too surprisingly, especially in the light of some of the academic literature then circulating on the subject of the relationship between central bank independence and long-run inflation performance, officials recommended reforms which would confer some degree of operational independence on the Reserve Bank. THE ORIGINS OF INFLATION TARGETING Inflation targeting as we now understand that term – with multi-year medium-term targets in an economy with liberalised prices, wages and financial markets – was pioneered in New Zealand1. However, it was not an inherent part of the original conception of an independent central bank. Rather, its genesis lay in the confluence of two sets of policy priorities in the late 1980’s. Our inflation targeting evolved – at times abruptly, at times almost as painfully as having teeth pulled – rather than being delivered fully formed and fully considered from some quasi-academic ivory tower high above The Terrace. Even before Roger Douglas had asked for specific proposals to reform the institutional arrangements for monetary policy, the managerialist approach to the public sector and its activities had been coming to the fore in New Zealand. Specifically, this took the form, later enshrined in the State Sector Act and the Public Finance Act, of giving public sector managers the authority to manage, but holding them directly accountable for outputs – i.e., the measurable products or services that each agency was mandated or contracted to deliver. For historical completeness, we should note that Italy, Greece and Portugal had all used published targets for inflation at times during the early 1980’s, and Sweden had briefly operated a form of inflation targeting in the 1930’s. However, none of these provided a complete structure for inflation targeting of the sort now understood by that term. In the Reserve Bank’s case, it was difficult to define meaningful outputs. There were suggestions that some form of monetary base measure might be appropriate, but this concept failed when it proved impossible to identify a stable relationship between this particular output and the sort of ultimate outcome – price stability – our political masters were seeking from an independent central bank. Eventually, it was accepted that the only practical solution was something of a hybrid. The Reserve Bank would be held accountable not for outputs, but primarily for the judgements it reached in pursuing the desired outcome itself. This was to be done mainly via the six-monthly Monetary Policy Statements, but also through an employment contract for the Governor which would state the inflation goal directly. Note that at that stage, it was not envisaged that there would be a high profile public role for the employment contract – any more than most public sector CEOs’ employment contracts are ordinarily matters of high public profile. The evolution of the Governor’s “employment contract” into what we now know as the Policy Targets Agreement (PTA) took place under pressure of another development. After successfully driving down inflation from a 1985 peak in the high teens, Roger Douglas became concerned that the public – including financial markets, employers and unions – were expecting the Government to be content with progress to that point and that inflation and, more importantly, inflationary expectations, were settling at around 5 to 7 percent. Without consulting officials, or, apparently, his parliamentary colleagues, Douglas announced in a TV interview on 1 April, 1988 that policy was to be directed to reducing inflation to “around 0 or 0 to 1 percent” over the following couple of years. This was as much a surprise to the Reserve Bank as it was to the community generally. Douglas was aiming, with this announcement, to influence inflation expectations and by that means to reduce the inevitable costs of disinflation. With the input of advice from officials over the subsequent few weeks, that initial announcement crystallised as the 0 to 2 percent inflation target to be achieved by the early 1990’s. It took real shape as a strictly defined target in the Bank’s 1989 Annual Report and in the 1989 Budget as one of a series of macroeconomic goals announced by David Caygill2. It is the case that the 1989 Act was passed without a single dissentient vote in Parliament. Don Brash has made that point on a number of occasions while also reminding us that one certain dissenter, Rob Muldoon, was hospitalised at the time. However, it is also the case that despite the bipartisan support evident on the evening of the vote, both major political parties struggled to reach positions where they could support the passage of the Bill. Significant opposition or reservations existed within both caucuses. Reservations about the new framework were also evident in submissions made to the Select Committee which considered the Bill. As the report of the Finance and Expenditure Committee notes, 10 of the 23 submissions received raised concerns about the proposal to assign monetary policy the single objective of price stability. Generally, and without challenging the desirability of low inflation, those submissions sought inclusion of a reference to real sector objectives as well. In the event, the FEC’s report was quite unequivocal on that point. “The Committee…. is firmly of the view that the primary function of monetary policy For the purposes of those attempting to analyse the impact of inflation targeting, we date its introduction in New Zealand from April 1988 rather than early 1990, which was when the Act came into effect and the current monetary policy structure was formalised. should be that set out in clause 8(i). Members acknowledge that monetary policy should not be made to wear the cost of inappropriate fiscal and micro-economic policies. Monetary policy at the end of the day can only hope to achieve one objective, that is, price stability.” Of course, this was not a new insight or perspective on the appropriate objective of monetary policy. To indulge a small historical diversion, it’s interesting to look back at the 1931 report of Sir Otto Niemeyer, the Bank of England official brought to New Zealand to advise on the formation of a central bank. His report led directly to the establishment of the Reserve Bank of New Zealand. Borrowing wording from the statutes of the Bank of Estonia, Niemeyer proposed “stability of the value of its notes as the primary duty of the Bank,” and required it “to exercise control over monetary circulation and credit towards that end.”3 That, argued Niemeyer, was simply the standard specification for a central bank at that time. As it transpired, his original proposal for the new central bank’s objective was amended slightly during the drafting of the 1933 Act by the addition of the words “to the end that the economic welfare of the Dominion may be promoted and maintained.” That amendment, of course, parallels the words added to the Policy Targets Agreement in December 1996. The PTA now reads that “… the Bank shall formulate and implement monetary policy with the intention of maintaining a stable general level of prices, so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy”. WHAT IS INFLATION TARGETING? A decade on from the passage of the new Act, inflation targeting has become a very widely practised, researched and analysed policy. But what is it? Bernanke et al4 provide the following definition: “Inflation targeting is a framework for monetary policy characterised by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy’s primary long-run goal. Among other important features of inflation targeting are vigorous efforts to communicate with the public about the plans and objectives of the monetary authorities, and, in many cases, mechanisms that strengthen the central bank’s accountability for attaining those objectives”. In providing that definition, the authors take some care to describe inflation targeting as a framework as opposed to a rule. In other words, inflation targeting fits somewhere between the extremes which feature in the “rules versus discretion” debate which raged in monetary policy circles in earlier years. Inflation targeting is not “automatic” in the sense of a Friedmanlike rule. But nor does inflation targeting allow the central bank full discretion. Rather, inflation targeting can be described as a form of “constrained discretion”. To quote Bernanke et al again, “By imposing a conceptual structure and its inherent discipline on the central Hawke, 1972 Bernanke et al, 1999 bank, but without eliminating all flexibility, inflation targeting combines some of the advantages traditionally ascribed to rules with those ascribed to discretion.”5 While we use the label “inflation targeting”, Lars Svensson6 uses a variation on that term which he regards as a more accurate description of the process – namely, “inflation forecast targeting”. Given the lags inherent in the operation of monetary policy, he argues that the essence of inflation targeting is a commitment to adjust policy to ensure that a credible or unbiased forecast of future inflation falls within the specified target. However we choose to define inflation targeting, it has certainly gained a very rapid acceptance around the world in a diverse range of countries. Table 1 lists the countries currently engaged in formal inflation targeting, with interest growing rapidly at present. There are many variants in the approach, but the essential elements described above are common to all. Table 1 Inflation Targets Internationally Country Date Adopted Target Target variable Australia Average of 2-3% over the medium term ‘Underlying’ PI up until October 1998; CPI thereafter Canada February 1991 Midpoint 2% + 1% band CPI Finland* February 1993 2% no explicit band CPI excluding indirect taxes, subsidies and housing-related costs New Zealand April 1988 0-3% 0 – 2% originally CPI excluding interest Spain* November 1994 2% CPI Sweden January 1993 Midpoint 2% +1% band CPI United Kingdom October 1992 2.5% +1% reporting range Retail price index excluding mortgage interest payments * Now members of the Euro area Bernanke et al, 1999 Svensson, 1997 NB. Czech Republic, Republic of Korea, Israel, Mexico and Chile also describe themselves as inflation targeters, but not necessarily with explicit, public commitments to specific targets of the sort listed above. THE EVOLUTION OF THE MONETARY POLICY FRAMEWORK It seems a decade is a long time in monetary policy. We have seen one full business cycle pass and that has been extensively reviewed, documented and analysed in recent Reserve Bank Bulletins. While the Reserve Bank Act has not changed in any significant respect, the way we go about “doing” monetary policy has changed over that time. The formal inflation target has been widened, the way we describe the targeted measure of inflation has shifted and our approach to dealing with the impact of external shocks or “caveats” has changed. In addition, a number of less formal innovations have occurred. Under this heading I include the development, and subsequent demise, of the housing adjusted price index (HAPI); the emergence of the “underlying inflation” concept, and its evolution into, effectively, the accountability measure for inflation performance before it was eased out of the limelight in 1997; the more recent extension of the policy horizon from around 4 quarters to the current 6 to 8 quarter timeframe; and the shift in thinking about the role of the exchange rate in the practice of inflation targeting, as embodied in both the dropping of the MCI from its direct implementation role and the extension of the policy horizon. Policy implementation has also gone through several stages before reaching the current Official Cash Rate (OCR) structure. Some degree of change was probably inevitable and even a healthy sign. As the pioneers of the inflation targeting process, it would have been a surprise if all aspects were “right” from day one. Perhaps more importantly, even if the framework had been conceived immaculately, the environment in which we operate today is not the same as that applying a decade earlier. Some degree of adaptation was necessary simply to meet those changing circumstances. Let me deal with just a couple of aspects of the changes over the decade. Firstly, the movements along the spectrum between what Svensson refers to as “strict” and “flexible” inflation targeting, and secondly, the evolution of the implementation framework from a quantity based regime to the current interest rate based (OCR) structure. Strict or flexible inflation targeters? As already noted, the initial move to inflation targets arose from a wish to influence inflationary expectations by stating clearly the Government’s commitments. The hard-edged character of the targets emerged a little later, partly as a consequence of the Bank taking up the role of shaping general inflationary expectations through a vigorous external communications programme that stressed the Bank’s commitment to the targets and the Governor’s personal accountability for achieving them. While clearly a useful device for communicating the strength of the Bank’s resolve to a wider public audience, the portrayal of the inflation target as hard-edged also carried risks given the lags and uncertainties in monetary policy decision making. A “strict” approach to inflation targeting encouraged a search for precision in calculating “core” or underlying inflation measures for accountability purposes and may have encouraged a shortening of policy horizons as the direct price effects of the exchange rate became more important to the achievement of the target outcomes. Both of those effects were evident in our monetary policy through the past 10 years. As inflation expectations have subsided, it has been possible to assume a degree more flexibility in the regime, and the current PTA reflects that. Rather than detailed calculations of the impact of specific shocks, as embodied in the old underlying inflation measure, the PTA now explicitly acknowledges that outcomes will occasionally fall outside the target range for a variety of reasons, even when the Bank is “constantly and diligently” striving to deliver price stability. In those circumstances, the Bank is required to provide a satisfactory rationale for its judgements. Ultimately, the Bank’s non-executive board members must assess the quality of those judgements and report their findings to the Treasurer. Embodied in the shift in emphasis over the past year or two has been the analytical work undertaken in reviewing the past business cycle. I won’t attempt to summarise that, since it has been published in recent Bulletins. But some key considerations have emerged with greater clarity than was previously available to us. These relate to the possible trade-off between volatility of inflation and output; the nature of the shocks we are likely to experience over the course of a business cycle; the nature of the interactions between those shocks, the inflation targets, and alternative policy reaction rules; and whether movements of the exchange rate are best considered to have their origins in “real” or “portfolio” shocks in the first instance. The judgements which we take from that work are: • the narrower the target range the more active monetary policy must be; • more activism implies more variability in interest rates, the exchange rate, and perhaps output; and (up to a point) less variability in inflation; • lower inflation expectations allow for a longer policy horizon, and less active monetary policy.7 Those judgements fit well with the wider target range introduced in December 1996 and with the shift in thinking about the exchange rate. Based on research undertaken on the nature of the shocks commonly experienced by the New Zealand economy, we now assume, in the first instance and in the absence of evidence to the contrary, that shifts in the exchange rate are ’real’ in character. As such, they do not require an immediate and offsetting interest rate adjustment to maintain longer-term price stability. The direct price consequences of an exchange rate movement shift in response to a real shock are likely to be transitory and, for that reason, are best ignored. In this respect, we have moved in the direction of the Reserve Bank of Australia. This shift in thinking is consistent with our dropping of the MCI from its central role in the implementation structure. In effect, the “banded” MCI approach we were using assumed exchange rate movements to be “portfolio” in nature. This shift in thinking on the exchange rate is also consistent with the lengthening of the policy horizon. In essence, we are accepting the prospect of somewhat greater variability in inflation outcomes around the mid-point of our target range, against the prospect of a little less variability in the instruments of monetary policy and perhaps in output. In doing so, we recognise the risk that the inflation target may be breached more frequently, and that the judgements we will be confronting with each quarterly Monetary Policy Statement have Drew and Orr, 1999 become more difficult. If we get those judgements wrong too often, we risk undermining public confidence in the Bank’s capacity to deliver consistent price stability and in that way could hinder, rather than enhance, overall economic performance. Implementation structures One aspect of the monetary policy regime that has given rise to repeated stresses and distractions is the implementation regime. The regime emerged in the late 1980s as essentially a quantity-based structure – first centred on the Primary Liquidity (PL) measure and then the settlement cash target. We were probably unique, at least within the OECD, in having no officially set or targeted interest rate. The preference for a quantity-based structure had its roots in our reluctance to fix a particular interest rate in the midst of the structural reforms and deregulation of the 1980s, probably encouraged by a degree of “frustrated monetarism” which continued to hope that some stable and usable relationships would emerge between prices and some form of money or credit aggregate. Those relationships did not emerge. While the implementation structure formally rested on the quantity of settlement cash provided to the banking system, increasingly the de facto vehicles for effecting changes in monetary conditions were statements based variously on TWI comfort zones, 90 day bank bill rates, and, briefly, MCI comfort zones. At times, references to the shape of the yield curve also served to reinforce a position. Finally, in February of 1999, the quantity-based structure was abandoned in favour of a more conventional arrangement which targets the overnight cash rate. The reasons for this shift were fairly straightforward in the end. The settlement cash target enabled us to indicate the desired direction of change in monetary conditions, but not the extent of change. As became clear, the relationship between the quantity of settlement cash made available to the system and prevailing monetary conditions was very elastic. For that reason, the settlement cash target ceased to be an effective policy instrument or a reliable policy signal. The MCI-based structure was intended to improve the communication of policy intentions, while explicitly recognising that both interest rates and the exchange rate are important to the monetary policy process in a small open economy. But any gains on that front were lost in the noise of short-term interest rate volatility. To be fair to the MCI, if anyone feels the need, we should recognise that it was put to a very stiff test with the onset of the Asian crisis and the accompanying sharp fall in the exchange rate. Any implementation structure was likely to experience a degree of stress through that period. Moreover, the concept of the MCI as a broad indicator of the overall stance of policy remains valid. What was unsuccessful was its direct application in intra-quarter policy implementation. In any event, the OCR is now in place, and appears to be working well. Certainly, short-term interest rate volatility has declined markedly, and that has been welcomed. Also welcome has been the much reduced frequency of Reserve Bank Open Mouth Operations intended to guide monetary conditions in a direction compatible with the longer term policy objectives and the renewed capacity to maintain focus on policy rather than ’tactics’. But we need to bear in mind that the OCR structure has so far operated in fairly benign circumstances, and that we certainly haven’t escaped the prospect of periodic stresses and awkward decisions. Finally, it is worth reminding ourselves that while day-to-day implementation structures have attracted a lot of attention over the past decade, the real action in monetary policy was elsewhere. What matters most in monetary policy are decisions on the policy stance over the course of the business cycle. In our case, the outlook for inflation is re-assessed with each quarterly forecast round and the monetary conditions required to deliver the required outcomes are reset. For the effective conduct of monetary policy over the longer haul, it is the quality of those decisions taken each quarter that is fundamental, not the particular implementation structure employed between those resets. ASSESSING THE NEW ZEALAND EXPERIENCE In one sense, assessing the success or otherwise of New Zealand’s inflation targeting regime is perfectly straightforward. Monetary policy has a single goal and whether that has been met or not is transparently obvious. We need only refer to figure 1 to make a judgement. The message in that figure is a positive one. Inflation fell to the target zone promptly, and has stayed within, or close to, the target range since. The exception of the 1995/96 period, when inflation was a little above the target range, was minor when taken in broader context. The critics could reasonably respond with a “So what? Much of the world has managed to reduce inflation over that period, most without the need for a regime as strict as that employed by New Zealand”. That, of course, is perfectly true. However, New Zealand had previously managed to produce and sustain markedly higher inflation than others in the OECD. What has happened under inflation targeting is a drop, not just in our absolute inflation rate, but also in our relative inflation rate. Compared to OECD averages, New Zealand’s inflation has moved from very much at the top end of the spectrum to the mainstream. ANNUAL INFLATION RATES: NEW ZEALAND AND SELECTED OECD COUNTRIES (Sources: Statistics New Zealand and International Financial Statistics, RBNZ calculation) Note also that our current inflation performance is not, in any sense, extremist by international standards. Rather, it sits at or about the OECD average. However, an assessment that stopped at inflation performance alone would be simplistic. As we have noted on many occasions, price stability is not an end in itself. Rather, it is a means to an end. Price stability is targeted only because that is the best contribution that monetary policy can make to broader economic welfare. So has our monetary policy made a positive contribution to our economic welfare more broadly defined? The key criticisms one hears of monetary policy relate to concerns that it has constrained growth to levels lower than could otherwise be sustained, that it has been correspondingly hostile to employment or even “requires” a given level of unemployment to meet the inflation target, and that it has damaged export performance by maintaining an overvalued exchange rate and excessively high interest rates. The latter point, of course, is relevant to our weak current account and associated high levels of external indebtedness. Those are all criticisms that the Reserve Bank takes seriously. Our recent research programmes have focused on reviewing the experience of the past business cycle to both uncover and describe the stylised facts, and to analyse the key drivers in that cycle. Again, without wanting to review that work in detail, it does show that the 1991 to 1997 expansion was both long and strong relative to the cycles that preceded it. That does not seem to support a proposition that inflation targeting, or the particular version of it practised in New Zealand, is inherently hostile to growth. Likewise, the employment creation which accompanied that growth cycle was strong, both relative to the two previous decades and relative to the 1990s experience of our peer group in the OECD. Certainly, we see nothing inherent in an inflation target that should “require” particular limits to unemployment levels or constraints on employment creation. As the US has been demonstrating with great clarity over recent years, strong growth, low levels of unemployment and stable, low, inflation can coexist for a sustained period of time in the right circumstances. Of course, that particular story has yet to be concluded, and it has far more characters in it than just Mr Greenspan’s monetary policy. The proposition that monetary policy has been persistently too tight, with interest rates and the exchange rate persistently too high, is difficult to reconcile with inflation outcomes that have been persistently above the mid-point of the target range. Our recent work has given us a pretty good understanding of the “real” influences that shaped the past cycle.8 Factors such as the surge in immigration, the associated house price cycle, the strength of the external sector early in the cycle and the influence of fiscal policy later in the cycle go a long way to explaining why interest rates and the exchange rate behaved the way they did. Would a different monetary policy have led to less impact on the tradeables sector, and possibly to a better current account outcome? I find it difficult to accept that case. The different monetary policy sought is generally an easier monetary policy. The most likely outcome of an easier monetary policy would have been higher inflation, a stronger and more sustained asset price cycle and, with that, the same sort of pressures on the real exchange rate and the tradeables sector as were experienced - albeit over a more extended period of time. A couple of points to bear in mind though. First, over much of the past decade, monetary policy has been engaged in a process of consolidating price stability – of ensuring that inflationary expectations are reduced and that public confidence in the durability of price stability is reinforced. As such, we could probably have expected monetary policy to be, on balance, somewhat restraining. For that reason, I don’t assume that the past decade is “as good as it gets” or in any sense the norm for the longer-term behaviour of monetary policy. But the key to that lies with the evolution of inflationary expectations. Secondly, monetary policy has acquired a high degree of public prominence, in large part a product of the vigorous campaign to influence inflationary expectations. I suspect that we have left the public with an impression that monetary policy is the source of almost every wobble experienced in the economy, while masking the real shocks that monetary policy is often responding to. One consequence of that is a tendency to look to monetary policy to solve all manner of economic difficulties. We’re not alone in that, of course. There seems to be a widespread but equally erroneous impression in the US that Alan Greenspan is the source of all economic good and evil. But such prominence for just one component of macro-policy is unlikely to lead to realistic and balanced public debate, and is ultimately destructive of good outcomes. THE LESSONS LEARNED In a recent review of the Australian experience with inflation targeting, Glenn Stevens, Assistant Governor of the RBA, observed “There are maybe six things we have learned about monetary policy in two centuries of economists and others thinking about it: • monetary policy affects principally, or only, prices in the medium term; • it affects activity in the short term; Brook, Collins and Smith, 1998 • because of lags, policy has to look forward; but • the future is uncertain, as is the impact of policy changes on the economy; • expectations matter, so giving people some idea of what you are trying to do, and acting consistently, is useful; • an adequate degree of operational independence for the central bank in the conduct of monetary policy is important.”9 Actually, Stevens footnoted a seventh candidate for his list that I thought worthy of inclusion – namely, “that monetary policy – and for that matter most other policies – usually can’t do everything that people might hope for.” That list is certainly consistent with my own thinking. However, we can add a few more specific lessons from our experiences over the past decade. • Despite the effort devoted to trying to reduce the public’s inflation expectations, and with that, the costs of disinflation, what really matters in terms of expectations is performance. It is the constant delivery of price stability that causes expectations to adapt to the new reality. • Forecasting is difficult. Given the lags inherent in monetary policy and the consequent need to be forward-looking, we will continue to work on enhancing our forecasting capacity. But it’s a tough game, especially around the turning points of the cycle. And as much as we try to look forward in shaping our monetary policy, our evolving policy stance is inevitably heavily influenced by new data and views of the recent past. • What is happening internationally matters. Our financial markets are increasingly integrated with those abroad. Shocks, surprises and policy decisions elsewhere are reflected in our markets instantly. Monetary policy in New Zealand will inevitably be influenced by, and have to react to, developments abroad. • Even if the inflation target framework has had a fairly modest influence on the public’s inflationary expectations, it has certainly exerted a very direct impact on the Reserve Bank’s approach to its monetary policy task. The target is at the front of our minds with each policy decision. I have no doubt that the framework has influenced the behaviour of the Bank’s Monetary Policy Committee and the choices made by the Governor at key points. CONCLUDING COMMENTS I have described the origins of our inflation targeting regime and its evolution over the past decade. With inflation expectations now better anchored at a level consistent with our “price stability” mandate, we see less need to react aggressively to anything and everything that might take inflation towards the edges or even outside the target range in the short run. Rather, we are focussed on policy settings which should ensure that inflation a year or two ahead will be at about the centre of the target range. In short, we have shifted the emphasis Stevens, 1999 from staying within the edges of the range in the short run to having inflation at about the mid-point in the medium term. At the margin, this should result in less short-term volatility in monetary policy. But I shouldn’t make too much of that evolution. While we think that there may be more scope for flexibility, we shouldn’t overestimate that scope, nor expect too much from it. It remains as true today as a decade ago that the most important contribution that monetary policy can make to real economic growth is through maintaining price stability, and we are not about to subordinate that objective in the interests of a policy approach that implies we can buy a bit more growth by tolerating a bit more inflation. We can’t. Nor has anything changed in terms of the real drivers of New Zealand’s growth performance. Those are found in how productive, innovative and creative we are, and how well we market what we produce to the rest of the world. If long-run price stability is the most important contribution that monetary policy can make to our broader economic welfare, is inflation targeting the best monetary policy framework available to us? You won’t be surprised to hear me answer with a clear ’yes’. As I have described, we found our way into inflation targeting, partly as a process of elimination, partly by accident, and partly by way of some original thinking about old problems. When we try to assess its particular contribution to our improved inflation performance, we run into all the usual difficulties of isolating the impact of our inflation targeting regime from all of the other influences at work over this period. In making that assessment, we could place a high weight on the shifts in political priorities which dated from July 1984, on the sweeping reforms that have occurred generally in New Zealand’s macro and micro policies, or on the shift in our trading partners’ inflation performance. It could be argued that the shift in political attitudes towards inflation was, ultimately, the only change that really mattered. We could also argue, reasonably, that the major changes in New Zealand’s monetary policy came with decisions to float the exchange rate and commit to market funding of the Government’s fiscal deficits. To accept those arguments, however, would miss some important points. Certainly, the political will to adopt a price stability target was an essential pre-requisite to any serious attack on well entrenched inflation. But as my counterpart at the Bank of England, Mervyn King, recently observed in reviewing the performance of their Monetary Policy Committee, “Institutions matter.” What our inflation targeting regime has done is to give the initial political commitment to price stability a degree of durability that transcends the particular politicians or central bankers in place in 1989 when the RBNZ Act was passed into law. The framework has shifted the incentives from an acceptance of inflation arising from all the familiar pressures towards a more robust resistance to any future re-emergence of inflationary tendencies. REFERENCES Bernanke, Ben S; Laubach, Thomas; Mishkin, Frederick S; Posen, Adam S. 1999. “Inflation targeting. Lessons from the international experience”. Princeton University Press. Brash, Donald. 1999. “Inflation targeting: An alternative way of achieving price stability”. A speech delivered on the occasion of the 50th anniversary of central banking in the Philippines. Reserve Bank of New Zealand Bulletin, Vol 62 No 1. Brook, Anne-Marie; Collins, Sean and Smith, Christie. 1998. “The 1991-97 business cycle in review”. Reserve Bank of New Zealand Bulletin, Vol 61 No 4. Drew, Aaron and Orr, Adrian. 1999. “The Reserve Bank’s role in the recent business cycle: Actions and evolution”. Reserve Bank of New Zealand Bulletin, Vol 62 No 1. Hawke, Gary. 1993. “Between Governments and Banks. A History of the Reserve Bank of New Zealand.” Government Printer. King, Mervyn. 1999. “The MPC Two Years On,” Lecture delivered to Queen’s University, Belfast. Sherwin, Murray. 1997. “Inflation targeting: The New Zealand experience”. Paper delivered to a Bank of Canada conference on Price Stability, Inflation Targets and Monetary Policy. Sherwin, Murray, 1999. “Strategic Choices in Inflation Targeting: The New Zealand Experience”. Paper delivered to an IMF and Central Bank of Brazil Seminar on inflation targeting. Stevens, Glenn. 1999. “Six Years of Inflation Targeting”. Address to Economic Society of Australia. Svensson, Lars E.O. 1997. “Inflation forecast targeting: Implementing and monitoring inflation targets”. European Economic Review, Vol 41.
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Comments by Dr Donald Brash, Governor of the Reserve Bank of New Zealand, on the Third Hong Kong Monetary Authority Distinguished Lecture given by Mr Trichet, in Hong Kong on 8 July 1999.
