description
stringlengths 27
553
| text
stringlengths 0
341k
⌀ | bank
stringclasses 118
values | Year
int64 2k
2.03k
| Month
int64 1
12
|
|---|---|---|---|---|
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics, Finance and Public Administration, Warrnambool, 6 December 2002. | I J Macfarlane: Overview of the Australian economy Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics, Finance and Public Administration, Warrnambool, 6 December 2002. * * * I would like to endorse the remarks of the Chairman and say what a pleasure it is to be in Warrnambool, for the second hearing to be conducted outside the Sydney-Melbourne-Canberra triangle. The first was in Wagga Wagga, and I remember at the time suggesting that the second should be a little further away from Canberra. Warrnambool passes that test and is an important agricultural and tourist centre, so it is a fitting venue for this meeting. I would also like to thank the Mayor of Warrnambool, Councillor James Nicol, for his hospitality in hosting a civic reception for the Committee and the members of the Bank appearing before it. I would like to start the substance of this statement by observing that in the six months between this Hearing and the previous one in May quite a lot has changed, and this has had an important influence on our judgment about what we have needed to do with monetary policy. This change has happened relatively steadily, with the result that the financial markets and the public more generally have had no trouble in adjusting to the changed outlook. We have assisted, where we thought necessary, by way of several speeches and articles on the subject over the past six months; they have probably helped at the margin, although I think the public was not having any difficulty in recognising the changing outlook as it unfolded. That being so, it could be argued that there is nothing further to add on the subject. However, I am very aware of the fact that I gave some quite frank indications about the expected future direction of monetary policy at the previous Hearing, and that those indications have not been followed through. So I would like to place on the record before this Committee another account of the changing circumstances, even at the risk of being accused of going over old ground. In May I said to this Committee that since the Australian economy was behaving normally, and the world economy was getting back to normal, unless unforeseen developments intruded, we should continue the process of getting real interest rates back to normal, while all the time carefully examining incoming data, both from here and abroad, to ensure that developments remained on track. We did continue the process of getting interest rates up towards normal in June, but have not done anything more in that direction in the following six months. Why not? I think the answer has been obvious to nearly everyone - something did intrude and the incoming data from abroad showed that developments were not remaining on track. After a promising start to the year, the world economy began to weaken about mid-year. Financial markets - particularly equity and bond markets - were the first to show this from about the beginning of the second quarter of the year. By mid-year there were also signs from a range of economic indicators in the United States and the Euro area that the recovery was likely to be weaker than formerly thought. These signs tended to become clearer as events progressed during the second half of the year. A good way of summarising this large body of data is to look at three indicators of perceptions of economic conditions: business confidence, consumer confidence, and consensus forecasts of GDP growth. As can be seen in the graphs for the United States and the Euro area, these indicators show a clear improvement in the first half of the year followed by a clear deterioration in the second half. So what we have seen for the world economy is a weakening through calendar year 2001, an apparent strong recovery in the first half of 2002, followed by a relapse in the second half of 2002. The relapse does not mean that the world economy is returning to recession, but it indicates that the recovery is going to be weaker than was thought likely in mid-year. This gradual change in outlook in the second half of the year obviously had implications for monetary policy around the world. In the first half of the year, those countries with strong fundamentals, such as Australia, Canada, New Zealand and Sweden, had started the process of getting their interest rates back up to normal. This process was occurring when we met in May, and, as I said at the time, it was a process that we thought would be continuing. In the event, it did not continue for much longer, and in fact none of these countries has raised rates since July, and one (Sweden) has cut them, as has the United States. The caution shown by central banks such as ours derived in part from the downward revisions to world growth, but also in part from our suspicion that the risks were on the downside. In other words, if an outcome very different to the consensus were to occur, it would be more likely to be weaker than stronger. Having said that, I recognise that even though the second half of the year has been disappointing compared with the first half, equity and bond markets have become a little more confident over the past month or so. It is too soon, of course, to know whether it represents a change in direction or just another blip in the data. Turning to the Australian economy, I will approach this by way of my usual practice of reviewing the forecasts I gave the Committee last time and presenting some new ones. Last time I said we expected GDP growth through 2002/03 to be between 3½ and 4 per cent - we are now forecasting around 3 per cent. Obviously, the major factor behind the reduction has been the drought, but the weaker world economy has also had an effect at the margin. On the other hand, the fact that house-building is now forecast to continue to expand for a longer period has pushed the forecast up somewhat. For next year, that is calendar 2003, our forecast is for growth through the year of 3¾ per cent. The fact that it is higher than the current financial year rests importantly on the assumption that there is a recovery from the drought in the second half of the year, and that the world economic recovery gradually picks up momentum through the year. As I said before, strength in house-building has continued for longer than earlier thought: nevertheless, we still expect a downturn to occur in that sector during the course of 2003, which will subtract from growth. On the inflation front, I said that we were forecasting the CPI to remain near the top of the target range in 2002/03, although we expected it to go down slightly for a time and to then come back up. Implicit in this forecast was that the rising phase would continue after mid-2003 and so, other things equal, begin to exceed the target range by the second half of 2003. What has happened so far is that headline CPI is slightly above 3 per cent, but our estimate of underlying inflation is that it is running at about 2¾ per cent. We see no reason now to expect underlying inflation to rise any further, and are now forecasting that it will stay around this rate through calendar 2003. The main reasons for this slight downward revision compared with our forecast six months ago are the lower forecasts for world and Australian growth. The price effects resulting from the drought will have the effect of holding up CPI inflation in the next quarter or two and then reducing it slightly later in the forecast period. I would now like to return to a subject which the Committee spent a fair bit of time discussing in May, namely residential property prices. As you know, we became particularly concerned about this issue when we noticed that virtually all of the increase in housing loan approvals in the past year was going to investors, not to aspiring owner-occupiers. At the same time, the building approvals data showed that monthly approvals to build multi-unit developments, i.e. apartments, had speeded up to an exceptionally fast pace, while approvals to build houses were going along steadily. These developments suggested to us that a disproportionate amount of the upward pressure on residential property prices was coming from investors. One response to this would have been to sit back and do and say nothing, on the grounds that the market would sort out the problem. We accept that it no doubt would, but it could take a lot of time, the excesses could get worse in the meantime, and the eventual resolution of the issue could cause a lot of financial distress. The problem is that the market works, but with long lags during which people are encouraged to take decisions based on little more than an optimistic extrapolation of the past. Developers will continue to put up new apartment blocks while ever there are investors willing to pre-commit to buy. When investors purchase apartments off the plan (and it is almost exclusively investors to which the marketing is directed), they are making a financial commitment the wisdom of which may not become apparent for 18 months or so. It is only when they take possession of the apartment that they discover whether they can find a tenant willing to pay high enough rent to justify the financial calculation that underlay the original purchase. Of course, any individual investor can hope to get around the problem by selling to another investor, but they in turn will depend on finding a renter. Investors as a group are dependent on finding enough tenants willing to pay sufficiently high rents when the time comes, which may be 18 months away or more. These investment calculations (or forecasts) are difficult, and we fear that many investors are just assuming that things will work out, which is a very dangerous thing to do if you are making a highly-leveraged investment. Certainly, recent trends would warn against such an assumption. From the best figures available, it is clear that rents are falling and that vacancy rates in apartments are rising. And, as the pipeline of partly-built buildings is completed, there will be many more new apartments coming onto the market in the next two years than in other recent years. Our purpose in what we have been saying is to try to get the market to work a little better and so avoid the overshooting that often characterises parts of the property market. We all remember the excesses that occurred in commercial property in the 1980s and the large falls in prices that followed them. Investors should remember that even when they are buying a residential unit, they are making a commercial property decision, i.e. they are borrowing for an investment which will be rented to a tenant with the purpose of making a profit. There are now some preliminary indications that market forces are starting to work at last. I have already referred to falling rents and rising vacancy rates, but there is also recent evidence of a flattening out or, in some cases, falls in apartment prices and marked falls in auction clearance rates in Sydney and Melbourne. There have also been reports of some of the more ambitious projects planned for Brisbane and Melbourne being withdrawn, which makes it all the more surprising that there has been such a large increase in October in approvals to build multi-unit buildings. On balance, however, these developments, if fully understood by investors, should make them very cautious and so limit the extent of over-supply in coming years. I suppose the other big event in our area that has occurred since we met last May is that we brought down the final report on the Reform of Credit Card Schemes in Australia in August. In this context, we welcome your endorsement of the reforms, Chairman, as being ‘an important win for Australian consumers’. Our intention, as stated in our document, is to put these reforms into effect in stages over the next year. Although the reforms are being challenged in court by the two main international credit card systems, I do not think this court action prevents me from answering questions. I do not think I need to say any more at present. We will have plenty of time to discuss any of the subjects I have covered plus any others that Committee members may wish to raise. | reserve bank of australia | 2,002 | 12 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Australian Business Economists/Economic Society of Australia (New South Wales Branch) Forecasting Conference Dinner, Sydney, 6 December 2002. | I J Macfarlane: Australia and the international cycle Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Australian Business Economists/Economic Society of Australia (New South Wales Branch) Forecasting Conference Dinner, Sydney, 6 December 2001. * * * I last spoke at this Conference Dinner two years ago, and a lot has happened to the Australian and world economies since that time. I am pleased to be invited back and given a platform from which to share a few thoughts with you tonight. In keeping with the theme of the Conference – which is about forecasting – I will address the issue of how well placed the Australian economy is to handle the challenges of the next year, particularly the international challenge. In a sense, the talk will also be a replacement for my regular half-yearly report to the Parliamentary Committee on Economics, Finance and Public Administration. Because of last month’s election, there has not been time to re-form the Committee and schedule a hearing date in the current half-year. I will start tonight by showing a graph which compares Australia’s current economic expansion with its predecessors in the 1970s and 1980s. Some people may think I am tempting fate by showing this graph at this particular juncture, but I have been doing so, from time to time, over the past three years without ill effect. What the graph shows is that the current expansion is a good deal longer and smoother than its predecessors. One of the most important reasons for this is that inflation has been a lot lower on average and less variable than in the earlier expansions. Monetary policy, therefore, has been able to play a different role than formerly – one that involves earlier movements in interest rates, but with smaller amplitudes of movement. The inflation targeting framework has been a crucial element in bringing about this result. Diagram 1: Expansions in GDP Cyclical trough = 100 Index Index 1990s 1980s 1970s Years since trough Table 1 Expansions in GDP Length of expansion in quarters Total increase Average growth rate Number of quarterly declines Standard deviation of quarterly growth rates Average inflation rate Standard deviation of quarterly inflation Percent. 1970s 1980s 1990s 26.6 3.1 1.1 11.2 1.2 36.5 4.5 0.9 6.9 0.7 40 so far 45.6 3.8 0.6 2.4 0.3 Percentage points. For most of the period of the current expansion, the international background has been benign. The exception until recently was the period between mid 1997 and the beginning of 1999, when the Asian crisis confronted us with a pronounced fall in the demand for our exports and some pretty skittish international capital markets. We survived – indeed, prospered – in that period, much better than any of us thought likely at the time. Now we are confronted with another period of weak international demand, and this time the United States – the former powerhouse of the world economy – is the principal source of the weakness. This time we confront a problem that is global rather than specific to our region. The current problems did not, of course, start on 11 September, and I think there has been a tendency to exaggerate the economic consequences of that event, and under-estimate the underlying weakness that preceded it. If I had to give a date when it became clear that the international economy was in for a rough ride, I would nominate 3 January, when the Fed surprised everyone with the first reduction in interest rates in this phase only a fortnight after their previous meeting at which they had kept rates constant. After a flurry of interest rate reductions around the world in the next few months, the situation then settled down for a while. In Australia, after our three initial reductions, we paused for four months while we evaluated the incoming information. By mid August, we had concluded that the international situation was worsening again, and we began a second round of easings in early September, about a week before the fateful events in New York. Thus, taking these events together, we have been in a situation where we were conscious of a weakening world economy for virtually a full year. During that time – or for the three quarters covered by the national accounts – the Australian economy has grown at an annual rate of 4 per cent, while the US has been flat. We have also done better than other comparable economies. This is a very encouraging result for us, but success so far does not guarantee success in the future. Indeed, there is a large body of opinion that says we are destined to follow where others have led. Table 2 Growth and Inflation in 2001 per cent, year-to-date annualised. GDP Growth CPI Inflation United States 0.2 2.1 Canada 0.5 1.8 Euro Area 0.9 2.5 United Kingdom 2.1 1.5 Australia 4.0 3.0 I suppose that is the question that has been on everyone’s lips for quite a few months – if the world economy goes into a recession, as the United States and Japan have done and much of the rest of the world seems to be doing, does that mean that Australia has to follow? People who would answer yes to this question would point out that we have done so in the past, for example, in the mid 1970s, the early 1980s and the early 1990s. Why should this time be any different? This is a view of the world that I would call historical determinism, and it may or may not be a good guide. But before we accept such a prediction, it should be challenged by a close examination of the circumstances then and now. What such an examination reveals is that present domestic circumstances are very different to those prevailing in the earlier episodes. To put it bluntly, we brought a lot of the problems on ourselves in the previous episodes, whereas this time we have not done so. On the previous occasions, we could not in all honesty make the claim that it was mainly the fault of the rest of the world – much of the fault was clearly of our own making. In other words, Australia had a lot of serious domestic imbalances that contributed to the downturns. Imbalances - then and now For a start, each of the earlier downturns was preceded by an episode of high inflation. In the 1970s and 1980s, the CPI was rising in double digits; in the 1990s, although this measure peaked at a lower rate – about 8 per cent – it was accompanied by unsustainably high asset price inflation. Accordingly, monetary policy had to be tightened on all three occasions to combat these imbalances, and short2 term interest rates reached very high levels – either a little above or below 20 per cent on each occasion. Nothing remotely like that has happened this time to either inflation or to interest rates. Perhaps more importantly, monetary policy this time has been able to be eased much earlier than on previous occasions – interest rates have been successively lowered for nearly a year now, during which the economy has been growing at a good rate. While I think the different behaviour of inflation and interest rates is the biggest change between then and now, there are a number of other factors that contributed to our difficulties in earlier times that are not present now. I have listed these before, but there is no harm in doing so again: • There were large rises in real wages that squeezed the business sector in the 1970s and 1980s. This time wages have grown at a reasonably steady 3½ per cent per annum over the past year or two. • There was an investment boom that led to over-capacity in the early 1980s. Investment has been quite subdued over the past two years, and, in more normal circumstances, we should be due for a pick-up. Even in current circumstances, a straightforward reading of last week’s Capex Survey suggests a rise in the current financial year, though it is concentrated mostly in one sector (mining). • In the early 1990s, the exchange rate appreciated sharply in the period ahead of the downturn. On this occasion, it goes without saying that the exchange rate is exerting an expansionary influence. • On each earlier occasion, the deficit on current account of the balance of payments widened by an amount that alarmed many people. On this occasion, it has fallen to a level not seen in more than 20 years. I will return to some of these subjects later, but before I do so, I would like to address another form of historical determinism. Imbalances - United States and Australia The macro-economic performances of Australia and the United States in terms of output growth and inflation were very similar over the 1990s. It would therefore not be unreasonable to ask the question of why they should not also be similar in the first few years of the new century. Again, I think there is a reasonably straightforward answer to that question which stresses some very big differences between the two economies. • The US economy exhibited in the late stages of its expansion two or three developments which arguably warranted the use of the term “bubble”: • The US stock market, particularly the technology sector as measured by the NASDAQ, rose to exceptional heights and has since fallen. The broad indices such as the S&P 500 or the Wilshire are down by about 25 per cent from their peak, whereas in Australia the ASX 200 is only down about 4 per cent. • In the United States, there was a burst of physical investment towards the end of the expansion, mainly in high technology equipment. We are now seeing the reaction to this and the consequent excess capacity, in the form of sharp falls in investment. As explained earlier, this pattern of action and reaction is absent in Australia. • The trade-weighted value of the US dollar has risen appreciably over recent years and, despite lowering interest rates faster than any other country this year, the currency remains at a very high level. These three factors were really a manifestation of the excessive euphoria associated with the widely held view that the secret of economic success was to pour resources into the “high tech” sector. In the event, the countries that were most exposed to that sector are the ones that are showing the largest falls in output. The transmission from the world to Australia So far, I have emphasised the strong points about the Australian economy, and the differences between us and other more vulnerable economies. But it would be foolish to deny that a fall, or even a pronounced slowdown, in the world economy and world trade would have a significant contractionary effect on the Australian economy. Clearly, such an effect will occur, some of which is already showing up. The two classical channels are through a fall in the volume of exports and through a lower terms of trade, but there may also be other channels. The remainder of my presentation will look at the probable size of these channels. Table 3 Export Contribution to GDP Period (year-ended) Contribution to GDP Mid 1970s Mar 1974 –1.4 Early 1980s Jun 1983 –0.9 Early 1990s Dec 1989 0.3 Downturns It is true that during world recessions, the volume of Australian exports usually falls. Table 3 shows that at the time of previous world recessions, Australia has experienced periods of falling or weak exports roughly coincident with these recessions. But the negative contributions to GDP in any one year are not large; the biggest we can identify is the 1.4 percentage points in the year to March 1974. Clearly, if the rest of the economy was growing at a reasonable rate, this would not be enough to induce a recession. Traditionally, the Australian economy has had a reputation for doing better than most other economies in the good times and suffering more in the bad times. One reflection of this was that the Australian dollar was seen as a “commodity currency” because it was heavily influenced by our terms of trade. Again, it is true that during previous world recessions, Australia experienced periods of falling terms of trade that coincided roughly with the recessions. The biggest negative contribution of 1.7 percentage points of GDI was in the year to March 1975 (following a massive positive contribution the previous two years). The magnitude of these effects is such that, although they have made a noticeable contribution to slowing the economy, they would not be enough to cause a recession. Table 4 Terms of Trade Contribution to National Income (GDI) Downturns Period Contribution to GDI Mid 1970s Year to Mar 1975 –1.7 Early 1980s Year to Mar 1982 –0.6 Early 1990s Year to Jun 1991 –1.2 Even if we add the export volume effects and the terms of trade effects together (noting that they usually cover different, but roughly adjacent, periods), the combined effect in any one year would not be enough to turn a reasonable positive growth rate into a negative one. The other conclusion that can be drawn from this table is that the contributions tend to be getting smaller, particularly for the most recent recession in the early 1990s. Diagram 2: Trade Prices Index March 1980 = 100 Prices in SDR terms Index Imports Exports Index Terms of Trade Index 1981 1985 1989 1993 1997 2001 I would like to say a little more about the terms of trade before I leave that subject. As I said earlier, there has been a tendency to see Australia as being some sort of “loser” in the international economic competition because of our vulnerability to terms of trade movements. There is an assumption that our terms of trade are subject to a long-term downward trend, that they are also cyclically sensitive, and that both of these characteristics stem from an unfortunate export mix, with its over-representation of “commodities”. I think this is a somewhat dated view for the following reasons: • On the question of long-run trends, it should be noted that the low point in our terms of trade was as far back as 1986/87. The two troughs since then have been at successively higher levels. • On the question of cyclical sensitivity, we have had conflicting signals over recent years. Our terms of trade fell between mid 1997 and mid 1998 as a result of the Asian crisis, but since that time, i.e. over the past three years, they have risen, even though the last of those three years has been a very weak one for the world economy. They are now above the peak they reached immediately before the Asian crisis. • The focus on our export prices is misplaced because the really interesting action seems to be taking place on import prices. They are not as cyclical as export prices, but they have shown a more pronounced downward trend over the 1990s, particularly over the past five years. We know that a lot of this is due to the sharp falls in the prices of telecommunications and computing equipment, but it is more widespread than this. Of the 29 categories of goods for which the ABS publishes import prices, 26 fell in SDR terms between 1996 and the present. Nearly all of them are categories of manufactured goods. Whether the trend in the price of a particular category of internationally-traded goods is up or down depends to a large extent on long-run supply elasticities. It now seems likely that the highest supply elasticities are to be found in large-scale manufacturing rather than resource-based goods. Semiconductors are an obvious example, as are less sophisticated products such as clothing, textiles and footwear, but it also seems to be true for electrical equipment, automobiles, and for many types of industrial equipment. In some senses, these are now the “commodities” of international trade. I am not suggesting that all manufactured goods have this characteristic, but it seems that most of them do. My conclusion from this discussion of movements in exports, imports and the terms of trade is that they are not big enough by themselves to transmit a world recession into a domestic recession. A fall in domestic spending would be required to bring about that result. Why should domestic spending fall if the domestic economy was in reasonably good shape? One possible explanation is multiplier effects from the export sector, but most econometric estimates suggest that these would not be large enough to tip the balance. Another channel is through confidence effects – perhaps business and consumer confidence are influenced, not only by domestic developments, but also by international ones. Given the massive amount of information about the US economy that is routinely transmitted to Australians, it would not be surprising if this were the case. It is clear that some international events show up in measures of confidence among Australian consumers and business, September 11 being an obvious example. But, on the other hand, consumer confidence is still above its long-term average, and like most measures of business confidence, its recent trough was in the March/April period of 2001 – about nine months ago. At that time, we were getting bad news on the domestic front, particularly the temporary decline in GDP in the December quarter of 2000. The level of confidence recovered from this temporary trough, and on average over the past six months, has been a good deal higher than earlier in the year, and has held up reasonably well through the recent international turmoil. There is one thing about recent business behaviour that has worried me a little, but so far it seems to be mainly confined to the United States. I am referring to the practice by companies of announcing large lay-offs of employment whenever a downward earnings revision occurs. This practice is no doubt designed to please investors and therefore to prop up the company’s share price. If these lay-offs are occurring as announced, it suggests a more rapid employment response than in previous downturns. While the practice may help one company when viewed in isolation, it is a serious error to think that companies in general can protect their earnings in this way. Earnings are meant to decline cyclically in circumstances such as the present because it is impossible to cut costs as fast as revenue is declining. The more the cyclical fall in earnings is resisted in this way, the more it is transferred to employment, and the more pronounced the cycle becomes. Conclusion Calendar year 2001 has been a difficult one for the world economy, and the first half of 2002 looks like remaining weak before a recovery gets underway. This would mean 18 months of economic weakness for the world economy, and be classified as a recession like those of the mid 1970s, early 1980s and early 1990s. The Australian economy has got through the first half of it in reasonably good shape considering the circumstances. Can we keep up our present performance until we are again in an environment of reasonable world growth? Can we span the valley? I have given a number of reasons why I think we can, even though we will experience falling exports, falling earnings and the usual inventory adjustments. These are examples of externally-induced contractionary effects that cannot be avoided, but which are not big enough by themselves to cause a recession. For that to occur, we would have to see an over-reaction by domestic consumers and businesses. The evidence to date from surveys of confidence, from household spending and from business investment intentions is that they are holding up reasonably well. Far from over-reacting, they are exerting a generally stabilising influence. If this changes for the worse, or if it appears that the outlook for the world economy is weaker than currently assumed, we will be prepared to adjust monetary policy accordingly. | reserve bank of australia | 2,002 | 12 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to 2003 CEDA Economic and Political Overview, Perth, 13 February 2003. | Glenn Stevens: The economic outlook Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to 2003 CEDA Economic and Political Overview, Perth, 13 February 2003. * * * I must begin by thanking CEDA for the invitation to join this conference, and saying how pleasant it is to be back in Perth. In addition, I would like to express our thanks to the many people here who have assisted members of our staff based here in their efforts to understand the local and national economic scene. We appreciate very much the time you have offered. I am told that many of the people with whom our economists have had recent discussions about the outlook are reasonably positive. The resource sector, which of course is quite important in Western Australia, has a fair bit of investment planned. But I will not speak in any detail about the Western Australian economy in particular, as there are others here who are probably better equipped to do that. My remarks will be mainly focussed on the international environment, and then the national economic scene. Let me now spend a few minutes talking about the current conditions abroad, before turning to the issues which will be important in the year ahead. It is helpful that we are discussing this just a few days after the release of the Bank's most recent Statement on Monetary Policy, which covers recent events and the policy implications in great detail. The world economy in 2002 – a promising start but disappointing finish A year ago, all eyes were on an apparent recovery in the US economy, which had experienced the mildest of recessions in 2001, and appeared to be in the early phase of a recovery, the strength of which was taking many people by surprise. Some of the more thoughtful observers wondered whether, given the particular nature of the recent business cycle, the weakness could all be over quite so quickly, but at the time the numbers coming in seemed to be lending support to a relatively optimistic prognosis. Hence, for several months during the first half of last year, talk of global recovery was in the air. Unfortunately, this confidence waned during the second half of the year. To be sure, there has been continued expansion in the US economy, but it seems hesitant and unconvincing. Measures of consumer and business confidence declined, and share prices continued to drift lower, through the second half of 2002. Since the peak in early 2000, US share prices have fallen by around half. Close observers of the market point out that a fall over three successive calendar years had not occurred for over sixty years. What is the essential characteristic of this episode? Everyone understands, I am sure, that during the second half of the 1990s, the United States (and many countries in Europe) experienced a period of extraordinary optimism about future returns to capital, particularly capital invested in information and communications technology. But while there is no doubt that such technology has powerful potential benefits for users, the big question has always been how many of the gains would be captured by the producers, as opposed to the consumers. The answer, apparently, on this occasion as in so many others in history, is: not much, certainly not as much as initially expected and not enough to validate all the investment, or valuations, which were a feature of the late 1990s. Remarkably, actual corporate profits in the US peaked in 1997 and declined thereafter, even as the valuations of expected future profits continued to rise until early 2000. It is not that surprising in retrospect that business capital spending in the United States subsequently slumped. Indeed, that single part of demand was responsible for putting the US economy into recession. A key feature of the recovery to date, moreover, is that US companies in many sectors have still been struggling to deliver the profits that had apparently been expected, as implied by the earlier levels of share prices. Even now, share prices in the US appear to embody expectations of considerable earnings growth in the next few years. All of this means that, in some important respects, the nature of this episode has been different to the normal business cycle events which characterised the second half of the twentieth century. The upswing of the 1990s did not end in a conventional acceleration of inflation and abrupt macroeconomic policy action to dampen those pressures. It ended with a period of corporate behaviour which, if anything, has probably created some deflationary pressures. The behaviour of households has been a stabilising force, keeping consumer demand rising (albeit more slowly than in earlier years), helped by the ability to access some of the very large accumulated wealth in the housing stock. In the short term, prospects for modest growth rest on that continuing until businesses are once again in a position to expand. Hopes which might have been held that Europe would emerge as an independent source of growth impetus for the global economy have been disappointed. Europe is an economy as big as the US, but in many important respects its structural features seem to leave it much less likely to be a source of dynamism. The euro area followed the US economy into another period of weakness during the second half of 2002. Japan, too, has been unable to chart an independent growth path based on domestic demand. Such growth as it experienced in 2002 was export driven. That gave way to a renewed period of contraction towards the end of the year. So across several fronts, the international environment, having looked as though it was improving noticeably early last year, turned out to be quite disappointing. The exception to this picture was in parts of Asia, particularly China, where growth has remained very strong in the past year. China is becoming a very significant source of supply for internationally traded manufactures, but also a source of demand for raw materials and various high-value services. These trends are already having quite noticeable effects on trade patterns, and will continue to do so for many years. Australia is as well placed as any country to benefit from this. International issues for 2003 The consensus of private forecasters calls for growth in the US economy of about 2.7 per cent in 2003. This is a forecast which envisages the 'soft spot' in late 2002 giving way to better growth in the early part of 2003. This helps to drive a forecast for world growth of about 3½ per cent, which is about the average growth over the past couple of decades. US economic policies are being altered in a way which will support the economy. For example, as we point out in our most recent Statement on Monetary Policy, the US government sector's financial balance swung towards deficit by about 4 per cent of GDP over the past two years and will continue in that direction in 2003. Some of this movement is the effect of the economy on the budget rather than actual measures taken, but discretionary budget measures have been quite substantial. In addition, US interest rates have fallen significantly, and are at their lowest levels in four decades. Contrary to what we hear in some quarters, macroeconomic policies are still effective. The likelihood is that the assistance being given by these policies will continue to support the US economy in the period ahead. The fact that the US financial system is not apparently seriously impaired by the fall-out in the financial markets is also a major bonus. But getting over the legacy of the boom will still take some time. In the interim, of course, the US economy is more vulnerable to the effects of other adverse shocks which may come along than ideally we would like. So while it is sensible, in my view, to be an optimist about the US economy in the medium term, people are still a bit nervous about the path from here to that medium term. And, unfortunately, the global economy continues to be more dependent on US-led growth than is ideal, due to the chronic weakness of Japan and the apparent lack of dynamism in Europe. One issue which I think could well come more sharply into focus this year is the value of the US dollar, which has come down in trade-weighted terms by about 12 per cent since the peak. The fall against the euro has been particularly noticeable – of the order of 25 per cent. Against the yen the fall has been much smaller. Substantial changes in exchange rates rarely occur without some controversy, because they always create winners and losers – so they can be uncomfortable for some. All countries concerned will have an interest in how exchange rate movements, especially among the big currencies, affect their economies, and I suspect we may see a good deal of discussion about this in the year ahead. Then there is, of course, the mooted military campaign to disarm the Iraqi regime. Right now, this is probably the number one identifiable source of uncertainty cited by international decision-makers. Historically, wars have usually been expansionary and inflationary for the combatants. But I suppose at present the uncertainty may be less about the conflict itself and more about the nature of the world which might follow it, so that previous experience, including the Gulf War of 1991, may not provide a useful guide as to what to expect. The world must have been an extremely uncertain place after World War II, or in the early 1950s with the Korean War and the apparent threat of confrontation at times between the nuclear powers during the Cold War. Yet this environment of geo-political tensions did not ultimately prevent the 1950s and 1960s from being a period in which prosperity increased fairly steadily in the Western industrial economies. So perhaps we should take care not to overstate these uncertainties. Underlying economic forces are still important. I venture to suggest that the continued rapid expansion of the Chinese economy will probably have a more profound impact on the world economy in the next ten years than a conflict with Iraq. The Australian economy The above makes clear, I trust, that the international environment facing Australia has been far from favourable over the past couple of years. Yet economic growth has remained pretty strong, driven by domestic demand. This has been associated with a widening in the current account deficit, which is now receiving some attention, so it is worth spending a few minutes considering the arithmetic of trade performance. That arithmetic is set out in the table below. The figures incorporate estimates for the December quarter of 2002, based on partial data available. After a strong recovery from the problems encountered in the Asian crisis, Australian exporters have generally found the going tough since about the middle of 2001. Between mid 2001 and the end of 2002, export volumes declined by about 2½ per cent. Remember that, on average, we expect exports to grow by about 7–8 per cent each year. So over the six quarters to the end of 2002, export volumes had fallen by some 12–13 per cent relative to the level they would have reached had they grown at trend rates. That's 3 per cent of GDP. Balance of Payments Per cent Change in Exports Change in Imports Real trade balance (per cent of GDP) Terms of trade – per cent – per cent of GDP Trade balance (per cent of GDP) Current account balance (per cent of GDP) Jun quarter 2001 – Dec quarter 2002 Annual average growth over 1990s Change relative to trend by Dec 2002 –2½ –4.6 7.6 7.7 –12½ 7½ 2.5 0.7 –3.9 –3.8 Imports, on the other hand, have risen relatively rapidly, as domestic demand has risen at a pretty robust pace over the period in question. They rose by some 15 per cent, even before the effects of recent aircraft imports. To this we add the effects on investment spending of having one of the world's strongest and most profitable airlines, which is stepping up its capital-expansion program at a time when many of its rivals are struggling to survive. Including the aircraft, we find that in total, imports have risen above their trend to the tune of 1½ per cent of GDP. The sum of the export and import effects gives us the change in the real trade balance – the drag on Australian GDP – over the six quarters in question. It has declined by 4½ per cent of GDP, with twothirds of that on the export side, and the other third on the import side. In terms of income, as opposed to output, there is a slight offset in that Australia's terms of trade – the price of exports in terms of imports – has increased (which is unusual in a period of global weakness). This means that the decline in the current account balance, at 3¾ per cent of GDP, is a bit smaller than the decline in the real trade balance over the period in question. This is the basic arithmetic of how the current account deficit has widened from about 2 per cent of GDP in mid 2001 to a little under 6 per cent in late 2002. No doubt we will hear much about the wider current account deficit in the year ahead. In thinking about this, it is worth remembering that the alternative to a temporary widening of the current account under the circumstances we faced would have been to slow down the Australian economy and our absorption of resources, in line with our lower income. After all, we cannot make the world's growth go faster, so if the current account were seen as a binding constraint, we would have had to slow down our own demand. That would have affected domestic production as well. No-one is seriously proposing that, and no other country would willingly do it (though some are on occasion forced to). Of course, if the world turned out such that markets for our exports were permanently subdued, then Australians would have to adjust. We would have to temper our demand for resources from abroad, and work harder at making our products relatively more attractive to international markets. But there is no good reason to assume that that is the situation at present. Moreover, the capital inflow which is the counterpart of the current account deficit is willingly arriving, at interest rates which suit the Australian economy quite well. Hence, it is perfectly sensible to allow a temporary widening of this deficit, as the economy copes with the (hopefully short-lived) loss of foreign income. It is true that this can't be sustained indefinitely, but it doesn't have to be. Indeed, this capacity to allow a temporary widening in the current account has helped the Australian economy to perform remarkably well in the face of two pretty disappointing years for the global economy. An acceleration of domestic demand has offset, so far, much of the weakening in foreign demand so that overall GDP growth has slowed only a little. Despite the weak world, and despite the pronounced slowing in several key service sectors of the economy, real GDP grew at an annualised pace of 3¼ per cent during the first three quarters of 2002, with the non-farm economy running a bit over 3½ per cent. The debilitating effects of drought on farmers and their surrounding regional communities will become more fully apparent in the next couple of quarterly figures, but overall the economy has turned in a very creditable performance. What has driven this growth in domestic demand? It has been a combination of ongoing expansion in consumer demand, high levels of investment in housing and the early phase of what will probably be a lengthy upward trend in business capital spending. For the household sector, as we spell out in our Statement on Monetary Policy, moderate rises have occurred in income, as employment has grown and wages have increased. Superimposed on this is a very large gain in the household sector's wealth over a run of years, due mainly to large rises in house prices. The stock of wealth is now about 7 times annual income for the household sector. So a rise in wealth of 11 per cent (the average rise per year since 1996) is the equivalent of about 75 per cent of a year's income. Only a tiny portion of that wealth is accessed – but even that tiny portion adds tangibly to the additional cash resources available to the household sector for other forms of investment or consumption. Over a number of years now, this has been an expansionary factor pushing along household spending in Australia. Household Assets* September quarter 2002 Level $ billion Share of total Per cent Annual Growth Per cent Year to Sep 2002 Average Sep 1996– Sep 2001 Housing Consumer durables 2,085 62.4 5.7 21.9 9.7 12.2 6.0 Financial assets 1,068 31.9 3.1 9.7 - Superannuation and life offices 15.1 0.0 11.5 - Equities and unit trusts 6.6 2.5 13.6 - Currency and deposits 9.1 10.9 6.6 - Other 1.1 -7.5 -2.6 Total 3,344 100.0 14.5 10.9 * Includes unincorporated sector. Sources: ABS, RBA Associated with the increasing size of the household sector's assets has been a run up in debt. Indeed, the capacity to borrow to acquire assets or to borrow against assets for other purposes has been a necessary condition for this dynamic to operate, and that capacity has been fostered by the relatively low level of interest rates. There is a good deal of discussion as to how long this process can go on, and whether the household sector is becoming overly indebted and so on. Relative to current income, debt has increased a lot; relative to the value of assets, debt has increased only modestly. Debt-servicing burdens have gradually increased, though they remain well below where they were in the period of very high interest rates in the 1980s. For the most part, our view has been that this general trend was to be expected in the circumstances of low nominal interest rates, greater access to financial products, and a starting point where Australian households had little debt by international standards. With one exception, we have not rushed to ring alarm bells about excessive debt. The exception is, of course, the rapid growth in debt to finance investment in rental properties, where we felt during 2002 that people were being drawn into a position of high leverage by unrealistic expectations of returns. At some stage down the track, this is likely to result in disappointment for many and distress for some – hence we had a duty to speak up. More generally, however, there is a very large accumulation of wealth which remains, as yet, untapped. One of the important questions is to what extent households will be inclined to draw on this in the future. Many factors will be at work in determining the answer. For a start, how permanent is the wealth gain? The more confident people are that it is permanent, the more likely they are to draw on it. Demographic and distributional factors will also be important – who owns the assets and who owes the debts? I think we are only in the early stages of coming to an understanding of all these things, and there will be much discussion of them in the years ahead. Then there is business investment activity, which as I noted earlier has been rising over the past year. Judging by the broad historical patterns, this has some way to run yet. Investment levels still seem a little lower than historical averages. Profits are strong, and new funding is readily available. Corporate balance sheets are strong. So conditions seem conducive to further investment increases, and indeed the available forward indicators point to further growth in the year ahead. Conclusion Australia still faces a difficult environment abroad. Uncertainty is high internationally at present, and confidence subdued. It is to our advantage that this appears to have affected Australians relatively little (indeed, it is comparatively rare to see Australians more confident in surveys than Americans) and this has helped Australia perform well. Nonetheless, global conditions have been a major drag on the economy over the past couple of years. In the coming year, domestic demand in Australia will continue to grow, although probably more moderately than in the recent past. Most forecasters anticipate that the drag from abroad will begin to ease as the year goes on. If so, the net of those forces will mean that Australia will record overall growth a bit lower than we have seen most of the time in recent years, although still a pretty respectable outcome. In the circumstances, I think that's about as good a result as we could sensibly hope to achieve. Provided that we remain relatively free of imbalances at home, we could then expect to benefit from better economic conditions abroad once the current adjustment phase gives way to greater optimism and expansion – even though we cannot be sure when that will be. A return to more normal weather patterns, which we all hope will occur, would also give a boost through the farm sector. Throughout that we all face challenges of various kinds, and I wish you well in meeting them. Thank you. | reserve bank of australia | 2,003 | 2 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to The Sydney Institute, Sydney, 3 April 2003. | I J Macfarlane: Do Australian households borrow too much? Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to The Sydney Institute, Sydney, 3 April 2003. * * * Tonight’s subject is one that has attracted increasing attention over recent years - namely, the growth of household debt. There is no doubt that this debt has grown quickly over the past decade, and this has prompted a number of people to suggest that it is too high and that it presents a threat to the future health of the economy. What I would like to do tonight is to examine household debt from several perspectives in order to form a judgment on whether its current level poses risks for the economy, and what those risks might be. My broad conclusion is that a proportion of households have clearly taken on more risk, which has increased the risk profile for the sector as a whole. This is likely to make household consumption more sensitive to changes in economic circumstances than it formerly was, but the overall risk for the economy has not gone up to the extent that would be indicated by the rise in the level of debt or in the debt to income ratio. The subject of household debt is one that we at the Reserve Bank have been thinking about, and writing about, for some time. Over the past year, we have produced a number of studies on debt and housing, which have laid out the main facts. I will summarise them briefly, before moving on to the more difficult task of making judgments about their economic significance. Those who want more detail can consult the studies listed below. What has happened? 1. Most studies concentrate on movements in the ratio of household debt to household incomes. Over the past decade, this ratio in Australia has risen from a level that was low by international standards (56 per cent) to one that is in the upper end of the range of other comparable countries (125 per cent). 2. The rise in household debt was mainly due to increased borrowing for housing. Housing debt accounts for 83 per cent of total household debt, and that percentage has risen slightly over the decade. The story of household debt is largely a story about housing and, of course, is intimately tied up with the subject of rising house prices. In the remainder of my talk I will deal only with housing debt and ignore other forms of household debt. 3. While borrowing for owner-occupation is still the largest part of housing debt, the fastest growing component has been borrowing for investor housing, which now represents 30 per cent of the stock of housing loans (compared with 18 per cent a decade ago). 4. The main reason that debt has risen is that households can afford to borrow more in a low interest rate environment like the past decade than in a high interest rate environment like the previous two decades. Allied to this is the fact that in a low inflation environment, the real value of the debt is not eroded as fast as it was in a higher inflation one. So each household that takes out a loan can borrow more at the start of the loan, and will run down the real value of the loan more slowly than formerly was the case. Analysis published by the Reserve Bank of Australia (RBA) last month shows that these two related explanations could account for an approximate doubling in the debt to income ratio when their effects had fully worked through the system. See ‘Recent Developments in Housing: Prices, Finance and Investor Attitudes’, RBA Bulletin, July 2002, ‘Innovations in the Provision of Finance for Investor Housing’, RBA Bulletin, December 2002, ‘Housing Equity Withdrawal’, RBA Bulletin, February 2003, and ‘Household Debt: What the Data Show’, RBA Bulletin, March 2003. See RBA Bulletin, March 2003, op cit. In principle, this would not be completed until the last loan taken out before the fall in interest rates was paid off, i.e. 25 years. But in practice it would be a lot shorter because on average mortgages are paid out or refinanced well before maturity. 5. Financial deregulation and the associated increase in competition among lenders has also played a role by making loans cheaper, easier to obtain, particularly to investors, and providing innovations such as home equity loans and redraw facilities. 6. Over 70 per cent of households either own their homes outright or are renting and therefore have no housing debt. Owner-occupied housing debt is concentrated in about 30 per cent of households, as it has been for decades, but that 30 per cent have considerably higher debt levels now. 7. For those households with mortgages, there is a pronounced pattern in the debt to income ratio and the debt-servicing ratio over the life cycle. Both these ratios peak in the 35-40 year age group and decline thereafter, usually to zero. 8. Other measures of household balance sheet health such as the debt-servicing ratio and the gearing ratio show considerably less of an upward trend than the debt to income ratio. What can we learn from the debt to income ratio? Does the sharp rise in the household debt to income ratio over the past decade mean that it is now too high, or, as some commentators put it, that it has reached an unsustainable level? Unfortunately, it is impossible to answer this question by looking at the aggregate ratio, even if we supplement our analysis by international comparisons (Graph 1). There does not appear to be a level at which bad things start to happen - Japan’s ratio levelled off at about 130 after the equity and property bubble burst, but it was corporate debt rather than household debt which fuelled the bubble. In the United Kingdom the ratio fell in the early 1990s after it reached 115, but has now resumed its upward path to be in the mid 120s, while in the Netherlands the ratio exceeds 180 and is still going up. Unfortunately, we have no detailed information on the distribution of household debt for investment housing. In what follows, we assume that investment properties are owned by households that already own or are paying off their owner-occupied property, i.e. renters do not own investment properties. Graph 1 The debt to income ratio is only one measure of the health of household balance sheets, and, as will be argued below, not the best measure. We have to ask why the debt to income ratio rose, before we can draw any conclusions. As we demonstrated earlier, the main reason it has risen is that interest rates have fallen: mortgage rates halved between the second half of the 1980s and the past five years. As a result, a household which borrowed up to the point where debt servicing equalled 30 per cent of gross income (a common yardstick used by banks and other mortgage lenders) would be able to nearly double the size of the mortgage and still make the same monthly repayments as before. In order to judge whether the resulting increase in debt represents an increase in risk, we have to go through the following mental exercise. Compare two households - one in 1993 and the other in 2003 that have the same percentage of their income used in debt service, and have the same gearing ratio (level of debt as a percentage of value of house), but with the 2003 household having a debt level nearly twice as high as the 1993 household. Is the 2003 household taking more risk than the 1993 household? My judgment is that the 2003 household is riskier in only one respect. For a given rise in interest rates, it will be more affected because the rise will apply to a larger loan. But it is probably not right to make the assumption about ‘a given rise in interest rates’. That is because in the low inflation/low interest rate environment we have today, interest rates do not move about as much as before. In the late 1980s, on one occasion the mortgage rate rose by 3½ percentage points in a year, in the 1990s we have had nothing like that (the largest rise in a year was 1¾ percentage points). So the answer to the question I posed above is that, provided the variability of interest rates has also fallen in proportion to the fall in the average interest rate level - which it has - the hypothetical household in 2003 is in no riskier a position than the hypothetical household in 1993. Does this mean that the large rise in housing debt that we have seen in practice has not made the household sector more vulnerable? No, it merely means that we cannot draw this conclusion from looking at the rise in the debt to income ratio without enquiring into its cause. If, as in the hypothetical example above, it is entirely due to a fall in the level of interest rates and a commensurate fall in the variability of interest rates, then risk has not increased. This is important because most of the rise in the debt to income ratio in Australia is of this type. But this does not mean that we can dismiss all concerns about the rise in household debt. This is because some of the rise in the debt to income ratio was due to factors other than the fall in interest rates, and these factors may well have resulted in households taking on more risk, and in many cases a lot more than they recognise. The rest of my talk will attempt to spell out these factors. Other factors behind the rise in the debt to income ratio Lower inflation The other variable that has a quantifiable and mechanical effect on the debt to income ratio is the rate of inflation or, more precisely, the rate of increase of household incomes. Not surprisingly, this is highly correlated with the rate of interest, but it has an identifiably separate influence. When the rate of growth of incomes slows, the debt to income ratio of each borrowing household is eroded more slowly than in a higher inflation environment. When a household first takes out a mortgage, it places itself in a somewhat vulnerable position in that its debt is a multiple of its income, and its debt-servicing ratio is at its maximum. It accepts the risks involved because it is a necessary part of the path to home ownership. In the past, the typical household only remained in this relatively ‘risky phase’ for a few years, mainly because its nominal income rose quickly (partly due to inflation), and secondly because its debt was reduced by principal repayment. In a low inflation environment, nominal incomes rise more slowly and so households remain in the ‘risky phase’ for longer. If they have fully factored this into their financial decisionmaking, it should not present a major problem, but if they are still operating on the assumption that inflation will quickly reduce debt burdens, they would be taking more risk than they perceive. Financial deregulation and increased competition A range of other factors has allowed households to maintain higher levels of debt for longer periods than previously, and most of these are, at least in part, attributable to innovations brought about by financial deregulation and increased competition among providers of credit. It is now much easier to refinance and so take out a larger loan either on an existing property or to purchase a more expensive one. Banks and mortgage brokers now actively encourage these activities, and so loan turnover has risen sharply. A similar process is seen with new lending products such as home equity loans and mortgages with a redraw facility. These developments have allowed borrowers to go back and top up their debt over their lifetime rather than simply allow it to decline through principal repayment. The contrast between the two types of behaviour is shown in Graph 2: the older pattern is shown in the top panel, and the newer one in the lower panel. Like the effect of lower inflation described earlier, this allows households to remain in the ‘risky phase’ for longer than was the case in earlier decades. The special case of lending for investor housing So far the analysis has implicitly assumed that we are talking about households that borrow for owneroccupation or, at the margin, for consumption. But the biggest single change over the past decade is the rapid increase in borrowing in order to purchase a dwelling for investment purposes. The annual growth rate in this type of borrowing has averaged 21.6 per cent over the past decade, compared with 13.4 per cent for borrowing for owner-occupation. To put this in another perspective - if borrowing for investment purposes had only risen at the same rate as borrowing for owner-occupation, the aggregate debt to income ratio would only have reached 109 per cent, not the 125 per cent that actually occurred. At the former figure, Australia would still be in the lower half of the countries shown in Graph 1. So borrowing for investor housing is a large part of the story of rising household debt in Australia. It is also different to borrowing for owner-occupation in several respects. First, it is a pure investment decision, not a lifestyle decision. Many people would choose to become owner-occupiers even if they understood that it might not be particularly profitable; it is hard to see why anyone would be an investor in housing other than because they expected it would be a profitable commercial decision (hence, the widespread use of ‘investment seminars’ to encourage this type of activity). Second, for a high proportion of these investors, tax considerations drive the profitability calculations and so provide an incentive to maximise debt. Thirdly, borrowing for investment purposes is inherently riskier than for owner-occupation, in that the investor cannot be sure of who is going to occupy the dwelling and on what terms, but the owner-occupier knows the answer to that question. See G.R. Stevens, ‘Some Observations on Low Inflation and Household Finances’, RBA Bulletin, October 1997. Graph 2 There are additional risks that now accompany investor housing as a result of how the industry has changed. A high proportion of investment is now in multi-unit apartment buildings, where developers pre-sell to investors, usually on 10 per cent deposit. They have, therefore, effectively transferred the first 10 per cent of price risk onto investors. Because the building may take about 18 months to complete, that means the investor will not know whether the risk has eventuated for 18 months. In economics, a lag between when a decision to increase supply is made and when the price effect occurs can lead to what is colloquially known as a ‘hog cycle’, and can be associated with large overshootings in prices. It is conceivable that at some point in time there could be a large reduction in investor demand for apartments, perhaps because of fears of over-supply. But because of the production lag, there would still be an 18-month supply of partly-built apartments to come onto the market and to be digested by it. With the trend towards large-scale developments which take longer to complete, it is possible that this lag has been lengthening in recent years. For these reasons, we at the Reserve Bank have been concerned about investor housing for some time. We are concerned not only because it has been a very large factor in explaining the growth of household debt, but because the risks involved are greater than in borrowing for owner-occupation, and are unlikely to be fully understood by the many newcomers to this activity. What do other financial ratios show? The most important financial ratio from the household perspective is the debt-servicing ratio - the ratio of interest payments to disposable income. Understanding the movements in this ratio is difficult, as shown in the appendix to this speech. Two measures of debt servicing are shown in Graph 3 - the bottom line shows only interest on mortgage debt and the top line adds in the interest on all other household borrowing. Both lines show a gradual upward trend, although their cyclical movements differ. By 2002, the debt-servicing ratio on mortgages had reached 6 per cent of household income, while total debt servicing reached 7½ per cent. If we were to add the required repayment of principal on to this line, there would be a larger tendency for the line to slope upwards. Our estimate is that households currently pay about 2½ per cent of income in required principal repayment, which brings their total debt servicing to 10 per cent of disposable income. These aggregate ratios sound quite low, but we should recognise that they are held down because they include all those households which have no debt. When we adjust for this, our estimate is that for households with housing debt, the total servicing payment (interest plus required payment of principal) averages 20 per cent of disposable income, compared with about 14 per cent 10 years ago. Thus, although interest rates have trended downwards through the period covered by Graph 3, debt servicing has trended upwards. Households have increased their borrowing by more than interest rates have fallen, an outcome consistent with the developments discussed in the previous section. Graph 3 Another financial ratio that is important in order to evaluate risk is the gearing ratio, which is the ratio of the value of housing debt to the value of the stock of housing assets (Graph 4). In Australia this has risen over the past decade from 13 per cent to 20 per cent, and therefore means that households as a whole have increased their risk. But most households hold no housing debt, so the average gearing ratio for those that do is about 43 per cent. One other fact that we can deduce is that the average gearing ratio for investors has risen a lot faster than for owner-occupiers over the past decade, although the level is not as high. It appears that there are two main classes of owners of investment properties: those that wish to live off the rental income and therefore hold little or no debt; and those that are mainly concerned with capital appreciation and tax minimisation and therefore aim for a high level of debt. Over the past decade, the sharp rise in the gearing ratio suggests that the second group have expanded a lot faster than the first. Response to shocks I would now like to return to the question of whether the rise in household debt will result in a reaction which will be disruptive to the economy. Some commentators have suggested that the debt to income ratio is now so high that it is unsustainable. If they mean by this that it will start to fall under its own weight, I think that this outcome is very unlikely. It is far more likely that the ratio will continue to rise for some time, even if more slowly. For a start, the effects of the lower interest rates and lower inflation have not yet fully worked their way through the system and, additionally, it is likely that over time more households will take advantage of the newer and more flexible debt products now on offer. An alternative measure of gearing, the value of total household debt to total household assets (which includes equity holdings, superannuation, etc.), has risen from 10 per cent to 15 per cent over the same period. Graph 4 A more fruitful approach to analysing the effects on the economy of the higher household debt level is to ask how it will affect the response to economic shocks. In other words, how differently will a ‘high household debt’ economy behave in the face of some temporary adversity compared with a ‘low household debt’ economy? Is it more likely now, for example, that an adverse shock to the economy will mean more households are forced into selling their homes, or having their banks foreclose on their mortgages? This is the sort of scenario which we would all dread because it would impart a sharp contractionary force to the economy. In principle, this could happen if the shock in question was a deep enough recession accompanied by a large enough rise in unemployment. If someone loses their job altogether or is forced to accept one at a much lower income, they may not be able to meet their debt-servicing obligations. However, the crucial variable here is the debt-servicing ratio - it is this which determines whether a household can keep its property when there is an interruption to its cash flow, not the absolute level of debt (or the debt to income ratio). And we know that the debt-servicing ratio has risen moderately - from about 14 per cent to 20 per cent. So our judgement would be that although the incidence of this type of extreme reaction would increase, it would not increase by a lot. Even if we judge that the incidence of this extreme reaction will still be relatively low, are there other forms of behaviour which are likely to have changed as a result of the higher debt-servicing ratio and higher gearing among indebted households? In other words, are households that can afford to meet their debt-servicing requirement likely to change their behaviour in other ways now that they have a higher debt level than formerly? It seems to me that the answer to this is yes. Households are bound to become more cautious if the prospect of an economic downturn increases, and this would show up as weaker consumption and a rise in precautionary savings. Thus, as a general conclusion, we should assume that consumption will become more sensitive to economic conditions. A related aspect is that it is often said that consumption is now more sensitive to a change in monetary policy. This is clearly true if we define a change in monetary policy as a given absolute rise in interest rates, say 50 basis points. Obviously, if households have more debt, a rise in interest rates will affect them more than if they had less, and so income after mortgage payments would fall more, and so would consumption. This has not gone unnoticed, and at the Reserve Bank we are aware that the heightening sensitivity of consumption means that to achieve a given change in the economy, a smaller change in interest rates will be required. What about the response to falling house prices? For those households that could afford to meet their debt-servicing obligations, one would have to assume that they would continue to do so, regardless of the fact that the price of their house was falling. Even in the extreme circumstance where the price fell below the debt level - referred to as negative equity - it is likely that owner-occupiers would endure the situation stoically because there would be little alternative. Again, the higher the gearing, the more their wealth would be affected and the more cautious they would become in their consumption spending. The behaviour of investors in this situation, however, could be quite different to owneroccupiers in that there would be a strong temptation to get rid of the troublesome investment, especially if the fall in price was caused by a difficulty in finding tenants. So for investors, there could be a flow-on from falling housing prices to increased selling pressure and hence further downward pressure on housing prices. Another channel through which the increased sensitivity of consumption could work is the phenomenon of housing equity injection/withdrawal. As we have seen, in the good times households can augment their consumption by effectively tapping into the increased equity in their homes (housing equity withdrawal). But if they become apprehensive about their economic prospects, they could easily cease this activity or go back to the old pattern of equity injection, which would involve reducing consumption. There is evidence from the United Kingdom that such a switch occurs when house prices fall. Apart from the heightened sensitivity of consumption, are there other risks that we have overlooked? In particular, are there risks to the lenders as well as to borrowers, and hence a possibility of some sort of financial crisis due to failure of financial institutions? Obviously, if the shock was large enough, we could not rule this out, but my guess is that it is highly unlikely. Throughout our work on household debt, we have assumed that lending standards of financial institutions, as typified by maximum debtservice ratios, have not been relaxed. This might be an over-simplification but, if it is, it is not a large one. I know APRA have been looking at this situation closely and have been subjecting banks to stress tests based on quite onerous scenarios - for example, a 25 per cent fall in house prices. Even under these extreme assumptions, even though bad debts rise markedly and there would be a lot of personal distress, it is very hard to conclude that there would be large-scale financial failure. Conclusions Although I started with the intention of keeping my talk simple, I am afraid that the subject matter ended up being far more technical than I thought. I will therefore attempt to compensate for this by keeping the conclusions as simple as possible. There is one important factor that should give us some reassurance about the large increase in household debt. That is, most of the increase was due to the halving in the mortgage rate and the inflation rate as we moved from the 1980s to the 1990s. If this was all that was at work, I would be comfortable, given the greater stability in interest rates, in concluding that there had not been a significant increase in the risk profile of the household sector. But other factors have also been at work, and I cannot help but think they are the result of the overconfidence that follows the experience of a strong and sustained economic expansion. Much as I think the expansion has a good deal further to run, I suspect that a significant number of households have chosen a debt level which makes sense in good times, but does not take into account the fact that bad times inevitably will occur at some time or other. The other factors that have been at work show up as a modest rise in the aggregate debt-servicing ratio and a similar rise in the aggregate gearing ratio. These are not because the maximum risk a typical household faces during its life cycle is larger than it formerly was, but because many more households are now staying at or near their maximum risk position for a longer period. The other development that has clearly increased risk is the exceptionally fast increase in borrowing for residential property for investment purposes, and the accompanying rapid expansion in apartment building, which show all the signs of a seriously over-extended market. As far as we can judge at this stage, the rise in household debt does not pose a significant danger of a financial crisis, i.e. the failure of significant financial institutions such as occurred in the early 1990s after the build-up in corporate debt. But it does suggest that household consumption will be a lot more sensitive to economic conditions than hitherto. Thus, we should expect a more pronounced cutback in There is some anecdotal evidence of a small relaxation in lending standards in that the proportion of ‘high loan to valuation’ loans has risen somewhat, and the emergence of the non-conforming lenders has meant that some borrowers who could not meet the standards of the traditional lenders can now obtain housing loans. consumption if adverse economic conditions occur. This increased sensitivity also has implications for monetary policy, a development we have been aware of for some time. At present, there are some tentative signs that both household borrowing and residential property development may be levelling out. There is no doubt that those developments, followed by a further scaling back, would be in the longer-term interest of the Australian economy. Appendix Some measurement issues Debt servicing One of the important aspects of any assessment of the sustainability of debt burdens is the extent of an economic entity’s income which must be devoted to debt servicing. The measure used in this speech is the ratio of interest payments by households to household disposable income. This is derived from information in the national accounts, with some adjustments. Graph A1 The upper line in Graph A1 (the same as Graph 3 in the text) shows the resulting series. The notable feature of this series is that the peak value for debt servicing was in the period of high interest rates in the late 1980s. Subsequently, debt servicing costs declined sharply as interest rates fell. The effects of interest rate changes in the 1990s are visible as cyclical rises and falls in debt servicing, around a slowly rising trend, caused by the increase in debt levels. Two adjustments have been made to the data published in the national accounts to arrive at the interest paid data used here. First, unlike the published national accounts data, the figures here are not measured net of Financial Intermediation Services Indirectly Measured (‘FISIM’), which treats some interest as payment for the financial intermediation services supplied to households which are not explicitly paid for by fees. In assessing the actual interest payments made by borrowers for the purposes at hand, gross interest payments are of more interest. Second, the published data show a level of interest expenses in the recent past which seems too low relative to what is implied by the level of debt and prevailing interest rates, both of which are fairly readily observable. From the December quarter 2000, the figures here use RBA staff estimates which vary the implied interest rate in line with the cash rate. The upward trend in debt servicing is clearer in the lower line in the graph, which shows the debt servicing requirement specifically for housing debt. Currently, about 6 per cent of household disposable income is devoted to servicing the interest cost of mortgages. This is higher by about 1 percentage point than the peak value in 1990, despite the much lower level of mortgage interest rates, because the size of mortgage debt outstanding is now so much higher. Allowing for principal repayments as well as interest would increase this by about 2½ percentage points, an amount which is likely to be larger now than in the past because of the higher levels of debt. The fact that total interest servicing costs - i.e. those for mortgages and other loans - were so high in 1990, so that the divergence between these two lines is greatest at that time, reflects two factors. First, personal loans were a much larger share of total household debt at that time than they are now. Second, the average rate of interest on personal loans is usually higher than for mortgages, and they rose much more in the late 1980s than did mortgage rates. Both these series represent averages across the household sector. But experience differs markedly between households. Slightly less than 30 per cent of households have an outstanding mortgage against their own house; about 40 per cent of households have no mortgage debt on the dwelling they own. These proportions are little changed from a decade ago. Based on data from the Australian Bureau of Statistics (ABS) and the Australian Taxation Office, the proportion of households owning investment properties is around 8 to 10 per cent. Some, though not all, of these properties are partly debt financed. Taking these facts into account, and allowing for the fact that households with debt have, on average, incomes about 30 per cent higher than the average for all households, interest and principal repayments probably account for something like 20 per cent of disposable income among those households who have debt. This has most likely increased by about 6 percentage points over the past decade. In summary, a closer analysis of debt servicing requirements suggests that the commonly quoted fact that the total interest servicing cost is less than in the late-1980s peak obscures the fact that debt servicing costs are on an upward trend - which only stands to reason given that overall debt levels are rising. Further, servicing costs of those households with debt are considerably higher than indicated by the average experience across the household sector, and have risen a good deal over the past ten years. Gearing ratios Turning to consideration of housing leverage - that is, the ratio of housing debt to the value of housing assets - Graph 4 in the speech showed that leverage had risen from about 13 per cent to about 20 per cent over the past decade. However, again this is the average across all households, including the majority of households who carry no debt at all. Arguably a more relevant measure is the leverage of those households which do carry debt - namely, owner occupiers with a mortgage still outstanding, and investors. Some estimation is involved here because the relevant data are not directly observable. On the assumption that the 30 per cent of households with debt against their homes also own 30 per cent of housing assets, we estimate that the ratio of debt to assets for indebted owner occupiers is about 46 per cent, up from 36 per cent ten years earlier. Among investors, the rise in leverage appears to have been steeper, though from a lower starting point. In 2002, it is estimated that investors had debt equivalent to 36 per cent of assets, compared with 16 per cent ten years earlier. Table 1 Estimated housing gearing ratios % increase Owner-occupiers 35.9 46.1 28.3 Investors 15.6 36.1 132.0 | reserve bank of australia | 2,003 | 4 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to South Australian Centre for Economic Studies April 2003 Economic Briefing, Adelaide, 10 April 2003. | Glenn Stevens: Inflation targeting - a decade of Australian experience1 Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to South Australian Centre for Economic Studies April 2003 Economic Briefing, Adelaide, 10 April 2003. * * * It is a pleasure to be here in Adelaide to take part in this Economic Briefing. As the title of this address makes clear, I would like to look back over a decade of experience using an inflation target for monetary policy in Australia. Just a couple of weeks ago saw the tenth anniversary of a speech by Bernie Fraser, then Governor of the Reserve Bank, in which the outlines of our target can be seen. It was, admittedly, a tentative beginning – there was no drum roll, or breathless talk of a new era. A reasonably careful reading of that speech was (and is) needed to see the contours of the approach to monetary policy which was being developed, and the framework was not fully formalised until the 1996 Statement on the Conduct of Monetary Policy. It is perhaps for this reason that some commentators believe that inflation targeting in Australia in fact began much later. But those who were there at the time – as I was – saw the material in that and a couple of other speeches of the period as quite significant, in that it associated intent of policy with numerical objectives for inflation, even if only fairly broadly defined ones. The behaviour of policy over the ensuing years was, moreover, quite consistent with those ideas. Hence I remain happy to claim that inflation targeting in Australia began about ten years ago in the first half of 1993. So it is appropriate to mark the occasion with a look back at how inflation targeting has worked as a system. This is not the first review I have done – I drew some initial conclusions in 1999 after six years of experience. But we now have four more years experience – four fairly eventful years – so we can refine our conclusions. I shall argue that inflation targeting has been a success, on several criteria. It remains, in my judgement, the best model available for Australia. But it is not enough to look backward. It is only fitting that we consider the capacity of this framework to adapt to changing circumstances in the years ahead. I argue that it will be an adaptable system – though to meet some of the challenges may require even more emphasis on the medium-term nature of the target which has been a hallmark (and a strength) of the Australian approach thus far. Why Inflation Targeting? First, some history. Graph 1 shows a long-run series for inflation in Australia, beginning in the mid 1950s. The post-World War II era was the time when persistently rising prices became a normal feature of economic life. Prior to that, there had been periods of inflation followed by periods of deflation, with relatively little drift in the price level over long periods. Through the 1950s, Australia had positive inflation, but it was quite low on average, even if rather variable. This was also the case through the first half of the 1960s. Markus Hyvonen provided excellent research assistance for this speech. 'Some Aspects of Monetary Policy', Talk by the Governor, B.W. Fraser, to Australian Business Economists (ABE), Sydney, 31 March 1993, Reserve Bank of Australia Bulletin, April 1993, pp. 1–7. See Statement on the Conduct of Monetary Policy – http://www.rba.gov.au/MonetaryPolicy/Statement_on_the_conduct_of_monetary_policy_1996.html In an earlier speech ('Six Years of Inflation Targeting', Sydney, 20 April 1999 – available at http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_may99/bu_0599_2.pdf), I treated in some detail the way the shift to inflation targeting was 'evolutionary rather than revolutionary'. Ian Macfarlane has provided a more comprehensive historical treatment of monetary policy (see 'Australian Monetary Policy in the Last Quarter of the Twentieth Century', Shann Memorial Lecture, University of Western Australia, September – available at http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_oct98/bu_1098_2.pdf). available at Graph 1 By the end of the 1960s, it had become clear that, not only did prices always rise, but the rate of increase was getting larger. Inflation was trending higher, and this continued in the 1970s. As Ian Macfarlane has pointed out, Australian inflation was already at 10 per cent when the OPEC I rise in oil prices in late 1973 pushed global inflation up to levels rarely seen before. Australia's inflation reached 17½ per cent. It did decline thereafter, but by the end of the 1970s, was still running at about 10 per cent. Following the recession of 1982–83, inflation fell to about 5 per cent, but quickly rose again as the recovery proceeded. Things were not helped by the large depreciation of the currency in 1985 and 1986, which pushed down the trade-weighted value of the Australian dollar by nearly 40 per cent in eighteen months. This was quite inflationary, given that a background environment of high inflation and relatively uncompetitive markets meant that price rises resulting from the exchange rate fall could be fairly easily passed on, quite unlike the situation we have seen in recent years. The depreciation could have been more inflationary, had it not been for the Prices and Incomes Accord in place at the time. This framework allowed for wage claims under the highly centralised system then in operation to be 'discounted' for the estimated impact on the CPI of the depreciation. This was helpful in containing second-round impacts of the exchange rate change. More generally, the Accord framework provided for a reduction in real wages and lower inflation than would probably otherwise have accompanied the strong growth experienced through most of the second half of the 1980s. Even so, by the end of the 1980s, Australia had experienced a period of two decades during which the rate of CPI inflation averaged 9 per cent. Not surprisingly, an inflation psychology was well and truly ingrained in the Australian community. Measures of inflation expectations showed them to be in double digits. The financial advice to a whole generation of Australians presumed that high inflation – with the incentives for tax-effective leverage that it produced – would be a permanent feature of economic life. Some people used to calculate the half-life of a dollar (about eight years) as a way of illustrating the erosion of the value of money. Another way of putting it was that a dollar in 1970 had purchasing power of 17 cents by 1990. This is not the place to rehearse at length the corrosive features of inflation, though we do well not to forget them. Inflation surely cannot foster saving, or a productive allocation of capital to long-term ends. The poor are more likely to be hurt by Through all this, various monetary policy frameworks had proven unsatisfactory. We had monetary targeting for about a decade, but targets were hard to hit in the regulated era, and even harder to hit after financial liberalisation, so that there was doubt about the role of money as an intermediate objective. We couldn't rely on the exchange rate as an anchor, because we didn't have the sort of domestic structural flexibility consistent with a pegged currency, particularly given the nature and size of the external shocks which hit the Australian economy. And a policy of completely unconstrained discretion lacked credibility precisely because there had been two decades of high inflation. So when inflation came down during the aftermath of the recession in the early 1990s, to rates which were lower than anything seen since the 1960s, the question was how to take advantage of the opportunity to lock in low inflation as economic growth recovered. Around the world, some countries were looking at a model in which there was no intermediate goal, like a monetary target, nor an operational goal, like a pegged exchange rate, but a numerical target for the final goal, namely inflation, combined with discretion to vary the policy instrument in pursuit of that goal. In the New Zealand case, the attraction of inflation targeting was based as much on management and governance considerations as on the niceties of monetary theory: the thinking was that inflation was the variable for which the central bank should be accountable, so make it explicitly part of a formal agreement between the Governor and the relevant Minister. Canada had its own slightly different conditions, as did the United Kingdom. What they all had in common was a relatively unsatisfactory history as far as inflation control was concerned. It is no secret that the RBA had some reservations about the new approach. We felt that the very low target numbers and, more importantly, the quite narrow target bands espoused in some countries would prove too demanding in Australia (and probably elsewhere too). Nonetheless, the idea of articulating the goals of policy in terms of the ultimate objective made a lot of common sense. And we felt that having achieved low inflation, articulating a policy of keeping it low and behaving consistently with that stated policy did offer the prospect of combining a measure of price stability and good growth (which was, after all, expected to be one of the benefits of having price stability). Why '2 to 3'? How did we come up with the particular formulation of '2 to 3 per cent, on average'? To be frank, this was to some extent serendipitous. We were already in that neighbourhood, with inflation down to about 2 per cent by 1992. When we looked around at the best performances on inflation, we saw first that no-one had managed to keep inflation within a very narrow band for long, and second, that the best average performances since World War II were in the 'two point something' region, with quite a wide degree of variation around that average. We formed the judgement that the Bundesbank, which was the inflation-fighting central bank par excellence of the 1970s, had been prepared to tolerate inflation of 2 per cent or a little more, but would always act to reduce inflation if it rose to 3 per cent or more. This seemed to be a fairly sensible approach. If we could achieve something like that in the 1990s, it would be a major improvement on inflation than the rich, whose affairs can be managed to protect them from, and in some cases to profit from, the effects of inflation. Society can learn to live with inflation by indexation, and adjustment to behaviour, but real resources are used in the process. Incidentally, it was never true, contrary to popular belief, that the RBNZ Governor's salary was linked to inflation performance. What was true was that he could be dismissed for failing to achieve the target. From 1952–1970, the figures for two leading low inflation countries were as follows: ______________________________________ Average Minimum Maximum ______________________________________ Germany 2.0 -2.6 4.6 Switzerland 2.2 -1.4 5.4 ______________________________________ our performance of the 1970s and 1980s. We could always argue later about whether the target might be a little lower or more tightly defined. The 'on average, over the cycle' part of the formulation came from the observation that inflation was hard to control precisely, and that attempts to do so over short periods risked exacerbating the sort of economic instability we were trying to lessen. Experience has in my view borne out this judgement, even though the Australian approach was initially widely thought to be a bit too soft. How has performance turned out? So much for the history of how we came to inflation targeting. Now I want to address performance. I offer several tests. First, have we achieved the target? Second, has the inflation psychology been removed from the economy? Third, has this been associated with any cost to growth, or has it instead been associated with good overall economic outcomes? Inflation performance was shown in Graph 1 over a long period. The low average rate of inflation, and its greater degree of stability, since mid 1993 is quite clear. Table 1 shows some relevant data. Table 1: Inflation in Australia(a) 1970s 1980s 1990s 1993-2002 CPI 10.1 8.3 2.3 2.3 CPI ex interest 10.1 8.1 2.8 2.5 10.1 (b) 8.1 2.5 n.a. Weighted median(c) 7.9 2.5 2.2 Trimmed mean(c) 7.9 2.5 2.2 2.6 2.3 Treasury underlying Market Sector ex volatile items Target variable(d) (a) (b) (c) (d) 2.4 Adjusted for RBA estimates of the effect of the new tax system Treasury underlying inflation series published from March 1972 to June 1999 See Box D in May 2002 Statement on Monetary Policy for details of the definition of underlying inflation Treasury underlying series from September 1993 to June 1998. CPI ex taxes and health policy changes thereafter In a paper given in 1995, my colleague, Guy Debelle, and I explained the target as follows: '…if, some years hence, we can look back and observe that the average rate of inflation has a "2" in front of the decimal place, that will be regarded as a success.' I can report that, after ten years, it is indeed the case that consumer price inflation, on any measure, has a 2 before the decimal place. For the target variable (which was the Treasury underlying CPI series until 1998 and the CPI thereafter ), and abstracting from the effect of the GST in 2000, the average inflation rate over the 38 quarters up to December 2002 is 2.4 per cent. G. Stevens and G. Debelle (1995), 'Monetary Policy Goals for Inflation in Australia', in A.G. Haldane (ed.), Targeting Inflation, Bank of England, London, pp. 81–100. The target was initially specified 'in underlying terms'. For practical purposes, the underlying CPI series devised by the Commonwealth Treasury was used as the yardstick. A key factor behind this choice was the inclusion of interest charges in the CPI for some years, which made for a perverse short-term relationship between monetary policy and inflation. From the September quarter 1998, the compilation of the CPI was changed to remove this component, replacing it with an alternative means of estimating housing costs. The Bank then indicated that the inflation target could be seen as applying to the published CPI. See Box D in the November 1998 Semi-Annual Statement on Monetary Policy – available at http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_nov98/bu_1198_1.pdf. Graph 2 There have been a few cyclical swings in inflation over the period. But these swings were pretty moderate (which is, after all, the intention with inflation targeting). The targeted inflation measure varied between a high of 3.3 per cent and a low of 1.4 per cent. Measured in underlying terms using the median CPI, which is a measure often used by the Bank's professional staff, the lowest inflation rate in the period was 1.3 per cent in March 1998, and the highest was 3.2 per cent reached briefly in late 2001. Overall then, inflation has stayed within about 1 percentage point of 2½ per cent. This is, in my view, a most satisfactory performance. Has the inflation psychology so prevalent in the 1970s and 1980s been removed from the economy? The answer is yes, with relatively few exceptions. Measures of inflation expectations are scarce, especially ones over a longer horizon. The Melbourne Institute's measure of expected inflation, derived from a monthly household survey and funded by the RBA over many years, showed a sharp break in 1990 when actual inflation came down. During the 1990s, it did not move much. It increased a lot in 2000 just ahead of the introduction of the GST which pushed the level of the CPI permanently higher and the rate of change of the CPI temporarily higher, and came down again shortly thereafter. The median measure averaged about 4½ per cent over the decade, which shows a persistent error in this measure of expectations (of the kind which is not supposed to occur in economics!). One reason for this is that there continues to be a significant proportion of households who anticipate inflation of 10 per cent or more even after a decade of inflation of 2½ per cent. Presumably our message has yet to filter through completely. Graph 3 To the extent we can extract information from business surveys, they suggest that most businesses expect a low single-digit inflation rate to prevail for the economy in general. Perhaps more importantly, few businesses appear to believe they have 'pricing power', and individual price changes against a low inflation backdrop are much more transparent than was the case under high inflation. Witness, for example, the degree of scrutiny of price rises in the period after the introduction of the GST, or the attention routinely given to changes in petrol prices. Much of this is due, of course, to the more competitive nature of markets and the activities of the competition authorities, but the low inflation environment is also an important factor. Perhaps the group who devotes most effort to anticipating inflation trends is professional investors in the bond market. Nominal bond rates are usually thought to embody an allowance for future inflation. The difference between the indexed bond yield – a real yield – and the conventional bond yield is a measure of the average rate of inflation anticipated over the life of the bond plus, probably, a premium for the variability of inflation. Initially, markets were sceptical that we would keep inflation to the targeted rate. But after monetary policy passed the first test in the inflation-targeting period – tightening in 1994 ahead of a pick-up in inflation in 1995, which was successfully capped and reversed – this measure of inflation expectations came down to levels which were consistent with the inflation target. There have been ups and downs in this gauge of expectations, which broadly corresponded to the cycle in actual inflation. But on the whole, from 1996 through to 2003, these expectations have been fairly closely matched to the 2 to 3 per cent target. In general, I think we can say that while high inflation expectations have not been eradicated from every corner of the economy, generally speaking inflation expectations are low, consistent with the inflation target, and quite stable. That is no small benefit because it allows policy more flexibility than would otherwise be the case in assisting output in the face of shocks. Has this performance on inflation been associated with any cost to growth? While we cannot know the counterfactual, I think everyone now acknowledges that Australia's growth performance in the past decade has been exceptionally good. Table 2 updates a table from an earlier evaluation of performance made by staff at the International Monetary Fund (IMF) in 1998, which compared Australia with other inflation-targeting countries and a group of non-inflation-targeting countries. R. Brooks (1998), 'Inflation and Monetary Policy Reform', in Australia: Benefiting from Economic Reform, International Monetary Fund, pp. 63–94. There are now more inflation-targeting countries than when that study was conducted and, of course, there are more years of experience. The Appendix details the construction of the data. For my present purposes, I will simply update the original table, but the Appendix also updates the sample of inflation-targeting countries. Table 2: Inflation and Growth Per Cent Annual inflation(a) Real GDP growth(b) Mean Stadard deviation(c) Mean Standard deviation(c) 1980–92 7.2 2.4 2.8 2.7 1993–present 2.3 0.6 3.9 1.1 1980 to adoption of targets(d) 10.2 6.1 2.3 2.6 Adoption of targets to latest 2.7 1.3 3.0 1.6 1980–92 6.4 3.9 2.6 2.0 1993–latest 2.2 0.9 2.9 1.8 Australia Other OECD inflation-targeting countries OECD non-inflation-targeting countries(e) (a) Headline consumer price inflation for all countries except Australia (the Treasury underlying CPI up to June quarter 1998 and the CPI since with an adjustment for the effects of tax and health policy changes), New Zealand (the CPI excluding credit services after December quarter 1989) and the United Kingdom (the Retail Price Index, excluding mortgage interest payments). Inflation rates are calculated as the year-ended change in the quarterly index (b) GDP growth rates are calculated as the year-ended change in the quarterly GDP series. Where quarterly data are not available, year-average growth calculated from IMF data are used (c) Calculated as the average of standard deviations across countries (d) Dates used for adoption of targets are: Canada, 1991; Finland, 1993; Greece, 1998; Iceland, 2001; New Zealand, 1990; Norway, 2001; Spain, 1994; Sweden, 1993; the United Kingdom, 1992 (e) Austria, Belgium, Denmark, France, Germany, Ireland, Italy, Japan, Luxembourg, Portugal and the United States. Finland and Spain are considered to have become non-inflation-targeting countries upon joining the third stage of the EMU in 1999, and Greece in 2001. The EMU is treated as a single entity after 1999 The table shows mean and standard deviations for inflation and real GDP growth for two periods: from 1980 to the adoption of inflation targeting, and since the adoption of inflation targeting. The data are for Australia and two country groups: other inflation-targeting countries in the Organisation for Economic Co-operation and Development (OECD), and other (non-inflation-targeting) countries in the OECD. The essential results are unchanged from those of a few years ago: • all groups observed a decline in inflation, much reduced inflation volatility, a pick-up in growth and reduced volatility of growth – it was a good period for most economies; • compared with non-inflation-targeting countries, inflation-targeting countries saw a bigger reduction in inflation (from a higher starting point), a proportionately larger reduction in inflation variability, a larger pick-up in growth and a more marked reduction in volatility of growth (again, from a higher starting point); • Australia enjoyed a smaller absolute variability in inflation, a bigger pick-up in growth, a bigger reduction in volatility of growth and a smaller absolute volatility in growth than either of the other two groups. This is a particularly good story for Australia. It is apparent that inflation targeting has been associated not with reduced growth, but faster growth on average and less variable growth, as well as less variable prices. I will be the first to say that monetary policy cannot claim all the credit for this performance. There were, of course, major pay-offs during this period from a wide range of policy initiatives which aimed to liberalise markets, and make them more competitive. It is crucial that people understand the importance of these outcomes and the reforms which drove them. Monetary policy, as a demand instrument, cannot change the supply side of the economy, which is where the vast bulk of the community's gains in income and wealth originate. That said, monetary policy has to be made in a way which is cognisant of, and adapts to, the changes taking place on the supply side. Without that adaptability, the gains from other reforms would not have been as easily or as quickly realised. It also has an important role in responding to cyclical demand-side shocks in a prompt, measured way. In general, I think the conduct of monetary policy during the period of inflation targeting has exerted a stabilising influence on the economy over the course of the business cycle, and has allowed the supply-side improvements to find expression in higher levels of non-inflationary growth. The Future The record of inflation targeting in Australia is a good one. But it is not enough to look only backwards. We need as well to be asking whether the system we have is capable of coping with circumstances different to, and less advantageous than, the ones we have seen to date. I'd like to organise our thoughts here around three issues. First, deflation. An argument might be made that fighting inflation is fighting the last war. Maybe the new enemy is deflation. Certainly, more countries have experienced deflation in the past year than for many years, if not decades, and in a great many more countries inflation is very low and renewed cyclical weakness could, if it occurred, push it down further, perhaps to or below zero in some cases. There is no time today to go into detail about how we ought to think about deflation. The point for today is that inflation targeting isn't just inflation fighting. It involves inflation fighting but it also involves deflation fighting in equal measure. To my knowledge, all the countries practicing inflation targeting view their targets as symmetric: undershoots are no better than overshoots. All targets are centred on a number above zero, partly to guard against unexpected lapses into deflation. Further, credible inflation targeting that helps anchor expectations of inflation above zero helps to avoid the worst kind of deflation, which is not a temporary decline in prices but a persistent and widespread expectation of falling prices. The second potential challenge is dealing with adverse supply-side shocks. Monetary policy works on the demand side of the economy. When the prevailing disturbances come from that side too – as they have in the conventional business cycles which we have experienced in the past – monetary policy can dampen fluctuations in demand and by doing so it will be stabilising price fluctuations. When the shocks emanate from the supply side of the economy, on the other hand, things can be more difficult. Adverse supply shocks push activity down and prices up. Should this persist for any length of time, monetary policy is faced with more awkward choices, though there is no uncertainty about what its longer-term objective ought to be: to control inflation. For most of its history, inflation targeting has coincided with, if anything, favourable supply shocks. We have had positive surprises on productivity, and in the supply-enhancing effects of internationalisation For my views, see 'Inflation, Deflation and All http://www.rba.gov.au/Speeches/2002/sp_dg_041202.html. That', Sydney, December – available at of production. These surprises tended to push output up and prices down. This has been, we have to admit, a very benign environment in which to operate monetary policy. It may not always be this way in future. Inflation-targeting central banks will certainly find challenges if adverse supply disturbances occur, but this is also true of any other monetary policy model we could think of. I imagine that inflation targeters, if faced with a rise in inflation above target due to supply shocks, will focus on gradually bringing inflation down again. If inflation expectations are well anchored near the target rate, as they appear to be in most countries, there is no reason to believe this will be unduly difficult, and in fact there would in such circumstances be flexibility to take some time to achieve convergence back to the target, which could help adjustment on the real side of the economy significantly. The third issue for the future is how, if at all, to respond to major movements in asset prices. This is the most difficult problem to tackle, both conceptually and in practice. Most people agree that asset price inflation per se should not be an objective of monetary policy. Most people also agree that, to the extent that asset price movements have implications for the course of the economy over the standard forecasting horizon of a couple of years – through wealth effects, for example – those effects should be allowed for in the setting of monetary policy. This is really just saying that in searching for the optimal policy setting to achieve the inflation target over a two-year horizon, all the relevant information should be taken into account. We can all sign up to that. But there is a lot more to asset price dynamics than that. These events typically have a lower frequency than the business cycle frequency to which our normal policy practices are attuned. They build up over a number of years. Furthermore, asset price movements and their effects are often asymmetric. When asset prices are rising, they can easily co-exist with low CPI inflation. But because this is often associated with a build up in debt, the ensuing correction in asset prices can cause acute distress to borrowers. This means both that spending behaviour is affected and that there can be a risk of systemic financial instability because distressed borrowers often mean a deterioration in the asset quality of the lenders. This, if it occurs, weakens the economy significantly and can push inflation down sharply. In that final phase of this asset price cycle, monetary policy will need to be easy. The question, however, is whether during the earlier phase it should be tighter than normal, in order to try to lessen the probability of a bust, at the expense of having somewhat lesser short-term growth and inflation lower than the announced target. Put another way, should policy accept a mild short-term undershoot of the inflation target in order to lessen the likelihood of a much bigger undershoot in three or four years' time? Here there is less agreement. Some people argue that there is a strong case for this additional response, particularly on the grounds that if the costs of the bust are large it is worth paying some cost to avoid it if at all possible. Others argue that a modest response of policy to the asset price problem would be ineffective in dampening the asset price dynamics, and that an aggressive response would bring on the problems that policymakers are setting out to avoid. In this view, policy should stick to its usual macroeconomic concerns, responding to any after-effects of the asset price cycle when they emerge. Does inflation targeting allow scope for responding to asset price concerns, if that is thought to be sensible? I think it does, provided we are prepared to adopt a sufficiently long time horizon. Inflation targeting is often presented, for expositional purposes, as a commitment to vary the instrument so as to keep the forecast inflation rate at the target at some particular horizon – two years, for example. But surely policymakers care, in principle at least, not just about the inflation rate two years from now, but the whole path of future prices. We care not only about where inflation will be two years from now, but where it might be heading at that time and how quickly. Consider two hypothetical outlooks. In one, a given set of policy interest rates assumed for the forecast is associated with inflation in two years' time at the target, but also with an asset price boom and increasing leverage, which means that there is an uncomfortably high probability that, beyond the two-year horizon, perhaps in year 4, there will be a crash which could impair the financial system, take the economy into recession and reduce inflation well below the target. In the alternative outlook, a For example, Lars Svensson (1997), 'Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets', European Economic Review, 41(6), pp. 1111–1146. higher assumed set of policy interest rates is associated with lower growth and lower than target inflation over the standard two-year horizon, but also with reduced risk of the really big fall in inflation and activity in year 4. Graph 4 Would we automatically select the first of these two possibilities purely on the basis that inflation is at target in two years' time? There would be a fair proportion of people who might select the second alternative, given the choice. Of course, life is not quite as simple as the hypothetical choice I have concocted here. We don't know enough about the behaviour of asset prices, much less their linkages to the economy through the financial sector, to make such forecasts with any confidence. Nor do we know much about how the dynamics might respond to monetary policy. So we cannot easily identify the optimal response to the situation. There would, as well, be significant communication issues associated with a policy which sought to reduce the risks associated with asset price developments, but which carried the side effect of slowing the economy. But despite the difficulties, it seems to me that thinking through the nature of risks posed by these asset price swings is helpful. Policy should not rush to respond to every asset price movement that comes along. But a case might be made, on rare occasions, to adopt a policy of 'least regret' so far as asset prices are concerned, if financial and macroeconomic stability were thought to be at risk. To do so would probably require an acceptance of a longer time horizon for inflation targets, and an acceptance of a bit more short-term deviation from the central point of the target. These issues remain unresolved among theorists and practitioners of monetary policy. There will be a good deal of further discussion about them in the period ahead. Conclusion Inflation targeting has been a successful model for monetary policy in Australia. It has been associated with lower, less variable inflation, and better and less variable economic growth. While I would not claim that improved overall economic performance has been entirely due to the adoption of inflation targeting, I do claim that this approach to policy has made a significant contribution. For discussion of these issues in more detail, see Claudio Borio and Philip Lowe (2002), 'Asset Prices, Financial and Monetary Stability: Exploring the Nexus', BIS Working Paper No. 114, July – available at http://www.bis.org/publ/work114.htm. Inflation targeting allows a considerable degree of short-term flexibility for monetary policy decisions, but also imposes the appropriate medium-term constraints. That's a very good combination. There are no alternative models at the moment for Australia's monetary policy which offer a better mix. We must still be on the look-out for challenges. Coping with cyclical fluctuations in the economy and shocks of various types will remain constant tasks. But I think that the most difficult issues likely to confront monetary policymakers in most advanced countries remain those associated with asset price swings. Opinion remains divided as to how to cope with them. But in the event that opinion coalesced in favour of some more active response to asset prices in the interests of longer-run financial and economic stability, I think inflation targeting as a system is sufficiently adaptable to encompass that. Will we return here in another decade to celebrate twenty years of inflation targeting? Actually, I hope not. My hope would be that a system for running policy which has worked well will continue to do so, adapting as needed to changing conditions, to the point that a sound monetary system is just part of the economic furniture and we spend our time debating other issues. I think we are well on the way to that situation, and our part in the RBA is to keep us on that track. APPENDIX (for Table 2) Table 2 is an updated version of a table prepared originally in Brooks (1998). The inflation rates are calculated as the year-ended change in the quarterly index. The GDP growth rates are calculated as the year-ended change in the quarterly GDP series. Where quarterly data are not available, year-average growth calculated from IMF data are used. Other overseas data are sourced from national statistical authorities and the OECD, while Australian data are sourced from the Australian Bureau of Statistics (ABS). Mean inflation and growth rates for the country groupings are calculated as simple averages of the country means. Similarly, the standard deviations are calculated as simple averages of the country standard deviations. The averages for the 'other OECD inflation-targeting countries' grouping are calculated based on dates when inflation targeting was adopted in each country, which are the same as in Brooks (1998). Large and small non-inflation-targeting countries are all put together in this version of the table, unlike in the original, because the advent of the euro left very few small non-inflation targeters. An alternative version of Table 2 is presented below, with Austria, Korea, Mexico, the Netherlands and Switzerland included, as these OECD countries were omitted by Brooks (1998). The inclusion of Korea and Mexico as inflation targeters makes the decline in inflation and inflation variability for the targeter group larger, but the pick-up in growth smaller and probably insignificant. The inclusion of Austria, the Netherlands and Switzerland as non-targeters makes relatively little difference to the story for that group as a whole. In this version of the table, Australia's performance still stands out as remarkably good. Inflation and Growth Per Cent Annual inflation(a) Real GDP growth(b) Mean Stadard deviation(c) Mean Standard deviation(c) 1980–92 7.2 2.4 2.8 2.7 1993–present 2.3 0.6 3.9 1.1 13.0 9.1 2.8 2.9 3.1 1.2 2.9 1.6 1980–92 5.9 3.5 2.5 2.0 1993–latest 2.1 0.9 2.7 1.7 Australia Other OECD inflation-targeting countries 1980 to adoption of targets(d) Adoption of targets to latest (e) OECD non-inflation-targeting countries (a) Headline consumer price inflation for all countries except Australia (the Treasury underlying CPI up to June quarter 1998 and the CPI since with an adjustment for the effects of tax and health policy changes), New Zealand (the CPI excluding credit services after December quarter 1989) and the United Kingdom (the Retail Price Index, excluding mortgage interest payments). Inflation rates are calculated as the year-ended change in the quarterly index (b) GDP growth rates are calculated as the year-ended change in the quarterly GDP series. Where quarterly data are not available, yearaverage growth calculated from IMF data are used (c) Calculated as the average of standard deviations across countries (d) Dates used for adoption of targets are: Canada, 1991; Finland, 1993; Greece, 1998; Iceland, 2001; New Zealand, 1990; Norway, 2001; Spain, 1994; Sweden, 1993; the United Kingdom, 1992 (e) Austria, Belgium, Denmark, France, Germany, Ireland, Italy, Japan, Luxembourg, Portugal and the United States. Finland and Spain are considered to have become non-inflation-targeting countries upon joining the third stage of the EMU in 1999, and Greece in 2001. The EMU is treated as a single entity after 1999 | reserve bank of australia | 2,003 | 4 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, 6 June 2003. | I J Macfarlane: Recent financial and economic developments in Australia Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, 6 June 2003. * * * In the six months since we last appeared before this Committee we have received a lot of information on the world economy, but it has not resolved the uncertainties we have lived with for a year or so now. As you will recall, 2002 started out on a promising note, but the momentum of global growth waned in the second half of the year. A return to firmer growth was expected early in 2003, but observers watching for signs of that quickly found the picture clouded by concerns about the growing likelihood of war in Iraq, and then its actual occurrence. The war itself carried obvious risks, not least of which was a big rise in the price of oil, and its effects on confidence masked the underlying economic trends. The relatively quick resolution of hostilities, and the associated drop in the price of oil, was a major plus for the global economy, compared with the possible alternative. Confidence recovered some ground and attention returned to underlying economic trends, but the incoming data did not give any encouragement; it is now clear that a pick-up in global growth has not occurred in the first half of 2003. The international forecasting community have now pushed the forecast pick-up back to the second half of the year, though there are few signs in support of this view as yet. It is not surprising, in this environment, that financial markets are giving rather mixed messages. Around the world bond yields have fallen recently to historical lows, indicating participants in this market see a weaker outlook for growth and inflation. Equity markets, on the other hand, have been steadier, after two-and-a-half years of falls. In the United States markets have even made noticeable gains in recent weeks, suggesting that some of the gloom may be lifting. Foreign exchange markets continue the trend that started about 18 months ago, with the US dollar falling, the Yen remaining broadly stable and a group of currencies including the Euro, the Swiss Franc and the Canadian, Australian and New Zealand dollars rising. Where does that leave Australia? I will start to answer that question in the traditional way by evaluating and then updating the forecasts that I gave the Committee last time. When we met in December last year, I said that we expected GDP to grow by 3 per cent through the year to June 2003, that is through the present financial year. This was slower than in other recent years, and an important reason for this was the temporary contractionary influence of the drought. When we moved the forecast horizon along six months, that is to the end of 2003, we expected the growth rate to rise to 3¾ per cent. The outcome for growth through 2002/03 looks like it will be close to the 3 per cent forecast, or only a little below it. As we look slightly further ahead, however, prospects are not as strong as they were. Instead of 3¾ per cent through calendar 2003, growth might now be more like 3 per cent. What has caused this downward revision to the outlook? The main explanation is the weaker performance of the world economy we have seen to date, which is affecting Australia’s trade performance. Our imports have continued to grow in line with our quite strong domestic demand, but our exports have fallen appreciably, and there is less confidence that they will be lifted in the near future by firmer foreign demand. I will say more about this in a few minutes. The inflation forecast I gave last time was for the rise in the CPI to exceed 3 per cent in the near term and then to ease to about 2¾ per cent in the 12 months to end 2003. The first part of this forecast has occurred as the CPI in the most recent 12-month period (to the March quarter 2003) ran at 3.4 per cent, pushed up by the high oil prices in that quarter. But the oil price pressures have already reversed, and when we looked at the likely outcome in the remainder of 2003 and into 2004 in the May Statement on Monetary Policy, we reduced our inflation forecast from 2¾ per cent to 2½ per cent, largely because of the higher exchange rate for the Australian dollar. Since the Statement was released, of course, the exchange rate has risen further. Let me say a little more about the domestic economy. The thing that stands out is that domestic demand had been growing at a very high rate. For example, it grew by 6½ per cent last year. This was unlikely to be continued over a long period, and over the most recent four quarters, it has slowed to 5½ per cent. We expect some further deceleration as we look ahead, but the most recent data do not suggest it will be large. Consumption has grown by 3½ per cent over the year to the March quarter and more recent data such as retail trade show good rises in the two most recent months – March and April. Given the growth in employment and incomes, and the fact that consumer confidence is above its longer-term average, prospects for consumption look quite good. Similarly, private investment according to the latest CAPEX survey is holding up well. We cannot expect a repeat of the 20 per cent growth we had last year, but a figure of the order of 10 per cent is likely, given the strength of investment in building and structures. The corporate sector is in excellent financial health, with conservative gearing, good profitability and ready access to credit, although it is not using much of this because of its ample internal sources of funds. Most of the surveys show readings at or above average for business conditions and business confidence. I do not wish to say much about residential construction other than that it has held up for longer than we or other forecasters expected, but it now appears to have peaked despite the boost that it is continuing to receive from alterations and additions. The experience among different industries is, as usual, quite varied. Although, in the aggregate, growth has been good, some sectors are suffering. Agriculture during the drought is the obvious example, but more recently the tourist and international transportation sectors have suffered a sharp fall in activity associated with the public reaction to the SARS virus, just when it looked like they were about to recover from the drop in travel associated with the Iraq War. Employment has grown by 2½ per cent over the past year although, as usual, the recorded figures show a very irregular pattern of growth. The unemployment rate at 6.1 per cent is about as low as it has been in the present expansion. As explained earlier, consumer prices are rising at 3.4 per cent per annum, and wage costs at about 3.6 per cent. Inflation has been close to or above 3 per cent for more than a year. This would be a source of concern if we expected the situation to persist long enough to become entrenched in expectations. But, as I said earlier, inflation is likely to decline in coming quarters, and overall growth in labour costs is consistent with the inflation target. These figures contrast with the much lower rates of increase occurring in major economies overseas where demand is much weaker and inflation targets – implicit or explicit – are, or are in danger of, being undershot. Before leaving the domestic economy, I will make a few remarks about the growth of credit. Aggregate credit has grown by 13 per cent over the past year, which is quite a high figure in an economy where nominal GDP has grown by 6 per cent. When we look more closely, we find that household credit has grown by 20 per cent and that credit to the household sector for housing purposes has grown by 21 per cent. Credit for investors in housing is growing at a pace of about 28 per cent. Thus, we have a situation where credit is growing a good deal faster than appears necessary to satisfy the needs of the economy, and that this situation is wholly due to credit being channelled into the housing sector. When we see these kinds of figures, it is hard not to conclude that a significant part of this must be directed to speculative purposes. There is, of course, plenty of other evidence to support this supposition. Overall, an examination of the domestic economy leads us to conclude that there is little or no evidence to suggest that monetary policy has been too tight, or is currently exerting a constricting influence on domestic demand. But that is only part of the story, and possibly the smaller part – policy must also take into account the impact of international forces. Let me now return, therefore, to the global economy, and then I will conclude by trying to make an assessment of the balance of risks which face the Australian economy. After the short-lived optimism that followed the end of the Iraq War and the fall in oil prices, and amidst the flow of mixed economic data, observers of the international economy were confronted with two pieces of news, both emanating from the United States, which gave pause for thought. The first was the Fed’s communiqué from the early May Federal Open Market Committee Meeting. In it, the Fed stated that the balance of risks on inflation was in the downward direction. While the Fed did not mention the word “deflation”, and it clearly does not regard that as the most likely outcome, markets interpreted the Fed as saying that deflation was now at least a possibility that had to be included into the range of conceivable outcomes. US bond yields soon dropped to 45-year lows. The second piece of news from the United States was the Secretary of the Treasury’s comments on the value of the US dollar. This was virtually unanimously interpreted as signalling the end of the “strong dollar policy” and an acceptance that a declining dollar was in the interest of the US economy. The interpretation gained added plausibility, despite later denials, when it was seen in conjunction with the Fed’s earlier announcement on downward risks to the inflation outlook. The likelihood that the US dollar might decline further, with tacit acquiescence from the US authorities, has led many observers to believe that a significant change is occurring in the international environment. A declining US dollar helps the US economy adjust to its problems, but also shifts those problems in part to other countries. In passing, I have to say that I am not criticising the United States for this – to date, they have shouldered more than their fair share of the responsibility for getting a global expansion going. But, if we are interested in increasing global growth, rather than just having a redistribution of the pattern of growth between countries, many countries which have enjoyed the stimulus of exporting to the United States when the US dollar was high will need to find domestic sources of expansion. There is a great deal of scepticism about how successful the two main areas outside the United States – Japan and the Euro area – will be in this endeavour. It is in this general context that some central banks have reduced interest rates over the past few days. As you know, we did not. This was not because we are unaware of the downward risks that are presented by the global economy, nor because we think our economy is somehow immune to international problems. It was because we clearly have stronger domestic conditions in place already as a result of current policy settings (not to mention higher inflation than most countries), and hence have not had the same sense of urgency in reducing interest rates that several others clearly did. We are, however, very conscious of the risks the Australian economy faces. Obviously, the first one is that the world economy fails to recover and that, in time, this feeds through to a protracted weakening in the Australian economy. The main direct channel through which this could occur would be a further weakening in exports. At the same time, we have seen that because our economy is healthy relative to others, and hence our interest rates are not as low as others, foreign investors have found Australian dollar-denominated assets attractive to acquire. Thus, a second channel could be through an excessive appreciation of the Australian dollar. Not that I think what has happened to date could be in any way labelled excessive. The trade-weighted exchange rate has returned to its post-float average, while the rate against the US dollar is still well below the post-float average. On the purely domestic front, the main risk is associated with the rapid growth of household credit. Not only does it seem excessive in terms of purely domestic needs, it is far higher than in any other comparable country. Most of the credit has been directed towards bidding up the price of housing and, in some parts of the housing market, the motivation has been dominated by the pursuit of speculative gain. Will this continue? I think there is now some evidence that in the most speculative hot spots, a degree of common sense is returning. Investor interest in inner-city apartments is well down, and a number of proposed projects have been shelved. In addition, estimates of vacancy rates are being revised upwards and rents are falling. If this interpretation is correct, it should in time be reflected in the normal statistical collections on credit and prices. But these statistics inevitably contain quite long lags, so they will be the last indicators to turn down. When we put the two sets of risks together, there are several possible outcomes. A weakening world outlook and an abating of domestic credit and asset market pressures would provide a reasonably clear prognosis for monetary policy. In the other direction, so too would a combination of a clear strengthening in the world economy and continued domestic buoyancy. A third possible combination, and the most favourable one for Australia, would be a firming world economy and easing in domestic pressures, resulting in a more balanced growth outcome for the Australian economy. But the combination that would be most damaging to the Australian economy would be if the household sector were to continue putting itself into a more exposed position at the rate it has over the past few years, while at the same time a further weakening of the world economy was starting to feed through to activity and incomes. That would be a recipe for ensuring that, when the house price correction came, as it inevitably would if the world economy was weak enough, it would be bigger and more disruptive than otherwise. I am not saying that this is the most likely outcome, only that it is a risk we have to take into account. It is this risk that adds an extra degree of complexity to the making of monetary policy in Australia, and gives some context to my earlier remarks about there having been less urgency in Australia than elsewhere to respond to the weakening world economy. In conclusion, the international environment has not yet improved in the way we had hoped, and the changing fortunes of the US dollar throw an additional complication into the mix. To date, the domestic economy has weathered the unfavourable international environment very well. Nonetheless, growth will be further adversely affected in the period ahead if the international situation does not improve. If this were to occur, it would change the balance of forces that has been keeping interest rates steady over the past year. | reserve bank of australia | 2,003 | 6 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Business Council of Australia Annual Dinner, Melbourne, 8 July 2003. | I J Macfarlane: Observations regarding stability in the Australian economy Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to Business Council of Australia Annual Dinner, Melbourne, 8 July 2003. * * * I would like to start by thanking the Business Council of Australia for inviting me to its Annual Dinner. This is the first such occasion I have attended, and I note that the price of my invitation is that I have to give the after-dinner speech. Given the time of day, you will be pleased to hear that I will confine myself to a few simple observations, rather than delivering an economic treatise. Some people may be expecting a commentary on the current outlook for monetary policy, but I am afraid they will be disappointed. Last week we made a decision on monetary policy at our July Board Meeting, and it received a lot of press coverage. Not everyone agreed with the decision, but I have to say that I was quite impressed with the quality of the discussion it generated. I think there is a very well informed and reasoned appreciation of the conflicting pressures and trade-offs we at the Reserve Bank face. Given that, I am reluctant to add any more at this stage, because, no matter how carefully modulated my comments, I would run a great risk of destabilising a basically stable situation. Instead, I would like to move into my talk by starting with the observation that the Australian economy has now gained international recognition for its stability, whereas in previous decades it was noted more for its booms and busts. In the jargon of financial markets, investing in Australia is now a “stability” or “safe haven” play whereas formerly it was known as a “cyclical” play. The latter term meant that the Australian economy did better than the world economy when the world economy was doing well, and worse when it was doing badly. The change in the world’s perception of the Australian economy from one of instability to one of stability has obvious advantages to us, but it does not eliminate the need for hard policy decisions - it simply changes the nature of those decisions. But before discussing that, I would like to illustrate some of the changes in the behaviour of economic variables that have given rise to the changed perception of the Australian economy. The first clear sign that the Australian economy was showing a new-found stability was the way in which it handled the Asian crisis. Although we had a higher share of our exports going to the crisisaffected Asian economies than any other developed country, we were able to negotiate this difficult period without any noticeable economic slowdown. It was not that our exports were unaffected - total exports fell by 6 per cent in 1997/98 and exports to Asia by 19 per cent - but that strong domestic demand offset that effect. GDP Year-ended change, constant prices % % Australia* NJA (ex China) -4 -8 -4 -8 * Non-farm GDP Sources: ABS; CEIC The second episode where Australia’s relative stability showed up was during the recent recession that occurred among the major economies in 2001. Over the course of that year, the G7 economies showed zero growth whereas we grew by about 4 per cent. Another interesting feature of that period was the divergent pattern between the Australian and US economies. It used to be common to remark on the close link between growth in the Australian and US economies, but that pattern broke down during the recent US recession. Note that we did have a slowdown in the second half of 2000, but that was a once-off effect caused by a fall in house-building following the introduction of the GST. Turning to financial variables, the one we are most frequently made aware of is equity prices. Again, Australia stands out for relative stability. If we compare the behaviour of the ASX 200 with its equivalents in the US, UK and Europe, the contrast is very striking. The boom and bust behaviour of the other three indices is hardly apparent at all in our stock prices, and over the whole six-and-a-half year period since the start of 1997, our stock market has risen as much from end-point to end-point as any of them. Two real economic variables that are closely related to my previous graph are business fixed investment and the profit share of GDP. For simplicity, I have only compared the Australian experience to that of the US. On business fixed investment, again we have experienced none of the boom and bust that was apparent in the US. In fact, our business fixed investment remained remarkably subdued during the period of booming stock markets, but has picked up over the last 18 months or so, when it has been most useful for us in a counter-cyclical sense. GDP Year-ended change, constant prices % % Australia* US* -2 -2 * Non-farm GDP Sources: ABS; Thomson Financial Datastream Share Price Indices January 1997=100 Index Index Europe US Australia UK Sources: Bloomberg; Datastream Business Fixed Investment Share of GDP, constant prices % % US Australia Sources: ABS; Thomson Financial Datastream The comparison for profits is very similar. Corporate profits in Australia have risen relatively smoothly over the past decade, while in the US they rose until about the end of 1997, but have fallen thereafter. The interesting thing to notice about the US was that profits were falling through the boom years on the stock market of 1998 and 1999. Real Corporate Profits* September 1994 = 100 Index Index Australia I think I have shown enough to get my story across, so I will not labour the point by showing any more comparisons. Instead, I will try to answer the questions of why our recent outcomes have been more stable than in the past, and why they have been more stable than most comparable countries. US * Net of depreciation and interest Sources: ABS; Bureau of Economic Analysis The first of these questions is why has the Australian economy recently been more stable than it formerly was? My answer to this is that it is largely the result of policy reforms, but luck also played a part, which I will refer to later. On economic policy, I would point to a number of major reforms over the past 20 years that have been crucial: · The floating of the exchange rate. · The non-inflationary financing of budget deficits through the tender of government debt. · The move of monetary policy to one based on an independent central bank and inflationtargeting regime. · The move towards a more disciplined fiscal policy. · Labour market deregulation. The main change here was to decentralise, i.e. to move away from a system based on a National Wage Case which awarded every worker a given percentage rise once a year (or, in earlier times, once a quarter). The labour force looks a lot different today, with a considerably smaller proportion working for the government, and a smaller proportion unionised. · The opening up of the economy to international influences, both through the reduction in tariffs and the abolition of controls on capital movements. · Competition policy applied both to the private sector and the government sector, and significant privatisation of the latter. These changes have generally moved the economy away from centralisation to decentralisation and away from regulation towards deregulation. They have resulted in a myriad of small changes occurring almost continually, rather than a few large ones. So the economy shows more day-to-day volatility but is less likely to build up the pressure that results in crises and large disruptive adjustments. There is another reason why the performance of the Australian economy has become more stable than formerly which is not the result of deliberate policy decisions. I refer to the changed behaviour of our terms of trade, a subject I have spoken of on many previous occasions. The terms of trade is the ratio of the price of our exports to the price of our imports, that is the “buying power” of our exports. For much of the 20th century our terms of trade trended downwards because the prices of commodities, which make up much of our exports, failed to keep up with the prices of manufactures, which make up most of our imports. In my view, this trend started to change about 15 years ago, as new sources of low-cost manufactures started to come on stream from Asia, particularly from China. Now it is manufactures prices that act like “commodity” prices, and not just in a trend sense, but cyclically too. You will note from my next graph that in the recent major-country recession of 2001, our terms of trade actually improved. Normally, we would have expected them to fall, which would have magnified the contractionary effect of the global slowdown. The second question is why has the Australian economy recently shown much more stable behaviour than the much larger and more diversified US economy? This is not what you would normally expect of the two economies on the basis of their size or their history. I think the major reason for this is that the US had an asset price boom and bust - commonly known as a bubble - and we did not. I have already shown the rise then fall in equity prices, profits and business investment in the US and the effect this has had on economic activity. The US economy is suffering from a hangover after the binge; we did not have the binge and so have avoided the hangover. I would like to say that it was excellent economic policy that prevented us from participating in the binge, but that would be claiming too much. Noone really understands the relationship between macro-economic policy and asset price booms and busts well enough to make that claim. The unfortunate fact is that it seems to be possible to experience an asset price boom in an economy where macro-economic policy settings seem to be relatively well disciplined and inflation quite restrained. One thing we do know, however, both from the US experience and the earlier Japanese experience, is that once the asset price boom has turned into a bust, the effect on the macroeconomic policy settings is profound. Partly this is because the contracting economy affects the policy settings, and partly it is because policymakers are quick to adjust their levers in an attempt to head off the contraction. Again, a comparison with the US makes the point. On fiscal policy, the Australian budgetary position has varied little over recent years, with predominantly small surpluses being the order of the day. In contrast, the US budgetary position has moved from a surplus of 2 per cent of GDP in 2000 to an expected deficit of 4 per cent of GDP in 2003. The US has used a huge amount of its fiscal ammunition, while we have not even started to do so. Terms of Trade March 1982 = 100 Index Index Source: ABS National Budget Balance Per cent of GDP % % US Australia -2 -2 -4 -4 -6 Official Short-term Interest Rates % % Australia On monetary policy, the contrast between the two countries is equally pronounced. The US put US interest rates up slightly more than we did in 1999/2000, but the difference was minor. However, since the US recession hit in 2001, they have reduced their interest rates much more than us. From a peak in the second half of 2000, Sources: Federal Reserve Bank of New York; RBA they have come down by 5½ percentage points, while we have come down in net terms by 1½ percentage points. I do not want to give the impression that I think stability of interest rates is a goal in its own right - only that it reflects the greater stability of the Australian economy. -6 Sources: Commonwealth Treasury; Thomson Financial Datastream Again, the contrast in both of the above policy variables between the two countries is as great as the contrast in the other variables I showed earlier, with Australia again representing stability and the US instability. Equally importantly, stability was not pushed at the price of lower growth: to the contrary, the Australian economy has grown faster than the US, not just over the past few years, but over the past decade. This, of course, has been the main point of my presentation this evening. The other point, I hope that has come out, is that the really large examples of instability in recent decades have emanated from a species of financial event - namely, an asset price boom and bust - rather than from the normal cyclical fluctuations we are all familiar with under the heading of the business cycle. | reserve bank of australia | 2,003 | 7 |
Introduction by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Panel Discussion on Financial Stability - Consilium, Coolum, 9 August 2003. | I J Macfarlane: What is the biggest risk to financial and economic stability? Introduction by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Panel Discussion on Financial Stability - Consilium, Coolum, 9 August 2003. * * * From the perspective of a developed OECD (Organisation for Economic Co-operation and Development) economy, what is the biggest risk to financial and economic stability? I suspect that at various stages over the past few decades, we would have come up with different answers. For much of the period, we would point to our apparent inability to control inflation, or to oil price shocks, or to governments’ inability to control their finances. At other times, people would point to more purely financial vulnerabilities, such as fragile under-capitalised banking systems, excessive short-term international capital movements, poor prudential regulation or inadequate systems of governance. Others would point to the tendency of governments, central banks or the IMF (International Monetary Fund) to bail out failed systems and so create a moral hazard, as the main risk to future stability. You can make a good case for most of the candidates I have put forward. However, I think there is one other risk that we have become aware of that now seems to be larger than those I have listed above. I refer to asset price booms and busts. While the existence of these was recognised, they were usually regarded as historical curiosities, or at least very low frequency events (e.g. once or twice a century). The US experience in 1929 and its aftermath was the classic case until recently. But now that we have seen the world’s second largest economy - Japan experience one in the 1980s, and the world’s largest one - the United States - experience one in the 1990s, they seem to be not quite so ‘low frequency’. We should also not forget that many other economies, including our own, experienced an asset price boom and bust in the late 1980s and early 1990s. Although they were not of the size of the Japanese one, or of the international significance of the US one, they were very costly to their respective economies. What can be done about this tendency of otherwise well-managed economies to exhibit periodical asset price booms and busts? One response would be to give the task to monetary policy, so you will probably expect me to expound on this subject. Unfortunately, I must disappoint you because the subject is too complex to cover in the short time I have available, and besides, we at the Reserve Bank are hosting a conference on the subject in about a week’s time. Instead, I want to follow a different path and ask are there factors that contribute to asset price booms, that can be identified and eliminated or, at least, reduced? I have in mind various incentives, informational deficiencies and dubious practices which occur during the boom, but which we always seem to discover well after the bust has occurred. We realise then that these practices allowed distorted views of the profitability of businesses and investment strategies to remain in place long after they should have been corrected. Each boom is different and the lessons we learn after the bust has occurred are also different. For example, after the asset price booms of the late 1980s collapsed, we learned that a lot of the problem was due to very poor banking practices - connected lending, concentrated risks, weak credit committees, forbearance whereby new loans were made to service existing debt, etc. In response to this, there have been enormous improvements in banks’ risk management, accounting practices and bank supervision. Partly as a result, or partly due to good luck, banks do not figure prominently in the wash-up of the latest boom - the US equity boom. Instead, we discovered a new set of dubious or unsavoury practices. · First, were features of the system that gave a very strong incentive for the major players to push up asset prices. The use of equity-based remuneration, particularly options, gave management a huge incentive to concentrate on short-term increases in share prices, particularly as they knew that the investment community demanded it. · Second, there were many means available to make profits look larger than they really were. The non-expensing of options being the most obvious, but others would include the use of special purpose vehicles and other off-balance sheet entities, the non-recognition of deficiencies in company-sponsored defined-benefit pension funds and the bringing forward of revenue recognition. In this country, we saw some very creative things being done with financial re-insurance, which basically had the aim of inflating recorded profits. · Thirdly, there was a failure of the counterweights in the system to limit the excesses. In particular, the conflicts of interest in the auditing profession and the lack of independence or forcefulness of boards of directors meant that excesses were not detected. Another counterweight is supposed to be the independence and scepticism of security analysts, but this was clearly compromised by the fact that the most prominent of them were working for investment banks which were sellers of securities and so had a strong incentive to look favourably on rising share prices. One could construct a long list of abuses, and a correspondingly long list of needed reforms. In various countries this is being done by governments and their agencies - particularly the conduct-of-business regulators such as ASIC (Australian Securities and Investments Commission) in Australia or the SEC (Securities and Exchange Commission) in the United States. Internationally, a lot of this is being co-ordinated by the Financial Stability Forum. Usually it is being pursued in the interests of investor protection and of ensuring the integrity of markets. But from my perspective, I see these reforms as serving the equally important macro-economic purpose of reducing the tendency for asset price booms to occur, or shortening somewhat their duration. I would not be so confident as to suggest that the reforms, no matter how well designed, would be able to prevent such booms, but any reduction in their extent will reduce the severity of the subsequent bust. I will conclude by making a comment about what we mean by a systemic financial crisis. Usually, it means a series of bank failures, bank runs, and the government or central bank having to recapitalise the banking system. Because of the improvement in banks’ risk management and bank supervision, we have not even been close to systemic financial failure in any major country on this occasion. For this we should be thankful. But what we are getting instead are failures in the non-finance sector, Enron, WorldCom, etc., and more particularly a severe tightening of belts in the corporate sector with consequent contractionary effects on investment and employment. So the thing that is different this time is that the boom has not been followed by a financial crisis, but by an economic contraction as the most severely stretched parts of the economy seek to restore their balance sheets. | reserve bank of australia | 2,003 | 8 |
Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, 30 August 2003. | Glenn Stevens: Structural change and the conduct of monetary policy Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, 30 August 2003. * * * Thank you to the organisers for the invitation to take part in this symposium. I’d like to arrange my remarks around three types of structural change. The first is change in the underlying structure of the real economy. The second is change in the inflation process. The third is change in the financial structure. I will argue that the last is probably the most difficult for central banks to deal with. Structural change in the real economy Changes in industries’ relative shares of production or employment, or changes in the extent to which foreign competitors penetrate national markets, have always been a feature of market economies. This kind of structural change reflects shifting tastes, the opening of new markets, the advent of new competitors and the introduction of new technologies and so on, which periodically disrupt established patterns of production, distribution and consumption. What’s monetary policy’s job in the face of such changes? Generally speaking, it is simply to let them occur, and to resist any temptation to use monetary policy to address the adjustment issues. Monetary policy cannot, for example, cure an unemployment problem that is the result of the collision of changing industrial patterns with rigid labour market practices. Nor can it address the inter-regional differences in an economy caused by concentration of declining sectors in one area and of growing sectors in another. Other policies must come to the fore in dealing with these sorts of problems. (That said, an improvement in structural policies which enhances the economy’s supply side should ideally be complemented by more accommodating demand management, all other things equal.) That is not to say that these sorts of structural change may not raise some technical issues for monetary policy. They may well affect our judgement as to what setting of the instrument will contribute to the long run goals of policy, which themselves are invariant to the changed structure. If structural changes are, for example, affecting the relationships between conventional measures of economic slack and prices, or the economy’s medium-term potential output path, or the relevance of particular economic indicators, then that should be taken into account in setting the instrument. How does one go about that? There is no simple device available for this purpose. It is essentially a matter of trying to be quick learners - continually being on the look out for things which are different to the past, and not being too wedded to particular empirical representations of the economy. We have to develop some notion of the economy’s behaviour - it’s not good enough to say we know nothing. But ‘models’ of the economy - whether of the formal or informal kind - need to be viewed as working hypotheses, continually open to amendment in the light of new experience. This holds as well for analytical constructs we commonly use, like output gaps, NAIRUs, natural real interest rates and so on. It’s important to keep these devices in the realm of useful ways of organising our thinking, and to take care not to elevate numerical estimates of them to central status, lest a shift in relationships take policy-makers off course. The RBA’s approach has been to do our best with various pieces of empirical research in these and other areas, and to allow them to inform our judgement about the outlook and policy, but not in any sense to be a substitute for that judgment. I’m sure that the same occurs in other central banks. Provided we are mindful of these broad principles, and I think most central banks are, we should be able to cope with shifting economic structure acceptably well. And there is little to suggest that this sort It could be added that taking on board some of these sorts of change may involve being prepared on occasion to give some weight to judgement before all the empirical evidence is crystal clear - while recognising that you might be wrong and trying to weigh the costs of being wrong. A case in point would be the way US policy makers backed their judgement about higher trend productivity growth before it was all that clear in the official data. of ongoing evolution of economic structure poses greater problems for policy makers today that it has in the past. A different type of structural change has to do with the time series properties of the economy - in particular, the degree of variation from quarter to quarter. As we have heard at this conference, there seems to be reasonably clear evidence that, for many of the major countries, this variation diminished during the 1990s. This was also true in Australia’s case, where the standard deviation of quarterly GDP growth in the 1990s was about one third lower than in the 1980s, and two thirds lower than in the 1970s. Better policies, more flexible economies, and smaller shocks - that is, better luck - are all (complementary) explanations for this phenomenon. That is a very favourable environment for central bankers. To some extent, we’ve been given an easier hand to play than some of our predecessors. I for one would very much like to see it continue! Of course, it may not continue. Shocks could be bigger in future. Or structural policy improvements might be partly reversed (e.g. if there were an increase in protectionism). Perhaps the relatively stable geopolitical environment which must have helped growth in the 1990s will not be present in the decade ahead. In such a world, monetary policy makers would face a tougher time. Even optimal policy adjustments would most likely be associated with more volatile overall performance. Whether financial market prices currently embody any significant probability of such an outcome is an interesting question to ponder - my guess is they do not. In a scenario like this, expectations about what monetary policy might be able to deliver in terms of smoothing the business cycle and year to year inflation rates could turn out to be disappointed, and we would all have a more difficult time explaining this to our respective citizens. But apart from sharpening our communication skills, there is not much we can do about these possibilities other than to wait to see if they occur. Structural change in the inflation process The second type of structural change about which I want to talk is change in the inflation process. In the post-world war II era, we have witnessed two structural changes in the properties of the aggregate price level. First, there was a tendency for persistent inflation, to an extent not seen before, which had become quite noticeable by the late 1960s. ‘The Great Inflation’ accelerated in the 1970s, and for most industrial countries, the peak inflation rate was reached some time between about 1974 and 1982. Since then, we have seen a second phase, during which the continual rise in the price level has slowed down, and in many places we today see, more or less, price stability. A few factors made a contribution to these swings, including adverse supply shocks in the 1970s, and favourable ones for much for the 1990s. These sorts of things can make monetary policy’s job harder or easier, though of course monetary policy ultimately has to take responsibility for price level outcomes in the long run. One of the central lessons drawn from that experience was the importance of expectations in the inflation process. The more ambitious expansionary policies could only deliver the intended gains while expectations remained stable. Once expectations started to move up, policies were less effective in boosting output, because people behave differently when inflation is thought to be a part of the economic furniture. Moreover expectations of continuing inflation, once they had developed, proved to be fairly stubborn, which tended to constrain the ability of monetary policy to support the economy when demand was weak. But by the same token, something we observe today is that when expectations are anchored at appropriately low levels, monetary policy has more flexibility. Policy makers have room to be a little more tolerant, for example, of a decline in the exchange rate. Our own experience in the aftermath of the Asian financial crisis from 1997 was that in the face of a pronounced weakening in the exchange rate, inflation expectations remained quite well anchored. While inflation did increase temporarily as a result of the fall in the exchange rate, the likelihood of a persistent problem with inflation was low. Hence monetary policy was able to follow a fairly accommodative stance, in the face of a very weak international environment, rather than needing to tighten to safe-guard medium-term price stability. This would not have been possible in earlier times, and the extra flexibility made a considerable difference to economic performance. So expectations matter, and it is not unreasonable to think that the efforts of policy makers to be clear about their goal of controlling inflation, and to act consistently with that goal, made a difference to the characteristics of the inflation process. That in turn has allowed policy some additional short-run flexibility. The question many have recently debated is whether there is now another sea change occurring in the inflation process every bit as profound as that which took place during the 1960s, but in the other direction. That is, is the prevailing problem in future going to be not inflation, but deflation? For my own country the answer is clearly ‘no’, for the foreseeable future. Others are more qualified to answer for other countries. But either way, here again expectations will be important. While they are strongly held above zero, it will be easier for monetary policy to help get an economy out of an incipient deflation. Were expectations of deflation to become entrenched, on the other hand, policy would face a much more difficult task to remedy the situation. This highlights the importance of articulating the goals of policy as clearly as possible, so as to give expectations an anchor. For inflation targeting countries such as Australia, stressing the symmetry of the target is quite important in this context. Countries such as the US without a formal target have also indicated that there is an inflation rate so low as to be undesirable. Mere announcements are not in themselves enough, of course, and have to be backed up by credible policy actions, and in countries where chronically weak demand is already accompanied by flat or falling prices, not all of these actions will necessarily be in the realm of monetary policy. But to be clear that policy is seeking to maintain, or to return to, low but above zero inflation is probably a necessary, even if not sufficient, condition for adequate outcomes. Experience of previous periods of deflation in our own countries (admittedly not first hand for most of us here) and observation of Japan’s travails in the past decade, also points to the importance of financial structure. This leads naturally into my third topic. Changes in financial structure There has rightly been much emphasis on corporate sector finances, and government finances, in most of the industrial countries for many years. One or both of these areas have created big problems in just about every country at one time or another, and in a number of countries the struggle to get public finances in order is set to continue for some time ahead. But one of the most striking areas of financial change in recent times has been the increased opportunity for households to adjust their financial positions, certainly in the English speaking countries. Access to credit has expanded remarkably over the past couple of decades. The structural decline in inflation has produced much lower nominal interest rates, and it is nominal rates which matter for households looking to borrow to finance a housing investment. At the same time, lenders find households less risky borrowers than companies. Both these factors are encouraging households to take on more leverage. Financial innovation also means there is much greater opportunity to collateralise assets. With the big run up in house prices which has occurred, there is a very large pool of potential collateral which has not as yet been tapped. And a fairly long period of relative economic stability - in Australia’s case, a quite long expansion, now in its thirteenth year - has meant that people feel more comfortable with more leverage. In Australia’s case, household gross assets are now about 8½ times current income, compared with about 5 times in 1980, and about 6 times as recently as the mid 1990s. Financial assets have grown, but much of the increased wealth has been in the form of dwellings. Since 1997, the Australia-wide median price for an established house has doubled. At the same time Australian households are more indebted. The ratio of debt to income has risen, from a point well below that seen in comparable countries in the mid 1990s to now being towards the top of the range seen in like countries today. Leverage - the ratio of debt to assets - has not increased as fast as the ratio of debt to income (which implies that net worth has increased substantially) and it remains lower than in some other comparable countries, but even so it has increased noticeably. These trends show few signs, at present, of imminent change. It’s true that generally lower pass through of exchange rate changes to inflation has also helped in instances like the one I mention here - though I can’t help feeling that the low inflation environment generally, and the associated set of expectations, have been important in driving that result. We are yet to see the full ramifications of this structural change in household behaviour and balance sheets. The fact that balance sheets are so much bigger presumably means that changes in wealth are likely to matter more, relative to changes in things like current income, than they used to in determining the course of household spending over the business cycle. Secondly, higher leverage means that negative shocks to income are more likely to be amplified as they work their way through the economic system. Moreover, leverage may yet increase a good deal further, since the as-yetuntapped equity in the housing stock is still very large, and the capacity to access it is growing. And thirdly, of course, higher leverage means that monetary policy’s impact via its effect on the behaviour of borrowers will be bigger than in the past - especially in a country like Australia where the majority of household debt is at floating rates. The asset price channel of policy might also end up being bigger. We have watched these developments with rather mixed feelings. For some years, the most plausible explanation for the trends I have just described was that there were good fundamental reasons for a change in households’ balance sheets. Households had for various reasons been constrained to a position of relatively low borrowing, but when the various constraints were lifted, it was inevitable, perhaps even desirable, that there would be a period of strong growth in lending to households as they moved towards a new balance sheet equilibrium. From the mid 1990s until about 2001, this seemed the best story. But over the past year or two, we have become less confident that a sensible one-time balance sheet adjustment should still be continuing, and more concerned that an increasing number of households may be putting themselves in a position of vulnerability. This is, of course, our particular experience of the thorny question of monetary policy, debt and asset prices. Like other central banks we have grappled with the question of what, if any, response monetary policy ought to make to this situation and, like others, we have not found that question amenable to a straightforward answer. On the one hand, these developments are exerting some expansionary impetus to the economy at a time when global demand conditions are weak. To that extent, they are helpful in avoiding undue weakness in the Australian economy. On