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Mr Brash comments on the address given by Mr Trichet Comments by Dr Donald Brash, Governor of the Reserve Bank of New Zealand, on the Third Hong Kong Monetary Authority Distinguished Lecture given by Mr Trichet, in Hong Kong on 8 July 1999. Thank you for giving me this opportunity to comment on M. Trichet’s address. The subject of the address - “Risks and Challenges of the International Financial Scene” - is indeed a very topical and appropriate subject for the Hong Kong Monetary Authority Distinguished Lecture. And M. Trichet has raised a number of interesting points for me to comment on. The Asian crisis and other episodes of economic and financial distress have undoubtedly highlighted a number of vulnerabilities in the global economy. As a small and open economy, New Zealand has not been immune to the effects of regional and global financial distress, and we are mindful of the lessons that can be taken from it. My comments this afternoon are therefore made from the perspective of someone who is acutely aware of the potential vulnerability of small, open economies in a world of mobile international capital. Financial crises are inherently complex and each one has its own unique causes and dynamics. I am therefore wary of generalising as to the factors that have contributed to the Asian crisis. In the short time available to me, I will not attempt a comprehensive analysis. But I think a number of general observations can he made. This provides a basis for reflecting on the changes to international financial architecture that are required to reduce the risk and severity of future economic instability. To me, there are four issues that particularly warrant policy attention: • The risks associated with short-term foreign capital – and particularly the risk of sudden and large capital outflows in response to perceived or actual deterioration in economic conditions and associated changes in market sentiment. • The risks associated with pegged exchange rates. These risks include the potential fiscal costs of supporting an exchange rate perceived by the market as unsustainable, the potential for the exchange rate to become incompatible with other economic policy objectives, the risk of currency speculation and market manipulation, and the reduced incentives for exchange rate risk hedging. • The implications of weak financial systems. We have seen that weaknesses in financial systems can place constraints on the maintenance of a pegged exchange rate, but can also create systemic instability and impose severe costs on the real economy when the currency is permitted to depreciate. And we have seen that weak financial systems can place substantial constraints on the availability of new credit and hence delay economic recovery. • The risks of inadequate transparency. Lack of transparency, both in the public and private sectors, can exacerbate financial distress by reducing the scope for market disciplines to operate and by weakening the ability of creditors and investors to make informed decisions. In some cases, herd behaviour and resultant over-selling of currencies can be attributed in part to inadequate transparency. What, then, can be done to address these problems and restore the global economy to sound health? Before setting out some specific thoughts, I think a number of general points are worth mentioning: • First, we should not pretend that risks can be eliminated or that we can create a world where financial distress does not occur. There will always be periods of financial distress. No policy framework at national or international levels, will entirely eliminate these risks. And nor should we seek to do so. For we need to remind ourselves that there is always a trade-off between risk and return. If we seek to eliminate risks, not only will we be bound to fail, but we will also risk undermining the prospects for strong and sustainable economic growth. And, within reason, a degree of financial distress need not necessarily be a bad thing. The most we can hope to achieve is to reduce the risks and severity of economic distress in the future, and to create a resilience within economic structures to facilitate orderly recoveries from periods of distress. • Second, we need to accept that modem economies are inherently complex and that there are no magic solutions. We need to be realistic as to what can be achieved. In that regard, I believe the best solutions will not lie in grand designs, but rather will be relatively modest and incremental in nature. • Third, while some solutions may lie in changes to international financial architecture, I believe that the most productive remedies are generally those that apply at the national level - a point made strongly in an address given last month by Joseph Yam. There is a danger that the debate on the grander elements of international financial architecture could distract attention from the need for sound policy reform at the national level. • And finally, we should not fall into the trap of placing excessive reliance on any one policy response. For example, financial regulation alone cannot provide all the solutions. And equally, improved transparency and market disciplines on their own will not be sufficient. The answer lies in striking a sensible balance among a number of mutually supportive policies. That balance will almost certainly vary from country to country. Hence, we should not seek to pursue a “once size fits all” type of approach. Taking into account these general observations, I believe the most productive focus for international and national economic reforms lies in a few key areas: • Strengthening financial markets. • Reducing vulnerability to short-term capital flows. • Promoting greater transparency – at all levels. • Involving private creditors in debt resolution arrangements. As you will note, these four areas overlap significantly with some of the issues addressed by M. Trichet. Let me elaborate a little on these points. Strengthening financial markets. The importance of robust financial markets has been clearly demonstrated in many countries over recent years, most recently in Asia. Given the critical role that financial markets play in the wider economy, and the problems created when financial markets are in a weakened state, particularly in a world of mobile capital, it is essential that steps be taken to strengthen financial markets. A number of positive measures are already being taken to this end. The development of the Basel Core Principles on Banking Supervision is one of these, as M. Trichet has mentioned. Effective banking supervision arrangements are clearly an important element in creating robust financial systems and the Basel Core Principles have the potential to play a helpful role in assisting governments to improve their supervisory arrangements. However, I would make two cautionary points. First, it is important that the Core Principles do not become prescriptive, rigid templates to be applied uniformly in all countries. The optimal design of banking supervision arrangements will necessarily vary from country to country, depending on market structure, institutional arrangements and the effectiveness of market disciplines. It is important that, in advancing the Core Principles, governments have the leeway to depart tom the specifics of the principles where they consider it appropriate to do so. And, in assessing compliance with the Core Principles, it is important that emphasis is placed on the quality of policy and policy outcomes, rather than on whether there has been strict compliance with the details of the Principles. This is also true for the other international standards being developed. Second, it will not surprise you when I say that there are dangers in placing too much reliance on banking supervision, or in pursuing regulation with excessive vigour. Banking supervision and some regulation of risk-taking are important ingredients in the policy mix, but they are not sufficient in themselves to promote financial system stability. And there are dangers in taking regulation too far – we need to be sensitive to the compliance costs, regulatory distortions, moral hazard risks and potential impediments to financial innovation that can result from excessive or poorly designed regulation. The essential partnership to banking supervision is the role market discipline can play in creating the right incentives for the sound management of banking risks. I believe that many governments have tended to under-estimate the importance of market discipline and that some government interventions have reduced the effectiveness of this discipline – to the detriment of banking system soundness. I would therefore urge policy-makers to take steps to strengthen market discipline in their economies. This ran be done in a number of ways. An important step in this process is increasing the quality and frequency of disclosure made by financial institutions and strengthening the accountability of bank management and directors. In this regard, international initiatives to improve corporate governance and to strengthen financial disclosure and auditing arrangements are welcome developments. A number of other measures can also be taken to strengthen financial markets – although some of these are not without controversy and do require political commitment. Possibilities include privatising or improving the governance arrangements for government-owned banks, improving the contestability of financial systems and, importantly, ensuring that financial safety nets and the strategies for addressing bank failures do not shield creditors from any possibility of loss. Reducing vulnerability to short-term capital flows. Short-term capital flows clearly played a major role in the Asian crisis. In some cases, large capital inflows contributed to an overheating of asset markets and an excessive growth in credit while shifts in market sentiment resulted in rapid capital outflows, with severe consequences for currency stability, liquidity and financial system soundness. It is obviously important that steps be taken to reduce the vulnerability of economies to the volatility of short-term capital flows, to the extent possible. We live in a world of increasing capital mobility and I think we would all agree that the benefits this brings outweigh the costs. In particular, international mobility of capital strengthens the disciplines on policy-makers to maintain sound and credible policies, improves the efficiency of resource allocation and assists in economic development. Turning the clock back to a world of closed capital accounts is neither feasible nor desirable. But I think a number of measures can be taken to reduce the risks associated with short-term capital volatility. • Adopting and maintaining sound, sustainable and credible macro and microeconomic policies is clearly essential. Although credible policies will not eliminate the risk of sudden capital outflows, they can be expected to assist in reducing volatility by creating a stronger basis for creditors and investors to make intelligent investment decisions and by improving investor confidence. • The choice of exchange rate regime is also an important factor in determining an economy’s vulnerability to short-term capital flows. We have seen the dangers associated with pegged exchange rates – including the tendency for pegged rates to become inconsistent with economic fundamentals, the risk of currency speculation and the costs of holding the peg in the face of sudden capital outflows. Another danger is that pegged exchange rates reduce the incentives for financial institutions and corporate entities to hedge against foreign exchange risk, with predictable consequences in the event that the peg proves to be unsustainable. For these reasons, a new orthodoxy seems to be emerging an exchange rate policy. This thinking suggests that currencies should either be firmly anchored (for example, by way of a currency board arrangement such as that operated by Hong Kong) so that markets have confidence that the rate will be maintained, or that more flexible exchange rate regimes should be adopted. My own inclination is to think that there are advantages in countries adopting more flexible exchange rate regimes. Flexible exchange rate regimes offer a number of benefits, including promoting greater scope to pursue an independent well focused monetary policy, reducing the risks of market manipulation and one-way bets, reducing the fiscal costs inherent in supporting fixed rates and sharpening the incentives for exchange rate risk hedging by government and private sector entities. This last point should perhaps be stressed. When banks and corporates know that the exchange rate is floating, and may move in either direction, the incentive to borrow heavily overseas is sharply reduced – or at the least, the incentive to hedge the risks associated with overseas borrowing is greatly increased. On this basis, when capital inflows become capital outflows, and the exchange rate falls, banks and corporates – and indeed governments – are much less likely to be seriously damaged. • Where a fixed exchange rate is maintained, then another important element in reducing the risks associated with short-term capital flows is for a country to ensure that its holdings of reserves at least equal total short-term borrowings. • The imposition of controls on capital flows – particularly capital inflows – has been an approach adopted by a number of countries to reduce capital volatility, with varying degrees of success. I would certainly not rule out the role that controls on capital inflows can play in reducing the volatility of capital flows or in altering the maturity composition of capital flows, particularly as a transition measure or when financial systems are weak. However, I must confess that I do have some serious reservations about them. In particular, I am mindful that capital controls are susceptible to evasion and that there is a risk of them becoming less effective as market participants become more adept at evading them. This is particularly so in a market where new derivative instruments are evolving rapidly and national boundaries are becoming increasingly less relevant. Moreover, capital controls can be expensive to enforce and have the potential to create undesirable distortions to resource allocation. I also believe there is a risk that controls on capital flows can reduce the incentives for governments to adopt and maintain sound and credible macro and microeconomic policies. It is for these sorts of reasons that New Zealand has rejected the use of capital controls. Promoting greater transparency. The third key issue I have identified as a focus for national and international economic reform is transparency – a point made by M. Trichet. In my assessment, lack of transparency – in the public and private sectors – has been an important element in contributing to financial instability. I therefore endorse international initiatives to encourage greater transparency – at all levels within the economic community – including the transparency of the international financial institutions, national governments, central banks, government-owned corporate entities and the private sector. Greater transparency can be expected to increase the quality of economic policy and public and private sector decision-making, to sharpen the effectiveness of market discipline and to reduce the tendency for herd behaviour in currency and bond markets. The development of international standards on transparency of fiscal monetary and financial regulation policy by the IMF is a positive development in this context. Similarly, the development of disclosure principles by the Basel Committee on Banking Supervision and continued development of international accounting and audit standards will also be of assistance. Involving private creditors in debt resolution arrangements. One of the important themes in the ongoing discussions on international financial architecture is the need to find ways to more effectively involve the private sector in international debt default resolution processes. This is a very important issue and one that warrants careful attention, as M. Trichet’s address made clear. Existing responses to international financial crises tend to either run the risk that some private sector creditors are insulated from loss as a result of rescue operations, or run the risk that debt defaults occur in a disorderly and damaging manner. Neither is satisfactory. Insulating private creditors from loss, by bailing out sovereign or private borrowers, clearly weakens market discipline – both on the borrowers and the lenders. I have little doubt that this is one of the reasons why international lenders have, in some cases, under-estimated the risks associated with their lending, resulting in an inappropriate pricing of debt. As a result, borrowers have, in some cases, enjoyed access to an excessive level of credit and have not been as discerning as they might otherwise have been in determining how these funds will be applied. Involving private creditors in the resolution of debt servicing difficulties, and ensuring that they are exposed to their fair share of potential losses, are therefore important steps in creating an appropriate set of market disciplines on both lenders and borrowers. However, it is equally important that this process does not lead to disorderly debt defaults. Defaults by debtors certainly help to instil market discipline, but they also risk significant disruption to financial markets and tend to impose higher costs on borrowers and lenders, as well as third parties, than might have been the case had the debt servicing difficulties been resolved in a more orderly manner. A number of policies have been identified in the debate on this issue – some quite modest, and others rather ambitious. The issues involved are highly complex. Overall, I believe the most productive initiatives are those that involve relatively modest, practical solutions. In my assessment, the options that offer greatest chance of implementation, and that warrant further detailed work, include: • The adoption of majority voting clauses in loan documentation. This would facilitate negotiated solutions for the benefits of the majority of creditors and assist in achieving a more orderly workout process. • Collective representation clauses, enabling a trustee to negotiate on behalf of creditors, might also assist in facilitating orderly resolution of debt defaults. • Developing structures, such as standing committees of creditors, to facilitate better communication between creditors and debtors may also assist in reducing information gaps and initiating negotiations. • Another important element, particularly in dealing with debt defaults by banks and corporate entities, is the development of appropriate insolvency laws at a national level, equipping national judicial systems to administer these laws and facilitating effective cross-jurisdictional enforcement. Let me conclude by thanking M. Trichet for his address and for providing us with some new perspectives on issues relating to reforms of the international financial architecture. I am sure we can all agree that the issues are complex and that there are no easy solutions to be found. However, I am confident that discussions such as these, and the good work being carried out in many international fora, will lead to a better understanding of the causes and dynamics of financial crises and will provide the basis for developing appropriate policy responses.
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Address by Murray Sherwin, Deputy Governor of the Reserve Bank of New Zealand, to the International Law Association in Wellington, New Zealand on 9 July 1999.
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Mr Sherwin discusses reform of the global financial architecture from a New Zealand perspective Address by Murray Sherwin, Deputy Governor of the Reserve Bank of New Zealand, to the International Law Association in Wellington, New Zealand on 9 July 1999. In October of last year, I gave an address to a meeting of the New Zealand Institute of International Affairs under the title “Asian Prospects and Challenges”. That address took place while the effects of the Asian crisis were still unfolding and in the wake of the Russian default, the subsequent collapse and rescue of the LTCM hedge fund, and the associated blowout in global risk premia. Brazil was in strife at the time, and the calls for a substantial overhaul of the global financial architecture were loud and strident. The key themes in that address were that: • The countries of Asia had suffered a severe shock, and that the initial financial impact would be followed by “real” impacts in the form of declining output and incomes, declining asset values, company failures, rising unemployment along with increasing poverty and social stresses. • The damage to balance sheets was enormous, with the financial sectors of the worst affected countries carrying capital losses of the order of 25 to 50 percent of GDP. Substantial capital losses had also occurred in the corporate sectors of those countries. • Those balance sheet holes would have to be filled before any economic recovery could be considered robust. Foreign investment would inevitably have to play a significant role in that task, and would bring other benefits besides speeding the recovery. • To entice private investors back into the region, it would be necessary to make substantial progress on such basic components of market infrastructure such as accounting standards, audit standards, transparency, the legal underpinnings of bankruptcy law proceedings and commercial law more generally. • Better risk identification and risk management would be necessary, in both the public and private sectors. • Asia would eventually recover, but growth would probably settle at something closer to 4 to 6 percent rather than the 7 to 10 percent growth rates of old. In one sense, the 7 months since I made those comments have shown me to be the perennial pessimist that economists traditionally are. It is not called the dismal science for nothing. Whereas in October, the consensus expectation for the 1999 growth of the six most affected Asian economies was around 0.9 percent, the corresponding number now is +1.1 percent. Recovery has appeared earlier and stronger than I had expected. In another sense, however, I think my comments of last October remain absolutely valid. The list of prerequisites for robust sustainable growth in Asia is unaltered. And while progress has been made on many fronts, my concern is that the reform process remains inadequate. Indeed, the risk now is that an early return to positive growth is, in some cases, weakening the political will to undertake those still necessary domestic policy reforms. To that extent, the recovery now underway is that much more susceptible to reversal and that much more vulnerable to further crises in the future. While Asia has been recovering, the debate continues on what caused the crash, and how a repetition can be avoided. If nothing else, the constant shuttling of international bureaucrats to meetings of this “G” or that “G” has kept otherwise empty airlines and hotels in business. What I would like to do today is survey some of the work taking place under the general heading of “reforming the global financial architecture” and to put some New Zealand perspectives on that process. Note that these are not necessarily the views of the New Zealand Government. Rather they are the views of an individual who happens to have followed the discussion and attended a number of meetings where these issues were under discussion. My comments will be necessarily partial and selective. Why that is so is neatly summarized by Barry Eichengreen (University of California, Berkeley) in a recent publication (“Toward a New International Financial Architecture. A practical Post-Asia Agenda”, Institute for International Economics, 1999). Eichengreen notes that the list of proposals for reform grows longer day by day. Moreover, he notes that: “Many of these proposals are contradictory and mutually incompatible. Some recommend that policymakers renew their efforts to liberalize international capital markets, while others plump for the reimposition of capital controls. Some insist on the need for greater exchange rate flexibility, while others regard nothing as more important than the re-establishment of stable, even fixed exchange rates between currencies. Some suggest that the international community should respond more forcefully to crises, while others recommend that it stand back and let nature, in the form of the markets, take its course. Some emphasize the need for more funding for the IMF while others call for the abolition of the institution. Some suggest that the Fund must root out corruption and compel countries to install the institutional prerequisites for stable financial markets, while others insist that it should limit its advice to monetary and fiscal policies and refrain from meddling in the internal affairs of its members.” I will quote Eichengreen at length, largely because I find his analysis and assessment as persuasive as any I have encountered on this subject – which is another way of saying that for the most part I agree with him. I am particularly attracted to his dismissal of the more ambitious reform proposals, including those sponsored by some G7 governments, as unworthy of much discussion simply because “They have not a snowball’s chance in hell of being implemented. They all assume a degree of intellectual consensus and political will that simply does not exist.” Eichengreen goes on to list a set of key assumptions that condition his thinking on these issues. Those also bear repeating: • Liberalized financial markets have compelling benefits. This is an argument about savings mobilization, and efficient allocation of investment, together with the benefits of allowing consumption smoothing and risk diversification. Note that it is not a closed-minded piece of ideology, but a proposition that, despite their obvious weaknesses, markets generally do a better job of allocating resources than do governments. • International financial liberalization and growing international capital flows are largely inevitable and irreversible. At the core of the global trend towards financial liberalization lie changes in information and communications technology. This rapidly emerging and pervasive technological capability makes it more difficult to restrict the range of financial transactions in which market participants engage. As the technology becomes more pervasive, and the benefits from accessing it expand, so too the costs associated with constraints on its use must grow. Moreover, it is difficult to limit international financial transactions when domestic financial transactions are being freed. Given that the case for domestic capital market liberalisation is overwhelming, it follows that it will be increasingly difficult and costly to limit international financial transactions. • Notwithstanding the manifest benefits of financial liberalisation, capital markets do not work perfectly; they are characterised by information asymmetries that give rise to sharp corrections and, in the worst case, financial crises. Here, Eichengreen recognises that there are characteristics of financial markets that make them prone to occasional distress, to overshooting and to herd behaviour. The banking system will often be the point at which stresses associated with this behaviour come to the surface. So, however positively we view markets, history and the structure of financial markets warns us to expect periodic crises. • This instability provides a compelling argument for erecting a financial safety net, despite the moral hazard that may result. Eichengreen argues that history shows the need for deposit insurance and a lender of last resort to contain systemic risks to the financial market. He suggests that, by analogy, there is an argument for an international lender of last resort, but muses whether the IMF or any other candidate has the capacity to carry out such a role, or the ability to contain the moral hazard that results. In domestic markets, he argues that moral hazard concerns underscore the need for vigorous supervision and regulation of financial institutions covered by lender of last resort facilities. It is in this area that I have the greatest reservations about the Eichengreen prescription, reflecting our own aversion to excessive reliance on banking supervision and on well-intentioned, but ultimately self-defeating, financial safety nets. But in accepting his previous point that occasional bouts of financial instability are likely to be a characteristic of deregulated financial systems, we are compelled to consider the need for some means of moderating the impact of those inevitable bouts of instability. Where we differ, I think, is on the potential to push the management of those risks back to the private sector. • Information and transaction costs prevent decentralised markets from quickly and efficiently resolving crises. Creditors face incentives to run for the exits at the first sign of trouble and, in doing so, are likely to exacerbate any emerging problem. This makes it difficult to orchestrate outcomes that might better preserve value and facilitate its “fairer” distribution. At the national level, insolvency and bankruptcy codes exist which give the courts power to impose restructuring and settlement terms. In Eichengreen’s view, the absence of an international bankruptcy court with similar powers is a problem. • Economic policy is framed in a politicised environment. This is a very simple but important point. It cannot be assumed that regulators and other economic policy makers will carry out their tasks without allowing themselves to be influenced by political considerations. And mostly, national governments will not cede their sovereignty or control of domestic economic affairs to an international body. That is a reality that should influence any thinking on the list of proposals to reform the international financial architecture. Pulling all of this together, Eichengreen’s conclusions are “…predicated on the notion that international capital mobility is now a financial fact of life, and the problem for policy is ensure that the benefits of capital mobility exceed its costs rather than pretending that it can be made to go away. They are based on the belief that financial markets can malfunction, creating a compelling case for a financial safety net and therefore a role for the IMF, but also posing problems of moral hazard that must be addressed. They acknowledge that crises will still occur and that there is a need to create institutional mechanisms to overcome the information asymmetries and collective-action problems that prevent them from being rapidly resolved. They acknowledge the existence of political limits…[on the range of policy options].” With that backdrop, let me turn to the efforts to reform the global financial architecture that are now underway in a number of different international forums. What we can see, first up, is that those with modest ambitions are least likely to be disappointed with what will emerge at the end of this process of reform. The current list of work underway is summarized in a paper presented in April this year to the IMF’s Interim Committee. That paper listed the following initiatives, in best IMF bureaucratese, as “reforms that, at a general level, command broad support.” • To promote transparency and accountability, and to develop, disseminate and monitor implementation of better standards and best practices; • To strengthen financial systems, including through better supervision, and appropriate mechanisms for managing bank failures; • To pay greater attention to the orderly liberalization of capital markets; • To involve the private sector more fully in forestalling and resolving crises; • To ensure that systemic issues are adequately addressed, including the appropriate exchange rate regimes and the adequacy of the Fund’s resources. The paper also made reference to the essential lead role of the World Bank in developing codes of good practices in social policies and in developing social safety nets before crisis strikes. To take each of those in turn: Transparency and standards Broadly, this looks like being the most significant product of the whole global financial architecture reform effort. The primary initiatives include improved quality, coverage and timeliness of national statistics; improved accounting and audit standards; developing codes of good practice on transparency in fiscal, monetary and financial regulation policies; enhanced transparency within the operations of the major international financial institutions; and improved bankruptcy, corporate governance, insurance and securities regulation. It is mostly unspectacular, quite technical and thoroughly conventional. It aims mostly at sharpening the incentives towards good governance, together with improved risk identification and risk management within both the public and private sectors. Generally it is about ensuring that domestic market and policy structures are compatible with the reality and disciplines of internationally mobile capital. In general, this seems like thoroughly sensible work. If there are reservations on my part, they relate largely to the risk that international standard setting becomes a substitute for intelligent case-by-case risk assessment. Standards of good practice can too readily become excessively rigid templates which fail to adequately distinguish between diverse circumstances or fail to evolve with changing circumstances. Form can come to dominate substance and, in those circumstances, such standards can become an impediment to sensible risk management rather than an aid. In essence, the risk is that those responsible for the management of banks or other enterprises stop thinking about the underlying risks their businesses face and, instead, become focused on what is required to conform to the regulators’ standards. Strengthening financial systems A number of different agencies have fingers in this particular pie. The Basel Committee of Banking Supervisors is reviewing gaps in its existing framework. The work underway includes data related issues, methods for dealing with weak banks, disclosure standards, financial sector safety nets, licensing, governance plus legal and judicial issues. In addition, a review of the 1988 Capital Accord is underway. Banks’ dealings with highly leveraged institutions (hedge funds) have also been under review, with an eye to reducing the risk of further surprises of the LTCM type. The Financial Stability Forum has been established, under the chairmanship of Andrew Crockett, General Manager of the BIS, with the aim of strengthening cooperation among the international organisations, regulatory associations and expert groups with responsibilities in the field of financial regulation and oversight. The core work is taking place in three groups looking at, respectively, hedge funds, off-shore financial centres and short-term capital flows. The International Accounting Standards Committee (IASC) is completing its work on developing a core set of international accounting standards that could be adopted for international cross-border listings. The OECD and the World Bank have finalised the development of guiding principles on corporate governance. The IMF is strengthening its surveillance of countries’ financial systems in the course of its Article IV consultations, with a view to improving evaluations of their soundness and vulnerabilities. This is also likely to include reviews of member countries’ compliance with the various standards, guidelines and principles referred to. The IMF, World Bank and the UN Commission on International Trade Law (UNCITRAL) are all working on guidelines for effective insolvency regimes, especially for use in developing countries. Again, this work falls mostly into the category of good, sturdy but unspectacular. Nothing wrong with that, of course. However, the most important work in the field of strengthening financial systems rests not with the myriad of international agencies listed above, but with the countries now vulnerable to financial crises. The hard effort will be in lifting management quality in banks in the developing and emerging economies, in improving risk recognition and risk management, in improving the regulatory regimes in those countries and improving the quality of regulators and supervisors. And the solution for weak banking systems is not government underwriting. It lies in building structures in which individual banks can be allowed to fail, and in which shareholders can be allowed to suffer losses, without putting in jeopardy the entire financial system of the countries concerned. To put some particular New Zealand perspectives on these issues, I feel that strengthening the market disciplines on banks and other corporate entities is an important policy objective. Governments cannot underwrite private entrepreneurial activity without encouraging over-investment and leaving themselves vulnerable to subsequent collapses. In the banking sector, the empirical evidence seems overwhelming that government-owned banks are likely to be weakest in risk management. (Depositors assume they cannot fail, because of government ownership. The managers, for that reason, are less likely to be sensitive to deteriorating asset quality). And government-owned banks are most likely to be encouraged into dubious lending for reasons other than sound commercial judgement. Moreover, you will not be surprised to hear a New Zealander argue that real benefits can flow from a willingness to allow foreign ownership of banks. Those benefits include access to skills and control systems that might not be available locally, the introduction of international business standards into local markets, and reduced vulnerability to inappropriate political influence. Another important element is that the introduction of foreign capital constitutes a useful device for spreading risk in small and narrowly based economies. The consequences of unforeseen shocks are thus rendered less damaging. Well capitalised and reputable foreign owned banks are less likely to fail and have the capacity to bear some of the consequences of a localised shock. If necessary, foreign owners can provide additional equity to support their local banking operation. Capital account issues There has been a long-standing presumption within the Western economic orthodoxy that the case for liberalising capital account transactions is essentially analogous to that for liberalising trade. That presumption has come under serious review and challenge subsequent to the Asian meltdown of 1997 and 1998. Recent debates at the Board of the IMF reflect that revisionism, with a new willingness to accept that capital account liberalisation carries risks and needs to be managed. Discussion tends to focus on issues of the speed and sequencing of capital account liberalisation, and on the role and effectiveness of capital controls. On the question of controls, a new orthodoxy seems to be emerging around the distinction between controls on inflows of capital à la Chile (more worthy in some circumstances) and controls on outflows of capital (unworthy generally, although some still see a temporary role in crisis situations). The on-going work in this area within the IMF relates to reviewing the experience of countries in using different forms of capital controls, and in liberalising different components of the capital account, seeking to draw conclusions for best practices. There is also work underway to improve the reporting and monitoring of capital flows, especially private sector short-term flows related to interbank transactions. As a very small economy, well integrated with global financial markets, New Zealand well understands the concerns some countries have regarding the risks and uncertainties that international capital mobility can pose. But like Eichengreen, I have long since come to accept that capital mobility is just one of the realities of life. Like good food and wine, it can be wonderfully enjoyable – when taken with due recognition of one’s capacity to absorb it. But fatal when taken to excess. To take the good food and wine metaphor a little further, the ready availability of essentially endless quantities of gourmet fare simply makes all the more important the qualities of discipline and self-control. It is, of course, possible that the restaurateur will assist you in exercising that self-restraint, but none of us should rely on him to do so. So it rests primarily with each country to manage its own affairs to gain the undoubted benefits of access to the pool of international savings, while avoiding the damage from over-indulgence. To quote Eichengreen again “… badly managed banks and open international capital markets are a combustible mix. The most direct way of reducing this danger is to strengthen banks’ risk-management practices and supervisors’ oversight and regulation of those practices”. But that doesn’t leave the provider of capital without responsibility, which brings me to one of the most challenging aspects of the current debate. Involving the private sector in forestalling and resolving crises By the time the Asian crisis had completed its first lap early in 1998, it had become abundantly clear that, to use a term coined by Michel Camdessus, the world had just witnessed “the first financial crisis of the 21st century”. Camdessus was acknowledging that the Asian crisis was different from those that the IMF had grown accustomed to dealing with over its first 50 years. No longer could the IMF assume that failures of macro-policy, primarily monetary and fiscal policies, would lie at the core of every crisis. Instead, Asia represented essentially a crisis of the private sector. I think that is an important part of the explanation for why the IMF found it so difficult to respond to the Asian crisis, and why its critics contend so vigorously that the IMF “got it wrong” in Asia. In essence, the Fund was confronted with a set of problems that were, in many respects, new and unfamiliar. If the origins of the Asian crisis lay in the private sector, what of the solutions? I think one important conclusion that flows very readily from the Asian experience is that raising large scale public funding for rescue packages, as occurred in Thailand and Indonesia, and was done more in “virtual” form for Korea, will be difficult to repeat in the future. This is particularly the case where funds raised from the taxpayers of the international community are seen to be going mostly to facilitate the escape of private investors from investments that have turned, for whatever reason, to mush. For that reason, the question of “bailing-in the private sector” has been a topic of intense debate amongst those who think about international economic crisis management. This term covers a range of suggested measures by which the private sector would be obliged to take a share of the downside risk of cross-border investment activities. I won’t dwell on the particular proposals that have emerged. In general, there seems to be broad acceptance of the principle that private investors should bear their fair share of the risks. However, just what that means, and how that might be achieved are questions of enormous complexity. A key issue, it seems, is that emerging countries are often in favour of the private foreign investors sharing risks (ie, taking some losses when trouble strikes), but many seem reluctant to face the prospect of increased cost of funds, and/or reduced supply of foreign investment, that will be associated with contracts that put more risk on the investor. That is both unfortunate and misguided. Any increased costs should be viewed in the same way as an insurance premium – the price paid for reduced risk. There is a great deal that can be done to make countries less vulnerable to volatile capital flows – and coincidentally, to reduce those insurance costs. These include: • Avoiding an accumulation of short-term debt and ensuring that reserves and banking system liquidity are adequate to provide a significant buffer against a disruption in investment flows. • Avoiding “off-balance sheet” transactions or loan contract clauses allowing the lender to withdraw funding at short notice. • Exploring the possibilities for private contingent credit lines that provide additional liquidity, or reduce debt service burdens, at times of stress. that have the effect of Also, some degree of consensus seems to be emerging around the need to re-assess the capital standards established by the Basel Committee on Banking Supervision with a view to reducing the perceived bias towards short-term interbank credit lines from industrial countries to emerging market banks. In addition, there is a great deal of work underway in exploring the possibilities of modified bond contracts. This is aimed at making it easier to manage a restructuring of bond terms, for example, to lengthen the maturity or defer interest payments temporarily, in the event of a crisis. Systemic issues Under this category comes research work to better understand the implications for economic policy makers of the globalisation of the international monetary and financial system. A key area for attention is that of exchange rate regimes, the impact of exchange rate volatility and how best to manage the inevitable swings in capital flows. I believe that much of this work will end up focusing heavily on strengthening financial systems – stronger balance sheets with more equity, improved risk recognition and risk management, stronger accounting and audit standards, increased transparency and improved standards of banking supervision. This is all aimed at providing a more stable basis for cross-border investment flows rather than trying to act directly to stabilise or control those flows. Also under the “systemic issues” heading comes work on developing the IMF’s capacity to respond to crises. We have already seen the new Contingent Credit Line (CCL) introduced. Personally, I see very little merit in this, and many dangers. For the IMF to be recommitting to support particular countries simply raises the stakes when policy quality deteriorates to the point where the Fund should withdraw that pre-commitment. It also implies that when faced with capital flight, access to additional funding is a key part of the required response. The risk, or course, is that access to additional funding simply further defers the necessary policy and asset price adjustments, and makes the subsequent collapse all the more expensive. In addition to the CCL, the IMF now has access to the NAB funding, which together with the GAB gives it around US$ 46 billion in available resources for crisis management. It now has its 11th quota increase in place as well, which lifts total quotas from around US$ 200 billion to US$ 290 billion. The unfinished debates relate to the role of the IMF and World Bank going forward, issues of representation at the key policy forums – the old established structures now in place in bodies like the IMF and its Interim Committee now look to be thoroughly out of synch with the current global distribution of economic weight. For all of that, as the G22/G33 progression showed, the old order is not yet ready to die. APEC My final comments on this territory relate to the place of APEC in this territory. Much of the debate I have covered will emerge in a variety of guises within the APEC Finance process. This is primarily the responsibility of my Treasury and MFAT colleagues, rather than the Reserve Bank, so I will step only lightly here. The New Zealand priorities for the APEC Finance Ministers process will focus on three key themes: • • • Open robust economies Credible, effective processes, and Strong global economies. Under the first of these, finding ways to encourage the development of strong financial markets within the APEC group is a key to meeting the long-term goal of open markets. APEC will not be looking to duplicate work already taking place under the various umbrellas I have referred to. But it can draw on that work, and use processes such at individual action plans (IAP’s) and voluntary action plans (VAP’s) to give it momentum within APEC. New Zealand is promoting a VAP on Supporting Freer and Stable Capital Flows. This is split into two parts. Part 1 is an information-gathering phase and has already started. It includes some work being commissioned from the IMF on countries’ experiences with capital account liberalisation (including the efficacy of capital controls as a transition measure), a PECC update of a 1995 survey of impediments to investment within each APEC economy, and an ADB study of the role played by capital in the economic development process along with work on reform sequencing. I understand that Part 1 is intended to be completed in the next year or so, with a synthesis of the various studies being submitted to APEC Finance Ministers in September 2000. Part 2 is intended to take the form of Voluntary Action Plans by individual APEC economies, drawing on the wisdom distilled in Part 1. An initiative on strengthening financial markets is being developed as a pilot of part 2 of the VAP. This initiative will involve pulling together the relevant international standards in the area of financial markets, as reference points for economies to self assess the adequacy of their policies and to identify future reforms, and as a basis for peer review within APEC. This initiative will focus on such matters as banking supervision, payments systems, corporate governance and disclosure standards. This initiative will be discussed further at the APEC Finance Deputies’ meeting in Wellington in August. The issue of developing domestic bond markets has also been prominent on the APEC Finance Agenda. Guidelines of best practice in this field are being developed for preliminary discussion in August. The objective here is to encourage APEC economies to remove the impediments to the development of domestic bond markets, in recognition that some economies are very dependent on the banking system for funding. Other areas of work involve, for example, the ADB efforts to coordinate a project aimed at boosting training for APEC area banking supervisors and securities market regulators and some useful work already undertaken in the field of corporate governance. APEC represents an interesting grouping of economies, with diverse experience and diverse circumstances. Hopefully, New Zealand can apply its time in the chair to help focus the APEC discussion on reform of the global financial architecture. If we are successful, we can ensure that APEC is an effective “outreach” mechanism providing cogent, well thought through and influential commentary to the G7, IMF and other key forums considering the architectural issues.
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Comments on accepting the NZIER/Qantas Economics Award by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, held in Auckland on 18 August 1999.
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Mr Brash comments on the economic reforms of the last 15 years in New Zealand Comments on accepting the NZIER/Qantas Economics Award by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, held in Auckland on 18 August 1999. * * * Mr Chairman, ladies and gentlemen, I was greatly flattered to be nominated for this NZIER/Qantas economics award, and feel deeply honoured to have been selected to receive it. I regard the earlier recipients of the award as among the giants of the economics profession, and I have been privileged to work with all of them in one way or another. I am also very much aware that, while my name is on the award, I owe that fact in large measure to the efforts of a great many other people, including my colleagues on the Monetary and Economic Council, on the Committee of Inquiry into Inflation Accounting, on the New Zealand Planning Council, on the Economic Monitoring Group, and on the various taxation advisory committees I was privileged to chair in the eighties; to the efforts of my colleagues and staff in the Reserve Bank; and of course to my teachers and family over a great many years. Thank you. I was told I might speak briefly on accepting the award. What to talk about? It hardly seems the appropriate moment to speak about the Official Cash Rate, so I thought I might be allowed a little licence to add my contribution to the debate currently raging on all sides about the success or otherwise of the economic reforms of the last 15 years. But before I do that I want to say that I sometimes wonder whether we New Zealanders are not congenitally prone to wild swings in mood: we are either riding high in self esteem, confident that we can take on the world and win, as we were in the mid-eighties and mid-nineties, or we are utterly gloomy, convinced that a cyclical downturn in net immigration represents the end of civilisation as we know it, with our only hope being to plead with Australia to take us on as a distant Tasmania. As Doug Myers mentioned in a speech a week ago, “we have developed a cottage industry of pessimism”.1 I do not propose to assess why we have this tendency to wild swings in mood, nor even to offer a comprehensive assessment of the economic reforms of the last 15 years. That can not be done in 15 minutes. But let me make just a few observations. First, I believe that there are several aspects of those reforms where the results are measurable and clearly positive. For example, I believe we can now safely conclude that the monetary policy framework put in place as part of that overall reform process has been hugely successful. And I say that as someone who had only a small involvement in the original design of that framework. Am I saying that the framework guarantees against mistakes in the formulation and implementation of monetary policy? Of course not. No framework can do that. We have made mistakes in the past and, since we do not have (or claim to have) perfect foresight, we will certainly make mistakes in the future. But the monetary policy framework conceived when Roger Douglas was Minister of Finance as a way of depoliticising the operation of monetary policy, brought to Parliament by David Caygill, passed into law without a single dissentient vote, and now supported by most political parties is an outstandingly good one, and has already been emulated by a number of other countries. It has helped us to reduce inflation from well above the levels in other developed countries to a level closely consistent with those in Australia, the United States, and Europe. It has helped us to reduce long-term interest rates from 1000 basis points above US long-term interest rates in the mid-eighties to less than 100 basis points above US long-term rates in the recent past. That improvement in inflation “Wake up New Zealand”, speech to the Tauranga Chamber of Commerce, 11 August 1999. performance has been of benefit to the New Zealand economy and of benefit to New Zealand society more generally. Second, I believe that there are several aspects of the reforms where the results are not so easily measurable, at least in terms of conventional macroeconomic statistics, but where the results are again unambiguously positive. With banks now falling over themselves to lend money, who wants to go back to having to get down on bended knee to get a home mortgage loan? With new phone connections now available in most parts of the country within days of making a request and the cost of domestic toll calls down some 80 per cent in real terms in the last decade, who wants to go back to waiting 12 to 18 months for a residential phone connection? And who wants to go back to the old level of in-flight service on domestic airlines? Or to five-day-per-week shopping? Or to paying 60 cents for mailing a surface letter (the cost in 1986 in 1999 dollars), instead of today’s 40 cents? None of these benefits show up very clearly in GDP statistics, but all of them have made a big, and a beneficial, impact on our lives. Few of us would want to lose them. But what about economic growth? Surely growth in GDP has been disappointingly slow since 1984, and this proves beyond reasonable doubt that the reforms have failed? Certainly, taking the whole 15 year period growth has been disappointing. I am not at all sure, however, that it is legitimate to conclude that therefore the reforms have made no difference to our potential growth rate. In the first several years of the period, the New Zealand economy was going through huge changes made inevitable by the decision to abolish quantitative import controls, to reduce tariffs, to abolish export subsidies, to corporatise and then privatise many state-owned enterprises, to deregulate the banking sector, and to reduce inflation from levels well above the developed country average. A lot of the capital built up in the period before 1984 was destroyed when the subsidies and protection on which that capital was totally dependent were eliminated. While there is some debate about the speed with which subsidies were eliminated, there is little or no debate that abolishing those subsidies was in the interests of the long-term health of the New Zealand economy. But inevitably the short-term result of these moves was to leave the overall level of GDP looking pretty flat. It was, on a small scale, similar to the kind of trauma which the former Soviet bloc countries have gone through in recent years, with whole industries wiped out and, in their case, overall GDP shrinking substantially. New Zealand’s GDP did not shrink to any significant extent, but for six or seven years it barely grew at all. From the early nineties, however, the picture is much more encouraging. In the six years from 1992 to 1997, growth in GDP averaged 3 per cent per annum – not the 4 or 5 per cent per annum which we achieved when we were first emerging from the recession but better over those six years than the growth in Japan, in continental Europe, and in the United Kingdom, and almost identical to the growth in Australia, on average over those six years. We would of course like to be growing faster, and unless we do we will not regain any of the ground lost relative to Australia during the sixties, seventies and eighties, when we were growing quite a bit more slowly than Australia and other developed countries. But we still did very much better in the six years to 1997 than we did in the previous three decades. But what about 1998? I suspect the fact that Australia grew at more than 4 per cent in 1998 while we grew not at all in that year is at the root of a lot of our current gloom. How could we bomb out so badly, when both countries had a very similar exposure to the Asian crisis? This isn’t the place to provide a comprehensive answer to this question, and indeed I don’t think anybody yet has a comprehensive answer to this question. Some blame poor monetary policy decisions by the Reserve Bank for the difference. I don’t share that view and see the impact of New Zealand’s severe drought as being a much more relevant factor, but then I am clearly not an objective observer. But even if, for the sake of the argument, monetary policy caused all of the difference between Australian growth and New Zealand growth in 1998, that was at most a temporary impact, and monetary policy in New Zealand was eased very substantially over the course of 1997 and 1998. Official forecasts suggest that growth in New Zealand over the next two years will be closely similar to that in Australia, as it was for the six years prior to 1998. So it is hard to see strong grounds for pessimism there. But what about productivity? Now we are getting to the heart of the matter, and there has been some pessimism, even among professional economists, that New Zealand’s productivity performance has not improved discernibly as a result of 15 years of reform. To shed some light on this issue, the Reserve Bank, the Treasury, and the Department of Labour commissioned some work on productivity by Denis Lawrence, director of the Tasman Asia Pacific economic consultancy, and Erwin Diewert, professor of economics at the University of British Columbia, and their conclusion, as summarised by them in the New Zealand Herald exactly one week ago, was that “to the extent we can make like-withlike comparisons between New Zealand and Australia (another country that has had a sizeable but more gradual reform programme over a similar period) New Zealand’s performance (in multi-factor productivity) appears to be at least comparable”.22 Indeed, they suggested that if sectors where productivity is very hard to measure (such as banking and community services) are excluded from the numbers on both sides of the Tasman, New Zealand productivity seems to have been as good as, or even a little higher than, in Australia in recent years. So we have plenty of reasons for being optimistic. We have more natural resources per capita than a great many other countries, but not so many that we are tempted into ignoring the real source of our future prosperity, which is the skills and education of our people. We have a framework for both monetary and fiscal policy which is the envy of a great many other countries, and that framework has already delivered us consistently low inflation for nearly a decade and a huge reduction in net public sector debt. Despite important differences of opinion on a whole range of issues, we have a substantial measure of consensus about some of the really important policy questions. Remarkably for a country which, until the mid-eighties, had a long history of controls on almost everything, we have a public service which is almost totally free of corruption. Similarly, we have a judiciary which has never been suspected of corruption. New technologies which were not even dreamt of when Britain entered the European Union substantially reduce the tyranny of distance by reducing the cost of finding and servicing distant markets. New technologies create new business opportunities by making us less dependent on the economies of large scale production, thereby reducing the relevance of our small local market. The Reserve Bank estimates that our sustainable rate of growth is currently around 3 per cent per annum. I am convinced that, with the right policies and the right attitudes, we can do even better. Where do professional economists fit into all this? Having devoted the first half of my speech to arguing that the current mood of pessimism about the fruits of the last 15 years of reform is considerably overdone, I want to use the second half of my address to talk about where I think professional economists have let the side down. I am not talking about all of my colleagues of course. Some have done a superb job of explaining how the world works. But too often you, I, we have remained silent in the face of very considerable public and political confusion and uncertainty. Take, for example, the rather limited public comprehension of what has been happening to the New Zealand economy over the last 30 or 40 years. It seems, to me at least, that for several decades prior to the early seventies New Zealand enjoyed a standard of living which was high by international standards because we had unfettered access to the British market for everything which our very efficient farming sector could produce. We taxed our farming sector by providing protection to our inefficient manufacturing sector, and used the revenue to build a generous system of state-funded health, education, and welfare. This may not have been sustainable indefinitely in any event, because the real price of our commodity exports was steadily declining (although improving productivity in the farming sector was doing a pretty good job of offsetting this decline in price). But the viability of the whole approach was jeopardised when Britain entered what was then referred to as the Common Market in the early seventies. All of a sudden, our farming sector was under severe pressure. For more than a decade, we tried to pretend we could box on regardless. We made no serious attempt to help the farming sector by reducing the protection given to inefficient sectors. We made no serious attempt to tailor our social welfare system to the cloth available. Indeed, in 1975 we introduced a Domestic Purposes Benefit which would, over 20 years, grow to involve a fiscal cost almost as big as the Unemployment Benefit. In the same year, we killed off an embryonic contributory superannuation scheme and replaced it with a very generous taxpayer-funded scheme. New Zealand Herald, 11 August 1999. What successive Governments have been grappling with over the last 15 years is finding ways to make more of the economy internationally competitive, to take up some of the load which the farming sector can no longer carry, while trying to explain to a sceptical public why the erstwhile generosity of the state may not be able to continue. Alas, they have got precious little help from professional economists in explaining this story to the public, and in some respects we economists have actually encouraged the public’s reluctance to change. Or take another example. Tariffs. To the best of my recollection, I have only ever met two economists in my life who believed that tariff protection was a desirable long-term feature of economic policy (a few more have accepted the infant industry argument in favour of temporary protection). Economists are probably more united against tariffs and import controls than they are on any other single issue. And yet we allow to go unchallenged statement after statement, on talk-back radio and in the print media, suggesting that New Zealand has been daft to reduce its tariffs ahead of our trading partners, and that the only reason we are doing so is because politicians, or Treasury officials, are driven by some mad theory. Or perhaps just by a desire to look holier-than-thou in international trade negotiations. The idea that we should reduce tariffs in New Zealand no matter how stupid other countries are about raising theirs is incomprehensible to most of the public, and yet is an idea which would be accepted by almost all economists. Of course we would be better off if other countries did not raise tariffs against our lamb, or our kiwifruit, or our butter, or our cheese, or our beef, or our fish. But even when they do raise such tariffs, it is not in our own interests to reciprocate in kind. Economists know that, but have not done a terribly good job of helping the public to understand that. Or take a third example. Health care. I am certainly not going to step into the political maelstrom which is the health care debate, at least in part because I simply do not know what to suggest or recommend. But every economist knows from the days of Economics 101 that if you offer to supply something for free, the demand for it will be enormous, and that if you don’t use price to limit that demand, you will soon be unable to meet the demand – whether you devote 6 per cent, 8 per cent, or 10 per cent of GDP to health care – and will be faced with long queues. In recent years, and contrary, I suspect, to public perception, government spending on health care has risen somewhat faster than GDP. (In the year to March 1984, government spending on health care took 5.6 per cent of GDP, while in the June 1999 year government spending on health care is estimated to have absorbed 6.4 per cent of GDP.) I simply do not know what proportion of GDP New Zealand should be spending on health care. But I do know that, no matter how much is spent on health, there will always be queues unless price or some arbitrary political decision is part of the rationing process. Of course queues may be an optimal way of dealing with the situation. As I said, I don’t want to enter the substance of this debate. All I am saying is that economists would do a service to rational discussion of health care if they made the nature of the issues clear. At the end of the day, what I am seeking from my professional colleagues is a greater commitment to assist in the formulation of economically sound policy. At the moment, politicians of all of the major political parties are hugely constrained by the fact that, while more economically literate than people in many other countries, the general public do not have a good understanding of some of these crucial issues. How, for example, do political leaders grapple with the gradually growing fiscal cost of National Superannuation, or encourage rational public discussion of the issue, when a news item in one of our largest daily newspapers could say, about the present Government’s decision to maintain the real value of National Superannuation by indexing it to the CPI rather than to wages, “up to half the superannuitants in New Zealand could be pushed below the poverty line when their pensions are reduced tomorrow”.33 I suspect it is true that the great majority of superannuitants today believe that their National Superannuation payments have been reduced or are about to be reduced, and yet of course economists know that that is not true, either in nominal terms or in real terms. It is true in relative terms of course, but a reduction in relative terms is assuredly not what most people think of “Elderly pushed into poverty”, The Dominion, 31 March 1999. when they talk about a reduction in a benefit. To the best of my knowledge, no economist challenged that newspaper claim, or similar statements made on the electronic media. Let me make it clear that I am not, here, arguing for any particular “solution” to the growing fiscal cost of National Superannuation. There are obviously a range of possible solutions, including an increase in income tax. All I am saying, and saying as strongly as I know how, is that we will not improve our economic performance, nor get the sound policy decisions on which that improved economic performance depends, without a better public understanding of the nature of the issues. Economists can not of course achieve that on their own. It requires leadership from political leaders, from business organisations, and from community leaders also. But as those with a professional understanding of tariffs, budgets, monetary policy, taxes, and all the rest, economists surely have a major responsibility to help in building public understanding of the choices and the dilemmas. As an aside, the Reserve Bank decided to sponsor the production of a textbook on economic policy for the Journalists Training Organisation a year or so back. This textbook will be launched next week. It does not attempt to promote a single view of economic policy, and contains chapters written by a wide range of New Zealand economists and financial journalists. It is the Bank’s attempt to ensure that journalists, at least, have access to information on some of these important issues. Perhaps it is appropriate to end with a quotation from a speech given just last week by Mr Kerry McDonald, managing director of Comalco New Zealand and of course for a number of years Director of the New Zealand Institute of Economic Research. In that speech4 he observed: “It seems that there simply isn’t a decisive constituency in New Zealand for increased growth and living standards. No one is demonstrating for it, and few are fussed by the lack of it. Many want the fruits; they want the cargo to arrive, but not the hard effort of creating the economic wealth in the first place.” As a fifth generation New Zealander, I badly want Kerry McDonald to be wrong. I suspect he wants to be wrong himself. I know that, when I threw my hat into the political arena in 1980, what motivated me was a fear that, unless we could arrest our relative economic decline, my kids would leave New Zealand as soon as they were old enough to choose, and the country which I love would gradually sink into the sand. I think that we have as a country made some real progress in recent years at arresting that decline. The last 15 years have certainly not been in vain. But in part because of the failure of the economics profession, the public seem to imagine that half a century of relative decline can be arrested by just a few years of reform. It can’t be. There is still much to be done. Economists can assist sensible public discussion of the issues, and if we fail to do that, we may yet, like the good people of Hamlyn, see our children disappearing over the horizon.4 “Is a high performance business environment possible in New Zealand?”, speech to the NZ Institute of Management, Canterbury Division, 9 August 1999.
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Opening address given by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the SEANZA Forum of Banking Supervisors' conference, held in Auckland on 11 November 1999.
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Mr Brash gives an address on the development of international standards Opening address given by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the SEANZA Forum of Banking Supervisors’ conference, held in Auckland on 11 November 1999. * * * It’s a great pleasure to welcome you all to New Zealand and to the SEANZA Forum of Banking Supervisors’ Conference. I would especially like to welcome our guest speakers: William Coen from the Basel Committee Secretariat, Roland Raskopf from the Financial Stability Institute, and Clive Briault from the Financial Services Authority. We very much appreciate their giving up valuable time to be with us, particularly given the long distances they have had to travel to get here. I am sure that they will make a very valuable contribution to our discussions over the next two days. I would also like to extend a special welcome to the delegate from Macau. In the past, Macau has been an observer at these conferences. However, since the last meeting of the Forum it has become a full member of SEANZA. As some of you will know, the SEANZA Group has a long history. It originally grew out of a 1956 meeting of central bank governors from British Commonwealth countries in the Asia Pacific region. The governors decided that the central banks in the region should pool their resources to provide an intensive and systematic training course for promising central bank staff. The first such course was held in Australia in 1957. These courses continue to be held once every two years. The last course was held in New Zealand last year, while the next one will be held next year in Sri Lanka. The SEANZA Forum of Banking Supervisors was established in 1984 as an offshoot of the main SEANZA group. The objective was to provide a means for banking supervisors from the region to establish contact with each other, in order to exchange information on issues and problems of common interest. Initially only central banks were represented at the Forum. More recently, special purpose regulatory bodies like the Korean Financial Supervisory Service and APRA in Australia have joined. Since SEANZA was first established, the number of countries in the SEANZA group has gradually expanded, to the extent that each country now gets the opportunity to host these conferences only once every 40 years. That probably means I won’t get the chance to give the opening address at one of these conferences again, and that none of us here today will attend the next New Zealand conference! No doubt the issues under discussion at that conference will be quite a bit different from those being considered here, and the financial system will look radically different from the way it does today. Already we are seeing rapid change in the financial sector. Over recent years, advances in computer and communications technology, and financial market liberalisation, have led to increasing globalisation of financial markets. At the same time, banks are under pressure to keep their costs down. As a result, many banks that operate in a number of different countries are choosing to centralise activities in one regional centre rather than duplicate services in each country. We are particularly aware of this trend in New Zealand as all of our banks except one are foreign owned. We are increasingly finding that these banks are using computer systems located in another country, or that parts of their New Zealand business are not in fact being conducted here at all. For example, a phone call to a bank’s treasury may be answered by someone located in Sydney rather than in Wellington or Auckland. Or we find that particular types of transactions entered into with New Zealand-based customers are being booked through another jurisdiction and do not appear on the New Zealand balance sheet. These trends make it more important than ever for supervisors in the region to get together and talk about matters of common interest, both in groups like this and on a one-to-one basis. At the same time, boundaries between different types of financial institution are becoming increasingly blurred. Financial conglomerates offering a wide range of financial services are becoming increasingly common. These developments are reflected in the three main themes of this conference: international standards, supervisory structures (and by that I mean the question of whether supervision is best conducted through a so-called “mega regulator” or through more traditional, functionally-based, supervisory structures), and the supervision of conglomerates. These are all very important and topical issues. I would like to talk a little about one of these themes – the development of international standards. There are two main points I would like to make. First, while there is a definite role for international standards, it is very important that they are implemented in a way that takes into account the individual circumstances of each country. Secondly, it is possible to have too much of a good thing in this area. We will not necessarily be able to achieve our overall objective – a sound and efficient financial system – by adding further layers of complexity to our supervisory rule books. In fact we may weaken rather than strengthen the financial infrastructure if we go down this route. The Basel Committee on Banking Supervision has been instrumental in producing a number of important international standards on the supervision of banks, including the Capital Accord and minimum standards governing the supervision of banks’ cross-border establishments. Similarly, other supervisors such as IOSCO and the International Association of Insurance Supervisors have pursued co-operation in their areas of responsibility. And in the early 1990s, in recognition of the emergence and growth of financial conglomerates, banking, securities and insurance supervisors from G10 countries began to work together to identify the problems that conglomerates can cause, and to consider ways to overcome them. The Mexican crisis in 1995, in particular, and the widespread incidence and high cost of banking problems recently in this region have prompted calls for concerted international action to promote the soundness of financial systems. These calls have strengthened over the last couple of years, with the G7 countries calling for the adoption of strong prudential standards in emerging countries and encouraging the international financial institutions to increase their efforts to promote effective supervisory structures in those countries. The Basel Committee has been at the forefront of this effort with the release of the Core Principles. The IMF and the World Bank are also involved. The IMF is making evaluation of financial supervision and regulation part of its annual country reviews, and the World Bank is emphasising the strengthening of financial infrastructure as an important part of its structural assistance programmes. These initiatives have many positive aspects. International harmonisation and co-operation are very important in what is rapidly becoming a “borderless” global financial system. Also, it is important that the risks that supervisors should take into account in their supervision are identified, and that benchmarks are established whereby countries can measure their progress in establishing appropriate supervisory regimes. As supervisors, we can derive a great deal of benefit from such an approach. Bank customers and banks themselves also benefit from the international comparability made possible by the use of common measurement and disclosure frameworks. Nevertheless, I believe it is important not to assume that supervisory arrangements should be, or can be, the same in every country. In my view, they must be tailored to the individual circumstances of each country. What is appropriate for a small country like New Zealand may be totally inappropriate for a large country like the United States, and vice versa. To give just one example, non-bank financial institutions need not be licensed or supervised in order to take deposits in New Zealand. Here that does not cause any problems because the non-bank sector is tiny relative to the bank sector, and people are generally aware of the differences between banks and non-banks, and of the fact that non-banks may be more risky than banks. However, I would be the first to acknowledge that such an approach would not necessarily be the best for all other countries. In many countries, retail depositors typically use non-bank financial institutions rather than banks and it may therefore be important that those institutions are licensed and supervised. Similarly, in some countries where there are perhaps thousands of licensed financial institutions and a very large population – and generous deposit insurance or a strong implicit government guarantee of bank deposits – it may well be desirable for the supervisor to check the bona fides of bank management. In New Zealand, with its relatively small population and absence of deposit insurance, we are satisfied that the public is well able to make its own assessment of the quality of bank management and has an incentive to do so, and in these circumstances there is no need for the supervisor to take on this role. Thus, while we strongly support the introduction of international standards in principle, we would not like to see a one-size-fits-all or checklist, tick-the-boxes, approach. International standards need to be interpreted with an appropriate degree of flexibility in order to adequately cater for the individual circumstances of each country. Further, when devising supervisory policies we need to bear in mind not only the individual circumstances of our own countries but also the need to ensure that policies harness market forces to the extent possible, rather than undermine them. As Alan Greenspan said in 1997: “As financial transactions become increasingly rapid and complex, I believe we have no choice but to harness market forces, as best we can, to reinforce our supervisory objectives. The appeal of market-led discipline lies not only in its cost effectiveness and flexibility but also in its limited intrusiveness and its greater adaptability to changing financial environments. Measures to enhance market discipline involve providing private investors the incentives and the means to reward good bank performance and penalise poor performance. Expanded risk management disclosures by financial institutions is a significant step in this direction.”1 Indeed, Mr Greenspan made the same point again exactly one month ago, when addressing the American Bankers Association in Phoenix, Arizona. In that speech he said: “A one-size-fits-all approach to regulation and supervision is inefficient and, frankly, untenable in a world in which banks vary dramatically in terms of size, business mix, and appetite for risk … Policymakers must be sensitive to the tradeoffs between more detailed supervision and regulation, on the one hand, and moral hazard and the smothering of innovation and competitive response, on the other. Heavier supervision and regulation designed to reduce systemic risk would likely lead to the virtual abdication of risk evaluation by creditors of such entities, who could – in such an environment – rely almost totally on the authorities to discipline and protect the bank. The resultant reduction in market discipline would, in turn, increase the risks in the banking system, quite the opposite of what is intended … Supervisors have little choice but to try to rely more – not less – on market discipline – augmented by more effective public disclosures – to carry an increasing share of the oversight load … The potential for oversight through market discipline is significant, and success in this area may well reduce the need to rely on more stringent governmental supervision and regulation.”2 I am pleased that the profound truth of this view is being recognised more widely and that international standards are increasingly reflective of this. The use of banks’ own models in the measurement of market risk is one example. Increased emphasis on the role of disclosure is another. These developments recognise that, as banks’ activities become increasingly complex and change occurs with ever greater rapidity, it becomes more and more difficult to place reliance on detailed rules. Often supervisors are dealing with yesterday’s problem rather than the one that is emerging today. What we should aim to do is to harness and reinforce market disciplines to achieve the outcome we are seeking – a sound and efficient financial system. Bank directors and management have a detailed knowledge of their bank’s business. We need to make sure that this knowledge is used in the measurement and management of risk. We also need to make sure that supervision is not carried out in a way that will reduce incentives for bank customers to monitor the performance and risk profile of their bank. To the extent that supervisors ensure that these things happen, we can expect banks to operate more prudently. As supervisors, we need to be realistic about what supervision can achieve. It is certainly clear from the record that there have been significant weaknesses in some countries’ banking systems, and that Speaking at the Conference on Bank Structure and Competition hosted by the Federal Reserve Bank of Chicago, 1 May 1997. Speaking at the American Bankers Association conference in Phoenix, Arizona, 11 October 1999. these weaknesses have both contributed to the emergence and severity of financial crises and complicated the task of resolving them. However, I am myself somewhat dubious about the proposition that “poor supervision” was the primary cause of these weaknesses. There has been a tendency to give supervision the blame for problems that have originated elsewhere, or to seek supervisory remedies for problems that might be better solved in other ways. I would also note that supervision can sometimes be part of the “problem” rather than part of the solution – particularly when there has been excessive regulatory forbearance and/or excessive reliance on the public safety net. I believe that supervision should be seen as only one of the factors influencing the health of the financial system. In this regard I am pleased to note that the Basel Core Principles recognise this by identifying the preconditions for effective banking supervision, including sound and sustainable macro-economic policies, a well developed public infrastructure, and effective market disciplines. I am sure that we can all agree that all of these factors are vital to the development of a sound financial system. In conclusion, as financial markets become increasingly globalised, supervisory co-operation and harmonisation become increasingly important. Groups such as SEANZA play an important role in achieving these objectives, as do international supervisory standards. But I believe it is important that we don’t assume that international standards are the holy grail and that their adoption will necessarily lead to a sounder financial system. Supervision is only one of a number of factors impacting on the performance of the financial sector. It is important that we have good supervision, but we should not over-emphasise its importance. I hope that you will find this conference stimulating and that you will enjoy your time in New Zealand.
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Speech given by Dr Donald T Brash, Governor, Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, in Christchurch on 28 January 2000.