the other hand, the household sector’s ability to cope with some future contractionary shock is probably being impaired, at the margin, as leverage continues to increase. While we do not think that there would be any significant financial sector fragility as a direct result of this increased debt even if house prices were to fall in the near term, we fear that there could still be significant general economic fall out if the economy is subject to some other shock, mainly because household consumption could retreat quite quickly. Dealing with all this is still very much a work in progress, but as I reflect on our own experience to date and that of others, a few observations come to mind. First, it is not very helpful to couch the discussion in terms of whether monetary policy should try to prick ‘bubbles’. This tends to side-track discussion on to questions like whether we can confidently identify, indeed even define, ‘bubbles’, and whether or not aggressive policy action is appropriate if we can. A more helpful way to set it out it is to think about the balance of risks facing the economy: is there something occurring which is increasingly likely to be a misalignment, a subsequent reversal of which could prove to be disruptive? And if so, is there some monetary policy course which, while possibly involving some short-run cost to economic activity, would reduce the risk of bigger loss of economic activity later? Can we, to use the popular metaphor, buy some insurance and at what price? Second, any response by monetary policy is bound to be relatively moderate, because the uncertainty about the effect of policy on the dynamics of asset prices is considerable. That means that asset prices are still likely to move quite a bit in these episodes. Policy’s ability to smooth things out is limited (which is something we already know as a general proposition anyway). Third, I am inclined to agree with recent work in the Bank of England that suggests that it is possible, at least in principle, to embed this discussion within a medium-term inflation targeting framework. For inflation targeting countries, it would certainly be a retrograde step in my view to be perceived as walking away from a framework which has for a decade delivered good results, in favour of some explicit pursuit of asset prices per se. Fourthly, even if we do bring asset prices and debt within the existing framework, we have a difficult problem in practice. Our approach to monetary policy, and our presentation of the objectives of monetary policy, are usually geared to horizons of a year or two. This holds for most explicit inflation targeters and also, I think, for those with more implicit goals. But asset price events and the balance sheet changes which accompany them usually do not occur neatly on that frequency. The really big ones can be once-in-a-generation developments. If it were to be decided that monetary policy should be more responsive to asset price events, such an approach would have to be motivated by a broader and rather more long-term notion of financial and monetary stability than is in common use today. For those of us who use explicit inflation targets, for example, there would be a need to focus on a longer time horizon and perhaps somewhat greater toleration of short run deviations from the medium-term target. The presentational difficulties of this, while not necessarily insurmountable, are certainly not trivial. If we do need to move in the direction of giving asset price and debt developments more weight in the conduct of monetary policy than hitherto, we need to educate our respective communities about these issues. That education process is probably a good thing anyway, regardless of policy intentions. Conclusion Discussion about these matters is doubtless set to continue. It is pretty certain that structural change will always be with us. Central banks have routinely to be on the look out for the sorts of changes which, while leaving ultimate objectives unchanged, might alter the short term tactics of policy settings. But I think that financial structure changes, which often occur over longish periods, will probably be for central banks the most difficult ones to handle. | reserve bank of australia | 2,003 | 9 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists and the Economic Society of Australia (NSW Branch), Sydney, 17 September 2003. | Glenn Stevens: Economic conditions and prospects Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists and the Economic Society of Australia (NSW Branch), Sydney, 17 September 2003. * * * Thank you to the Australian Business Economists and the Economic Society for the invitation to speak to you today. It is a pleasure to renew my association with both groups, which goes back many years. As the title of my address indicates, I intend to offer an update of our thinking about recent economic performance and prospects for the period ahead. I’ll begin by taking stock of the international scene, and then move on to the Australian economy. I will then, having set the context, make a few comments about recent monetary policy issues. The global economy The world economy, and particularly the group of large industrial countries, has performed weakly for the past three years or so. Much attention has, as always, focussed on the US. The characteristics of this particular episode in the US are well known: a very large share price boom and bust; a capital investment boom, which then broke sharply, after views about the likely return on investment changed dramatically; a stabilising role played by the US household sector, which has been prepared to borrow and spend; and periodic shocks to confidence resulting from terrorist acts, war and so on. The outcomes might have been much worse, but for exceptionally large monetary and fiscal policy stimulus applied by the US authorities, and the fact that holdings of assets whose prices declined were not highly leveraged. In fact, given the magnitude of the events, the US economy has done well to perform the way it has. Outcomes for the world economy might have been better, on the other hand, had global demand not been so dependent on the US. Unfortunately, Japan and Europe also relapsed into weakness in 2001. In the case of the euro area, performance has been less convincing than that of the US over the past couple of years. Mainland Europe shared some of the business cycle problems of the US but had neither the same degree of supply-side dynamism, nor the same scope for expansionary policy action, to aid recovery. Japan, as we all know, has struggled for some years to deal with financial imbalances, deflationary pressure, supply-side inflexibility, and political stalemate regarding remedial measures. China, on the other hand, has increasingly been an important force in the world economy. It is probably reaching the point of equality with Japan, about now, in terms of its size in international trade. China’s growing economic importance is evident in the data, and also in the way in which the renminbi exchange rate is becoming an important political issue - just like the yen. Against that general backdrop, assessments of the near-term outlook for the global economy have undergone some important changes over the past eighteen months. Through the first half of 2002, indications of strengthening growth saw hopes rising for better times, only to be disappointed in the second half of the year. Activity remained sluggish and confidence took a hit from the aftershocks of the bubble, in the form of, inter alia, accounting and governance scandals (that is, some of the sorts of things which emerge after every period of excess). During the first half of 2003, growth and confidence were still at a rather low ebb. Things which did not help confidence were the anticipation of war in Iraq, and the associated rise in oil prices. The outbreak of Severe Acute Respiratory Syndrome (SARS) was also very damaging to a part of the international business scene still struggling with the effects of earlier shocks. Then there was the spectre of deflation. It’s understandable that this would be a concern, since inflation rates were already below zero in a few countries, and low to very low in most others. A period of below-par growth was likely, if anything, to push inflation down further. My own views about the way we should think about deflation were given nearly a year ago. I thought that it was possible that a few more countries could experience deflation briefly, but that the likelihood of widespread, protracted and corrosive deflation was low, at least absent a significant policy error. Nonetheless, since prudent central banks operate on the logic of least regret, some of them had to give attention to the issue, just in case, and they did so during the past nine months. The US Federal Reserve, in particular, made it clear that it wanted to err on the side of ease, since even a low probability of inflation falling ‘too far’ was something to be resisted, and openly discussed measures that could be employed were interest rates to reach the zero lower bound. The Iraq war was over quickly and its direct economic effects have been expansionary for the US economy in recent months. But all these accumulated worries affected perceptions of the outlook through to mid year. The clearest indication of this was that bond markets pushed down yields to levels not seen in decades. There were some special factors in operation but, even allowing for those, the tone of bond markets in May and June can only be described as particularly pessimistic. There also seemed to be some uncertainty, even if only briefly, about the US Administration’s intentions for the US dollar. Given the rapid rise against the US dollar of the Australian dollar during that period, this caught our attention. There was a period, in other words, when it was not that hard to imagine a rather nasty international outcome - one where the fear of deflation in the US and elsewhere, regardless of how well based it was, could affect behaviour, and where the US dollar could be moving rapidly downwards, exporting any deflation pressure to other countries, including Australia. While the probability of this scenario was still not that high, it seemed to be increasing, to the point where it caused us some discomfort. Readers of the Governor’s 6 June remarks to the House Economics Committee could see quite clearly the degree of concern at that time. We can all feel some genuine relief that things have looked better since. After a weak early part of the year, the US economy is doing much better in the second half. SARS had a big, but temporary, impact in east Asia, but relatively little impact elsewhere. East Asia is now recovering quickly from that. China continues to grow rapidly. The US economy, while experiencing very low inflation, has not slipped into deflation, and some countries which have experienced deflation seem to be experiencing a bit less of it now (e.g. China). Japan has, I think it is fair to say, surprised most people with solid growth over recent quarters. The euro area remains the weakest of the major regions, although there are tentative signs of improving conditions there in some of the most recent survey data. For the first time in a while, consensus forecasts for world growth are edging higher, not lower. Financial market pricing also clearly has retreated from the pessimism in May and June: the exceptionally low bond rates have risen to being simply quite low. Share markets had already turned somewhat more optimistic earlier, and have remained so. While we could argue about the extent to which future profits growth in the US is required to validate current pricing, what seems in little doubt is that actual profits in the US have recovered quite strongly to date. That is testimony to the capacity of the US corporate sector to respond aggressively to problems, which is ultimately a source of dynamism for the US economy. Finally, after a very strong upward trend earlier in the year, the Australian dollar has traded fairly steadily in recent times. None of this is to say that the world economy is completely out of danger. Things could still go wrong while ongoing adjustments continue. There could be new shocks. Or the US expansion might wane if the growth in demand and output does not find some reflection in higher employment, thus starving the system of some of the fuel for further expansion in demand. Even if things are proceeding well, we will inevitably see the odd patch of weak data. Once the danger of excessive near-term weakness is past, moreover, there will be issues to address - like the long-term trend in government finances in a number of countries. But these sorts of caveats apply in every cycle, to some degree. The fact remains that things look better than they did three or four months ago, and noticeably better than we feared, at that time, they might look by now. That we are now talking about whether the pick-up extends into 2004, rather than whether it is occurring at all, is welcome progress. The bigger issue has always been, and remains, the nature of the peace. This will probably cost more than the war and presumably adds to uncertainty about the medium-term economic outlook, but seems not to affect short-run perceptions in the same way as actual conflict. The Australian economy The Australian economy has been significantly affected by the weakness in the world scene over the past few years. This is most evident in the trends in exports. In the June quarter of 2003, aggregate export volumes were about 2 per cent lower than in the middle of 2000 (just before the Olympics spike). This is a series which in the 1990s grew at an average rate of 7½ per cent per year. If that is a crude gauge of ‘normal’ performance, there was an export volume shortfall of over 20 per cent by the middle of this year. That’s over 5 per cent of GDP, which is a much more substantial effect than seen in the Asian crisis. Why was the effect bigger on this occasion, even though the Asian crisis had a bigger impact on the growth rates of our particular trading-partner group? The answer is mainly, I think, because the Asian crisis was a regional problem which occurred against a backdrop of strength elsewhere (as we now know, but didn’t at the time). So many of Australia’s exporters could find other markets. That is obviously harder to do when the problem lies with the global economy. In addition, of course, there was the effect of the drought on rural exports, and of the events of 11 September 2001 and SARS on exports of tourism services, which were over and above the normal effects of global weakness. How has the economy handled the loss of income? In a world of open capital markets, one would expect that a temporary reduction in income would in part be reflected in slower growth of spending, but in part also in a temporary change in our saving behaviour - saving less of our own income, drawing more on the saving of others. That is, we smooth our living standards in the face of swings in income. This behaviour means that there is some slowing in GDP growth, but much less than would be the case, were our spending behaviour to be confined to following much more closely the reduction in income. At the same time, as we all know, a long-term adjustment has been under way in the structure of households’ balance sheets, which has been tending to elevate spending relative to income for some time. It so happens that the direction of this effect has, in the past couple of years, suited what was needed to adapt to the international conjunctural circumstances. We can’t distinguish from the data what was the result of this structural change and what was due to a cyclical response to a particular income shock. But the broad effects of the combined forces are fairly clear in the national income accounts. We have seen domestic final demand rise by over 4½ per cent over the past year - to be sure, more moderate than the 6-7 per cent pace it was recording a while back, but still faster than average. Real net exports fell by 3½ per cent of GDP over the latest year, influenced by the world economy and the drought. Between them, those two factors did most of the work pegging GDP growth back to a below-average 2 per cent over the year. Over the same period, the current account deficit has increased by about 3 per cent of GDP. This is smaller than the decline in real net trade volumes because Australia’s terms of trade have continued to improve over the past year - by nearly 3 per cent, which is worth about ½ per cent of GDP in additional income. So the Australian community, by having access to capital markets, and facing macroeconomic policy settings which remained on the expansionary side, was able to continue to increase its spending at a very strong pace, even though income growth was impaired by international events. This involved declining rates of saving out of current income, and some extraction of accumulated equity from the dwelling stock. Generally speaking, to have that flexibility is a good thing - with the proviso that, as with all good things, we don’t want to over-indulge. We can anticipate that, over the coming year, the two factors weakening overall performance over the past year will not recur, and indeed some reversal of these effects is likely. It is widely acknowledged now that there will be a strong recovery in farm production. The prospect of some continuing improvement in international conditions means that the downward trend in non-farm exports should bottom out, and a recovery begin. At the same time, domestic demand growth should moderate a little. Capital spending by firms will probably continue to rise, but not as quickly, on current indications, as it has over the past year. Some decline in dwelling construction activity has occurred, although this looks smaller than earlier thought. Consumption spending looks likely in the near term to continue to benefit from steady growth in incomes, high levels of confidence and the higher and more accessible wealth available to households. If this outlook is correct, growth in the economy has probably already slowed as much as it is likely to. The year-ended growth rate of non-farm GDP will decline for another quarter as an earlier very strong quarter drops out. But the pace of expansion through the second half of 2003 is probably going to be at least as good as it was in the first. If the global economy continues on its present track, Australian growth should clearly be picking up by the first half of next year. Inflation will be pushed down a bit by the earlier exchange rate appreciation for a while, but is still thought likely to be about 2½ per cent in the medium term, based on the usual assumptions about oil prices, exchange rates and interest rates, and the above growth outlook. This picture is much as was described in our Statement on Monetary Policy on 11 August. Since that document was published, it is fair to say that the downside risks to the global economy have retreated further. Most recent data on the Australian economy also seem consistent with a moderation in non-farm growth in the first half of the year, but suggest that it has neither been particularly pronounced, nor showed signs of being long-lived. Risks and policy considerations It has become much better understood in recent years that once a coherent framework for monetary policy is in place, the regular policy decision is essentially a matter of responding to the changing balance of risks to the outlook. The RBA’s Board certainly has had a busy time over the past year or more evaluating and deciding how to respond to the evolving balance of international and domestic risks. It takes a lot more work than you might think to leave rates unchanged for fifteen consecutive months! In the middle of last year, it looked as though the international economy was returning to stronger conditions, and Australian domestic demand was growing very strongly indeed. To foster an inflation outcome consistent with our medium-term target, we believed that it would be prudent under such conditions to return interest rates to normal, or ‘neutral’, from a relatively expansionary setting. Two initial steps were taken, and the likelihood of further steps clearly signalled. But in the event, the process did not continue, because the world economy began turning out differently to what we had assumed. By the end of 2002, it was clear that any thought of near-term tightening could go off the agenda for a while. The world economy had clearly lost some momentum, and for the time being, this meant that a steady interest rate structure would probably be associated with achieving our policy objectives. That remained the story through to the middle of 2003, as the Iraq war came and went, most international data looked on the soft side, the drought continued, and financial market sentiment waxed and waned. The outlook for Australia was for moderate growth - quite a good outcome in the circumstances - but our feeling was that the risks stemming from international developments were tilted to the downside. Inflation, if anything, looked a little higher than had been expected, although our judgement was that in the medium term, it would still turn out to be consistent with the target. That was a macroeconomic outlook which certainly did not, in my view at least, amount to an obvious case for monetary policy to be noticeably easier than was already in place. A reasonable case could be made that policy should be easier than neutral - but it already was, and had been for some time. Our conviction that the level of interest rates was exerting stimulus to the economy - a conviction strengthened when we looked at the demand for credit and the behaviour of asset markets - and a view that the inflation-targeting framework does not call for trying to fine tune outcomes, have both been important in policy deliberations. At the same time, it should be obvious that the shifting assessment of the balance of risks to the outlook (which can occur without there necessarily being major changes to central forecasts) has also been critical. When, after a period of disappointing international outcomes in the first half of 2003, the external threats to the economic outlook seemed suddenly to be building up rather dangerously through May and early June, it looked like a case to ease policy was building. Throughout this period, the situation was complicated by another type of risk. While views about the international situation were changing, at home the demand for credit from households, far from diminishing, seemed to be strengthening. Apart from the fact that this meant that the near-term outlook for domestic demand might well be stronger than assumed, the Bank had an obligation to consider the medium-term soundness of the economy in addition to the short-run conjuncture. There is no doubt that the preparedness of households to borrow has been imparting some strength to demand and general buoyancy to the economy and asset markets, and that this has been helpful in supporting growth in the circumstances of the past couple of years. But there cannot be much doubt either that running up debt today must diminish the scope to do so in future, and that it must also impair, at the margin, the capacity of some households to cope with adverse shocks which might come along. There are times when the above is a risk which just has to be incurred because another possible outcome is even worse. A disastrous international environment, coupled with a soaring exchange rate, would probably be one such time. That is why, in June, we publicly contemplated the possibility of easing. But we had to be fairly sure that the alternative was going to be pretty bad before we took action which we knew would be likely to inflame an asset market and borrowing boom. Monetary policy might not be able to do much to end an asset price boom without a fair bit of collateral damage so, at least, it is commonly claimed. But whatever one’s view on that, surely policy should avoid needlessly adding to the boom. ‘First, do no harm’ is a good motto here. We have sought to balance these various concerns over the past several months. Although in early June a case to ease looked like it was building, it had not strengthened sufficiently by the time of the July meeting to warrant action. In August the case got weaker, and it got weaker again by early September. Essentially what happened was that the risks to growth from abroad abated, while those posed by the rapid rise in debt did not. This recent experience, and the one a year earlier, is instructive in the discussion about central bank communication. What it shows is that, while it is natural for market participants and the media to want central banks to say more and more about their intentions, people need to keep very much in mind that our assessment of what we might need to do is, of necessity, highly conditional on a view of the future. And the future often turns up the unexpected - to which we need to respond by revising our intentions. So it is important that observers not only listen to the central bank’s words, but also continue to look closely at the actual information coming in. I know the majority of you do. Secondly, because the future cannot be known, and because things can change quickly, people need some understanding of the principles which guide central bank behaviour. So there is probably more to be gained by continued efforts at articulating how our framework for policy works, than by providing ever more frequent commentary on events. Such information hopefully provides interested observers with a device to filter, in real time, the information becoming available. This, combined with a periodic account, after the event, of how we filtered it, is the most helpful form of transparency - describing how we think about things and, within that framework, why we did what we did. The most recent Statement on Monetary Policy, in fact, goes a good deal further down this track than most of its predecessors. Conclusion The world economy is still not entirely in the clear, but is better than it was, and a fair bit better than it might have been. It is sensible at present to look for further improvement, while keeping in mind the possibility of regression. If things work out acceptably well abroad, the Australian economy will next year have a better chance of balanced growth than we have had for a few years. We will continue to assess the evolving balance of risks and will respond, in a measured fashion, as needed - and we’ll do our best to keep you informed. | reserve bank of australia | 2,003 | 9 |
Tenth Annual Sir Edward ¿Weary¿ Dunlop Asialink Lecture by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, Sy... | I J Macfarlane: Asia’s role in Australia’s economic future Tenth Annual Sir Edward “Weary” Dunlop Asialink Lecture by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, Sydney, 16 October 2003. * * * I would like to start by thanking the University of Melbourne’s Asialink Centre for inviting me to deliver this lecture commemorating such a distinguished Australian as Sir Edward “Weary” Dunlop. It is a great honour, and I will devote the major part of my lecture tonight to Australia’s economic relations with Asia - a theme of which I am sure he would have approved. But before moving on to the main topic, I would like to follow normal practice by saying a few words about the person whose memory we are honouring. In doing so, however, I intend to follow up on a couple of unusual connections that occurred to me as I was preparing the lecture. I do not intend to dwell on Weary Dunlop’s achievements or his place in Australia’s history or folklore. I assume that everyone here tonight is familiar with these.1 Instead, I ask your indulgence to start by drawing what you may find is a tenuous connection between Weary Dunlop and two important economists, one he may or may not have met, the other he certainly did meet. The first economist was Professor L.F. Giblin, who was Australia’s foremost economist in the inter-war period. Since he held a chair in economics at Melbourne University in the 1930s, the two men may have met, but there is no record of them having done so. But if they had, it would have been an interesting meeting because from what we know from their biographies, they had some remarkable similarities. Both were big strong men and natural leaders. Both had excellent minds and rose to the top of their professions. Both were decorated for their courage in war - Giblin in the first world war, Dunlop in the second. Both were outstanding sportsmen in the same sport - rugby. If Dunlop, the Victorian, playing rugby for Australia is a sporting oddity, what of Giblin, the Tasmanian, playing rugby for England during his Cambridge days? The connection with the other economist of note was only recently revealed, and I am indebted to Professor Leeson of Murdoch University for his excellent detective work. When Weary Dunlop and Sir Laurens van der Post, amongst others, were in the Japanese prisoner-of-war camps in Indonesia and Thailand, they tell of the miniaturised home-made wireless that they used clandestinely to keep up with the course of the war. This device had been cobbled together by a fellow prisoner of war - a New Zealand officer in the RAF. That officer we now know was Flight Lieutenant A.W.H. (Bill) Phillips,2 known to economists the world over as the inventor of the “Phillips Curve”. Phillips had been trained in New Zealand and Australia as an electrical engineer, had spent time in Asia before the war, spoke fluent Cantonese, and only embarked on a career in economics after his discharge from the RAF when the war ended. Output growth Enough of these biographical curiosities. I will now turn to the main subject of my lecture tonight which is the role of Asia in Australia’s economic future. I think for most of the past two decades, there was general agreement on the importance - if not the primacy - of Asia in Australia’s economic future. But this agreement suffered a couple of setbacks in the 1990s. First, Japan, the biggest Asian economy and the one which had been the main driving force, fell back into a period of very slow growth at the beginning of the 1990s. Second, the Asian crisis which started in mid-1997 and lasted for about 18 months, severely dented many people’s confidence in Asia’s future. For those who are not, the relevant references are “The War Diaries of Weary Dunlop”, Penguin, 1990, and “Weary: The Life of Sir Edward Dunlop”, Sue Ebury, Penguin, 1995. Sir Laurens van der Post refers to him in his book “The Night of the New Moon”. Weary Dunlop also referred to him in his published war diaries (entry for 5 November 1942) and confirmed in conversation with Leeson that Bill Phillips was the New Zealand RAF officer who built the wireless. This event - the Asian crisis - had a profound influence on opinion for three or four years. Many people saw it as evidence that the “Asian miracle” had feet of clay after all. There was a widespread view among western observers that the crisis was the inevitable result of severe governance deficiencies in Asian countries, and that these deficiencies would hold back further economic development. During the “tech boom” and the period of infatuation with the “new economy” in the late 1990s, perceptions of Asia suffered again as its economy was compared unfavourably with more technologically advanced western economies, especially the United States. We now know that governance deficiencies were not confined to Asia, and that some countries that were pointing the finger had governance deficiencies closer to home to worry about. The infatuation with the “new economy” also resulted in a bubble, the bursting of which has been exerting a dampening influence on world economic growth for the past three years. We also know that during the period when many Asian countries were suffering from the crisis, one important Asian country - China - was powering ahead. Now the dust of the Asian crisis has largely settled, it is worth sitting back and taking a fresh look at Asia’s place in the world economy, and particularly its place in Australia’s economic future. I propose to start this task by looking at the world economy and asking the question - which regions are increasing their share of output, and which regions are finding that their share is falling? I will use a long-running International Monetary Fund (IMF) data base for the comparisons, the results of which are shown in Tables 1 and 2. Table 1 Asian output (excluding Japan) Per cent Change in share Share of world output 1982-2002 1997-2002 China India Korea Indonesia Taiwan Thailand Philippines Malaysia Hong Kong Vietnam Singapore 3.76 3.00 0.81 1.17 0.53 0.58 0.82 0.26 0.29 0.20 0.13 10.27 4.28 1.67 1.87 0.99 1.08 0.69 0.47 0.42 0.34 0.24 12.67 4.77 1.77 1.58 1.01 0.95 0.68 0.45 0.40 0.37 0.24 –17 –16 –12 –1 –5 –5 Total 11.56 22.32 24.88 115.3 11.5 Total (ex China) 7.79 12.05 12.22 56.7 1.4 PPP basis. Source: IMF, World Economic Outlook database. No-one should be surprised to find that over the past 20 years Asia’s share of world output has risen noticeably, or that the share of the developed OECD countries has fallen. Note that I include Japan in the latter group because it is a developed high-income country and as such has been a member of the OECD since the 1960s. While much of the rise in the share of Asia is due to China, even when it is excluded, the rest of Asia’s share still rises from 7.8 per cent to 12.2 per cent over the two decades. In the above comparison, I chose a 20-year period because it gives a good idea of how longer-term trends have developed. If we instead chose the past five years for the comparison, we would be choosing Asia’s worst period, that is the one that contains the Asian crisis. As a result, we might expect to find a different conclusion. But even here, the same picture emerges - Asia’s share of world output has risen from 22.3 per cent to 24.9 per cent. It is true that most of this growth is due to China, but even without China, Asia’s share rises slightly. Thus, the conclusion is that, whatever time period we choose, Asia’s share of world output is rising.3 Before we leave the tables, it is worth having a look at the performance of OECD countries in more detail. Over the 20-year period from 1982 to 2002, there are only two significant OECD countries that have increased their share of world output - Australia and the United States.4 I have used this fact before to try and cheer up my fellow citizens who for a long time were inclined to assume that we were slipping behind. When we shift the comparison to the past five years, Australia still comes out looking good. We have increased our position more than any other significant OECD country, and the only other ones to show an increase over this shorter period were Canada, Greece, Finland and Spain. The general conclusion from these comparisons is that Asia has been, and still remains, the world’s fastest growing region and that Australia has done well compared to other high-income developed OECD countries. The two facts are, of course, not independent. Table 2 OECD output Per cent Share of world output1 Change in share 1982-2002 1997-2002 United States Japan Germany France United Kingdom Italy Canada Spain Australia Netherlands Belgium Sweden Austria Switzerland Greece Portugal Denmark Norway Finland New Zealand 20.78 8.32 5.45 3.95 3.52 3.92 2.08 1.86 1.08 0.98 0.75 0.62 0.56 0.63 0.47 0.41 0.40 0.31 0.33 0.21 21.32 8.20 4.78 3.25 3.23 3.26 1.95 1.73 1.11 0.91 0.62 0.49 0.48 0.48 0.38 0.38 0.35 0.31 0.28 0.17 21.10 7.11 4.43 3.20 3.12 3.04 2.02 1.76 1.15 0.89 0.59 0.49 0.46 0.45 0.40 0.37 0.33 0.30 0.29 0.17 1.6 –14.5 –18.7 –19.1 –11.3 –22.4 –3.1 –5.3 7.3 –9.8 –20.9 –21.8 –17.5 –28.7 –15.2 –10.2 –16.4 –3.1 –13.1 –19.2 –1.0 –13.3 –7.3 –1.7 –3.5 –6.6 3.2 1.7 4.0 –2.3 –4.5 –1.1 –4.2 –7.4 3.1 –2.2 –5.1 –5.1 1.1 –2.5 Total 56.6 53.7 51.7 –8.7 –3.8 PPP basis. Source: IMF, World Economic Outlook database. If we take a long enough sweep of history, this should not surprise us. Angus Maddison, who is the favoured authority on economic growth over the long run of history, records that in 1820 Asia, excluding Japan, accounted for 56 per cent of world output (and China alone, 33 per cent). By 1913, Asia’s share had fallen to 22 per cent, with China down to 9 per cent. Plus two very small economies - Ireland and Luxembourg. Trade and investment But that still leaves open a number of questions. Have our exports become over-reliant on Asia? Alternatively, have we kept up our share of Asian imports? Has the closeness of our trade linkage been mirrored in the capital markets? And are we well placed to adapt to future changes in patterns of growth, as we appear to have done in the past two decades? These are the questions I will address in the remainder of my talk tonight. More than half of Australia’s exports go to Asia, and the proportion has not greatly altered over the past two decades (Table 3). It rose in the 1980s to peak at 59 per cent in 1996/97, then fell back slightly as the Asian crisis had its effects to a figure of 55 per cent in 2001/02. Within this relatively stable total, there has been a clear fall in the share going to Japan, and a commensurate rise in the share going to non-Japan Asia (NJA). The other thing that stands out is that the share going to China, while clearly increasing, is still quite low. Moreover, when we look at these exports to Asia and compare them to the total imports that these economies are taking in, we see that Australia’s share is quite small - less than 5 per cent in most cases, and only 2 per cent for China (Table 4). Clearly, there is a huge amount of room for expansion here. Table 3 Australia’s merchandise exports by region Share of total 1981/82 1991/92 1996/97 2001/02 Asia Japan NJA NJA ex China China EU US Other 48.8 27.8 21.0 18.2 2.9 12.7 11.0 27.5 58.0 26.5 31.5 28.8 2.6 13.0 9.5 19.6 58.9 19.5 39.4 34.9 4.5 10.3 7.0 23.8 54.9 18.8 36.1 29.7 6.4 11.9 9.9 23.2 Total 100.0 100.0 100.0 100.0 Source: ABS. Table 4 Australia’s share of merchandise imports Per cent of total; year to May 2003 China 1.9 Hong Kong 0.9 India 2.2 Indonesia 5.2 Korea 3.7 Malaysia 1.6 Philippines 1.5 Singapore 2.0 Thailand 2.3 Source: IMF, Direction of Trade Statistics. One of the major characteristics of the development of Asia over the past decade has been the increase in cross-border interdependence of production, as China became the centre for labourintensive phases of manufacturing using intermediate inputs manufactured elsewhere, which were then re-exported as finished manufactures. As a result, there has been a large increase in intra-Asian trade, particularly between China and its neighbours. This intra-Asian trade, which is predominantly in manufactures, has grown more quickly than trade between Asia and the rest of the world. It mirrors a general shift in the trade patterns of developing economies which are now predominantly exporters of manufactured goods. As recently as 1980, only 25 per cent of the exports of developing countries were manufactures; now the figure is well over 80 per cent - for Asian countries, the figure is likely to be over 90 per cent. The question for Australia then is whether our exports to Asia are growing as fast as those of other countries into Asia. It is difficult to answer this with precision, in large part because of gaps and inconsistencies in data, but the approximate calculations we have made suggest that our exports are keeping up (Graphs 1, 2 and 3). These graphs look at imports into non-Japan Asia and its two biggest economies - China and Korea. As already established, the relevant question for us is whether imports from Australia are growing as fast as imports from other countries outside the region. The data we have suggest that this is the case; imports from Australia have grown faster than imports from the G10 countries. This is less true for China, where our performance is more or less in line with the G10 countries, but for Korea, imports from Australia have grown a lot faster than their imports from G10 countries. Graph 1 Graph 2 Graph 3 As we would probably expect, when we look at the breakdown of Asian imports by category, it is in categories such as food, fuels and crude materials that Australia’s performance has been particularly strong. Imports of these goods to China and Korea from Australia have grown much more quickly than their total imports. Australia has been increasing its exports of manufactures into Asia as well, particularly to China, but this is from a very small base. Exports of manufactures to China grew at an annual rate of 22 per cent over the past five years, but even then they represent only 4 per cent of our total manufactured exports. In summary, I think these comparisons show that we have been doing reasonably well. Our pattern of international trade is strongly integrated into Asia, and apart from a small downward adjustment due to the probably temporary effects of the Asian crisis, the trend is stable. There appears to be a lot of upside potential in the trading relationship with China, given our low market share in that country. When we come to financial integration, however, the story is very different because we do not have a high propensity to buy Asian financial assets (Table 5). I have always been struck by the contrast between the closeness of our trading relationship with Asia and the lack of closeness in our financial integration into Asia. Australian direct investment in Asia, that is owning or having a controlling share in Asian companies, has always been relatively small. We have always been more comfortable running businesses in the United States, Europe (especially the United Kingdom) and New Zealand. What is perhaps more surprising is that the share of direct investment going to Asia has fallen over the past decade, particularly over the most recent five years. During this most recent period, the share of our direct investment going to the United States has risen sharply, which is not unique to Australia the strong performance of the US economy during the stock market boom years around the turn of the century attracted significant direct investment from all developed economies, and portfolio investment from everyone. While Asia is a very big player in the world of international trade and is also a major recipient of direct foreign investment, it receives very little portfolio investment. Financial markets generally in the region are not well developed, and portfolio investment is costly and involves investors taking risks that are hard to evaluate. The lack of development is reflected in the low weights for the region in the global market indexes which drive so much of the allocation of portfolio investment in the present world: Asia accounts for less than 4 per cent of the Morgan Stanley MSCI global equity index - the most widely used - and an even smaller share of global bond market indexes. In both cases, the shares are very much lower than the region’s 25 per cent share in world GDP. Needless to say, the share of Australia’s outward portfolio investment going to Asia is also quite small, accounting for only 10.9 per cent of our portfolio investment in 2002. Table 5 Destination of Australia’s foreign direct investment Per cent of total stock as at 30 June United States European Union Japan Non-Japan Asia Other 13.1 17.2 na 34.6 35.1 26.3 34.9 0.5 16.4 21.8 28.0 37.4 0.3 12.6 21.7 47.8 22.2 0.2 7.4 22.4 Total 100.0 100.0 100.0 100.0 5.8 3.5 44.8 11.0 89.0 16.8 156.3 22.0 Memo: Total Australian FDI $b Per cent of GDP Source: ABS. In its foreign economic relations, Australia has given a very prominent place to Asia over recent decades. As a result, Australia is a member of a range of Asian regional institutions aimed at encouraging growth and trade. We at the Reserve Bank are also involved closely in a number of similar groups that bring the central banks of the region together. The main aim of these meetings is to find ways of encouraging the growth of Asian financial markets in order to emulate the success of Asia in the international goods markets. One concrete outcome of such co-operation has been the establishment of the Asian Bond Fund, through which central banks in the region (including the RBA) have invested some of our foreign reserves in bonds issued by Asian governments. So far, the only bonds included have been those denominated in US dollars. In time, however, the central banks of the region hope to add bonds issued in local currency into the Asian Bond Fund. We believe that this will help regional bond markets develop greater liquidity and become attractive to a broader range of investors. In time, there should be an increase in investment flows both within Asia and between Asia and other economies. This is likely to see an increase in financial integration, but the process will be a slow one. The future Of course, the global economy does not stand still and we do not know how the recent trends within Asia will develop. The story of the rise of China seems likely to have some way yet to run. But I doubt that the rise in importance of China, and its impact on Australia, will turn out to be the end of the story for Asia because the next chapter will probably contain a greater role for India. In terms of population, India is growing at twice the rate of China and fast approaching it in size. It is noteworthy too that India is now looking to the Asian region in its trade policy, recently concluding an agreement with Association of South Eastern Nations (ASEAN) to eliminate most tariffs within eight years, at the same time as ASEAN is eliminating internal tariff barriers and concluding free trade agreements with China and Japan. If India emerges as a second Asian engine of growth, Australia will face new opportunities and challenges. But we are well placed to respond to its increasing demands for imports of food, materials and intermediate goods. As with Korea, Australia has had a rising share over the past five years of India’s imports of materials. We must make sure that we have the flexibility to respond to this additional source of growth if it happens, just as we have responded to the shift from Japan to the rest of east Asia and then to China over the past two decades. Concluding comments My main message - the importance of Asia to Australia’s economic future - is not a new one, but it is one that people lost sight of for a while. But it will be different in the future in that China will assume an increasingly important role, just as Japan did in the 1960s and 1970s. In this sense, China is currently the big story, just as India will probably be the next. At the moment, there is great apprehension in the rest of Asia about China’s rising dominance. Countries that compete with China as exporters of manufactures, and recipients of direct foreign investment, feel that they will be overwhelmed. I think most people in Australia have welcomed the growing importance of China. This is in part because we do not see China as a competitor because we do not compete with them in low-tech highvolume manufacturing. We tend to see them as a complementary economy. I do not think we would be able to take the same comfort if we had maintained the old heavily-protected manufacturing sector we had in the first half of the post-war period. This complementarity does not mean that Australia has to see itself as only a provider of resourcebased products from our mines and farms. Manufactured exports to China, while they are small, are growing strongly. There is still plenty of scope for the further expansion of our high-value-added manufacturing and service exports. It is remarkable how much of the growth in international trade is intra-industry trade - that is two countries both exporting to each other within the same type of product. This is particularly true of manufacturing. I will conclude my talk tonight with two small but concrete examples of how intra-industry trade between Australia and China is developing. These examples are drawn from the Reserve Bank’s Small Business Panel, a meeting we have with small businesses originally designed to hear their views about finance, but now covering a wider range of topics. The two examples I will conclude with tonight are as follows: • One member of the Panel, who runs a company producing petrol and diesel driven electricity generators, said he was experiencing a lot of competition for small generators from Chinese imports. However, he was doing better in the export market and had just won a tender for an important export order. When questioned, he revealed that it was for the Chinese army! As an aside, the engines on his generators are imported from Japan and Italy. This is symptomatic of the extent of intra-industry international trade that occurs these days. • Another Panel member runs a company that installs wooden floors in Victoria using a special locking device between the floorboards. His Australian supplier stopped supplying the specially finished floorboards, and so he was forced to look elsewhere. Eventually, he came up with a system whereby he ships the bulk wood to Malaysia, they glue and machine it to his requirements, and he receives it ready for installation in Australia at 20 per cent below the price of his former supplier. He is now exploring the alternative of moving his source of supply to China at a probable saving of 50 per cent. | reserve bank of australia | 2,003 | 10 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to 2003 Melbourne Institute Economic and Social Outlo... | I J Macfarlane: Economic opportunities and risks over the coming decades Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to 2003 Melbourne Institute Economic and Social Outlook Conference Dinner, Melbourne,13 November 2003. * * * In keeping with the theme of this year’s conference, I have chosen a subject which has a long-run focus. No doubt this will disappoint some who were hoping that I would deal with the ‘here and now’ of Australian monetary policy. But I should point out that within the last week or so we have put out both a press release and a detailed quarterly report on monetary policy and in a few weeks time I will appear before a Parliamentary Committee for three hours of grilling on the same subject. I think we keep the public well informed on the evolution of our thinking on monetary policy, and therefore do not feel the need to deal with it every time I speak in public. My talk tonight will bear a family resemblance to the talk I gave 18 months ago at the first of these conferences jointly organised by the Melbourne Institute and The Australian newspaper. As in that talk, my approach will be to start with the world and work back to Australia’s place in it. I should say at the outset that I have always been an optimist when I consider Australia’s place in the world. That is, I think that the opportunities before us outnumber the risks and I think that Australia is in a much better position than nearly all of the other countries I could name. It does not mean that success will fall in our lap - we will still have to make a lot of hard decisions, many of which will not be particularly popular, but this will be nothing new. Optimism is not the normal Australian position when viewing our place in the world. There has been an abiding gloominess amongst most observers who were pre-occupied with the view that we as a country were slipping down the international rankings, and that this would continue. This pessimism was particularly rife in the 1980s, re-emerged briefly during the ‘tech boom’, but fortunately there is less of it now. The fact that we have had more than a decade of good economic performance, notwithstanding a difficult international environment at times, has helped build confidence in our ability to make our way in the world. Let me say a few words about international rankings. There are several organisations that publish rankings of countries according to income or GDP per capita. That is, they rank countries from the richest down to the poorest. In the past, I have been critical of these rankings because there are so many statistical assumptions that are involved in their construction that the results are very approximate, and therefore cannot form the basis of policy interpretation or aspiration. To illustrate this, Table 1 shows the rankings for the year 2000 as calculated by three separate organisations - the World Bank, the OECD (Organisation for Economic Co-operation and Development) and Penn World Tables (University of Pennsylvania). As you can see, there is a good deal of similarity between the three rankings, but Australia’s position is variously recorded as seventh, tenth and twelfth out of 22 countries. Table 1 GDP per capita rankings - OECD countries, 2000 Penn World Tables World Bank OECD United States United States United States Norway Switzerland Norway Canada Norway Switzerland Denmark Iceland Denmark Switzerland Belgium Iceland Ireland Denmark Ireland Australia Canada Canada Iceland Japan Netherlands Japan Austria Austria Netherlands Netherlands Australia Belgium Ireland Belgium Austria Australia Japan Sweden Germany Germany Finland Finland Finland United Kingdom France Italy Germany Sweden Sweden France United Kingdom United Kingdom Italy Italy France New Zealand Spain New Zealand Spain New Zealand Spain Portugal Portugal Portugal Greece Greece Greece PPP weights. Sources: Penn World Tables; World Bank; OECD. Notwithstanding these reservations, it should be pointed out that the period when Australia was slipping down the rankings appears to have ended (Table 2). Using the Penn World Tables, Australia has moved up from tenth in 1990 to seventh in 2000, while the World Bank numbers show it moving up from sixteenth in 1990 to ninth in 2002. I do not wish to make much of this, given my reservations about these rankings, but at least it should put a stop to stories about how we are falling behind. Table 2 GDP per capita rankings - Penn World Tables Switzerland United States United States United States United States Switzerland Switzerland Norway New Zealand Canada Canada Canada Denmark Norway Japan Denmark Australia Iceland Denmark Switzerland Sweden Denmark Iceland Ireland Canada Sweden Sweden Australia United Kingdom Australia Norway Iceland Netherlands Netherlands Finland Japan Norway France Australia Netherlands France Belgium France Belgium Belgium Austria Belgium Austria Finland Germany Austria Sweden Iceland Japan Netherlands Finland Austria Finland Germany United Kingdom Italy Italy Italy Germany Ireland United Kingdom United Kingdom France Spain New Zealand New Zealand Italy Japan Greece Ireland New Zealand Greece Spain Spain Spain Portugal Ireland Portugal Portugal Portugal Greece Greece Table 2 (cont) GDP per capita rankings - World Bank Switzerland Switzerland Norway United States United States United States Norway Norway Ireland Iceland Iceland Denmark Denmark Denmark Iceland Canada Canada Canada Austria Japan Austria Germany Austria Switzerland Belgium Germany Australia Netherlands Belgium Netherlands France France Belgium Australia Netherlands Germany Sweden Italy France Italy Sweden Finland Japan Finland United Kingdom Finland Australia Japan United Kingdom United Kingdom Italy New Zealand New Zealand Sweden Greece Spain Spain Spain Ireland New Zealand Ireland Greece Greece Portugal Portugal Portugal As I said earlier, I think we are well placed for another good performance over the coming decade for two broad reasons. First, our geographic position. When we look at the major regions of the world over the past four decades, we note from the right-hand panels of Diagram 1 that both Continental Europe and Japan show a distinct downward trend in their growth rates as we move forward from decade to decade. For the English-speaking countries, this has not been the case; even though they have not regained the growth rates of the 1960s, the three decades after that show, if anything, a slight upward trend. The thing that stands out about East Asia is just how fast growth has been in each decade (greater than 6 per cent per annum), and again there is no sign of a downward trend. Graph 1 Over any measure, say, 20 years, 10 years or even five years, Asia is the fastest growing region in the world, despite what we can now see was a relatively brief setback during the Asian crisis. And there is no reason to believe that it will not continue. In fact, there is reason to believe that it will become more pronounced. Over the past few decades, a number of smallish Asian countries learned how to grow quickly, and now we are seeing the two truly huge countries - China followed by India - achieve the same sort of consistent high growth rates. Graph 2 Graph 3 A lot of countries are terrified by this, as they see China and India threatening their own industries. Other countries see themselves in a position to benefit from this growth, and Australia surely has to be one of them. The potential benefit comes from the fact that China and India will not only be large exporters, but will be large importers as well. For example, over the past year, Chinese imports rose by 40 per cent. The countries that are threatened have one or both of the following characteristics: • they have large manufacturing sectors, often propped up with various protective devices; and • they have relatively rigid regulations which make it difficult to shift resources (mainly labour) from the declining sectors into the potential growth sectors. Large parts of the world’s manufacturing industry are being effectively transferred to China, so in other countries new jobs will have to be found for the people so displaced. The test these countries face is whether they can rise to the occasion or whether they will simply try and prop up yesterday’s industries. (As an aside, I am relieved that we are not having to face the coming challenge with the sort of heavily protected manufacturing sector and centralised wage system that we had a couple of decades ago. I am sure we would have failed the test.) My second cause for optimism is related to the first. For most of the 20th century, as the new postcolonial countries were opened up, there was a massive expansion in the supply of resource-based products like the ones we have traditionally produced and exported. In resource-based, I include both agricultural products and minerals and metals. The prices of these products trended downwards relative to the prices of the things that we tended to import like manufactures and services. In economic parlance, the terms of trade moved against us decade by decade, and this held back the growth in our real incomes (Graph 4). Incidentally, this was the principal reason why we slipped down the international league table of income per head. I think this long trend has at last turned - by my estimate, since about the middle of the 1980s. Now the massive expansion in capacity around the world is in manufacturing (mainly Asian manufacturing) and the greatest downward pressure on pricing is occurring there. Thus, our export prices are now doing better than our import prices, and our terms of trade has risen on average over the past 15 years (Graph 5). The mirror image of this is to be found in China’s terms of trade which has fallen by 30 per cent between 1978 and 2001. Graph 4 Graph 5 A lot of people would object to this line of reasoning as they would say that I seem to be accepting that we will remain a quarry and a farm. That is not true. I thoroughly applaud our success in broadening our export base into elaborately transformed manufactures and services, and will have more to say about this later. But with the best will in the world, most of our exports will still be resource-based in a decade’s time and probably two decades’ time. It has taken 20 years for the resource-based share of exports to fall from 70 per cent to 60 per cent, so you can see that change is relatively gradual in this area. We should assume that over the next decade or so we will still be a major exporter of resourcebased products, but we should take comfort from the fact that this will not be the disadvantage that it once was. What are our advantages and disadvantages? Apart from being in the right place and producing the right output, what are our advantages compared with other countries? First, we should compare ourselves with other developed countries with a similar level of income per head; these are mainly European. Compared with this group, I think we have two big advantages flexibility and demographics. Certainly, our institutional framework in goods, labour and financial markets means we can adjust to change better than virtually all of the European competitors, even if we are only on a par with the British and Canadians, and less flexible than the United States. On demographics, our population is aging less quickly than virtually any other developed country, thanks to our high level of immigration. But even though we are better off than others, we should not delude ourselves into thinking that we do not have some big challenges facing us brought about by an aging population, a subject to which I will return. Second, if we compare ourselves with the countries of Asia, we have three clear advantages: • we have a better legal and regulatory infrastructure; • we have a less-polluted physical environment; and • a higher proportion of our labour force is skilled. Against this, we have less flexibility in the labour market and a more expensive social welfare system. While the latter makes for a better and fairer society, it has to be financed by relatively high taxes, a combination of factors which means that our savings rate is low by Asian standards. This means that we will continue to rely on foreign savings to augment our own, and hence we need to remain an attractive place for foreigners to invest. Against this background, what should we do to maximise our advantages? First, I think there will be a huge premium on flexibility. The countries that can adapt to the emergence of China and India and other parts of Asia will thrive, while those that go into defensive mode will stagnate. I think that the market by itself will probably do quite a good job of handling the challenge, although at times it may need assistance. The main risk is that there will be public pressure put on the Government to prevent the changes which may be painful in the short run, but which will be in our long-term interest. Secondly, there will be a premium on moving up the skill spectrum. This can be seen most clearly in manufacturing where the mass-production of standard items will become dominated by the big Asian countries, and we must find other avenues which are opened up by the possession of more specialised skills. This is more complicated than it sounds. Some people think that China is only going to dominate low-tech things such as textiles, clothing and footwear, basic utensils, consumer electronics, etc. But they could dominate a lot more than that; they could dominate anything that can be produced on a large scale, even if it is technologically sophisticated, such as cars and semiconductors. What we will need to be good at will be in producing things that are specialised rather than mass-produced, skill-intensive and which, in many cases, may be difficult to identify other than by trial and error. They will include both manufactured goods and specialised services for export, but will also involve using the best applied science available to increase productivity in our traditional resourcebased industries and in those parts of the economy not involved in international trade such as construction or domestic transport. There are no short cuts here. The thing we know is that profitable opportunities will only be found if we have a culture of inquiry and innovation. This in turn can only happen if we have a vigorous educational and scientific environment where excellence is valued and rewarded. An illustration of this is if we think back to the discussions in 2000 at the height of the technology boom. There was a widely-held view at that time that the countries that would get ahead were those that manufactured IT and telecommunications equipment, and that if you did not do so you would fall behind. There was even the suggestion floated in this country that we should entice Intel to open a chip factory here. In fact, all the research that has now come to light shows that it is the application of the new technologies which leads to the big increases in productivity, not the manufacture. In fact, manufacturing often takes place in a huge foreign-owned factory, using orthodox mass production techniques, with very little spin-off to the rest of the economy. My third theme is demographic. All around the developed world, populations are aging and the growth of working-age populations is slowing or, in some cases, falling. More retired people are being supported by fewer working people. We should be looking ahead and encouraging higher labour force participation by older workers. The Intergenerational Report produced by the Government will be a very useful document on which to base thinking on policy options. If we are not careful, there is a potential for conflict between generations. The young may resent the tax burden imposed on them to pay for pension and health expenditure on the old. This will particularly be the case if they see the old as owning most of the community’s assets. Housing is the most obvious example, where people of my generation have benefited from 30 years of asset price inflation, while new entrants to the workforce struggle to buy their first home. At the same time, people - retirees in particular - are likely to be feeling less secure as they may be disappointed with the rates of return they are receiving on their savings. It seems to me that the community has not yet come to terms with the fact that nominal rates of return on financial and real assets are likely to be much lower over the coming decade or so than over the previous two decades. Returns were held up first by inflation (although, to some extent, this was illusory) and then by an asset price boom that lasted from 1983 to 2000 - the final instalment of which reached bubble proportions in many countries. We are presently witnessing the unwinding of this unsustainable situation. A good illustration of the long swings in rates of return is illustrated below by the change over the past 130 years in real equity prices in the United States. Graph 6 The potential for intergenerational conflict exists in all countries, and their future economic success depends in some sense on how they handle it. The countries that will do worst are those where the population is aging the fastest, and those where their governments have given the most generous promises. Again, we are looking mainly at Europe to find this combination of problems. But even in Australia, the conflict could become a problem and lead to all sorts of behavioural changes. At the very least, we should question the assumption that age and poverty are positively related and that concessions to alleviate the latter should be directed at the former. In fact, I think we will have to go further and be pre-emptive in conditioning the public, particularly the grey-headed part, to accept that policy must be forward looking and directed to ensuring a vigorous Australian economy and society 20 years hence. This will mean giving priority to tomorrow’s working-age population, rather than satisfying the demands of yesterday’s. Last time I spoke at this forum, I ended by making a plea for raising the priority attached to improving the level of excellence in tertiary education. Although I am not an expert in this subject and was merely quoting others more expert than myself, I was surprised at the favourable public reaction my observations received. I can think of no better way of ending this speech than again stating my view that an improvement in the quality of tertiary education is probably the best investment we can make in our future. | reserve bank of australia | 2,003 | 11 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics, Finance and Public Administration, Brisbane, 8 December 2003. | I J Macfarlane: Overview of the Australian economy Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics, Finance and Public Administration, Brisbane, 8 December 2003. * * * Mr Chairman, it is a pleasure to be here today in front of your Committee again, and I am very pleased that we have been able to meet in Brisbane for the first time. As you know, we take these hearings very seriously because they enable Parliament, through its representatives on the Committee, to question the Reserve Bank in depth and in public. As usual I will make some introductory remarks in which I will focus on three subjects: • how the situation has changed since the statement I gave to this Committee in June; • how our forecasts have evolved; • the background to our monetary policy actions. 1. June and Now Calendar year 2003 was an unusual one for the world economy. In the first half, prospects for world growth looked doubtful, with the most extreme uncertainty being concentrated in mid-year. If you remember, this is when talk of possible deflation in the United States reached its peak, and the US authorities gave the impression that they needed lower interest rates and a lower US dollar to help them through. In Europe, economic activity was weakening, and Asia received a temporary knock-back from the Severe Acute Respiratory Syndrome (SARS) outbreak. At that time, virtually all the central banks of note - the Federal Reserve Bank of New York (the Fed), the Bank of England, the European Central Bank (ECB), the Bank of Canada, etc. - reduced interest rates, and I indicated to this Committee that if things did not improve, we might also have to do so. In the event, we did not because we witnessed one of the sharpest turnarounds in economic prospects any of us has seen. While in the June quarter most major countries, including many in Asia, saw declines in Gross Domestic Product (GDP), by the September quarter they were all growing strongly. The weakness we had seen in the June quarter turned out to be a ‘false signal’. In financial markets, bond yields rose sharply, share prices continued to rise, and various prices connected with international trade, such as commodity prices and transport prices, also rose. Talk of deflation ceased and the short-lived bout of monetary easing stopped. Business and consumer confidence indicators around the world rose back to levels consistent with reasonable economic growth. At the same time as perceptions of the world economy were being raised, the general run of economic indicators in Australia continued to improve, particularly employment, retail sales, construction activity and business and consumer confidence. Prospects for farm production also picked up sharply following widespread rain, even though it was not uniform across the country. Economic conditions here and abroad had returned to something relatively normal and, as a consequence, we judged that we no longer needed such an expansionary setting of monetary policy: interest rates were raised accordingly in November and December. 2. Forecasts At this point, I will follow my usual practice by discussing the forecasts I gave you at the previous meeting, then adding some new ones for the coming calendar year. When we last met in June, I said that we expected GDP to grow by 3 per cent in real terms over the course of 2003. With three quarters of the year behind us, we now expect that the figure will come in a little higher, at about 3½ per cent. The thing to notice, however, is the big difference between the two halves of the year, with growth in the first half being at an annual rate of 2 per cent, and growth in the second half expected to be at an annual rate of around 5 per cent. The other thing to notice is that growth of domestic demand (Gross National Expenditure - GNE) through 2003, at 5 per cent, is again expected to be well above the figure of 3½ per cent for GDP. Over the course of 2004, we expect GDP to grow by 4 per cent. The profile of growth, however, is unlikely to be smooth. It would not surprise us if the four-quarter-ended growth rate of GDP reached 4½ per cent in mid 2004 due to the effects of the sharp rise in farm GDP, before returning to 4 per cent by end year. If the world economy continues to surprise on the strong side, as it has in recent months, our GDP growth could be even higher. On inflation, we said last time that we expected the CPI to increase by 2½ per cent over calendar 2003. We now think it will be a little lower at 2¼ per cent, largely due to the exchange rate being higher than assumed in our earlier forecast. Over the course of 2004, we expect the CPI to increase by 2 per cent, but in mid 2004 it could well be below that because the maximum effects of the higher Australian dollar could be being felt then. As we stated in our quarterly statement, this expectation implies that the profile of inflation will exhibit a shallow U-shape - falling from its present 2½ per cent to below 2 per cent in mid 2004, but then rising back to 2 per cent by end 2004, 2½ per cent by mid 2005, and continuing under upward pressure thereafter. Of course, it is difficult to be precise about these things, especially since future levels of the exchange rate will play a major role. I will say more about this later. 3. Monetary Policy As I outlined at the start of these remarks, with growth in the world economy getting back to normal, and growth in the Australian economy also getting back to normal, or slightly above it, we could no longer see a justification for Australian interest rates being clearly below normal. That is, the major reason for the two increases in interest rates this quarter is the same as I gave to this Committee 18 months ago in late May 2002 when talking about the tightening then. Another way of putting this is to say that if we had maintained the low level of interest rates we had at the beginning of 2002, there would have been a gradual build-up in inflationary pressures as the growth rates of the world and Australian economies rose through 2003, 2004 and beyond. Interest rates were just too low for an economy that was growing that well. As it turned out, this process of returning interest rates to more normal levels has been a gradual one. Two increases in interest rates were made in mid-2002, then there was a 16-month gap to the next two increases. I have explained in the previous two meetings of this Committee why that long gap occurred. It is clear that, despite our best endeavours to explain ourselves, a number of people think that the Bank tightened to cool down the property market. In fact, I have more than once received unsolicited advice that it would be better for us to explain our action in this way because people could more easily identify with it. The overheated property market is something that people can see around them; it is much more concrete than such concepts as inflation-targeting or returning interest rates to normal. However, such an approach would not be consistent with the truth. For a start, signs of overheating in the housing market were clearly evident through the second half of 2002 and all through 2003, yet the Bank did not change monetary policy. It was only when it became clear that good economic growth had returned both globally and domestically that rates were raised. I have often stressed that monetary policy has to be set taking into account the average of all the parts of the economy, not to what is happening in one sector. Of course, if a sector is overheated, it may push up the average for the economy, and in that way exert a disproportionate influence. It is also true that, historically, borrowing for housing purposes has been one of the more interest-sensitive sectors, and so it may have been more affected than other sectors by the previous low level of interest rates and it may respond more than other sectors to the recent increases. But that does not mean we singled it out. We have also been accused of setting monetary policy in relation to the Sydney and Melbourne housing markets, and ignoring the rest of the country. This clearly cannot be true in the case of the recent tightenings, as house prices in Sydney and Melbourne are growing less quickly than in other states; in fact, housing prices in some parts of these cities are already falling. In Australia we have conducted monetary policy by using an inflation-targeting regime for about a decade now. It has been a very successful regime in that it has delivered (along with various other reforms) the longest period of uninterrupted good economic growth in the post war period, at a rate exceeding that of all other significant developed economies. It has concentrated our minds at the Reserve Bank in that we have been very conscious of our need to deliver the results to which we have committed. Over the 10-year period, inflation has averaged 2.4 per cent. By acting early on monetary policy to keep inflation in check, we have avoided large swings in interest rates and thereby allowed the economy to prosper. As you are aware, our target is a relatively flexible one in that we aim to achieve an average rate of somewhere between 2 and 3 per cent. It is that average by which we should be judged, or made accountable. But there are some observers who think that the system should be more prescriptive than this and there should be some strict rule which should determine our actions. For example, a few people still think we should aim to keep inflation between 2 and 3 per cent at all times. This is a clear misinterpretation of our system because it fails to realise that it is the average we are interested in. On a number of occasions, inflation has been above 3 per cent and below 2 per cent. In fact, about 45 per cent of the time it has been outside the 2 to 3 per cent range, and we have not regarded this as a failure of policy. Since our objective is to achieve an average inflation rate, there are multiple paths for inflation which are consistent with meeting our medium-term objective. We wish to choose the one which best satisfies the other obligations contained in our Act, which I summarise as achieving sustainable growth in income and employment. We are not simplistically committed to achieving the minimum possible variability in the inflation rate, or even hitting the target at some fixed period ahead, such as two years. Another approach sometimes put to us is to say that we should raise interest rates if, and only if, our forecast for inflation is above 3 per cent, and lower them if, and only if, it is below 2 per cent. Again, this is a misinterpretation of how the system works. It also ignores the complications and uncertainties involved in economic forecasting. The forecast horizon relevant for policy today is at least two, or even three, years. We can be relatively confident about forecasts for the first half of that horizon, as much of what is going to happen over that period is already set in place. But we can be less confident about the forecasts for the second half. The situation is particularly uncertain when, as is the case at present, the direction of inflation is expected to change during the forecast period. Since this type of forecast is so hard to make, we, like a number of other central banks, do not wish to lead the public to believe we can do this with much precision. In fact, we tend to appeal to the balance of risks around the central forecast in order to convey our message. In last month’s quarterly statement we said that the balance of risks was shifting to the upside, which was meant to indicate that inflation was on an upward trajectory through the course of the second year. We also drew attention to the fact that domestic price pressures were increasing, as shown by the fact that the rate of increase in the prices of ‘non-internationally traded goods and services’ had increased from 2 per cent to 4 per cent over the past few years. That does not mean that inflation will rise to 4 per cent once the exchange rate effects have worn off, but at least a significant part of the economy will be influenced by this figure. In summary, I want to assure the Committee that the Bank remains committed to the inflation targeting framework and that the decisions taken over the past 18 months have been fully consistent with that framework. It does not seem plausible to us to argue that the Bank could have been confident of meeting its inflation commitments if interest rates had been held at 30-year lows in the face of the pick up in the international and domestic economies that is currently under way. Finally, let me end by updating you on a few developments in the payments policy reforms. Since we last met, the challenges brought against the Reserve Bank’s reforms to credit card schemes by MasterCard and Visa were dismissed by the Federal Court. Both schemes subsequently appealed, but Visa has withdrawn its appeal. The new interchange fees for Bankcard, MasterCard and Visa came into effect at the end of October, almost halving the fees. The Reserve Bank is monitoring the flow through of this to merchant service fees. The data are still being gathered, but anecdotal evidence suggests that merchants are starting to see a reduction in the merchant service fees they pay to banks. There have been several developments in other payments streams, and I will be happy to answer questions on those when they arise, but I am aware that I have already taken a fair amount of your time, so I will finish at this point. | reserve bank of australia | 2,003 | 12 |
Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists and the Economic Society (NSW Branch), Sydney, 17 February 2004. | Glenn Stevens: Recent issues for the conduct of monetary policy Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists and the Economic Society (NSW Branch), Sydney, 17 February 2004. * * * Thank you to the ABE and the Economic Society for putting on such an enjoyable occasion and inviting me to speak. I don’t intend to say much about current economic conditions or the short-term outlook. The Bank has just released its Statement on Monetary Policy, and there is no end of discussion at this time of year in various conferences about what may lie ahead. Instead, I want to make some observations about several issues which have been important in the conduct of policy over the past couple of years. These issues of principle are worth clarifying as they are likely to be of more enduring importance than comments about the current state of the economy. Background The past two or three years have seen some highly unusual circumstances for the conduct of monetary policy. Internationally, we saw in 2001 and 2002 the weakest economic conditions in the major countries as a group for about twenty years. Several of them encountered recession - and recovery tended to be rather halting, which seems related to the unwinding of the share market bubble and associated excesses in the US and elsewhere. It has also been a period of very low and declining inflation, as conventionally measured by CPIs. The long disinflation which began in the early 1980s has resulted in price stability in most countries, and the possibility of inflation falling too far - becoming deflation - was openly talked about around the world last year in a way which had not happened in half a century. A result of all of this has been that interest rates in the world’s key financial centres have fallen to exceptionally low levels. At present, the average short-term interest rate in the ‘big three’ economies is 1 per cent, the lowest in a hundred years. There have also been major changes in exchange rates over the past year or two. The US dollar, formerly very strong, has weakened considerably against the euro and other major floating currencies; most Asian currencies have depreciated against other currencies roughly pari passu with the US dollar. Through all this, the Australian economy has to date maintained a pace of growth envied by most others, in the face of some pretty unfavourable shocks. It is the first time anyone can recall the US having a recession without that also being followed by a recession in Australia. The reasons for this have been discussed on other occasions, so they don’t need detailed repetition. One of them was, in our judgement, a fairly expansionary setting of monetary policy.1 At the same time, there has been a very substantial build up in debt in the Australian household sector. During the second half of 2003, it became increasingly clear that the US economy, after a period of rather mediocre growth and a moment of genuine concern about deflation, was starting to experience the stronger performance for which people in the US - and everywhere else! - had been waiting. Other regions seemed to be noticing an improvement too. People became more confident that prospects for 2004 were looking up. At the Reserve Bank, we concluded that the stance of monetary policy in Australia should adapt to changing international and domestic circumstances, and we adjusted interest rates up by a total of 50 basis points in the closing months of the year. During recent discussion, several quite important issues have come more clearly into focus. I’d like to take up three of those today: • the role of inflation forecasts in making monetary policy under inflation targeting; Australian households and businesses having had less of the over-confidence and associated excesses than in some other countries in the late 1990s is another part of the explanation. Allowing the exchange rate to move has been a third. And, of course, a background of sound structural and budgetary policies over a number of years has made the economy more robust to shocks. All of these have been important. • the concept of the natural or neutral interest rate - its uses and limitations; and • the importance of asset prices and credit, and how policymakers take account of them. Inflation targeting and the use of forecasts Inflation targeting has been in operation for a decade or so in Australia, and a little longer in some other countries. The general idea, put at its most simple, is that policy seeks to keep inflation roughly in line with an announced numerical goal, over time. There is no pretence to fine tuning here. The framework simply embodies the things we know about monetary policy from long experience: that its long-run goal should be (and can only be) prices; that its capacity for short-term control of inflation is limited, and its short-run effect on economic activity important, so the price goal should be pursued gradually; and that expectations matter, so it is helpful to tell people what the goal of policy is and how we are going about achieving it. Because monetary policy operates with quite a long lag, it is important to think not just about where inflation has been, but where it is likely to be in the future. Hence the practice of inflation targeting, and the rhetoric of inflation targeting, have emphasised the importance of being forward-looking. Unavoidably, this means that forecasts have become more prominent. Indeed, many descriptions of inflation targeting have adopted the shorthand of saying that it involves adjusting the instrument so as to keep the conditional forecast of inflation at target, over some given horizon. I have used that shorthand myself as a way of getting across the essence of the approach. But like all simplifications, this abstracts from some important practical issues, and it may easily convey an impression that inflation targeting is rather mechanical, focussing exclusively on the inflation forecast at one horizon. That impression would be unfortunate, because inflation targeting is not, and never has been, a policy rule, and the inflation forecast per se does not determine in some mechanistic way the central bank’s policy reaction. Forecasts are very important in assessing the need for policy adjustments, but there is no unique mapping from one to the other, and other considerations than just the numerical forecast have, quite properly, a bearing on the decision. In elaborating on this, there are a couple of points to make. First, the notion that inflation might be targeted at one particular horizon - six or eight quarters ahead or whatever - may be useful as a pedagogical device, but in fact policymakers care more about the general path of the inflation rate than about how it looks at one particular point. Policy settings which could be expected to achieve an ‘on target’ result x quarters ahead, but at the risk of significant problems in quarters x+1, x+2 and so on, will see policymakers looking for an alternative course of action. While, again, no one is pretending that the path of prices can be fine-tuned, a concern for the general path of inflation, as opposed to one point on the path, offers the best chance of achieving the inflation target on average.2 This is relevant to the late 2003 decisions, which saw inflation at 2½ per cent during 2005 but most likely on the way higher than that subsequently. That general trajectory, as opposed to one point on it, was given some weight. More generally, economic forecasting is difficult and imprecise. In practice, it can sometimes be hard for the forecasters to make a confident call that higher or lower inflation is on the cards until it is imminent or even under way. Similar problems characterise forecasts for other variables. This is just inherent in the forecasting process. One reason is that there are a host of potential factors which cannot be incorporated easily in a numerical forecast. Unexpected changes in exchange rates, bond rates, property prices and share prices, the effects of financial structure changes, and so on can have important effects. Typically, they are assumed not to occur for the purposes of making formal forecasts. Even when changes are observed, their effects can in some cases be particularly difficult to quantify. Hence, they are normally listed under ‘risks’. This doesn’t mean we should disregard forecasts or try to make policy without them. But it does mean that policymakers cannot assume that the forecasts will give a signal which is sufficiently reliable on its own to be the sole basis for policy. It also means that risks often feature more prominently in policy deliberations than do the forecasts themselves. In principle, the central bank is seeking to solve a dynamic optimisation problem in which the variability of the whole path of prices around the target (and the variability of output) is minimised, in expectation, by the path of interest rates we choose. This is an appropriate moment at which to deal with an argument which is sometimes heard, that our 2-3 per cent average inflation target means that we should tighten policy if, but only if, our forecast for inflation exceeds 3 per cent. By the same logic, we should ease policy if, and only if, the forecast is less than 2 per cent. This interprets the 2-3 per cent specification not so much as a target to be achieved on average, as a zone of inaction for policy: do nothing until a trigger point is reached, regardless of the level of interest rates currently in place. I think this is not the right way to operate policy. To see why, remember that it is the level of interest rates which matters. To be sure, changes in interest rates make the news, and may well have some announcement effect in themselves - mainly if they shift expectations about the level of interest rates in the future. But monetary policy does not stop working when the changes in interest rates stop. A persistently higher or lower level of interest rates affects cash flow positions, relative rates of return on assets, discount rates and so on, and hence behaviour, over quite a long period. Very low, constant, interest rates do not produce a one-time lift in inflation. They will eventually produce, in a normal economy, continually rising inflation. High rates will produce, if held long enough, continually falling inflation and eventually deflation. It follows that the setting of the policy instrument which starts a movement in inflation back to the target following a deviation is not the setting which will keep inflation at the target once it gets there.3 Equally, a setting which is designed to counter some shock which would otherwise push the economy off course will no longer be appropriate once that shock has waned. Once the circumstances that required an unusually high or low setting of interest rates pass, interest rates will need to be readjusted. The only question is when that should occur. For policymakers to wait until they are sure there will be a significant over-shoot or under-shoot of inflation from the target means that they would hold unusually low or high rates far longer than really needed - and would then need to correct very sharply, with quite large policy adjustments to recover the situation. Compared with a strategy of earlier but more modest adjustments, this could still achieve the same average inflation rate, but with more instability in the economy. The RBA has not conducted policy in that fashion. In late 1999 and the first half of 2000, we had a forecast that inflation would rise from 1½-2 per cent to about 2½ per cent by end 2000, and to close to 3 per cent by mid 2001. Consistent with the judgement that the interest rate which helped move inflation up to the target was not the interest rate which would keep it there, we moved rates up by 150 basis points in five steps. We didn’t wait until we had a forecast that inflation would clearly exceed 3 per cent before moving. In the event, inflation did end up exceeding 3 per cent in 2001 - which confirms that some tightening had definitely been required. In 2001, policy was being eased given the anticipated effects of the global recession and so on, even though inflation was turning out a bit higher than expected. The forecasts at the time said that inflation would, after a lag, come down to about 2½ per cent. We didn’t wait to get a forecast of below 2 per cent inflation before easing. We would have had to wait, most probably, until quite recently for that, which would have been too late. So policymakers have not followed the ‘zone of inaction’ approach in the past, nor are they doing so now. More generally, to return to the main topic of this section, they do not rely on the inflation forecasts alone to drive the policy decision. Policymakers have to consider the best numerical forecast available as a key input. But in making their decision, they must also develop their own sense of the balance of risks, and the consequences were some of those risks to crystallise. I think the historical record is clear that, in doing so, they have made better decisions than would have been the case had they been driven exclusively by forecasts, even forecasts which by most standards were pretty good. The ‘neutral’ rate of interest The idea that there is a neutral setting of monetary policy has been prominent in policy discussion in the past few years. In Australia, the Bank has used this language on occasion when explaining adjustments to interest rates. This, of course, is not a new point. See the Governor’s November 1999 remarks to the House of Representatives Standing Committee on Economics, Finance and Public Administration at http://www.aph.gov.au/hansard/reps/commttee/r2791.pdf. A key reason that we think it is a useful concept stems from our conviction that, as noted earlier, it is the level of interest rates which does most of the work in monetary policy. Given that, we need some basis on which to assess whether the level of rates is high or low. This is where ‘neutral’ comes in. This notion is not something we just dreamed up. It has quite a long pedigree in economics, stretching back at least as far as the great Swedish economist, Knut Wicksell, writing over a century ago. For Wicksell, the ‘natural’ rate was the rate of return earned by fixed capital. He distinguished it from the ‘money’ rate of interest, which was set in the money market by the combined actions of the central bank and the private banking system. When the money rate was below the natural rate, there would be an incentive to borrow to invest and credit would expand, pushing up prices. The reverse occurred in the case where the money rate rose above the neutral rate. This was known as Wicksell’s ‘cumulative process’. The idea was taken up by Keynes in the Treatise on Money, and further refined in the General Theory.4 The modern world is more complex than the world of Wicksell and Keynes. We do not expect to drive monthly policy decisions direct from the dusty pages of old books, however classic they may be. But the essential insight is still useful. Imagine aggregate demand in the economy growing along a path which uses the economy’s productive resources fully - no more and no less - so that the economy is operating at its potential level of output, inflation is at the target and is expected to remain there. The level of interest rates which would, absent other shocks, perpetuate this happy state of affairs is the ‘neutral’ rate, so named because it does not move the economy off the hypothetical path in either direction. When, due to some shock, the economy is operating below its potential for other than a brief period, we would expect that part of the stabilising mechanism would be that interest rates would be lower than neutral. And they would be higher than neutral when the economy was tending to overheat. This neutral rate is not, however, an observable magnitude: there is no statistical release you can consult to find out its value. Nor, of course, are other magnitudes which are common in the lexicon of macroeconomic policy, like ‘full employment’, ‘price stability’, or ‘sustainable growth’. We can offer a conceptual definition of these terms, but empirical estimates of them always have a margin for error and can never be assumed to be immutable. That does not render the ideas useless; indeed, people expect us to pursue some of them as policy goals. But it does mean that there isn’t much room for dogmatism about particular estimates, as the Governor has stressed over the past several years. To the extent that we can say anything useful about where a neutral rate might be, it will probably be based on the experience of the past decade or so, during which inflation expectations have been fairly low and well-anchored, and we have been following a stable policy regime.5 Over that period, cash rates between 4 and 5 per cent have been associated with marked accelerations in domestic demand on three occasions. Cash rates of 6¼-7½ per cent helped to slow it a couple of times. Those crude facts suggest that ‘neutral’ is, or at least was, somewhere in between those two levels. Through all that, inflation has had mild cyclical swings but no trend, which might suggest that rates have been close to neutral on average. On the other hand, the fact that the economy has grown sufficiently fast to gradually reduce the degree of spare capacity, and hence faster than its likely long run sustainable rate, might suggest a setting somewhat below neutral was, on average, in place over that period. It was this sort of rough figuring that was the basis of the range of figures the Governor gave when questioned about this issue a couple of years ago.6 I conjecture that empirical techniques which do the computation in a more sophisticated fashion would arrive at similar answers. For those with an historical interest, Wicksell’s exposition is in Interest and Prices, published in 1898. In the Treatise on Money (1930), Keynes defines the natural rate as that rate at which savings and investment are equal, distinguishes this from the market rate of interest, and goes on to say that ‘every departure of the market rate from the natural rate tends ... to set up a disturbance of the price level’ by causing saving and investment to diverge. In the General Theory, Keynes regards this natural rate as not being unique - there are now, in his view, a multiplicity of natural rates, and various levels of equilibrium output and employment levels - and hence not very helpful. He proceeds to define instead a ‘neutral rate’ as: ‘… the rate … which is consistent with full employment’ (p. 243 of Macmillan 1973 edition). It is quite clear that these concepts, through their various manifestations, are looking towards a concept of neutrality which is associated with neither inflationary nor deflationary pressure. Some earlier periods of history may be relevant, but for much of the post-World War II period, regulations on interest rates and associated credit rationing meant that monetary policy did not affect the economy in the same way as it does now. In addition, it’s clear that the broad trend in inflation of this period was upward, certainly from the early 1960s until the mid to late 1970s. This suggests that, on average, monetary policy was expansionary for quite a lengthy period of time. That, of course, means that there is no precise number for ‘neutral’. To the extent we can offer a range, it is unlikely to be a narrow one.7 This imprecision might be frustrating, if people are looking for specific guidance about the near-term path of rates. But it isn’t surprising that attempts to estimate an empirical counterpart to an analytical construct come up with only pretty loose results - it has ever been thus. In fact, we should view with suspicion any claim that ‘neutral’ can be pinned down closely. For those looking for short term guidance, it may be equally frustrating that, while in some fabled world without disturbances policy would be set at ‘neutral’ much of the time, in the real world it often isn’t, because disturbances have a habit of occurring.8 Persistent global economic weakness, for example, seen as dampening Australian growth, was one such factor over recent years. Given that Australia is open to global capital markets, the level of international interest rates can also impinge on interest rates here - causing us to be away from ‘neutral’ at times, possibly for substantial periods.9 That may be as much as we can realistically say about ‘neutral’. The concept helps us to remember that the level of rates matters, and that unusually high or low rates will most likely have to give way to more ‘normal’ levels eventually. But while it can in some circumstances give an indication of what the direction of rate changes should be, it is unlikely to give precise guidance on the size or timing. Asset prices I now turn to the topical question of asset prices and monetary policy. It is obviously something on a lot of minds, given the events in the US over the past five years and the preceding ‘bubble economy’ in Japan - and of course the run up in housing prices and debt in Australia. Among the central banking community and other observers, it is generally agreed that: • asset prices per se should not be a target for monetary policy; but • they should be analysed for what they say about the likely evolution of the macroeconomy over the coming year or two and, to that extent, movements in asset prices warrant a policy response. The more difficult part of the discussion is when we confront the question of whether policy should do more than the above - that is, should it respond by more than is suggested by the estimated short-term effects of the asset price changes on the macroeconomy through the standard channels like wealth effects and so on? The case in favour rests on the idea that credit-financed asset price booms, when they reverse, are likely to be highly contractionary for the economy. This may well be over a horizon longer than the usual one to two-year forecasting horizon, so that conventional forecasts may not capture these dynamics. But over that longer horizon, on this argument, the economy will probably be better off if the boom is smaller or stops earlier, rather than later. Policy which responds to the boom to an extent greater than required just by the short-term outlook may assist this. The opposing case does not deny the possibility that the boom will end painfully, but essentially says that modest action will be ineffective in restraining the boom, and aggressive action risks bringing on See remarks to the House of Representatives Standing Committee on Economics, Finance and Public Administration, May 2002, at http://www.aph.gov.au/hansard/reps/commttee/r5558.pdf. It is worth noting that, in principle, the neutral rate can vary, though one would not normally expect it to be a cyclical variable. For example, it will be affected by things which affect the real expected return to capital. Things like persistent changes in productivity growth, for example, might affect the neutral rate. It would, in principle, be affected by secular changes in saving behaviour. That’s before we have considered the question of whether changes in interest margins (e.g. between cash and mortgage rates) or levels of indebtedness may have a bearing on it. But while it is likely that the ‘neutral’ rate is subject to low-frequency fluctuations, I think it is reasonable to assume that it is sufficiently slow moving that it is still a useful concept, provided we don’t adopt the strong assumption that it never moves. Indeed, Wicksell expected that a stable equilibrium where the market and natural rates were equal would rarely, if ever, occur for any length of time. In a world in which capital flowed quickly to arbitrage away any differences in rates of return on capital across countries, there would presumably not be noticeable differences between the ‘neutral’ rate between countries. There would just be one global neutral rate, with country risk premia. But in the current world, while capital mobility has increased a lot in recent decades, the vast bulk of the capital of most nations’ citizens is still invested at home, and differences in rates of return seem to persist. Hence, it still makes sense to think there is a neutral rate for policy which is distinct from international rates, though the actual setting of policy cannot be completely invariant to what happens abroad. the very recession that policy meant to avoid. On this view, policy should continue as normal during the boom, but stand ready to clean up afterwards. This debate has been going on for a number of years now. Much has been learned (although I don’t think one could say that people have found substantial agreement). Some of the work at our conference last year demonstrated that the dynamics of asset booms and busts are sufficiently complex and non linear that we should take great care in any response to a well-developed boom (which, of course, is the only type of boom where the issue arises - no-one advocates dealing with incipient booms). This indicates that a cavalier attitude to ‘pricking bubbles’ is not in order. At the same time, it is increasingly clear that a narrow policy focus confined to the product of conventional economic analysis over a one to two year horizon can miss very important developments in the financial sector and asset markets, which often play out over longer horizons but which can have major economic implications. Surely we ignore these at our peril. So where does this leave us? I believe it should leave us trying to think about outcomes and risks, and policy settings which seek to manage those risks, over a horizon a bit longer than is common in much discussion of economic policy. Is this a departure from our long-established medium-term, flexible approach to inflation targeting? Definitely not. In fact, it dovetails quite well with the long-held view that policy should not respond solely to the inflation forecast at some fixed horizon and ignore other considerations. All that is new is that there is an additional dimension to the general rationale to maintain, and on occasion to use, the flexibility the system has always had. Recent Policy These considerations have been relevant in our conduct of policy. With the global economy improving during the second half of 2003, it was clear that the Australian economy would not need interest rates to be only just above generation lows for much longer. It is true that inflation as measured by the CPI is likely to look quite low for the coming year or more because the exchange rate has been rising. But that sort of outlook is disguising pressure in the non-traded sector. If non-traded inflation were to build up further steam, and then the currency were at some point to decline - which history suggests it will people could get quite a nasty surprise at how quickly overall inflation could increase. Not only that, but the non-traded part of inflation also tends to be harder, once it does increase, to reduce again. If we care about the medium term path for the economy, these are all relevant considerations. At the same time, the demand for credit was exceptionally high, and indeed picked up from mid 2003 to about October, after a number of years of sustained strength. Few people are now completely sanguine about the potential problems this could bring if it continues. There remains, as I have said, a good deal of debate about whether, and how aggressively, monetary policy might apply high interest rates to handle an asset boom. But it is hard to see a case in such circumstances for holding rates unusually low, in the absence of other powerful contractionary forces. It certainly seemed to us imprudent, to say the least, to leave interest rates so low, given that the international factors which had held them there were fast evaporating. A risk-management approach to policy pointed to the advisability of removing some of that stimulus. It is possible to argue that a central bank following a narrow inflation-targeting approach could have waited longer before raising interest rates. But that view supposes a rather mechanical and short-term approach. At the risk of labouring the point, our approach has never been like that, and isn’t now. It has always stressed the desirability of taking account of things other than just the narrow short-term inflation outlook where it was sensible to do so, with the proviso that medium-term inflation performance be in line with the announced objectives. Hence the words ‘on average, over the cycle’ or other similar language, have always been a feature of our inflation target. A decade ago, this language was far too vague for the tastes of many critics, who doubted we would have the resolve to keep inflation low. But the record shows that the system has worked well. Sensibly operated, it will continue to do so. Conclusion Good policy uses the best available analysis, systematising what we can know about the economy from past experience, without assuming that the future will be like the past in every respect. It must avoid both the hubris of thinking we know everything and the despairing assumption that we know nothing. The apparatus I have described above has, in my view, been useful in helping sensible thinking about policy. But we shouldn’t get too carried away by any sense of numerical precision, or become too wedded to the idea that forecasts, or estimates of the neutral interest rate - or various other concepts which could be cited - will give us an exact guide to policy decisions. That is asking too much of them. Monetary policy always has needed some element of judgement - informed judgement desirably, and of course subject to appropriate accountability. Policymakers have to make their decisions on the basis of incomplete information and uncertainty about the future, balancing the risks of various outcomes and the pay-offs and penalties attached to the various possibilities. Policy frameworks also retain, desirably, sufficient flexibility to help them adapt to different circumstances and challenges. Inflation targeting began in an era in which memories of two decades of bad performance were fresh, and understandably emphasised the importance of controlling CPI inflation. Inflation in Australia has been well controlled for a decade now. Yet the challenges for policy seem as great as ever, as we have observed that asset market and financial instability can occur, and can be costly, under conditions of price stability. It is surely sensible that policymakers should care about these problems and should do what they can to ameliorate them - even if that is not very much. At the very least, we have to try hard to avoid exacerbating them. There is no inherent conflict between such an aspiration and the accepted long run goal of maintaining price stability - indeed, over any sensible horizon, the two go together. But we need to be prepared to think about the balance of risks over that horizon and to give those considerations due weight in policy decisions. Of course that may not be easy to do, and perhaps it is not straightforward to explain, but it seems nonetheless to be a worthwhile endeavour. | reserve bank of australia | 2,004 | 2 |
Inaugural Di Yerbury Economic and Financial Studies Lecture by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, Sydney, 14 April 2004. | I J Macfarlane: The world economy and its implications for Australia Inaugural Di Yerbury Economic and Financial Studies Lecture by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, Sydney, 14 April 2004. * * * It is a great honour to be invited by Macquarie University to deliver the Inaugural Di Yerbury Economic and Financial Studies Lecture tonight. I also note that this is the 40th anniversary of the establishment of Macquarie University. For fourteen of those years Professor Yerbury has been Vice-Chancellor - a remarkable achievement by any standard. Our paths first crossed in the late 1960s - although neither of us has much recollection of it - when Di was a lecturer and I was a tutor in the Economics Faculty at Monash University. Since then, of course, Professor Yerbury has gone on to an illustrious career in academia, government and university administration. The world economy I will speak tonight about recent developments in the world economy and their implications for Australia. It is about 18 months since I spoke about the world economy, and a number of things have changed in that time, mainly for the better. Despite various hesitations and temporary setbacks, the recovery from the world recession that beset G7 countries in 2001 has consolidated. For the world economy as a whole, GDP growth picked up in 2002, again in 2003, and is forecast to be higher again at a relatively robust 4.4 per cent in 2004 (Graph 1). Over the past four quarters, both the United States and Japan have reported growth in excess of 4 per cent, and in non-Japan Asia it has been a lot higher. Graph 1 At the same time, inflation in almost all countries has remained low. At the level of final goods prices, as shown by consumer price indices, inflation is low almost everywhere, and few countries report upward pressure. Not surprisingly, this reassuring macro-economic picture has led to a return of confidence to financial markets. Share markets around the world have risen appreciably from their troughs in early 2003, and in many markets price earnings ratios are well above medium-term averages. A similar return of confidence has occurred in debt markets, where spreads have narrowed to historic lows. Borrowers in emerging market economies can obtain finance on very advantageous terms as investors chase yields. A similar process is at work for sub-prime and even sub-investment grade borrowers in developed economies. Such a compression of spreads means that providers of capital perceive risks to have been greatly reduced and therefore do not need to be enticed with high premia to compensate for those risks. While the performance of the world economy has improved and the downward risks abated, this has not been reflected to any great extent in economic policies. With few exceptions, the stances of monetary and fiscal policies are still at the expansionary settings to which they were moved in order to offset the fall in asset prices and associated recessions in 2001. In fact, for the three major economies - the United States, the Euro area and Japan - monetary policy, as indicated by interest rates, is, if anything, more expansionary now than it was in 2001. If we construct a measure of the average shortterm interest rates for the world, the present level is the lowest since the Second World War (Graph 2). Of course, nominal interest rates are not necessarily the best indicator of the stance of monetary policy1, but when they are as low as they are at present, they must be telling us something. Graph 2 A similar picture applies to fiscal policy. The fiscal deficit among G7 countries has increased noticeably in the past three years and is now at least as large as any experienced since the early 1960s (Graph 3). Other measures, such as the yield curve, also suggest very expansionary monetary policy settings. The evidence from quantitative data is harder to read because of its volatility but, in both the United States and Europe, credit growth has picked up from the lows reached a couple of years ago. Over the past year, credit has grown by 8 per cent in the United States and 6 per cent in Europe. In China, credit has grown by around 20 per cent, but in Japan it is still declining. Graph 3 I have not spent a great deal of time on outlining these developments, but I think we can agree that there does appear to be a contrast between, on the one hand, a reasonably buoyant world economy and confident financial markets, and on the other hand, an exceptionally expansionary setting of macro-economic policies. I would now like to spend some time on the questions of why is it so, and how will it be resolved? The main reason that the average level of world interest rates is so low at present is that interest rates in key countries - particularly the United States - are at historical lows. And in the case of the United States, it is the absence of domestic inflationary pressure that explains why there has been no inclination on the part of the Fed to move to a less expansionary stance of monetary policy. The United States makes its monetary policy for its own domestic needs: no-one could expect it (or any other country) to do otherwise. The problem is that a number of other countries, which fix their exchange rates to the US dollar, effectively also match US monetary policy. Another group of countries, even though they have no desire to match US monetary policy, are nevertheless limited in the extent to which they can depart from it by exchange rate considerations. The net effect of all this is that, to some extent, the United States sets the world’s monetary policy - a partial return to the situation that prevailed under the Bretton Woods system. This may or may not be a bad thing, depending on where you view it from. For some parts of the world, where economic activity is subdued and domestic inflationary pressures non-existent, an extremely low interest rate structure like that in the United States may be suitable. But for other parts of the world, it could lead to the build-up of imbalances. For the world as a whole, we do not yet know whether the maintenance of an extremely low average interest rate is helpful or harmful to its longer-term interests. On the one hand, the after-effects of the bursting of asset price bubbles are still exerting downward pressure on goods and services prices in the United States and Europe, and in Japan (where it has been going on for a decade or more). More importantly, the downward pressure on goods prices - particularly internationally traded manufactured goods prices - caused by the massive expansion in Chinese capacity continues apace. This is a structural phenomenon which has been with us for some time now and can be expected to remain important for the foreseeable future, particularly with India joining in. It is what economists call a positive supply shock, and among many of its effects, the one most relevant to the current discussion is that it has made the maintenance of low CPI inflation easier than it formerly was. While these influences are important, we should not forget that the international business cycle is also alive and well, and can be expected to have an influence as we go forward. Good economic growth and expansionary policies are now starting to make their presence felt in a range of international markets. Commodity prices (as shown in the CRB Index, Graph 4) have risen over the past two years and are now at their highest level since 1989. The biggest rises so far have been among base metals, where the prices of nickel, lead and copper have more than doubled over the past year. Others such as zinc and aluminium have also risen sharply. The prices of bulk commodities such as iron ore and steaming and coking coal have also shown large increases in the recent contract re-negotiations. This demand has spilled down into the supply chain so we see increasing prices for such things as transporting goods (as shown by the Baltic Dry Index, Graph 5), and for wrapping them, as shown by the cost of new and recycled cardboard. Graph 4 Graph 5 As yet, this price pressure at the raw material and wholesale level has not fed into consumer prices, except in Asia where there is some evidence of this occurring, particularly in China. On asset prices, however, there has been a lot of action as investors have pushed up prices of equities, again particularly in Asia (Graph 6) Lenders have also been prepared to lend at relatively small spreads to borrowers who until recently were regarded as not credit-worthy. This offers some support for the view that assets are being over-priced and risk under-priced. The so-called ‘carry trade’, where intermediaries borrow very cheaply in the United States, Japan or the Euro area and onlend to other countries, particularly emerging markets, has regained much of the attractiveness it had immediately prior to the Asian crisis. This is, by definition, a highly-leveraged and hence risky activity. Graph 6 I do not want to give you the impression that the present easy stance of global monetary policy is already causing the world economy to overheat and financial markets to disregard risk. We have not reached that stage yet, but the longer monetary policy remains at this setting, the greater is the likelihood of these results. I have no doubt that this is understood by central banks around the world and in time the degree of monetary expansion will be reduced. In the meantime, it has made things more difficult in some ways for those countries where domestic demand has remained buoyant and domestic costs and prices have not been under downward pressure. The Australian economy Where does this leave Australia? My previous sentence may have given you the impression that it made life difficult for us. In one respect (which I will come to in a moment), this has been the case, but overall, developments in the world economy have worked to our advantage. Certainly, a recovery in world economic activity is good for all countries, including Australia. The fact that the area of strongest growth is again in Asia means we benefit more than most other countries because we do so much of our trade with this region. The fact that commodity prices are rising is also of great benefit to us in that it contributes to a rise in our terms of trade (Graph 7). We are simultaneously gaining from stronger export prices for a wide range of our exports, and also receiving the benefit of falling import prices for the many manufactured goods that we import. This amounts to a rise in Australia’s real income. Graph 7 I have made the point on several occasions in the past that the long period when Australia suffered a trend decline in its terms of trade (approximately from the beginning of the 20th century) probably came to an end in the mid 1980s. Since, then the terms of trade have fluctuated, but around a generally rising trend. We should expect this upward trend will continue in the foreseeable future. The Reserve Bank Index of Commodity Prices shows that commodity prices have already risen appreciably over the past couple of years (when measured in a neutral numeraire). When the increases in the prices of steaming and coking coal and iron ore flow through into the index, we will soon see a further substantial rise (the blue dot in Graph 8). Graph 8 To put these things in perspective, the current upswing in the global economy comes after a couple of years of significant under-performance, which had a serious impact on Australia’s exports. It will take some time to recover the lost ground on that front, but the present combination of buoyant world growth, rising commodity prices and falling manufacturing prices is a favourable one for Australia. It increases the chance of more balanced growth outcomes for the Australian economy in the period ahead, and therefore of further prolonging the economic expansion. What could go wrong? There were two big risks to this generally favourable outlook. The first was the excessive growth of overall credit, especially to the household sector for housing purchases, and the consequent rapid increase in housing prices. The second was that the exchange rate could be pushed quickly to an unrealistically high level. Both of these risks now look to be less menacing than they did a few months ago, but we cannot be confident that they have gone away completely. I will start with the second of these risks because it is the one that directly results from our interaction with the rest of the world. We should not have been surprised that the Australian dollar rose over the past three years given its extraordinarily low starting point, the rising terms of trade, the fact that the US dollar was finally weakening and the associated fact that US interest rates were so low. I think this was well understood by the public, including by exporters and manufacturers, even though they saw their margins shrinking and competition increasing. Apprehension started to increase, however, when in the relatively short period between early November and mid February, the rate against the US dollar rose from US70 cents to US80 cents (14 per cent) and against the TWI from 61 to 66 (9 per cent). This was an uncomfortably fast rate of increase and the prospect of it continuing was clearly a consideration to be taken into account in formulating monetary policy. If there had been a domestic need to tighten earlier this year, as there well could have been, there would have been an extremely difficult decision to make. This is the type of conflict that can arise when the world has such an exceptionally low level of interest rates, but some countries do not need, or would be positively harmed by sharing, the same low interest rate structure. The other risk we faced was that the excessive growth of credit to the household sector would continue, so fuelling further asset price rises, particularly in housing. This risk is diminishing. It now seems likely that the peak in credit demand was reached around October 2003 when monthly loan approvals for housing (owner-occupation plus investment) reached over $15 billion per month, an increase of 40 per cent over the year earlier. Since then, we have had four monthly declines in loan approvals and they are now running at about $12 billion per month. Some may be inclined to think that a decline of this magnitude - 20 per cent - represents a sharp fall in the provision of housing finance. But $12 billion per month is still a rapid rate of lending and, if continued, would be consistent with the stock of housing credit growing at a twelve-month-ended rate of about 18 per cent by end 2004. Admittedly, this would be well down on its peak of 23.6 per cent, but would still be unsustainably high. What we are talking about here is the difference between a flow (loan approvals) and a stock (household credit). The flow would have to fall quite a lot in order to bring the growth of the stock back to a sustainable rate.2 The jury is still out on what is going to happen here. There is no doubt that there are some areas of housing - Melbourne and Sydney apartments - where over-supply is pushing down prices, and off-theplan purchasers and some developers are feeling the pinch. But elsewhere the slowdown, if any, has been more muted. We will naturally be keeping a close eye on these developments to see that the return to a more sustainable rate of credit growth continues. Last year was a difficult period for monetary policy where, for much of the time, excessive domestic credit growth co-existed with a rapidly rising exchange rate. As we have proceeded through 2004, the situation has been made easier in that both have eased back a little. These are both welcome developments, but we cannot be sure whether they signal a new trend or are only pauses. Similarly, we are still waiting for the durability of the world economic recovery to be sufficiently recognised so that the major central banks around the world can start the process of returning interest rates to more normal levels. When that happens, the combination of a more stable exchange rate and a more restrained pace of credit expansion will become a lot easier to achieve. This estimate is based on the average historical relationship between loan approvals and the change in the outstanding stock of credit. For a further discussion of this relationship, see Box C from the February 2004 Statement on Monetary Policy. | reserve bank of australia | 2,004 | 4 |
Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at the APEC Business Forum 2004, Sydney, 15 April 2004. | Glenn Stevens: Regional financial arrangements - recent developments Speech by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at the APEC Business Forum 2004, Sydney, 15 April 2004. * * * It has become better recognised in recent years that the quality of financial infrastructure is one among several factors which help countries gain from international opening. A high-quality financial sector can assist local producers operating in a globalised economy to manage their risks more effectively. It also helps the domestic economy harness the greater availability of foreign capital. Yet the experience of the east Asian countries in the late 1990s demonstrated that international openness also exposes any residual weaknesses in the financial sector, and that can potentially amplify the effects of international shocks to the great cost of the local economy. Since the Asian crisis, a great deal of effort has gone into trying to build more robust financial sectors in Asia. Some of the most important work has been to repair and strengthen banking systems, a costly and time-consuming process. This has involved use of public funds to re-capitalise banks, and efforts to do a better job of prudential supervision. All of that has to be supported by efforts to clarify property rights, bankruptcy procedures and so on, and various countries in the region are working on those things. One of the key initiatives around at present is the development of Asian bond markets. There are several groups seeking to make a contribution in this area and it is on this that I want to focus my remarks. To a non-financial audience, the question might occur: what’s the big deal about bond markets? A key reason for wanting well-developed capital markets is that having a diversity of funding sources for governments, businesses and individuals, and a diverse range of opportunities for investors, is advantageous. A system which relies entirely on bank financing, or heavily on foreign capital market financing, arguably unduly concentrates funding risks. A full set of capital markets, on the other hand, offers a more comprehensive combination of financing and risk management to an economy. It would particularly offer currency risk matching for both borrowers and lenders in a way which would have been helpful during the Asian crisis. A deep and liquid official bond market also aids in pricing of assets and risks in the economy. Indeed, some countries have seen sufficient value in having a government debt market that they have taken steps to create one even though the government had no need to borrow (e.g. Hong Kong, Singapore) or to sustain one even when government debt was running down (e.g. Australia). In the east Asian region outside Japan, the local currency bond markets collectively are thought to be about US$1.1 trillion in terms of total stock outstanding, up from around US$350 billion a decade or so ago. That is a sizeable sum, but of course it is dispersed around a number of countries in what are essentially a series of local markets. Some countries in the region have first-rate financial infrastructure - legal and regulatory frameworks, trading platforms, clearing and settlement systems, and taxation arrangements. Other countries need, in the opinion of expert observers, more work to lift the quality of their infrastructure. Moreover, to develop a genuine regional market, in which savers and investors in the region can transact on a common set of arrangements, requires attention to harmonisation of many of these aspects of financial infrastructure. All of this is worth doing. The potential financing needs of some of the middle-income but fast-growing economies like China are very large indeed. To that could be added, if we shift our gaze a bit further west, the large and growing economic size of India. Hence there is likely to be significant pay-off to efforts to develop better functioning markets. A question which arises at this point is whether the priority should be at regional level, in efforts to develop a regional, cross-border market, or at the level of individual countries, developing their own markets. Efforts on both fronts are surely needed. A regional market would offer some efficiencies and enhancements to issuers and investors, but would have to be underpinned by the individual country components. It is in each country’s own interest to improve the functioning of their own market in any event. So the case for local initiatives is clear. But the push to take part in a regional project may well create the sort of dynamic which is helpful in overcoming obstacles at the national level, and the collective and individual outcomes will be stronger the more effectively market practices, and regulatory and legal issues can be harmonised at a ‘best practice’ standard. Hence, done with good sense, it seems to me that local and regional efforts should be able to be consistent and mutually reinforcing. Co-operative efforts have been initiated by various groupings to try to identify, and hopefully remove, the various structural impediments and to put in place some things which might accelerate market development. Work under the banner of APEC is seeking to promote securitisation and credit guarantee markets, in order to try to narrow the perceived credit and liquidity mismatch between borrowers in the region and institutional investors. This is helpful, so long as it does not amount to governments taking on large contingent liabilities which weaken their own credit rating. Then we have the Asian Bond Fund being developed by the eleven central banks in the Asia Pacific region known as EMEAP.1 The first step (ABF I) was the creation of a fund which pooled a small portion of the US dollar reserves held by the member central banks to invest in US dollar denominated bonds issued by east Asian governments, as opposed to the US Government. This fund commenced operations last July.2 The second and more difficult, but more fundamental, step will be the creation of ABF II, to invest in local currency-denominated sovereign and quasi-sovereign bonds in the region. Progress in developing the overall structure of this fund is well-advanced. The EMEAP central banks are now in the process of detailed study of design. As it happens, there was earlier today a press release informing markets and other observers of progress.3 While this work obviously adds slightly to demand for Asian bonds, the objective is not to lower artificially the funding costs for governments in the region by trying to divert major sums of central bank or other official money. Rather, it is to identify and remove where possible impediments to bond market investment, to develop some useful infrastructure for investors, and to show the way with a small investment by official institutions. Once established, the ABF II will hopefully be emulated by the private sector, and some parts of the ABF II infrastructure itself will be available for use by private investors looking to acquire an exposure to Asian local currency debt. A well functioning market will, of course, surely deliver lower cost borrowing to well run government programs and to private borrowers over time. Apart from APEC and EMEAP mentioned above, there is also work being done under the auspices of ASEAN plus 3, and the Asian Cooperation Dialogue. So clearly there is a lot of work going on. To date, these groups have managed to avoid working at cross purposes. As the various initiatives actually take more concrete form, it will be important to continue that parallel and complementary development - hence a degree of information sharing will be useful. But ultimately, after all the facilitation efforts are completed, a critical factor determining the vibrancy of bond markets in the Asian region, as in any region, will be the quality of countries’ policies. This starts with macroeconomic policies aimed at fiscal sustainability and price stability - where Asia generally has an exemplary record. It will include strong efforts at financial supervision - an area where a number of countries need ongoing development. It will also involve, in my view, the willingness of individual countries and their governments to allow markets to set prices and to play a major role in the allocation of funds - something some countries in the region have been less comfortable doing up to now. Most likely, countries will need to allow foreign firms to participate actively in market trading activities in order for market making behaviour to flourish in key markets. Australia’s experience is that the “embrace of the market” in this way can, on occasion, be uncomfortable. Markets will routinely react, and on occasion over-react, to government policies and other things which occur in the economy. Sometimes the market’s reaction is uninformed, unfair or just plain wrong. But over the longer run, vibrant, if on occasion volatile, financial sectors do confer worthwhile benefits on an economy. They are not in any sense a magic bullet to achieve prosperity, but the evidence is fairly clear that properly functioning financial sectors do contribute to better growth. That is a not inconsiderable benefit to the firms, governments and citizens of the countries concerned. Executives’ Meeting of East Asia-Pacific Central Banks. Details of this group’s composition, history and work can be found at http://www.emeap.org. See http://www.emeap.org/press/02june03.htm. See http://www.emeap.org/press/15apr04.htm. | reserve bank of australia | 2,004 | 4 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (Queensland Branch), Brisbane, 2 June 2004. | Glenn Stevens: Economic conditions and prospects - June 2004 Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (Queensland Branch), Brisbane, 2 June 2004. * * * Thank you for the invitation to speak to you today. I plan to cover the evolving economic picture both abroad and at home. As some of you may know, the Bank released a month ago our latest comprehensive treatment of the economy and financial markets. The Governor is also due to appear in front of a Parliamentary Committee on Friday of this week, to speak on the economy. My remarks today, therefore, fit into a rather small window in the unfolding narrative. Accordingly, I will not begin any major new lines of inquiry, but mainly give a brief update on a few of the themes which have been running for some time. The world economy It is still the case that the world economy is gaining strength, and forecasts for economic growth have generally been moving upwards. According to the main official international bodies (the IMF and the OECD), growth in the world economy will be about 4½ per cent in both 2004 and 2005. If that sequence occurs, it will be the strongest two-year growth performance since the late 1970s. Of course, these figures are just forecasts, not guarantees of performance. But by this stage of the year, it would take something pretty dramatic to change the estimated outcome for 2004 by much. The strong number for next year - which is a fairly recent feature of most people’s forecasts - basically reflects growing confidence that the recovery is well entrenched. It embodies further solid US growth, recognises a marked improvement in economic performance in Japan and ongoing strong growth in Asia. Continental Europe is the main area of softness, though even there things seem to be improving a bit. As usual, perceptions about the global cycle have been heavily affected by the ebbs and flows of confidence in the American economy. Following a somewhat hesitant early phase of recovery from early 2002 until mid 2003, the more robust performance of the US through the second half of last year and into early 2004 has been characterised by strongly rising corporate profits and an upturn in business investment spending. Over recent months, it has also driven rises in employment levels. This was the key sign for which most observers had been waiting, to indicate that the recovery had reached the self-sustaining stage, where initial demand expansion has produced enough output growth to push up incomes, which in turn feed back into renewed growth in demand. Confirmation of these trends in the US has greatly enhanced confidence about the global upswing. World GDP Growth Year-average percentage change % Forecasts – May 2004 % 30-year average Sources: Data – IMF; forecasts – Consensus Economics US Corporate Profits after Tax and Investment Per cent of GDP % % Business investment Corporate profits 1950 1956 1986 1992 Source: Bureau of Economic Analysis Once that occurred, it was perhaps inevitable that talk would turn to the question of how much longer official interest rates in the US would remain so low. A point that we have made repeatedly is that, in thinking about interest rates, it is the level of rates which matters and that level has been extremely low in America (and, for that matter, in other major regions or countries like the euro area and Japan). A setting such as this, designed to ward off the risks of deflation and chronic weakness in aggregate demand, has to give way to more normal settings once it is clear that those dangers are abating. The debate the US is going through at present is over when that process of normalisation will start and how quickly it will proceed. Market participants are currently betting that it will begin quite soon - within the next month - but will proceed fairly gradually. In due course, the Japanese and the Europeans will also presumably have such a discussion, though there seems no particular urgency to have it at the moment. Such an adjustment by the US Fed is unlikely to kill the recovery in US aggregate demand - it is more an indication that the Fed thinks the recovery is in solid shape. It would be more worrying if the return to normal interest rates in the US were not in prospect. US Federal Funds Rate % % Expectations (based on market yields) Sources: Bloomberg; US Federal Reserve That said, there is obviously a period of adjustment in financial markets under way as the anticipated changes to the cost of US funds are absorbed. Risk is being re-priced in a wide range of markets. Emerging market bond spreads have moved out a little, though US domestic spreads are little changed. Share prices have softened recently in a number of countries, and especially in Asia. The US dollar has firmed against most currencies. To a large extent, these movements reflect the unwinding of positions which were prompted by the very low US short-term rates and the resulting search for more yield - and more risk - in various other asset classes. Such adjustments are to be expected once the period of very low US rates looks like it is coming to an end. In fact we should, for the most part, welcome them. On most measures, spreads are still quite low relative to historical norms. Arguably, risk was being underpriced until recently anyway, which is hardly a recipe for longer-run stability. So all in all, a gradual return to a more normal constellation of US interest rates should be seen as a good thing. Emerging Market Spreads US Corporate Spreads Relative to 10-year US Government bonds Relative to 7 to10-year US Government bonds Bps Bps Latin America* Bps Bps 'Junk' bonds BBB Asia (B-rated) A AAA l l l l l l l l * Break in series due to removal of restructured Argentine debt. Source: Bloomberg l l l l l l l l Source: Bloomberg All of this attention given to the US economy and the changes to global financial markets as a result of likely changes in US monetary policy is par for the course. More noteworthy of late, however, is the prominence given to the growing role of China in the world economy. China is making a tangible difference to global economic output - and was a key reason, for example, why global output did not slow as much as the output of the advanced country group in 2001 and 2002. In some quarters, the rise of China as a source of supply of manufactured products on world markets has been seen as a cause for concern - since China has such a large supply of low-cost labour, much of which has not yet been tapped. No doubt, the rise of China is changing the economics of global manufacturing - though it is hardly the first time in history that this kind of thing has occurred. But it is also changing the economics of production of other things. China is not just a source of supply for goods, it is a source of demand for goods and services as well. Indeed, China’s trade surplus with the rest of the world is quite small, and relatively stable, suggesting that China has been putting as much additional demand as supply into the world economy. A number of countries have been affected by the demand side of China’s expansion, not least Australia, where we now see China accounting for about 10 per cent of our foreign trade, up from 5 per cent as recently as 1998. China’s demand for resources to supply its industrial expansion has put upward pressure on prices for steel and its raw materials (iron ore, coking coal), and on the costs of shipping. These effects have amplified the normal cyclical pick-up caused by general recovery in the industrial economies around the world. The Australian resource sector might have been able to supply even more of this demand had more capacity been available, but constraints seem to have been binding in some areas (which, of course, is one reason the effect on prices has been so strong). Presumably there are good prospects for expanding investment in various parts of the resources sector in the years ahead. The rapid growth of China’s demand for energy has also surely had a tangible impact on oil prices. While there are apparently some short-term special factors at work in the most recent very high oil prices, the trend increase in the global demand for oil is now strongly influenced by China (and other rapidly growing countries in Asia), as shown in the chart below. The figures which put this trend at its most stark are as follows. Over the two years to March this year, global demand for oil rose by about 4 million barrels a day. About 1.5 million barrels of this came from the OECD countries as a group - who use over 60 per cent of supply. About 2.1 million barrels a day in additional demand came from Asia including India, with 1.5 million barrels of that from China alone.1 Cumulative Global Oil Demand Growth Since 1997, million barrels per day million bpd Projection million bpd Other Asia (excl. China) China -2 OECD -2 Source: International Energy Agency Now it is important to keep the recent rise in oil prices in perspective: it is nothing like as large in proportionate terms as occurred in the “OPEC” shocks of 1973 and 1979. The level of real oil prices remains much lower than in either of those episodes and the share of oil in total production costs for advanced economies is much lower than it was in those days. Oil Price Real base = January 1970 US$ US$ Nominal Real However, given the extent of Chinese and Asian demand generally, and their likely trend growth in the future, it seems entirely possible that the level of real oil prices of the 1990s will turn out to have been on the low side of what could be the norm in the future. More generally, we can see a quite important change in relative prices occurring associated with the rise of China: prices for many manufactured goods are declining relative to those of resources. As a supplier of resources and a consumer of manufactures, Australia benefits from this relative price change. No-one can say for sure, of course, whether it will continue for a long time, but it does appear to be in distinct contrast to the previous long-term downward trend in Australia’s terms of trade. Source of these figures is the International Energy Agency (IEA), an inter-governmental body within the OECD. Certainly, it is beyond serious dispute now that the weight of China in the world economy - both in its secular growth rate, and the dynamic of its business cycle - is something which has to be carefully considered. China has problems, of course - as with any country trying to industrialise rapidly, balancing the rapid growth in demand and supply, and avoiding other problems, is no easy task. Right now the Chinese authorities are attempting to moderate the economy’s growth rate, given clear signs of overheating. Some of those pessimistic about global prospects in 2005 worry that the slowdown will turn out to be abrupt. The fact that China has had a very large build-up in credit, and that its banks carry the legacy of decades of lending to state enterprises on non-commercial criteria, make the job harder. Equally, the authorities have for the past decade shown an impressive capacity to manage the economy quite successfully through some difficult times. Hence, while there is some risk of a slump in China, we should not assume it. Even if an unexpectedly large slowdown did occur, it would be very unlikely to change the long-run outlook for China of strong growth and continuing emergence as one of the world’s largest economies. I haven’t even mentioned India yet but one should mention it, as an economy with a very large population, and turning out quite strong growth rates over the past few years. We will be hearing a lot more about India’s impact on the global scene during this decade. The Australian economy The Australian economy has continued grow. In the second half of 2003, real GDP expanded at an annualised pace of over 5 per cent, as the farm sector gained ground on the back of better climatic conditions, and the non-farm economy continued to expand, helped by strong domestic spending and the early stage of a recovery in exports. It was unlikely that growth at that pace would persist, and according to figures released earlier today, the speed of growth early in 2004 was noticeably more moderate. A range of business surveys suggest that conditions experienced in the first four or five months of 2004, while as strong as those of late 2003, were nonetheless better than average. Consumer demand is not advancing at the same pace this year as it did in the second half of 2003, though tax reductions in the coming year will presumably offer support to consumer spending. Employment has continued to rise, and the rate of unemployment is at its lowest for over 20 years. While employment growth last year owed a good deal to the effects of high levels of residential construction and the associated demand for materials, of late it looks as though employment in some of the professional services sectors has begun to increase again, after a slower period since mid 2001. Hence, as the anticipated decline in dwelling construction takes shape this year, overall employment levels should continue to increase, even if at a reduced pace from that seen over recent months. Growth in the state of Queensland, in particular, has been very strong indeed over the past year, and much faster than for the nation as a whole. Consumer spending is recorded as having grown by over 8 per cent through 2003, compared with 5 per cent for the rest of Australia. Dwelling investment spending surged to an all-time high in Queensland at the end of last year, while for the rest of the country it was high, but no higher than the pre-GST peak in 2000. Employment growth has also been faster in the sunshine State than in virtually all the other states. Dwelling Investment Household Consumption Expenditure June 2000 = 100 Year-ended percentage change % % Index Index Queensland Queensland Rest of Australia Rest of Australia -2 -2 Source: ABS Source: ABS Queensland has, of course, the highest rate of population growth of any of the states, with net migration from Victoria and NSW in particular. So we would expect most aggregates to be rising faster than elsewhere, but in 2003 growth in spending per head still outstripped the rest of Australia, and the employment growth sufficiently exceeded growth in the labour force that Queensland’s unemployment rate - which is routinely higher than the national average - closed quite a bit of the gap to the other States. In short, Queensland had a pretty good year. Employment Growth Unemployment Rate Three-month-ended average Year to latest three months % % % Queensland Queensland Rest of Australia Rest of Australia -2 -2 -4 % Source: ABS -4 Source: ABS The housing market has been a key issue for the economy over the past couple of years and, as you would know, the RBA has had quite a bit to say about it. A misconception that we still see from time to time is that some people seem to think we have been concerned mainly about excessive rates of construction. Construction has been very strong, and there may be over-supply in some areas. But our main concern has not been about the addition of 130,000 to 150,000 new dwellings each year. Rather we have been worried by the market for the existing 7½ million dwellings and the way in which they were changing hands for higher and higher prices, with an associated build-up in debt levels. That is, we have been worried about the housing market as an asset market, and about the borrowing behaviour of participants in that market. The concern was not out of a desire to target house prices, but more over the potential risks to macroeconomic stability from a major boom - and possible bust - in the household sector’s main asset class. On the most recent readings, there has been a distinct softening in most of the major housing markets, with more than one data series showing an outright fall in prices in the March quarter in several cities. This was associated with a decline in the demand for credit, though on the most recent data that demand still seems very strong. House prices in Brisbane and the Gold Coast declined a little on these measures, though not by as much as those further south. Median House Prices $'000 $'000 Sydney Gold Coast Melbourne Brisbane Source: Australian Property Monitors In our judgement, this is a welcome development. While various fundamental reasons can be advanced for dwelling prices to have risen noticeably in the 1990s, it was hard to avoid the conclusion that strong speculative forces were at work over the past couple of years. That was not a healthy state of affairs and the sooner it passed, the better. It is just about impossible, of course, to predict with any precision how all of this will unfold from here. Much will depend on what else is occurring in the economy. In individual cases, the extent of leverage will be very important. My own view is that the palpable sense of disappointment being felt by many leveraged investors in residential property is likely to grow further for the next year or so, possibly longer. For many owner-occupiers, on the other hand, a moderate decline in prices should not create major discomfort, in an environment of ongoing growth in employment and wages, as well as reduced taxes. In fact, it is hard to imagine a much more benign backdrop for the aftermath of an asset and credit boom than one where growth in employment and income is continuing, the world economy is picking up and the Australian economy is relatively free of other domestic imbalances. Even so, we anticipate that housing market developments will be a factor at work in reducing the rapid pace of growth in domestic spending to something more moderate. Rising house prices and the capacity to collateralise the higher wealth has accommodated a rise in consumption which has consistently outpaced the rise in income over several years. In a world where dwelling prices have stopped rising and even declined somewhat, perceptions of ongoing rapid increases in wealth are presumably now in the process of dissipating. This will weaken positive wealth effects, and could possibly lead to a partial reversal in time. On the other hand, the earlier increases in dwelling prices were very large, and even with the latest data showing declines, a big cumulative rise in wealth has occurred over the past decade, most of which has not been tapped. So there may yet be some expansionary impetus in the pipeline from those earlier gains. Consumption, Wealth and Income* Current prices % % Ratio of wealth to income % % Year-ended percentage change Consumption Income * Disposable income net of depreciation Sources: ABS; RBA The net effect is therefore hard to judge, but on balance, we are inclined to think that consumer demand will grow more in line with income over the next year or two - that is, by something less than last year’s cracking pace. That, together with some decline in dwelling construction activity, will result in slower growth in overall domestic spending. With the world economy doing quite well, on the other hand, external demand is expected to be stronger - the international environment will be boosting Australia, rather than restraining it. It is encouraging that this picture seems, slowly, to be emerging in the available data. Risks to this outlook stemming from a rising Australian dollar have abated somewhat of late. The result then is expected to be good growth overall, and more balanced growth (as between external and domestic demand) than seen for some time. Inflation will be affected over the period ahead by the fluctuations in the exchange rate and oil prices, but most likely will be consistent with our 2-3 per cent medium-term target. Internationally, the scene has turned (in the space of only twelve months) from one of concern about deflation to one of inflation going higher. Fears of widespread deflation were, in my view, always a little overdone, and the swing in some quarters to fear of inflation might also be unduly pessimistic. Nonetheless, it seems we are in a new phase of the international cycle and these developments will bear close watching. At this stage for Australia, though, prospects seem to be for acceptable inflation performance over the coming year or so. I will leave further elaboration of the Bank’s view of the outlook, since the Governor will do this on Friday. Conclusion Overall, this is a pretty positive picture for the Australian economy. “Beautiful one day, perfect the next” would perhaps be an overstatement. But generally good economic conditions offer, I trust, ample opportunity for profitable enterprise on the part of CEDA members and others here in Queensland. I wish you every success. | reserve bank of australia | 2,004 | 6 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 4 June 2004. | I J Macfarlane: Recent financial and economic developments in Australia Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 4 June 2004. * * * It is a pleasure for me to be here in front of the Committee once again. As usual, I will start by reviewing the forecasts I gave to the Committee six months ago in Brisbane, then provide you with an update of our current forecasts. I will then move on to discussing the risks to these forecasts, both in the upward and the downward direction. Last December we thought that GDP growth in calendar 2003 would be about 3½ per cent. We now know that it came in at 3.9 per cent, with the second half of the year being a lot stronger than the first half, but with growth slipping to 3.2 per cent in the four quarters to March 2004. Our forecast for growth through calendar 2004 is now 3¾ per cent. We began to lower our forecast because of weaker-than-expected exports and retail trade and stronger imports. We then raised the forecast following the Budget, but have lowered it again to take on board the March quarter national accounts released two days ago. I must say, however, that I think the market has over-reacted to the March quarter GDP figure. It only lowered our forecast in the mechanical sense that one of the four quarters is now lower than in our previous forecast. It did not materially change our view about the trajectory over the rest of the year, if anything it raised it. On inflation, we had forecast 2¼ per cent for the CPI increase over calendar 2003 and it came in a bit higher at 2.4 per cent, but has since receded to 2 per cent in the four quarters to March 2004. For calendar 2004, headline inflation will be heavily influenced by movements in oil prices, so it is best to look at underlying inflation. We are still forecasting that underlying measures will be running at about 2 per cent, as we did last time we met. By end 2005, both headline and underlying measures are likely to have moved up to about 2½ per cent. So we still have a shallow saucer-shaped profile for underlying inflation over the next year. Given the recent rise in petrol prices, the headline increase is likely to be higher than the underlying in the short run. This is a pretty good outlook for growth and inflation, both in absolute terms and, more particularly, relative to how things might have turned out. I would like to illustrate this latter point by referring back to a framework I put before the Committee a year ago when we met in Melbourne. This contained four possible scenarios, which I will recap. The first was: “a weakening world outlook and an abating of domestic credit and asset market pressures. This would provide a reasonably clear prognosis for monetary policy. In other words, if it were weak internationally, and weak domestically, that would be easy. In the other direction, so too would a combination of a clear strengthening of the world economy and continued domestic buoyancy. That would be easy. A third possible combination, and the most favourable one for Australia, would be a firming world economy and an easing in domestic pressures, resulting in more balanced growth for the Australian economy. But the combination that would be most damaging to the Australian economy would be if the household sector were to continue putting itself into a more exposed position at the rate it has over the past few years while, at the same time, a further weakening of the world economy was starting to feed through to Australian activity and incomes.” The last-mentioned of these possible outcomes, and the most unfavourable, was a distinct possibility in the middle of last year, but fortunately it did not come to pass. What occurred instead in the second half of last year was the second-mentioned possibility - a strengthening world economy and a continuation of domestic credit and asset market pressures centred on housing. This was the environment in which we decided twice to raise the cash rate. What has happened so far this year - although it took some time to clearly identify it - was the third-mentioned possibility - a transition to a set of conditions in line with a firming in the world economy and an easing in domestic pressures. This was the most favourable outcome and the one most likely to result in a more balanced growth for the Australian economy. I outlined this in a speech I gave to Macquarie University in April and we spelled it out more fully in our quarterly Statement on Monetary Policy published last month. The fact that conditions began to develop along these lines is also the reason why, after two rate rises in late 2003, we have not seen the need for action on monetary policy in any of our Board Meetings this year. In short, we have been comfortable with developments - a lot more so than we were for most of last year. But, as always, there are risks to the outlook, so I will spend the rest of my presentation discussing them. On the external side, consensus forecasts for the growth of the world economy in 2004 put it well above 4 per cent, with a similar figure for 2005. Certainly, the bulk of the economic data supports this relatively optimistic outlook. We are in the third year of an international expansion, and unless something unforeseen comes along, we should expect the expansion to last for a good few years longer. This is not the impression you would get by following press reports of financial market developments, where downside risks to the outlook always seem to be easier to identify than upside ones. The risk of a further rise in the oil price is a constant concern, and there is some substance to these apprehensions, but I will say no more on the subject at present as Mr Stevens has already delivered a piece covering it a couple of days ago. A number of others in the market worry that policy tightening in China will be overdone, leading to a collapse of the Chinese economy. I have more confidence in China than that, and welcome the news that the Chinese authorities have been taking steps to rein in excessive investment. More generally, financial markets have had difficulty coming to grips with the fact that the long period of very low world interest rates must come to an end, and that they will have to adjust to an international environment of rising world interest rates over the next few years. Overall, we think these concerns are overdone and we are comfortable working on the assumption that the consensus forecast for a good world recovery is a reasonable one. We should also note that higher oil prices and higher interest rates are a symptom of global strength, not global weakness. We should also not rule out the risks on the upside. It may turn out to be the case that very low world interest rates were kept in place for too long a period. In this case, we could see greater inflationary pressure than we currently expect. In this scenario, I believe the main result would be a faster rise in world interest rates, as markets reacted to the prospect, and the reality of central banks acting to keep inflation under control. Turning now to the Australian economy, I want to start by re-emphasising that monetary policy is determined by developments in the economy as a whole, not by developments in any one component. For example, for much of 2002/03, domestic demand was increasing at an exceptionally strong pace, but the external sector was subtracting from growth. Inflation at this time was also above 3 per cent. Even so, we did not use monetary policy to rein in the rapid growth of domestic demand because, for the economy as a whole, growth was not excessive and was not threatening our inflation objective over the medium term, despite being above it in the short run. While monetary policy is directed at the economy as a whole, it does not mean that we have to direct an equal amount of attention to each of its components. Those parts that are obviously exhibiting a serious imbalance will attract more of our attention than those that are relatively well behaved. This explains why we have spent so much time talking about, and researching, the excessively rapid growth in housing credit and, until recently, house prices. While other economic variables were more important for the overall macro-economic outlook, for example consumption and wage growth, their behaviour was not as clearly aberrant and therefore not in need of such intensive study. The forecast for GDP growth in 2004 that I presented before is based on the view that domestic demand will slow from its former rapid pace, but at the same time the subtraction from growth due to the external sector will gradually diminish. Consumption has recently slowed a bit, although it continues to be supported by strong employment growth and will benefit from the tax cuts later in the year. Business fixed investment, particularly in building and structures, will add to growth but not to the same extent as in recent years. Residential investment is expected to subtract from growth and government spending will add to it. Overall, expected GDP growth of 3¾ per cent would be a good outcome. At this stage, we are not assuming a significant drought effect over the coming twelve months, but this remains a downward risk, given the dry conditions prevailing in some parts of the country so far this year. On the inflation front, we do not see a problem over the next twelve months. Beyond that, the picture is of necessity more difficult to quantify. Last time we met we were slightly troubled by the fact that inflation in the non-traded sector was over 4 per cent, and that if this continued it might imply a medium-term outlook for inflation somewhat above 3 per cent. This is still a risk, but we have taken some comfort from the fact that some of the sectors that were pushing it up - such as house-building and property services - should slow as the pressure comes off the house-building sector. The continued modest growth in average wages to date also gives us some confidence. To the extent that there is an upward risk on inflation in the medium term, it is more likely to come from international developments as the world recovery gathers momentum. I will conclude by saying a few words about housing credit and house prices. As we said in our quarterly Statement on Monetary Policy, “The run-up in credit growth and the associated boom in house prices in recent years presented two implications for the economy: they tended to boost growth in the short term, but carried the risk of a damaging correction if they continued too long.” In fact, they represented the one internal imbalance that could have put at risk the continuation of the long economic expansion that has been so beneficial to the Australian community. It is not surprising, therefore, that we experienced a feeling of relief when data started to emerge this year which suggested the worst of the excesses may be past. First, we saw three monthly reductions in loan approvals starting in November 2003 which amounted to a cumulative fall of 20 per cent. Approvals are now running at about $12 billion per month instead of $15 billion at their peak last year. It is still far too early to know whether lending is returning to a sustainable pace - certainly $12 billion per month is still far too high - but at least some progress has been made. Certainly, the prospect of a return to sustainable rates of growth of credit seems brighter than for several years, and with it the increased likelihood that the run of good economic outcomes of the last decade will continue. More recently, we received very strong evidence that housing prices have not only slowed their rate of increase, but have fallen in level terms so far this year. This has occurred in most state capital cities, including the two largest, for Australia on average, and for both houses and apartments. As the fall in prices becomes widely known, it should allow potential house purchasers to take their time and not be afraid, as so many were, that they had to rush in and buy for fear of missing their last opportunity. It should enable them to resist the blandishments of the banks, brokers and other commission agents plying them with offers of seemingly generous quantities of credit. It should also reinforce the recent tendency of investors to question their assumptions about easy capital gains. As such, we expect that the housing market will continue to go through a much-needed cooling phase for some time yet. That is all I wish to say about the economy at this stage, but I will be happy to answer any questions you wish to put to me. I am also conscious that I have been talking on the economy for quite a while and have not left any time to cover the various other areas of the Bank’s responsibilities, such as contributing to the soundness of the financial system, ensuring the efficiency of the payments system and issuing Australia’s currency. But I am sure these can all be covered during the question and answer session. | reserve bank of australia | 2,004 | 6 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Economic Society of Victoria and the Australian Industry Group ¿Economic Focus - Australia¿s Prospects¿, Melbourne, 17 August 2004. | Glenn Stevens: Better than a coin toss? The thankless task of economic forecasting1 Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Economic Society of Victoria and the Australian Industry Group “Economic Focus - Australia’s Prospects”, Melbourne, 17 August 2004. The references for the speech can be found on the Reserve Bank of Australia’s website. * * * One of my best forecasts was made by accident. In mid 1999, at one of the regular Parliamentary hearings we have each six months, I was asked about the prospects for the rate of unemployment, which at the time had been fluctuating around 7½ per cent for several months.2 My answer was that unemployment would fall to ‘the low sevens, 7 per cent, something like that’ by the end of that year. A decline of up to half a percentage point in half a year was, I thought, a reasonably bold forecast; I didn’t think it was likely to go below 7 per cent at that stage. But the Hansard reporters recorded my words as ‘below 7’, not ‘the low sevens’. Hence I was recorded as in effect saying that the unemployment rate would decline quite quickly, and before long have a six before the decimal point for the first time in about a decade. I was worried at the time that this seemed much too bold, but the unemployment rate did indeed fall below 7 per cent around the end of 1999. Hence I am happy to have that forecast on the record, even though I didn’t actually intend to make it. Perhaps that says that chance plays as big a role in forecasting as it seems to in many other areas of life. These days I am more of a consumer of economic forecasts than a producer of them, and while I suppose a former forecaster never entirely loses interest in the forecasting process, it is in the capacity of user that I have come here today. Hence I do not propose to make any forecasts - there are presumably more than enough to choose from as a result of the conference. I will rather offer a few observations about the general processes of forming and using forecasts. Making economic forecasts remains an occupational necessity, but something of a chore, for many economists including those giving policy advice. For those receiving advice and charged with the responsibility of helping to make decisions, key issues remain deciding how much to stake on a particular view of the outlook, and how to think about the consequences of the forecast and associated policy being