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Mr Brash gives an address on the building blocks of economic growth Speech given by Dr Donald T Brash, Governor, Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, in Christchurch on 28 January 2000. Introduction and retrospective Over the past few years, as this speech has become an established part of my diary, I have used the occasion to address various issues of the day, such as developments with the exchange rate, the balance of payments and the Reserve Bank’s inflation target. Since this is my first public speech of the new millennium, the temptation is to step back much further than usual and attempt to place current economic and monetary policy matters into the context of the past thousand years. Instead I want to speak on a subject that is of rather more immediate interest, economic growth. What drives it, what will help us do better, and where does monetary policy fit into the scheme of things? To get ahead of myself for just a minute, there won’t be too much about monetary policy. Good monetary policy is important, but even the best monetary policy in the world will not of itself generate growth. But as topical as growth is, history matters when we think about growth. So let me indulge just briefly in a piece of millennium contextualising. In an excellent survey a few weeks ago, The Economist magazine1 reviewed humanity’s experience of economic growth over the past 1000 years. That survey observed that the steady rise in living standards that we in the Western world now take for granted is, in fact, a fairly recent phenomenon. Had I lived at the turn of the last millennium, for example, my life would almost certainly have been – in the famous words of Thomas Hobbes - “poor, nasty, brutish and short”. My lifestyle would have been essentially unchanged from that of my ancient grandparents and great grandparents. Prior to about the middle of the 18th century, economic growth was so slow that it was often imperceptible within the span of a lifetime. The staggering growth of the last two or three centuries has supported a huge increase in population. And, in the West, ours is the first age in which affluence has been enjoyed by more than just a tiny fraction of the population. Even the less well-off can have access to things that were scarcely dreamed of by even the wealthiest at the beginning of the twentieth century – things like an electric washing machine, a television, a stereo, a computer, vaccination against disease, contact lenses, air travel and so on. So what happened to launch us into an age in which rising living standards and increasing wealth have become the norm rather than the exception? To understand that is to give ourselves a much better chance of understanding the way ahead. Knowledge helped: the fruits of formal scientific endeavours, and of the applied curiosity of so many remarkable men and women. But, as The Economist essay notes, much of the knowledge that proved so important in sparking the extraordinary growth in Britain, and subsequently elsewhere, was not new. Some of the key technologies were available in Rome and China hundreds of years earlier. So knowledge alone was not sufficient. It did not give rise to sustained economic growth in China. Indeed, in many cases the technologies that proved so valuable in Western Europe centuries later had, by then, been completely lost to the Chinese. So if knowledge alone is not sufficient to promote growth, what are the other factors or attributes required? 25-31 December 1999 issue. There is no simple formula. Indeed, that is one of the things that make economics so interesting. As we look to history to identify the successful economies, and then try to analyse what made them so, we find ourselves wading into the uncertain fields of social values, politics and institutions. We have to grapple with such things as property rights, law and order, the ability to contract into the future with confidence, culture and values, an openness to innovation, social cohesion, public infrastructure, fair and efficient taxes, and sound money. Before anyone objects, let me volunteer immediately that that list is neither comprehensive nor ranked in order of importance. But whatever the full story, we quickly find two themes emerging: sustained growth and prosperity required an openness to change, and both vigorous markets and good government had important roles to play. In short, markets and governments needed each other. What about the future? Well, all that is interesting history, but what does it mean for 21st century New Zealand? Clearly, New Zealanders want rising standards of living. Rising living standards have a number of dimensions – each of us places value on a variety of different things, some traded in the market-place, others not. But there is a widely-shared consensus that strong economic growth is a key foundation on which broadly-based increases in living standards can be built. Equally clearly, there is a degree of public dissatisfaction with both the pace and the nature of the economic growth achieved in recent decades. And the facts are quite stark. Our standard of living has improved over the years. But the improvements in New Zealand have not matched those enjoyed by Australians or others in Europe and North America. Does that slide in relative living standards mean that the reforms of the past 15 years were misdirected or wrong? Again, my view is clear. The reforms were necessary, they were generally well-directed and, on the whole, they were well-executed. They helped deliver us both increased actual growth during the 1990s – we’ve broadly kept pace with the world in the 1990s – and they’ve increased our potential for growth in the years ahead. But the challenge now is to sustain the growth, and begin to close the gap between average incomes in New Zealand and incomes in other developed countries. We did very well for a long time because there weren’t many of us, and climate meant we were very efficient producers of agricultural products that were prized by rapidly growing urban populations abroad. But as Denmark can’t today prosper on fine bacon, or Italy on the very best olive oil, so the best Canterbury lamb and good Akaroa wine won’t be enough to keep us at the leading edge of the nations of the world. The pressures we have been responding to in the last 20 years are largely beyond the control of any government – a continuation of a two-centuries-long slide in the real price of commodities and basic manufactures, falling transportation and information costs, and new technologies that increasingly both require and reward skills. Add to that a legacy of change postponed. As I travel the country talking with groups like this, it is very clear that New Zealanders are anxious about the way forward and are groping for answers about what will restore our relative position in the world. And there seems to me to be no good reason why New Zealanders should not aspire to living standards within, say, the top 10 of OECD nations. We were there in the 1950s, and indeed probably for much of the early part of the twentieth century as well. We now stand at about 20th, near the bottom of the OECD league, with average incomes 20 per cent adrift of even middle-ranking countries like Australia, Sweden, and Ireland. We are capable of reversing the trend but there are few certainties, no quick fixes, and no guarantees. Governments cannot simply push a button labelled “high growth”, and no one will gift growth to us. Some things we know work; others we suspect might. But in other areas, we simply have no idea whether we are hurting or helping (or neither) the cause of growth. Often it seems that the pre-conditions for growth are laid down across decades, perhaps centuries. If so, they are hard to lose, but also hard to gain. In many respects, government policies and private sector practices are very different in, say, the United States and Germany – and yet both are wealthy, growing, economies. And no matter what the policy regime, the countries of West Africa, for example, are likely to be desperately poor for decades to come. Probably a few things matter a lot, and a lot of things matter a little. Unfortunately, it is often easiest to do something about things that won’t do very much to boost long-term prospects. Some things we simply can’t change. Geography matters, and drawing a circle centred on Christchurch with a radius of 2100 kilometres will always encompass only a few million New Zealanders and a lot of seagulls. Similar circles centred on Dublin, Helsinki, or Singapore encompass hundreds of millions of people. That harsh fact makes it all the more important that we get right what we can influence. What else matters? First, and to go back to the history I started with, we can say confidently that knowledge matters. That has rarely been more obvious than over the past few years in the United States. As we speak, the US economy is on the verge of breaking all previous records for uninterrupted growth – by next month, a record 107 months. During the 1990s, many think that the sustainable medium-term growth rate of the US economy has risen from around 2.5 per cent in the early 1990s, to around 3 or even 3.5 per cent today. In large part, that increase reflects the extraordinary developments in information technology in recent decades that are now coming to fruition. Record-high share prices year after year do raise questions about how much is sustainable, but the change in the underlying technology is real and will not be lost – it is transforming the US, and indeed the entire developed world. So knowledge matters, and it will matter increasingly. We need people with ideas and innovations, and entrepreneurs to help convert those innovations into successful businesses. But we also need social attitudes that encourage both ideas and enterprise, and financial markets that support and sustain that enterprise. New Zealand will lift itself back to the top tier of OECD economies only with firms and workers that are equipped with the skills and energy to participate fully in a knowledge-based economy. And not simply to participate, but to be at the leading edge of developing and applying new technologies, and finding markets for them. A number of firms here in Christchurch – including Aoraki Corporation, run by our own director, Sir Gilbert Simpson – are already a part of that drive, but we still have a considerable way to go. This is certainly not a technology-averse society. We lead the world in the take-up of new banking technologies (such as EFT-POS); leading-edge New Zealand technology played a big part in winning – and, we all hope, retaining – the America’s Cup. And yet it is sobering to turn from the impressive anecdotes to the hard data, where we find that New Zealand’s ratio of exports of high-tech products to our imports of such products is among the very lowest in the developed world – ahead only of OECD laggards Greece and Turkey. There has been considerable debate in recent years about the role that government support for research and development can, or should, play in helping foster this sort of orientation in our firms. In its recent briefing papers, the Ministry of Research, Science, and Technology has highlighted that New Zealand stands out as providing less support than most other countries. I am no expert in this field, and the potential costs and benefits of such policies need to be weighed carefully. There can be considerable costs to getting policy wrong. But that cuts two ways: there are costs in adopting measures that later prove to be lemons, but there are also costs in not adopting initiatives that should in fact be pursued. New Zealand’s history is, of course, littered with examples of the former sort. I suspect we should be wary of dogmatism about things that are likely to be of secondary importance, especially when we still know relatively little about the longer-term impact of the general tax and spending policies that affect incentives throughout the economy and society. Turning from firms to their workers, there are signs that the quality of the labour force is improving. The number of students enrolled in tertiary education has increased markedly throughout the 1990s, and whereas only 5.5 per cent of the adult population had a university degree in 1986, by 1996 that number had risen to 8.5 per cent. The performance of the education sector remains critical to the future of New Zealanders. But schools and universities can’t do it alone. They can only work with the raw material they are given – children who are already shaped by the attitudes and practices of their parents, peers and communities. Many young New Zealanders are still leaving school less well-educated than their international counterparts. And a disproportionate number of Maori and Pacific Islanders are leaving school without qualifications and, as a result, are working in low-skilled jobs. Over the coming decades, this group will form an increasingly large part of the working age population. Raising Maori and Pacific Islander educational performance provides a significant opportunity for improving New Zealand’s growth prospects. And the threat to social cohesion – and, hence, to the capacity of the country to adapt and grow – is equally real if, as a nation, we fail on this count. A key aspect of any successful growth strategy will be openness to international trade and a thoroughgoing integration into the global economy. When so much about growth is uncertain, this is one area in which economists find relatively little to dispute, particularly for a small country such as New Zealand. Studies show a clear link between the openness of an economy – openness, that is, to international trade, investment, and ideas – and economic growth. Openness enables us to specialise, to find global and not just local markets (and rewards) for innovative products, and it provides the constant discipline and challenge of the fresh ideas, perspectives and products the wider world is making available. For much of the last half century New Zealand was not an open economy. Indeed, although we now have quite an open economy, we opened up only relatively recently. And that is reflected in our ratio of trade to GDP, which – contrary to much popular mythology – is much lower than would be expected for a country our size. The length of time an economy has been open also matters. Attitudes and values, skills and markets, can only rarely be transformed overnight, no matter what happens to the direct financial incentives firms and individuals face. By its nature, culture, whether business or otherwise, changes relatively slowly. In a sense, none of this should be a surprise to a New Zealand audience. From the early European sealers and whalers, to those exchanging flax for muskets, through our agricultural age, to the dawn of the 21 st century today, so much of our economic activity has depended on two-way foreign trade. Even for the small settler communities at the end of the earth 150 years ago, it never made sense to attempt to self-sufficiently meet all their own material needs. Self-sufficiency makes so much less sense today, if we value prosperity and opportunity at all. With all due respect to the Christchurch technology sector, and I have a great deal of respect for it, think of the inefficiency and waste involved if we’d had to develop and maintain our own Microsoft, meeting only New Zealand needs, our own Boeing, our own Vodafone. And equally, the prospects for our own innovators – Tait Electronics or Aoraki Corporation, say – would have been bleak had they been limited to New Zealand sales alone. As a nation, we turned inwards in the late 1930s, taking the protectionist route to development. The advocates of that change were unquestionably well-motivated. They too recognised that in the longrun agriculture was unlikely to sustain first-world living standards and strong growth. But equally clearly it was a wrong turning that delayed our adjustment, our shift to a high-tech globally-integrated economy, by several decades. We pay the price for that now, in at least two ways. First, our economy and people are less able to take advantage of the opportunities that beckon this decade than we might have been if we’d avoided the by-ways of protection. But, second, we face the very real human and social costs of adjusting away from the industry structures which the protective policies of the 1930s onwards bequeathed us. There are no easy answers to the practical questions of just how fast we should move away from that protectionist route. Much of the work has already been done, even though the current government and its predecessor have answered slightly differently the questions about the protective barriers that remain. Trade matters – it is simply vital to our future – but I believe there is also a strong recognition of the need to bring people along. Speaking only a couple of weeks ago of the changes new technology is bringing about in the US, Alan Greenspan – himself an enthusiastic advocate of the market economy – noted: But as we seek to manage what is now this increasingly palpable historic change in the way businesses and workers create value, our nation needs to address the associated dislocations that emerge, especially among workers who see the security of their jobs and their lives threatened. Societies cannot thrive when significant segments perceive its functioning as unjust.2 If an innovative and competitive private sector is important, so too is an innovative and efficient public sector. In my many years of observing political processes, I find it difficult to recall a period when the calls for increased public spending were more intense – health, education, superannuation, defence, conservation, R & D and industry support can all present strong cases as to why more public spending in those areas is desirable. Yet we know that our public spending is now not particularly low by the standards of other countries – and health, education, and welfare spending (as a share of GDP) is higher today than it was 15 years ago. We know also that much of our workforce is mobile, and that tax rates are one – though of course only one – part of the equation that skilled young New Zealanders face as they make their judgements about whether to stay or go. Likewise our companies are increasingly mobile. They don’t have to be based in New Zealand, especially as they grow and find bigger and easier markets elsewhere. Our public infrastructure, business environment and tax regime will increasingly figure in the decisions about where companies choose to reside. I am not here arguing that small government is necessarily better government. The evidence of successful economies internationally is quite mixed on that front. Across quite a range, the size of government seems to matter less than does the quality of government policy. But it seems axiomatic that, when government represents the biggest single sector of the economy, its own efficiency and effectiveness will be an important influence on overall economic performance. This takes me to another important component in successful growth strategies – macroeconomic stability. By that I mean the overall balance of government taxes and spending – the fiscal balance – and the thrust of monetary policy. The goal of fiscal policy in recent years has been to maintain surpluses and reduce public sector indebtedness. Progress on that front has been impressive. A string of fiscal surpluses since 1993/94 and a sharply-reduced government debt to GDP ratio may seem of little relevance in the face of pressing social needs. But there can be little doubt that this improved fiscal performance has contributed to improving overall economic performance in New Zealand. And of course improving economic performance – and in particular faster growth – also makes us able to more readily fund additional public spending over the medium-term. In principle and other things being equal, an improvement in the fiscal position tends in the short term to ease the pressures on monetary policy, and hence on interest rates and the exchange rate. The opposite is also true. But these are transitional effects only. Perhaps more important are the medium-term effects. First, the much-reduced public debt achieved in recent years provides the government with greater breathing space to cope with adverse shocks to our economy in future – and, of course, adverse shocks will happen again. The lower debt levels will also help the government cope with the marked increase in the pension burden after 2010 as the post-war “baby-boomers” move into retirement years, without major increases in tax rates. Secondly, and more directly relevant to our growth prospects for the next decade or two, the lower the level of public debt, the lower our interest rates are likely to be on average over the course of the business cycle. In fact, of course, our long-term real interest rates have been – and remain – consistently higher than those of countries such as the US, Australia, and the UK, despite the improved fiscal position. We have paid – and continue to pay – a premium price for access to world capital markets. That acts as a drag on our growth prospects – projects that would otherwise be done simply don’t get done because the cost of capital is too high. So what is going on here? We pay that premium price for capital because we save insufficient ourselves. Part of the price of growth is deferring gratification – and as a nation we don’t rate terribly well on that score. In fact, we “Technology and the economy”, remarks to the Economic Club of New York, 13 January 2000. now have one of the lowest savings rates (as a share of income) in the developed world, and that is reflected in the disconcertingly large current account deficit and our huge dependence on external debt and equity capital. By running operating surpluses, the government has reduced its call on the pool of domestic savings, and so helped to avoid putting upward pressure on interest rates. But the government cannot sensibly offset without limit the low savings of the private sector. The other part of macroeconomic stability is my own territory, monetary policy. Next week marks a decade since the Reserve Bank was formally made independent, and since 1988 we’ve been required to target, and deliver, price stability. The Reserve Bank’s mandate is to ensure that CPI inflation stays within the 0 to 3 per cent range set by agreement with the Government. Price stability isn’t the most important objective a society can aspire to – far from it. The real objectives lie elsewhere – growth, employment, equity, justice and so forth. But monetary policy is targeted on price stability for two reasons: first, because inflation is damaging, even at quite low levels, and secondly, because over time monetary policy cannot durably affect anything other than inflation. By maintaining long-term price stability – and in particular by building public confidence that price stability will be a permanent feature of our economy – we ensure that monetary policy doesn’t act as a drag on our growth prospects. Let me dwell just briefly on some of the shorter-term connections between monetary policy and growth, including some that achieved a certain prominence with the new Policy Targets Agreement signed by Dr Michael Cullen and me on 16 December last year. Monetary policy responds to forecasts of emerging inflation pressures looking one to two years ahead (and not to the most recent actual CPI). The trigger here is not growth itself. Economic growth is good, and we certainly do not, as some have suggested, live in fear of it. What prompts an increase in the OCR is when growth in demand looks like getting out of line with growth in the capacity of the economy to supply goods and services. When that looks like happening, there is a risk that inflation will pick up, and in those circumstances an increase in the OCR, to lean against the growth in demand, is in order. Can I stress that the economy’s capacity is determined by the whole variety of things I’ve talked about today, and hardly at all by anything under the control of the Reserve Bank. As I said right at the start, the best monetary policy in the world will not, of itself, generate growth. Over the last few years, as inflation expectations have settled down, and markets and the public have come to believe that price stability will endure, monetary policy has been able to think a little more about medium-term prospects and outcomes. The extent of the change shouldn’t be overstated – we’ve always recognised that monetary policy works only with a lag – but we’ve been able to be a little more relaxed about short-term “wobbles” in the inflation rate, such as those caused by moves in the exchange rate. We do this because we recognise that to react too much to short-term movements in inflation could induce unnecessary variability in economic activity and output. In a sense, that is just what the new provision in the Policy Targets Agreement recognises. We didn’t seek the change, and yet its addition helpfully, and more formally, reminds us that there are, in the short-term, sometimes trade-offs. If that is so, then we need to think seriously about the implications for the short-term variability of output, interest and exchange rates when deciding on the OCR needed to ensure that medium-term price stability is maintained. In some circumstances, accepting a bit more short-term variability in inflation may mean a bit less variability in interest and exchange rates, and vice versa. I say may, because it isn’t the case in all circumstances. In many situations, the best way to minimise fluctuations in inflation, output, interest rates, and the exchange rate will be to adjust the OCR firmly and promptly to guard against imbalances emerging in the economy. None of this – in fact, nothing – will alter the fact that a growing and prosperous New Zealand economy will always live in an uncertain world subject to shocks and surprises. Monetary policy can assist in responding to shocks – moving to stimulatory mode as Asia struck, moving back towards neutral now, heading for restraining mode as and when growth begins to put strain on capacity and threatens to reignite inflationary pressures. But we won’t – indeed can’t – remove the economic cycle, or the bulk of the big cycles in interest and exchange rates. In all this, I hope I don’t appear defensive when I remind you – as I must often remind myself – that in a world of huge uncertainty a very considerable element of art is involved in reaching monetary policy decisions. That means it will often only be with the benefit of very considerable hindsight that the final verdict can be delivered on whether or not the best decisions were made at the time. Conclusion Improving our economic growth performance is a big part of what the public look to governments and their officials to provide. But while sustained strong growth inevitably involves governments, there are severe limitations on what governments alone can do. Firms, individuals and markets generate growth. And yet firms and individuals are affected in so many ways by what governments do that without a cohesive society and good government it is almost impossible to have sustained and broadly-based economic growth. Much has been done in New Zealand in recent decades as governments, firms and individuals have begun to awaken to the implications of the world economy for New Zealand’s future economic prospects. Change takes time, and recent economic performance suggests New Zealand will probably not close the gap that has developed between our incomes and those of our fellow OECD countries in the near future. There are no guarantees, and nothing can be taken for granted, but there are a number of causes for greater optimism in the longer term. New Zealanders are increasingly better educated, firms and workers are more experienced in managing the open economy, macroeconomic credibility has been established; and over time, exposure to the competitive pressures and opportunities of an increasingly high-tech world should help transform the nature of New Zealand business. Monetary policy will continue to do what it can, providing a stable backdrop against which firms and households can plan for a better New Zealand in the new millennium.
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Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Auckland Regional Chamber of Commerce & Industry, Auckland, on 21 March 2000.
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Mr Brash: Will the Reserve Bank choke the recovery? Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Auckland Regional Chamber of Commerce & Industry, Auckland, on 21 March 2000. * * * Introduction Ladies and Gentlemen, I was invited to give this address after a number of pretty aggressive attacks on the Reserve Bank, on monetary policy, and on me personally in the Auckland media in late January and early February, after the Bank increased the Official Cash Rate from 5 per cent to 5.25 per cent in the middle of January. Who does Don Brash, an unelected bureaucrat whose name appeared on no ballot paper in the last election, think he is, to be making such important decisions? Why does Don Brash refuse to engage publicly with any of the media on the issue? Why is New Zealand the only OECD country that “persists in intervention to fuel another self-induced recession” (this from the Auckland Chamber of Commerce itself, using the same words after our increase in the Official Cash Rate in January, and again after the further increase last week)? Wouldn’t life be much better if we simply did away with such intervention, and allowed pure market forces to determine interest rates? Hasn’t the Reserve Bank, and the way in which it has run monetary policy under the Reserve Bank Act of 1989, caused New Zealand’s huge balance of payments deficit, and won’t pushing up the Official Cash Rate simply make matters worse? Why did the Bank increase the Official Cash Rate as the economy was just beginning to emerge from the recession? Surely it was inappropriate to tighten policy when the Government Statistician has shown that inflation in the latest year was below the mid-point of the 0 to 3 per cent inflation target? Why does the Reserve Bank claim the right to be the sole judge of how fast the New Zealand economy can grow? Isn’t it possible that New Zealand, like the United States and other developed countries, can now grow faster than before without inflation? These and other questions poured forth – and this despite the fact that January’s modest increase of 25 basis points had already been fully priced into financial markets (as indeed last week’s adjustment to the OCR had been also)! Some questions based on misunderstanding I welcome the opportunity to respond to these questions this morning. Some of them raise important issues, though I think it is fair to say also that others simply reflect misunderstandings. For example, and contrary to the view once expressed by former Prime Minister David Lange, there is no sense in which Don Brash has huge or unfettered power. Parliament has made it clear that the Reserve Bank must use its ability to influence monetary conditions to maintain price stability. Parliament has made it clear that what price stability means has to be the subject of a formal agreement between the Government and the Bank’s Governor. And of course, that agreement currently requires me to keep the CPI inflation rate between 0 and 3 per cent (with some qualifications). The Government has made it clear that that is what I have to deliver, and under the Reserve Bank Act the Government has the right to change that target, unilaterally if they wish to do so, provided that any change is made public. So any decisions which Don Brash makes are tightly constrained, are based on the best information which my colleagues can gather, and are made to achieve an objective which Parliament has laid down. In no sense am I an unconstrained bureaucrat. The suggestion that I am reluctant to engage in debate with the media arose, I suspect, because in January we issued a press statement announcing and explaining the increase in the Official Cash Rate but then declined to answer further media questions. It is always a difficult judgement about how frequently the Bank should comment on monetary conditions “on the record”. On that occasion, I felt that had I given an interview to one journalist I would have had to give interviews to quite a number, and I was reluctant to run the risk of sending a multiplicity of messages which might have confused more than it enlightened. In general, however, we are more accessible to the media than any other central bank that I know of, and no central bank is more transparent about the rationale for its decisions. And have we been the only central bank in an OECD country to adjust monetary policy in a tightening direction in recent times? Hardly. In the last six months, the central banks of Australia, Canada, Sweden, Switzerland, the United Kingdom, the United States and the European Monetary Union have all tightened monetary policy on several occasions. That in itself does not make it sensible for us to tighten policy, of course, but at very least it makes it clear that what we have been doing is typical of what is happening in many parts of the world. But why not let “pure market forces” determine interest rates? As somebody who has a great deal of confidence in market forces, it feels a bit strange to have to disagree with those who advocate letting market forces be the sole determinant of interest rates. Of course, market forces do determine interest rates to a very large degree. Central banks really have a strong influence only on short-term interest rates. But why do we need central banks at all? This is not the place to give a comprehensive answer to this question.1 But it might be worth noting that, to the best of my knowledge, no country in the world currently operates without the services of a central bank. In other words, all countries that I am aware of have their own central bank, or effectively use the services of another country’s central bank (through using that other country’s currency, or tying their own currency to that of some other country). And all of those central banks intervene, as we do, by influencing short-term interest rates. What about the balance of payments? Surely, the Reserve Bank and its obsession with price stability have been a major contributor to the large current account deficit which New Zealand has experienced over the last decade? Well, actually no. New Zealand has had a current account deficit in every year since 1974, through a range of monetary policy regimes. Indeed, the largest deficit experienced over that 25 year period, relative to GDP, was in the mid-seventies, with another very large deficit in the mid-eighties. I am myself absolutely persuaded that, even if the Reserve Bank Act were amended to make the Bank responsible for reducing the balance of payments deficit, monetary policy has no ability to produce any sustainable reduction in that deficit. Indeed, I do not even know whether reducing a current account deficit would involve tightening monetary policy (which would push up the exchange rate but slow down domestic spending) or easing monetary policy (which would tend to push down the exchange rate but accelerate domestic spending). But surely it was daft for the Reserve Bank to tighten policy just as the New Zealand economy was emerging from a recession? Well, it might have been daft to do that if that is what we had done, but of course we did not. New Zealand experienced a brief, mild, recession in the first half of 1998, in significant part because of the impact of the Asian crisis and of a severe drought. But the economy But see “Monetary policy and the free-market economy”, an address to the Auckland Manufacturers’ Association, 22 February 1996. started growing again in the third quarter of 1998, and despite a few wobbles has been growing with increasing vigour since that time. Most commentators believe that over calendar 1999 the economy grew by over 4 per cent, and that is in line with our own estimate. (We know that the economy grew by 3.1 per cent in the first three quarters of the year, and our Monetary Policy Statement published last week suggested that December quarter GDP grew by a further 1 per cent. Many commentators are already suggesting that that 1 per cent estimate will prove to be too low.) It also seems very clear that as a result of that growth the small amount of excess productive capacity which existed in the economy through much of 1998 and 1999 has now been largely, or perhaps completely, used up. A tightening of monetary policy over the last four months has been entirely appropriate. So those are the questions and comments with which it is pretty easy to deal. More fundamental questions But there are some fundamental questions which must be taken more seriously, questions about the relationship between inflation and growth which go to the heart of monetary policy decision-making. How fast can the New Zealand economy grow without generating inflation? What does 1999 tell us about the answer to that question? Let me try to answer those questions, while acknowledging that in some areas we ourselves do not have answers. Before doing that, it may be helpful to explain something about the way we look at this issue. This is best illustrated in a graph. The straight line A/B represents the gradual growth in the economy’s capacity to deliver goods and services without inflation. If demand exceeds the line A/B, then prices will have a tendency to rise. If demand falls short of that line, then prices will have a tendency to fall. (I say “have a tendency to rise” and “have a tendency to fall” because of course there are many other things which have an influence on prices, including changes in international prices, changes in government charging policy, changes in tariff policies, and similar factors.) The slope of the line, in other words the trend rate of growth in the economy’s capacity to supply, is largely driven by factors like the growth in the labour force, the quality of the education system, the quality of management decision-making, the openness of the economy, the quality of the judicial system, the quality of the industrial relations framework, and so on. Monetary policy can help by delivering price stability, because that helps people interpret relative price changes more easily than they can do in the presence of high and variable inflation, and avoids the distortions which the interaction of inflation with the tax system often creates. But the main factors affecting trend growth are the other ones I have mentioned. Monetary policy helps at the margin by keeping prices stable. In practice, of course, A/B is not a straight line – it varies in response to a whole raft of factors, including things like changes in net migration. Like the capacity to supply, demand also tends to fluctuate – in response to changes in international conditions, in response to changes in public confidence, in response to changes in government policy, in response to the introduction of new inventions, in response to changes in wealth, in response to a whole host of things – and yes, in response to changes in monetary policy. The key point to note is that when demand falls short of the economy’s capacity, as at points C and E, it is possible for the economy to grow rapidly while at the same time inflation is low or falling. Conversely, when demand exceeds the economy’s capacity, as at D, it is perfectly possible for the economy to grow very slowly, or indeed even to shrink somewhat, while at the same time inflation is rising. It seems to me that, conceptually at least, point C represents the state of the New Zealand economy in the early nineties (with very rapid growth but low inflation despite a big fall in the exchange rate); D represents the state of the economy in 1996 and 1997 (with growth slowing but inflation pushing up to and beyond the top of the then 0 to 2 per cent target range); and E represents where we have been over the last couple of years (with the economy first contracting briefly, then growing quite strongly, but with inflation low or falling). Seen in this light, we should perhaps not have been surprised that there was very little inflation in the second half of 1999, despite the fact that growth in that half of the year probably ran at an annualised rate of over 6 per cent; or that inflation in the year as a whole was just 1.3 per cent, despite growth in the whole year of at least 4 per cent. As already mentioned, other factors influence the inflation rate in the short-term of course – things like international oil prices, changes in government pricing policies, and so on – but the trend inflation which is the proper focus of monetary policy is basically a function of the relationship between demand and the economy’s capacity to supply. But of course this tells us nothing about how fast the New Zealand economy can grow without generating inflation. What is that “sustainable growth rate”? What, in other words, is the slope of the line A/B? Nobody, and certainly not the Reserve Bank, knows the answer to that question with certainty. But because the answer to the question is so fundamental to our decisions about monetary policy, we can not avoid making an estimate of that sustainable growth rate. We are forced to reach a judgement on the matter. At the present time, we estimate that the sustainable growth rate of the New Zealand economy is around 3 per cent per annum. Of course, the economy can grow faster than that for a time if it starts from a situation of excess capacity, as was the case in the early nineties and was the case in mid-1998. But when that excess capacity is used up, the economy needs to slow to about the sustainable growth rate or risk inflation beginning to pick up. Some people worry that the Reserve Bank can do considerable damage to the economy by assuming too low a sustainable growth rate, by assuming, say, a 3 per cent growth rate where in reality the economy could grow at 4 or 5 per cent if only the Bank would allow demand to expand more rapidly. But if the economy is really capable of growing at 5 per cent and the Bank runs monetary policy on the assumption that it is only capable of growing at 3 per cent, then quite quickly demand will fall below capacity to supply, there will be a strong tendency for prices to fall, and the inflation rate gets pushed down towards the bottom of the 0 to 3 per cent target range. And since we take not going through the bottom of the target as seriously as we take not going through the top, we are forced to ease monetary policy to let demand expand. In other words, we can’t avoid making a judgement about sustainable growth, and we can’t get it wrong for too long before we are forced to adjust our estimate. Indeed, we had a rather higher estimate of the sustainable growth rate of the economy in the mid-nineties but revised it down as we found inflation consistently pushing up towards, and briefly beyond, the top of the target range. Whenever any new piece of data comes out about inflation or GDP, we look again at whether our current estimate of sustainable growth is still reasonable. What about the “new paradigm”? As discussed in our Monetary Policy Statement last week, there are those who believe that recent US experience, with rapid growth and low inflation, points towards some new ability for modern economies operating with the latest technology and in competition with producers from all over the world to grow more rapidly than previously believed without inflation. Local optimists argue that New Zealand too could see more rapid growth with low inflation if only the Reserve Bank were not so cautious. Others suggest that, even in the US, the conjunction of low inflation with rapid growth has reflected in large part the disinflationary impact of some one-off factors, such as the recent weakness in world commodity prices, and the recent strength of the US dollar. They note that there is not yet any strong evidence in New Zealand to suggest that there has been a significant increase in the trend rate of productivity growth of the sort which might be required to justify a belief in the “new paradigm” in New Zealand. As our Statement last week noted, we are not yet persuaded that there is evidence of any fundamental change in the relationship between growth and inflation in New Zealand. But we are open-minded on the issue, and will continue to examine the data for evidence of such a change. Indeed, a whole section of the Statement was devoted to acknowledging that, while we have no doubt about the need to reduce the stimulus which monetary policy has been providing to the economy in recent times, there is much less certainty about how far monetary policy will need to tighten beyond the next few months. Conclusion And this is my main message to you today. All the evidence suggests that, after a very brief recession two years ago and growth of 3 to 4 per cent per annum since the middle of 1998, the excess productive capacity in the economy is largely gone. (In other words, referring back to my graph, we have passed point E and the demand line is very close indeed to the supply line.) It was appropriate that monetary conditions were stimulatory while demand fell well short of capacity. If we are right that demand and supply are now close to balance, however – and there is now a large body of official statistics and unofficial anecdotes supporting this view – it is high time that this stimulus was removed. And of course that is what we have been seeking to do with the increases in the Official Cash Rate in November, January, and now in March. We project that we will need to continue this reduction in stimulus, this easing back on the accelerator, over the next few months. But will we need to step on the brakes, and if so, how hard? The answer, as so often in economic matters, is “it depends”. Our Statement projects some need for monetary policy to become restrictive, to apply the brakes, over the next year or two. But at this stage this seems likely to involve a rather milder tightening in monetary conditions than has been the case historically. One of the reasons for this belief is that New Zealanders now carry a lot more debt, relative to their incomes, than they did a decade ago. We are assuming a relatively moderate rate of growth in household sector expenditure in the next few years as a result. In particular, we are assuming that the rate at which new debt is taken on will slow down as compared with the nineties, and that increases in interest rates will have a bigger impact on consumption expenditure and even on new house-building than in the nineties. Of course, we could be wrong on this assumption, in either direction. There is not much evidence yet that increased debt levels have encouraged a slow-down in the rate at which consumption is growing, so it is possible that demand arising from the household sector will be stronger than we now project, requiring firmer monetary conditions than we now project. Conversely, debt levels may be such that even small increases in interest rates induce a slow-down in consumption spending and in house-building, requiring monetary conditions to be rather easier than now projected. Another important area of uncertainty is the exchange rate. At the present time, the New Zealand dollar is close to its lowest level ever, on a trade-weighted basis. There are many reasons for this. New Zealand short-term interest rates have been lower than those in several other English-speaking countries, providing little inducement to foreigners to invest in New Zealand dollar assets. The commodity prices of greatest relevance to New Zealand seem to be recovering rather more slowly than do some other commodity prices. There has been some nervousness about the political environment, among investors both here and abroad. New Zealand has a large current account deficit, which looks likely to improve only slowly. To the extent that the exchange rate is weak because of low commodity prices, we know that offsetting the stimulus of the low exchange rate is the disinflationary effect of weak export prices. This would suggest no need for monetary policy to react. On the other hand, to the extent that exchange rate weakness simply reflects other factors, such as the current account deficit or nervousness about the political environment, the Bank may well need to adjust monetary policy to avoid the total demand pressures on the New Zealand economy exceeding the country’s capacity to supply. In this event, of course, interest rates may need to rise by more than projected in our Statement last week, as I noted at that time. But of one thing you can be absolutely certain. The Reserve Bank has absolutely not the slightest interest in choking off the recovery. All the evidence suggests that the economy has been growing with increasing vigour over the last couple of years, and most commentators expect it to continue growing at between 3 and 4 per cent per annum for at least the next couple of years. All the evidence suggests that, in these circumstances, it is high time to ease off the accelerator and ponder whether to touch the brakes. As Ian Macfarlane, the Governor of the Reserve Bank of Australia, said recently, an alternative way of describing the objective of a central bank committed to safe-guarding price stability is to say that the central bank wants to let the economy “grow as fast as possible without breaking the inflation objective, but no faster”.2 That is exactly how I see the mission of the Reserve Bank of New Zealand. Price stability is not an end in itself. Rather, it has always been the best contribution which monetary policy can make to allowing the economy to grow at its maximum sustainable pace. Speech by Mr Ian Macfarlane, Governor of the Reserve Bank of Australia, to the CEDA annual general meeting dinner, Melbourne, 28 November 1996.
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Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Auckland Rotary Club, Auckland, on 22 May 2000.
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Donald T Brash: The pros and cons of currency union - a Reserve Bank perspective Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Auckland Rotary Club, Auckland, on 22 May 2000. * * * Introduction In recent years, there has been a huge increase in interest in exchange rate regimes, both within New Zealand and internationally. Should countries maintain their own currencies, or adopt the currency of some other country or group of countries? If countries maintain their own currencies, should they “float”, or attempt to “peg” to the currency of some other country? As you know, New Zealand has had its own currency for many decades, and since March 1985 that currency has been floating against other currencies, with its value determined day to day in the financial market. But through the mid-nineties as our exchange rate appreciated strongly, many people became concerned about whether this was the best arrangement for New Zealand (between early 1993 and early 1997, an inflation-adjusted trade-weighted measure of the New Zealand dollar appreciated by some 29 per cent, putting considerable pressure on exporters and those competing with imports). Interest in the subject has become even more widespread in the last couple of years, with 11 of the countries of Europe abandoning their own currencies and forming a currency union, and with the growing interest in several Latin American countries in adopting the United States dollar. Last month, Sir Frank Holmes and Dr Arthur Grimes, two highly-regarded economists, released a study they had undertaken for the Australia New Zealand Business Council entitled An ANZAC dollar?, and this has further intensified public and political interest in the matter. It is clear that there is strong interest in the subject on the part of the business community. So today I want to make some comments from a Reserve Bank perspective. But at the very outset I want to make it clear that any decision to abandon our own currency is fundamentally a political issue. Currency unions are generally formed as part of a larger strategic push to integrate the countries entering the currency union, often in combination with free trade agreements, harmonisation of legal standards, and liberalised migration laws. Viewed in this way, entering a currency union is a major foreign policy decision, and thus a matter for elected politicians. It is not a matter on which a central banker should express an overall opinion, and I will not be doing so. But the choice of currency regime does have important economic implications which need to be carefully assessed, and I believe it is appropriate for me to comment on those. One other point should be clarified at the outset. There are some differences between “currency union” (implying a new central bank and a new currency to cover a range of countries and currencies, as in the case of the European Monetary Union) and “dollarisation” (implying the simple adoption of the currency of another country, whether in New Zealand’s case that be the Australian dollar or the United States dollar). And the most important of those differences for us is whether New Zealand would have any part in making the decisions about the monetary policy which would affect us. In a currency union, all the countries included in the union in principle have a say in forming monetary policy for the area covered by the union. All countries have a voice at the table, even if that is only a single voice among many. In the case of dollarisation, however, only the country whose currency is adopted makes the decisions about monetary policy. The study by Sir Frank Holmes and Arthur Grimes suggested that a currency union with Australia (involving a new central bank for both countries, and a new currency) could have some useful benefits for New Zealand. And they suggested a currency union, rather than New Zealand’s adoption of the Australian dollar, largely for reasons of political acceptability in New Zealand. Whether such an approach would meet the political acceptability test in Australia, of course, is a bit debatable. Preliminary comments from Australia suggest no interest whatsoever in abandoning the Australian dollar in favour of a new trans-Tasman currency. But whether currency union with Australia, or the simple adoption of the Australian dollar by New Zealand, the outcome would in substance be very similar. With the exception of who gets the seigniorage income, on which I will comment in a moment, both options would involve New Zealand’s relinquishing any effective control over monetary policy in New Zealand. In the case of the United States dollar, currency union is not even being raised as a possible option. The only possibility in that case would involve New Zealand’s adopting the United States dollar. And that too, of course, would mean relinquishing any control over our own monetary policy. Since the term “currency union” has been widely used in New Zealand to include both currency union as properly understood and the simple process of adopting another country’s currency, I will for the most part use the term “currency union” in the balance of my comments, while recognising that for all practical purposes we are talking about “dollarisation”, be it “Australian dollarisation” or “US dollarisation”. Some myths about currency union Before I comment on some of the economic advantages and disadvantages of currency union, it might be helpful to dispose of a few of the myths that have become rather prevalent. The first myth is that the Reserve Bank is opposed to currency union, perhaps because “Don Brash would lose his job”. Certainly, if we “dollarised”, using either the Australian dollar or the US dollar, there would be no need for anybody to be employed by the Reserve Bank of New Zealand and those now employed by the Bank would lose their jobs. If we went into a currency union, presumably with Australia, it is also likely that many existing Reserve Bank staff would lose their jobs (though I must admit that the European precedent perhaps suggests that job losses would not be great in that situation!). But I can assure you that neither the Reserve Bank nor Don Brash is opposed to currency union. Nor are we promoting currency union. As indicated a moment ago, the Bank’s responsibility is to advise Ministers about the economic implications of currency union, both the pros and the cons, and to foster informed public discussion on the issue. The second myth is that small countries are in some ways just too vulnerable to have their own currencies in the modern world. This is sometimes expressed in terms of the metaphor of a tiny rowing boat, tossed around in a turbulent ocean, with the turbulence arising from the vast flows of capital which every day wash backwards and forwards at the click of a mouse. But there are some extremely successful small countries with their own currencies - Singapore and Switzerland spring immediately to mind - and, contrary to popular mythology, the New Zealand dollar is not a particularly volatile currency. Not a particularly volatile currency? No. The Reserve Bank has looked at this issue both in terms of short-term volatility and in terms of the big exchange rate swings which are, I suspect, of rather greater concern. Looking at short-term volatility (measured as 30 day volatility against the United States dollar), the New Zealand dollar was more volatile than the Australian dollar, the British pound, the Japanese yen, and the German mark between the time of the float in March 1985 and August 1988. But for most of the period since September 1988, and indeed on average over that whole 12 year period, the New Zealand dollar has been somewhat less volatile than any of those currencies. Looking at the big exchange rate swings which made life difficult for exporters and those competing with imports at some stages during the last decade, we compared the size of the exchange rate appreciation from trough to peak for each of the same currencies. We found that the maximum appreciation which the New Zealand dollar experienced during the decade (measured on an inflation-adjusted, trade-weighted, basis) was, to be sure, at 29 per cent rather greater than that experienced by the Australian dollar (at 20 per cent), but was closely similar to the maximum trough-to-peak appreciation experienced by the German mark (27 per cent), the United States dollar (also 27 per cent) and the British pound (31 per cent), and very substantially smaller than that experienced by the Japanese yen (62 per cent). In other words, as I have indicated on other occasions and contrary to much current mythology, the big exchange rate swings experienced by the New Zealand dollar during the nineties were not in the least unusual by the standards of other currencies. This suggests rather unambiguously that, while currency union would eliminate nominal exchange rate uncertainty for New Zealand traders trading within the currency union, there is no currency which we could adopt which would eliminate big exchange rate swings against countries outside the currency union. And since New Zealand’s trade with Australia amounts to little more than 20 per cent of the total, a currency union with Australia would still leave most of our exporters facing currency uncertainty. In other words, currency union with Australia would buy nominal exchange rate certainty for those handling little more than 20 per cent of our trade (perhaps especially those in the manufacturing sector), while leaving those handling the other 80 per cent of our trade still facing such uncertainty. And I say currency union would buy some traders “nominal exchange rate certainty” to make it clear that currency union would not buy anybody real exchange rate certainty, or in other words, certainty of a constant exchange rate after inflation has been taken into account. This is something which Hong Kong has discovered over the years. Although it has had a currency which has been tightly tied to the US dollar since the early eighties, its real, or inflation-adjusted, exchange rate has appreciated quite strongly, both because the US dollar has appreciated against most other currencies and because Hong Kong’s inflation rate has been markedly higher than that in the United States. This has led to the steady erosion of the competitive position of Hong Kong’s manufacturing sector, and indeed has been one of the factors leading to a move of manufacturing out of Hong Kong into southern China. The third myth is that a currency union with Australia would greatly increase competition in the New Zealand banking sector, to everybody’s benefit. I find it very hard to see why this might be the case given that all of the large Australian banks are already actively involved in the New Zealand market. Moreover, New Zealand already has an open and contestable banking sector. There are few regulatory obstacles to foreign banks entering New Zealand, provided that they meet certain minimum qualitative criteria. It is clearly not necessary to enter a currency union in order to derive the benefits of foreign competition in the banking sector. In this regard, I was struck by the figures released by KPMG earlier this month, which suggested that the net interest margin earned by the major banks in New Zealand has been falling steadily in recent years, and is now markedly lower than the net interest margin earned by Australian and US banks.1 The fourth myth is that currency union with Australia would somehow suddenly enable the New Zealand economy to grow as quickly as the Australian economy, or enable New Zealanders to be instantly richer. That perception appears to drive quite a lot of the public comment on this matter. But of course that is nonsense. The fundamental driver of living standards in New Zealand is the rate at which we can improve productivity. Currency union may have a modest bearing on our productivity performance, as I will argue in a moment, but fundamentally productivity is about the quality of our education system, the quality of New Zealand management, the incentives provided by the tax and benefit system to work and acquire skills, attitudes to work and leisure, the pace of innovation, and so on. Currency union would have little effect on these matters. Currency union within Australia itself has certainly not guaranteed that economic growth in Tasmania and South Australia will match that in Queensland - any more than currency union within New Zealand has guaranteed that Southland will enjoy Auckland growth rates. And Panama’s adoption of the US dollar in 1904 has not enabled Panama to perform as well as the US economy. Other factors, and other policies, are very much more important for our long-term growth than whether we are part of a currency union. And my final myth is the argument that, because other countries are forming currency unions, or dollarising, New Zealand should do the same. But the reasons why other countries are forming Financial Institutions Performance Survey 2000, KPMG. currency unions or dollarising have very little relevance to New Zealand. The countries of the European Monetary Union formed a currency union, involving a new central bank and a new currency, in a situation where intra-union trade flows were a high proportion of the trade of most of the member countries (certainly a much higher proportion than is the New Zealand/Australia situation), and where currency union was simply one part of a very much wider agenda of political, economic, and regulatory integration. The countries of Latin America have, in some cases, locked themselves to the US dollar, and in some cases are thinking of full US dollarisation, after decades of extremely poor money management and hyper-inflation. Neither of these situations has any relevance to New Zealand. Moreover, in the last few years a large number of countries, particularly but not exclusively in Asia, have moved away from tying their currencies tightly to some other currency, in favour of a floating exchange rate. Certainly there has not been a generalised international move towards currency union or dollarisation. The real economic pros and cons of currency union But there are some valid arguments why a currency union might have economic advantages. To begin with, a currency union seems certain to reduce the transaction costs incurred now by traders and travellers exchanging New Zealand dollars for other currencies. This would probably not produce a huge saving in a currency union with Australia - although there would be worthwhile benefits for tourists in both directions - but, because so much international trade is conducted in US dollars, the savings would be rather greater if we were to adopt the US dollar as our own currency. Second, a currency union with Australia might reduce average New Zealand interest rates a little. Over the last decade or so, Australian long-term interest rates have been pretty similar to those in New Zealand, but for much of that period (though not currently) Australia’s short-term interest rates were appreciably lower than those in New Zealand. Adopting the US dollar would currently reduce interest rates in New Zealand by rather more. Although the differences are much less now than they were a decade ago, US interest rates are currently lower across the entire range of maturities than those in New Zealand. By adopting either the Australian dollar or the US dollar, we would avoid the need to pay the currency risk premium which savers currently demand for holding New Zealand dollar assets. (There could well be on-going differences in interest rates between New Zealand on the one hand and Australia or the United States on the other, of course, arising from credit and liquidity risks, but the differences would be smaller than currently.) But it is also the case that a currency union would remove any chance of New Zealand interest rates falling below those in Australia (or the United States, if it was the US dollar we adopted). While it might seem unlikely that New Zealand interest rates would ever fall below those in Australia and the United States, it is worth recalling that New Zealand’s long-term interest rates were somewhat lower than those in Australia through the first half of the nineties and slightly lower than those in the United States for a time in 1994; and that most interest rates in Canada, Singapore, Switzerland and the European Monetary Union are below those in the United States today. The main reason why New Zealand interest rates have been so high in the last decade is that through much of that period we have been coping with the hang-over of high inflationary expectations, especially in the property market, the result of two or three decades of high inflation bingeing. The United States had very high interest rates in the early eighties, as it grappled with high inflationary expectations. If New Zealand continues to keep inflation well under control, and continues to maintain the confidence of financial markets by following a prudent fiscal policy, it seems entirely reasonable to expect that in time New Zealand interest rates could fall below those in both Australia and the United States. In forming a currency union, we would in effect be betting that, no matter with whom we formed that currency union, their policy performance would be better than our own could have been for the indefinite future. Third, while currency union, with Australia or any other single country, would not eliminate the exchange rate uncertainty which New Zealand exporters face, it would clearly eliminate the nominal exchange rate uncertainty for trade with the country or countries forming part of the currency union (and probably reduce the real exchange rate uncertainty also). As indicated earlier, a currency union with Australia would eliminate nominal exchange rate uncertainty on only a relatively small part of our total trade, but it is quite an important part of our trade in a qualitative sense. A much larger part of our manufactured exports go to Australia than to any other single destination, and the Australian market is particularly important as a “testing ground” for small companies just getting into the business of exporting. As a result of this reduction in exchange rate uncertainty within the currency union, it seems very likely that currency union would stimulate trade with other parts of the currency union. Empirical research on the effects of currency uncertainty on trade is, unfortunately, not very conclusive, with some studies suggesting that the effects of currency uncertainty are actually pretty small and others suggesting that they are quite significant. My own rather subjective view is that a currency union would indeed increase trade between New Zealand and other parts of the union, and that seems to be the view of the business community also. If that is correct, then a currency union, with Australia or the United States, would stimulate trade within the currency union, and to that extent could produce some worthwhile productivity gains, as New Zealand producers moved into areas of greatest comparative advantage. This is probably particularly true of a currency union with the United States. There is already substantial trans-Tasman trade, and for that reason arguably less scope for increasing it through the creation of a currency union. On the other side of the ledger, there would be one potentially major and one more minor disadvantage of a currency union. The potentially major disadvantage would be the loss of an independent monetary policy, and hence loss of a very important way of moderating demand shocks and of any ability to influence our own inflation rate. And this loss would seem to apply whether the currency union was with Australia or the United States, and whether it involved the creation of a new central bank (possible in the case of Australia) or simply dollarisation. (Clearly, in the event of New Zealand’s entering a formal currency union with Australia, involving a new central bank with representatives from both countries and a new currency, New Zealand would have some say in the formulation of monetary policy, but realistically that say could only ever be a small voice alongside the much larger voice of the Australian economy.) Views will differ on how important that loss would be. But we can see from recent international experience that the loss can have very substantial and sometimes very adverse implications. And those implications would potentially be more significant if we were to form a currency union with the United States than if we were to form a currency union with Australia, given the broad similarity between the New Zealand and Australian economies. There seems little doubt that the fact that Argentina has had a more prolonged recession over the last few years than have some of the other major countries of Latin America has been largely a result of the fact that Argentina has been tightly tied to the United States dollar through its currency board arrangement. As a consequence, the Argentine currency has been pushed upwards, along with the US dollar, against the currencies of many of Argentina’s trading partners. Similarly, Hong Kong seems to have had a more prolonged recession than many other Asian economies for the same sort of reason. (Interestingly, during the nineties the trade-weighted real appreciation of the Hong Kong dollar, tied tightly to the US dollar, was much greater than the maximum appreciation of the New Zealand dollar during the nineties.) Conversely, it seems clear that within the European Monetary Union some of the smaller economies such as Ireland have been over-heating rather dramatically recently, with monetary policy determined by the new European Central Bank in the interests of the whole currency union almost certainly too easy for those smaller economies. While that may create prosperity in the short-term, it may create considerable difficulties down the road. I well recall the mid-nineties, when the most common complaint I encountered speaking to audiences outside Auckland was that they were suffering from high real interest rates and a rising real exchange rate even though there was no inflation (so at least it was claimed!) in those areas, the only inflation being confined to Auckland. Even had these claims been true, the reality was that all parts of New Zealand formed then, and still form, a currency union, and there is only room for one interest rate structure and one exchange rate within a currency union. Were we to join Australia in a currency union, our interest rates and the exchange rate we faced would be influenced by the common central bank (in the case of a genuine currency union), or by the Reserve Bank of Australia (in the case of Australian dollarisation). In practice, it would be the needs of the Australian economy which would dominate the monetary policy decisions in either case. And of course, adopting the US dollar would mean accepting whatever monetary policy seemed appropriate for the US economy. This would probably tend to increase the magnitude of New Zealand business cycles, and the variability of New Zealand’s inflation rate. With no ability to use New Zealand monetary policy to deal with these cycles, it would be necessary to use fiscal policy more actively, and to encourage more flexibility, both up and down, in prices and wages, to moderate these cycles. The minor disadvantage of dollarising, and at this point I need to make a distinction between dollarising and forming a currency union where a new currency is established for the countries forming part of the union, would be the loss of what central bankers call seigniorage income. This is the income which a central bank generates by issuing little pieces of paper, or in our case little pieces of plastic, and calling them money. What happens is that we issue these little pieces of plastic in exchange for good value, and we invest that value in government securities at the going market interest rate. The interest income earned is called seigniorage income, and in New Zealand it amounts to about $130 million each year (a currency on issue of a little over $2 billion, invested in government securities to yield somewhat over 6 per cent per annum). If we were to join a currency union modelled on the European Monetary Union, we would retain a share of the seigniorage income appropriate to our relative size in the new currency union. But if we were simply to adopt the Australian dollar or the US dollar, it is very likely that we would lose the benefit of that income to the country whose currency we adopted. Not a huge loss perhaps, but $130 million each year, growing gradually, should not be given away without some thought! How to weight the pros and cons? As I indicated at the commencement of my comments, joining a currency union, or adopting the currency of another country, has potentially important implications which go well beyond economic issues. But even focusing on the economic issues, weighting the various pros and cons is not easy. It is sobering to note that Canada, a country doing almost 80 per cent of its trade with the United States, has nevertheless chosen to retain its own currency. And a recent article by a senior economist at the Bank of Canada argued that, given the way in which Canada’s terms of trade behave relative to those of the United States, having a separate Canadian currency was very much in Canada’s national interest.2 It seems clear from the survey conducted for the Holmes/Grimes study by the National Bank of New Zealand that a substantial majority of the New Zealand business community - or at very least a substantial majority of those who responded to the survey - are in favour of a currency union with Australia. But I am not myself entirely sure what to make of this strong support for currency union with Australia. Of course businesses are in favour of less currency uncertainty. I suspect if the business community were asked if they were in favour of lower taxation they would also register a strongly favourable reaction. The real question is not whether less currency uncertainty would be helpful but whether less currency uncertainty would compensate for the costs of a currency union, such as the risks of greater variability in output and domestic inflation. And the answer to that question is much less clear. To illustrate, let’s suppose there is a sharp fall in New Zealand export prices. With our own currency, this is quite likely to lead to a fall in the New Zealand dollar, as it did in the second half of 1997 and Murray, John (1999), “Why Canada needs a flexible exchange rate”, Bank of Canada working paper 99-12. 1998. This fall in the currency cushions New Zealand exporters to some extent from the adverse impact of the fall in world commodity prices, effectively by spreading the “pain” of that fall across the rest of us, who find that our New Zealand dollars can now buy fewer imports than before. Without our own currency, on the other hand, there is an increased risk that a fall in New Zealand export prices leads to no fall in our (new) currency, our exporters have to suffer the full pain of the fall in international prices, and may well be forced to lay off staff and reduce output. That has an indirect effect, of course, on the rest of the country, but those who are not closely associated with the export industries may be relatively little affected. In the final analysis, the choice of exchange rate regime is mainly a choice about the nature of the pain we prefer to experience as a consequence of international shocks. It does not provide an opportunity to escape the pain inevitably caused by those shocks. Conclusion It would be nice to conclude my comments today with a clear conclusion, or an on-balance judgement. I don’t propose to do that, partly because the decision about currency regime is, as I have indicated, finally a matter for elected politicians not for central bankers, and partly because even the economic pros and cons do not point to a clear conclusion. Moreover, it may well be appropriate to widen the range of options somewhat, and to think more laterally before we reach any conclusions at all. For example, might it be possible to negotiate a comprehensive free trade agreement with the United States as part of a package involving our adoption of the US dollar and surrender of the relevant seigniorage income? Losing the seigniorage income might well be a worthwhile concession in return for a free trade agreement with the US. Clearly, there are lots of potential options. There can be little doubt that this issue will be a matter for public discussion and debate for a considerable time to come. I believe the Reserve Bank has already made a constructive contribution to that discussion, through the publication of a number of papers relevant to the issue. But it is crystal clear that currency union is not a magic path to substantially faster New Zealand growth. It is no substitute for domestic policies that promote stronger productivity growth. It is not an issue which should be decided in haste. And it is not an issue on which the Reserve Bank will be taking sides. Anybody who accuses me of promoting a currency union, or for that matter of opposing a currency union, has not read this speech!
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Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to Belgian Financial Forum, Antwerp Region, Brussels, on 6 June 2000.