wrong. For both producers and users of forecasts, it is also worth looking back at forecast errors - not to berate the forecasters, but rather to see what we can learn from those errors about the way the economy works. Evidence on accuracy It has long been understood that economic forecasts are not all that good. Most elements of the round-up that I gave five years ago3 still seem apposite. First, forecasts are better than a coin toss - that is, an economic forecast can more often than not be expected to outperform a random process or some very simple extrapolative rule - though often not by all that much. This is not true, however, for some financial variables, where the economics profession’s forecasting embarrassment is greatest. There is some evidence that, in Australia, forecasts improved in the past decade. The table shows that the average absolute error of one-year-ahead forecasts for both GDP growth and CPI inflation in The Age Survey from 1994 to 2003 declined to just over half what it had been in the preceding 10 years. Of course, that period has been one of much reduced volatility in the economy, a fact that has been Jonathan Kearns provided invaluable assistance in preparation for this speech. Because of data revisions, the unemployment rate for May 1999 is today recorded at 7.0 per cent. But this was originally published as 7.5 per cent. Stevens (1999). noted before.4 So maybe it was just easier to make forecasts in that period, and the real test will come when the economy enters rougher waters. A crude way of assessing this would be to see whether a comparison of The Age forecasts with those from a naïve forecast rule - that the future value is the same as the current one - revealed an improvement. The second column gives the forecast errors for such a naïve rule. The Theil statistic in the final column shows the ratio of the two errors. ‘Good’ forecasts have a value less than unity - that is, the forecasters add value in the sense of lowering forecast errors compared with the naïve rule. While The Age panel’s performance improves a lot in the past decade, so does that of the naïve forecast rule. The Theil statistic suggests that the forecasters were adding some value in both periods, but with no major changes between the two. So we shouldn’t get too carried away by lower forecast errors in recent years. To give Australian forecasters their due, however, arguments that a more stable economy is easier to forecast presumably apply just as much to the US economy (at least for most of the period), but the evidence from the US Survey of Professional Forecasters is that there was no absolute improvement in forecast accuracy over the past decade. The extent of value added by the forecasters, as measured by this simple test, actually declined. Forecast Errors* Percentage points Australian CPI Inflation Australian GDP Growth Absolute forecast error Naïve rule error Theil statistic 1984-1993 1.77 2.61 0.68 1994-2003 0.92 1.63 0.56 Absolute forecast error Naïve rule error Theil statistic 1984-1993 1.81 2.68 0.67 1994-2003 0.88 1.11 0.79 (The Age Survey) US CPI Inflation US GDP Growth Absolute forecast error Naïve rule error Theil statistic 1984-1993 0.67 0.82 0.82 1994-2003 0.60 0.62 0.96 Absolute forecast error Naïve rule error Theil statistic 1984-1993 1.12 2.05 0.55 1994-2003 1.35 1.47 0.92 (Survey of Professional Forecasters) * Mean absolute forecast errors for one-year-ahead forecasts. A second key finding is that the accuracy of forecasts tends to decline somewhat as the forecasting horizon lengthens. For most countries, the accuracy of inflation forecasts is superior to that of growth forecasts at short horizons. I conjecture that this reflects the facts that inflation has a fair bit of inertia. GDP growth, on the other hand, has much less inertial behaviour and its measurement is probably subject to more sampling error. Hence, forecasts one or two quarters ahead for inflation are pretty good compared with growth forecasts. But over longer horizons where inertia weakens, this advantage for the inflation forecasters diminishes. My thumbnail sketch is in a paper with David Gruen in Gruen and Stevens (2000). A more sophisticated analysis is Simon (2001). The RBA has been compiling a survey of private forecasts of inflation for about a decade. Participants - which include some of you here - are asked for a forecast of the CPI over a one and two-year horizon. We have eight years of data from about fifteen forecasters which enables us to make some observations about the way accuracy diminishes with horizon. As expected, the mean absolute error of the year-ended forecasts increases quickly out to about a year. In part this is mechanical as the number of quarters actually being forecast rises from one to four, but the underlying quarterly errors probably get a bit larger too. But between a five quarter and an eight quarter horizon, there isn’t that much loss of accuracy. So those comfortable with a horizon of just over a year shouldn’t have too much trouble accepting a two-year forecast. That said, the confidence interval for this set of forecasts is still fairly wide. Graph 1 Third, extreme movements are rarely well-forecast. Late in 2000, Consensus forecasts for US GDP growth in 2001 were about 3½ per cent. But as we now know, the US economy experienced a recession in 2001, and recorded year-average expansion in GDP of about 1 per cent. This was not well-anticipated by the forecasters. Recessions seldom are.5 Other major events - like financial crises have likewise usually not been well-predicted even though in most cases, with hindsight, several warning signs can be seen to have been flashing. Fourth, structural shifts which are not business cycle events, but which have profound implications for the course of the economy over the medium term, are not well-forecast either and often are not even recognised for some time after their emergence. The rise in US productivity growth in the 1990s is a case in point. (So was the slowing in productivity growth in the mid 1970s.) The permanent downshift in Australia’s inflation rate in the 1990s is another. Finally, it is hard to find evidence that any one forecaster is consistently superior. Indeed, one study of Australian forecasters suggests that outstanding performance in one year has a high likelihood of being followed by very poor performance in the next.6 Most studies find that averaging a panel of forecasters will give a better consistent forecast than using any individual forecaster. These points are all familiar, and leave all of us with much about which to be modest. But I don’t wish to denigrate forecasters. The effort to make a forecast, to articulate it, and to describe how and why it In fact, given the amount of noise in statistics, combined with their publication lag, it is quite common that professional observers cannot detect (from the figures anyway) that the economy is even in recession until the contraction has been going on for some time. The NBER recession dating committee, for example, did not declare the March 2001 peak in the US economy until November that year. Norman (2001). might be wrong has some value. We just need to keep in mind that numerical forecasts are not much more than opinion formed (hopefully) within a coherent and disciplined framework. They are not guarantees of performance, and should always be accompanied by a discussion of risks. That discussion is likely to be at least as useful as the point estimates themselves. Use of models versus judgement Let me turn now to some questions to do with the formation of forecasts. One of the perennial ones is the respective roles of formal models and subjective judgement. It seems to me obvious that we need both. Any judgemental forecast embodies some notion of how the economy works, unless the numbers really are drawn from a dart board. Most forecasters make some effort to ensure their forecasts for different variables are consistent with each other, and tell some sort of story that can be related to presumed behaviour. That is to say, they have a model of sorts, even if a fairly informal one. Econometric models are a more formal way of representing the relationships in the historical data. It is usually helpful occasionally to confront the notions in our heads with the data to see if there is any validation for our prejudices. That said, formal models come, or should come, with various usage warnings. To begin with, there seems to be some evidence that simple models often are more useful than more complex ones, perhaps because they are more robust and so less likely to come unstuck due to structural change, etc. Because their workings are more transparent, users may also be able to spot problems more easily when they start to break down. Simplicity, of course, has to be traded off against the general principle that the economy has many complex interactions, which simple models can miss. But, in general, complex is not always better, especially for short-term forecasting.7 Second, some modelling techniques which are thought to be best practice for describing history may not be optimal for forecasting purposes. A case in point is the use of cointegration models, where the deviation from an estimated long-run equilibrium level can be a powerful factor affecting short-run forecasts of changes, as the model wants to move the dependent variable towards the supposed long-run equilibrium. But if there has been a level shift in the equilibrium relationship, such a forecast will be highly misleading, and probably less accurate than a forecast from a model in differences, even though the latter is often considered theoretically less pure.8 Another warning is that many models which are in use today are not directly estimated from the data. Many are ‘calibrated’ - which is to say that certain properties such as means and variances are standardised against the actual data - but that is not the same as testing hypotheses embodied in the model against the data. These models often have very strong theoretical properties, to which most of us would sign up as general propositions, but which can drive the behaviour of the model over the horizon relevant for business cycle forecasting to a substantial degree. Such models have their place, particularly for long-term simulation exercises. But, in my opinion, their use for short-term forecasting in a policy context needs particular care. In the end, we will probably get the most useful forecasts by combining stable, simple models that capture empirically the most important macroeconomic dynamics in the economy, with judgement informed by the vast array of non-model, and sometimes non-quantitative, information about the current state of the economy which is available in the plethora of partial indicators (not all of which are published by the official statistical agencies). A finding in the US literature is that the Federal Reserve staff forecasts compiled in the Green Book outperform both private forecasts, particularly for inflation, and pure model forecasts (Romer and Romer (2000)). Sims (2002), reviewing this evidence and confirming the finding, attributes a good deal of the performance improvement to the effort to get a more accurate estimate of the current state of the economy, so reducing the errors in the very early period of the forecast. In other words, the judgement of specialist data watchers, combined with insights of well-understood models of both the formal and informal variety, works better than any single technique. I find this a plausible conclusion. See Hendry and Clements (2001). For a more detailed discussion of this sort of issue in forecasting using models, see Sims (2002) and Hendry and Clements (2003). Learning To this we can add that learning is crucial, which is to say that observing the pattern of forecast errors and seeking to draw conclusions for our ‘model’ of the economy and therefore its future behaviour can, hopefully, improve future forecasts. This is a rather Bayesian idea: we can’t know what the economy’s parameters are, and we should not view them as set in concrete anyway - they are subject to variation. One starts with some priors about what these parameters are, i.e. how the economy works. These priors are then confronted by a data sample, and the result is the posterior distribution of parameter values - that is, better-informed guesses about the way things work. As time goes by and new data become available, this working hypothesis of the economy’s properties and likely future behaviour is updated. While I could not say that we implement this idea rigorously quarter by quarter in practice, I find it quite appealing as a way of conceptualising both the forecasting of the economy and the conduct of policy. Let us then look at two examples of forecast errors, and see what they teach us. The first chart is for year-ahead forecasts of US GDP growth, from the Survey of Professional Forecasters. The shaded area is the range of forecasts, with the inter-quartile range - the middle 50 per cent of forecasts - in a darker colour. The average forecast is the line in the middle of this range. The forecasts are plotted forward by one year, so that they can be compared with actual year-ended growth, the blue line in the graph. For several years in the second half of the 1990s, virtually all forecasters persistently underestimated the pace of US growth. Time does not permit a detailed decomposition of the errors into their various causal components. Suffice to say that, as is now well-known, productivity growth in the US picked up, and so therefore did the US economy’s potential growth rate, at least for a period of several years. If we looked as well at forecasts of US inflation, we would find that unexpectedly high growth was not generally accompanied by unexpectedly high inflation. So strong demand growth was met with rapid supply growth. In other words, a high-level treatment of the forecasting errors points us to the productivity story. (Of course, having understood that did not make forecasters much better at predicting the 2001 recession. The ‘new economy’ was as prone to cyclical setbacks as the old.) Graph 2 The second chart shows some forecasts closer to home: those enunciated by the RBA in the Statements on Monetary Policy in the late 1990s. The chart shows underlying inflation as measured either by the Treasury underlying series or by the median CPI change (since 1998).9 Starting from the middle of each year, it shows the RBA’s outlook as set out in the Statement on Monetary Policy (or the previous quarterly article on The Economy and Financial Markets before the Statements became quarterly) which appeared in August. Graph 3 Several points are of interest. First, through 1997 and 1998, inflation was below the 2-3 per cent target, but was expected to rise over the ensuing period. The rise in inflation did eventually occur, but took longer than originally expected. What was going on here? One important feature of the behaviour of inflation in the late 1990s and the early part of this decade was that changes in the exchange rate had less effect over a one- to two-year horizon than previous experience had suggested. We began to detect this as time went by, and accordingly lowered our estimates of the short and medium-term impact of exchange rate changes on the CPI. For 2000 and 2001, forecasts tended to be a little on the low side. We believed that inflation was generally tending to increase and this turned out to be right, but the trend was ultimately a bit stronger than forecasters expected.10 The downward move in inflation since the peak has proceeded in two phases. The forecasts seemed to have had errors on both sides during that period. The most recent forecasts, as you know, suggest that inflation will remain about where it is at present for a few quarters and then move up during 2005, as the effects of the earlier rise in the exchange rate gradually wane. These forecasts are a little higher than ones made earlier in the year partly because the exchange rate is not as high as it was then.11 So looking back over this period of seven years we find that, early on, our inflation forecasts tended to persistently be a bit high (a pattern observed for a few years prior to 1997 as well). Lessening the The inflation target is, of course, for the CPI (since 1998). But the main forecasting approach is to forecast a measure of underlying inflation, then add known or assumed 'special factors', mainly oil prices or tax changes, to get the CPI forecast. So for the purposes here, it is most useful to consider the forecasts for underlying inflation. Forecasting was very difficult indeed in the period around the time of the GST, when the price level was due to show a substantial, but once only, rise over several quarters, with the exact quarterly profile highly uncertain. We made no public forecast of a time path through the period from 1 July 2000 to June 2001 (hence the dotted segment of the lines), but made forecasts of where inflation would settle thereafter. In fact, differences in the exchange rate outcome from what was assumed are often a significant contributor to forecast errors. A full treatment of forecast performance, for which there is not space here, would need to take that into careful account. expected impact of exchange rate changes seems to have helped to improve the forecasts. There appears, though, to have been some residual tendency to underestimate how far inflation would go in a new direction once it had turned. I don’t have a graph which characterises as neatly the forecast errors on growth, but I think it is wellknown that the Australian economy has over the same period surprised on the upside more often than on the downside. What have we learned from that? One lesson is that the economy’s improved inherent flexibility has helped it cope with shocks which in previous times would probably have derailed growth. Another conclusion, at least on my own part, is that the structural change in household balance sheets which has been under way since about 1995 has consistently been an expansionary factor. Let me mount one of my hobby horses for a moment here. Reverting back to the discussion of models of the economy, informal or formal, this points to an important gap in knowledge. Conventional models of the macro economy are long on detail about demand, output gaps, inflation and so on, but relatively underdeveloped in the financial sphere. But with agents facing fewer and fewer capital market imperfections, the relationships between asset price changes and balance sheet adjustments seem to be of increasing importance to the course of the economy over time. This is where more attention needs to be focused by modellers and forecasters, as well as policy-makers. Forecasts and decision making Turning to the role of forecasts in making decisions, the task of preparing some sort of forecast is one that, while thankless, nonetheless must be performed. Decisions based on looking in the rear-view mirror are unlikely to be optimal; trying to look forward, as difficult as that is, should help to achieve better outcomes. This is particularly the case when the decision is one, as in monetary policy, whose effects take a long time to show up, but I think this point generalises to decisions in, say, investment management. Decision-makers will therefore want to have not just a set of numbers but a sensible story about the future. Regardless of how a forecast was arrived at - from a formal model, judgement, some combination - it is more useful to decision-makers if its main features, and the factors driving them, can be fairly simply explained. The plausibility test of a view is most effectively applied when the story is kept as straightforward as possible (though not more so). A forecast is even more useful if the forecaster can identify key assumptions, be they about exogenous variables or the structure of the economy, and what the consequences would probably be were those assumptions to be astray. We can, of course, look to the statistical properties of econometric models to give some indication of the size of likely confidence intervals around a central forecast, and that is a reasonable place to start a discussion of uncertainty and risks. Consumers of forecasts should routinely be told something about the size of past errors. But anyone looking to make a decision on the basis of a set of forecasts - like an investment manager, or an economic policy-maker - looks for some judgement about possibilities to which history may not be a good guide. What if the underlying structure of the economy is changing - i.e. the model parameters are shifting? Suppose, for example, the responsiveness of inflation to exchange rate changes is less than it used to be? What if the economy is more responsive than it used to be to recent changes in interest rates? For that matter, what if it is less responsive? If an outcome is different from the central forecast for some key variable, is it more likely to be higher or lower? Decision-makers, in other words, are interested in forming a judgement about the balance of risks. That judgement can only be subjective, to be sure - but that is where the experience of a good forecaster is most valuable. The decision-maker will then want to combine that subjective assessment of the risks with some sense of the relative costs and benefits of the possible outcomes, and decide which risks they should most avoid, and which they are prepared to run. This much is, I hope, well understood these days: the question asked of forecasters shouldn’t just be ‘what’s the number?’ It should also be ‘how could you be wrong?’ Hopefully you will probe some of these sorts of questions later today. Forecasters also need to cast their minds a bit further afield than just the next quarter or two. Perhaps this is where many private forecasters, with a horizon driven by the short-term demands of the financial markets, part company with official forecasters who do not, and should not, share that imperative to focus so heavily on the next figure. The conduct of policy needs to adopt a medium-term focus, and possibly more so than in the past. The economy’s heightened short-term stability and flexibility quite possibly delays the consequences of inappropriate policy settings. But it surely does not eliminate them. Some of the recent issues with which we have had to deal, moreover, like the run-up in housing prices and credit, play out over a longer time horizon than the typical short-term forecast covers. So we could easily have been lulled by a reassuring one-year forecast into ignoring problems that would be likely to build up beyond that horizon. Realistically, forecasters cannot be expected confidently to predict how some of these longer-term dynamics will play out. But there is little doubt that such things are becoming more important. Forecasters will be more useful the more they can help decision-makers to think through what might happen, even if they cannot say with precision what will happen. Conclusion One of the old forecasters’ clichés is to say that, on any particular occasion, there is more than the usual degree of uncertainty. Most forecasting meetings I recall seemed to start that way - even in periods which, we now know with hindsight, turned out to have been remarkably stable by historical standards. Most of the time, such comments are surely an exaggeration. It might be more correct to say that at any one time there are undoubtedly new sources of uncertainty, which people find hard to quantify because they have no historical comparison to go by. In this sense, forecasting has grown no easier despite the advances in statistical and analytical technology over the years. Given the above, it would seem that it is very important to keep in mind the idea that any forecast is a working hypothesis, based on an understanding of the economy’s properties which is likely to continue evolving. Further, a simple focus on a single central forecast alone is unlikely to be as useful as an approach that contemplates one or more alternative possibilities, and helps decision-makers think through their implications. I wish you all the ideal combination of insight and luck in your forthcoming deliberations. | reserve bank of australia | 2,004 | 8 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to ¿The Bottom Line¿ Luncheon, Melbourne, 25 August 2004. | I J Macfarlane: Geography, resources or institutions? Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to “The Bottom Line” Luncheon, Melbourne, 25 August 2004. * * * It is always a pleasure to be in Melbourne, particularly when I am in these gracious and peaceful surroundings and contributing to such a good cause as the Bottom Line Luncheon. By a strange coincidence the Patron of the Foundation is Hugh Morgan, my fellow Board Member of the Reserve Bank, and the Chairman is Professor Adrian Polglase, an old school friend. How could I refuse the invitation to speak today? I notice on the invitation that I am listed as speaking about the economic outlook. I am afraid the author of the invitation took a few liberties here, and so I will disappoint those who are expecting an analysis of current economic conditions and prospects. We at the Reserve Bank put out an exhaustive account of these earlier in the month and my deputy elaborated on them a week ago. A third rendition within a month would be counter-productive, so I will speak on a different topic, although it could be considered my views on the economic outlook in a very long-term sense. I would like to look at the factors that shape the economic success of a country in the very long run that is, over the centuries - and, of course, I will pay particular attention to Australia. I propose to do this by briefly examining four factors which influence growth, and which can be summarised by four distinctive catchphrases: the tyranny of distance, geography is destiny, the resource curse, and institutions matter. (a) The tyranny of distance The first factor is a country’s position on the map - its distance from other countries or its degree of isolation. My remarks on this will necessarily be heavily influenced by Geoffrey Blainey’s classic study which originated the term. We have always assumed that Australia was at a disadvantage because of its relative isolation from the world’s great centres of commerce. This has certainly been true from the beginning. The late start of European settlement was not just because they took so long to find us, or that for the first two hundred years Europeans only sighted the barren north west coast. Even if they had found the temperate east coast two hundred years before Cook, there would not have been an economic reason to occupy the land. There were no valuables to be exchanged with the native population, such as precious metals and spices, and no case for permanent settlement because the American continent offered everything we could offer and was much closer. It was only a couple of coincidences that caused the British Government to take the extraordinary decision to establish a settlement at a place only once visited, and at the other end of the earth. This isolation continued to disadvantage us economically despite our abundant resources and relatively small population. Transport costs were enormous and delays immense. It took five months to reach England by sail, and even when steam replaced sail and modern ocean liners replaced steam, it still took about four weeks for the journey. Air travel has shortened it to about 24 hours, but it took ages for us to forget our old attitudes. We were accustomed to an overseas trip, even a business trip, being a long drawn-out affair. We had occasions before air travel when Australian Prime Ministers would spend more than a year at a time in London. Going over old Reserve Bank records of the 1960s and 1970s, I noticed earlier Governors going on business trips that lasted seven weeks. Today a one-week business trip is a long one. Modern transport and communications have enormously reduced the tyranny of distance, even if it has made our lives more hurried. The other factor that has reduced the tyranny of distance for us is the growth of Asia. The Atlantic Ocean, with Europe and America on each side, is no longer the undisputed centre of world economic activity. Asia and the Pacific Rim, while not as rich as the Atlantic, are clearly the area of fastest growth and largest population. This has presented enormous opportunities for Australia and, by and large, we have been adaptable enough to seize the chances offered. But it still has not completely dispelled the tyranny of distance. For example, many international companies headquartered in the United States or Europe still find it more convenient to put their Asian headquarters in Singapore, Hong Kong or Tokyo because they are only one flight away from headquarters, whereas major Australian cities are two flights away. We should also remember that Australia’s capital cities are in its southern half, while the capitals of our big trading partners - Tokyo, Seoul and Beijing - are in northern Asia. It would be easier if we were talking about Darwin and Jakarta, but that is not where the real action is. (b) Geography is destiny It is widely believed that geography determines whether a country will be rich or poor. This is because most of the world’s poorest countries are nearer to the equator than the richer ones. Being in the tropics is thus regarded as condemning a country to relative poverty. Of course, this does not have much relevance for Australia because the populous two-thirds of our country is in the temperate zone. But it is also interesting to reflect on the question of why we should expect a hot climate to be associated with poverty. It certainly was not always so; in fact it was the opposite. For example, in pre-Columbian America, it was the hot areas populated by Aztecs, Incas and Mayans that were richer than the temperate areas. In 1667, under the Treaty of Breda, the Dutch gave up their claims on Manhattan to the English in order to retain the island of Run (in what is now Indonesia). The superior value they placed on Run was due to its being the world’s principal source of nutmeg. In the 18th century, France had only enough armed forces to protect one of its two main American possessions - Canada and Haiti. It chose the latter because it was more valuable, being a major producer of sugar. Even in recent years, some of the success stories among developing economies have been in tropical climates - Singapore, Hong Kong, Thailand, Malaysia and, until recently, Indonesia. Certainly, a tropical climate does not condemn a country to poverty, even if most of the world’s poverty is in the tropics. As I will explain later, the correlation between geography and poverty can be explained at a deeper level by institutional factors and the incentives that businesses and workers face. There is, however, a lot of evidence suggesting that to be landlocked and in the tropics is so big a disadvantage that no country has yet overcome it. Sub-Saharan Africa is the best example of this. (c) The resource curse There is a widespread view that countries with abundant resources (particularly of minerals and oil) under-perform resource-poor countries. There is even some statistical evidence to suggest that this has happened on average over the post-war period.1 The arguments behind this relationship are based on the belief that: • possession of resources is a windfall which makes the community less energetic in pursuing other economic activities; • resource extraction is a low-tech/low value-added activity; and • the price of resources inevitably falls relative to the price of manufactured goods. The first response to this thesis is to recognise that, even if true, it only applies on average and that there are many cases where the opposite applies. We are all aware of the failure of countries such as Nigeria and Venezuela to capitalise on their oil reserves, the Congo (Democratic Republic) on its copper, or Argentina on its pastoral resources. But could anyone suggest that rich countries such as Australia or Canada have been disadvantaged by their possession of mineral wealth. A better example still is the United States, “which was the world’s leading mineral economy in the very historical period during which it became the world’s leader in manufacturing (roughly between 1890 and 1910).”2 The answer again is that economic success or failure depends on the institutions and Auty (2001), Sachs and Warner (2001), Sachs (2003). Wright and Czelusta (2004). incentives. Those countries that get these right will not suffer a resource curse, but those that get them wrong and allow policy to be dominated by a self-defeating battle over economic rents will under-perform. The assumption that the extractive industries are low-tech is also quite wrong. If they are conducted efficiently, they are very knowledge intensive and research is continuing to lead to many technological breakthroughs. Of course, it was not always so. “Australia was a leading gold-mining country in the nineteenth century, but was an under-achiever with respect to virtually every other mineral, particularly coal, iron ore and bauxite. . . . Australia’s share of world production lagged well behind its actual share of mineral wealth (based on modern estimates). In a nation with a strong mining sector and a cultural heritage similar to that of the United States, why should this have been so?”3 The answer is that we did not have the right set of institutions or sufficient technical know-how to compete with the world’s best. That is no longer the case since a complete change of mindset in the 1960s. For example, R & D expenditure by the mining sector now accounts for almost 20 per cent of R & D by all industries in Australia, and we lead the world in mining software, with one estimate suggesting we now supply 60 to 70 per cent of mining software worldwide.4 On the third point about the prices of resources falling relative to the prices of manufactured goods, I will say little because I have covered this point so many times before. Suffice to say that after an 80-year trend-fall, Australia’s Terms of Trade - which is the ratio of our resource-intensive export prices to our manufacturing-intensive import prices - bottomed in 1985 but have on average risen since. More importantly, few now doubt that it is manufacturing prices which are under continued downward pressure as a result of the rapid expansion of capacity in Asia, particularly in China. (d) Institutions matter More and more, development economists and economic historians are coming to the conclusion that, at the deepest level, a sound institutional framework is the crucial ingredient for sustained economic performance, and that it is far more important than distance, geography or the presence of resources. One only has to look at the extreme differences in economic performance between South and North Korea, or West and (formerly) East Germany to see how different institutions can outweigh the same geography, culture and resources. The different economic performance of Australia and Argentina is another clear case, as is the more general economic superiority of the former British colonies over the former Spanish colonies, which has been a subject of recent studies emphasising the importance of institutions over geography.5 What are the “deep” institutions that are conducive to sustained economic performance? • The first one is the enforcement of property rights. No-one will venture capital for an economic project if success leads to confiscation by the government or other powerful forces. Thus, the enforcement of property rights means a strong body of commercial law (particularly the law of contract), impartial courts, honest police force, etc. It also means eliminating, or at least minimising, corruption. It often used to be thought that corruption “greased the wheels of commerce” and helped things get done. But modern research has unequivocally shown the higher the level of corruption, the worse the economic performance.6 • The second institutional requirement is constraints on the ability of government or other elites to exercise arbitrary power. This usually means an open society, democratic political system and a free press, but I would also add institutions that encourage competition by challenging monopoly powers. An important ally in this is the openness of the economy to Wright and Czelusta (ibid). Stoeckel (1999). Acemoglu, Johnson and Robinson (2003). Mauro (1995). international trade in goods and ideas, which has been shown to have a significant correlation with economic performance.7 • Some degree of equal opportunity so that people can invest in human capital formation. In this area, by far the most important component is access to education and an economic structure where positions of importance and authority are open to all comers on the basis of merit. The term “deep” is used to describe the above institutions because they are embedded in laws, constitutions and culture and are not amenable to quick change. In addition to the deep institutional framework, there are a number of other practices and policies that a country has to get right in order to achieve sustained growth in living standards. The most obvious ones, from my perspective, are sound monetary and fiscal policy and a resilient exchange rate regime, but there are many more that space does not permit me to list. It takes decades, or perhaps centuries, for deep institutions to evolve, and many attempts to simply impose these institutions in developing countries have failed. But that does not mean the process should not be continued, only that it needs to be done more sympathetically whereby the local population become more involved and can feel they own the reforms. For countries like Australia, that start with basically good deep institutions, the job of maintaining the standard is easier, but it still requires constant attention and change. For every reform that protects the weak against the strong, there are other reforms that break down some cosy arrangement and thus reduce the level of security for the weak or for the weak and strong alike. Useful reforms will often be opposed by either organised labour or organised business, and sometimes the one reform will be simultaneously opposed by both. It is always difficult when a reform has major distributional consequences. Fortunately, in my own area the distributional consequences are of secondary importance, and with the benefit of hindsight, reform has been easier than in many other areas. The transition from a monetary policy regime that had quite short horizons, a multitude of aims and where daily decisions were taken politically as in the 1970s and 1980s, to the one we have today was achieved within a decade. It is often the case that reforms that seemed difficult at the time are well accepted in retrospect, and may even come to be seen as inevitable. The present monetary policy regime based on central bank independence and an inflation target was controversial a decade ago, but with good results now on the board it has undoubted bilateral political and community support. Similarly, the floating of the exchange rate was a decision that was hotly debated over a long period, but does anyone want to go back to any of the variants on a fixed exchange rate regime that preceded it? More controversial were the reductions in tariffs that have occurred over the past thirty years, but here again there are few voices that would wish to turn the clock back. Or would we wish to go back to the immigration policy we had during the first half of the twentieth century? The list could go on and on. It is the nature of a first-rate democratic country that it will constantly be involved in economic reforms, or at least constant updating of its economic framework, and that the changes involved will generate political uncertainty and resistance. But that is the price of achieving and maintaining a first-rate set of institutions, and that is an essential condition for our continuing economic prosperity. Bibiliography Acemoglu, D., Johnson, S. and Robinson, J., “Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution”, Quarterly Journal of Economics, November 2002. Auty, R., “The Political Economy of Resource-Driven Growth”, European Economic Review, 45, 2001. Baldwin, R.E., “Openness and Growth: What’s the Empirical Relationship?”, NBER Working Paper 9578, 2003. Blainey, G., The Tyranny of Distance, Macmillan, revised edition 2001. Dowrick, S., “Openness and Growth”, in International Integration of the Australian Economy, Reserve Bank of Australia, July 1994. Dowrick (1994), Baldwin (2003). Gylfason, T., “Institutions and Economic Performance”, CESifo DICE Report 2/2004. Mauro, P., “Corruption and Growth”, Quarterly Journal of Economics, Vol. 110, No. 3, 1995. Sachs, J. and Warner, A., “The Curse of Natural Resources”, European Economic Review, May 2001. Sachs, J., “Institutions Matter, But Not for Everything”, Finance and Development, June 2003. Stoeckel, A., Minerals: Our Wealth Down Under, Canberra, Centre for International Economics, 1994. Wright, G. and Czelusta, J., “The Myth of the Resource Curse”, Challenge, March/April 2004. | reserve bank of australia | 2,004 | 8 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to CEDA Annual Dinner, Melbourne, 16 November 2004. | I J Macfarlane: Monetary policy and financial stability Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to CEDA Annual Dinner, Melbourne, 16 November 2004. * * * It is a great pleasure to be here again in Melbourne addressing CEDA’s Annual Dinner. This is the fifth time I have done so, and it is like returning to be with old friends. I usually talk about some aspect of monetary policy, and will do so again tonight, starting with something very familiar and then moving to newer territory. When we look back to fifteen or twenty years ago, the thing about monetary policy that stands out is the lack of clarity about what it was expected to achieve. That is, what should be its ultimate objective, and therefore what should it be accountable for? This lack of clarity applied both inside the Reserve Bank and outside it. I am sure some of you are familiar with the wide variety of objectives for monetary policy that were put forward at the time. As well as the familiar aims of low inflation, low unemployment and good economic growth, there were those who felt it should also be aimed at improving the balance of payments, promoting investment or limiting the growth of credit or some other monetary aggregate. Others put forward the view that it should aim to rein in the growth of asset prices. We now recognise that there are a lot of good economic arguments against having such a wide set of aims, but I will not go into those tonight. Instead, I will say a few words about accountability and independence. A government cannot be expected to allow independence to its central bank unless that bank is also accountable to it and to the wider public. That is, the central bank must be able to be judged on whether or not it has achieved its agreed objective. When there are half a dozen objectives, this becomes impossible because there is very little chance that the optimal outcome for all these variables could be achieved at the one time. If the central bank was held accountable for failing to achieve one objective, it could always defend itself by saying that its efforts were directed at one or more of the other objectives which it viewed as more important at the time. Thus, the old system failed the test of being accountable, and hence there was a reluctance to fully recognise the independence that was essential for the ultimate success of monetary policy. It is true that the Reserve Bank Act specified multiple objectives for monetary policy, but the Bank had failed to articulate a clear framework for setting priorities among these objectives. The resolution of this problem was found in the present monetary policy regime whereby independence was recognised, and the central bank was given the task of achieving an inflation target. This made sense in terms of economic logic because in the long run it is only a nominal variable such as the rate of inflation (or nominal GDP) that can be influenced by monetary policy. It also, in time, received community support because it became recognised that low inflation was a necessary condition for sustained economic growth, which in turn was the pre-condition for lower unemployment. In this way, it placed the general objectives in the Reserve Bank Act within a logically coherent framework. But in addition to these purely economic improvements, the system now fulfilled the requirement of accountability. Everyone could see whether the central bank had achieved its agreed objective or not. I mention this because it is often forgotten that the origin of inflation targeting was the desire for accountability. When the economic reformers in New Zealand under Roger Douglas came into power they recognised that no arm of their government had a quantifiable objective by which it could be judged. They then began the process of setting out objectives for each department, agency and authority. When they came to the central bank they concluded, after much discussion and research, that the most sensible objective to judge it by was the rate of inflation. So in 1989, they - that is, the government - set an inflation target for the central bank. It was thus the desire for accountability that was the initial impetus for the inflation targeting model, which was eventually adopted in various forms around the world. We in Australia are very comfortable with this model, although we adopted a less rigid one than the early starters like New Zealand and Canada. In our view, it is the best monetary policy regime we have experienced and the best one available, but it is not perfect. It has yielded excellent results so far for its central objective - an average rate of inflation of two point something per cent during the eleven years it has been in operation. This, in turn, has underpinned an economic expansion that is in its fourteenth year and has helped the unemployment rate fall to its lowest level for a quarter of a century. But there are, no doubt, some people who are still disappointed with the outcome for some other economic variables. Some have pointed to weaker-than-hoped-for export growth and a current account deficit of about 6 per cent of GDP. Others, including ourselves, have worried about a high rate of growth of credit and, until recently, an excessive rate of growth of house prices. I can understand people’s concerns and their desire for better and better economic performance, but I hope they are not pinning too much faith in monetary policy because there is a limit to what it can be expected to perform. In essence, monetary policy has one instrument - it can set the path of short-term interest rates. Over the past dozen years or so, it has set a path which has achieved the outcomes for inflation, growth and employment which I have just outlined. What would have happened if, instead, we had aimed our monetary policy at one of the other objectives put forward, say a substantially lower growth of credit. I am not sure whether we would have been able to achieve this, but I do know that the attempt to do so would have required setting a path of interest rates which was significantly higher than the one we did. This, in turn, would have meant that the outcomes for inflation and economic growth would have been lower than we actually achieved. I do not think this would have been a good economic result, and it certainly would have violated the letter and the spirit of our agreement on accountability. As I said earlier, a central bank cannot be accountable for everything, and our monetary regime recognises this, while at the same time choosing the right objective to be accountable for. This, of course, does not mean that we ignore credit and asset prices. Movements in these variables can affect the future path of the economy and the evolution of inflation. So we need to study them closely, understand the forces driving their movements, and the risks that they pose. But they are not appropriate targets for monetary policy. I hope that what I have just said does not leave you with the impression that we have a very narrow interpretation of our responsibilities. If that has happened, it is unintentional and is because I have only spoken so far about our monetary policy responsibilities, but we also have a duty to do what we can to ensure financial stability. Financial stability means the avoidance of financial shocks that are large enough to cause economic damage to the real economy. It should not be forgotten that many central banks, including most notably the US Federal Reserve, owe their origins to the desire to avoid financial crises - the monetary policy functions only came later in their life. At the Reserve Bank, our financial stability responsibilities are handled in several ways. For a start, we run the high-value wholesale payments system, which is the epicentre of the financial system. We are also responsible for the policies and procedures that ensure that the system can continue to operate, even if one or more of its members fails. Our payments responsibilities go further than this and extend to the competition and efficiency of the system, for which the Government has provided us with separate legislative powers and a separate Board, but I do not need to delve further into these in the context of tonight’s talk. While our responsibilities and powers with respect to the payments system are clearly defined, that is not the case with our more general responsibilities for financial system stability. In this broader area, we have to work closely with other bodies that have clearly defined regulatory powers. An important role for the Reserve Bank is to identify potential vulnerabilities in the financial system, conduct research and provide our twice-yearly Financial Stability Review. Externally, I chair the Council of Financial Regulators, which also includes the Chairman of APRA, the Chairman of ASIC and the Secretary to the Treasury. The Council of Financial Regulators, at its meetings and on an informal basis between meetings, keeps members aware of developments in each of the separate areas, and attempts to achieve a co-ordinated approach to problems that extend beyond one regulator. It also tries to plan ahead in order to put in place policies that reduce the risk of a financial crisis, or help to manage one should it occur. In this latter aim, the Reserve Bank’s ability to act as lender of last resort is crucial. The exchanges of views that occur at these meetings are extremely valuable, as is the opportunity the Council provides for staff of the Reserve Bank, APRA, ASIC and the Treasury to work together on common projects. Many of the subjects discussed are regulatory in nature, but the Council also affords an opportunity to exchange views on economic and market developments which may affect the vulnerability of the financial system. This is of particular interest to the Reserve Bank, as these developments have more of a macro-economic character. It is where our responsibilities for monetary policy and financial stability overlap. At the moment, as our recent Financial Stability Review pointed out, all the conventional measures of the health of the Australian financial system are giving extremely favourable readings. For financial intermediaries, capital positions are strong, profits are high and non-performing loans exceptionally low. In financial markets, volatility is low, as are spreads on corporate debt over treasuries. It is not hard to see why many market participants would feel that things have never been safer. But we should remember that it is in these circumstances where the biggest mistakes can be made. When everyone feels that risks are at their minimum, over-confidence can take over and elementary precautions start to get watered down. In addition, competitive pressures from those who under-estimate risk can push even the more prudent institutions into actions they will later regret. Let me illustrate this point in relation to household borrowing. Following the more than halving of inflation and interest rates that occurred over the past decade or so, there was a surge in household borrowing and an accompanying rise in house prices. We have examined this process at length before, so I will not go over it again tonight. During this process, banks and other lenders were able to grow their balance sheets rapidly and, despite narrowing margins, were able to record rising profits year after year. At some point, however, the surge in household borrowing had to slow, and house prices stabilise, or fall. That is what has been happening over the past three quarters, and it is an entirely helpful development. Had the credit growth and house price growth of 2003 continued through 2004, the risks of future financial instability would have been much larger than is now the case. It is important that this slowing in household credit be accepted by financial intermediaries as a fact of life, even though it probably means the heady growth of profits from mortgage lending they have become accustomed to may not continue. There is a risk, however, that in attempting to resist the slowing in credit demand, financial intermediaries may be tempted to further lower lending standards, and that would carry with it serious medium-term risks. When I said earlier that lenders may be tempted to further lower lending standards, the use of the word further was deliberate. The incentives in the mortgage distribution system have changed in such a way that there has been a step-by-step reduction in credit standards over recent years. A significant proportion of mortgages are now sold by brokers who are paid by commissions on volumes sold. The growth of low-doc home loans means that intermediaries are now lending to individuals whose income is not substantiated. There has also been an upward drift in the maximum permissible debt-servicing ratio. When once a maximum of 30 per cent of gross income was the norm, now it is possible for borrowers on above-average income to go as high as 50 per cent of gross income (and a much higher percentage of net income). The new lending models used by the banks (and provided on their websites to potential borrowers) seem to regard the bulk of income above subsistence as being available for debt-servicing. It is not hard to see how a situation like this develops. Once a few lenders adopt an aggressive approach, others must match them or lose market share. They are then re-assured by standard risk-management models, which are based on Australia’s history of extraordinarily low mortgage defaults. Even those lenders who have reservations find it difficult to follow a different path, especially as the lenders taking on more risk may well be rewarded by higher profits (and higher share prices) in the short run. There have been a few occasions recently where banks have taken the decision to tighten up on lending to particular sectors, e.g. inner city apartments. Despite this causing some pain to developers, it is a good thing overall for the economy. But these have been small steps compared to the much bigger drift to lower credit standards, and it may be more difficult to expect future instances of such prudence in an environment of slowing overall credit growth. We highlighted some of these concerns in our recent Financial Stability Review, and I am taking the opportunity tonight to repeat them. They were also made last week by Dr Laker, the Chairman of APRA, in a speech which sadly went unreported. I am not suggesting we have an urgent problem on our hands, but if present trends continue we could well have one in a few years. More importantly, I think the time to air these concerns is when confidence is at its highest and people are least likely to worry about the future. One of the great benefits of the long economic expansion we have now had is that it has restored consumer and business confidence, and people’s pride in Australia’s ability to achieve economic success in a difficult world. But when thinking about financial stability, it is important to look beyond the present favourable circumstances and attempt to foresee potential risks ahead. In doing so, one runs the risk of sounding like a Cassandra occasionally, but, for central bankers, this has to be accepted as one of the risks of the job. | reserve bank of australia | 2,004 | 11 |
Address by Mr Glenn Stevens Deputy Governor of the Reserve Bank of Australia to the Australian Business Economists and the Economic Society of Australia (NSW Branch) Annual Forecasting Conference Dinner Sydney 14 December 2004 | Glenn Stevens: Economic and financial conditions December 2004 Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists and the Economic Society of Australia (NSW Branch), Annual Forecasting Conference Dinner, Sydney, 14 December 2004. * * * 2004 turned out to be a year of considerably stronger output in the global economy. According to the international panel of private forecasters recently polled by Consensus Economics Inc, global GDP1 will have risen by 5 per cent in 2004. This does not include the recent round of data revisions in Japan, and so may be adjusted down a little. Even so, it is hard to see how the outcome will not be at least a full percentage point above the long-run average and as strong as any year in the past thirty. Graph 1 Click to view larger As always, there were short-term departures from the established trend. The US “soft patch” in mid year followed a brief period when price statistics in the US had people worried about inflation. The number one topic of discussion the previous year, of course, had been deflation. There were also periodic concerns that the attempts to engineer a slowdown in China might over-achieve, resulting in a slump of global significance. The various short-term concerns were overdone, as is so often the case, but were to be expected given that an innumerable army of analysts, commentators and financial market players extensively debate every twist and turn of the economic data, many of which turn out to be statistical noise. A more genuine reason for some discomfort is perhaps that, despite vigorous global growth in total, there is a feeling that it is a little lop-sided, with some areas participating less than fully. The euro area, for example, has struggled to “gain traction”. As measured by the IMF's PPP-weighted approach. 1/7 In 2005, some slowing is envisaged but forecasters apparently expect growth still to be better than average. It might be revised down a bit in the near term reflecting some softer recent data. But even a noticeable downgrade would leave growth at about average, which would be quite a reasonable outcome. In the course of expansions lasting a number of years, it is quite common for there to be the odd slower year; they can’t all be above average. One factor affecting people’s expectations will presumably be energy prices. Measured against the SDR, so as to avoid valuation effects of the decline in the US dollar, the average oil price in the second half of 2004 was about 50 per cent higher than the average over the period 2001-2003. Assessing the implications of this change requires us first to ask why it occurred. The oil shocks of the mid and late 1970s resulted from OPEC actions to drive up the price by restricting supply. In such a scenario, costs of production for industrial users of energy are raised, which means some combination of higher prices and lower profits ensues. Possibly some of the capital stock is rendered uneconomic. For households, the rise in oil prices reduces purchasing power, so imparting a contractionary impact on other areas of demand.2 The situation when the disturbance emanates on the demand side is different. The initiating shock here is expansionary in nature: somewhere in the world, there is unexpected strength in energy-intensive production of goods and services. Prices rise, but so does output. Admittedly, output would have risen even further had the supply of oil been perfectly elastic, but a demand-driven rise in oil prices is a sign of global growth strength, not weakness. Graph 2 Click to view larger That is the bulk of the story in the past few years. With global GDP having grown by about 12 per cent over the past three years, oil demand is estimated to have increased by about 6½ per cent over the same period. Granted, there have been periods of pressure on prices driven by uncertainty over current or future supply, but the main story is one of demand. A key assumption of this analysis is that there is only limited short-term scope to substitute towards other sources of energy or to otherwise use oil more efficiently, which is reasonable for the short term though not the long term. It also assumes that the income gain accruing to oil exporters does not lead to demand expansion in those countries sufficient to offset the contractionary impact in the oil-importing countries. 2/7 There is, of course, an important compositional element too. Much of the additional growth in demand is coming from the Asian region. This means that traditional big users of oil in the developed countries are competing for resources in a way they had not been accustomed to doing in the past. A rise in the oil price could well seem to them quite like the supply shock scenario - higher prices and lower output. Hence, if oil prices were to remain quite high, economic prospects for some of the western industrial countries, particularly those whose economies were not especially robust to begin with, could be more noticeably affected than would be the case in, say, China or India. A really serious adverse shock from this source looks less likely now, however, than it did a month or two ago, with oil prices having declined quite sharply from their peak. Financial markets have certainly responded in a fairly relaxed way to these developments. Bond yields remain fairly low by historical standards, particularly given the back-drop of a tightening cycle by the Federal Reserve. This is a rather different response to some other episodes where oil prices have risen substantially, as shown in the table below, which suggests that a persistent rise in inflation is regarded as unlikely. This may reflect an expectation that the adverse effects on growth for the industrial countries will inhibit any lasting inflation impact, but is also consistent with the idea that neither growth nor inflation may be affected by very much or for very long. Change in US 10-year Government Bond Yield 1 year into oil price rise Beginning of oil price rise Change in bond yield (bps) September 1973 +104 December 1978 +118 June 1990 –19 February 1999 +113 October 2003 –28 Source: US Federal Reserve, Global Financial Data The latter view probably fits more easily with the fact that markets are demanding relatively little compensation for credit risk. A significant weakening of growth in the industrial countries would surely have some adverse implications for emerging market countries, and lesser quality corporates. If that were expected, we would presumably see it reflected in risk spreads - but we do not see that. At present, then, markets apparently do not anticipate much in the way of adverse impact from the energy price changes. Either that, or there is a tension between various markets, the resolution of which will be fascinating to watch. But the main point is still that the current level of oil prices is mainly a sign of global demand strength it is just that some of the strength is in different places from historical patterns. For Australia, a global growth situation that is strong enough to be exerting upward pressure on energy (and other resource) prices, and where growth is weighted towards Asia, seems for the moment to be quite a favourable one. ***** According to the national accounts, Australia recorded moderate growth in 2004. It looks like GDP growth over the four quarters to December will be less than 3 per cent unless there is a big surprise for the December quarter or upward revisions to previous quarters. Let me leave aside the apparent contrast with the picture painted by the various business surveys, which is considerably stronger, and for the moment take the figures as given. That leaves growth running more slowly than was anticipated earlier in the year. But if output growth fell slightly short of expectations, it was not due to apparent lack of demand. Growth in domestic final demand has run at something like 5 per cent over the past year, and an average rate of nearly 6 per 3/7 cent per year over the past three years. And growth in global demand for things Australia produces has, over the past year or two, been generally as strong as at any time in the past few decades. Graph 3 Click to view larger If demand growth is so strong, why hasn’t the economy grown faster? Have we hit capacity limits? Indicators of capacity utilisation available in business surveys are certainly at or close to the highest levels seen in the past 15 years. This is a feature across surveys, and has been for some time. In the labour market, the rate of unemployment is at its lowest for more than 25 years. Other measures of under-utilisation of labour are not at two-decade lows, but have nonetheless declined a good deal. A significant proportion of firms refer to difficulties in finding suitable staff. Areas of skill shortage have emerged. Observable upward pressure on wage and salary rates is minor at this stage, though there are reports of non-wage employment costs rising in some sectors. The clearest evidence of hard capacity constraints is probably on the export side. In some parts of the resource sector there was a significant volume of investment in the second half of the 1990s, but a subsequent period of weak commodity prices saw investment decline to very low levels. Hence, the increase in demand in the past two years apparently left some producers without the capacity to take full advantage of the conditions by shipping higher output, though of course they have enjoyed higher prices. The rise in prices presumably reflects pressure on capacity globally, which suggests that producers everywhere were surprised. There have also been reports of capacity constraints in some of the key areas of transport infrastructure, such as ports and rail. A decline in exports of some fuels was due to a rundown in reserves, a capacity constraint of another sort. At the margin, the weakness of manufactured exports might reflect the strength of domestic demand, which for some producers may have presented an opportunity for sales in an easier market than some foreign alternatives. It might reflect the rise in the exchange rate (ie demand rather than supply), though the export weakness dates from a time when the exchange rate was much lower. So where does this leave us? There is no hard and fast answer, but there are reasonable grounds for thinking that the Australian economy is now operating closer to full capacity than it has for some time. We don’t want to overstate this: it could not be claimed that physical limits have been reached across the board (though apparently they have been in a few areas). The best forecast for inflation, moreover, remains one of only a gradual increase over the coming two years, and no recent price or wage data have cast any doubt on that view. But it does seem to be getting a bit harder to coax above-average growth from the economy. 4/7 In the thirteenth and fourteenth years of expansion, this is not surprising. Most of the easy gains in lifting output by reducing cyclical slack are by now behind us. It just means that very strong demand growth is now less likely than before to foster rapid output growth and more likely, at some stage, to risk pressure on prices, even though that does not seem imminent at the moment. It was therefore appropriate to have the somewhat less accommodative monetary stance of the past year and to signal in recent Statements the likelihood - assuming the economy evolved as expected - of higher interest rates at some stage. A continuation of a robust expansion will, it seems, be increasingly dependent on enhancing the supply side: growing the capital stock, more effectively matching the supply of and demand for both skilled and unskilled labour, and innovation to lift the productivity of all the factors of production. ***** I have talked about exports, but not as yet addressed the issue of Australia’s current account deficit. But since it has been in the news recently, is there anything useful to be said? The risk in this is that people may misinterpret my remarks as indicating that the current account deficit is, per se, something to be addressed by monetary policy. So I shall state clearly that it is not. Actually, whether the current account position should be an objective of any policy is not obvious - that would need to be argued. But whatever one’s view on that question, let me be clear that the current account is not, and should not be, an objective for monetary policy. We have had that debate in Australia. It was settled more than a decade ago, and I do not wish to re-open it. With those preliminaries, let us see what can be said about recent trends. The trade arithmetic is wellknown. It may therefore be of more interest to examine the financial counterparts - that is, to look at the changes in saving and investment behaviour. The table examines, from this perspective, the six episodes of current account widening over the past 25 years. Cyclical changes in Australia’s saving-investment position Per cent of GDP ∆Saving ∆Investment Of which dwellings ∆Net ∆CAD Dec-79 to Dec-81 –0.9 3.9 0.7 –4.8 –4.8 Dec-83 to Jun-86 –1.0 1.9 0.2 –2.9 –3.1 Mar-88 to Mar-90 0.3 1.5 0.7 –1.2 –3.1 Dec-93 to Mar-95 –0.8 0.7 0.2 –1.5 –3.5 Jun-97 to Mar-99 –1.4 2.9 0.7 –4.3 –4.0 Sep-01 to Sep-04 –1.3 3.0 1.7 –4.3 –4.7 Source: ABS In the majority of episodes, the share of national income being saved declines. In every episode, investment increases. In each case, part of the rise in investment is dwelling investment. But what is striking is the prominence of dwelling investment in the latest episode. The size of the run-up is much larger than in the other five episodes. As of the middle of 2004, moreover, according to the national accounts, dwelling investment was almost 7 per cent of GDP,3 higher even than the feverish pre-GST peak, and a full percentage point of GDP higher than at the other peaks in the past 40 years. Graph 4 This figure excludes the transfer expenses associated with investment activities, which for dwellings grew to be about 1½ per cent of GDP by mid 2004 (but has since fallen due to the decline in real estate turnover). 5/7 Click to view larger This was not obviously related to population growth, which was not unusually high in the recent period. The number of new dwellings constructed was not unusual compared with previous booms. What is new is that the quality and size of dwellings, both new dwellings and those being renovated, are higher than in the past. That is to say, the community has much higher standards for accommodation than was formerly the case, and is investing additional resources accordingly. Was this a good investment? For that part of the investment undertaken in expectation of commercial returns, some reservations must be recorded. Rental yields are now low compared with history, and hence capital gain is presumably required for an acceptable return to be earned. But with assets generously priced, and signs that capital values are in fact declining, there is a good chance many of these investors will find themselves disappointed. For owner-occupiers, the question of whether it was a good investment has no clear answer. Unlike investment for business purposes, which is presumably undertaken in expectation of a cash return, the main return from a higher quality dwelling stock for owner-occupiers will be an enhanced flow of dwelling services, which is not received in cash. These households were confident that their future income would be sufficient to afford that higher consumption of dwelling services, paid for in the form of higher debt servicing. We can’t know as yet whether or not that judgement was correct. Is the rise in the current account deficit associated with this, in itself, a problem? To assess that, it is helpful to ask two questions: • what are the risks? and • who is running them? In cross-border capital flows, the main complication is that someone is bearing exchange rate risk. If a current account deficit turns out to be a problem, it is usually because domestic entities have borrowed foreign currency unhedged. At some point the exchange rate falls, leaving the financial position of borrowers under strain, as both the principal value and the debt servicing cost of the loan are higher in terms of the local currency in which the borrowers earn their income. But in this case the borrowers’ obligations are in Australian dollars, not foreign currency, and the same is true for the intermediaries who funded the loans (and hedged their risk). Foreign suppliers of capital are, in fact, bearing the exchange rate risk. So if there is a problem here, it is not that Australian households borrowed from foreigners, in particular, to fund investment in the dwelling stock, it is that they borrowed from anyone to do so. The risk they are running is not exchange rate risk, it is simply that their future income may not be as high as expected, leaving it harder than they anticipated to 6/7 service their Australian dollar borrowings. This is another way of saying what we have said a number of times: that a position of higher leverage leaves households more vulnerable than they would otherwise have been to a negative shock to income. How serious a risk this ultimately is remains to be seen, but the same degree of concern would, in my view, be there regardless of the state of the current account. In saying this, I am mindful that those who are bearing the foreign exchange risk might wish to change that exposure, or just slow the rate at which they accumulate it, for one reason or other, at some time or other. What would be the implications of such a change in view? It is fairly extreme to assume that there would be a total ‘sudden stop’ of capital flow, as occurs periodically for some emerging market countries operating under fixed exchange rates that become unsustainable. In all Australia’s experience under the floating exchange rate over the past two decades, that has never occurred. Even in the days of greatest concern about the external accounts in the 1980s, substantial capital inflow into Australia continued - the equivalent of between 3 and 6 per cent of our GDP per annum. What did occur, on occasion, was that the cost of foreign capital rose, mainly in the form of a decline in the foreign currency price of Australian assets - ie a fall in the exchange rate. Were concern about the current account position to emerge at some point in the future, a similar result might be expected. Having said that, no one can know if such an adjustment will occur, let alone when. But if it did occur, the experience of the past decade suggests we would be able to cope. We have absorbed substantial exchange rate movements, without the economy being derailed. So it seems to me that rather than fretting about the current account deficit per se, it is more sensible to focus on the underlying imbalances in the economy. The current account outcomes may be pointing out those imbalances indeed the high current account deficit of the past couple of years does point to the housing story - but it was the behaviour driving the imbalance, rather than the nationality of those supplying the funds, that was the issue. Conclusion At this time of year, it is often tempting to think that the year was full of the unexpected. But as these things go, 2004 was not especially exciting. Despite various risks, global economic growth went pretty well. It was not derailed by geopolitical uncertainty, SARS, financial crisis or by “global imbalances”. In fact, it offered an external environment for Australia that has seldom been bettered. At home, the economy turned in a steady performance. Unemployment is lower than a year ago, confidence and profits are high, inflation contained. Even if growth seemed, on the official data, a little lower than expected, it was not for want of demand, suggesting that the focus on supply-side improvements - always very important - should come even more to the fore. The most significant imbalance - a credit-funded boom in purchase of housing - began to unwind in about the most benign fashion one would dare imagine. One can only hope that 2005 turns out to be similarly uneventful, at home and abroad. No doubt there is something unexpected coming down the road. In time we shall see what it is. But for now, I wish you all a very merry Christmas, and a prosperous (and uneventful) new year. 7/7 | reserve bank of australia | 2,004 | 12 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 18 February 2005. | I J Macfarlane: Recent financial and economic developments in Australia Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 18 February 2005. * * * It is a pleasure to be back in front of the Committee after a break of about eight months. As you know, we take these appearances very seriously and appreciate the opportunity it gives us to explain our position to Parliament and to the public. I hope the new Committee will find it as valuable as we do. Earlier this month we issued our quarterly Statement on Monetary Policy which set out pretty clearly how we see the current situation. So instead of going over the same material again, I would like to review the medium-term aspects of economic policy. As you know, the current economic expansion, which is in its fourteenth year, is the longest expansion we have had since quarterly national accounts statistics were first published in 1959. We had one from 1961 to 1974 that was nearly as long, but it ended up with inflation pushing up into double digits followed by a recession. The following two expansions lasted about eight years each before they came to an end. In the current expansion, the annual growth rate has averaged 3.7 per cent, but, like all expansions, it has not been completely smooth. For example, the annual growth rate has been as high as 6¼ per cent and as low as 1½ per cent; on two occasions, there has been a quarterly fall in GDP. But overall results have been very favourable: inflation has averaged 2.5 per cent per annum and we have seen the unemployment rate fall from 10.9 per cent to 5.1 per cent. The longevity of the expansion has been due in part to the fact that it has been possible to avoid obvious excesses in the economy. Relatively small changes in policy have prevented the build-up of the type of excess which in the past required a large and determined policy response. The excesses on previous occasions have been of three main types. The most common was a rise in inflation. The second was an asset price boom and bust, and the third, particularly in the fixed exchange rate era, was a balance of payments crisis. I would now like to review the current situation in light of the risks posed by these three types of excesses. The inflation rate is the one that our inflation-targeting monetary policy is specifically designed to control. We feel pretty confident that the type of strong monetary policy response to rising inflation that had been necessary in the past is unlikely to be needed again as long as we are vigilant. While pressures will undoubtedly arise, they should not be as powerful or as widespread as previously. First, the inflation-targeting regime means that the longer inflation has been contained, and the lower are inflationary expectations, the easier it is to keep things that way. Second, there have been important changes in wage setting arrangements that have meant that pressure in labour markets does not feed as quickly as previously into wage inflation. The main changes have been the decentralisation via enterprise bargaining and the lengthening of contracts out to two or three years. The third influence on inflation has been the increase in competition both at home and from abroad. But inflationary pressures can not be completely eliminated and can be expected to make their presence felt as the economy pushes up against capacity constraints. That is something that is happening now, although it is a piecemeal process. There is no economy-wide definite dividing line between a situation of ample capacity and one where growth is limited by capacity constraints. For example, there has clearly been pressure on capacity in the building industry for some years, as anyone attempting to get a house built or renovated will confirm. Over the past year, many parts of the resources and heavy engineering sectors have also been at virtually full capacity, and this has, among other things, limited our export performance. Some parts of the services sector, such as accountancy and other professional services, are also fully stretched. On the other hand, there are other parts of the economy where things are relatively normal. But overall we are hearing more reports of businesses finding difficulty in hiring suitable labour and having to pay more for material inputs. The most obvious signs of this are the increases now being seen in producer prices at all levels and output prices for building and construction. There has not as yet been a big effect on consumer prices, but even so, the rise over the past year has been higher than our earlier forecasts had suggested. We have not seen evidence of an acceleration in across-the-board wages in the standard statistical series, although there is plenty of evidence from surveys that businesses are finding it more difficult to attract labour and that wage pressures are rising. Of course, there is no reason why the inflationary process has to be triggered by a wage acceleration; it could just as easily start with prices themselves and then move on to wages. The second risk that I mentioned earlier was a boom and bust in asset prices. I do not think this is a serious risk at the moment, although it was not that long ago that it posed a threat. In 2003, we had both household borrowing and house prices growing at over 20 per cent, and that was on top of several earlier years of strong rises. If 2004 had produced another year of 20 per cent growth, then we would have had the makings of a serious boom and bust situation. As it was, 2004 was a very good year in this respect as borrowing slowed and house prices retreated for most of the year. Growth in borrowing seems to have now settled for the time being at a rate of about 13 per cent per annum, and house prices may have risen in the December quarter of 2004. It is too early yet to know where either borrowing or house prices are headed. The third risk I mentioned was the balance of payments, where the current account deficit is estimated to be 6¾ per cent of GDP. This is not very different to the level reached on a number of occasions over the past two decades, but it is disappointing given that it has occurred against the background of a reasonably buoyant world economy and a strong rise in the Terms of Trade. Strong domestic demand pushing up imports is part of the story, but the bigger part is the failure of the volume of exports to rise sufficiently to take advantage of the strong world demand. We have recently analysed this at some length, and presented our conclusions in our quarterly statement. I will be happy to talk about this later in more detail. But while the balance of payments result is disappointing, it is not of itself a reason for a monetary policy response. At this point, I usually look back at the forecasts I gave the Committee last time to see how the outlook has changed. I also make a couple of new forecasts. On economic growth, last year was one of the few examples where the growth rate we now expect will be well below what we had forecast. In the middle of last year we were forecasting 3¾ per cent growth for the year to the December quarter 2004; now we think that when we receive the December quarter national accounts next month, they will show a growth rate of not much more than 2 per cent. How do we explain the difference? One explanation would emphasise that the national accounts are showing a picture of the economy which is considerably weaker than that shown by most other indicators. For example, employment growth has been booming throughout the twelve months that GDP has apparently been restrained. The lagging nature of the employment/GDP relationship may explain part of this, but not all of it. There is a similar discrepancy in the comparison with high business confidence, high consumer confidence, increasing business profits, booming share market and government tax receipts. It would be tempting to disregard the national accounts entirely and rely instead on the other indicators of economic activity mentioned above. However, I do not intend to do so. While I think there is some tendency for the national accounts to be understating the level of economic activity at the moment, I think that they are right in the sense that they show that growth has slowed somewhat from 2003 to 2004. The next question is to ask why. This is where capacity constraints enter the picture again. Economic policy in Australia, most notably monetary policy, has allowed domestic demand over recent years to run at a reasonably fast pace. But as can be seen from the numbers below, this has not been translated into an equivalent growth of output as measured by GDP. Table 1 Growth of demand December Growth of GDP 4 quarter ended growth rate 4.3 4.3 6.7 3.2 5.8 4.3 2004* 4.3 3.0 * 4 quarters to September quarter The most obvious explanation for this discrepancy is one particular capacity constraint, namely that which has restricted the expansion of our export volumes, particularly resource exports. But it is highly likely that other capacity constraints have also begun to operate. For example, the growth of manufactured and service exports has also slowed and this is partly due to the fact that an increasing proportion of existing capacity is used to supply fast-growing domestic demand. After nearly fourteen years of economic expansion, we do not have the spare capacity we once had. Looking ahead, we have to recognise this situation. Attempting to maintain demand growth at the rates to which we were accustomed would risk a rise in inflation and would probably not result in an appreciable increase in output growth. Fortunately, demand has already started to slow somewhat and it is getting closer to the growth of output. Despite its growth probably being understated, GDP is also starting to slow under the constraints imposed by capacity limitations. I think we will have to get used to seeing GDP growth rates starting with the numbers 2 or 3 rather than 3 or 4 for a time. On inflation, our forecast a year ago for underlying inflation in the four quarters to the December quarter 2004 was 1½ per cent. At our June meeting we had raised it to 2 per cent. In the event, it came in at 2¼ per cent, while the headline figure was 2.6 per cent. Some of this was due to the increase in the oil price, but some of it was more general, as indicated by the fact that the December quarter CPI came in above all forecasters' estimates. Overall, the inflation outcome to date is still a good result given the pressures we are now starting to see around us, but looking over a longer period it seems that inflation has now reached a trough and is showing signs of turning up. At earlier stages of production, there has been a noticeable pick-up in prices between the first half of 2004 and the second half. Table 2 Producer Prices (excluding oil) 2004 I 2004 II Preliminary 2.5 6.0 Intermediate 1.6 5.1 Final 2.7 4.7 Looking ahead, we forecast gradual rises in underlying inflation, with it reaching 2½ per cent by end 2005 and 3 per cent by end 2006. Like all forecasts, they are smoother than reality will probably turn out to be, and they are subject to risks. Our assessment is that the risks are more likely to be on the upside, as we do not see any obvious downward source of risk unless there was a sharp weakening in the world economy, an eventuality on which we would place a low probability. I suppose you could conclude that this combination of weaker-than-expected GDP growth and higher-than-expected inflation is a disappointing situation. But while less than ideal, the figures I have quoted are still pretty good for this stage of an expansion. Our feeling is that we – that is, policy makers and the public – will have to realise that there comes a time when we have to accept some moderation in growth in order to prevent the build-up in the sort of imbalances that have got us into trouble in the past. | reserve bank of australia | 2,005 | 2 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the AIBF Industry Forum 2005, Sydney, 23 March 2005. | I J Macfarlane: Gresham’s Law of Payments Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the AIBF Industry Forum 2005, Sydney, 23 March 2005. * * * I suppose I should start by explaining why I have chosen this title for my talk today. Gresham's Law is usually stated simply as 'the bad currency drives out the good' and it refers to a time when all transactions used coins. If you had to buy one pound's worth of merchandise and you had two coins – one which you knew contained one pound's worth of gold and another where some of the gold had been shaved off – you would pass the second coin and keep the first one. In that way, most of the transactions would take place using the inferior transaction medium and the superior one would play a minor role. Note that this can occur only if both the inferior and superior transaction medium were accepted at the same price, or in modern parlance, the price signals were not getting through to the users. Having introduced this quaint historical economic law, I would now like to put it aside for a moment and move on to the main subject of my talk today, which is the regulation of the retail payments system. As you are probably aware, the Payments System Board of the Reserve Bank, of which I am the Chairman, is charged by an act of Parliament with responsibility for the efficiency, competition and safety of the payments system. This is quite a daunting task, and has involved us in an enormous amount of research and consultation on payments system issues, some controversy with payments system providers and, to a lesser extent, with some payments system users. Most of us at the Reserve Bank come from a background in economics and hence have a predisposition in favour of free markets and a sceptical attitude towards intervention in those markets unless there is a clearly defined economic rationale for it. After much analysis and discussion, we came to the view some time ago that there was, in fact, an overwhelming case for regulation of some parts of this market, and that competition, such as it was, would not lead to an optimal outcome in terms of the public benefit. In my remarks this afternoon I would like to set out why this is so and, in the process, I hope it will become clear why I introduced this talk by referring to Sir Thomas Gresham and his famous law. There are five basic ways of making a payment in the Australian retail payments system: with cash, cheque, credit card, debit card (EFTPOS) and electronic transfer. When we looked at how these methods of payment were evolving, we saw that credit cards were growing faster than the other means of payment. This was initially somewhat surprising as credit card transactions are more expensive than most other means of payment – that is, they involve a larger payment from the users of the payments system to the providers of the payments system. In effect, what was happening was that the most expensive way of paying was driving out the cheaper ways and, in the process, raising the average cost of the Australian retail payments system. Why was this possible? We concluded this was because there was an asymmetry between the price signals (and the capacity to act on them) faced by the two classes of payments system users – the cardholders and the merchants. For cardholders, the price signal they received was that credit card transactions were free, or could even result in receiving a payment in the form of 'points'. Furthermore, cardholders were able to act on this signal as they were the party that chose the method of payment at the point of sale. Merchants, on the other hand, received a signal that the credit card was the most expensive way of making a payment (via the merchant service fee that was paid to their bank). But merchants had no power to influence the method of payment for the transaction – for that was in the hands of the cardholder. Thus, the incentives in the system were designed to encourage the decision-maker to choose the form of payment that was the most expensive from the perspective of society as a whole. Now it could be argued that merchants could have refused to accept credit cards in the first place. But that would have been a big decision, and the fact is that most merchants felt that they would forgo too many sales if they had taken that path (particularly if their competitors did not). They did not feel that they had much bargaining power vis-à-vis the credit card schemes and the banks. And until our recent reforms, they did not have the power to 'pass on' the merchant service fee to the customer, that is, employ the 'user pays' principle by insisting that if customers use an expensive means of payment they should pay more than if they use a cheaper one. Merchants now have that power as a result of our reforms, but in most cases they are reluctant to use it as the public have become accustomed to the old system and thus often resist the transition to 'user pays'. In short, the asymmetry in price signals is still there despite our efforts to redress the imbalance by 'empowering the merchants'. It is this asymmetry which is at the heart of the process whereby the more expensive means of payment expands at the expense of the less expensive. The mechanism that allows the asymmetry to be exploited is the system of fees that banks in the payments system pay one another – commonly known as interchange fees. In the case of credit cards, the fee is paid from the merchant's bank to the cardholder's bank on each transaction. These fees play an important role in determining the prices charged to both merchants and cardholders for payment services, yet they are not subject to the normal competitive forces that operate in most other markets. To the extent that competitive forces work at all, they perversely have had two effects: • they have encouraged the high-interchange-fee means of payment to grow at the expense of the low-interchange-fee one; • they have tended to push interchange fees up for the competing systems, not down. In this respect, the Australian experience is not unique. There are many examples around the world where these two effects are evident. I would like to illustrate this process by drawing on three examples, two of which are from the United States and the third from Australia. I am using US examples, not because examples do not exist elsewhere, but simply because legal cases in the United States have shone the spotlight on interchange fees more intensely than has been the case elsewhere, and because in many other countries interchange fees remain closely guarded secrets. Competition Between Credit Card Schemes The first example relates to the interchange fees in the MasterCard and Visa credit card systems in the United States, where over the past decade there have been a series of competitive increases in these fees (Graph 1). There is an incentive for each scheme to raise its interchange fee in order to encourage banks to issue its cards because the higher fee provides the issuing bank with more revenue. The issuing banks in turn use the revenue to attract cardholders away from the scheme with the lower fee by offering cardholders more attractive pricing or more 'reward points'. Once one of the schemes raised interchange fees to give itself an advantage in attracting issuers and cardholders, the other responded in the same way. The result has been that competition amongst the schemes has seen fees increase from under 1.3 per cent in 1994 to 1.65 per cent today – a perverse outcome to anyone with an economics background who expects competition to lower prices. I might add that this is three times the average level of interchange fees in Australia following the Reserve Bank's reforms in 2003. Graph 1 Of course the increase in US interchange fees has to be paid for by somebody. And, in the first instance, that somebody is the merchant, since interchange fees are built into the merchant service fee (what the merchant's bank charges it for processing credit card transactions). Not surprisingly, average merchant service fees have increased broadly in line with the increase in interchange fees since the mid 1990s. The end result is that merchants have to bear the extra costs of the competition between the credit card schemes. But, of course, the story does not stop here. Ultimately, higher merchant costs flow through into higher prices for the customers of those merchants. This is a cost borne by all consumers whether they use a credit card or not. Competition Between Debit Card Schemes There is a similar story in the competition between two types of debit card systems in the United States. In one system, operated mainly as regional networks, transactions are authorised by PIN (the PIN-based systems), while in the other, operated by Visa and MasterCard, transactions are authorised by signature (the scheme-based systems). The interchange fee paid by the merchant's bank to issuing banks is much higher in the schemebased systems than the PIN-based systems (Graph 2). As a result, issuing banks have been switching to the scheme-based systems and their share of the market has increased from 45 per cent to 60 per cent over the past decade (Graph 2). The PIN-based schemes have retaliated to some extent, and their interchange fees have more than doubled over the decade, although they are still well below the scheme-based systems' interchange fees. Once again, interchange fees have encouraged the growth of the relatively expensive payments system at the expense of the lower-cost system, and forced the lower-cost scheme to raise the price that is charged to merchants. Graph 2 There is an interesting additional twist to this story, and it concerns the question of why the merchants of America allowed this to happen? Why didn't they resist more strongly the inroads into their profits caused by the expansion of the expensive system? Partly, of course, it was because they could pass the costs on to consumers in the form of higher prices, but there was an additional factor at work. This was the 'tie-in' arrangement imposed by Visa and MasterCard that forced any merchant accepting their credit cards to also accept their debit cards. By the mid 1990s, the merchants had become so upset by this rule that they took the credit card schemes to court – in what became known as the Wal-Mart case – arguing that the rule breached antitrust laws. In April 2003, the case was finally settled, with Visa and MasterCard agreeing to abolish the rule, reduce the interchange fee, and pay damages of $3 billion to the merchants. Credit and Debit Cards in Australia This brings me back to where I started. In Australia, prior to the Bank's recent reforms, the average interchange fee for a $100 transaction paid to a credit cardholder's bank was 95 cents. In the Australian EFTPOS/debit card system,1 the interchange fee flows in the opposite direction and the cardholder's bank has to pay around 20 cents per transaction to the merchant's bank (Graph 3). Given these flows, it is clear why card issuing banks wanted to issue credit cards rather than EFTPOS cards – they received $1.15 more for each $100 transaction. Debit cards can be used to make purchases via the EFTPOS system or to withdraw cash from ATMs. In the following account of the Australian case, I will employ the widely-used term EFTPOS rather than debit card. I will ignore the other type of debit card – the Visa debit – because that has a separate set of characteristics, some of which are under separate regulatory review. During the mid 1990s, the Australian banks worked hard at developing reward schemes (largely financed by their interchange fee receipts) to encourage cardholders to use credit cards. Reward points, together with interest-free credit, meant that many cardholders were being paid 1 per cent or more of the value of each transaction by credit card. Not surprisingly, there was a big shift towards credit cards, with transaction numbers growing at 20 to 30 per cent for around five years, while EFTPOS growth fell to less than 10 per cent per year. As with the US experience, a higher-cost payments system was displacing a lower-cost one, and the community's resources devoted to making payments increased. Graph 3 One of the longer-term aims of our reforms is to reduce the distortions in the payments system caused by the pattern of interchange fees. If large differences in the fees in the credit card and EFTPOS systems continue, it is hard to see why in the long run banks would continue to put resources into promoting the EFTPOS system. This is why we think that the merchants who oppose our EFTPOS reforms are extremely short-sighted. Without the proposed reforms, we could see a gradual withering away of the EFTPOS system, so that the merchants would face a larger and larger proportion of their sales taking place using the higher-cost credit card system. Back to Gresham's Law It is pretty obvious by now where Gresham's Law fits into my account, so I hardly need to spell it out. Instead of the bad currency driving out the good, we have the high-cost means of payment driving out the low-cost one. To take the most obvious example, a credit card offers the same service to a merchant – irrevocable payment – as a debit card, yet costs the merchant a lot more. To the cardholder, the credit card offers more – about 50 days free credit – yet it costs less, with the cardholder often receiving payment for using it. Clearly, the second condition for Gresham's Law is met, namely that the price signals to the decision-maker do not reflect the underlying costs, that is the “user pays” principle is not being applied. This tendency for competition to favour the high-cost product seems to be a feature of card-based systems around the world and explains the increasing attention given to the system by competition regulators. Before I finish, I would like to reassure you that in some other parts of the retail payments system, the normal laws of economics are leading to the normal results. The cheque provides the best illustration of this. All over the world the cheque – universally acknowledged as a relatively high-cost means of payment – is in decline, replaced by more efficient forms of electronic payment. The most important reason for this is that banks at both ends of the payments chain are charging their customers for the costs of writing and depositing cheques. So the “user pays” principle works well in this case, but of course, there are no interchange fees. At the Reserve Bank, we are in favour of a retail payments system that provides users with a wide choice of options from a wide range of providers. Each payments method has its strengths and weaknesses, and so users should be able to choose the most suitable payments method for each particular type of transaction. In some cases the pricing of the transaction enables them to do so in a manner which contributes to an efficient low-cost retail payments system, while in some other cases it does not. The best way of improving efficiency is usually to increase competition rather than to regulate, but I think I have shown that some parts of the retail payments system are constructed in such a way that competition increases costs and reduces efficiency. In those areas, regulation is required, and the Reserve Bank through the Payments System Board will continue with its task of improving efficiency, competition and safety of the retail payments system. | reserve bank of australia | 2,005 | 3 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Irving Fisher Committee for Financial Statistics of the International Statistical Institute, Sydney, 8 April 2005. | Glenn Stevens: The changing statistical needs of central banks Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Irving Fisher Committee for Financial Statistics of the International Statistical Institute, Sydney, 8 April 2005. * * * It is a pleasure to speak to you today about central banking and statistics, and particularly to see such a large gathering of statisticians, including from central banks, here in Sydney. It will be interesting to see whether there is a statistically significant impact on economic activity in the Sydney region as a result of your conference. I suppose that will depend on whether your rate and type of expenditure differs in a statistically significant way from that of the various other groups who occupy this precinct from week to week. Today's proceedings are organised by a committee named for Irving Fisher. Reading just a little about his life, one is struck by the breadth of his endeavours. These were covered very nicely in a speech some years ago by Hans van Wijk, former chair of the Irving Fisher Committee.1 Fisher worked on monetary theory, and on understanding the determinants of the rate of interest, saving and investment. The distinction between the nominal and real rate of interest – second nature to economists today – was first made by Fisher. He worked on index-number issues – the 'Fisher ideal index' is named after him. And he worked on understanding the nature of business cycles. A particularly insightful analysis of the role of asset price and credit fluctuations in propagating business cycles appeared in the 1930s.2 I have noticed that this has been quoted with increasing frequency in recent years, as similar issues have resurfaced (a theme to which I want to return shortly). So it seems particularly apt that either as central bankers or as statisticians, or both, we remember Fisher. Moreover central banks have long been intense users of statistics. Using the RBA as an example, our Economics and Financial Markets areas track several thousand individual economic and financial time series on a monthly or quarterly basis, for the purposes of making an assessment of current and prospective economic conditions as background for the Bank's monetary policy decision process. The majority of these data, particularly those seeking to measure the 'real' side of the economy and prices, are produced by other bodies, usually the official statistical agencies, both in Australia and abroad. Let me say at this point how much we, in the RBA, value the professionalism and assistance of the Australian Bureau of Statistics. The willingness of ABS officers to help our staff understand the nuances of the various series is a great help as we try to put together the various pieces of the jigsaw that make up the Australian economy, in order to decide what we should do to preserve macroeconomic stability. I am sure that in other countries this relationship is equally vital. Central banks are also major compilers of statistics in their own right. The bulk of central banks, for example, put together data on the balance sheets of banks and other institutions. This is usually a by-product of regulatory powers, a result in many instances of legislation for increased oversight of the banking system after the economic and financial collapses which happened in the 1930s, when Irving Fisher was at the peak of his career. Hence it is natural that it is usually central banks which publish measures of money and credit, as well as series for official interest rates, exchange rates and so on. A good many central banks publish data on the balance of payments as well, which I suspect is often a legacy of exchange controls. In many less-developed countries, the central bank is often one of the most capable and best-resourced institutions, and so is called on to bear additional statistical responsibilities. So central banks have a major interest in compiling, disseminating and using statistics. I want to suggest, however, that the statistical needs and interests of central banks are changing, as is the data environment in which they operate. I will elaborate on this theme under three general headings: • The growth of the financial sector, and especially of the size of the balance sheet of the household sector in the past decade or more, has significant implications for the way the http://www.ifcommittee.org/FisherBiogr.htm 'The Debt-Deflation Theory of Great Depressions', 1933, Econometrica, 1, pp 337–357. economy is likely to behave in the future, for the kind of analysis central banks conduct and therefore for the sorts of statistics they need to have. • New emphases in the mandates of central banks – in particular the explicit focus on financial system stability (as opposed to prudential supervision of individual institutions) – carry implications for data collections and the way we process them. • The changing data environment, and in particular more private provision of data, provides both opportunities for central banks to exploit that information, but also some potential pitfalls. The financial sector and balance sheets For a long time, data from the 'real' side of the economy were of primary interest to macroeconomic policy-makers. This presumably followed the intellectual currents in economics. The development of national income accounting in the 1940s, and the growing optimism about the capacity of macroeconomic policy to deliver consistently high levels of output and employment, emphasised the measurement, forecasting and control of aggregate demand. The various partial indicators of economic activity, culminating in the quarterly estimates of national income and spending, were the raw statistical materials with which generations of economists learned to work their trade. Of course, central bankers always paid a good deal of attention to financial data like interest rates, lending, credit and money data, but even in central banks I suspect that until the mid 1970s most of the prestigious analytical jobs were in the areas dealing with the real economy. This period was also the heyday of large scale macroeconometric model building, usually with great detail on the expenditure side of national accounting and with associated data requirements. It's worth noting, incidentally, that these models typically failed to capture adequately the inter-linkages between the real and financial sides of the economy. For some time, of course, the financial side was seen as just a passive add-on – many people thought that changes in balance sheets didn't matter much, and that movements in asset prices were of second-order importance. A common view for many years, in fact, was that monetary policy didn't matter much. As the intellectual battle raged over what activist stabilisation policy could, in fact, achieve, the economic and financial upheavals of the 1970s ushered in a period in which financial variables were suddenly seen as much more important – money did matter after all – and discussion focussed much more on financial quantities. There was the observed correlation between measures of the money stock and the price level. Irving Fisher's Equation of Exchange, MV=PQ, made an appearance here, as the quantity theory of money was turned into a policy prescription of beguiling simplicity: if only central banks could control 'M', they would in due course stabilise 'P'. That idea seemed very appealing in the mid 1970s, but as we all know, the policy process turned out to be more complex than that. Today is not the time to explore all that again. It suffices to say that, despite tremendous efforts in developing and analysing a host of measures of money, attempts to impart stability by targeting closely the money stock were much less successful in practice than in theory. Most countries have moved away from that idea towards some sort of implicit or explicit targeting of the ultimate objective, prices, using the short-term nominal interest rate as the instrument. Yet it would be a mistake to think that this shift signifies that the behaviour of the financial sector has once again come to be viewed as unimportant to the economy. On the contrary, the way in which the financial system responds to financial prices, to regulation (or deregulation) and to the demand for products by the household and business sectors, and the way in which it is constantly innovating, has a major bearing on the path of economic activity. Moreover, the importance of these links is growing. Opinions vary on whether or not this is a good thing. It has been claimed, for example, that the growth of derivatives markets potentially enhances economic stability, insofar as risks inherent in life can be shifted from those who do not wish to run them to those who do. It has also been claimed that such innovations are highly dangerous – 'financial weapons of mass destruction' was one colourful description.3 Either way, an interaction of financial processes with the real economy is in mind; what is at issue is where the risks inherent in economic life are ultimately borne, and whether the people running them understand them and have been paid an appropriate price to do so. This is an area http://www.berkshirehathaway.com/letters/2002pdf.pdf where the statistical collections find it hard to keep up, particularly with the proliferation of financial activity which crosses national borders or occurs off-balance sheet. Another trend which is playing a powerful role in the modern economy is the growth in the household sector's assets, occurring in parallel with the increase in households' access to credit. The growth of aggregate wealth, together with the constant search for new products and new business by financial intermediaries, has seen the increasing collateralisation of the housing stock. Your home was always the collateral for a mortgage loan, of course, but these days you are much more likely to be using it as collateral for a loan for some other purpose as well. Possibly you are doing so at a stage in life when you would traditionally have been debt free. If you are at all creditworthy, moreover, there is no shortage of institutions lining up to lend to you. This is a major issue in several countries, and we have seen extensive (and as yet largely unresolved) debates about what amount of household debt is 'sustainable'. Perhaps the trend towards larger and more leveraged household balance sheets has largely run its course. Certainly for Australia, our analysis of its main underlying causes has tended to suggest that it should be a one-time portfolio adjustment, not a permanently different trend rate of growth in debt. But it is also possible that we are some time from seeing any end to that adjustment process since, in principle, there is no obvious reason why a much higher proportion of the housing stock might not yet be collateralised. If it were, there would be a lot more borrowing ahead. Either way, with the stock of household wealth now twice as large, relative to the flow of current income, as it was in the early 1980s, and the equity contained therein much more accessible via products such as re-draw facilities and home equity loans, and more recently reverse mortgages, these changes have the potential to exert bigger influences on economic performance than in the past. Yet the statistical information about some important elements of these phenomena is poor. Take dwelling prices, a key ingredient in estimating aggregate household wealth. In Australia, there are five series that are routinely used. Because dwellings are far from homogeneous, and change hands only infrequently, getting a good representation of the true change in price of existing dwellings from one quarter or year to the next is much more difficult than, for example, getting a reasonable index of changes in share prices. A major problem is that compositional effects on the observed mean or median price of dwellings can be very large if transactions shift between high and low-value parts of the property market between one observation and the next. Another problem is that most series tend to be dated from the time a property settlement is advised to official records, which may be some months after the sale and price were agreed. Some series try very hard to overcome these sorts of problems, but at the cost of being either untimely or highly prone to revision (or both). Other series are more timely but are unable to overcome technical flaws and so contain a high degree of short-term variability. Memo to statisticians, in central banks or elsewhere: policy-makers need better data on housing prices. In Australia, the ABS is responding to this challenge with efforts to improve their house price series. The RBA very much welcomes this, and has been pleased to have the opportunity to be involved in the discussions that the ABS has had with various interested parties. In an ideal world, we would perhaps collect data from real estate agents at the time that sales and prices are first agreed. This would offer near-universal coverage and a high degree of timeliness, and allow collection of more data on the characteristics of each house, allowing more control for compositional effects and quality changes. However, for cost-benefit reasons, including considerations of reporting burdens, the ABS has decided instead to collect data from financial institutions providing finance for transactions. Although this may not be quite as comprehensive or as timely as an ideal data set, it will still be a major improvement compared with collecting data from state governments after the settlement of transactions. We look forward to being able to use the new series in due course. Better data on house prices will be valuable, but central banks also need a good sense of people's behaviour in response to changes in asset prices. How do we get this? Traditionally, this sort of question has tended to be addressed by using time series for spending and wealth to estimate 'wealth effects', with the answer usually being that for every dollar of wealth change, there is an effect of a few cents on spending. But such estimates could well be hopelessly outdated given the immense increase in the capacity to borrow against collateral that has extended even to people of fairly modest incomes in the past decade. Hence there are demands for direct answers to questions like: • what do people actually do with the equity extracted from dwellings through borrowing? • how are debt and wealth distributed across the population by income, or by age or region? • how is changed borrowing behaviour likely to affect the inter-generational transfer of wealth? There is growing tendency to look to direct surveys of the population for the answers to these questions. Here let me make mention of a survey that the RBA is currently working on, which focuses on the extent to which households used mortgage finance for non-housing purposes over 2004. The Bank engaged a private research firm to conduct the survey, which was designed jointly, drawing on the Bank's existing knowledge about household debt, and the research firm's expertise in questionnaire design. The main field work was undertaken in January and February this year and the Australian public were generally very co-operative. Indeed, Reserve Bank staff took a number of calls, emails and letters from people taking an active interest in the survey (though also, it must be said, a number of calls telling us to mind our own business!). The results will be published later this year. An earlier example of using customised survey data to address a specific issue was the survey of hedging practices of Australian enterprises in late 2001. This was conducted by the ABS with major input and funding from the RBA. It was motivated by the fact that while Australia had very substantial foreign liabilities, the foreign currency exposures reported by the financial sector were very small (as would be expected given that such exposures carry capital requirements). Clearly these entities engaged in substantial hedging, but we knew little about the other sectors of the economy. Hence we approached the ABS to carry out a survey to fill in the missing pieces. What we found was that even though net liabilities to foreigners were (and still are) substantial, the Australian community as a whole had, at end 2001, a modest net foreign currency asset position. The difference is of course due to the fact that foreign demand for Australian dollar-denominated assets was substantial, which has remained true in the period since. Hence while absorbing substantial resources from abroad, Australian entities were not, by and large, accumulating large foreign currency risks. This was a very important fact to know, and I think it has had a significant impact on the views various observers, including ratings agencies, have formed about the country's external accounts. Work is currently under way in the ABS for an update of this survey, with substantial funding support from the RBA. These are just two examples of the use of one-off surveys. In due course, regular statistical collections may well adapt to provide more information on some of these questions, but that takes time. Hence, I think there could well be more of this sort of approach by central banks in future: use of customised survey information to address specific questions which arise because of fast-moving structural change in the economy. An implication of this for central bank statisticians could be, I suppose, that a somewhat different set of skills might be required. Time series expertise – I can recall in the past reading, or trying to read, lengthy papers on the X-11 seasonal adjustment technique as applied to monetary data – might be relatively less in demand, and knowledge of how to design, implement and interpret surveys giving a cross section or panel data set, more in demand. Central banks might of course need to contract out for that expertise – and may well use official agencies for that purpose, though there is ample competition from private firms. Changing mandate Not unrelated to the growing size and complexity of the financial sector of the economy is the rise in emphasis on financial system stability as a 'charter item' for central banks. Financial stability as an objective has, of course, been around for as long as central banking. The lender of last resort function – to liquefy the system in times of crisis – was in fact a major part of the raison d'être of the modern central bank. But we have seen in the past decade or so a clearer focus on identifying potential threats to system stability and working to reduce them. This has been reflected in the structure of some central banks, as for example in the 'stability wing' of the Bank of England, and the creation of a System Stability function in the RBA. It has also been reflected in the advent of regular publications about stability issues by central banks, in our case the Financial Stability Review now published twice each year. In this audience it is worth asking: what is the data set needed for this task? Thus far, in our own experience and, as best I can tell, that of some other central banks, the data used by the work on system stability overlap to some extent with those used by the macroeconomists in their monetary policy work. In our case, aggregates for credit, household sector debt servicing burdens, risk spreads and so on are commonly used for both types of work. That is because the ranking question of late has been whether the extent of additional household leverage amounts to a risk to financial stability. It turns out that this pretty much depends on whether it constitutes a risk to macroeconomic stability first. That is, our assessment is that high household debt is unlikely, of itself, to lead directly to distress for lenders, or to a growth slump. Where there is a risk is that some other contractionary shock might be amplified by high levels of debt, with potential impacts on the economy. That might affect financial firms' profitability indirectly. Thus far, then, the data sets used by the macro policy people and those by the financial stability people have been similar. As our work on system stability issues continues to develop, however, I suspect we will need different sorts of statistical tools. There are likely to be two dimensions. First, while to date stability analysts have mostly been content to work with aggregates – that is, mean outcomes – they are becoming much more interested in the dispersion of experiences around the mean. The question will be not just how much debt is there, but who has it, and what are their other characteristics? To take one example, the household debt servicing ratio in Australia is higher now than it has been before. But the implications of this may be quite different if it is mainly high income earners who have the largest debts (for which there does seem to be some evidence) compared with what would be the case if the debt is concentrated unduly in people of low incomes. Similarly, on the side of exposures to risk in the financial sector, the question will be: where does it reside? The apparent total amount of risk could look quite acceptable but the concentration might not be. Second, there will be intense focus on the inter-linkages – the correlations – between institutions, portfolios and markets. In a full assessment of the resilience of the financial system in the face of an event which affects housing prices, for example, the direct effect on a bank's portfolio of housing loans of lower house prices and/or higher unemployment is only part of the story. Other elements would include how the bank's portfolio of business loans would be affected by the same event, including through the second-round effects of households' spending responding to the deterioration in their financial position. A shock large enough to cause the household sector significant problems in servicing mortgages would presumably be associated with some belt tightening for business borrowers too. Hence there could be a correlation between the two portfolios, and not necessarily the same one as in the past. These interrelationships point to stress testing, for individual institutions and systems, as the way in which assessments of stability and resilience need to be conducted. The raw materials for the required data sets here are the historical loan portfolios, defaults experience and so on of the individual lending institutions. For the most part, these are in the hands of the institutions themselves and the bodies which collect the prudential data. The processing of these raw data to produce a fully-developed stress test of the system will be in the hands of the institution responsible for assessing the stability of the system – which is usually the central bank. This points to the need for arrangements which foster close co-operation, particularly where the central bank is not the bank supervisor and hence may not collect data directly (as is the case in Australia). The kinds of analysis needed for a robust treatment of system stability also require substantial analytical and statistical skills in central banks: it's not just a matter of having the right data but being able to use it. Many countries have found this to be the case when participating in the Financial Sector Assessment Programs, or FSAPs, run jointly by the International Monetary Fund and the World Bank. This is a comprehensive process which assesses the strength of a country's financial system, and often involves stress testing which moves well beyond the single-factor sensitivity tests which banks and their supervisors usually conduct. Australia will begin our own FSAP later this year, and the Reserve Bank is chairing the stress test exercise, working with APRA, the Treasury and the private sector. Changing data environment A third feature of the statistical landscape today is the proliferation of data collected and disseminated by private sector entities. One of the most common examples is industry associations or individual firms compiling data on aspects of business conditions. At last count there were, for example, some thirteen nationwide and several regional surveys of business conditions in the Australian economy or major parts of it. Another area is measures of housing prices, where private associations or research companies produce four of the five recognised series. Some of these private data sets command, rightly, the attention of economists and policy-makers. The issue of quality of data is key, however. Where an entity which has a vested interest is releasing data, upon which they then base claims for advancing their own opinions or agenda, we should take care. Some private surveys one occasionally sees could only be described as crude advertising or propaganda. Not so long ago a new series for housing prices in Australia was launched, with great fanfare, by a lending institution. It turned out that the prices used were based mostly on potential borrowers' own subjective valuations of their own houses, rather than any actual transactions. The index was compiled by the lending department of the institution in question and appeared to be a marketing tool rather than a serious attempt to measure prices. Somehow it was not surprising that it showed significant rises in prices, when the better-known series were tending to show a decline. These sorts of series don't deserve to be taken seriously. Part of the art of policy-making is developing a sense of how to distinguish noise and signal from this mass of 'information'. Before placing too much weight on an indicator, some knowledge of how it is put together is obviously important. To this end, it is often worthwhile for people in the policy analysis process to develop a good dialogue with the compilers of these data. On occasion, well-trained people in the bureaucracy have been able to suggest methodological improvements to privately-compiled surveys. No survey of economic conditions should have much weight attached to it until we have seen its performance over a period of time long enough for some business cycle fluctuations to be observed. I grant that, in Australia, a very long expansion means that this test is getting a bit demanding. But even within an expansion there are fluctuations in the pace of growth and a good business survey should pick these up. Most surveys will be found, in my experience, to have given some false signals as well as some genuine ones. This issue of type I versus type II errors can be critical in judging the state of affairs at key points in the business cycle, using survey data. It is in the area of financial prices where the proliferation of private data is perhaps most marked. The vast bulk of data on pricing of financial instruments is privately compiled, a result of the size of private financial markets and their continuous nature. Where financial instruments are traded on exchanges, their prices are easily observed, and there are relatively few challenges associated with compiling pricing data. However, with the increasing shift towards over-the-counter (OTC) and non-standard products, this task is more difficult and it becomes necessary to rely more on financial institutions' proprietary data. There is no real alternative to this, but of course we need to take care to be satisfied as to the accuracy and impartiality of the data and it is incumbent on private providers of data to be prepared to provide some assurance here. As central banks increasingly use such data sets to infer market attitudes to risk and expectations about the future (a process which incidentally requires increasingly sophisticated analytical skills), all these issues seem likely to grow in importance over the years ahead. Many challenges will surely come our way. Conclusion Central banks are heavy consumers of information, and hence of statistics, and always will be. But the nature of the information we need to do our job, both in the monetary policy field and the financial stability field, is changing. The larger and more dynamic role played by the financial sector, and the greater prominence and impact of swings in household balance sheets, raise as many challenges for our statistical collections, and for the way we process them, as they do for policy itself. Just as supervisors of financial institutions or markets need to keep pace with developments, the challenge before our statisticians is to keep the nature and coverage of our collections fresh and relevant in a changing world. This is particularly pertinent for financial data. Just as important, a capacity to use relevant data to calibrate previous and potential future correlations between portfolios, institutions and markets is key to a sound assessment of stability and resilience of the system as a whole. This is a big task, which will never be finished. Let us grapple with it with vigour. But first, enjoy the rest of your visit to Sydney. | reserve bank of australia | 2,005 | 4 |
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Australian Institute of Company Directors, Sydney, 14 June 2005. | I J Macfarlane: Global influences on the Australian economy Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Australian Institute of Company Directors, Sydney, 14 June 2005. * * * Let me start by saying what a pleasure it is to be here before such a distinguished gathering at the Australian Institute of Company Directors. I have not spoken on the economy since February, so I will take this opportunity to do so today. My main topic is how global and domestic influences are interacting on the Australian economy. But before doing that I would like to say a few words about monetary policy, in particular how it is formulated. As readers of the financial press, you will have encountered reports nearly every day of some new economic statistic being released, and some pundit giving an opinion of what this implies for future movements in interest rates. You could be forgiven for thinking that the formulation of monetary policy was simply a matter of collecting the latest month’s statistics, weighing them up to see whether they were strong or weak on balance, and then adjusting interest rates accordingly. This very short-term view of monetary policy arises because journalists have to write a story every day and economists in financial institutions have to advise their dealing rooms every day. But monetary policy is a much more slowly evolving process than this, and there are elements in the process that are more important than the evaluation of the latest statistics. The first of these is to have a clearly enunciated framework of what monetary policy is seeking to do, and the second is to have a view of how the world economy is evolving and how it is affecting Australia. Let me now say a little more about each of these subjects. What can monetary policy achieve? Views about what monetary policy can and cannot achieve have evolved over the past century or two. The current consensus, based on the experience of the post-war period, is that the principal contribution it can make to economic well-being is to maintain low and stable inflation. As a result, a number of countries, including Australia, have adopted a monetary policy regime based on inflationtargeting. Ours is designed to ensure that the average rate of increase in consumer prices is between 2 and 3 per cent. Note that it is expressed as an average over time; the actual rate does not have to stay between 2 and 3, and in fact it has often been outside that range, though not by much. The centrality of inflation in the monetary policy regime is not because inflation is all we care about. It is there because we believe that low inflation is a necessary condition for sustainable economic growth and good monetary policy is essential to its achievement. The results over the past fourteen years provide evidence in support of this assessment. It is important to have a framework because there has historically been a temptation to use monetary policy for too many purposes. We still hear calls from time to time to raise interest rates to improve the balance of payments or to stop rising house prices, or, on the other hand, to lower rates because the economy has slowed. In the past, these and other motives often lay behind monetary policy changes, but now it is easier to resist such temptations because they have to be viewed within a more general framework based on their likely implications for future inflation. The world economy and Australia’s place The second important element is to have a view about how the world economy is evolving and how this will affect Australia. It is fair to say that the major macro-economic events that have affected Australia have to a large extent been imported rather than home-grown. In Australia, the two major economic events of the last century - the Depression of the thirties and the Inflation of the seventies the world’s only peacetime inflation - were both part of worldwide developments. More recently, the international business cycle has been the main determinant of our own; the three most recent Australian recessions of 1974, 1982 and 1990 were part of global recessions. Over this period, we have not had an entirely self-induced recession. Our one significant deviation from the international business cycle is that we did avoid the (admittedly mild) 2001 recession that affected most G7 countries. Similarly, our inflation experience shadowed that of the OECD-area, although we were later than most in bringing it down after the initial surge in the seventies; our good inflation record only dates from the early 1990s. I think it is true to say that if you wished to forecast the path of the Australian economy, and you were able to have foreknowledge of only one economic variable, the one you would choose would be the path of the world economy. That is not to say that we have no influence over our own destiny - we can make the situation better or worse than it would otherwise be - but we cannot escape the influence of the world business cycle and the other factors that feed off it. Once the central bank has established what it is trying to achieve with monetary policy and how world events are shaping the direction of the Australian economy, then it is in a position to evaluate the multitude of statistics about the economy that each day brings forth. They essentially indicate whether the ‘big picture’ view of how the economy is evolving is on track or not. Mainly they show whether events are happening quicker or slower than expected, but in extremis , they could mean that the overall assessment was incorrect. There is so much semi-random variability in economic statistics that, unless the underlying processes are known, the statistics alone are unlikely to be able to show where the economy is heading; this is particularly the case if too much emphasis is placed on one month’s statistics. The current situation I have spoken on several occasions about the risks that can develop as an economic expansion lengthens and economic imbalances emerge. With the Australian economy in the fourteenth year of expansion, we have naturally paid particular attention to these imbalances. The one that was most prominent until recently was the sharp increase in house prices and household debt. More recently, it has been the emergence of capacity constraints in some parts of the economy. No-one should be surprised by this development; it would be remarkable for any economy in the fourteenth year of an expansion if this were not to happen. Finally, we have seen the Australian current account deficit as a per cent of GDP move relatively quickly from its smallest level in twenty years to its largest. These developments are all related, as I hope to show, but I will start my story as usual from the perspective of the world economy. After the mild recession of 2001, the world economy moved into an expansionary phase, which has been robust overall, but has been marked by very disparate growth rates among major regions. Two regions in particular - Japan and Europe - have made only minimal contributions to the expansion which has been led by the United States, China and other East Asian countries. A notable feature this time is that the rest of the world, which tends to be overlooked in most assessments, has also grown strongly. By the rest of the world, I mean Latin America, India, the Middle East, Eastern Europe, former Soviet Union, etc. Overall, despite these regional divergences, the world economy has expanded at above-average rates over the past few years providing a very favourable backdrop to the Australian economy. Consensus forecasts for 2005 and 2006 are also for above-trend growth, although somewhat lower than last year. A particular feature of the world economy in this episode is that commodity prices, led by Chinese demand, have risen sharply at a relatively early stage of the global expansion. Apart from oil, the rises have been concentrated in base metals and the two bulk commodities important for Australia - coal and iron ore. As a result, Australia’s export prices have received a huge boost. Our terms of trade, which is the ratio of our export prices to our import prices, rose more quickly and to a higher level than anything we had experienced since the early 1970s commodity price boom (Graph 1). Graph 1 A rise in the terms of trade is an increase in the country’s real income. We estimate it has increased our real income by an amount equivalent to about 1½ percentage points of GDP on average in each of the last two years and more is to come.1 Some of this accrues to workers in the resource sector, some to domestic shareholders and a significant amount through increased taxation and royalties to governments. When the additional income is spent, it provides a significant boost to domestic demand through increased consumption and investment as well as via the government sector, although some flows overseas through imports. In the past, we have sometimes had difficulty in coping with these expansionary effects, as they pushed up inflation and added to the boom and bust character of the Australian economy. With domestic demand in Australia growing at over 5 per cent in 2002/03 and 2003/04, which is well above long-term potential, and with the economy approaching full capacity in a number of sectors, the extra domestic demand generated by the exceptional rises in the terms of trade could well have had serious inflationary consequences if it had continued. This was particularly so as important prices such as those for oil, steel, plastics, shipping and other inputs to production were rising rapidly around the world. It was these types of concerns that led the Bank to raise interest rates a little further earlier this year. In the event, the economic situation has evolved quite favourably, with domestic demand continuing to slow to what appears to be a sustainable pace. Output, as measured by GDP, has also slowed and some people are disappointed that GDP growth is now running at a below-average rate, but I view recent events as a healthy correction, and certainly a much better outcome than several other potential outcomes. There are also indications that inflationary pressures are not building as quickly as might have been expected earlier in the year. How has this relatively orderly slowdown come about? The first reason for the slowing in domestic demand is the change that has occurred in the housing sector. Fuelled by a rapid increase in mortgage lending, house prices rose sharply and house-building activity surged in the first few years of this decade. Over the past year, however, we have had a turnaround in all three; house prices have flattened, mortgage lending has slowed and house-building has contracted modestly (Graph 2). The direct effect of the last-mentioned is the easiest to measure; This figure is the difference between the growth rates of real GDP and Real Gross Domestic Income for the two years to the March quarter 2005. house-building grew by 11.1 per cent last financial year and has contracted by 5.3 per cent so far this year. This means it added 0.7 per cent to the growth of demand last year and has taken 0.3 per cent off this year. Note, however, that as a per cent of GDP, housing is still high by historical standards. A second reason for the slowing in domestic demand may be the indirect effects of the change in the housing market. These are harder to measure, but there is some evidence that the flattening of house prices has led households to tighten their belts. Growth in borrowing against housing has slowed to an annualised rate of 10 per cent in the first four months of 2005. While this is well down from a year ago, it is still faster than the growth in household incomes. After several years when borrowing was much higher than housing investment as households withdrew equity to fund consumption, it appears that housing equity withdrawal has now ceased. In line with this, growth in consumption has slowed from 5.9 per cent in 2003/04 to an annual rate of 3.4 per cent so far this year. In other words, while households have stopped adding to their consumption by borrowing against the equity in their houses, there has not been a major scaling back in order to build up savings. It is hard to know whether this household consolidation will continue, for how long it will last, or whether it will intensify. It is early times yet and the situation bears close watching. As a result of these two influences - the slowing in consumption and the fall in house-building domestic demand growth has fallen from just over 6 per cent to about 3½ per cent so far this financial year. Business investment continues to grow strongly, which is important given our need to increase capacity, particularly in the exporting sector. Strong employment growth is also underpinning the economic expansion. Growth of 3½ per cent in domestic demand sounds reasonable, but growth in output, as measured by GDP of only 1.9 per cent over the past year, sounds less satisfactory. What lies behind the lower output growth? The simplest factor to identify is the fall in farm output of 16 per cent. Setting this aside, the growth in non-farm GDP is 2.6 per cent over the past year. But the more interesting story concerns the balance of payments, so I will conclude by saying a few words about our external trade position. It is well-known that, despite the rise in world prices for our resource exports, Australian exporters have struggled to increase export volumes over recent years. In large part, this is because of the size and speed of the rise in demand coupled with the very limited investment in capacity that has taken place in the late 1990s and early in this decade. This is a worldwide phenomenon; it was because world producers were not able to increase supply to match the increase in demand that world commodity prices increased in the first place. A couple of port bottlenecks in Australia also limited our supply response, but they are not the main part of the story. At the same time as export volumes remained weak, import volumes over recent years rose strongly. Imports were boosted by the strong domestic demand, partly reflecting the increase in real income due to the terms of trade rise, and by the accompanying rise in the exchange rate. This latter factor, combined with the worldwide fall in the prices of manufactured goods, meant that import prices in Australian dollars fell sharply until recently which encouraged import volumes to rise strongly. This is a normal process whereby a floating exchange rate relieves the pressure on domestic supply and inflation, but at some cost to the balance of payments. The good news is that it does not go on forever. In time, export volumes begin to rise again, as I believe they are now, and the slowing in domestic demand feeds through into slower import growth. While the rising exchange rate has been an important factor over the past couple of years, if we look at it over the past five years or so, it did not rise as much as would have been expected on the basis of its past relationship with the terms of trade (Graph 3). Interest differentials in Australia’s favour also pointed to a larger rise in the exchange rate. This suggests that some other factors must have been at work in the opposite direction, perhaps concern about the weakness in export volumes or broader apprehension about the widening current account deficit itself. Graph 2 Graph 3 Conclusion What do we make of all this? The big picture is, I think, that the world business cycle is still at an early stage of expansion, so we can expect continued economic growth over the next few years. This, together with our higher terms of trade and strong investment growth in the presence of some capacity constraints, is exerting an expansionary influence on domestic activity and upward pressure on inflation, mainly at the producer price level, although we also expect consumer price inflation to increase somewhat from its present rate. At the same time, the economy is at present being affected by some countervailing forces. Consumption has slowed and house-building and farm output are falling; these have exerted a moderating influence and may continue to do so. While there is a natural tendency to be disappointed that the second set of influences is now occurring, the fact is that the economy could not have taken on board the external situation without this moderation in the domestic economy. A failure to slow would most probably have produced the set of economic imbalances, particularly rising inflation, that have ended previous expansions. In this respect, the recent moderation in growth is more likely to prolong the expansion than bring it to an end. | reserve bank of australia | 2,005 | 6 |
Presentation by Mr Ian J Macfarlane, Governor of the Reser0ve Bank of Australia, to the Chinese Academy of Social Sciences, Beijing, 12 May 2005. | Ian J Macfarlane: Payment imbalances Presentation by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to the Chinese Academy of Social Sciences, Beijing, 12 May 2005. * * * My talk today is about payments imbalances in the world economy, a subject that has received exhaustive attention over recent years. The reason for this is simple: it is not just that there are large imbalances between deficit and surplus countries, but that the pattern seems to have become entrenched over recent years. Table 1 below summarises the results for the past five years. Most of the discussion has centred around the sustainability of the deficits, especially the deficit of the United States. Not surprisingly, the United States Government is then urged to adopt policies to reduce its deficit, and other countries are also encouraged to adjust their policies with the aim of reducing the US current account deficit. The US Administration has become quite vocal on this subject, but it is not clear that its outspokenness is helping to resolve the issue. I find this approach of starting with the US current account deficit not to be very constructive for several reasons which I will outline in this talk. Table 1: Current Account Per cent of GDP Memo USD billion Source: IMF Japan 2.5 2.1 2.8 3.2 3.7 China 1.9 1.5 2.8 3.2 4.2 Other east Asia 4.7 5.5 6.8 6.6 Euro area -0.5 0.2 0.8 0.3 0.4 United States -4.2 -3.8 -4.5 -4.8 -5.7 Other 0.8 0.4 0.5 1.3 1.6 171.8 70.0 123.7 35.6 -665.9 187.6 Current versus capital deficits versus surpluses A balance of payments account measures two separate concepts, each of which is the mirror image of the other: • it identifies whether a country has absorbed more goods and services than it produced; and • it identifies whether a country has lent to or invested more abroad than it has received from abroad. The first is summarised by the current account and the second by the capital account; the two by definition have to add to zero. Attention is invariably concentrated on the current account rather than the capital account, and especially when the current account is in deficit. Why should we assume that the deficits are the problem? Why not assume that the surpluses are the problem? I think the answer is that there is a belief that current account deficits are unsustainable, whereas surpluses could go on forever. This was a reasonable assumption for most of the post-war period, particularly under the Bretton Woods system, but may no longer be so. In a world of floating exchange rates and mobile international capital, the old rules may no longer apply. The discipline applied by the international market place on developed countries with current account deficits now may be very weak. Even under earlier monetary regimes, there are examples of countries that have maintained current account deficits for long periods. The United States in the nineteenth century is a good example, as is Australia in the twentieth. In the 1970s, Singapore ran a current account deficit which averaged 15 per cent for a decade. For developed countries with deep financial markets and little or no foreign currency exposure in their borrowing, current account deficits are not the problem they once were. The United States has now run a current account deficit for fifteen years. During the first phase, it was predominantly financed by private investment and the US dollar strengthened. During the more recent phase, the gross inflows have still been private, but financing from foreign central banks has also been important and nearly matches the size of the current account deficit. Over the past four years, the US dollar has depreciated, but after fifteen years of cumulative deficits, the effective exchange rate of the US dollar is similar to what it was at the start of that period. The important point is that, despite widespread predictions to the contrary, it has not been difficult for the United States to finance its deficit. So the scenario whereby world financial markets react to the US current account deficit by withdrawing funding has disappointed those who thought it would come into play. It may happen yet, but people have been predicting it for a long time and yet it seems no closer. A large part of the reason for this is that investors who want to get out of US dollars have to run up their holdings of another currency – they cannot get out of US dollars into nothing. They have to take the risks involved in holding some other currency, possibly at an historically high exchange rate, and they may well be reluctant to do so. The other mechanism that could bring about a correction would be if the United States chose to implement policies aimed at reducing its current account deficit. This is not something that the Government would embrace quickly, as the population, by and large, is not complaining about the current situation whereby their consumption is subsidised by cheap loans from the rest of the world. Some of the appropriate policies may be worthwhile on other grounds, such as reducing the budget deficit, so I do not wish to argue against them. All I want to point out is that the usual policies which could reduce the current account deficit are not very appealing politically. In a world of floating exchange rates, all the policies available to the US Government involve reducing domestic demand, increasing national savings and putting downward pressure on domestic prices and wages. They are all restrictive and aimed at reducing consumers' purchasing power. Short of a crisis, most governments are reluctant to adopt such policies. Thus, my judgment is that the difficulties of sustaining current account deficits have been overstated for any country whose financial markets are developed enough to be able to borrow in its own currency. Of course, this is even more so if its own currency is a reserve currency which foreign central banks are willing to accumulate. Current account surpluses and lending I would now like to approach the subject of imbalances from the side of the surplus countries, particularly Asian countries. The thing that stands out today is that Asian countries run large surpluses, which amount to a bit more than half the deficit run by the United States.1 As we have seen, when a country runs a surplus on its current account, it has to be exactly matched by capital outflows in the form of loans or investment abroad. Thus, we have the counter-intuitive situation of a region consisting predominantly of developing countries lending to the richest developed country in the world. Not only does this seem to be counter to economic logic, it is also contrary to historical experience. Developing countries are characterised by relatively small amounts of capital relative to labour, and hence relatively high rates of return on additions to their capital stock. It makes sense for funds to flow from the mature economies to the developing economies in order to receive a higher rate of return on those funds. To some extent, this is happening, principally through direct investment, but this is dwarfed by other flows in the opposite direction so that overall finance is flowing from the developing to the mature. Historically, it has gone the other way. In the nineteenth century, the main movement was from old Europe to the new and expanding United States, and this flow continued in the twentieth century as newer areas such as Australia, Argentina, Canada, etc. received funds from Europe and later the United States. Another comparison, which takes in private capital flows as well as the current account, is to look at the accumulation of international reserves by Asian countries. In 2004, they added US$508 billion to reserves, which amounts to over 75 per cent of the US current account deficit. There are a number of explanations for this unusual pattern of capital flows. Many people attribute it to the desire by Asian countries to keep their exchange rates low in order to maintain competitiveness. I do not wish to argue that this has not been a factor, but I think there is a more important explanation. There are two relevant facts about this pattern of capital flows. The first is that it is a relatively recent phenomenon. Table 2 below compares the pattern in 1996 – the year before the Asian crisis – with the pattern now. In all cases, the Asian current account surpluses were much smaller (or were deficits) in the earlier period than now. This pattern is not consistent with the view that competitiveness considerations were the main driver, because if that were so, Asian countries would not have waited until the past five years to put them into effect. Table 2: Current Account Per cent of GDP 1992-1996 2000-2004 Source: IMF Japan 2.4 2.9 China 0.4 2.7 Other east Asia -0.7 5.7 United States -1.3 -4.6 The second fact is that, as shown in Table 3, the predominant change in economic behaviour by the Asian countries between the two periods has not been to increase saving, but to reduce investment. In the case of Japan, investment has fallen by 5.2 per cent of GDP since 1996, and in the rest of Asia (excluding China), it has fallen by 8.7 per cent of GDP over the same period. China is different, in that both savings and investment have not changed by much. Table 3: Saving and Investment in Asia Per cent of GDP Japan Saving Investment 31.5 29.2 1992-1996 27.6 24.8 2000-2004* * Data for China only available till 2003 Sources: CEIC; IMF; RBA Saving 40.8 41.9 China Investment 40.2 39.7 Other east Asia Saving Investment 32.9 33.6 30.6 24.6 My conclusion is that because of the timing and the composition of the change in the Asian current account position, much of the reason behind it can be attributed to the fallout from the Asian crisis of 1997/98 and the desire of Asian governments to avoid a repeat of it. After the devastation faced by Thailand, Korea and Indonesia (and observed with interest by China), Asian countries felt they had to make their economies more resilient to international capital flows. The simplest way of doing that was to cut expenditure (particularly investment expenditure), keep savings high, run current account surpluses and build up reserves. Since the reserves are largely in US dollars, that means lending to the United States. There is a cost to this as it means forgoing spending and building up savings which will be lent at a low interest rate. It is a very expensive form of insurance designed to reassure international investors of the ability of the country to withstand a crisis. I remember that up until a couple of years ago, officials from Asian countries (especially China) usually started any presentation on their economy by referring to their high level of international reserves. They do not do that any more since the level has become so high that they exceed any likely need. Thus, I think that in a world of floating exchange rates and mobile international capital, a number of emerging market economies came to the conclusion that the international financial system was so potentially unstable that the only way they could participate was by paying this large insurance premium in the form of cheap loans to the United States. I have a feeling that this sentiment is starting to change now, but it was a large part of the reason that we have ended up where we have. This is not a new thought of mine, because I was already worrying about it in 1998 when I wrote: “I fear that a number of emerging market countries will take…(the) safety-first policy…(of) building up large international reserves - a new type of mercantilism. The problem with this solution is that to build up the reserves they would have to run current account surpluses for the foreseeable future. ...The final irony, if this situation eventuates, would be that we would have an international system in which the poor countries lend to the rich so they can spend more than their income.”2 Sustainability of surpluses I think it is possible to argue that for countries with a fixed exchange rate, surpluses may be more difficult to sustain in the long run than deficits are for some other countries. I speak from experience here as Australia faced this problem in the early 1970s and did not handle it successfully. At that time, Australia briefly experienced a current account surplus and also became a favourable destination for capital flows. As the money poured in from both these sources it had to be sterilised or it would flow directly into the banking system and through that into money and credit aggregates, with obvious inflationary results. The problem we found was that in order to sell the official paper in sufficient volumes to soak up the inflow, interest rates had to be raised, and this induced further inflow. In the end, the monetary aggregates grew too quickly and inflation soon rose to an unacceptable rate. We came to the conclusion then that it was not possible to restrain an over-exuberant and inflation-prone economy only by domestic tightening. Exchange rate adjustment was required in order to take away the 'one way bet' aspect of the exchange rate. We eventually did this, but we were too slow and the inflation had already become entrenched. So far, China has made a much better job of handling this situation than we in Australia did 30 years ago. And, of course, it is made easier by the fact that it is occurring in a world environment of low and stable inflation rather than the rising inflation of 30 years ago. But, ultimately, I think the point will be reached where domestic restraint has to be augmented by action on the exchange rate. Sterilisation is not as easy as it sounds. If all the central bank does is sell official paper to the commercial banks at a below-market interest rate, it is not really sterilisation. It merely exchanges commercial banks' balances at the central bank for central bank paper, but does not offset the initial increase in bank deposits caused by the official purchase of foreign currency. For sterilisation to offset the initial rise in bank deposits, the official paper must be sold at an interest rate that attracts nonbanks to withdraw deposits from the commercial banks in order to buy the official paper. This is rarely done because it would push up interest rates and attract more inflow. Instead, countries usually rely on a combination of raising reserve requirements and direct lending guidelines to limit the growth in banks' balance sheets, and hence the money supply. These have their own set of problems for both commercial banks and/or central bank profitability, and hence cannot be maintained indefinitely. Ultimately, the inflow of foreign funds through the current and capital accounts has to be reduced through a higher exchange rate. It is in the country's own domestic interest to do so, but it is difficult to make the decision at the right time, i.e. before the inflationary consequences in goods and asset markets show up. We in Australia did not pass that test, but I suspect China will handle it better than we did. Conclusion I have tried to make a number of points in this talk, but I may not have been as clear as I would like to have been. I will, therefore, conclude by restating my main points in the simplest of terms. • it is not fruitful to approach the current needs of international policy by asking what can various countries do to reduce the US current account deficit; • it is not clear to me that current account deficits are less sustainable (for some countries at least) than are current account surpluses; • the current level of reserves in Asia owes much to these countries' memories of the Asian crisis, and their determination not to go through such a situation again; “Recent International Developments in Perspective”, Reserve Bank Bulletin, December 1998. • the combination of rapid economic growth, a fixed exchange rate and persistent current account surpluses is not sustainable into the medium term, and it is in the domestic interests of a country in this situation to adjust its exchange rate; and • whether this has an appreciable influence on other countries' balance of payments position is of secondary importance. | reserve bank of australia | 2,005 | 7 |
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, 12 August 2005. | I J Macfarlane: Some recent economic developments in Australia Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne, 12 August 2005. * * * I would like to start by saying how pleased I am to be back in Melbourne in these familiar surroundings. Since these half-yearly hearings started in May 1997, this is the sixth time we have appeared in Melbourne, and the seventh time in Victoria – the other time being in Warrnambool in 2002. I hope that the discussions are as fruitful and informative as they have been on the earlier occasions. On Monday we released our quarterly Statement on Monetary Policy, and you will not be surprised to hear that what I have to say today is very similar to it. In fact, what I have to say is also very similar to a speech I gave on 14 June. The past couple of months or so has been a particularly stable period and we have not felt the need to change our views much, if at all. Rather than going over all the recent developments at this time, I will concentrate on a few that I think are important. The first, as always, is the world economy. It would be possible for someone reading the newspapers to get the impression that the world economy is in a parlous state – rising oil prices, large US current account deficit, China on a knife edge, Japan still stagnating, the US dollar about to plunge, etc. You will be pleased to hear that we are not of that view. In fact, we have for quite a long time been relatively optimistic about the outlook for the world economy. When looked at region by region, there is good growth nearly everywhere. Obviously, the United States, China, India and East Asia are doing well, but the places we tend to overlook are also doing well – for example, Latin America, the Middle East and the former Soviet Union. Even Africa has picked up, and so has Japan. The only area that continues to disappoint is continental Europe, particularly the big three – Germany, France and Italy. Oil price increases are a source of concern, but their rise is primarily due to strong world demand, not to supply restriction as was the case in OPEC I and II. They also do not appear to have added to inflation or inflationary expectations, and so have not required a policy response. Much discussion recently has focused on the US current account deficit as a source of risk to the world economy. It has been argued that the United States might encounter difficulty financing its deficit and that this would put downward pressure on the US dollar and upward pressure on world interest rates. In fact, the US current account deficit has been financed relatively easily, and the US dollar has risen over the past year. More importantly, long-term real interest rates around the world have stayed exceptionally low, which indicates a more-than-adequate supply of world savings, rather than a shortage. Although China has been cited as a third source of risk to the global expansion, it continues to power ahead, and the recent changes to its exchange rate regime, although small, will improve its prospects at the margin. The most reasonable assumption is that the current world expansion, which has been going for almost 3½ years, will continue for a good while yet. Most private forecasts for global economic growth for the rest of this year and the next show above-average rates, although not as strong as in 2004. The second subject I would like to say a few words about is the interaction between developments in the housing market and household spending and saving. Recent evidence from several countries, including Australia, shows that during periods where house prices are rising rapidly, households tend to react to this by increasing their consumption expenditure faster than their income. They can do this by either reducing discretionary savings, or by borrowing against the equity in their house to finance non-housing expenditure, a process referred to as 'housing equity withdrawal'. This process occurred in Australia, particularly in 2002 and 2003. Over the past eighteen months, during which Australian house prices on average have not risen, this process seems to have stopped, and so consumption and borrowing have slowed noticeably. In the eighteen months to the December quarter of 2003, real retail trade rose by 10 per cent, whereas in the most recent eighteen months it has risen by 4½ per cent. These developments have not been a concern to us because: • The pace of growth in domestic demand had been clearly unsustainable, averaging 6 per cent per annum in 2002 and 2003. This needed to be brought back to a more sustainable pace, and this necessarily involved some slowing in consumption. • Other parts of the economy are still showing good growth, particularly employment and investment. The external sector is also exerting an expansionary influence through higher demand for exports and higher export prices. • After periods of rapid borrowing and rising interest servicing costs, a period of consolidation is welcome. The corporate sector did this in the early 1990s and is now in excellent shape; the household sector will be in a better position in the long run if it also consolidates its balance sheet. Nevertheless, we are taking a great interest in the relationship between housing and household spending, as it has been and will probably continue to be an important influence on economic developments. One area where it has been influential has been in explaining the different economic performance of the different states. We have also recently undertaken a survey of a sample of households to study the extent to which they have engaged in mortgage equity withdrawal and to see how the funds were used. We will soon be reporting on the results of that survey. The third subject I would like to cover is inflation and inflation prospects. This is particularly important given that our monetary policy is based on inflation targeting. That is, we want to ensure that the rate of inflation averages somewhere between 2 and 3 percent. We aim for this – not because inflation is all we care about – but because the maintenance of low inflation is a necessary condition for having a long economic expansion in output and employment. Over the past two years, inflation in Australia has been restrained by the appreciation of the Australian dollar which took place between mid 2001 and the beginning of 2004. However, there have been a number of influences which have pointed to a rise in inflation further ahead: • the fact that after a long expansion we were encountering some capacity constraints; • the rising prices of oil and some other important industrial inputs; and • the fact that the downward influence on prices from the exchange rate appreciation would eventually fade away. The likely extent of the upward pressure has been difficult to assess as the signals have varied quite a bit. When I was last before you in February, the signals were quite strong. We had received two quarters of large rises in producer prices at all stages of production and the increase in the CPI in the fourth quarter of 2004 had exceeded everyone's expectations. There was also some evidence that the slowdown in credit had run its course and was picking up again. Shortly after we met last time, the Bank raised the cash rate by 25 basis points. Since that time we have had more reassuring news on inflation. There is also some evidence that the monetary policy tightening itself may have had a quicker effect than normal. I do not want to make too much of this point, but the saturation coverage of the event in the print and electronic media must have had some dampening effect on expectations, as some surveys have suggested. It would not be surprising if the household sector had become more sensitive to news about interest rates, given the increased debt and debt servicing loads that it is now carrying. To cut a long story short, the next set of producer and consumer price inflation data that we received was more reassuring. True, it was only one quarter's information and that was not enough to change our numerical forecast of inflation, but it did lead us to conclude in our May Statement on Monetary Policy that there was no longer an upward risk to our inflation forecast. The subsequent set of data confirmed a similar picture. With two quarterly sets of more reassuring price data now behind us, we were able in our recently released August Statement on Monetary Policy to conclude that the CPI increase will peak at 3 per cent per annum in the second half of next year. As was widely noticed, we also refrained from making the point we have been making for the past year or so about it 'being unlikely that there would be no further rises in the course of the expansion'. That does not mean that further rises could not happen; it only means that in our present estimation there is no longer a more than 50 per cent possibility of it happening. This is a pretty comfortable position in which to be. We are not expecting to change monetary policy in the near term, and when we look further into the future we no longer see a clear probability of it moving in one direction rather than the other. Importantly, this is also the collective view of the market, as shown by the yield curve and by economists' forecasts. Of course, individuals do not all share this view, but on average that is the collective forecast. I do not intend to say any more about the economy or monetary policy at this stage, but, of course, am happy to answer any questions that you have on these subjects. I am also happy to answer any questions on the other important area of the Bank's responsibilities, namely financial system stability. Within that general area, the subject that has attracted the most recent attention has been the regulation of the retail payments system by the Bank's Payments System Board. I know that Committee members have met with the various industry participants, including members of the Bank's Payments Policy Department, to discuss the main issues, and, of course, I would be happy to address any questions members have on that subject. | reserve bank of australia | 2,005 | 8 |