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Donald T Brash: Central banks and financial system stability in an uncertain world Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to Belgian Financial Forum, Antwerp Region, Brussels, on 6 June 2000. * * * Introduction I am very pleased to be here in Antwerp this evening, and to have the opportunity of sharing with you some of the Reserve Bank of New Zealand’s views on promoting financial system stability. Everybody in this room is confronted with uncertainty in their daily interface with financial markets. For those of us who are central bankers or bank supervisors, the task is to guide the dynamic, complex and unpredictable processes in financial markets towards outcomes that meet the policy preferences of our country. For the Reserve Bank of New Zealand, our task is to deliver price stability and a sound and efficient financial system within a liberal economic policy paradigm. The uncertain world that we operate in can be highlighted by the relatively frequent and unpredictable episodes of financial instability experienced over the past couple of decades. Since 1980, over two-thirds of IMF member countries have experienced at least one serious banking-sector difficulty. In some countries, bank losses nearly or completely exhausted the banking system’s capital. In some countries, financial collapses have required significant fiscal expenditure to resolve. And, as we all know, national financial crises have been transmitted to other countries, threatening not only the economic well-being of those countries but also the stability of the international financial system as a whole. Oceans of ink have been spilt in analysing the causes of these crises. Most detached observers seem to agree that the underlying problems can be traced to certain fundamental weaknesses, weaknesses which clearly varied from country to country, but which have included poor quality credit analysis by banks and other financial institutions, politically-directed lending by banks, the end of an asset price bubble (typically real estate), sharply increased real exchange rates in a pegged exchange rate situation, distorted incentives in financial markets, and a lack of transparency in financial markets. The widespread incidence and significant economic cost of financial sector problems have prompted calls for concerted international action to promote the soundness of financial systems. These calls have strengthened considerably over the last couple of years. The Basel Committee has been at the forefront of this effort with the release of the Core Principles and proposals for a new Capital Accord. The IMF is making evaluation of financial supervision and regulation part of its annual country reviews, and the World Bank is emphasising the strengthening of financial infrastructure as an important part of its structural assistance programmes. While these international initiatives have many positive features, there are aspects that conflict with our approach to promoting soundness and efficiency of the New Zealand financial system and give us some concern. I will elaborate on these in a moment. At the national level, the preservation of a stable financial system remains one of the most challenging tasks facing governments today. New Zealand is no exception. Not all of you will be aware that New Zealand had its own banking system problems less than 10 years ago. As a result of these problems, our largest bank would almost certainly have failed had the government, as majority shareholder, not been willing on two occasions to provide a substantial capital injection. One very major financial institution (not a bank, but certainly a quasi-bank, and an institution which was in the process of applying for a banking licence) did fail, one of the largest failures in New Zealand’s history. Another bank would have failed had its private sector shareholder not been in a position to inject very large amounts of additional capital, and even after that was done the institution was eventually wound up. At no point did it look likely that the whole banking system might fail, but we certainly had major problems with some of the largest participants in the system. What lessons did we learn from that experience? There were of course a whole host of factors that caused these difficulties. One important factor was the sheer inexperience of many of our bankers: they had been accustomed to a highly protected environment, and were ill-prepared to deal with the demands of a deregulated environment. Nevertheless, I think there were four important lessons that are worth sharing with you. While every country has to make judgements and decisions in the light of its own particular circumstances – and certainly no two countries are exactly alike – some of the lessons we learnt in promoting financial system stability may have relevance to other countries as well. I will deal with the monetary policy lessons last and somewhat succinctly, leaving most of my comments to the prudential policy lessons, where we have moved away from the more traditional ‘rules-based’ approach to supervising banks. I have chosen to dwell mainly on the prudential policy lessons, as it is here that our experience may have more relevance for you. I suspect that I do not have much to offer the National Bank of Belgium on the monetary policy front, given your interests are likely to be more concentrated on monetary union issues with a single monetary policy for the euro area now having been in operation for over a year. (As the issue of currency union for New Zealand is currently a matter of public discussion in my country, if we have time I would welcome any comments members of the audience might want to make on your experience with monetary union so far.) Prudential policy lessons from New Zealand Lesson 1: encourage banks to behave prudently First, I believe it is important that banks are given every incentive to behave prudently. This may seem a self-evident statement, but it is astonishing how frequently the importance of this principle is ignored. In New Zealand’s case, we diminished this incentive to behave prudently by allowing the view to go unchallenged that banks were effectively ‘sovereign risk’, or at least ‘too big to fail’. This meant that bank creditors felt little need to assess the creditworthiness of the banks with which they deposited funds - banks were, it was widely believed, effectively guaranteed by government. Bank boards and managements may have felt similarly protected against the possibility of failure, and made loans with a disregard for risk which was, in some cases, breath-taking. This so-called ‘moral hazard problem’ may have been particularly severe in the case of two of the three institutions which got into serious difficulties in the late eighties, both of them owned wholly or in part by government. There was little or no direction of their lending by government, but the management of both institutions certainly embarked upon lending transactions in the newly liberalised environment which rapidly got them into serious difficulties. For some of the other countries that have experienced financial instability in recent years, it is possible that the incentive for banks to behave prudently was seriously eroded not only by the impression that most large financial institutions would not be allowed to fail but also by the extent to which governments directed the lending activities of the banks themselves. After all, if governments are going to become extensively involved in directing where banks should and should not lend, it is not unreasonable if the banks and their creditors assume that governments will ‘see them right’ if things go wrong. Bank management certainly has little incentive to carefully assess credit risk if, at the end of the day, the decision on whether or not to lend will be made by the bank’s board under the influence or direction of higher political authority. At the moment, as we all know, there is a great deal of international attention focused on how this problem of poor credit decisions in the banking sector can be dealt with. Most of the attention appears to be on how to strengthen external regulation of the banking sector, and how to make banking more independent of political influence. Certainly, freeing banks from political interference in their credit decisions is very desirable, and strengthening ‘rules-based’ banking supervision is one possible way to reduce the risks of future problems in the banking system. But we in New Zealand are not persuaded that strengthening ‘rules-based’ banking supervision is the only way to proceed, or indeed is even necessarily the best way to proceed in all circumstances. When we reviewed what we were doing in banking supervision in the early nineties, we became concerned. At that time, we were conducting banking supervision along conventional Basel Committee lines. We were gathering very large amounts of confidential information from banks on a quarterly (sometimes a monthly) basis. We were laying down a large number of rules and limits designed to ensure that banks behaved prudently. Several things prompted us to review that approach, and one of them was a worry about the risks which we were incurring on behalf of taxpayers. What would happen if, despite our banking supervision, a bank were to get into difficulties? Might depositors argue that they wanted full compensation, since while they had had no knowledge of the bank’s financial condition we in the Reserve Bank were not only fully aware of that condition but were also responsible for laying down the rules and limits by which the bank had been obliged to operate? We consoled ourselves with the thought that our banking supervision was so good that no banks would fail under our watchful eye. But then we looked abroad – at the United States, at Japan, at Scandinavia, at the United Kingdom and at Australia. We found banks going down in significant numbers, despite some extremely professional and politically-independent banking supervision. We could not be confident that traditional banking supervision would prevent bank failure, and we could be confident that, by being the sole recipient of detailed financial information on banks and the main arbiter of what constituted prudent banking behaviour, there was a major risk that we would be held liable, politically and morally if not legally, for any losses incurred by depositors. Then we became aware of anecdotal evidence that our banking supervision was reducing the incentive for bank directors to make their own decisions about crucial aspects of their bank’s operations. In other words, because the Reserve Bank was laying down maximum individual credit limits, and limits on open foreign exchange positions, and guidelines for internal controls, some bank directors were assuming that they were necessarily behaving prudently provided they were operating within those limits and guidelines. They stopped addressing the risks which their own banks were facing and simply complied with the general limits and guidelines. To the extent that that was true – and we found some evidence that it was true in some banks – we concluded that our banking supervision might actually be increasing the risk of bank failure, by reducing the incentive for bank directors and bank managers to make their own careful assessment of risk. The outcome of our review was to substantially strengthen disciplines on the directors and managers of banks to operate their banks prudently, and to strengthen the ability of the marketplace to discipline banks. We also retain a system of supervisory discipline, which we take very seriously. But we retain only a few absolute rules within that framework, principally that all banks must at least meet the Basel capital adequacy rules. We rely mainly on a requirement that banks disclose to the public a substantial amount of financial and risk information quarterly. In addition, all bank directors must sign off these quarterly statements, at the same time attesting to the fact that the internal controls of their banks are appropriate to the nature of their banking business, and that those controls are being properly applied. We in the Reserve Bank do not attempt to tell banks what those controls should look like, but directors signing those quarterly statements without making a careful assessment of the adequacy of internal controls are exposing themselves to very considerable legal risk in the event that their bank gets into difficulty. We have also gone out of our way on a number of occasions to make it clear to the public that neither the Reserve Bank nor the government of New Zealand is guaranteeing individual banks, and we published a booklet designed to assist the general public to interpret banks’ financial information. None of these actions is a guarantee against imprudent bank behaviour of course, but we believe that we have gone a considerable distance towards ensuring that banks face strong incentives to behave prudently. No bank operating in New Zealand is now owned by government, none is guaranteed by government, none is obliged to lend to particular sectors or companies, and our supervision is based heavily on mandatory public disclosure and director attestations. Three years ago, Alan Greenspan commented that ‘regulation by government unavoidably involves some element of perverse incentives. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish.’1 We have tried to minimise those perverse incentives. As William McDonough, President of the Federal Reserve Bank of New York and Chairman of the Basel Committee on Banking Supervision, said in March this year, ‘… given the accelerating pace of change and innovation in the financial services industry, our notion of supervision must encompass discipline applied by the marketplace, as well as official supervision.’2 In New Zealand, our notion of supervision relies heavily on marketplace discipline. Of course, to some extent our approach only works because there is a clear framework of company law which makes it clear that company directors and managers have unambiguous responsibilities. Having agreed accounting rules is important. Having risk-proofed payments systems is important. Having a vigorous media, with probing financial journalists, is also of great value, so that when a bank is forced to disclose to the public a deteriorating financial position, or a breach of one of the few rules we retain, there is at least a reasonable chance of that being picked up and sensibly analysed by the media. Not all countries are so lucky. Where countries do not have this infrastructure in place, a more hands-on involvement by supervisors in banks’ activities may well be appropriate. Where this infrastructure is in place, as it is in New Zealand, we believe that a supervisory regime based largely on self-discipline and market discipline is a viable option. I mentioned a little earlier that we have concerns about some of the international initiatives currently underway to address financial system instability. The major issue for us is that we see some of the initiatives as potentially undermining the incentives we have established for banks to behave prudently. While there is increasing recognition of the need to harness and reinforce market mechanisms in the pursuit of supervisory goals, at the same time the international supervisory community appears to be moving towards an ever more prescriptive and intrusive approach to banking supervision. An example is the supervisory validation and supervisor intervention proposals in the Basel Committee’s June 1999 consultative paper on a new Capital Accord. If these proposals were implemented in New Zealand, they could considerably weaken market incentives and distort the behaviour of bank directors and managers. We see this occurring as a result of the supervisor becoming more directly involved in the management of banks, with the associated risk of the government being drawn in to underwriting banks in times of stress. Another potential risk for us is that, because we do things differently, we might be assessed as not fully complying with the Basel Committee’s Core Principles and other international standards that are being developed. The concern we have is that New Zealand banks might end up being penalised (for example, through higher borrowing costs if risk weights in the Capital Accord are linked to compliance with international standards). This could result if the process of assessing compliance with international standards becomes a ‘one-size-fits-all’, checklist, mechanical tick-the-boxes, approach. We have stressed in our submissions to the Basel Committee that assessing compliance with any international standard needs to be focussed on looking at whether the substance, rather than the form, of the standard is being met. I should add that, notwithstanding these concerns, New Zealand strongly supports the introduction of international standards. We consider international harmonisation and co-operation as very important in what is rapidly becoming a ‘borderless’ global financial system. Our plea is that the implementation of such standards be done with the appropriate degree of flexibility to adequately cater for the individual circumstances of each country. To be frank with you, it is impossible to say for sure whether our prudential policy approach is working or not. We have had no bank failures since the new policy was implemented, but then we had Remarks by the Chairman of the Board of the US Federal Reserve System, Dr Alan Greenspan, at the annual conference of the Association of Private Enterprise Education, Arlington, Virginia, 12 April 1997. Speech by Mr William J McDonough, President of the Federal Reserve Bank of New York and Chairman of the Basel Committee on Banking Supervision, before The Monetary Authority of Singapore, Singapore, on 24 March 2000 no bank failures in the previous 100 years either (although we certainly had some banks which would have failed, in the late eighties, had their shareholders not injected a lot more capital). Moreover, all but one of the 17 banks in New Zealand are now foreign-owned, an increase in the proportion of banks in foreign ownership over the last decade, and that also means that the New Zealand case is not necessarily a compelling demonstration of the validity of our market-based approach. But there has been quite a lot of anecdotal evidence that bank directors are now taking their responsibilities more seriously, and there seems to have been a marked increase in the attention given to internal controls. We had a mild recession in the first half of 1998, and a related fall in the value of the New Zealand dollar of some 30 per cent against the US dollar (from peak to trough), and our banks came through this with absolutely minimal adverse effects, with low ratios of impaired assets and continuing strong profitability. So far at least, we are well satisfied by the way in which the new system is working. To conclude what has been a long first lesson, let me illustrate my main point with a specific event. A few months after the new system first came into operation, at the beginning of 1996, one bank was obliged to disclose to the public the fact that it had had a credit exposure to its shareholder bank which considerably exceeded the limit which we had stipulated for such exposure. The attention focused on this issue by the media, and indeed by other banks, created strong incentives for the bank never to repeat that mistake – quite probably stronger incentives than any threat of central bank sanction could have created. Lesson 2: beware of government ownership of banks and remove barriers to foreign ownership The second lesson from the New Zealand experience in the late eighties is that the ownership of banks is an important issue. For us, the issue was in part government ownership of banks and in part foreign ownership of banks. The government-owned financial institutions almost without exception suffered various degrees of financial difficulty – sometimes because their managers had undertaken imprudent lending, and sometimes because they had been obliged to invest in large amounts of government securities at sub-market interest rates. The large foreign-owned banks suffered to a much more limited extent from the bad debts and losses which the government-owned banks experienced. There have been various reasons given for this difference, but the most plausible is that the large foreign-owned banks were under the watchful eye of experienced parent banks, and were therefore much less able to stray into some of the riskier propositions which tempted the government-owned institutions, especially in the years immediately after the banking sector was liberalised in the mid-eighties. (The newly-arrived foreign-owned banks, however, often did succumb to the temptation of lending on risky propositions, perhaps because, being quite small both in absolute terms and in relation to their overseas parents, they were subject to much less intensive parental scrutiny.) More recently, New Zealand has been running a very large balance of payments deficit, probably amounting to more than 7 per cent of GDP at the present time. This balance of payments deficit has been experienced at a time when the government itself is running a fiscal surplus. In other words, it has been the private sector which has been borrowing heavily from overseas, not the public sector. And while some of this borrowing has been done by the corporate sector directly, much of it has been done by the banking sector. Comparable levels of overseas borrowing by banks in other countries have been sufficient to make foreign lenders very nervous (for example, in some Asian countries in recent years), and yet similar nervousness has not been at all evident in New Zealand. Why? I can only conclude that the foreign lenders take considerable comfort from the fact that most of the banks operating in New Zealand now are in fact wholly-owned by foreign banks, or are indeed branches of foreign banks. Those parents are seen as being financially strong, and fully able to back the operations of their New Zealand subsidiaries or branches. (It may also be relevant that, overwhelmingly, the overseas borrowing being undertaken by New Zealand banks carries no foreign exchange risk for the banks themselves.) In some countries, there is political reluctance to allow foreign institutions unrestricted entry into local banking sectors. I would have to say that, as a country where all but one of our 17 banks are owned and controlled overseas, we have seen absolutely no disadvantages from this situation, and many advantages. We have a financially stable banking sector, with vigorously competing and highly innovative banks, all of them subject to the monetary policy influence of the central bank. I have no doubt at all that the banking sector is considerably more stable than would have been the case had all the banks been domestically-owned, whether in the private sector or in the public sector. Monetary policy lessons from New Zealand Lesson 3: keep prices stable The third lesson from our experience has been the crucial importance for financial system stability of keeping prices stable. I am sure that for this audience the assignment of monetary policy to the objective of keeping prices stable is not extraordinary, as evidenced by price stability being the primary objective of the single monetary policy of the Eurosystem. But let me comment on the link between price stability and financial system stability. By the late eighties, New Zealand had experienced nearly 20 years during which consumer price inflation had been above 10 per cent almost without a break. Interest rates after adjustment for tax and inflation were often strongly negative, and there was as a consequence a strong incentive to invest in real estate and shares, using as much borrowed money as could be obtained. This was undoubtedly an important contributor to the severe difficulties which both the corporate sector and some parts of the banking sector experienced when monetary policy was tightened in order to reduce inflation in the second half of the eighties. Interest rates went up and asset prices went down, and several banks incurred very large losses as a consequence. In New Zealand, monetary policy has been directed at achieving and maintaining domestic price stability since the mid-eighties, with the exchange rate being allowed to float freely since March 1985. Prior to that, the objectives of monetary policy had been much more confused. In New Zealand, as indeed in many other countries, there had been a deeply engrained belief that monetary policy could be used directly to achieve faster growth in output and employment. There was a widespread belief that policy-makers could choose to tolerate a somewhat higher level of inflation in exchange for more growth and a lower level of unemployment. (After all, Bill Phillips of Phillips Curve fame was New Zealand’s best known economist.) Since the mid-eighties, we have accepted that there is no such trade-off between inflation on the one hand and growth or employment on the other, and that the best thing monetary policy can do to foster sustainable growth in output and employment is to deliver predictably stable prices, or a very low rate of measured inflation. And, of course, a sound banking sector is more likely in an environment of steady economic growth. Unfortunately, relatively low consumer price inflation is not always accompanied by low asset price inflation. There is no single explanation for asset price inflation and, as New Zealand itself discovered in the mid-nineties, with quite a strong increase in the price of both residential and rural property, it is often extraordinarily difficult to restrain asset price inflation even when inflation in consumer prices is low. Nevertheless, we are confident that monetary policy targeted on low consumer price inflation in combination with a floating exchange rate is likely to result in a weaker and less sustained asset price cycle than would otherwise be the case. The problems caused by asset price inflation have been well illustrated in parts of Asia in recent years. It is at least possible that asset price inflation in Japan in the late eighties – the reversal of which has done so much damage to bank balance sheets in that country – was a consequence of monetary policy being kept too easy for too long, whether to appease the United States after the Plaza Accord or for some other reason I know not. Similarly, it may well be that if central banks in some other Asian countries had not been so preoccupied with trying to avoid the appreciation of their currencies against the US dollar as capital flowed into these economies in the mid-nineties, their interest rates would have been higher and asset price inflation commensurately reduced. And of course if asset price inflation had been less, the over-investment in certain kinds of real estate would presumably have been less and, with it, the subsequent fall in asset prices. Lesson 4: avoid pegging the exchange rate And that brings me on rather naturally to the final lesson from New Zealand’s experience, and that is the danger of pegging the exchange rate unless one is prepared to go all the way to full currency union as you have done in Belgium, or at least to a currency board, as Hong Kong and some other countries have done. In New Zealand, we had a pegged exchange rate until March 1985, as I have mentioned. Prior to that date, it was not uncommon for companies to borrow overseas, often at interest rates which were very much lower than those within the high inflation New Zealand economy. Some companies made rather spectacular losses when the New Zealand dollar was devalued from time to time, or when, even when pegged, the New Zealand dollar depreciated against the currency in which the loan was denominated. (Borrowing in Swiss francs was particularly popular, and particularly painful, for some companies.) But the losses were probably fairly moderate in comparison to the loss which the government itself incurred on behalf of taxpayers in 1984. In that year, the New Zealand dollar was devalued by 20 per cent after a foreign exchange crisis and the government, which had written very large volumes of forward exchange contracts with companies trying to protect their positions, incurred losses of many hundreds of millions of dollars. Since March 1985, the New Zealand dollar has been freely floating, and indeed I suspect we may be the only central bank that can claim not to have intervened directly in the foreign exchange market for more than 15 years. (I say ‘directly’ because from time to time we did adjust monetary policy when we felt that movements in the exchange rate seemed likely to threaten our single goal of low inflation.) One of the benefits of this has been that, though many companies and banks have borrowed overseas, none of this borrowing was undertaken in the belief that there was no currency risk involved. Overseas interest rates were frequently much lower than those in New Zealand but, after factoring in the exchange rate risk, the incentive to borrow offshore in foreign currency was substantially reduced. As a consequence, when, after a period of strong New Zealand dollar appreciation between early 1993 and early 1997, the New Zealand dollar fell by some 30 per cent against the US dollar, there were very few companies unhappy about that fall – and indeed plenty of exporters who were delighted. Even fewer of our banks were caught out by the depreciation, and to the best of my knowledge none incurred losses as a consequence of the move. Because they knew that the New Zealand dollar was freely floating, they were careful to avoid taking on unhedged positions in foreign currency. Conclusion In conclusion, in a world of open capital markets, the challenges facing banks are very considerable. Central banks can not prevent all banks from getting into trouble, and nor should they try to do so. But central banks do have a responsibility in all our countries to promote the stability of the banking sector. In my own view, they can best do that by creating strong incentives for banks to behave prudently; by discouraging government ownership of banks, and removing barriers to the foreign ownership of banks; by keeping the focus of monetary policy on price stability; and by not creating the impression that borrowing in foreign currency is a riskless activity. We learnt those lessons the hard way.
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Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Electralines Business Breakfast Forum, on 2 August 2000.
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Donald T Brash: Can the Reserve Bank ignore the current increase in inflation? Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Electralines Business Breakfast Forum, on 2 August 2000. * * * Introduction In the middle of May this year, when the Reserve Bank last issued a quarterly Monetary Policy Statement, we projected inflation in the June quarter to be just 0.3 per cent, and inflation in the year to March 2001 to be just 1.6 per cent. What a lot can change in two and a half months! Even before that May Statement was published, the Government had sharply increased the tax on cigarettes, adding around 14 per cent to their price. Within hours of the publication of that May Statement, the trade-weighted measure of the New Zealand dollar had depreciated close to its lowest level in history. Within weeks of the publication of that May Statement, the price of petrol had increased by some 15 per cent, the result of a sharp further increase in the international price of oil and of the depreciation of the New Zealand dollar. As a result, it was clear well before the announcement of the actual inflation figure for the June quarter, of 0.7 per cent, that inflation for that quarter would considerably exceed our original estimate of 0.3 per cent, and that inflation for the year to March 2001 will almost certainly considerably exceed our estimate of 1.6 per cent. Some commentators are suggesting that inflation is now likely to exceed 3 per cent for the year to December 2000, and almost all commentators are at least expecting inflation to well exceed our midMay estimate. What does this imply for the way in which the Reserve Bank implements monetary policy? It is clearly inappropriate for me to speculate on what we may or may not do when we release our August Monetary Policy Statement in two weeks’ time, but I want to use this occasion to reiterate and emphasise some of the points relevant to this issue. In all cases, these points have been made previously, but I suspect that some of them may have been forgotten or ignored. Of caveats and underlying inflation The first point to reiterate is that, from the time I signed my very first agreement with the Minister of Finance (the Hon David Caygill) in early 1990, shortly after the passage of legislation requiring the Reserve Bank to use monetary policy to deliver price stability, the Bank has been expected not to react to price changes arising from things like big changes in international prices and changes in indirect taxes. We used to refer to these things as “caveats”, and to calculate the inflation rate excluding the impact of such “caveatable” shocks. For convenience, we used to refer to the inflation rate excluding such caveatable shocks as the “underlying inflation rate”. In the agreement I signed with the present Minister of Finance, the Hon Dr Michael Cullen, in December last year, as in the agreement signed with the Rt Hon Winston Peters in late 1997, the wording is slightly different from the wording used in 1990, but the substance is the same, namely that: “There is a range of events that can have a significant temporary impact on inflation as measured by the CPI, and mask the underlying trend in prices which is the proper focus of monetary policy. These events may even lead to inflation outcomes outside the target range. Such disturbances include, for example, shifts in the aggregate price level as a result of exceptional movements in the prices of commodities traded in world markets, changes in indirect taxes, significant government policy changes that directly affect prices, or a natural disaster affecting a major part of the economy. When disturbances of (this) kind…arise, the Bank shall react in a manner which prevents general inflationary pressures emerging.” And the Reserve Bank is directed to ignore, or “look through” in the jargon, the price effects of such events not in order to make my life easier but to make your life easier. In other words, the Bank is directed not to react to such one-off price shocks on the grounds that trying to offset them would involve more economic cost than would be warranted. For example, while monetary policy could in principle be tightened aggressively so that other prices in the economy would fall sufficiently to offset the direct price effects of an increase in the international price of oil, the Minister has decided, and I have agreed, that doing that would involve more economic and social damage than could be justified. We no longer calculate “underlying inflation” in the way we used to do, and that is true for a whole raft of reasons, including the fact that there was always some public suspicion that “underlying inflation” was a Reserve Bank invention to help Don Brash keep his job. But the reality which that term reflected is as valid today as it was a decade ago. In other words, we are not interested in trying to use monetary policy to suppress the price changes which emanate from international oil price changes or from changes in indirect taxation. And when we look forward to the end of the year, it seems pretty clear that much of the sharp increase in inflation which is now expected by most commentators will be the direct result of such factors, and should as a result be ignored by the Reserve Bank in setting monetary policy. Partly because we expressly don’t react to certain kinds of price changes, actual inflation can often be expected to fluctuate over quite a wide range - certainly over the full 0 to 3 per cent range, and occasionally outside that range. And we set interest rates with the objective of keeping inflation somewhere near the middle of the target range in one to two years’ time precisely because we know that in practice there will be all sorts of unexpected shocks and developments, ranging from Asian crises to changes in cigarette taxes, which will move prices both up and down, away from that mid-point. We improve our chances of having inflation remain within the target range most of the time by constantly aiming to keep inflation near the mid-point of the range in the medium-term. But we recognise that there will be all kinds of developments which will result in somewhat different outcomes, and indeed should result in somewhat different outcomes. But it is crucially important to stress that the Reserve Bank can ignore the impact of these one-off “shocks” to the inflation rate only if we New Zealanders do not use them as an excuse to start a more generalised and enduring increase in the inflation rate. If a doctor, in reviewing his or her fees, says “Well, the CPI went up by 3 per cent, so I had better put up my fees by 3 per cent also”, then we have a problem. If a producer of widgets sees that the CPI has increased by 3 per cent, and automatically puts his prices up too, then we have a problem. If local authorities see a 3 per cent increase in the CPI as adequate justification for them to increase rates and fees by that amount, then we have a problem. And if wages and salaries are automatically increased by 3 per cent to compensate for the increase in the CPI, then we have a problem. The reality is that, when the international price of oil goes up - to use the current example - we New Zealanders become poorer, and it is utterly futile to suppose that we can compensate ourselves for that fact by giving ourselves higher incomes. To the extent that some New Zealanders succeed in winning such compensation, the gain is achieved at the expense of other New Zealanders, since in aggregate we are all worse off. To put it bluntly, if the Reserve Bank is to be able to “look through” the impact of things like the increase in petrol and cigarette prices in implementing monetary policy, we New Zealanders also need to “look through” the impact of those things on the CPI. To the extent that we don’t, and instead seek compensation for the impact of those things on the CPI, the Bank will need to tighten monetary policy to a greater extent. The only alternative would be permanently higher inflation, and that would help nobody and hurt those least able to protect themselves. In recent years, the Reserve Bank has been happy to report that inflationary expectations are now well anchored at a low level. We have been able to say that, as a result, we expect that smaller adjustments in interest rates will be required to maintain price stability, and of course this is good news. It would be a tragedy if sloppy thinking by price setters, and a return to an indexation mentality, meant that the benefits of those lower inflationary expectations were lost. The impact of the exchange rate on inflation The second point I want to reiterate is the relevance of the exchange rate to inflation. The exchange rate has two effects on the inflation rate. First, there is the more or less immediate impact of movements in the exchange rate on the prices of goods and services which are traded internationally, or which could be traded internationally. We know, for example, that when the New Zealand dollar depreciates the New Zealand dollar price of oil goes up, and the price of petrol goes up with it, quite apart from any impact of an increase in the international price of oil measured in US dollars. Similarly, the price of milk goes up, even though milk is not imported, because the New Zealand dollar price of milk on the international market goes up with the depreciation of the New Zealand dollar. These so-called “direct price effects” of a movement in the exchange rate typically affect New Zealand’s inflation rate quite quickly, usually within six to 12 months. We used to think that a 1 per cent depreciation in the exchange rate would produce an increase in the inflation rate of about 0.3 per cent within 12 months as a result of these more or less immediate direct effects. But for some years now, the impact of a change in the exchange rate seems to have produced a much smaller impact on inflation than that, for reasons which are not entirely clear. The same relatively mild impact of exchange rate movements on inflation has been observed in Australia, Canada, and the United Kingdom in recent years. But whether the impact is as big as we thought it was in the early nineties or as small as it seems to have been more recently, we now recognise that this short-term impact of movements in the exchange rate is not something which always calls for a monetary policy response. This is because the effects of such exchange rate movements on the inflation rate may have come and gone before adjustments in monetary policy can have much offsetting effect on the inflation rate. But again, the Reserve Bank’s ability not to react to the temporary inflation movements associated with exchange rate changes depends on whether we New Zealanders accept that the direct price effects of exchange rate depreciation are not matters which justify our seeking compensation through higher incomes. If we collectively seek such compensation, then the Bank is faced not with a one-off price level adjustment but with the potential for ongoing upwards pressure on prices. In that event, we would have no alternative than to lean against that by running a somewhat tighter monetary policy than otherwise. The second way in which the exchange rate is relevant to inflation is through the effect which the exchange rate has on the demand for New Zealand-produced goods and services. When the exchange rate depreciates, goods and services produced in New Zealand become cheaper relative to the price of goods and services produced abroad. Foreigners seek to buy more of the goods and services produced here, and so also do New Zealanders. In other words, our exports become more price-competitive overseas, and domestically-produced goods and services become more price-competitive vis-à-vis imports. Those producing exports and import-substitutes see an increase in their sales. If they are operating at full capacity, they will seek to expand production by increasing investment and hiring more staff. And this is great - until such time as the demand for additional resources from exporters and those producing import substitutes collides with the demands for resources emanating from the domestic, so-called “non-tradable”, parts of the economy. If the total demand for resources is greater than the resources available, then at some point inflation will begin to develop. So in assessing the appropriate stance of monetary policy, the Reserve Bank can not ignore these indirect effects of the exchange rate on the total demand for New Zealand goods and services. The exchange rate is always relevant to assessing the appropriate stance of monetary policy. Does this mean that the Reserve Bank has some secret exchange rate target, or perhaps some secret exchange rate floor? Does it mean that we might increase interest rates to “prop up” the exchange rate? Absolutely not. It just means, to repeat, that we have to set overnight interest rates in recognition of these medium-term effects of the exchange rate on total demand. If the export sectors, and the sectors supplying import substitutes, were demanding more resources than the domestic sectors of the economy were willing to release, then interest rates would need to rise somewhat to avoid that conflict generating on-going inflation. Does this mean that the Reserve Bank has resurrected the Monetary Conditions Index (MCI)? Absolutely not again, if by that is meant: are we seeking some semi-automatic movement in interest rates to offset movements in the exchange rate? If the exchange rate moves, either up or down, we always have to try to assess the reasons for that movement. It may be, for example, that a depreciation in the exchange rate reflects actual or potential weakness in international commodity prices which would have a disinflationary impact on the economy fully offsetting the inflationary impact of the depreciation, thus requiring no offsetting interest rate increase. But the exchange rate does affect the demand for New Zealand-made goods and services, and therefore has medium-term implications for the inflation rate. So while we can often ignore the direct and relatively immediate price effects of movements in the exchange rate, assuming that these direct price effects do not generate “second-round” inflation pressures, we can not ignore these medium-term implications. Monetary policy and the balance of payments deficit Finally, allow me some observations on the relationship between monetary policy and the balance of payments. I have often argued that monetary policy has no ability to influence the balance of payments deficit, certainly on any kind of sustainable basis. Indeed, I do not even know whether, if I were instructed to use monetary policy to reduce the deficit (through the Government’s using the so-called “over-ride” provision in the legislation), I would be tightening or easing monetary policy. Tightening policy would presumably cause the exchange rate to appreciate, making the deficit larger, but might also slow domestic demand, making the deficit smaller. The problem arises from the fact that no central bank has discovered a reliable technique for changing the mix of monetary conditions so that, for example, monetary policy could be tightened through an increase in interest rates without at the same time putting upward pressure on the exchange rate. I have also argued in the past that, eventually, in a situation where the exchange rate is floating and the government is running a fiscal surplus, the balance of payments deficit would reduce of its own accord. That is based on a recognition that, in those circumstances, a balance of payments deficit reflects the fact that the private sector is spending more than its income - or in other words, is a net borrower - and that this situation is unlikely to continue indefinitely. At some point, either New Zealanders will decide to borrow less or foreigners will decide to lend us less. If foreigners tire of lending us their savings before we New Zealanders tire of borrowing them, the likely outcome is a change in the mix of monetary conditions, in the direction of a lower exchange rate and somewhat higher interest rates. We know that such a change in the mix of monetary conditions tends to reduce the balance of payments deficit (and if we had had any doubts on this score they would have been allayed by the speed at which the large balance of payments deficits which some Asian countries had prior to the recent crisis were converted into surpluses). The concern which I have expressed on previous occasions, however, is about the social and economic costs which might be paid if the change in the mix of monetary conditions takes place too abruptly, as it certainly did in the Asian crisis economies. It is at least possible, however, that what we have been witnessing in recent months is in fact a gradual change in the mix of monetary conditions of the sort which will, over the next few years, see quite a significant reduction in the balance of payments deficit. Certainly the exchange rate, on any measure, is at an historically low level and is providing strong stimulus to export industries and to those producing import substitutes. Interest rates are not at a particularly high level - indeed, they are well below the levels reached in the mid-eighties and mid-nineties, at least in nominal terms - and I suspect that that may have something to do with the fact that New Zealanders are getting a little less enthusiastic about borrowing at much the same time as foreigners are getting a little less enthusiastic about lending us their savings. But it is important that we all understand what curing the balance of payments deficit implies. It implies that for a period of some years those producing exports and import substitutes will enjoy rather stronger levels of growth, in sales and incomes, than those producing goods mainly for the domestic market. In plain English, that means that farmers, export manufacturers, fishing companies, tourist operators, and the like are likely to be relatively prosperous, while those in industries such as construction and retailing may be somewhat less so. It implies that consumption spending may grow rather more slowly than total disposable income, with the difference going into increased saving. It implies that interest rates may favour savers rather than borrowers for a period, and that as a consequence household sector borrowing may grow more slowly than household sector income, rather than substantially faster than household sector income, as for the last 15 years. None of these changes would be good or bad in themselves, though no doubt there would be many who would welcome signs that we New Zealanders have an ability to live within our means. But they would certainly involve changes which we would all need to be mindful of in interpreting economic indicators. For example, whereas once upon a time the state of the residential building industry was of fundamental importance in assessing the strength of the New Zealand economy, it may well be that over the next few years, as resources are attracted into export and import-competing industries, the residential building industry becomes a little less important in a relative sense. Similarly, the rate at which consumer spending grows may slow somewhat in the years ahead, after a period during which it grew substantially faster than household sector income. At the same time, we may see strong growth in industries, and regions, which have a heavy emphasis on exporting. Mr Chairman, as you can see, I have been careful to avoid giving even the slightest hint about what the Reserve Bank will be saying in its Monetary Policy Statement in two weeks’ time. But I have appreciated this opportunity of putting that Statement into context, and repeating some of the messages which may have been lost sight of in recent months. Most important of all, the Bank’s ability to ignore the “spike” in inflation which seems likely to lie ahead of us depends crucially on the willingness of New Zealanders themselves to ignore that spike in negotiating increases in their own incomes. If they do not, there can not be the slightest doubt that monetary policy will need to be tighter than would otherwise be the case.
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Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the American Chamber of Commerce, Auckland, on 5 October 2000.
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Donald T Brash: The fall of the New Zealand dollar - why has it happened, and what does it mean? Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the American Chamber of Commerce, Auckland, on 5 October 2000. * * * Introduction Over the last few weeks, the most common questions I have been asked at public meetings up and down the country have concerned the New Zealand dollar exchange rate. Why has it fallen so steeply? What does it mean for New Zealand’s future? Will it continue to fall from here? Why doesn’t “somebody” - by which most people mean either the Government or the Reserve Bank - do something about it? While some of these questions can not be answered with any degree of certainty, it may be helpful to put a Reserve Bank perspective on them. Why has the New Zealand dollar fallen so steeply? First, a few facts. Between its peak of more than 71 US cents in November 1996 and its trough of just over 40 US cents at present, the New Zealand dollar depreciated by some 44 per cent against the US dollar, a substantial depreciation over less than four years in anybody’s language. Measured against the Reserve Bank’s trade-weighted index (TWI), which measures the New Zealand dollar against a basket of five currencies, the fall was somewhat less dramatic, from 69 in late April 1997 to around 47 at present, but that still represented a depreciation of 32 per cent. Whether measured against the US dollar or against the TWI, the New Zealand dollar is currently close to its lowest level in history. Why has this happened? I think the first point to make is that, at its most recent cyclical peak in late 1996 or early 1997 (depending on which measure is used), the New Zealand dollar was almost certainly over-valued. Inflationary pressures had been strong in 1995 and 1996, and monetary policy needed to be firm in order to deal with those pressures. In part, this was reflected in an appreciation in the exchange rate, to the point where exporters, and those competing with imports, were in many cases under considerable pressure. In other words, some of the fall in the exchange rate over the last few years has simply reversed the over-valuation of 1996 and early 1997. But that still leaves a lot of the depreciation unexplained. Once upon a time, it used to be argued that what drove exchange rates was differences in national interest rates, and the strong appreciation of the New Zealand dollar in the mid-nineties was substantially explained in these terms, as I have indicated. Our interest rates were well above those in major capital markets, and this attracted foreign savings into New Zealand, thus pushing up the exchange rate. But in recent times Japanese interest rates have been well below those in, say, the United States, yet the Japanese yen has been one of the few currencies to remain reasonably stable against the US dollar. And over the last six months, central banks in several countries, including both New Zealand and Australia, have seen their currencies fall despite increases in official interest rates which have been broadly similar in magnitude to those in the United States. There is certainly more to it than interest rate differentials. Once upon a time, it used to be argued that what drove exchange rates was differences in national economic growth rates, perhaps because of a perception that countries with relatively rapid economic growth were more likely to attract investment capital, or to have to push up interest rates to control inflation, both factors likely to encourage an appreciation in their exchange rates. But in recent times, Australia’s exchange rate has fallen despite its economic growth being very similar to that in the United States, whereas Japan’s exchange rate has not fallen despite Japanese growth falling well short of America’s. There is certainly more to it than growth differentials. Once upon a time, it used to be argued that what drove exchange rates was differences in balance of payments positions, with countries having large current account deficits (like New Zealand) tending to have weak exchange rates and countries having large current account surpluses (like Japan) tending to have strong exchange rates. Well, Japan has certainly had a strong exchange rate and New Zealand has certainly had a weak exchange rate in recent times, but New Zealand’s exchange rate rose strongly through the mid-nineties despite our relatively substantial current account deficit, and the United States, with a strong currency, currently has the largest current account deficit for many years. Indeed, America’s current account deficit, while smaller than New Zealand’s relative to our respective GDPs, is now larger relative to America’s exports of goods and services than is New Zealand’s deficit relative to our exports of goods and services. The countries of the European Monetary Union have a net current account position which is very close to balance at present - neither surplus nor deficit - but the euro has been depreciating more or less steadily since its inception at the beginning of 1999. There is certainly more to it than current account deficits. Once upon a time, it used to be argued that exchange rate movements reflected financial market perceptions of the political complexion of the relevant governments, with the exchange rates of countries with “left-wing” governments tending to depreciate and the exchange rates of countries with “right-wing” governments tending to appreciate. In recent months, the Australian dollar has depreciated a little less than has the New Zealand dollar, and since Australia has a right-of-centre government and New Zealand a left-of-centre government that could be seen to lend some credibility to this theory. But on the other hand, since last year’s election there has been no discernible increase in the margin between yields on New Zealand government 10-year bonds on the one hand and yields on 10-year Australian government bonds and 10-year US Treasuries on the other, suggesting that financial markets in fact see no increase in the risk on New Zealand bonds as a result of the change in government. There is certainly more to it than politics. There are, of course, lots of other explanations offered for movements in the exchange rate, and it is not my purpose here to offer a comprehensive list of those explanations. I suspect that a whole range of factors explain the recent depreciation of the New Zealand dollar, including our large balance of payments deficit (and large accumulation of external liabilities as a result of running a balance of payments deficit for almost three decades); a perception that New Zealand (like Australia) is an “old economy” where things are made or grown, rather than a “new economy” of bright ideas and high productivity; the absence of any particular “reason” to buy New Zealand dollar assets now that our interest rates are closely comparable to those in major capital markets; and some nervousness on the part of financial markets (whether warranted or not) about the policy direction of the Government. In part at least, the “fall of the New Zealand dollar” is really a story about the rise of the US dollar. The US economy has been growing strongly, and the US equity market has risen very strongly over the past decade. This has attracted into the US savings from all over the world. Not surprisingly, the US dollar has risen as a result, not just against the New Zealand dollar but against a great many other currencies also. Between the beginning of 1999 and the end of September this year, for example, the Australian dollar and British pound depreciated by about 12 per cent against the US dollar, the Swedish and Norwegian currencies by about 16 per cent, the Swiss franc by about 21 per cent, the New Zealand dollar by about 23 per cent, and the euro by almost 25 per cent. Clearly, the fall in our currency is not just the result of the New Zealand dollar being the currency of a small economy: the currencies of much larger economies have also fallen significantly against the US dollar in recent times. And over and above all these fundamental factors, there is the possibility - indeed the probability - that some of the depreciation simply reflects the dynamics of the foreign exchange markets: various forms of “reef-fish” behaviour, to use former Prime Minister David Lange’s expression, have almost certainly been at play. In short, the facts make it clear that there is no single, simple, explanation for the fall in the value of the New Zealand dollar over the last two or three years. It follows that exaggerated claims that the fall can be pinned on just one thing - whatever that one thing might be - are almost certainly wrong, and are unhelpful in improving our understanding of the implications. At this time, we need cool heads and rational thinking, not extravagant claims or counter-claims. What effect will the fall in the exchange rate have on our economy? Whether the depreciation in the New Zealand dollar has a relatively minor effect on the New Zealand economy or a more substantial effect depends in part on whether the depreciation is in reality just the other side of the strong appreciation of the US dollar - and so likely to be reversed reasonably quickly if the factors which have driven US dollar strength abate; or whether it is in some sense part of a long-anticipated market reaction to New Zealand’s specific circumstances, such as our large balance of payments deficit and very large accumulated foreign liabilities - and so likely to be more enduring. Whatever the real explanation - and it seems to me very likely that there are aspects of both stories in the present situation - the direct and fairly immediate effect of the fall in the exchange rate is that the New Zealand dollar price of the goods and services which we import, and of the goods and services which we export, will go up. (And this includes the New Zealand dollar price of things which could be exported, such as milk and meat, because the prices of goods of this kind are also directly affected by the depreciation of the exchange rate.) These price rises will not happen instantaneously, particularly where importers and exporters have covered their foreign exchange risk in the forward market. To the extent that that has happened, it will take a little while for the New Zealand dollar prices of imports and exports to go up. But go up they certainly will. (Not all of those price increases will reach consumers in full, however, if some of the price increases are absorbed out of the margins of foreign exporters or local importers and distributors. Moreover, a decline in the quality of some goods, difficult to measure accurately in the CPI, may also mask effective price rises.) The effect of these relative price changes - where the prices of imports, import substitutes, and exportable goods and services go up relative to the prices of things which can only be traded within the New Zealand economy - will be to increase the income of those of us producing goods and services which are exportable, or which compete with imports, relative to the rest of us. And in that sense the lower exchange rate can be seen as a healthy development. It is the floating exchange rate at work, encouraging the production of goods and services which will reduce our balance of payments deficit and discouraging the consumption of goods and services which are imported or could be exported. To the extent that the low exchange rate persists, and is not negated by higher domestic inflation, this is likely to see stronger growth in exports of goods and services, slower growth in imports of goods and services, and a reduction in New Zealand’s balance of payments deficit on current account. And happily, unlike many of the countries which saw bank and corporate balance sheets devastated when their exchange rates fell sharply during 1997-98, the fall in the New Zealand dollar has had only minimal effect on bank and corporate balance sheets here. Yes, there are a few companies which wish they had not taken out so much forward cover on their export receipts when the exchange rate was higher. But these contracts represent “profits foregone”, not the kind of disasters which wiped out so many banks and corporates in Indonesia and Thailand when their exchange rates fell. And the reason for this is that, perhaps because New Zealand has had a freely floating exchange rate for more than 15 years now, banks and corporates in New Zealand tend not to borrow overseas in foreign currency without hedging the exchange rate risk. Indeed, at the end of March last, the Government Statistician estimates that some 97 per cent of all overseas liabilities owed by banks and corporates in New Zealand were “hedged”, roughly one-third of it through some kind of natural hedge and the balance hedged through financial markets. So there appears to be little risk of the depreciation in the New Zealand dollar having any significant adverse impact on the financial strength of the New Zealand financial system or corporate sector, and of course the New Zealand government now has no net foreign-currency-denominated liabilities at all. But there is one important caveat to this positive story. A currency depreciation does not make the country better off, at least in the short term: it simply redistributes income, or at least the purchasing power of income, from some New Zealanders to other New Zealanders. Some of us are made better off by the depreciation; some of us are made worse off. But if those of us who are made worse off by the depreciation - those of us, in other words, who face higher prices for petrol, and milk, and meat, and clothing, and TV sets, and cars but get no “offset” through producing higher-priced exports or import-substitutes - fight hard to retain our real income, by pushing up our prices, fees, wages, and salaries, then of course the whole process becomes much more painful. And this is where the Reserve Bank is relevant. As I said in a speech in Kapiti early in August, the Bank may be able to ignore the initial, direct, impact of a fall in the exchange rate on prices, but our ability to do that “depends on whether we New Zealanders accept that the direct price effects of exchange rate depreciation are not matters which justify our seeking compensation through higher incomes. If we collectively seek such compensation, then the Bank is faced not with a one-off price level adjustment but with the potential for ongoing upwards pressure on prices.” And that not only has the potential to produce ongoing inflation, but at least for a time may frustrate the very shift in relative incomes and prices which is required to reduce the current account deficit, and which the depreciation would otherwise produce. If the Bank were obliged to tighten monetary policy because of ongoing upwards pressure on prices, the result would probably be at least a temporary increase in unemployment and a loss of output. On the other hand, if the Bank failed to lean against that inflation, we would almost certainly see not only the economic and social damage of the inflation itself but also a still lower exchange rate - and still a need to tighten monetary policy, indeed by even more, to reign that inflation back in. There can be no doubt that, if we see prices, and fees, and wages, and salaries beginning to suggest ongoing inflation, as distinct from the first round effects of the depreciation, the Bank will tighten monetary policy. Beyond the direct price effects of the depreciation, over the longer-term the depreciation will, if sustained, encourage people and capital to move out of industries serving a primarily domestic market (such as residential construction and retailing), and into industries producing goods and services for export, or in competition with imports (such as agriculture, forestry, manufacturing, tourism, fishing, horticulture, viticulture, software, and so on). Thus, to the extent that the exchange rate depreciation reflects the need for a movement of resources from so-called “non-tradable sectors” to “tradable sectors”, it is entirely healthy, is consistent with a reduction in the country’s balance of payments deficit, and may well lead to a better allocation of resources and thus a somewhat faster rate of economic growth in the medium term. Even so, if the tradable sectors have a very strong demand for people and capital, at some point that has the potential to lead to inflation unless the non-tradable sectors are simultaneously releasing people and capital. The Reserve Bank again makes its best contribution to this process by ensuring that inflation is kept under control, because it is the emergence of inflation which signals that the total demand pressures on the country’s resources are beginning to exceed the country’s capacity to supply. To sum up this point, the fall in the exchange rate has the potential to produce quite a major change in the structure of the New Zealand economy, to the point where we may see a significant reduction in the size of current account deficits. The Reserve Bank best ensures that that happens, however, by leaning against any attempts by those of us in non-tradable sectors to resist the fall in our real income that that depreciation inevitably means - or in other words, by leaning against any “second-round” inflationary pressures resulting from the depreciation. Will the New Zealand dollar continue to fall from here? Let me quickly say that I do not know the answer to this question. Nobody does. If you had asked me three months ago whether the New Zealand dollar would reach 40 US cents, I would have replied that I thought that that was very unlikely. So clearly I can not rule out the possibility that the exchange rate will fall further. But I do nevertheless believe that over the longer term we will see some strengthening of the New Zealand dollar. Work we are doing at the Reserve Bank using a variety of approaches to the determination of New Zealand’s “equilibrium exchange rate” strongly suggests that the “equilibrium exchange rate” is higher than the exchange rate we have today. One major investment bank which specialises in the analysis of currency trends has recently cut its forecast of the New Zealand dollar exchange rate in three months’ time from 52 US cents to 48 US cents, a reduction certainly, but still well above the current exchange rate.1 Some other commentators are less bullish, but I know of none which is suggesting that the New Zealand dollar should be lower on fundamental grounds. And if the currently-low exchange rate does in fact produce the reduction in the balance of payments deficit which seems likely, then in due course the confidence of both local and overseas investors in New-Zealand-dollar-denominated assets will return, and some appreciation of the exchange rate with it. Why doesn’t “somebody” do something about the low exchange rate? Well, rather than waiting for that return of confidence, or for a reduction in the extent to which the US is dominating investors’ radar screens, is there anything which might be done to reverse the decline in the exchange rate more quickly, if that were thought desirable? In principle, there are three things that might be done to try to achieve this objective. First, the Government or the Reserve Bank could try “jaw-boning” the dollar up. In other words, we could make impassioned statements about how much we believe the New Zealand dollar to be under-valued and how strongly we expect the exchange rate to rise. Alas, experience here and abroad with statements of this kind, at least when taken in isolation, suggests that they typically work for about 15 minutes. Secondly, the Reserve Bank could tighten monetary policy by increasing interest rates. When interest rates are increased in response to an increase in inflationary pressure, tightening monetary policy is seen as a sensible thing to be doing and therefore something which is likely to endure for at least a time. But when interest rates are simply increased in response to a weak exchange rate, in the absence of inflationary pressure, financial markets recognise that higher interest rates are likely to be a temporary phenomenon, followed by lower interest rates. In this situation, not only may an increase in interest rates not help to support the exchange rate, it may actually cause a further decline in the exchange rate. Thirdly, the Reserve Bank could intervene directly in the foreign exchange market, by buying New Zealand dollars with some of the foreign exchange reserves which we currently hold. Many central banks intervene in the market for their currency, and the New Zealand central bank is unusual, perhaps unique, in not having done so in the more than 15 years since our currency was floated in March 1985. We have never ruled out the possibility of intervening in the market for the New Zealand dollar to counteract “disorderly market conditions”, but to date we have not been satisfied that “disorderly market conditions” exist. Should we be intervening to reverse the “over-shooting” part of the recent sharp depreciation? So far at least we have not been persuaded that such intervention would be likely to have any large or lasting benefit. At best, it might knock the “tops and bottoms” off the exchange rate cycle, or perhaps arrest a trend where those trading on that trend are the dominant influence on the market. And offsetting those potentially modest gains, there would of course also be some real risks and potential costs to New Zealand taxpayers associated with such intervention. The Weekly Analyst, Goldman Sachs, 19 September 2000. In short, there appears to be no quick or easy course of action which could be reasonably assured of reversing the decline in the New Zealand dollar, even if there were full agreement on the desirability of that. What about a currency union with Australia? Would this help? I dealt with some of the economic pros and cons of currency union in a speech some four months ago,2 and I do not want to add to that at this point. But it is important that nobody think that currency union is a silver bullet, a panacea either for the current weakness in the exchange rate or for the performance of the economy more generally. The Australian dollar is also close to its lowest level ever at present, so that a combined Australian-New Zealand currency would almost certainly be weak at present also. And of course almost nobody on the Australian side of the Tasman is talking about a currency union, and almost nobody on the New Zealand side is talking about our simply adopting the Australian dollar. The likelihood of a currency union any time soon therefore seems extremely low, whatever the merits and demerits of such a union. No, there is no quick or easy way to reverse the recent decline in the New Zealand dollar. We need to recognise that a significant part of the depreciation since early 1997 has simply been the reversal of an over-valued currency at that time, and as such has been desirable. We need to recognise that another significant part of the depreciation is simply a reflection of the strength of the US dollar, and as such may not continue indefinitely. And in part we need to recognise that the depreciation is a market adjustment to our longstanding tendency to spend beyond our means, borrowing the savings of other countries to do so. Our best course of action, indeed perhaps our only sensible course of action, is to continue doing the things which will make us a prosperous economy - continue to run fiscal surpluses, continue to keep inflation low, continue to improve the flexibility of the economy, continue to remove regulatory barriers to resource mobility, continue to improve incentive structures so that investment goes into those areas with the highest social and economic return, continue to ensure that governance structures in the banking and corporate sectors encourage prudent behaviour, continue to improve the education system, continue to welcome foreign investment, and do everything possible to encourage a culture which values initiative, innovation, hard work, saving and all the rest. Sound policies across the whole breadth of the economy are the best way of ensuring that the exchange rate recovers over the medium term, and of course the best way of ensuring prosperity for all New Zealanders as well. A prosperous New Zealand, with low inflation, will enjoy a strong currency over the long term, and productivity growth to justify that strength. The Pros and Cons of Currency Union: A Reserve Bank Perspective, a speech to the Auckland Rotary Club on 22 May 2000.
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Speech by Mr Murray Sherwin, Deputy Governor of the Reserve Bank of New Zealand, to the Bank of Thailand Symposium "Practical experiences on inflation targeting", held in Bangkok, on 20 October 2000.