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the Economic Society of Australia Dinner, Melbourne, 28 September 2005. | I J Macfarlane: What are the global imbalances? Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the Economic Society of Australia Dinner, Melbourne, 28 September 2005. * 1. * * Introduction I have given a number of speeches to the Economic Society over the years, and it is a pleasure to be doing so again tonight. The last time I gave the closing address to the Conference of Economists was in 1997 in Hobart. The subject I want to speak about tonight is one which has loomed particularly large in international macro-economic discussion in the period since then. I refer to the subject of global imbalances in international payments. Most of the discussion, at least until quite recently, focussed on the large US current account deficit and questioned its sustainability and the risks it posed to the world economy. Tonight I would like to approach the subject of global payments imbalances from a broader perspective. In doing so, the focus of attention is shifted towards Asia, recognition is given to the weakness of Europe, and the United States is cast into an accommodating role, rather than an initiating one. When we look at the global economy over the past half dozen years, there are a number of developments that have been difficult to satisfactorily understand and explain. I suggest that the following five developments are the central ones in need of an explanation. 1. Why did the US current account deficit start to widen sharply after 1997, reach such a high percentage of GDP, and yet has been relatively easily financed? 2. Why has Asia run such large current account surpluses and built up such a high level of international reserves? 3. Why did the world's central banks push short-term interest rates to their lowest level for a century, and why has this apparently easy monetary policy not led to an appreciable pick-up in inflation? 4. Why have bond yields been so low, and why have they stayed low even when short-term interest rates have been raised? 5. Against this background of wide payments imbalances, why have the margins for risk in corporate and emerging market debt been so exceptionally low? A number of explanations have been put forward to account for each of these developments. The most common explanation has started with the widening US current account deficit, and attributed it mainly to excessive spending and borrowing and insufficient saving by US households and the US Government.1 While this explanation is consistent with the widening US current account deficit, it has a number of shortcomings because it is inconsistent with some other developments we observe in the global economy. For an explanation to have any plausibility, it must be consistent with all the five simultaneous developments listed above. In my view, the most promising explanation at present is one which starts with the surplus countries and focuses on why national savings are so much higher than national investment in those countries.2 See Mann (1999 and 2002), Obsfeld and Rogoff (2000 and 2004) and Peterson (2004). Ben Bernanke, while a Governor of the US Federal Reserve Board, gave the best explanation along these lines. He originally called it the “glut of savings” argument, but it could more appropriately be called the “dearth of investment” argument because there has not really been an increase in world savings, only a redistribution. Alternatively, we could call it the “glut of savings in surplus countries” argument. See Bernanke (2005A, 2005B). 1/10 Although it is not, in itself, a complete explanation of everything that has happened, it is the most plausible in that it is consistent with all the five developments listed above. 2. The excess of savings in the surplus countries The best starting point for any explanation is to recognise that there is a wide disparity between saving rates in different countries. Broadly speaking, Asian countries tend to have high saving rates, AngloSaxon ones low saving rates, and other countries somewhere in between (row 1 of Table 1). For balance of payments purposes, this would not matter if investment rates in each country matched the saving rate, but this is not the case (row 2 of Table 1). In countries with high saving rates, investment rates, while high, are not as high as the saving rate, and these countries run a current account surplus. The opposite applies in the low saving countries. To understand developments in current accounts, we have to understand developments in saving and investment ratios in different countries and regions. In short, Asian countries have more savings than they wish to invest in their own countries, and so they have to invest or lend abroad. This is the most basic of all balance of payments identities. Other countries that invest more than they save have to finance their investment by using the savings of foreigners. The actual channel can take many forms, but that is not crucial to the story. To complicate the story slightly, it is not only Asian countries that are running surpluses at the moment. As a result of the high oil price, the Middle East and Russia are also doing so, as are the Latin American countries for different reasons. While acknowledging these surpluses, I intend to leave them out of the rest of my account on the grounds that they are a good deal smaller than in Asia, and that, on past experience, they are likely to be temporary. For those who want to follow them up, I recommend a recent paper on our website.3 Returning to Asia, we can ask why these countries do not invest more in themselves, and can find several explanations which I will outline later. Whatever the explanation, we should probably accept that in the medium term, a surplus of Asian saving over Asian domestic investment will be a fact of life; hence, Asia will run large current account surpluses and therefore will have an excess supply of savings to be invested abroad. Given that this is going to happen, some other countries must run deficits – this is another important balance of payments identity which must hold. If no other country was prepared to run a deficit, then the world economy would enter a downward spiral with ex ante saving greater than ex ante investment. Clearly, the countries that will run the deficits will be those where consumers, businesses For a fuller account of these developments, see Orsmond (2005) and IMF (2005). 2/10 and governments are most willing to spend and whose financial systems are most efficient at intermediating the flow of world savings. For ease of exposition, we can focus on three main regions of the world – Asia, the Euro area and the anglosphere (mainly the United States, but also the United Kingdom, Canada, Australia and New Zealand). Asia runs a large current account surplus, and we might expect it to be balanced by deficits in the other two regions. In fact, the entire deficit shows up in the Anglosphere, with the Euro area in approximate balance. While balance sounds like a good thing, the Euro area has achieved this largely because of weak domestic demand and high unemployment over recent years. So what appears to be a balance in European payments, is in fact an important imbalance in the global economy. As explained before, the Asian surplus has to be invested in the rest of the world, and it will tend to flow to those regions which offer the highest return on capital. While foreign investment flows both ways, in net terms it has flowed from Asia mainly to the United States and has underpinned the level of the US dollar, despite the US current account deficit, and provided easy access to finance for US borrowers in the business, household and government sectors. 3. How does this explanation fit the five questions? (i) The ease of financing the US current account deficit There have been widespread fears expressed over the past half dozen years that the United States would have difficulty financing its deficit, that the US dollar would fall sharply, and that real interest rates in the United States would rise as borrowers competed for funds. In fact, the US current account deficit has been relatively easily financed despite it continuing for fifteen years and reaching 6 per cent of GDP. The US dollar in real effective terms today is at or slightly above its level of fifteen years ago when the recent run of deficits started (Graph 1). Although it has fallen in net terms since its early 2002 peak, this has only unwound its rise since the mid 1990s. This is not what one would expect for a country having difficulty attracting the funds to finance its deficit. Similarly, the real interest rate at which borrowing has occurred is a lot lower than a decade ago, a subject I will address later. Overall, the US experience is consistent with a plentiful supply of internationally-mobile savings rather than one where it has had to struggle to find the funds to finance its spending. 3/10 (ii) The continuation of Asian surpluses This is the starting point of my explanation, not something that has to be explained by the other developments. Even so, it is of some interest to know why Asian countries seem content with the situation. Although there are some common factors among these countries, there are also some interesting differences. Japan is the easiest to deal with as it has had a large surplus for a long time, as you would expect from a high-income country with a rapidly-ageing population. But the situations of China and other East Asia are more interesting as they have only moved into significant surplus over the past half dozen years. 4/10 In the case of other East Asia , I think it is very clear that this occurred as a reaction to the pain they suffered during the Asian crisis of 1997/98. Both the Asian private and government sectors cut back sharply and this shows up as a fall in the investment ratio of about 7 or 8 per cent of GDP to a lower level, at which it has stayed (see Graph 3). The governments of the region reached the conclusion that they “had to make their economies more resilient to international capital flows. The simplest way of doing this was to cut expenditure (particularly investment expenditure), keep savings high, run current account surpluses and build up international reserves”.4 Macfarlane (2005). 5/10 In China 's case, the story is more complicated.5 It did not suffer in the Asian crisis, but it still absorbed the same lesson as the countries that did. That is one of the reasons that China has chosen to run current account surpluses and build international reserves. But a more over-riding reason is the awareness by its government that, as a result of its economic liberalisation, it has to create about 20 million jobs per year just to absorb the exodus of workers from the countryside. In other words, it has to run its economy at an exceptionally fast pace, and is reluctant to adopt policies which might run counter to this aim in the short run, even if they would contribute to maintaining longer-run sustainability. See Dooley, Folkerts-Landau and Garber (2003 and 2005) for an interesting account of the Asian approach to balance of payments adjustment. 6/10 I think historians will regard the economic liberalisation of China as the major economic event of the past 30 years, with its effects showing up in countries and economic variables that at first sight seem remote from it. To date, the size of the Chinese surpluses have been smaller than for Japan and other East Asia , but China 's influence in other ways has been greater. All Asian countries are acutely aware of their level of competitiveness vis-à-vis China, both in international trade and investment, and this is an additional reason why they have resisted appreciations of their own currencies. The rapid increase in Chinese manufactured output and exports, based on its exceptionally low labour costs, has affected its competitors in Asia as much as its customers such as the United States. (iii) Low central bank interest rates The high supply of Asian savings is not the explanation for the sharp fall in central-bank-determined interest rates in 2001 and 2002. That fall was a response by central banks in the developed countries to the collapse of the global equity market boom and associated recession that occurred in most of their countries. But the interesting question is why did those interest rates go so low; for the United States , Japan and the Euro area they fell below their 1930s levels. And why have they stayed so low, even accepting that the United States has gone some way to restoring them to a more neutral level? The answer has to be that inflation has remained so low. If inflation had picked up in the way that it did in earlier cyclical recoveries, central-bank-determined interest rates would have risen more by now. So the real issue is why have inflationary pressures stayed so low? An ex ante excess supply of world saving means that it would be unlikely for a situation of generalised excess demand in the world's goods markets to occur, and hence for inflationary pressures to emerge. Another way of thinking about this is to remember that a surplus of savings in a given country means that the country is producing more goods and services than it absorbs in domestic spending. In China's case, there has been a massive increase in its capacity to produce manufactured goods, and its domestic spending has not kept pace with the expansion in supply. The result has been a rapidly growing supply of lowcost manufactured goods supplied by China to the rest of the world. The same has been true on a smaller scale for other Asian countries running surpluses. The increased productive capacity in China and other parts of Asia can be seen as part of the mechanism by which their trade and current account surpluses have been exerting downward pressure on global inflation. 7/10 (iv) Why bond yields have remained at historically low levels The fact that bond yields have remained low despite rising oil prices and the Fed raising short-term interest rates is really the nub of the issue. If excessive US spending and inadequate saving were the main story affecting the world economy, bond rates would be rising not falling. Clearly, developments in the bond market are far more consistent with a world of plentiful saving than one of excessive spending and borrowing. The low level of nominal interest rates may be partly explained by the forces already cited which have held down inflation. But real interest rates have also fallen to extremely low levels.6 (Graph 5). Thus, it is not only inflation and inflationary expectations that are at work – the real demand and supply for borrowed funds must have changed. In economic terms, a fall in price suggests that the supply curve of saving has moved outwards relative to the demand curve. (v) Why risk margins have narrowed Again, this is entirely consistent with a world of excess supply of funds looking for attractive yields. With yields on high quality government paper having been driven down to low levels, investors have been attracted to other securities that can offer something higher. Thus, margins on all grades of corporate debt and emerging market debt have been driven down. This has occurred despite the recent history of US corporate scandals and the default by Argentina, which would normally have heightened perceptions of risk in these securities. Of course, this search for yield has not just affected debt; it also explains rising prices on assets of all types from houses to equities as investors take advantage of low borrowing costs and seek alternative investments. Only in periods of unanticipated sharp rises in inflation have they been lower. 8/10 4. Two counterfactuals Some observers may think that in my explanation of global developments, US profligacy and excessive reliance on debt have been let off too lightly. What, they may ask, would have happened if increased US spending and reduced savings had not been accommodated by Asian saving and lending? The answer is that the increased US spending and lower US saving would not have occurred, or would only have occurred on a greatly reduced scale. If the excess world saving had not been available, the global economy would have been in the opposite position, namely excess demand in goods and capital markets. US demand for funds would have pushed up bond rates, inflationary pressures would mean US monetary policy would be tighter, and the US Government would have difficulty funding its budget deficit. Businesses and households in the United States would face tougher monetary and fiscal policies and spending would be more restrained. Despite higher US interest rates, the US dollar would probably be weaker because foreign demand for US assets would be lower. The US current account deficit would be smaller due to the weaker domestic demand and lower US dollar. It is not clear whether the world economy would be weaker or stronger. On the one hand, the extra Asian spending would have pushed up world demand. On the other hand, higher inflation, higher world interest rates and reduced US spending would have held it down. But the imbalances in international payments would have been smaller. I do not want to give the impression that the large US current account deficit is not an imbalance, or that it can go on rising forever. Clearly, that is not the case. My view is only that we should not start our analysis with the US current account, or look to its remediation as the key to unwinding the imbalances. For example, the most commonly heard prescription is for the United States to reduce its call on world savings by reducing its fiscal deficit. However, if my analysis is correct, a reduction in the US fiscal deficit by itself would be unlikely to have a major impact on international imbalances.7 In the absence of policy changes in Asia, the Asian countries would be likely to continue running surpluses, and so a fiscal contraction in the United States would only add a contractionary influence to a global economy already characterised by surplus saving and unusually low interest rates. Another view that has recently been put is that it was excessively loose monetary policy rather than saving/investment imbalances that was at the heart of the problem. This view is generally bolstered by some reference to excessive liquidity, although the concept is left undefined. I do not find this argument at all convincing. There is no doubt that world interest rates have been exceptionally low, but does that of itself mean that monetary policy has been exceptionally loose? To maintain this view, you would have to believe, for example, that monetary policy in Japan and Europe , where there has been weak demand growth and negligible inflation for a number of years, should have been tightened, i.e. European and Japanese interest rates should have been raised. This would make no sense. The low level of interest rates in most developed countries is not the first cause of the global imbalances, it is the result of them. 5. Conclusions In making Asia the focus of my account, I hope I did not give the impression that I am blaming Asia for the imbalances. This is not the case, partly because I have never been a pessimist about the sustainability of the imbalances, and partly because I can sympathise with much of the recent Asian experience, particularly during the Asian crisis. My account takes its form purely from the fact that it is the only one that seems to me to be consistent with the five questions I posed at the beginning. It is the only one that explains why there is downward pressure on CPI inflation and interest rates, and in consequence upward pressure on asset prices. As a central banker, I cannot complain about these events because they have made my central task of maintaining low inflation easier. Similarly, as an Bernanke (2005A) reported a Federal Reserve study which estimated that balancing the federal budget would reduce the current account deficit in the medium term by less than 1 per cent of GDP. The IMF estimate that a permanent 1 percentage point of GDP improvement in the US budgetary position would lower the current account deficit by ½ of one per cent of GDP. 9/10 Australian, I can see that the impressive economic development of Asia has benefited our complementary economy in many ways. I have not provided any assessment of the risks involved in the current situation because that would involve another talk at least as long as tonight's. But, if it is any reassurance, I think we are seeing some early signs of a return to normality, even if they are small and the process likely to be a long one. The Fed's policy of gradually moving up US interest rates towards neutrality is the most obvious sign. The other one is China 's abandonment of its fixed parity to the US dollar. Although its upward movement so far is extremely modest, they have clearly set the direction for the future. To me, it is an extremely significant move and suggests that they will countenance policy changes which in the short run might slightly restrain demand, but in the long run increase the chances of sustainable growth. 10/10 | reserve bank of australia | 2,005 | 9 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Tasmanian Chamber of Commerce and Industry Business Dinner, Hobart, 11 October 2005. | Glenn Stevens: Economic conditions and prospects, October 2005 Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Tasmanian Chamber of Commerce and Industry Business Dinner, Hobart, 11 October 2005. * * * It is nice to be in Hobart and I thank the Tasmanian Chamber of Commerce and Industry for the invitation. It is now a couple of months since the Bank released its most recent quarterly assessment of economic conditions, at which time some of our staff paid one of their regular visits to Tasmania to consult with local businesses. So I intend to offer a brief instalment in the unfolding narrative of the economy, with the benefit of an extra couple of months' information. Of course, a few weeks from now we will release our next full Statement on Monetary Policy. I won't try to preview that in detail, but rather pick on one or two issues of note. I'll begin with the world economy. The world economy Graph 1 The year 2005 is turning out to be another pretty good one for global growth. In its recent World Economic Outlook released during late September, the IMF estimates growth in 2005 to be about 4¼ per cent. That is lower than in the preceding year, but 2004 was exceptional: in that year, we saw the fastest global growth in three decades. At this point, 2006 is thought likely to be another good year, though that forecast would be sensitive to events in the next few months. The US economy continues to expand at a good pace. The recovery from the dot-com-bust recession of 2001 has been quite strong, notwithstanding periodic talk about 'soft patches'. The US now, once again, stands pretty close to full employment. The US central bank, having been prepared to lower short-term interest rates dramatically to alleviate the downturn, is now well advanced in the process of returning them to normal, as they must if the economic expansion is to continue for an extended period. Meanwhile, China has continued to grow rapidly, despite fears of a slump at various stages. Japan – for years a dragging anchor on global growth – has posted some better numbers over the past year or so, and the debilitating effects of asset price deflation and balance sheet deterioration may finally be starting to wane. Japan looks more likely to be able to sustain growth now than at any time in over a decade. Elsewhere in east Asia, results are a bit mixed but in general show fairly healthy growth, though not at the pace seen for many years prior to the crisis of the late 1990s. The economy of continental Europe 1/8 remains a major disappointment both for its own citizens and policy-makers, and for those elsewhere looking for the global recovery to be a bit more balanced. Beset by the effects of ageing, high levels of government debt and great difficulties in achieving structural reform, the old continental European economies are struggling to keep up with the newer, more dynamic countries joining the European project from the east. At the same time, global rates of inflation remain low. Across about 50 significant countries around the world, the median inflation rate is about 2½ per cent. The scourge of the 1970s and early 1980s has been well and truly contained in most countries; there are relatively few really high inflation countries now. At the same time, the incidence of deflation (never that wide) has diminished in the past couple of years. Graph 2 There is, of course, the likelihood that the big rise in oil prices will push inflation up over the coming year, and some commentators are beginning to worry that this could be the start of an undesirable trend. Much will depend on how economies and policy-makers respond to the rise in oil prices, a subject to which I shall return shortly. For the moment, what is remarkable is that the rise in raw material prices over several years has not already pushed inflation rates up more than it has. It is partly as a result of this general climate of price stability that nominal long-term market interest rates are at 50-year lows. But even in real terms, long rates are unusually low. Apparently, financial markets have a very benign view of the risks associated with the medium-term outlook. 2/8 Graph 3 Given the prominence of discussion about 'global imbalances' – by which people mean the dependence of the global expansion on the strength of the US and China, and the rising current account deficit of the US – it is all the more remarkable that financial markets seem so sanguine. But as stated by the Governor1 a couple of weeks ago, a more careful analysis of the 'imbalances' shows that high rates of saving and low rates of investment in Asia have produced a very low cost of capital for the developed world, to which the US economy has responded, with the US current account deficit a natural result. While everyone agrees this cannot continue forever, forever is a long time and it may well continue for a while yet. It has already gone on much longer than many predicted would be possible, and for it to change, behaviour in Asia, as well as in the US, would need to alter. All of the above have been part of the scene for some time now, and were part of the state of play as of early August when we last gave our full views. What has changed of late? The questions that will naturally be on most people's minds are: what will be the effect on the US and global economies of Hurricanes Katrina and Rita? And what will be the effect of rising oil prices? Hurricanes Clearly these were first and foremost human tragedies on a massive scale, though thankfully, the death toll looks like it is turning out to be much smaller than was feared early on. As for the economic effects, clearly business activity has been hampered in the areas directly in the path of the hurricanes, though the impact of this on the US economy as a whole doesn't seem to have been particularly large. Longer term, those parts of the US capital stock which were damaged or destroyed need to be repaired or re-built. This will be expansionary as it adds to the demand for real resources. To give some perspective, estimates of damage seem to be around US$200 billion. If it took three years2 to do all the reconstruction, then we would see an addition to the level of demand equivalent to about half of one per cent of US GDP during that period. This would be in an economy which, just before the hurricanes hit, was travelling pretty well according to recent data. ‘What are the Global Imbalances?' (see http://www.rba.gov.au/Speeches/2005/sp_gov_280905.html). In the case of Cyclone Tracy, which happened on 24–25 December 1974, Darwin's pre-cyclone population numbers were able to be housed again by about the middle of 1978 (see http://www.ntlib.nt.gov.au/tracy). Following Hurricane Andrew in August 1992, surveys suggest that about two-thirds of displaced residents had returned to their homes by August 1994. Most of those who had not did not intend to do so (see Smith, Stanley K. and Christopher McCarty, ‘Demographic Effects of Natural Disasters: A Case Study of Hurricane Andrew', Demography¸ Vol. 33, 1996, pp. 265–275). 3/8 Energy prices A second key aspect of the hurricanes, of course, was that they damaged some very important infrastructure in the US energy supply chain, which happens to be concentrated along the Gulf coast. To some extent this has been addressed by the release of oil from stockpiles, and indeed the price of crude oil is now, if anything, a bit lower than it was immediately before Hurricane Katrina. The bigger problem is that the Gulf coast area has a large share of US refining capacity, which also suffered substantial damage. Hence the margin between crude oil prices and wholesale prices for refined products rose sharply, so Americans (and, for that matter, consumers elsewhere) saw substantial rises in prices at the pump. Graph 4 The effect of this, assuming other things equal, is to raise households' cost of living and transportation costs to businesses. Any number of commentators will remind us that, because it is hard for consumers rapidly to alter their behaviour away from using gasoline, they will, to some extent, simply have to pay the higher prices and spend less on other things. This imparts a mild contractionary impact on aggregate demand. That's true, but over time, consumers can adapt their behaviour (towards more fuel-efficient cars, for example) to lessen the real income loss. Most importantly in the US, the impact of the re-building will steadily make its presence felt. So there is a complex set of forces operating on the US economy, some contractionary but others expansionary. For those other economies who are net energy importers, the expansionary impact of the re-building is of course absent, so they are left with the uncomfortable combination of higher prices and slower growth, at the margin, than would otherwise have occurred. But it would be a serious mistake, I think, to focus on the effects of the hurricanes on energy prices in isolation. The fact is that energy prices had been rising for some time, as growing demand stretched supply capacity, before the hurricanes occurred. It is no secret, either, that Asia has been a major source of additional demand for oil (though demand in the US has also risen). Of the rise in global demand since 2000 of over 7 million barrels per day, about 3 million barrels has come from Asia, and almost 2 million from China alone. Nor is it only energy prices which have been rising. A great many prices of resource-type commodities have been rising quickly, largely for the same reason as oil prices: Asian and especially Chinese demand has stretched supply capacity. Yet this has not derailed the global economic expansion. Unlike the OPEC oil shocks of the 1970s, when the supply of oil was sharply curtailed, creating significant disruption for economic activity, over the past few years the supply of oil has been increasing – just not fast enough to accommodate rapidly rising demand at the old, low price. Far from crippling global growth, the higher price of oil reflects strong growth. Higher oil prices do reduce growth compared with what might have been possible had the supply of oil been perfectly elastic, but even with that reduction, the world economy is recording quite good growth. One illustration of this is that, eighteen months ago, the IMF forecast of global growth for 2005 was 4.4 per cent, with oil prices assumed to be under US$30. The latest estimate for 4/8 2005 is virtually unchanged at 4.3 per cent (with the same again expected in 2006), but with an average oil price now assumed to be US$54 in 2005, and US$62 in 2006. Monetary policy and oil prices How should monetary policy, in particular, respond to rising energy prices? Traditionally, policy-makers have abstracted from the effects of short-term fluctuations in oil prices. The case for doing so was that these swings are often driven by temporary supply-side disturbances. It would not make sense for monetary policy, whose effects take several years to play out, to respond to price fluctuations which might be reversed within a matter of months. Fluctuations in prices for some other things affected by supply disturbances – like fresh food – are treated the same way. It is for this reason that many central banks compute measures of 'core' or 'underlying' inflation – it helps us get a better idea how overall inflation will look when temporary disturbances have passed from the scene. Similarly, in cases where there is a large, permanent but one-time change in the level of energy prices which occurs because of a change in supply, it is not feasible for monetary policy to offset the immediate impact on the overall price level. Policy-makers in that situation will focus on ensuring the on-going rate of change of prices settles back fairly promptly. This means they will typically respond to signs of second-round effects which might emerge if, say, other prices or wages began to change in response to the initial oil price effect. But where there is a persistent trend for some particular price to rise quickly over a longish period because demand is strong, the case for ignoring that is weak. If oil prices, for example, rise quickly every year, it isn't really credible to abstract from them every year. Rather, the question is simply one of whether the combined set of all price movements, whether driven by energy prices or any other influence, will cause the CPI to rise quickly for an extended period. If the answer is yes, then that is called inflation, and is prima facie evidence that policy-makers should take action. If the answer is no, perhaps because non-energy prices are moving in an offsetting way, then price stability is being maintained, and there is no particular implication for policy. In recent years, policy-makers in most countries seem generally, thus far, to have felt that rising oil prices will not threaten medium-term inflation performance. This was partly because there was always thought to be the possibility of some reversal in the oil price itself, but also because overall inflation rates in most countries have remained quite low so far, despite energy price rises. While the strong growth in energy demand in Asia for several years has contributed to inflationary pressure through higher prices for oil, Asia has also contributed to deflationary pressure via its growing role as a supplier of manufactures and, increasingly, services. The fact that the overall rate of inflation through this period has been fairly well behaved, despite strong global economic growth, is distinctly in contrast to the situation prior to the OPEC episode in 1974. In that instance, inflation in most countries was already increasing before the rise in oil prices occurred. At issue, then, is whether that situation could change in the near future. It is doubtful that the hurricane-related shock per se would make a large difference. The bigger questions are, first, will the effects of the large cumulative rises in energy prices over several years continue to be accompanied by moderation in other prices, including international prices for traded manufactures and services, so keeping overall inflation in check? And second, will hitherto well-anchored inflation expectations – an important determinant of price and wage behaviour generally – remain that way? Policy-makers around the world will grapple with these issues in the period ahead. For now, I shall turn to the Australian economy. The Australian economy The terms of trade The Australian economy, like all other industrial economies, is adjusting to higher energy prices. The thing we are hearing most about is the negative impact on Australian households as they bear higher costs for their personal transportation, and the effect on both the goods and services producing sectors of the economy as they bear another increase in costs of production and distribution. But unlike many industrialised economies, there is also a major positive side for the Australian economy in higher prices for energy and raw materials. For those with an income stake in the extraction of these 5/8 resources – such as oil, coal, gas, and a number of other commodities which are inputs into global industrial production – times are very good indeed. The aggregate summary of this situation is Australia's terms of trade, which have risen by over 20 per cent in the past two years alone, and stand about 30 per cent above their average of the period 1975– 2000. Graph 5 This is a very different story to those of most industrialised economies, for whom recent developments represent a decline in the terms of trade and hence national income. Terms of Trade Percentage change Past Two years Australia Norway New Zealand Mexico Canada United Kingdom France Singapore Germany United States Thailand Taiwan Sweden Japan 23.4 9.3 8.6 8.5 4.2 0.2 -3.7 -4.8 -5.0 -7.0 -9.5 -12.6 -14.3 -16.6 Sources: ABS, Thomson Financial 6/8 The trade sector is just over one-fifth of the economy. So a 20–25 per cent gain equates to about 4–5 per cent of GDP – say, $40 billion – in additional annual income that is available. Part of that income accrues to foreign investors who have ownership stakes in resources enterprises, but a substantial proportion remains for Australians as shareholders, employees and citizens (via government taxes). There can be little doubt that this adds considerable buoyancy to the economy which would not otherwise be there. The first-round effect is clearest in the regions where resources have the greatest weight in economic activity. But there are still impacts around the rest of the country – for example, through the consumption of higher resource-derived incomes, and higher investment by the resource producers. Indeed, the prospects now appear to be for a significant expansion in capacity in various resource production areas, judging by the forward-looking indicators of capital expenditure. That will continue to exert stimulus for a range of other businesses around the country. Housing market These income gains have accelerated over the past two years, at a time when the dynamics of the Australian housing market have changed. From 1996 to 2003, Australian households borrowed at a rapid pace for the purposes of owning dwellings, either to occupy or to let out. The median price of dwellings in Australia rose in parallel, by 120 to 150 per cent, depending on the price measure used.3 The peak in prices nationally was about two years ago now, in the last quarter of 2003. Since then, median prices have risen further in some regions, but have fallen a little in Sydney and Melbourne, to give a flat performance for the national median price. This has been associated with a slowing in the pace of borrowing, particularly on the part of investors, though the rate of growth of outstanding credit remains, if anything, somewhat higher than one would expect to be a sustainable pace in the long run. This has been associated with a waning of an apparent wealth effect which had been in operation, where consumer spending rose faster than income for a number of years and household saving rates declined.4 Some estimates suggest that, in net terms, households actually withdrew some of the accumulated equity in the dwelling stock during the early years of this decade, a small proportion of which was probably used for consumption purposes. (The rest appears to have been placed into financial assets.) But since mid 2004, consumption spending has been proceeding in a more moderate fashion. At 3 per cent growth over the past year, it has been rising more in line with income. That is not a particularly weak outcome in any absolute sense, but it is a quite notable slowing from the earlier 6 per cent pace. It is quite fortuitous, of course, that this adjustment has coincided with the large income gains from the terms of trade. A scenario where the housing boom had gone on for two or three more years and then turned down at the same time as the terms of trade began a cyclical fall would have been much less attractive. Petrol prices I noted earlier that worldwide, rising energy prices over several years did not seem to have pushed up inflation much, so far, partly because there seemed to have been moderation in other prices. This same point can be nicely illustrated by Australia's Consumer Price Index. The chart below shows the change in the CPI, at the sub-group level,5 over the past two years. The figures are up to June 2005; new data for the September quarter will be published the week after next. In Tasmania, house prices rose by less over the same period though they have continued to rise of late. Tasmania still enjoys relatively lower costs of housing than the mainland. Not unrelated, I presume, is the trend in recent years for net interstate migration to, rather than from, Tasmania. Literally speaking, according to the national accounts, household spending on consumption has exceeded income for the past three years (i.e. saving was negative). This calculation includes an allowance for notional depreciation of the dwelling stock (which is treated as consumption of capital), but even in a gross sense, household saving, while positive, has been low. Here I separate automotive fuel from the transportation sub-group. 7/8 Automotive fuel prices had risen by about 23 per cent over the period. But a number of items which are affected by strong international competition had fallen in price. These include most electronics categories, household appliances, clothing and footwear, and furniture. Of course, changes in the exchange rate, and in particular an appreciating $A in 2003, have had an effect here, as have tariff reductions, but there is no doubt that competition from abroad has been intense. So while the growth in demand for energy in China and the rest of Asia has added to petrol costs, the rising production of manufactures in those countries has reduced other prices. The total CPI rise over the two years was 5 per cent, or 2½ per cent per year, which is exactly in line with the Bank's inflation target. Graph 6 We will get an update to this picture when the CPI and PPI data for the September quarter are published. The direct impact of the recent high energy prices will presumably be evident in the result. Over a somewhat longer horizon, there might be some indirect impacts of the higher energy costs – through the transport system, for example. Just how big these turn out to be will presumably depend on, among other things, whether demand conditions allow businesses simply to pass on energy and transport cost increases, as opposed to absorbing them by finding offsetting cost savings or accepting narrower profit margins. Longer term, the question to be asked is whether inflation – be it as a result of rises in energy costs, or from any other source – is likely to diverge persistently from a rate of 2–3 per cent. Apart from energy prices per se, factors to consider in assessing the outlook will be trends in international prices, the likelihood of temporarily higher CPI rises prompting second-round effects via, for example, higher wage claims or other cost increases, and the strength of aggregate demand in the economy. The Bank will publish its full updated assessment in its Statement on Monetary Policy on 7 November 2005. Conclusion The Australian economy is in its fifteenth year of expansion, having weathered a number of shocks, both favourable and adverse, during that time. The gradual correction of the housing excesses of the early part of this decade has gone well so far. It is our good fortune that this is unfolding alongside a global scene which is quite favourable at present. Even though there is undoubtedly a cyclical element to the international environment which will wane in time, I suspect that the growing weight of resource-hungry Asia will mean that our terms of trade will be higher on average in the next decade than they were in the last quarter of the twentieth century. The issue before us in the next year or two is whether the world and Australian economies can adapt to higher energy and resource prices without a significant bout of inflation. If we can, then in a year or two from now, the TCCI will be hearing about further opportunities for businesses and their employees, both in Tasmania and around the nation, to create the sustainable prosperity we all seek. 8/8 | reserve bank of australia | 2,005 | 10 |
Address by Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Asian Economic Panel hosted by the Lowy Institute for International Policy and the ANU Centre for Applied Macroeconomic Analysis, Sydney, 14 October 2005. | Glenn Stevens: Asian financial co-operation Address by Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Asian Economic Panel hosted by the Lowy Institute for International Policy and the ANU Centre for Applied Macroeconomic Analysis, Sydney, 14 October 2005. * * * It is a pleasure to take part in this Asian Economic Panel meeting, amid such a distinguished group of scholars and colleagues from the Asia Pacific region. For this brief session, I would like to offer a perspective on financial co-operation in Asia. Following the financial crisis which engulfed east Asia in 1997-98, many observers concluded that the region lacked effective mechanisms for co-operative responses to shocks, and particularly lacked a set of regional institutional arrangements which could withstand the vagaries of international capital flows. There were some avenues for co-operation or regional channels for assistance – some regional partners contributed to packages to assist Thailand, Indonesia and Korea for instance. But these were generally organised on an ad hoc basis, and in the context of IMF programs rather than any regional framework. More importantly, they could not directly address the underlying vulnerabilities, such as under-developed local capital markets, small financial systems and economies relative to the potential size of capital flows, weak banking systems and the like. That underlying dissatisfaction, coupled with disillusionment over the response of the global institutions, lies behind the attempts to do more to build up regional financial architecture since then. With that background, I'd like to address three questions. First, what do we mean when we use the term 'regional co-operation?' Second, I will ask how much has been achieved? And third, where to from here? What does 'co-operation' mean? Strictly speaking, we should distinguish between co-operation, co-ordination and integration. These are, of course, not the same, though they arguably lie on a continuum of engagement: it is one thing to co-operate, but to co-ordinate involves, as well as co-operation, a greater degree of commitment to adjust policies, while integration involves, in extremis, a degree of co-operation and commitment sufficient actually to cede sovereignty over one or more arms of policy. Taking that spectrum as a reference point, we can distinguish six, progressively stronger, degrees of financial co-operation between countries. First, is the sharing of information. This sounds straightforward enough but it actually takes a lengthy period of regular contact among senior officials, policy-makers, academics and so on to develop the sort of constructive and frank sharing of information that is really the foundation for genuine engagement. Sharing of information is more than just the exchange of facts and figures; it is learning about how other economies work, about how other policy-makers think, and about which approaches in the other countries have worked, which did not, and why. In a crisis, there must be timely sharing of market intelligence. Most important, if there is ever to be any prospect of collective action in response to regional problems, there has to be a shared analysis of what the problem is. The capacity to form that sort of analysis does not exist naturally; it has to be developed. The second degree of co-operation is having a set of arrangements to lend money in times of trouble. When one or more countries face the pressure of capital outflow, with associated downward pressure on their exchange rates, the idea is that these agreements provide a sense of mutual support which could increase market confidence. Generally, such arrangements increase the availability of resources to a country under pressure, though by a limited amount. Funds are usually available with conditions, at the discretion of the lender and with most of the risk remaining with the borrower. Going the next step involves joint work on improving the operation of local financial infrastructure. This can be viewed as harmonisation (i.e. as a mild form of co-ordination) which facilitates people managing their affairs across national boundaries more efficiently. This could potentially involve everything from listing requirements, tax treatment, arrangements for supervision of financial institutions, and so on. But policies are still made at national level and it is not necessary to have a 1/4 goal of harmonisation per se to think this sort of work is useful: it might simply be an effective device for improving the functioning of the individual local economies. The fourth degree of co-operation would be based on some agreed common goals, most likely some sort of regional effort to stabilise exchange rates. Here we are definitely talking about a form of policy co-ordination. In the pre-EMU European context, there was a mutual obligation to defend regional parities. This system was silent, notably, about the situation where all European currencies rose or fell together against the dollar. In principle, this would leave monetary policy remaining focussed on domestic objectives. One can then distinguish a fifth degree, in which that constraint is dropped and it is explicit that domestic policies will be adjusted to help achieve exchange rate goals agreed between the countries – a stronger form of co-ordination. The gold standard was such an arrangement, under which domestic objectives were subordinated to the collective objective of maintaining external stability. The sixth, and most extensive, form of co-operation is where individual countries cede control over an arm of policy to an international body, which conducts that policy in pursuit of a collective goal. In the monetary sphere, this would be monetary union, as in the Euro area, conducted by a regional central bank, and with a highly integrated payments system: a strong form of financial integration which, it is sometimes argued, could foster broader economic integration. What has Asia been doing? Within that framework, we can then ask: what has Asia been doing since the crisis of the late 1990s? The answer, essentially, is that it has been doing more of numbers 1 and 2 of the above, which were both occurring prior to the crisis. In addition, a lot more attention is being paid to number 3. There were various exercises in information sharing already in operation before the crisis, but these have intensified. ASEAN has a history of several decades, and ASEAN+3 has built on that to become an important forum. In the central banking world, the EMEAP1 group has been meeting regularly since 1991, but the scale of that work has grown significantly in recent years. There are regular meetings of finance ministry officials, numerous bilateral contacts, and of course meetings of the more academic variety, as you are having here today. There are more and more regional meetings and conferences. I simply re-iterate the point that the value of this will be maximised if we keep in mind the need to find, ultimately, a shared analysis of regional issues. That has to be a foundation of genuine co-operation. On the second form of co-operation, lending money in times of trouble, there has also been progress. Prior to the Asian crisis, there was a network of US dollar repurchase agreements between the EMEAP central banks. This was basically a symbolic exercise in the early days of Asian financial cooperation, around 1996; the arrangements were not activated during the crisis. Prior even to that, there was the network of foreign exchange swaps between the ASEAN countries which dated back to the mid 1970s, though these were small in size and had not been used since 1992. After the crisis there was, of course, the Chiang Mai Initiative, a series of bilateral foreign currency swaps of considerably larger size, under which a central bank would offer US dollars or its own currency to another central bank in exchange for a corresponding amount of that other country's currency. The nature of such swaps is that no foreign currency risk is run by either country in the swap itself: the rate for the reverse transaction is contracted in advance. Of course if the borrowing country sells the borrowed foreign exchange in order to support its own currency, it is then running a foreign exchange risk and the country initially supplying the funds is running a credit risk. The CMI swaps are mostly quite conditional – only a small portion of the money can be accessed without there being an IMF program in place in the borrowing country. That proportion is to be raised, but even then the bulk of the funds will still be conditional. The overall size of the lines is being increased, and there is discussion about a collective activation arrangement, as opposed to the current one where the parties to each bilateral line presumably negotiate over activation. Executives' Meeting of East Asia-Pacific Central Banks. 2/4 This is certainly a useful step towards financial co-operation, and has considerable symbolic value. But it remains exclusively a lending facility, where the additional resources available to a country under pressure can only be used by taking considerable risk. There is no obligation on the other countries to make market purchases of the weakening currency. Moreover, the CMI swap network has not yet been tested, and it is probably only workable when one or two countries come under pressure. If a number of countries are simultaneously experiencing pressure from capital markets, it would be only natural to expect a degree of reluctance to take on any additional obligations in defence of their neighbours. Hence, there still seems to be a perceived need for a large degree of self-insurance in the region (i.e. accumulation of large reserves of foreign currency). Efforts have also been made to accelerate the development of financial infrastructure. Work under the banner of APEC (Asia-Pacific Economic Co-operation) is seeking to promote securitisation and credit guarantee markets. The ASEAN+3 group is working towards the issuance of local currency debt by the multilateral institutions, with some success so far. The Asian Bond Funds 1 and 2, initiated by the regional central banks, have made good progress. The idea here is essentially to work out how to set up cross-border mutual-fund type structures to invest in bonds issued by regional governments and quasi-government authorities, and to show the way with a modest amount of central bank money. This is painstaking work. It involves such things as the development of customised bond market indexes, and efforts to remove the various small impediments that individual countries have managed, perhaps unintentionally, to put in the way of investors. As just one example, the Pan-Asia Index Fund component of the ABF2 is domiciled in Singapore, but listed in Hong Kong, the first time that has been done in Asia. This involved the relevant authorities working towards mutual recognition of their respective regulatory frameworks. ABF2 is a good example of the way a regional initiative can put the spotlight on local barriers to wellfunctioning local markets and exert some pressure for their removal.2 Indeed, to my mind, the value of these initiatives has been less the 'integration' aspect than the progress made in enabling eight local bond markets to function more effectively for foreign and domestic investors and, not least, for the governments and other borrowers of those countries. A well-functioning local-currency bond market allows a government much more economic policy flexibility than can be experienced when tied to foreign currency borrowing.3 And eight well-functioning, modest-sized, local bond markets amount to the same thing as a 'regional market' for most practical purposes. So in terms of developing the resilience of the region to the vagaries of international markets, there is value in increasing the capacity to provide financial support once a crisis hits. But I would argue there is more value in building financial infrastructure, through the activities in type 3 co-operation, which can make national systems more resilient in the face of shocks. Where to from here? What then of the future? In particular, what about steps 4 to 6? Is there any serious prospect of countries undertaking these higher levels of co-operation, or more correctly co-ordination and even integration, any time soon? There have been various calls for a common exchange rate policy, usually based around targeting a common basket, though to my knowledge there is no action plan currently available. One problem is that the interests of the countries are in some respects still rather divergent, not least because of the very different levels of economic development around Asia. There are a number of countries – China not least among them – whose prospective rates of productivity growth over the decades ahead will surely mean a substantial increase in their real exchange rate. Yet there are some others, such as Singapore or Hong Kong, who have already largely completed their productivity catch-up with the For a good discussion of this, see Guonan Ma and Eli Remolona (2005), 'Opening Markets Through a Regional Bond Fund: Lessons from ABF2', BIS Quarterly Review, June 2005, pp. 81–92 (at http://www.bis.org/publ/qtrpdf/r_qt0506g.pdf). Unhedged foreign currency debt, as was prominent in 1997, means that a fall in the currency pushes up debt servicing costs for the government, local corporates and banks, but a rise in interest rates to assist the exchange rate has the same adverse effect. Policy-makers can then face a currency crisis and a banking crisis simultaneously. A government which borrows in its own currency and encourages private borrowers to do the same has more options when its exchange rate comes under downward pressure. 3/4 advanced economies, and the associated real exchange rate appreciation. The idea that these two – who, of course, have very different exchange rate regimes at present, but both quite successful ones – would easily find an acceptable exchange rate linkage with the others is not one that is intuitively obvious. This point is strongest for these two cases, but I suspect it generalises further around the region. Moreover, most countries appear to me to remain determinedly focussed on the US dollar exchange rate. In other words, Asia is unlike pre-EMU Europe. The prime motivation for the European countries' exchange rate policies was to build monetary and financial stability inside Europe, rather than to follow a particular export-led growth model. In Asia, it is still the other way around: countries want financial and monetary stability, but they seem to want this within a US dollar zone. Presumably this is because they still place primacy on the export-led, FDI-enabled, model of economic growth, with focus on exports to outside the region. Another difference with Europe is that there is not a large bastion of economic stability within the region which is the obvious anchor for a currency arrangement. Until the mid 1990s, Japan might have been that country. But then Japan experienced a decade of stagnation, deflation, and concerns over financial sector solvency. Its government finances are also in a parlous state. Hence it seems unlikely that Japan could any time soon become the anchor currency of an Asian exchange rate system. The obvious potential candidate in the long run is China, but China does not presently maintain a convertible currency and does not have a forty-year record of economic and monetary stability the way Germany did by the end of the 1980s.4 And, as noted above, China has its own adjustments to make for some time ahead, in which others in the region might not want to share. Hence it seems unlikely, to me, that an Asia-wide exchange rate policy is likely any time soon. Most likely exchange rate policies will continue to be made with reference to the US dollar for a while yet. To the extent there is 'co-ordination' it will be accidental, as a result of similar activities by various countries directed towards managing exchange rates against the US dollar – with an eye, of course, on what their neighbours are doing. It would follow from this that the likelihood of a system of closer co-ordination in which domestic policies are allowed systematically to be affected by regional exchange rate concerns is pretty small. It further follows that the prospect for monetary union is quite remote indeed. Apart from the likelihood that some countries' real exchange rates will need to move a lot over the next twenty years to an extent that could be painful under a system of irrevocably fixed nominal rates, monetary union is a political as well as an economic decision. Indeed, for Europe, it was overwhelmingly a political decision (which is not to say it was wrong). You would all be able to judge better than I but my guess is that Asia's political leaders are nothing like ready to make such a decision involving ceding sovereignty to a supra-national institution. That is not to say that there is not a lot of worthwhile co-operative work to be done. On the contrary, I think that there is much value to be gained by pursuing type 3 co-operation: working on making the financial infrastructure reasonably consistent, well understood and easy to use for investors across the region. The reason for this is only partly to foster cross-border activity; it is also, in my view, because it is in the interests of each of these countries to have well-functioning (local currency-based) markets. This is much less glamorous than talking about regional exchange rate initiatives, but for some time ahead at least, is likely to have more pay-off. I do not wish to speak against sensible thought being given to more ambitious ideas. Preparations for joint exchange rate policies or monetary union take a long time. To make an informed decision at some (distant) future time, then, a lot of work would have to be done in the interim, and there is little harm in doing some over the coming decade. But we should take care that such work does not draw too many resources away from efforts in some of the less exciting areas which will have a concrete and timely pay-off. Germany’ s longer-run record, of course, was much more problematic: three hyper-inflations in the first half of the twentieth century was probably what seared into the collective German psyche the need for monetary stability. 4/4 | reserve bank of australia | 2,005 | 10 |
Remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the APEC Business Advisory Council, the Asian Bankers' Association and the Pacific Economic Co-operation Council Symposium on Promoting Good Corporate Governance and Transparency in APEC Financial Institutions, Melbourne, 19 October 2005. * | Glenn Stevens: Governance arrangements for effective public financial policies – a central banker's perspective Remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the APEC Business Advisory Council, the Asian Bankers' Association and the Pacific Economic Co-operation Council Symposium on Promoting Good Corporate Governance and Transparency in APEC Financial Institutions, Melbourne, 19 October 2005. * * * There is, these days, a great deal of discussion about corporate governance. This is largely because governance arrangements thought (with hindsight) to be deficient shared the blame for some spectacular corporate failures in the latter stages of the US tech boom of the late 1990s. Of course such problems are not that new. Indeed, one could safely assert that governance problems, broadly defined, can be found in the margins of most of the financial debacles of history; on plenty of occasions, they played a starring role. In Australia's own case, the collapses of the empires of some of the celebrated 'entrepreneurs' of the 1980s revealed serious failures of a governance nature (though not only of that nature). Given that so much has been written on the topic, there is probably not much that I could say which would be new. In fact, the most important principles of good governance are surely little changed over the long run of history, and are mostly simple good sense, combined with integrity. A sense by directors of fiduciary duty, independence, honesty, diligence, accountability and assurance surely have always lain at the heart of good governance, be it in corporations, governments or the local school canteen. Much of the current work on governance seems to be trying to embody such principles in a more explicit framework. Rather than trying to extend any of that detailed discussion, I want to focus on a few high-level principles for governance arrangements affecting national financial systems. I will interpret the term 'governance' broadly, to include not just the structure of decision-making in organisations but the general set of arrangements in the system. I will speak from the perspective of a central bank – which is where my experience as a Board member lies. Let's begin by asking what we want from a financial system in a market economy. In brief, we want a set of arrangements which facilitate: • the intermediation of private saving and investment, fostering resource allocation so that saving earns the highest risk-adjusted return, and that those with the skills to deploy capital can get it, and at the cheapest price; • an efficient, reliable and safe way of making payments; • mechanisms for private economic entities to manage their risks (either paying others to take the risk or accepting payment to take on risk); • availability of suitable financing for public-sector activities; • the avoidance of financial crises, if at all possible, or, if not possible, at least minimisation of their severity. This is a rather ambitious agenda. For several centuries we have been groping towards better arrangements, and it would be arrogant to assume we have nothing further to learn. But we have learned a few things about the importance of governance. One is that in banking, while the normal principles of corporate governance apply, that is not quite enough. Banking isn't just any other business. Its role in facilitating the business of the nation means that when banking goes seriously astray, the economy suffers more badly than it would if, say, the retailing industry got into trouble (as serious as the latter would be). Hence, certain higher standards of prudence are required of banks than of the average corporate entity, and there is more intrusive supervision of their activities. This is very important, but I will say no more about it, since the Chairman of APRA will speak later this morning. 1/4 Let me focus instead on two other issues at more length. In particular, I shall cover first, governance arrangements for central banks, and second, relationships between governments and private financial markets. 1. An independent central bank committed to monetary and financial stability A key central bank commitment is to preserve the value of money. A system where people are prepared to part with their money in order to facilitate the deployment of capital rests heavily on the idea that when they get it back, its purchasing power is not eroded by high inflation. Central bank governance is critical to achieving that. The central bank must, of course, have an adequate legislative basis – a legal standing that gives it powers and defines its objectives, including price stability. But apart from that, about the most important governance condition is independence in the day-to-day conduct of policy, so that an appropriate focus on the long run can be maintained. The idea of central bank independence from the political process is widely accepted now in the western industrialised world. This is a result partly of academic thinking about the structuring of the decision-making process, but mainly of long experience of the alternative model. I am not sure whether such independence is as widely accepted in Asia. Of course, the need for strong independence so as to enhance anti-inflation credibility has not been as big an issue in Asia as in some other regions, because inflation performance in Asia has mostly been very good. But the same principle arises in the conduct of bank supervision, whether that be in the central bank or another body: the officials in charge need to operate within a clearly understood framework, but without political interference in their day-to-day decisions. Central bank independence needs to be more than just of the political variety though: it also means the central bank having a capability of resisting the short-termism of financial markets (and, for that matter, the occasional intellectual fad which emanates from academia). Key to a central bank's role in fostering financial stability will be a capacity and willingness, on occasion, to cast a sceptical eye on pricing of assets and risk, and to question the idea, always heard in times of euphoria, that 'this time it is different'. Naturally, this comes with countervailing disciplines on the central bank of a governance nature. With operational independence comes the requirement to inform the public what we are doing, and why, and an acceptance that we will face public and Parliamentary scrutiny for our actions. So communication, to facilitate accountability, is important. There are some differences between central banks here: some communicate more fully and more frequently than others. But the similarities are probably greater than the differences. In most cases these days, the schedule of decision-making meetings is known; the goals of policy are fairly clear; and policy makers release a great deal of information about the way they are reading the economy and why they took the decisions they did. Alongside this accountability comes an increased focus on the role, composition and processes of the body which makes the policy decision. In some central banks, that body is a group of full-time experts; in others, it is a single individual. In our own case at the RBA, the decision-making body includes a majority of non-executive directors who generally bring a wide range of expertise and experience from outside the specialised field of central banking. There is, from time to time, discussion about which set of arrangements is best, and reasonable people can and do differ on this. But experience seems to be that several types of decision-making structure can work acceptably well. The question 'who is on the board?' is important, but perhaps not as important as the questions 'what are the board's goals?' and 'does the board have the tools, and the independence, to pursue them?' It goes without saying that a central bank must also have the highest reputation for probity, which carries obvious requirements for the behaviour of board members, Governors, management and staff. But in addition, as in the commercial arena, it must also have, and be seen to have, strong formal internal governance processes – in financial management, audit (including external audit) and risk management – so as to be able to provide appropriate assurance to its community. As in the commercial world, risk management is a rapidly growing area in central banks. It is likely, moreover, that an increasing share of the assistance given to emerging market countries in the next decade will be in helping them develop their own risk management and auditing capabilities. 2/4 2. Arm's length dealing with financial markets The second key arrangement for a well-functioning financial system – again using a fairly broad definition of the word 'governance' – is that the public sector deals at arm's length with financial markets. In other words, markets set financial prices and allocate financial resources. There are two dimensions here. First, governments should pay the market price for resources that they seek to use for public policy purposes. This means borrowing in the market (if borrowing is needed) at the market rate, not at an artificially reduced rate from banks or the central bank. (This is, of course, a key element of central bank independence. A central bank can't seriously hope to run an independent monetary policy if the demands of government finance dominate its balance sheet.) For markets to be able to price government borrowing properly, they need some information about governments' intentions – a degree of fiscal transparency is required. Such transparency is a good 'governance' principle for public policy anyway; countries which have adopted it, including Australia, find this is ultimately repaid by governments being able to obtain funding more cheaply. Second, care must be taken when governments direct financial resources by using their ownership stakes in financial institutions. At early stages of development, there may be a strong case for extensive public-sector involvement, where the private system is in its infancy. This was seen to be the case in Australia in earlier times. But as time goes by and the private sector becomes more vibrant, the benefits of extensive public-sector participation have to be weighed against the problems that it can bring. One such problem is the potential conflict between being a participant in the commercial sector and a regulator of it. This was a feature of the RBA itself, which began life as a publicly owned commercial bank and then saw central banking functions grow in importance to the point where the two were separated in 1960. In addition to managing such potential conflicts, governments have to be mindful of the financial risks to which they can be exposed in having ownership stakes in financial institutions. There are a host of governance issues associated with public ownership of business enterprises, which have been extensively canvassed elsewhere.1 There seems no good reason for the general governance principles for publicly owned enterprises espoused by bodies like the OECD not to be applied where the enterprises are financial ones. These stress a strong legal framework, a clear role for boards, appropriate relationships with other shareholders, disclosure requirements, etc. But it should be stressed that in a financial institution, more so than perhaps in most other businesses, prudent management of risk is critical, and governance arrangements have a key role to play. In Australia in the late 1980s and early 1990s, governance of banks owned and guaranteed by State governments, in particular, evidently was not strong enough to ensure those banks and their associated entities were managed prudently. As a result, some State-owned banks got into trouble and the owners – i.e. the taxpayers – of two States bore the losses. This was funded by higher taxes for some years. Whatever good reasons there might once have been for publicly owned banks – such as, in Australia's early history, to engender some public confidence in the banking system in its formative stages, or (later) to provide competition for the private banks – the costs seem to have outweighed any benefits by this time. Today, there are no government-owned banking entities in Australia, and the principle of 'arm's length' dealing between governments and private financial markets is well entrenched. That allows markets to play their proper function in the long run of allocating resources effectively (even if not optimally at every moment). It also keeps public-sector entities focused on their roles as custodians and regulators of the system, without adding the conflicts and risks associated with being an owner of capital at risk in the system. See, for example, the OECD Guidelines on Corporate Governance of State-Owned Enterprises (http://www.oecd.org/document/33/0,2340,en_2649_37439_34046561_1_1_1_37439,00.html), or in Australia, Review of (Uhrig Report), the Corporate Governance of Statutory Authorities and Office Holders (http://www.finance.gov.au/GovernanceStructures/docs/The_Uhrig_Report_July_2003.pdf). 3/4 Conclusion These are just two of many elements in getting the institutional and governance structure right in a national financial system, and no doubt more can be said. But generally speaking, policy-makers will want to foster competition, disclosure of information and well-functioning private markets on the one hand, and strong and independent public policy institutions operating within a clearly articulated policy framework on the other. Particular care is needed in cases where public ownership of enterprises has the potential to compromise the public interest. I trust that your discussions on governance today will be fruitful. 