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Murray Sherwin: Institutional frameworks for inflation targeting Speech by Mr Murray Sherwin, Deputy Governor of the Reserve Bank of New Zealand, to the Bank of Thailand Symposium “Practical experiences on inflation targeting”, held in Bangkok, on 20 October 2000. * * * Introduction Governor, distinguished guests, fellow central bankers, ladies and gentlemen. It is always a pleasure to find an opportunity to visit Thailand and this is no exception. Thank you, Governor, for the invitation. It is also a considerable honour to be invited to address this symposium on the subject of inflation targeting. The subject of today’s deliberations is an important one and I applaud the Bank of Thailand’s decision to convene this public symposium to air the issues. That decision is in the best traditions of transparency which characterises inflation targeting central banks. I have been asked to discuss institutional frameworks for inflation targeting. Inflation targeting has attracted increasing attention around the world over recent years. We have seen this approach to monetary policy spread from the small, open, OECD economies to a number of the emerging economies - in Eastern Europe, Latin America and now in Asia. The concept first emerged in my own country, New Zealand, in the late 1980s. In our case, it gained a formal institutional structure with the passage of a new charter for the Reserve Bank of New Zealand in 1989. Inflation targeting arose in New Zealand in an environment that will seem rather familiar to many of our Asian friends - at least in some important respects. It was developed in a very small, open economy that was adjusting to a newly-opened capital account, a newly-floated exchange rate, and newly-deregulated financial markets. It was developed with the recognition that a more traditional structure for monetary policy, perhaps one focused on targeting particular definitions of money supply, was likely to prove inadequate in this newly deregulated and rapidly evolving environment. While many other countries have now adopted inflation targeting, each country brings its own history, traditions and institutions to these decisions. For that reason, we find a variety of institutional structures are utilised. My comments today obviously will draw heavily on the New Zealand regime. And while I will attempt to generalise the lessons we have learned, and to draw from the experience and structures of other inflation targeting central banks, it is important to highlight up front that there are few fixed points for the architects of a new inflation targeting regime to fasten on. We are still learning and adapting as we go. So too are other inflation targeting central banks. Context These are awkward times for small, open economies as they struggle to find monetary and financial structures that will facilitate growth, prosperity and stability in a world characterised by increasing openness to trade and capital flows and, it seems, increasing volatility. The events of 1997 and 1998 demonstrated how rapidly stresses in one economy can be transmitted to others. They also underlined just how important are strong institutions, strong balance sheets - in both the public and the private sector - and strong risk management practices to ensuring robustness in the face of shocks. Dr Grenville, our next speaker, will deal with the issues of inflation targeting in a world of volatile capital flows. I see that as a key component of our discussions today because we know that we have to be able to devise structures that enable us to live in such a world. The evolution towards more open capital accounts and greater capital mobility is being driven largely by technological developments. Those new technologies bring us all enormous advantages and are fuelling extraordinary growth internationally. The challenge we all face is how to gain the advantages of the new technologies without being swamped by their other consequences - such as the enhanced mobility of capital, of goods, ideas, skills, people and resources generally. Amongst other things, this requires us to find institutional and policy structures that enable us to take advantage of the new technologies while acquiring the flexibility to adapt rapidly and without undue stress to new developments and shocks. The institutional structure employed for the conduct of monetary policy is just one of the factors that policymakers need consider in thinking about these issues. Trade policy, prudential regulation, accounting and audit standards, legal structures and bankruptcy provisions - amongst other elements of policy - are all very important and should not be overlooked in the design of robust institutional frameworks. But today we are here to consider just monetary policy. What is inflation targeting? First, a couple of definitional points to help locate the discussion we will be engaging in over the rest of the day. What is inflation targeting? A substantial study of inflation targeting was published in 1999 by Ben Bernanke, Thomas Laubach, Rick Mishkin and Adam Posen.1 In their book, they described it in the following way: “Inflation targeting is a framework for monetary policy characterised by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy’s primary long-run goal. Among other important features of inflation targeting are vigorous efforts to communicate with the public about the plans and objectives of the monetary authorities, and, in many cases, mechanisms that strengthen the central bank’s accountability for attaining those objectives.” In providing that definition, the authors of this study take some care to describe inflation targeting as a framework as opposed to a rule. In other words, inflation targeting fits somewhere between the extremes which feature in the “rules versus discretion” debate which raged in monetary policy circles in earlier years. Inflation targeting is not “automatic” in the sense of a Friedman-like rule by which growth in the money supply is governed in order to achieve the ultimate goal of price stability. But nor does inflation targeting allow the central bank full discretion to take decisions in any ad hoc or unconstrained fashion. Rather, inflation targeting can be described as a form of “constrained discretion”. To quote Bernanke et al again, “By imposing a conceptual structure and its inherent discipline on the central bank, but without eliminating all flexibility, inflation targeting combines some of the advantages traditionally ascribed to rules with those ascribed to discretion.” Of course, even within an inflation targeting regime, countries can choose the nature or extent of discretion they wish to leave with their central bankers. Such flexibility is one of the prime attractions of the inflation targeting approach. In New Zealand, the development of inflation targeting owed a lot more to the Harvard Business School than to the Chicago monetarists we are sometimes accused of following. The Reserve Bank of New Zealand was just one of a number of state agencies in the process of undergoing reform in the late-1980s, and the guiding principles for those reforms came from the text books on corporate governance rather than from those on monetary policy. The key concerns were for organisational effectiveness, with state agencies generally required to: • establish clear objectives; • provide for clear divisions of responsibility between the key decision makers; Bernanke et al, 1999 • provide for clear delegations of decision-making power which are aligned with the established responsibilities; • specify clear accountabilities so that those given the authority to make decisions may be held firmly accountable for the quality of their decisions; and • ensure transparency, so that all can see what decisions have been taken, by whom, against what objectives, and for what reason. Applying those principles to the central bank, we can see how the inflation targeting framework falls out fairly naturally. In the case of the Reserve Bank of New Zealand: • The objective is clear - we must deliver inflation outcomes of between 0 and 3%. • Also clear is the division of responsibility - it is the Governor who is solely charged with delivering the agreed inflation objective. • To that end, the Governor has decision-making authority required to undertake the task delegated to him - ministers are not consulted on monetary policy matters in the normal course of events. Indeed, to preserve the independence of the central bank, ministers are not informed of our periodic monetary policy decisions until just ahead of the public announcement and well after the decisions have been formally committed. • Having assigned the Governor the responsibility and authority to make decisions in line with the specified objective, we have a board of directors whose primary task is to monitor the Governor’s performance and thereby to hold him accountable for the quality of his decisions. Ultimately, the board could recommend the Governor’s dismissal should they feel that he is not diligently or competently pursuing the objective established for him - although, of course, there are intermediate courses of action available to the board before reaching such a drastic conclusion. • And finally, our framework demands a high degree of transparency. For example, the formal target for monetary policy is established in a published agreement. The Bank is obliged to publish formal statements laying out how monetary policy has evolved and why, and pointing the way forward for future decisions. A Select Committee of the Parliament routinely reviews the Bank’s conduct of policy in a public hearing. And while the Act provides for the government to over-ride the agreed policy targets agreement in certain circumstances, it also requires that to be done in a public process. Specific issues of institutional form Let me deal with a selection of the more specific issues which emerge in the design of an inflation targeting regime. This is necessarily just a small subset of the issues we could discuss, but hopefully I can shed some perspectives on some of the more significant institutional choices. An independent central bank? Inflation targeting and central bank independence tend to go hand in hand although it is certainly possible to conceive of structures where that is not the case. The case for central bank independence is well understood and well covered in the literature on time inconsistency. In essence, the public, and particularly its elected representatives, are likely to face incentives which bias them in favour of tolerating the risk of increased inflation. That bias emerges as a consequence of the long and variable lags associated with monetary policy decisions. The benefits of long-run price stability lie in the future. The costs that may be associated with attaining or preserving price stability are borne up front. And faced with the immediate imperatives of political life, our democratic representatives face pressures to defer the immediate investment in future price stability in favour of the immediate benefits of lower interest rates and/or faster growth. An independent central bank specifically charged with maintaining price stability, effectively empowered and resourced to do the job, and held accountable against the achievement of that objective, is a fairly logical response to dealing with that inherent inflationary bias by institutionalising a contrary bias in favour of long-run price stability. A common and understandable concern about the concept of an independent central bank is that it is inconsistent with the traditions of democratic parliamentary structures. We normally expect the authority of the state to be exercised by our elected representatives rather than by central bank bureaucrats. So how can we overcome that inconsistency? In our case, we have an Act of Parliament that spells out the medium term objective of the central bank in language that is quite broad and uncontentious. The Reserve Bank of New Zealand is obliged to pursue “stability in the general level of prices”. But what is meant by “stability in the general level of prices”? That is not defined in the Act. But the Minister of Finance and the Governor are obliged to agree an operational target and to publish that in a Policy Targets Agreement (PTA) covering the five-year term of the Governor. In effect, this is the Governor’s employment contract.2 We find this an important mechanism. It confers a degree of democratic legitimacy on the inflation target by openly committing the Minister and his government to the inflation target. Just as importantly, the government can over-ride this agreement where it feels there is good reason perhaps in some situation of crisis or unusual shock. That is provided for. But there are rules to be complied with. The over-ride must be published and must be tabled in the Parliament for debate. Any such over-ride can persist for no more than one year without again being subjected to Parliamentary scrutiny. As usual, there are alternative models available. In our case, we have instrument independence - in other words, the central bank has wide discretion in how it goes about achieving its inflation target. But we do not have goal independence - we do not establish for ourselves the target for monetary policy in the way, for instance, that the US Federal Reserve Board or the European Central Bank are empowered to do. We feel very comfortable with a structure that requires active government participation in establishing the goal of monetary policy. Indeed, we believe it is an important provision reinforcing the legitimacy of the central bank’s task. But it is clear that both models are viable and can operate effectively in their particular circumstances. Before leaving the subject of central bank independence, I should touch on one other important question - the funding of the central bank. We, like other central banks, have traditionally generated substantial profits through seignorage - issuing bank notes to the public and investing the proceeds in government bonds. Under our old structures, those profits were applied to the administration of the Bank at our own discretion with the residual surplus turned over to the government. It was clear at an early stage of our reforms that such a comfortable arrangement was never going to survive. But how to have an independent central bank while still imposing some reasonable degree of external financial constraint? Clearly the usual governmental process of annual appropriations was not suitable since this could provide a very direct route by which the independence of the Bank could be quickly undermined. Note that the RBNZ Act does not specifically oblige us to operate an inflation targeting regime. In principle, the PTA could specify some other intermediate target, eg a monetary aggregate, nominal GDP or even, at a stretch, the exchange rate. The significant constraint is that the intermediate target chosen must be consistent with some reasonable definition of “stability in the general level of prices”. This dilemma has been resolved, satisfactorily in my view, by a five-year funding agreement in which the Bank and the Minister agree on the quantum of funds that the Bank will be able to spend on its own operations. Any spending over that cap must be drawn from the Bank’s reserves, and under-spending of the agreed limit may be added to reserves. Our non-executive directors also play an important review role in monitoring the efficiency of our spending and internal management processes, just as they do in scrutinising the Governor’s monetary policy decisions. Decision-making structures As noted, the design of the Reserve Bank of New Zealand Act drew heavily on the principles of effective management. In that framework, it is not surprising that the Chief Executive - the Governor is assigned all of the key decision-making powers of the central bank. While this is not a unique provision, it is not that common. More often seen are arrangements where the key monetary policy powers are assigned to a board or a committee. The Federal Reserve Board’s Federal Open Market Committee, the Bank of England’s new Monetary Policy Committee, the Swedish Riksbank’s Executive Board and the Reserve Bank of Australia’s Board of Directors all provide alternative structures. In the New Zealand case, the single decision-maker model reflected a concern to retain clear accountability - if there is any fault to be found with the decisions of the central bank, there is no doubt about whom is to be held responsible. This is one area which is currently under review in New Zealand. Professor Lars Svensson of Stockholm University has been appointed to review a number of aspects of our monetary policy, including decision-making and governance structures. (I should note that, in commissioning this review, the government has specifically ruled out any change to the independence of the central bank or to the concept of a single, price stability target for monetary policy.) In preparing its submission for the Svensson review, the non-executive directors of our board, who are charged with monitoring the performance of the Governor, have looked at whether they should recommend the adoption of a committee-based decision making structure in place of the current single decision-maker model. The potentially negative features of a single decision-maker model include: • Exposure to single person risk. • Decision-making may be captured by a single train of thinking and result in inferior decisions. • A public perception may develop that a single individual, the Governor, has excessive power. If such a perception were to develop, the “legitimacy” of the central bank’s operational independence may come under question. • A single decision-maker may be insufficiently in touch with what is actually happening in the economy, or may have only a partial view of developments, thus resulting in inferior decisions. After careful deliberation, our non-executive directors have chosen to recommend the retention of the current single decision-maker structure. Their reasoning relates primarily to a preference for the greater clarity of accountability inherent in the current structure. Also important was a sense that the single decision-maker facilitates greater coherence and consistency in communication of monetary policy issues than is likely with committee structures, and greater effectiveness in the management of the organisation. Also, they felt that the risks of the current structure were significantly mitigated within our framework by such provisions as: • A rigorous process for appointing a Governor in which the Minister of Finance must make the appointment from candidates nominated by the board. • Constraints on the Governor’s decision-making authority which are inherent in the RBNZ Act and in the Policy Targets Agreement. • The monitoring of the Governor’s performance by the board to ensure that the Governor acts in a collegial manner, and has proper regard for the wide range of advice and input which is obtained from sources internal and external to the Bank. • The transparency provisions which ensure a close external scrutiny of the Governor’s decisions including, importantly, by financial markets. Further, the non-executive directors have recommended some changes intended to strengthen the board’s scrutiny of the decision-making processes and thereby reduce further any risks inherent in the single decision-maker model. Another consideration which emerged during the consideration of alternative decision-making structures related to concerns about potential conflicts of interest where external appointees are involved in monetary policy decision-making and the limited pool of available expertise and experience suited for such a task in a small country like New Zealand. Overall, I doubt that there are many general principles or lessons from international experience that can be applied in this area. In many cases, it seems that the formal differences between a single decision-maker and a committee structure are less obvious in practice than they are on paper. Moreover, it seems that some of the more interesting approaches to committee structures, such as that of the Bank of England and the Riksbank, are still evolving and settling down. For that reason it may be too soon to draw firm conclusions about the preferred decision-making structures. Single or multiple goals? The New Zealand framework quite deliberately and explicitly directs monetary policy towards a single objective - price stability. This approach stems from an understanding that, in the medium-term, monetary policy affects only the price level; it is not possible to engineer a higher trend rate of real growth merely from monetary expansion. The charters of some other central banks are broader, typically requiring monetary policy to place some weight on other objectives of economic policy such as growth and employment. In the New Zealand case, we felt that having a single price stability objective was helpful in providing clarity of purpose in the earlier stages of a significant disinflationary process. It also supports a clear accountability framework and fits with what we think monetary policy is able to achieve. But this is not to say that we see no connection between monetary policy and real variables such as growth and employment. On the contrary, maintenance of medium-term price stability we see as an important part of the environment required in order for resources to be allocated to where they can best be used. That, of course, is what achieving real growth and maximum employment is all about. Moreover, the way in which monetary policy is conducted in pursuit of price stability can also matter. Just as price stability is conducive to growth, so too is an environment of “monetary stability” in which interest and exchange rates are sufficiently stable to act as effective allocative mechanisms. In our case, as inflation has settled at low levels, we have come to devote considerably more attention to the nature of the trade-offs we may face in our day-to-day monetary policy strategies. In particular, we have been looking more closely at issues relating to the variability of inflation, on the one hand, and the variability of output, interest rates and the exchange rate, on the other hand. With a longer track record of successfully maintaining price stability comes a better anchoring of the public’s expectations about future inflation risks. From that comes the possibility that we can be more relaxed about short-term variations in inflation, particularly where looking through such short-term inflation “noise” enables us to deliver a degree more stability in interest rates, the exchange rate and, possibly, output. Again, in this area we find that the differences in practice between the New Zealand model, with the single goal of price stability, and other inflation targeters with a broader mandate, may be rather smaller than a casual reading of the respective charters might suggest. Conclusions We now have a decade of experience with inflation targeting in an increasingly diverse range of countries and circumstances. There seems little doubt that inflation targeting is proving to be an effective framework for monetary policy within these diverse settings. It seems especially well adapted to small, open economies with flexible exchange rates - providing the essential nominal anchor for monetary policy at a time when some of the more familiar guideposts have become less reliable. The core characteristics of inflation targeting relate to the public announcement of a target for inflation, explicit acknowledgement that low, stable inflation is monetary policy’s primary long-run goal, transparency about the objectives of policy and the rationale for monetary policy decisions, and strengthened accountability for the achievement of the goals of policy. The institutional framework for inflation targeting is important - to be effective, inflation targeting must assist in shaping decisions and behaviour. Well-designed institutional structures can be influential in shifting incentives and conditioning decision-making. But that does not mean that there is a particular formula or set of institutional arrangements that can readily be picked up and transplanted. No doubt, the Bank of Thailand is bringing its own perspectives to these issues, and adapting the experience and practice of others to find structures that best suit local conditions. I wish them well in that endeavour. References Bernanke, Ben S; Laubach, Thomas; Mishkin, Frederick S; Posen, Adam S 1999. “Inflation targeting. Lessons from the international experience”. Princeton University Press. Brash, Donald. 1999. “Inflation targeting: an alternative way of achieving price stability”. A speech delivered on the occasion of the 50th anniversary of central banking in the Philippines. Reserve Bank of New Zealand Bulletin, Vol 62 No 1. King, Mervyn. 1999. “The MPC Two Years On”, Lecture delivered to Queen’s University, Belfast. Reddell, Michael. 1999. “Origins and early development of the inflation target”. Reserve Bank of New Zealand Bulletin, Vol 62 No 3. Sherwin, Murray. 1999. “Inflation targeting: 10 years on”. Paper delivered to the New Zealand Association of Economists Conference in Rotorua. Reserve Bank of New Zealand Bulletin, Vol 62 No 3. Sherwin, Murray, 1999. “Strategic Choices in Inflation Targeting: The New Zealand Experience”. Paper delivered to an IMF and Central Bank of Brazil Seminar on inflation targeting. Stevens, Glenn. 1999. “Six Years of Inflation Targeting”. Address to Economic Society of Australia. Svensson, Lars E O 1997. “Inflation forecast targeting: Implementing and monitoring inflation targets”. European Economic Review, Vol 41.
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Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Trans-Tasman Business Circle, Sydney, 30 March 2001
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Donald T Brash: Central banks: what they can and cannot do Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Trans-Tasman Business Circle, Sydney, 30 March 2001. * * * Introduction It is a great pleasure for me to be back in Australia, addressing an audience hosted by the Trans-Tasman Business Circle and Australian Business Economists. Last year, I spoke about the history of inflation targeting in New Zealand, and noted the extent to which the Reserve Bank of Australia and the Reserve Bank of New Zealand had converged in their respective approaches to monetary policy. This year, it was suggested that I talk about recent developments in the New Zealand economy, and the immediate prospects. On reflection, however, I have chosen not to do that. My colleagues and I set out how we see the recent past and immediate future in our March Monetary Policy Statement, published just over two weeks ago, and I usually try to avoid making potentially market-moving comments except when I am announcing a formal review of our Official Cash Rate. The next such review is scheduled for 19 April. Instead, I want to talk about what central banks can achieve, and what they can not achieve, and to make some comparisons between the role of central banks and the role of central governments. And my motive in doing this is in large part because I believe that, in recent years, in New Zealand as in many other countries, the public have come to believe that central banks can achieve very much more than they can, in reality, deliver. There is a serious risk that, when the realisation dawns that the power of central banks is not in fact unlimited, or when economies which have been performing extremely well in recent years go through a period of slower growth, central banks will receive far more than their fair share of blame. Indeed, there are already signs of this blame and anger emerging in the United States: for much of the last decade, Alan Greenspan was widely assumed to be able to walk on water. Now there are angry accusations from many quarters that imply that he should have been able to keep the US economy growing above its trend potential indefinitely, and prices in the US share-market growing with it. Perhaps there are similar tendencies closer to home. In all developed countries and most developing countries, the central bank is charged with promoting stable money and a stable financial system. (This is true even though, in Australia and in many other countries, the task of supervising the institutions in the banking system has been allocated to a separate supervisory agency.) And these are extremely important goals. To see just how important, it is worth reflecting on the economic and human cost incurred by many countries when central banks got policy wrong and contributed to the strong deflation of the thirties. Or reflecting on the economic and human cost incurred by those countries which experienced hyperinflation at some stage during the last century. Or reflecting on the economic and human cost incurred by those countries, including many in our own region, which experienced severe banking sector crises in recent years. When central banks get it wrong, when they allow the value of the money which they issue to fluctuate substantially, as in the case of serious deflation or high inflation, or when they allow banking systems to become unstable, the damage which can be done is enormous. Savings can be destroyed. Businesses can be destroyed. Jobs can be destroyed. Lives can be destroyed. Indeed, whole societies can be destroyed. So let me not understate the importance of the role which central banks can play. When central banking is done well, it not only avoids those catastrophic results which have been seen around the globe from time to time, but also makes some positive contribution to economic growth, to social justice, and perhaps even to the integrity of society itself. As a former Governor of the US Federal Reserve System used to say, "a place that tolerates inflation is a place where no one tells the truth". What central banks can achieve Today I want to focus on the responsibility which central banks have for keeping the value of money stable, for keeping inflation low, rather than on their responsibility for the financial system. To what extent do central banks make a contribution to economic growth and social justice by keeping the value of money stable? Nobody seriously doubts that both hyper-inflation and significant deflation can do real damage to economic growth, and that by avoiding both central banks can make a considerable contribution. But what about the contribution to growth from keeping inflation in low single figures, as compared to the double-digit inflation which both our countries endured during much of the seventies and eighties? Perhaps inevitably, this is still a matter of ongoing debate among economists. Some claim that the contribution is negligible, that beyond avoiding the catastrophes of hyper-inflation and significant deflation the contribution which inflation control makes to economic growth is very small. Others see a rather larger contribution, through the fact that the pricing system works more efficiently to allocate resources when prices are on average stable, for example, or through the avoidance of the distortions caused by the interaction of inflation and a tax system based on the assumption that prices are stable. I myself see this latter point - the distortions caused by the interaction of even quite modest levels of inflation with a tax system designed on the assumption that prices are stable - as being particularly relevant to the way in which keeping inflation under tight control can assist economic growth. I find it hard to escape the conclusion that one of the reasons for New Zealanders' relatively heavy investment in property assets, and relatively low investment in financial assets, in recent decades is related to the fact that, under the present tax regime, inflation results in an "under-taxation" of property investment and an "over-taxation" of financial assets. I suspect also that the fact that government spending as a share of GDP increased so substantially over the seventies and eighties is in no small measure a result of the fact that inflation and relatively unchanging income tax brackets caused government's share of the national cake to expand steadily, without the politically uncomfortable need to actually raise tax rates. And if, as many believe, an increase in the government's share of GDP is associated with lower economic growth, this is another way in which inflation damages growth. But even those who see stable money as making a positive contribution to economic growth, as I do, do not see that contribution as large in the sense understood by most people. It is a growth contribution measured in fractions of one per cent, not the difference between, say, a 3 per cent annual growth rate and a 5 per cent annual growth rate. Of course, achieving even a small increase in annual growth is definitely worth having. One recent study estimates that a 10 percentage point increase in inflation reduces the growth rate of real per capita GDP by between 0.2 and 0.3 percentage points per annum, leading to GDP being some 4 to 7 per cent lower than otherwise after 30 years. Otmar Issing, now a member of the Executive Board of the European Central Bank and prior to that for many years the chief economist of the Bundesbank, reminds us that "With regard to the output gains found in most studies from price-stability and low inflation, it is important to bear in mind that they are permanent. Even if they may appear to be small in any one year, in present value terms, the size of these gains can be substantial. For example, discounted at a 3 per cent real interest rate, a 0.5 per cent gain in the level of output per year amounts to 17 per cent of GDP in present value terms. In fact, the empirical evidence suggests that the gains may be larger than this." Output gains of that magnitude are certainly worth having. But they don't represent the kind Cited by Jerry Jordan, President of the Federal Reserve Bank of Cleveland, in a speech entitled "The challenge of stability: Mexico's pursuit of sound money", 29 April 1999. Barro, R. (1995), "Inflation and Economic Growth", National Bureau of Economic Research Working Paper No. 5326. In this paper, the adverse effect of inflation on growth diminishes over time, with the economy converging back to its long-run growth rate, but at a permanently lower level of output. Issing, O. (2000), "Why Price Stability?", a paper delivered to the first ECB central banking conference in Frankfurt, 3 November 2000. of improvement in growth which many people think of when they think about improving the growth rate in our societies. In many ways, keeping the value of money broadly stable makes a bigger contribution to social justice than it does to economic growth. When money is not stable, when in other words there is inflation or deflation, the value of financial assets and liabilities changes in potentially major and unexpected ways. With inflation of 10 per cent per annum, for example, the value of a financial asset falls by about 85 per cent over 20 years, which means that those with savings see these all but wiped out, and those with debts benefit enormously. There are no doubt many reasons why New Zealanders had such a miserable savings record during the nineties - including deregulation of the financial sector and the removal of all restrictions on imports. But the searing experience of high rates of inflation during the seventies and eighties must surely have been a significant contributory factor. Two or three years ago, my colleagues in the Reserve Bank of New Zealand suggested that we should stop issuing five cent coins (as we stopped issuing one and two cent coins about a decade ago). I was surprised by the suggestion, until it was pointed out that the purchasing power of five cents in the late nineties was the same as the purchasing power of a half-penny when New Zealand converted to decimal currency in 1967 - and it never occurred to us to issue a half-cent coin at that time. In other words, the purchasing power of New Zealand's money had declined by over 90 per cent over a period of just 30 years - despite inflation being quite low for the last 10 years of that period. And in case you feel that New Zealand's performance was substantially worse than Australia's over that period, it is worth noting that the domestic purchasing power of the Australian dollar also fell heavily over the 30 years from 1967, by over 85 per cent. There is nothing fair, just, or even honest in a monetary system which steals people's savings, or rewards those lucky enough to go heavily into debt at the right time. There can be little doubt that some of those who today are wealthy in both our countries became wealthy as much through having the real value of their borrowings evaporate before their eyes as through their own efforts and initiative. And this sends absolutely the wrong message to everyone making saving, spending, and investment decisions. I know that when I returned to New Zealand in 1971 after living overseas for nine years, four of them in Australia, I bought a house for $43,000 by paying a small deposit and borrowing the balance. Fifteen years later, the house had a market value of nearly 10 times the price I paid for it, so that instead of owning just 10 per cent of it, as I did in 1971, with the bank effectively owning the balance, by 1986 I owned almost all of it. That increase in my equity was substantially larger than anything I had been able to save out of my post-tax income during those 15 years. On the other side of the ledger so to speak, my elderly uncle sold the apple orchard on which he had worked all his life, by chance also in 1971. To keep the sale proceeds safe - the orchard had represented virtually his entire life's savings - he invested them in 18 year government bonds, then yielding 5.4 per cent. Perhaps fortunately, he died before the bonds matured in 1989, because by that time the $30,000 for which he had sold his orchard would have bought him one small, four-cylinder, car - not much of a retirement nest egg. In 1971, $30,000 would have bought him 11 of the same fourcylinder cars, a much more substantial retirement nest egg. I, and people like me, benefited enormously at the expense of my uncle and people like him, and all because of inflation. Because in most societies interest rates are used as a way to try to compensate savers for the erosion of the principal value of their savings through inflation, there is an additional problem which often makes it particularly difficult for those with low incomes or few other assets to borrow at a time of high inflation. The problem arises from the fact that, when inflation is high and nominal interest rates are similarly high, the cash-flow problem of servicing a loan is quite difficult in the first few years of the loan, but very easy in the last few years of the loan. Put another way, using interest rates to compensate savers for the effects of inflation on their savings has the effect of front-loading the real burden of debt service. This may effectively deny those on low incomes any access to borrowing facilities in times of high inflation, even though the real interest rate on the loan is at a moderate level. So central banks can probably make some modest contribution to trend growth through keeping inflation low and stable, and can help to avoid the social injustices often caused by unstable money. In seeking to keep inflation low and stable, central banks may also have a tendency to smooth the economic cycle. It is now well understood that one of the more important determinants of changes in the inflation rate is the extent to which actual output diverges from potential output. When actual output falls short of what the economy could produce without difficulty - where, in other words, resources of capital and labour are under-utilised - there is a tendency for inflation to fall. Conversely, when the economy is straining to produce more than it can on a sustainable basis, when capital is being used around the clock and the labour market is tight, there is a tendency for inflation to rise. For this reason, all central banks, even those with no formal mandate to be concerned about output or employment, have to watch carefully what is happening to both in their attempt to keep inflation under control. Indeed, once inflation has been brought down to a low level, it is not much of an exaggeration to say that keeping inflation low and stable is mainly about trying to keep actual output tracking close to potential. And, by reducing the economic and social dislocation caused by booms and busts, that is a useful contribution which central banks can make. What central banks can not achieve But too often the general public assume that central banks can achieve very much more than in fact is possible. This tendency to exaggerate the role of central banks has been particularly evident in the United States in recent years, as I have mentioned, with the almost universal perception that the strong growth in US productivity since the mid-nineties has been closely related to the way in which the Federal Reserve System has operated monetary policy. Of course, the way in which the Fed has run policy appears at this stage to have been remarkably sound: monetary policy decision-makers appear to have correctly judged that there was a step increase in the rate of growth of productivity around the mid-nineties, and that potential output growth had increased as a consequence. But the main thing driving that step increase in the rate of growth of productivity was the application of some very sophisticated technology, initially in the manufacture of computers themselves and then, progressively, in much of the rest of the economy. Monetary policy did not impede that development, but of course did not create the new technology. Similarly in New Zealand, and perhaps also in Australia, there has been a tendency to attribute to monetary policy and central banks an influence on the economy out of all proportion to the reality. The reality is that, beyond the contribution they can make by maintaining inflation at a low level, central banks can not have any substantial effect on trend growth in output or trend growth in employment. By contrast, the policies of governments can have a material influence on both. This is not the place for a comprehensive discussion on the determinants of trend growth in output, but most of the studies which have examined this issue focus on issues quite unrelated to monetary policy. For example, some studies have suggested that high levels of taxation discourage growth through their effect on incentives to work, save and innovate. Others have pointed to the importance of protecting private property rights if growth is to be dynamic. Still others note the importance of human capital, and highlight the role of education as a determinant of economic growth. And there are many other factors too, such as the extent to which government regulations distort or disguise market signals, thus distorting the allocation of investment. Getting policies in all of these areas right is crucial if growth is to be increased, and none of them are policies susceptible to central bank influence. What about employment? Surely central banks have an impact on employment? Yes, monetary policy does have an impact on employment in the short-term, as it does on output in the short-term. But there is no evidence that I have seen that monetary policy can have any enduring effect on the level of employment. So what can deliver higher levels of employment on an enduring basis? The answer lies not with central banks but with choices made by governments and societies more generally. It was the soon-to-retire Secretary of the Australian Treasury, Mr Ted Evans, who had the courage to say in 1993 when Australian unemployment was 11 per cent of the work-force that unemployment at that level was "a matter of choice" - choices made by governments and societies. He went on to say that "If we are today looking for innovative solutions for reducing unemployment that is partly because, over the last two decades, we have found innovative ways of creating unemployment; more basically, it is because we choose now to accept the constraints imposed by the many economic and social policy choices made during those decades." And by saying that the unemployment level was a matter of choice, he was not suggesting that it was a choice for the central bank, but rather a choice of central government and society more generally. He went on to note that "There are now very few economists ... who would deny a relationship between labour costs and unemployment - indeed, doing so would require abandoning some of the most basic tenets of our economic training. That said, there are very few, any more, who would see a reduction in nominal wages as the preferred solution to an unemployment problem ... Such solutions are not preferred in the formalized labour market but we should be quite clear that that reflects a choice." In other words, he was suggesting, I believe correctly, that in the long-term unemployment is to a substantial extent a function of the relationship between the costs and risks associated with hiring people on the one hand, and the benefits, in terms of increased output, on the other. So job creation and employment levels are ultimately a function of things like labour market legislation, the level of the unemployment benefit, and the education system. And all of these things are matters quite unrelated to monetary policy. Rather, they have a great deal to do with government policy and the attitudes of the public, both as providers of jobs and as potential employees. More fundamentally, I suspect that trend growth in output and employment are both a function of culture and social attitudes. How much do we as a society value consumption today as compared to consumption tomorrow? How much do we value education? How much do we value being independent as compared to being dependent on the state? How highly do we regard private property rights? The answers to these questions are, I suspect, the primary determinants of both economic growth and employment growth, and none of them have much relation to monetary policy. I mentioned that, in the course of keeping inflation low and stable, central banks operate monetary policy with the objective of keeping actual output as close as possible to the trend of potential output. But that does not imply that monetary policy can guarantee an absence of booms and busts, or eliminate the business cycle. To begin with, the "trend of potential output" is not something which can be seen, felt, or measured. For this reason, it is impossible for any central bank to be sure when actual output is above, below, or equal to it. Rough calculations can be made of course, adding assumed growth in the labour force to assumed growth in productivity to come up with a ball-park number. But growth in the labour force can vary for all kinds of reasons, including in particular because of abrupt changes in net migration. And growth in productivity is also susceptible to change, as the experience of the United States over the last four decades clearly illustrates. Until the early seventies, US productivity growth was quite rapid. Then, in about 1973, for reasons which were certainly not clear at the time and are only dimly understood now, productivity growth slowed rather abruptly, and remained low until the mid-nineties. Then, apparently because of heavy investment in computers and related high-tech gadgetry, productivity growth picked up again quite strongly. Unless the central bank quickly becomes aware of these changes, monetary policy will be inappropriately too tight or too loose. Another reason not to expect that central banks can keep actual output growing at a rate exactly equal to the trend growth in potential output is that monetary policy affects demand, and hence inflationary pressure, with a considerable lag - and a lag which varies from economy to economy and from one period to another. And within the period between the time a central bank adjusts monetary policy and the time that policy adjustment affects output, and the further time before the change in output affects inflation, all manner of things may change in ways which are difficult or impossible to predict - the world economy might change (of huge importance to economies like New Zealand and Australia), the economy might be affected by a drought, government might change its taxation or spending policies, government might change its immigration policy, and so on. All these things, "shocks" in the jargon, can have a considerable effect on the relationship between demand and supply, and therefore on the relationship between actual output and potential output. So it is simply not possible for even the most diligent central bank to keep actual output always growing at the rate of growth of potential output, and all of us, within the central bank and outside, Address to the 1993 National Forecasting and Economic Policy Conference, 28 October 1993. need to remember that. There will be times when the economy slows, or even goes backward slightly, and it may be totally inappropriate to blame the central bank for that event. Governments can help to minimise the "shocks" hitting the economy by changing fiscal policy in a gradual and well-signalled way, so that monetary policy is not caught off-guard by a sudden shift in demand emanating from public sector policy choices. And governments can help by ensuring that the labour market is as flexible as possible, in order to ensure that, when shocks do hit the economy, they are not reflected in persistent increases in unemployment. Finally, it is worth noting that central banks can not solve regional, or sectoral, problems. In the midnineties, New Zealand saw quite strong inflationary pressures which required monetary policy to be tightened. In the public mind, if not always entirely in reality, these inflationary pressures were associated with a housing boom in Auckland. And wherever I travelled in New Zealand outside Auckland I was met by people asking why they had to face high real interest rates and a rising real exchange rate when, they claimed, the only inflationary pressures in the country were in Auckland. And always my answer was the same. All the parts of New Zealand are in a currency union, and it simply is not possible for the central bank to deliver different interest rates, or different exchange rates, to different parts of that currency union. The same reality is relevant today. At the moment, with the New Zealand dollar at a level which most observers believe is well below its long-term or equilibrium level, it is the export sectors of New Zealand which are enjoying the fruits of the relatively easy monetary conditions. Industries serving the domestic market, such as the construction industry, are finding life much tougher, in part because over the last year or two New Zealand has been experiencing a moderate level of net emigration. But it is quite impossible for monetary policy to resolve the problem facing the construction sector, or any other particular sector. Monetary policy must be directed at keeping inflation under control in the economy as a whole, and can not sensibly be used to deal with sectoral pressures. In conclusion Because I am a central banker, it will not surprise you to know that I believe that central banks can make a very useful contribution to the economy and to society more generally. By running monetary policy to keep the purchasing power of the money they issue stable, they can provide an environment conducive to growth in output and employment. By doing that, they also provide an environment which avoids the capricious redistribution of income and assets which is so often the consequence of inflation. But in some respects, central banks are a little like the judiciary, which most societies have also decided to make independent of day-to-day political influence in the interests of achieving the goals established by those societies in the best possible way. While both the judiciary and central banks can make a very useful contribution to the societies in which they operate, over the longer term central banks can't make economies grow much more rapidly, or materially reduce unemployment, or eliminate the business cycle, or deal with the problems of particular industries or sectors - any more than the members of the judiciary can make us all virtuous.
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