4/4 | reserve bank of australia | 2,005 | 10 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at the Financial Planning Association of Australia Limited, Gold Coast, Australia, 16 November 2005. | Glenn Stevens: Finance and the ageing population Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at the Financial Planning Association of Australia Limited, Gold Coast, Australia, 16 November 2005. * * * There has been much talk about the phenomenon of population ageing in recent years. Some of the figures, on their face, are stark. As a result of declining fertility, and rising longevity, the median age of the world's population is increasing by about three months each year.1 In Australia, whereas today there are about five people of 'working age' for every person over 65 years, by mid century there will be just over two, according to ABS population projections.2 Assuming all other things unchanged, that implies a substantial impact on the rate of growth of per capita national income, and on the proportion of national income required to sustain the non-working part of the population. That, in turn, would raise thorny issues of income distribution and require careful management of the policies which affect that distribution. Whether such an assumption – that all other things remain unchanged – should be made is another thing altogether. Indeed, if we know anything about economic behaviour at all, it is that everything else won't remain constant in the face of such profound changes in society's age structure (forecasts of which, themselves, assume that recent fertility rates persist, even though we know that fertility rates have varied a lot, in both directions, in the past eighty years). Individuals, markets and economies will adjust to these changes. I would like to explore some of the possible adjustment issues today. Much of the discussion of the ageing issue to date in Australia has been about the impact on government budgets (a lot of which seems to come via the health system, rather than solely through age-specific payments per se). Those matters are important, but surely there will be counterpart issues for private financial markets. In addressing a group of financial planners, it would seem appropriate at least to pose some of those questions, even if we cannot provide many of the answers. What is ageing and why does it occur? In popular discussion we often hear about the ageing 'baby boomers'. This generation – those born between 1946 and about 1965 – is getting close to retirement. Indeed, some members of the leading edge of this cohort have presumably started retirement over the past few years, and many more will be thinking about it in the next few years. There has been considerable speculation about the impact that this may have had, and prospectively might have, on asset market prices and returns. Some commentators have attributed the share market boom in many countries in the late 1990s to the efforts of 'boomers' to accumulate assets in their high-income, immediate pre-retirement working years.3 There is a corresponding concern in some quarters that, as boomers move through their older years, they will sell assets to facilitate consumption, leading to a slump in asset values. There are a few problems with that story, not least of which is that saving rates have tended to fall, rather than rise, in the past decade at the time when boomers were supposed to be seeking rapidly to build their net worth.4 But there is no doubt that the baby boom is an important demographic phenomenon. It was the result of a surge in fertility rates during and after the Second World War, after UN Population Division, World Population http://esa.un.org/unpp/index.asp?panel=1). ABS Cat. 3222.0, Population Projections, Australia 2002 to 2101. See discussion in J. Poterba (2004), ‘The Impact of Population Aging on Financial Markets', in Global Demographic Change: Economic Impacts and Policy Challenges, A Symposium Sponsored by the Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, Kansas City, pp. 163–216 http://www.kc.frb.org/PUBLICAT/SYMPOS/2004/pdf/Poterba2004.pdf). Another is that, in cases where we have information on asset decumulation in old age, it has historically been much smaller than would be consistent with the basic life-cycle saving view of the world. If that continues to be true, the mooted slump in asset values as the baby boomers run down their savings might be a more modest, drawn-out affair than sometimes feared. Prospects: 1/6 The Revision Population Database a slump which had started in the early 1920s and extended until the mid 1930s. Baby boomer women themselves, on the other hand, had lower fertility rates than their mothers, so that the succeeding generation, the children of the boomers, is relatively smaller. Thus the boomers are disproportionately large in the age distribution compared with both the previous and succeeding generations, and as they age, all other things equal, the median age of society rises. But it is worth noting that there would be ageing even if the baby boom had never occurred. Declining fertility is a long-term trend observed in all countries as part of the 'demographic transition'. Indeed, maybe the baby boom is best seen as a temporary departure from the long-term trend decline in fertility, in which case it actually put off ageing by a generation or so. Furthermore, aside from the influence of declining fertility, increasing longevity contributes to ageing of the population. Importantly for financial markets and planners, life expectancy has continued to increase, presumably due to numerous factors including advances in medicine and nutrition, and healthier lifestyles (e.g. a large decline in smoking). So ageing is not just about the baby boomers, as prominent a cohort as they (or we) are. The effects of the baby boomers are superimposed on a longer, more profound, trend, and they will eventually pass (though, admittedly, that is still some time off). The more far-reaching and long-lasting economic effects of ageing will come about more from the effects of longevity and declining fertility than from 'boomer' effects. Why should individuals care about ageing? Insofar as ageing occurs because of increased longevity, it's hard to see it as a bad thing. Unless increased longevity is of the type that involves an elongated period of being seriously unwell before death, and there is no evidence that that is the case, it is surely a good thing. People can look forward to being productive at things they enjoy, to consuming goods and services, and to enjoying the non-pecuniary 'goods' of life for longer. The problem comes about simply because people have to make decisions with significant long-run consequences at various points in their life. They make decisions about saving and asset allocation through their lives. And, of course, one of the biggest decisions is when to retire from the workforce. If this decision is more or less irreversible, then the individual has to ask: have I got enough assets to last me until I die? Rising life expectancy undermines the assumptions typically made in this area. Since the mid 1970s, life expectancy at age 65 has risen by about four years, to about 83 for men and 86 for women. Quite possibly it will keep edging up at that rate. Consider then someone who is today about 50 years of age, and intends retiring a decade from now. By retirement, they will probably face a world in which they can expect to live five or six years longer than they would have anticipated (had they thought about it) when they started work in the mid to late 1970s. Which means, if they were planning to provide for their own retirement needs out of accumulated savings, based on assumptions made earlier in their lives, they quite possibly will find that they won't have enough. The fact that most of us didn't think about this when we started work, of course, won't help matters. This is a complex area, and I am conscious that all of you in this room have far greater technical expertise than I in the actuarial intricacies of retirement income sufficiency. But if we imagine an individual with an expected forty-year working life, and a plan to accumulate enough assets to provide a reasonable fraction of pre-retirement income after they retire, with plausible assumed saving rates and asset returns, we can ask what effect a rise in life expectancy of, say, five years would have on the calculations for asset sufficiency. Roughly speaking, there would need to be a rise in the saving rate of several percentage points of income through their whole working life. Alternatively, asset returns would need to be perhaps 50 to 75 basis points higher, risk adjusted, through their whole working life. A third possibility is that our representative person could simply accept a lower retirement income. Finally, he or she could decide to retire later than originally planned, so accumulating more assets and shortening the draw-down period. Some combination of these possibilities could also be adopted, of course. These sums are arrived at in a hypothetical, modelled situation for the representative individual. But in practice, for many people, by the time they realise that they will have a problem of insufficient assets, it is quite likely to be late in their asset accumulation phase. So they can't save a few extra percentage 2/6 points of income over their whole life; they would have to save a great deal more over a short period towards the end of their working life. Nor will extra yield equivalent to half a percentage point or more every year for forty years be easy to find, at least without taking much more risk (wherein lies a major issue). It would be even harder to find if everyone is simultaneously attempting to save more since rates of return would be bid down. Equally, most people would find the prospect of noticeably lower post-retirement income hard to accept. So, in the end, my guess is that while people will adjust their saving behaviour to some extent, and this will have an effect on financial markets, a large part of the adjustment to the recognition of increasing life expectancy will ultimately need to take the form of prolonging working lives. The existence of the old-age pension, on which people can fall back if their own funds are inadequate, naturally complicates the analysis. Even so, one way or another, surely increasing longevity means we will have to get used to the idea of retiring later than we might once have done. In fact, the rule of thumb is likely to be that the proportion of total expected life spent working will need to be roughly constant, as life expectancy increases. People will start to make that adjustment naturally. I think it is probably already beginning. Presumably a role for public policy is to foster the adjustment, by making sure that the retirement income system does not inadvertently offer incentives in the opposite direction. That is a big topic, and would take me outside my usual area of expertise. So I shall turn instead to some of the implications of ageing for financial markets. Why should financial markets care about ageing? We have established that, for individuals, ageing in the form simply of living longer means that earlier notions of retirement age and asset sufficiency will be revisited. We need then to think about the various effects on financial markets. For as individuals seek to adjust their own behaviour, including through saving, investment and work/retirement decisions, there will surely be effects on market pricing and structure. In a world in which people live longer and enjoy longer retirement, they will need to build a higher stock of savings with which to retire. For a given length of working life (an assumption to be relaxed in a moment), this would require a higher rate of saving in each of their working years, and lower annual consumption every year of their life. The total size of accumulated assets would be higher in every year of life than would be the case with shorter life-spans. The amount of savings to be invested in the economy would be higher. The question would then arise: how would the additional capital which becomes available be deployed, and by whom? And what price changes are required to induce them to do so? Businesses may be inclined to adopt a more capital-intensive production technology if the availability of labour diminishes relative to capital as the population ages. But economics teaches that this shift in the capital-labour ratio would be associated with a higher real wage, relative to the return on capital. This stands to reason: if the situation is one of an impending relative scarcity of workers and a relative abundance for saving looking for a use, then the relative prices of the two factors of production would alter accordingly. So overall, this sounds like a scenario in which long-run returns to capital are lower (perhaps after an adjustment period in which the bidding down of yields produces a rise in asset values). Two things potentially moderate that tendency. First, the length of working life is not fixed and as I noted above, it seems likely that people will tend to delay their retirement. The mooted relative price change between capital and labour would reinforce that tendency by changing the incentives between work and retirement, in the direction of it being more rewarding to make the adjustment partly in the form of a longer working life, rather than entirely in the form of higher saving. Second, in a globalised world, 'surplus' capital arising from higher saving in any given country might, instead of simply lowering returns at home, flow abroad with little impact on home rates of return. One general prediction is that capital will flow from 'old' societies to 'young' ones, though it is actually more complex than that. Most societies are ageing; it is the different rates of ageing, and the different positions in the 'demographic transition', which would drive the potential capital flows. The 'older' societies are now seeing a decline in the share of their populations which is of working age, but some other countries, such as India and some other countries in Asia, will see a rise in this share for some time yet even though they too are ageing. This so called 'demographic dividend' arises now because 3/6 their fertility rates declined more recently than in the developed western countries. In such countries, investment rates will presumably need to be relatively higher, in order to provide the capital for the larger workforce to work with. So one might expect capital to flow towards them from countries which are more 'advanced' in the ageing process.5 One might have expected this to mean capital would flow into many developing countries in Asia. Over recent years, as it turns out, the reverse has been occurring. National investment rates fell in many countries in Asia after the financial crisis in 1997–98, and have not recovered much as yet. So 'surplus' saving in Asia has been flowing out of the region, towards the developed world. This reminds us that financial flows are responsive to a great many forces; demography is only one of them. Perhaps it is not surprising, then, that attempts to distil empirically the effects of changing demographic structure on asset prices and returns in the past have had mixed results. Some studies do find a significant relationship but others don't. Even in studies where demographic effects are statistically significant, the amount of variation in asset prices and returns that is explained by demographic factors is often small relative to the total degree of variation in those things. It would seem that, given our present state of knowledge at least, the cycle of euphoria and gloom still does much of the work in driving asset prices and returns. For that reason alone, not to mention the complexity of demographic effects themselves, any hypothesis about how ageing will affect financial prices shouldn't be held dogmatically. Added to that is the fact that the long-run state we are imagining is a long time away – assuming we ever get there. The transition towards it will have its own complications, not least because many people will only gradually recognise the implications of increasing longevity, and accordingly will adjust their behaviour only slowly. Nonetheless, a reasonable working hypothesis for the moment, in my judgement, is that we would expect to observe a tendency toward higher rates of saving, lower returns and longer working lives.6 Moving from these general points to more specific concerns of financial markets and institutions, a major issue exists in managing longevity risk for providers of defined-benefit pension plans. Such providers, of course, have an obligation to provide a stream of payments to pensioners for the remainder of their lives after retirement. If those lives turn out to be longer than expected, the pension plans will be under-funded. In some countries (not Australia), funding of defined-benefit obligations is turning out to be a major issue for household-name companies who carry the legacy costs of a large number of former employees with pension and other entitlements. Only a small part of these problems seems to be due to people living longer – mainly they reflect a period of less-than-expected returns and funding holidays taken by businesses. Nonetheless, they are a picture of the sorts of problems that could arise more frequently in an ageing scenario. A public policy question which we could expect to emerge in these countries is the extent to which shareholders of the companies in question will be able to shift these obligations on to their country's taxpayers, or indeed the pensioners themselves. But even if adequate funding is available, with the longer duration of obligations, the question is whether there are sufficient long-duration assets to hold. These factors can affect financial markets. Regulations requiring closer matching of duration in some countries in Europe have been nominated as one factor (though far from the only one) behind apparently strong demand for long-dated government securities in global markets. Some European governments have recently issued very long-dated securities – up to 50-year maturities – to tap this demand. There are also proposals to create 'longevity bonds' to help pension providers manage longevity risk. A more daring idea still is That said, some developing countries may, in due course, age quite rapidly. In China, for example, the share of population of working age has been rising quickly up to now. But between 2010 and 2050, it is expected to decline more quickly than in the United States, and by about the same as in Germany. In theory, ageing can in some circumstances produce lower saving rates. The reason is that people have a longer period over which compounding affects their wealth, so that they need a lower saving rate each year. See, for example, D. Bloom, D. Canning and M. Moore (2004), ‘The Effect of Improvements in Health and Longevity on Optimal Retirement and Saving', NBER Working Paper No. 10919 (http://papers.nber.org/papers/w10919.pdf). But in models which produce this result the yield on investment is assumed unchanged in the face of ageing, whereas it is reasonable to think that rates of return would be lower in an ageing scenario. Hence the power of compounding would probably not, in practice, be enough to allow a fall in saving rates. 4/6 that of a swap of exposures between pension funds and those industries which might expect to profit from longer life-spans. In Australia, there are relatively few defined-benefit plans these days; the growing pool of superannuation assets is predominantly of an accumulation type. Hence, these issues of funding adequacy and long-duration asset availability do not arise to quite the same extent for our superannuation funds. The risk that a retirement plan might be under-funded has been transferred to the retiree. Nonetheless, there is presumably a qualitatively similar, if quantitatively less pressing, issue on duration once people get to retirement, if we assume that it is desirable for them to purchase an income stream. Increasing longevity still presumably implies a requirement for assets of an appropriately longer duration to support these sorts of products; the question will be at what price they can be acquired. In fact as a general proposition, completeness in the set of financial markets and instruments is likely to be important in managing the various issues associated with ageing. Instruments which facilitate the transformation of assets into long-run income streams will presumably be increasingly needed. It is to our advantage, therefore, that Australia's financial market participants are at the dynamic and innovative end of the spectrum when it comes to creating and adopting new instruments, and we can expect them to respond well to the changing needs of the population. Along with that will come, of course, all the associated issues of pricing and risk, and the requirement for user education. Financial planners and ageing What then are we to say to financial planners about the implications of ageing for their work? It is obvious that as people come to terms with all the issues around ageing, they will focus increasingly on their saving, investment and retirement decisions. So there will be no shortage of demand for the services of good financial planners. But because the issues are of such importance, the performance of the financial planing industry will surely be subject to heightened scrutiny. It is not for me to prescribe how you should respond to these challenges. The Reserve Bank certainly has no regulatory power over, or supervisory responsibility for, the financial planning industry. Let me simply offer two broad observations. The first is that while financial planners have much to offer their clients in the form of advice on asset allocation and tax management, it still seems to me that probably about the biggest decision most of your clients are going to make is when to retire. I grant that for more than a few who have retired over the past two decades, the decision was not entirely voluntary. But I suspect that many people have been content to take early retirement, because they held an optimistic – probably too optimistic – set of assumptions about the future earning potential of their assets. They may well also have underestimated longevity. It gradually will be dawning on people that in a world of lower yields on most assets and increasing longevity, they are going to have to work hard at making their assets last – or, simply, work in the more normal sense of that word. Retirement ages will tend naturally to rise in the future as people realise that they need more resources for their lengthening lives. Financial planners can probably assist that natural, and inevitable, development by giving appropriate advice. As time goes by, I think that we will see a world in which later retirement is more feasible than it might have been in the past, because the demographic changes occurring themselves mean that an excess supply of labour, common from 1970 to 2000, will more than likely give way to excess demand for labour in the future. Surely firms are going to find it to their advantage to keep their older employees, and will need to offer effective inducements to them in order to do so. So while people will need to be productive for longer in order to adjust to longer life expectancy, it will hopefully be not only more feasible, but also more rewarding, for them to expend their energies in that fashion. Second, because increasing longevity will likely mean an ever-increasing focus on the adequacy of assets, rates of return (and, one trusts, risk), it surely follows that there will also be more attention paid to the fee structure of the service providers in the funds management and advising businesses. For fund managers, the era of high nominal yields on many assets disguised the fee structure – just as high inflation distorted a great many price signals in the economy. When yields are lower, and people have a keener appreciation of the importance of the earnings on their savings, fees are more visible. Those offering advice, who usually (and rightly) point out to people the power of compound interest, 5/6 will surely see people concerned about that power being weakened through a long flow of commissions. One can easily imagine the fees for financial advice and managing funds being of more community interest than the fees on bank accounts. This will be a challenge for the industry. Conclusion The phenomenon of ageing is one of the key long-run developments our society faces. To the extent that it reflects greater longevity, there is no reason to fear it (though of course declining fertility, if it proceeded far enough, would bring much bigger concerns). We simply need to adjust to it. To date much discussion has, understandably, been focussed on the impacts on government finances. As important as they are, participants in private financial markets should also take an interest. Financial arrangements will be able to adapt to the needs of an ageing population, I expect, but they will adapt more smoothly if we have some realistic discussion of the issues. I am sure that this will provide business opportunities of one form or another for the more alert and innovative market participants, including in the financial planning industry. I wish you well in your deliberations here today, and in your future efforts to serve the community. 6/6 | reserve bank of australia | 2,005 | 11 |
Talk by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to Australian Business Economists, Annual Forecasting Conference Dinner, Sydney, 13 December 2005. | Ian J Macfarlane: Some observations on recent economic developments Talk by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to Australian Business Economists, Annual Forecasting Conference Dinner, Sydney, 13 December 2005. * * * I see from my records that this is the sixth time that I have addressed the Australian Business Economists, but the last time was four years ago. At that time most of the G7 countries were in recession and interest rates were still heading down. The world looks a lot better now as it adjusts to stronger growth and a new set of challenges. I confess that I had difficulty in deciding on a topic for tonight's talk. There were, in my view, no burning issues that I wanted to address, or messages that I wanted to leave my listeners with. In the event, I have decided to talk about three topics: how the world has coped with a tripling of oil prices, how the world is emerging from a period of exceptionally low interest rates, and, quite separately, is there an Australian model of macro-economic policy? Oil prices I will start with oil prices. At the beginning of 2002, when oil prices averaged about $US20 per barrel, most observers would have been very apprehensive if they had known that over the following three years prices would more than treble to a recent peak of $US70 per barrel. I think it would have been assumed that this event would lead to a significant rise in inflation and a major slowing, if not contraction, in the world economy. Memories of OPEC I in 1973 and OPEC II in 1979 when oil prices rose by a factor of three or four were still being seen as a guide to possible outcomes. Certainly, over the past couple of years, the media has been full of stories about rises in oil prices and the dislocations and hardships they have caused. But looking back from our current vantage point, the thing that stands out is how comfortably the world economy has handled developments. Virtually all of the rise in oil prices has by now been reflected in statistics on inflation and GDP growth, and the results have been surprisingly small. Global GDP growth was 4 per cent per annum or higher in 2003 and 2004 and is expected to remain so in 2005 and 2006. Of course, a lot of this growth has come from outside the OECD area, with the figures for OECD area growth being more than 1 per cent lower than for global growth. On inflation, the pick-up has been quite modest, with most OECD countries still recording headline inflation below 3 per cent per annum in the 12 months to September 2005. Interestingly, the United States where headline inflation was 4.7 per cent, stands out on the upside and lifts the OECD average inflation rate to 3.3 per cent. In Australia, as you are aware, headline CPI rose by 3.0 per cent in the year to the September quarter, up from a recent low point of 2.0 per cent eighteen months earlier. There have been a number of reasons for these favourable outcomes around the world, including the developed world's lower oil dependency compared with earlier years, but I will concentrate on a few that I think are important. The main reason that economic growth was so little affected was that the rise in oil prices was caused by strong world growth, particularly from developing countries such as China and India. For the world as a whole, the rise in oil prices was not a negative supply shock, as it was in the seventies, but was the result of a positive demand shock. Of course, global growth could well have been stronger in the absence of the oil price rise, but even with its constraining effect, there was still plenty of growth to go around and current forecasts are still looking good. On why the rise in inflation was so modest, the story is very interesting. We should start by reviewing a bit of history; this shows that even before OPEC I and II came along, OECD area inflation was rising year by year. Immediately before OPEC I, it had already risen to nearly 9 per cent, with Australia being one of the highest at 10.1 per cent. Inflationary expectations were also on the rise. In the business community the assumption was that any increase in costs could be easily passed on into prices, and the unions assumed that all wages would be indexed to rising inflation. The situation is very different now. After more than a decade of low and stable inflation, inflationary expectations are better anchored. Discipline in goods markets from domestic and foreign competitors means the old 'cost plus' mentality no longer prevails. While pass-through at the first round still occurs, as the rise in retail petrol prices demonstrates, subsequent price pressures are often absorbed. With only limited and manageable increases in overall inflation throughout the world, monetary tightenings specifically directed at oil-price-instigated inflation have not been needed. That is all I wish to say about oil prices, other than to add the caveat that I am only talking about the increases to date. Obviously, if we enter a new round of similar increases, the situation would have to be reassessed. World interest rates It is well known that the world has recently gone through a phase of exceptionally low interest rates, but I am not sure that people appreciate how low they were by historical standards. In fact it is not much of an exaggeration to say that interest rates in mid 2003 were at their lowest level for a century. This was the time when official overnight rates – the ones set by central banks – were 1 per cent in the United States, 2 per cent in the euro area, and zero in Japan. The only qualifications I have to make to my earlier generalisation is to concede that rates may have been slightly lower during the second world war in some countries such as the United States and United Kingdom when quantity rationing was the norm, but they have not been lower in peace time. We can construct an indicator of world interest rates for a century or more using a weighted average of the rates for the United States, United Kingdom, Germany and Japan. Graph 1 shows the results for official overnight interest rates or their nearest equivalent since 1860. Although the graph is dominated by the high interest rates during the great inflation of the 1970s, the readings for 2002 and 2003 are lower than any other time in this long span of years.1 Part of the explanation is that inflation was low, but it was only low compared to the post-war standard – it was not low compared to most of the period covered by the graph. In fact if we construct simple measures of real interest rates (based on realised inflation rates), they were also low by the standards of earlier low inflation periods.2 In Table 1, real interest rates in the first five years of this decade are lower than in any previous decade apart from those containing the two world wars and the 1970s. Graph 1 The observation for 1923, the year of the Weimar inflation in Germany, had to be deleted because it did not fit on the scale. The problem with most measures of real interest rates is that they become negative during periods of unanticipated rises in inflation such as the 1970s. For this reason, meaningful comparisons of real interest rates (using realised inflation rates) should only be made for periods of low and stable inflation such as the present. We could ask the question of why such low interest rates were put in place in this decade when it had not been seen to be necessary to do so on earlier occasions. This is a very big question and I do not propose to answer it tonight.3 Nor do I wish to maintain that a different global monetary policy should have been put in place. Defenders of the monetary policy that was pursued would argue that it resulted in continuing low inflation and reasonable economic growth for the world economy, apart from the mildest post-war recession in 2001. They would say that in light of this outcome, it would be hard to argue for a higher level of interest rates during the period. Usually when interest rates are kept very low for an extended period the main risk is that there will be a pronounced pick-up in inflation. As we know, there has been little of that on a global scale, or indeed in individual countries, even though commodity prices have risen sharply. Where the risks have mainly arisen has been in the financial sphere, where there has been a 'search for yield' and a driving up of many asset prices. So far this decade, the most obvious sign of the latter phenomenon has been the surge in house prices, particularly in those anglo countries with very competitive financial sectors such as the United States, United Kingdom and Australia. What I have been describing so far is a global development, and although we in Australia have shared it in some aspects, in others we have differed. The main aspect in which we differed was that we did not reduce interest rates to anywhere near the extent they were reduced in the three biggest monetary areas – the United States, Japan and the euro area. The low point in our short-term interest rates of 4¼ per cent this decade was not very different to the low point in the 1990s of 4¾ per cent. We were also the only country of any significance to resist the general trend to lower interest rates during 2003. Nevertheless, we still have shown many of the same symptoms in our asset markets that others have shown. What we are seeing now around the world is a gradual return to normality in interest rates. We in Australia can make some claim to being the first in this process because we began in mid 2002. Over the past two years the predominant tendency among countries has been to raise interest rates. Virtually every developed country except Japan has now participated, with the move by the ECB earlier this month being an important step. The point I want to make that links the first two parts of this talk together is that the major reason for the rises in interest rates is, I think, the need for a return to normality, not a specific fear about oil prices. Of course the two are related in that the low level of interest rates has accommodated the growth in demand that lay behind the rise in oil prices. But the most important factor behind the recent For a partial answer see I.J. Macfarlane, “What are the Global Imbalances?”, Reserve Bank Bulletin, October 2005. moves is the realisation that the world could not have safely continued with the sort of interest rates that prevailed in 2002 and 2003. Is there an Australian model? I was recently visited by the Chilean Minister of Finance who, like many in the same position in Latin America, is a very good professional economist. Our discussions were very interesting, and at one stage he answered one of my questions by saying that Chile 'was following the Australian model'. He meant this in a very specific way, and it is worth examining exactly what he meant by the term. First, he was talking about a macro-economic policy model that had the following structural features: • a floating exchange rate with a currency viewed as a commodity currency; • a monetary policy regime based on central bank independence and an inflation target; • a disciplined fiscal policy which aims at balance or surplus in the medium term. These were important, but the most important characteristic he wished to focus on was the internationalisation of the currency, i.e. the ability for Australian entities to borrow abroad in Australian dollars, or to borrow abroad in foreign currency and hedge back into Australian dollars. This allows Australian corporations and banks to participate fully in international financial markets without incurring foreign currency risk (or to only incur it where they have a 'natural hedge' such as foreign currency export earnings or to finance a foreign acquisition). We, of course, have been very aware of the importance of this characteristic and regard it as a virtual necessity if a country is to be able to run a floating exchange rate regime successfully. But many, if not most, countries do not reach this stage. It was foreign currency exposure which led to the collapse of many Asian banks and corporations when their currencies fell during the Asian crisis. In Latin America, traditionally all foreign borrowing was in US dollars, which made their countries extremely vulnerable to falls in their exchange rates. It also gave rise to what is known as 'fear of floating' which means the tendency for their central banks to quickly resort to raising interest rates whenever the exchange rate is in danger of falling. What the Chilean Finance Minister called the Australian model, of course, is not unique to Australia,4 but it is associated with Australia in Latin American and Asian economic circles because of Australia's success in withstanding the Asian crisis. While some countries such as Chile see it as a sort of role model, many Asian countries have chosen a different path by running current account surpluses, building up large holdings of international reserves and resisting changes in their exchange rates. As you know, we think this is a major reason for the growing global payments imbalances, and would be happier if they followed a model closer to our own. But that is another story. The interesting issue for other economies, particularly emerging market economies, is how do you reach the situation where you can borrow abroad in your own currency, or, to put it differently, where investors in other countries will willingly hold assets denominated in your own currency. When we look back and see how Australia reached this position, it is a very interesting (and reasonably recent) story. The major step occurred when the Government decided that it would borrow honestly from its own citizens. That is, it would stop using captive arrangements that force financial institutions to take government paper, and stop setting the interest rate on its own paper. In our case this occurred when we introduced the tender system for selling Treasury notes in 1979 and bonds in 1982, and soon after made clear that the Government would no longer borrow from the Reserve Bank, but instead borrow from the public to finance the budget deficit dollar for dollar. At first we had to accept very high interest rates, but in time demand for government paper expanded, and most importantly overseas investors began to find Australian government bonds denominated in Australian dollars an attractive investment. It was not necessary to ask them to invest, nor to do 'road shows' on Wall Street to entice them. At the Canada and New Zealand also have the characteristics listed when describing the Australian model. For a discussion of the difference between Australia and some other commodity exporters, see: Barry Eichengreen and Ricardo Hausmann (1999), “Exchange Rates and Financial Fragility,” in Federal Reserve Bank of Kansas City, New Challenges for Monetary Policy, pp329–368; and Ricardo J. Caballero, Kevin Cowan and Jonathan Kearns (2005), “Fear of Sudden Stops: Lessons from Australia and Chile,” Journal of Policy Reform, Vol.8 (4), pp313–354. same time, old habits died hard so that as recently as March 1987 the Australian Government made its last overseas borrowing in the US market in US dollars. In time, overseas investors became comfortable with holding Australian government paper, semi and local paper, and eventually corporate bonds and asset-backed securities. Turnover in the Australian dollar is sixth amongst the world currencies and there is ample liquidity in both currency and asset markets. The relevant derivative contracts have grown, and so provided hedging opportunities. As we point out in a forthcoming Bulletin article, Australia as a whole has for some time had a long foreign currency position. That is, we have more foreign-currency-denominated assets than foreign-currencydenominated liabilities, a far cry from our position in the early post-float period. I want to conclude now by briefly revisiting the subject of why economies, including our own, have exhibited more stability than in earlier periods. Is it because policymakers have become better forecasters and more adept at timely adjustment to the levers of economic policy? It would be tempting to answer yes to this, but I suspect it is only a small part of the answer. A more plausible explanation is that our economy has become more resilient. That is, we have systematically modified our institutional framework so that it is more flexible and more able to adjust to economic shocks than formerly. What I have described above is a good example of this process at work. | reserve bank of australia | 2,005 | 12 |
Opening remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to The 18th Australasian Finance and Banking Conference 2005, Sydney, 14 December 2005. | Glenn Stevens: Financial challenges and opportunities in the Asia-Pacific region for the 21st century Opening remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to The 18th Australasian Finance and Banking Conference 2005, Sydney, 14 December 2005. * * * It is a pleasure to be here to open the 18th Australasian Finance and Banking Conference. Our national and international financial markets play an increasingly prominent role in day-to-day life. They are certainly in the news. Not a single television or radio news bulletin passes without us being informed of the latest daily, or even intra-daily, movement in the US stock market, the exchange rate, the price of gold and – probably of more interest to the average person – the price of crude oil. I suspect that, to no small extent, this almost obsessive focus on short-term price movements reflects the need for a high-capacity media to have a large amount of apparent 'news' to convey, even when the quantity of genuine information is small. The high-frequency nature of financial market trading – a new piece of 'news' every minute – is a natural source of grist for this particular mill. How useful this actually is, on the other hand, one could debate. Likewise, the short-term reporting schedule of corporate and fund management results is perhaps understandable, viewed from the perspective of accountability in an era in which trust in management has been weakened. But, at the same time, it probably exacerbates the natural human tendency toward myopia and impulsive decision-making by investors, while the attendant pressure on managers to deliver steadily improving results period by period hardly seems conducive to far-sighted decisions. It remains to be seen, moreover, what will be the effect on behaviour of changes to accounting standards which will almost certainly increase the apparent short-term volatility of corporate results. Some have argued, I think persuasively, that an undue focus by investors and managers on the short term is a significant impediment to long-run performance. This seems an issue worthy of further study. Hopefully, you might spare some time for that at this conference. In any event, there is no doubt that the functioning of our financial systems is very important. Once upon a time, when asked what was the role of a financial system, we might have answered: to match the resources of savers and the needs of entrepreneurial types, so as to enable the deployment of capital in some prospectively profitable venture. That (rather 19th-Century-sounding) definition, with an emphasis on intermediation, is still correct as far as it goes. But these days, with an increasing proportion of society's capital – even our infrastructure – held in marketable form, the role of markets in pricing assets is key. We would add, as well, that the role of a financial system is to price risk, in ever more finely defined bundles, and to allow people to adjust their portfolios so as to be exposed to just those risks, and opportunities, that they desire – no more and no less. The system's efforts to provide just that set of possibilities has led to a plethora of sophisticated and increasingly complex products. This development, in turn, has raised questions by various observers and regulators as to whether those who have ended up holding certain risks are fully aware of them. Questions have also been asked of late about the back-office infrastructure supporting the most complex transactions, and there is a degree of concentration in some of these markets which could conceivably be problematic under less benign market conditions. Nonetheless, these functions beyond pure intermediation seem only likely to grow further in importance for various reasons, not least among them demographic trends. As people confront longevity risk, in addition to the usual battery of market risks, the search will be on for new instruments and practices which enable this risk to be priced and managed. While it is highly doubtful, in my view, that ageing can be addressed simply by financial engineering, the financial system will have a role to play. Its effectiveness and efficiency in that role will be a focus of discussion in years to come. It's appropriate, therefore, that some parts of the conference program will be devoted to topics in the retirement income area. It is also fitting that the conference has adopted the title 'Financial Challenges and Opportunities in the Asia Pacific Region for the 21st Century'. The Asia-Pacific has been, and remains, a source of economic dynamism – that's the 'opportunity' part. But it has also been a scene of considerable financial turmoil over the past decade – that is the 'challenge' part. You have had some thoughtful presentations this morning on some of the issues. I could not do justice to all of them in brief remarks. Allow me to touch briefly on just a couple of themes. The first is the potential, and need, for financial development in Asia. It has been apparent for some time that east Asia's weight in global production of goods and services is increasing (Japan aside). Non-Japan east Asia, including China, has seen its share of global GDP almost double, to about 20 per cent, since 1990. It is likely to rise further in the period ahead. The extent of merchandise trade within the region has also grown rapidly, as trade barriers have declined and cross-border component sourcing has increased. So Asia is, these days, a powerful force in international trade. Yet, according to many east Asian people themselves, the development of Asia's financial system has not kept pace. It is not so much the size of the banking systems which is in mind here – in a number of cases, these are actually quite large (though there are some important exceptions like Indonesia, or the Philippines). Rather, it is the depth, resilience to shocks and capacity to intermediate the region's savings within the region that is at issue. With the onset of the financial crisis of 1997–98, it was apparent that Asia was not resilient to disturbances in international capital markets. Foreign capital had flowed into east Asia – something which made sense then, and still makes sense now. The exchange rate risk associated with these flows, however, was being borne mostly in the recipient countries: they had borrowed foreign currency unhedged. The result of these exposures was that, when exchange rates moved, the pain was concentrated in banks and/or their customers in Asia, something which exacerbated the crisis and put policy-makers in an impossible position. Because of heavy reliance on bank funding, with somewhat under-developed general capital markets, this was very damaging for a number of regional economies. Post crisis, still keen on a fair degree of exchange rate stability, but unsure of the extent of likely support from the international community in the event of another crisis, the countries of east Asia have opted for greater self insurance against volatility of international capital flows. This takes the form of vastly increased holdings of official reserve assets, mainly the US dollar. While this response has been understandable, some even in Asia have questioned whether it makes sense for Asia to operate, in effect, as an extension of the US dollar zone. Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, laments the situation in the following terms: Whether we like it or not, we now find ourselves in the unenviable position of holding a substantial part of our savings in the financial liabilities of an economy that does not save, fearing that a diversification of a small part of such holdings might lead to a sharp fall in the value of the rest, thus shooting ourselves in the foot. We also find ourselves somewhat stuck with recycling a large part of our savings through the developed markets back into the region in a much more volatile form, occasionally creating havoc in our monetary and financial systems.1 The challenge for Asia then, according to its own financial leaders, is to develop a financial system which can allocate local savings to local needs more directly, can be resilient to the risks associated with international capital flows, and be somewhat less dependent on banks as a funding channel. This is no small task. Thus far, apart from managing the fall-out from the crisis, efforts have been made to strengthen banking systems. A good deal of work has also occurred to improve capital markets, particularly bond markets. One of the key breakthroughs will be when Asian governments and corporates can borrow as needed in open markets, in their own currency and at an acceptable price, leaving any currency risk to others willing to bear it – like foreign investors. Australian borrowers have been in this happy position for a long time now, like their counterparts in other advanced economies. For emerging market countries to enjoy the same opportunity would be a major improvement on the past. For this to occur, there needs to be a confluence of high-quality issuers, informed investors, and wellfunctioning markets to allow hedging and swaps. As Asian authorities seek to facilitate the Remarks made at the recent Global Bond Summit, Hong Kong. Available at http://www.info.gov.hk/hkma/eng/speeches/speechs/joseph/20051115e1.htm development of these markets by removing impediments, and the occasional modest official transaction, opportunities will presumably exist for capable market players in Australasia to play a role. Opportunities might also lie, perhaps over a longer horizon, in the area of household finance, since the number of middle-income Asian households is rising quickly, and their income growth is rapid. It could be anticipated that their demand for more sophisticated asset and liability products will correspondingly grow. One would think that Australasian institutions would be well placed, given the skills acquired in their home markets, to take part in any such development. A second, not unrelated, theme is the so-called 'global imbalances' issue. There is no time to rehearse all the arguments here, but one simple point can be made. As the size of capital flows from Asia to the US increased over the past decade or so, the price – the interest rate – declined. Hence, it would appear that developments on the supply side of this market were very important in driving the phenomenon. That is a reminder that if the capital is to flow more slowly to the US, adjustments to Asian behaviour will be part of the process. The increased net supply of saving from Asia reflected a sharp decline in corporate investment in the Asian region (outside of China) after the crisis. At some point, Asian corporate investment will presumably recover. One would also imagine that, in some cases, there is a need for upgrades to public infrastructure, and a case for higher-quality private housing. Hence, in due course, the net supply of Asian saving to international markets, other things equal, will decline. Just when that will be, of course, and what other changes might accompany such developments, no-one can say. But no discussion of the challenges in the Asia-Pacific region would be complete without some coverage of such issues. Let me conclude by saying how fitting it is that the conference takes place in Sydney, one of the AsiaPacific's major financial centres. As the first largish market to open in the world trading day and as the financial centre of a medium-sized, developed economy, Sydney plays a prominent role in the region's financial trading, even though some other markets are somewhat larger. It is the leading market for the world's sixth most actively traded currency. Australia's share of global foreign currency trading, at about 3½ per cent, is higher than in a number of comparably sized economies, and is about three times Australia's weight in world GDP. Markets here are sophisticated and liquid, and the participants innovative. Sydney, and Australia more generally, has much to offer the region in financial services expertise. That said, participants here would be only too aware that financial market operations are highly competitive and the local players need to remain on their toes. So it is good to see some local market participants thinking about how to contribute to the development of vibrant markets in the region. These and other interesting issues will no doubt be covered in the conference, if they have not already been. I wish you well in your deliberations. | reserve bank of australia | 2,005 | 12 |
Opening statement by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Canberra, 17 February 2006. | I J Macfarlane: Australia's economic situation and implications to monetary policy Opening statement by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Canberra, 17 February 2006. * * * It is a pleasure to be back here again in front of the Committee, and to be having this hearing in Canberra for the first time in a number of years. I note that the membership of the Committee has changed again, particularly on the Government side. That is something that has happened pretty well continuously in the nearly ten years I have been reporting to it under the current arrangements, but it has not interfered with the Committee's effectiveness. As you know, we had our February Board Meeting last week and we issued our quarterly Statement on Monetary Policy earlier this week. This document spelled out in detail how we see the current situation in the economy, and why the stance of monetary policy is where it is. This morning I would like to take the opportunity of looking at the broader trends in Australia's economic situation and examining the implications they have for the stance of monetary policy going forward. I will take as a starting point Australia's current economic expansion. For years I have made the point that progress in winding back economic slack is made not by high growth in any individual year, but by maintaining an expansion over a sustained period. Australia's current expansion began in late 1991 and is now in its fifteenth year. This means that it is already significantly longer than its predecessors in the 1960s, 1970s and 1980s. The expansion has been marked by good growth in GDP, which has averaged 3¾ per cent per annum over this period, one of the best performances in the developed world. A consequence of the sustained expansion is that the economic slack generated in the last recession has been gradually used up. One indicator of this is the unemployment rate, which has trended down from a peak of 11 per cent in 1993 to be currently just over 5 per cent. Other indicators of the economy's capacity utilisation are also at cyclically high levels. Business surveys report that businesses are operating at close to their highest levels of capacity utilisation since the late 1980s. The surveys have also been reporting high levels of labour scarcity. For the past year or so, many businesses have been in the unusual position of reporting that scarcity of suitable labour was a bigger constraint on their activities than their traditional concerns about the adequacy of demand or sales. Given the maturity of the expansion it should not be surprising if the average growth of the economy is now less than it was in the earlier stages. As a general principle, it is easier for an economy to grow quickly when there is a large pool of unused resources to be re-employed, and in Australia's current position in the cycle, that source of growth is now much more limited. So, in the absence of a significant lift in trend productivity growth, we should expect to see annual GDP growth rates mainly in the 2s and 3s, rather than in the 3s and 4s as was typical for most of the expansion. It is not surprising therefore that growth of the economy over the latest year for which data are available was 2.6 per cent, or an annualised rate of 3 per cent for the latest half-year. Business investment has been a major driver of growth in recent years, expanding by 18 per cent over the past year, and at an average annual rate of 14 per cent over the past three years. The upswing in business investment is being stimulated by high commodity prices and favourable financial conditions. With strong investment growth and an expected improvement in exports, our forecast for the economy overall is that annual GDP growth will pick up modestly during 2006 to about 3¼ per cent. While strong business investment obviously contributes to capacity expansion, the sorts of outcomes envisaged for GDP growth would imply that the economy will continue to operate close to full capacity. While the overall growth of the economy during the current expansion has been good, there has been concern expressed about its composition. In particular, the growth of the economy over the past few years has been more than fully accounted for by growth in domestic spending, while Australia's export performance has been disappointing. In consequence, Australia's current account deficit has remained high at around 6 per cent of GDP recently, despite a strong international environment and rising commodity prices. Notwithstanding these concerns, it needs to be emphasized that monetary policy cannot be expected to target a particular composition of growth or current account deficit. Any attempt to do so (for example, by running a much tighter policy in order to constrain domestic demand) would be counterproductive and would detract from the Bank's broader macroeconomic goals. The global business cycle Australia's economic situation should also be viewed against the backdrop of the global business cycle. In broad terms, business cycles across various countries have tended to move together, at least among countries in the developed world. That is, there has been a reasonably high correlation in the timing of recessions and expansions among developed countries over the past few decades. Most of the advanced countries experienced recessions in the mid 1970s, the early 1980s and the early 1990s, and many did so in 2001. It is relatively unusual for countries in this group to experience what might be termed a 'home-grown' recession, that is, a recession not shared by the major industrial countries. Similarly, it is fairly unusual for countries to skip an international recession, though Australia and some other countries have recently done so, as did Japan in the early 1980s. This is not to say that domestic conditions and policies are unimportant. Nevertheless, as a general rule, when the world economy as a whole is in a sustained expansion, there is a good chance that an expansion will also be continuing in an economy such as Australia. Currently the world economy is expanding strongly. The recovery from the global downturn in 2001 is now well established and, on past experience, the expansion should still have some way to run. While growth to date has been led mainly by the United States and China, there have been encouraging signs over the past year that growth is becoming very broadly based, with conditions improving in Japan as well as in a number of other economies. Assessments of the risks to the global growth outlook have focused mainly on the effects of higher oil prices and on the possibility that the US current account imbalance will have a disruptive effect on the world economy. However, there is little sign that these forces are restricting growth at present. World GDP growth in 2005 is estimated to have been above average, and most observers expect this to continue in 2006. This growth performance has been accompanied by generally subdued inflation outcomes. One factor behind this was the increased focus on inflation control by central banks around the world, after the high inflation of the 1970s and 1980s. Many central banks have now adopted numerical inflation targets and others have clearly become more focused on inflation control even without adopting explicit targets. At the same time, the importance of structural factors, and particularly the industrialisation of China, should be recognised. The huge pool of low-cost labour that this has brought into play has put sustained downward pressure on a wide range of prices of internationally traded goods. The terms of trade One consequence of these developments has been a marked upswing in Australia's terms of trade, defined as the ratio of our export to import prices. Currently Australia is benefiting from the largest cumulative increase in our terms of trade since the early 1970s. The main factor driving this has been the rapid growth in global demand for resources, with China in particular contributing strongly. As a result, world prices for a wide range of resource commodities have been increasing sharply. Over the past three years Australia's terms of trade have increased by around 30 per cent. This is estimated to have added 1½–2 percentage points per annum to the growth in national income over this period, a significant expansionary force for the economy as a whole. The economic effects can be seen in a number of areas including strong growth in business investment, company profits, share prices and imports. Increased export prices also tend to boost government revenues through company taxes and a range of federal and state royalties. Interest rates and financial markets Although Australia avoided the recession that engulfed many developed countries at the start of this decade, it was not totally unaffected by world events, and the Bank found it necessary in 2001 to cut the cash rate to 4.25 per cent in a series of steps. While that was a new low for Australian official interest rates – the previous low had been 4.75 per cent in the late 1990s – it was a relatively muted response compared with the very large cuts in interest rates that occurred elsewhere in the world. In mid 2002, with both domestic and global economic conditions improving, the Bank began the process of restoring official interest rates to more normal levels. It did this in five steps over three years – two in mid 2002, two in late 2003 and one in early 2005 – a more gradual tightening cycle than normal. At the current level of 5.5 per cent, the cash rate is in line with its average over the low inflation period since 1993. There is therefore a sense that the current level is relatively neutral in terms of its impact on economic activity and inflation. One complication in assessing the level of interest rates, however, is that competition in the financial sector has seen margins between the cash rate and institutions' lending rates narrow over recent years, so the interest rates faced by borrowers are still a little below average. Australia moved to restore normal interest rates well ahead of other developed economies. All the major countries had reduced interest rates to unprecedented levels in the early part of this decade – 0 per cent in Japan, 1 per cent in the United States and 2 per cent in the euro area – and they maintained this position for a prolonged period. Of the major countries, the United States was the first to raise rates, with the Fed beginning to tighten in mid 2004. The European Central Bank has only just started the process in recent months and the Bank of Japan is not expected to start lifting rates for some time yet. Thus, even though the Fed has now restored the funds rate to a relatively normal level of 4.5 per cent, world policy interest rates on average remain well below normal. Another unusual aspect of current global interest rates is that long-term rates, which are set by the demand for and supply of funds in capital markets, have remained quite low in the face of rising official interest rates. Although various explanations have been put forward for this unusual behaviour, the most likely cause is an ex ante excess supply of savings relative to investment around the world, with Asia accounting for a large part of the excess global savings. For equity markets, the combination of low interest rates, strong economic growth and low inflation has proved very beneficial, with global share markets rising solidly in each of the past three years. This has been underpinned by strong growth in profits so that, notwithstanding the rise in share prices, P/E ratios have been declining on average. It is worth noting that the Australian share market has behaved quite differently from the global market over the past decade. It was affected much less than most markets by the tech bubble and the subsequent collapse, and in recent years has been rising faster than average. Along with the Canadian share market, it is the only major market that is currently above earlier peak levels, whereas in Europe and the United States share markets are still about 20 per cent below their early 2000 peaks. The Australian dollar has remained in a relatively steady range over the past couple of years, at levels that are a little above average against the US dollar and about 10 per cent above average in tradeweighted terms. Some people have found this steadiness puzzling against the background of very strong rises in commodity prices and the terms of trade, as such episodes in the past have been associated with strong rises in the currency. A key to understanding the different behaviour on this occasion is the change in the interest differential with the United States. This has narrowed appreciably over the past 18 months because the Fed has tightened much more than we have. Domestic credit and debt In recent years we have given a lot of attention to the growth of household debt and its possible effects on the macro economy. I would like to say a little more about it today and will divide the subject into two aspects: the shorter-term cyclical fluctuations in household credit growth, and the fact that various debt ratios have trended upwards over time. Regarding the first of these issues, the most recent cyclical peak in household credit growth occurred around the end of 2003, when it reached an annual rate of over 20 per cent. Since the bulk of household borrowing is housing-related, it is not surprising that this phenomenon was closely associated with a sharp run-up in house prices. Nationwide house prices increased strongly for several years up to late 2003, reaching a peak growth rate of around 20 per cent in that year. The increases in credit and house prices were inter-related, with credit availability fuelling the price rises, while rising house prices meant people had to borrow larger amounts to achieve home ownership. Much of this behaviour was driven by expectations, particularly in the investor market, of future price gains – the classic definition of bubble-like behaviour. In the period since late 2003, both the housing market and the demand for credit have cooled. Nationwide house prices have been broadly flat over the past two years and prices have fallen in Sydney. Household credit growth has eased back to an annual rate of around 12 per cent. Although this might still be regarded as quite high in absolute terms, it is towards the lower end of the range in which it has fluctuated in the past two decades. While there are some tentative signs that credit and housing market conditions have firmed a little in recent months, the risks to the economy posed by the over-heating in housing and credit markets in the period up to late 2003 have eased. Households now seem to have entered a period of greater financial caution, and this may act as a restraining influence on the growth of household spending for a while to come. The second issue is the high average growth rate of household credit over an extended period. This is a longer-run issue and one on which it is more difficult to make firm judgments. For more than a decade, household indebtedness has grown at a rate well in excess of the growth in household incomes. This has meant that the aggregate ratio of household debt to household income has trended upwards, as has the proportion of household income required to service the debt, and the gearing ratio (debt to value of household assets). Simple rules of thumb would suggest that this cannot be sustained indefinitely. Yet there are a number of reasons why these ratios may rise further. In a low-inflation environment, nominal interest rates are also low, and households are able to service much higher levels of debt than they could in the past. A significant proportion of households still carry little or no debt, and in the years ahead might choose to borrow more. Attitudes towards borrowing appear to be changing, with people becoming more willing to borrow against assets later in life. For these and other reasons, it is quite possible that the rise in household debt ratios could go a good distance further. The risk, of course, is that the process goes too far and that a painful correction ensues. There has been much debate around the world about the role of monetary policy in these circumstances, with the consensus being that the best it can do is to continue to pursue the general objectives of macroeconomic stability and low inflation. We should also not forget influences on the supply side. Banks and other providers of credit to households have been competing vigorously to expand or protect their market share. In the process, lending standards have been progressively eroded so that lenders are now engaging in practices that would have been regarded as out of the question five or ten years ago. These are matters in which prudential regulators are taking a strong interest. While the growth of household borrowing has been relatively high throughout the current expansion, business borrowing on average has been more restrained. This is the reverse of the pattern that was observed in the 1980s and, as a result, the business sector generally is in good financial shape with low levels of debt. In the past two or three years businesses have begun to take advantage of that position by again expanding their borrowing and lifting the rate of growth in their investment spending. Business credit has thus strengthened quite markedly, so that it is now growing at a rate of 16 per cent, well above that for the household sector. Inflation Australia's inflation performance over the past decade or so has been consistent with the Bank's medium-term target. Since 1993, when the 2–3 per cent objective was first articulated, average CPI inflation (excluding the one-off GST effect) has been 2.5 per cent. Of course, the inflation rate has inevitably fluctuated quite a bit from year to year, including periods where it has been above 3 and below 2. But it should be remembered that the Bank's objective is expressed in terms of average outcomes, and should not be thought of as a rigid commitment to eliminate short-term fluctuations in inflation. In the latest year, inflation in underlying terms has been close to 2½ per cent, though the headline CPI figure is higher, principally reflecting the effect of rising fuel prices. While inflation has remained contained over the past decade it is important, as always, to consider how inflationary pressures might evolve from here. At the current stage of the expansion there are a number of factors that might be expected to put upward pressure on inflation. The economy is operating at a high level of capacity utilisation, the labour market is relatively tight, and there have been some large increases in raw materials costs. Aggregate wages growth has picked up over the past year, and businesses generally are reporting difficulty in attracting labour. These conditions underpin the current forecast of a modest rise in underlying inflation over the year ahead. Based on the current level of oil prices, this forecast implies that headline CPI inflation would remain close to 3 per cent in the short term. This outlook is, as usual, subject to significant uncertainty. One area of uncertainty relates to wages growth, where there is a risk that current labour market tightness will result in higher-than-expected wage increases. This will be an important area to watch in the months ahead. On the other hand, the latest CPI figure was a little below expectations, and may indicate that global disinflationary forces are stronger than had been expected. There are also some tentative signs that conditions in the labour market are easing. The issue over the period ahead will be whether these latter forces prove sufficient to contain inflation in an economy operating with little spare capacity. In these circumstances, the Board at its recent meeting judged the current policy setting to be broadly consistent with the economy's requirements for the time being. Looking ahead, however, it felt that on balance, based on the considerations I have outlined here today, it is more likely that the next move in interest rates would be up rather than down. | reserve bank of australia | 2,006 | 2 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Institute of Chartered Accountants in Australia, Financial Services Seminar, Melbourne, 22 February 2006. | Glenn Stevens: Some observations on recent economic and financial trends Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Institute of Chartered Accountants in Australia, Financial Services Seminar, Melbourne, 22 February 2006. * * * Accounting Today's program shows that you are looking intently at some of the big forces shaping the environment for the financial services industry. There are a number of forces at work, including changes to regulation, accounting, technology and attitudes in the community. In the accounting field, Australian entities are, of course, working to implement the change to International Financial Reporting Standards. There is a host of issues associated with all of this, some of which have been quite contentious, particularly for some parts of the banking and finance industries. So I am relieved to say that the Reserve Bank has no role in developing or enforcing accounting standards, though we do of course have to produce our own accounts consistent with the relevant standards. It may interest you to know in this context that the Reserve Bank has itself made the change to IFRS, and will present its 2005/06 accounts on this basis in the Annual Report later this year, just like any listed company. To our knowledge, we are the only major central bank to adopt IFRS in full, as yet. This continues the RBA's practice for many years of adopting commercial standards of financial disclosure. For the most part, the effects of IFRS on our accounts are fairly small. The main one of substance is the recognition of the surplus in the staff superannuation fund on the balance sheet. This potentially adds some volatility to annual results as measured by the accounting standard, as the position of the fund alters with market prices. But sensibly applied, and combined with the wise provisions of the Reserve Bank Act 1959, which govern the way in which the Bank's earnings are distributed to the Commonwealth, there should not be too much additional variability in the dividend. 1 There is an important general point there. Differing accounting treatments have the potential to affect the behaviour of decision-makers in different ways, the more so when combined with regulatory requirements. A number of commentators have suggested, for example, that one factor behind the extraordinary demand for long-dated government securities we currently observe in several European countries reflects, at least in part, the attempt by trustees and managers of defined-benefit pension plans to restructure their portfolios in response to changes in accounting conventions and regulatory requirements. In the UK, perhaps the most striking case, index-linked government securities have recently traded at real yields of less than half of 1 per cent for a 50-year security. Pension fund buying is prominent among the explanations on offer for this phenomenon. In many countries, central bank accounting is regarded as unique and is often subject to particular legislative provisions or tailor-made approaches. In Australia's case, the Reserve Bank Act 1959 is not prescriptive about accounting, but is quite particular about how the earnings of the Bank are to be distributed to its owner – the Commonwealth. Valuation gains on assets – which can on occasion be substantial – contribute to profits, but are only available to the Commonwealth as a dividend when realised. Unrealised gains are retained in reserves against the possibility of future valuation losses. This is a very sensible arrangement because it prevents a situation where the central bank might come under pressure to distribute unrealised gains, eroding its capacity to cope with inevitable subsequent unrealised losses (and, potentially, requiring recapitalisation at government expense). It has been a problem for some central banks, but never in Australia. Graph 1 The accounting difference between the discounted value of a fund's future obligations and the value of its assets is these days (quite properly) recorded on the sponsoring company's balance sheet. A market bond rate is used to discount liabilities, as opposed to the older convention of using an assumed fund earning rate. Unless the fund's assets are also placed in bonds, movements in bond rates will affect the solvency position from year to year, which in turn will affect corporate results. At the same time, stricter pension rules now require any measured funding gap between assets and liabilities to be made good more quickly than used to be the case. Perhaps it is not surprising that UK pension trustees have changed asset allocations in the direction of holding more indexed bonds. This lessens the likelihood of nasty solvency surprises in any one year, though the associated downward pressure on bond yields has itself weakened the average solvency position, as measured. One can, of course, see why accounting rules stipulate that valuations of assets and liabilities should, for most purposes, use market prices and interest rates. Equally, pension rules requiring plan providers to fund adequately their obligations protect the plan beneficiaries against the risk of the company failing and leaving insufficient funds. But if the behavioural response to all this is a rush into assets yielding a real return of half of 1 per cent per year for 50 years, there will be a very large increase in the long-run cost of providing the pensions which are the whole object of the exercise. That increase in costs will, in turn, eventually place a question mark over the viability of the schemes. Hence, the question in the UK is whether the combination of regulatory and accounting reforms is ultimately going to strengthen the private pension system or hasten its demise. The point I am making from this foreign example is that accounting matters, and not only to accountants. It doesn't just inform us of the state of an enterprise, it affects behaviour - hopefully for the better, but either way can often have unforeseen interactions with regulatory signals. Stated accounts are also viewed through the lens of market or media perceptions, which all too often are focused on the very short run. These sorts of considerations are, in practice, quite important. Let me turn now to some remarks about general economic trends, beginning with the external environment. The Global Environment We have been living through some remarkable developments in the world economy over the past decade. Growth performance has improved, with global GDP growth averaging 3.8 per cent since 1996, compared with 3.4 per cent for the preceding two decades. That doesn't sound like a big difference but it is: almost half a percentage point extra growth on average, every year, is definitely worth having. What's more, the variability of growth has declined, with the standard deviation of annual growth falling from about 1.1 per cent to 0.9 per cent. The mean growth rate has risen substantially, while variability has declined: any portfolio manager would like to deliver that combination. While all this has occurred, moreover, global inflation rates have declined, become less variable and less dispersed among countries. There are very few countries with seriously high inflation now. Graph 2 Yet while the aggregate performance has improved, we hear more talk than ever before about socalled ‘imbalances'. By this, people mean that the expansion in the world economy has been associated with a largish and growing deficit on trade and current accounts for the United States, the counterpart of which is a string of surpluses in a number of other countries. (Indeed, one of the few countries with which the US does not run a trade deficit is Australia.) It is historically a bit unusual for a country as large and wealthy as the US, issuer of the world's main reserve currency, to sustain deficits of this size, and increasing, over a lengthy period. Graph 3 There are three questions worth posing about all this. First, how did it come about? Second, was there an alternative path available for the United States (and the world) which would have been more attractive? And third, what might happen from here? It is worth recalling that rising US trade deficits were regarded as a concern as far back as the mid 1980s. 2 It was a common view then that deficits much smaller than today's were unsustainable. There has been a trend going on here for 20 years at least. Hence, we should be wary of explanations that rely only on factors which have been at work just lately; something structural in American behaviour, prompting a lower rate of saving out of current income, has been going on for a long time. That is a topic for a whole speech on its own. For today, I will take it as a given. But if that were all there was to it, one would expect that long-term interest rates would be rising: other things equal, a lower rate of saving by the world's largest economy ought to be reflected in a higher scarcity value for saving. Yet over recent times, as the US current account deficit has continued to grow, long-term interest rates have remained low, and are lower today than 10 years ago. How so? Over the past seven or eight years, it seems that behaviour in other countries has had a lot to do with the pattern of capital flows. Internationally mobile capital that had flowed into east Asia earlier in the 1990s reversed course and flowed out after mid 1997. (Something similar happened a little later in Latin America.) Domestic investment activity collapsed, and there was a surplus of saving over desired investment. Subsequently, the Asian countries also made voluntary outflows of official capital. Seeing the crisis as a result of not having had enough foreign reserve assets to defend their currencies against speculative attack, and judging that the international insurance offered by the IMF was insufficient and came at unfavourable terms, many policy-makers in Asia decided to self-insure against another crisis of the same kind. They did so by intervening to build up large holdings of US dollars (and, in the process, offering their traded-goods producers a competitive advantage as a way of fostering recovery from recession). China was not badly affected by the crisis but nonetheless for its own reasons has been following a similar strategy. While China's investment rate is extremely high, its saving seems even higher, and it has accumulated a large stock of dollar assets. So it appears that there has been in a number of countries an excess of saving over national investment needs, which has flowed abroad looking for returns. All other things given, this puts downward pressure on the international cost of capital. In which regions of the world would such capital end up? The answer is that it would be expected to gravitate to those regions where the demand for capital is most likely to rise in response to a decline in its price. Those regions have tended to be mainly (though not exclusively) the English-speaking countries with well-developed and innovative financial systems, optimistic populations and high levels of home ownership, the US foremost among them (but also including the UK and Australia). The households of these countries responded to a decline in the cost of capital by using more of it. Countries where populations were inherently pessimistic rather than optimistic about the future - some parts of continental Europe, say, or Japan - seemed less interested in using that cheaper capital. Other factors have also been at work, of course. No single cause ever explains everything. But the above, I think, explains a lot of the pattern of global growth and the payment ‘imbalances' that have characterised it in recent years. Was there a more ‘balanced' path of global expansion that could have been taken instead? It is far from clear that there was. Suppose, for example, that the authorities in the US, concerned about a rising trade deficit, had slowed their economy in order to reduce imports. All other things equal, the world economy would have grown more slowly as a result. The recovery we have seen in Asia from the crisis would have been slower and more difficult, and there would have been insufficient global demand to utilise the available productive resources. It is possible that the surplus countries would have reacted by expanding their domestic demand sufficiently to offset the weaker demand from the US, but in my judgement this would have been unlikely. Hence, what might perhaps have The following was fairly representative of the consensus at the time: “The United States cannot continue to have annual trade deficits of US$100 billion, financed by an ever-increasing inflow of foreign capital. The US trade deficit will therefore soon have to shrink … Indeed, within the next decade the United States will undoubtedly exchange its trade deficit for a trade surplus.” (Martin Feldstein, Foreign Affairs, 1987– available at http://www.foreignaffairs.org/19870301faessay7841/martin-feldstein/correcting-the-trade-deficit.html). Since that time, the US trade deficit has averaged US$227 billion per year, and is currently running at about US$730 billion per annum. The point here is not that deficits don't matter, but that the willingness of capital to flow across national boundaries seems to have greatly increased. Hence, notions of what was sustainable that were predicated on observations from an earlier era of limited capital mobility proved not to be very useful in making predictions. been a more balanced global path with smaller current account deficits and surpluses would almost certainly have been a weaker one for all countries. As it was, policy-makers in the US (and a number of other countries) sought to combine full employment and price stability by allowing domestic demand to run ahead more strongly. This provided enough demand both to absorb the Asian trade surplus and keep the output of their domestic economies near full capacity. These policy-makers didn't do this out of altruism; they did it because they judged it to be in their nations' best interests. Nonetheless, their behaviour was, in my view, a stabilising force. ‘Unbalanced' growth has, so far, been better than the likely alternative. Has this strategy carried risks? Yes, it has. In the faster growing countries, household debt levels have increased, and asset prices have risen. Higher leverage, other things equal, means that households would be more exposed if economic activity turns down than they would have been otherwise. These risks have been weighed against the risks in the alternative path, and policy-makers are managing them as best they can. As for what might happen from here, it is common for observers to warn against the risk that the ‘imbalances' may unwind in a disruptive fashion. Often this is not spelled out. What is sometimes meant, I think, is that those currently accumulating dollar-denominated claims suddenly change their minds, precipitating abrupt movements in exchange rates and interest rates. Such developments might, in this view, lead to a pronounced weakening of domestic demand in countries like the US if long-term interest rates rose abruptly, while a big decline in the dollar might affect the ability of areas like Europe to export. One can never rule out the possibility that financial markets will suffer a sudden and dramatic loss of confidence. But it is not as though markets are unaware of the various ‘imbalances' or the associated risks – they read about them on a daily basis. Yet the actual pricing for risk in markets apparently suggests an assessment that risks in general are of relatively little concern at present. Graph 4 In the event that there is some market discontinuity, I suspect that it is more likely to be sparked by some sort of credit event that prompts a change in appetite for risk in general, than by reactions to current account positions per se. It is not obvious that US interest rates would rise, or the dollar fall, in the face of such an event. That is not to say that there are no adjustments to various national strategies which would be in the interests of the countries concerned, and which would assist in re-balancing global growth while retaining global full employment. But that proviso - retaining full employment - is key. If the adjustment is undertaken only by the countries with large current account deficits, it is hard to see how it could not be contractionary for growth everywhere. That would not be the ideal solution. Australia's Domestic Economy and Monetary Policy There is not very much I can say that is new on the domestic economy, given the recent release of our Statement on Monetary Policy and our appearance before the House Economics Committee last week. Let me reiterate the main themes. Graph 5 Growth in domestic demand in Australia has moderated somewhat over the past year and a half. This is not unwelcome, as continued expansion at an annual pace of 6 per cent, which we saw for several years, was unlikely to be able to continue without causing overheating. As it was, some individual sectors were overheating at times. The residential construction sector, for example, operated at peak levels over a few years, and saw shortages of tradespeople, construction delays and substantial increases in costs. Pressure was also transmitted to those parts of the manufacturing sector which supply materials. Had this been a more general story across the economy, we would have witnessed a significant rise in overall inflation, necessitating a much more active tightening of monetary policy. But because some other parts of the economy were for a time growing more slowly, and because prices of tradeable goods were reduced owing to global competition (and an appreciation in the currency), the policy response was very gradual. It was essentially limited to returning interest rates to approximately normal levels after a period in which they had been unusually low. The shift in the composition of demand is also welcome. Household spending had risen rapidly for several years, outstripping income gains, boosted in part by the exuberance associated with the housing boom. As that boom subsided - as it turns out, so far, in a very benign way - so household demand has gradually slowed. Businesses, meanwhile, have continued to ramp up investment spending, in response to the widening incidence of capacity constraints in the economy - something which has been an increasingly prominent theme in our regular discussions with companies across the country in the past couple of years. With global demand for resources strong and prices high, the resource sector is prominent in the pick-up in investment, but other sectors too are responding to the need for more capacity. Business profitability, though squeezed in some areas by rising costs of materials and labour, remains in good shape, and of course the cost of external finance remains quite favourable. So conditions seem quite propitious for further growth in investment. Over the medium term, the resulting increase in capacity will help to accommodate good, noninflationary growth. In the short term, though, the act of adding to capacity itself adds to demand, potentially putting pressure on productive resources. So it is fortuitous that household demands have moderated at the same time as business investment has increased. Inflation is well contained at present, despite a number of forces being at work which ordinarily could be expected to push it noticeably higher. A tight labour market has been putting pressure on labour costs. A strong world economy has pushed up demand for various commodities, whose prices have responded, raising input costs for businesses. Graph 6 Through all that, CPI inflation has risen to 2.8 per cent in 2005, from 2.4 per cent in 2003. The Bank computes a range of measures of core or underlying inflation, designed to abstract from temporary price movements so as to show the longer-term trends. In our most recent Statement on Monetary Policy, these were characterised as running at about 2½ per cent, little changed from the outcomes of the preceding couple of years. In summary, despite a fully employed economy and higher oil and raw materials prices, overall inflation has remained quite well behaved. If anything, it is probably running slightly lower than we expected six months ago. While small deviations in outcomes from those forecast are not unusual and are not necessarily of significance - we are talking about fractions of a percentage point here, which certainly are not significant in the statistical sense - it is worth contemplating what might account for lower than expected inflation. There are two hypotheses on offer. The first is that the steady internationalisation of trade in goods and services continues to exert pricing discipline on domestic producers, and that this discipline is, at the margin, a bit more powerful when growth in demand has softened, as it seems to have done. Hence, this hypothesis holds, while a number of costs are rising, firms are working hard to find offsetting savings and absorbing some of the impact in their margins. It might be argued that this price discipline coming from international trends will persist, as the emergence of China and India continues. The alternative hypothesis is one of lags: that the full impact of the cost increases seen over the past couple of years will show up in time even with the discipline of foreign competition. Unless demand conditions are particularly weak, firms will manage to pass on cost increases and restore margins. On this view, noticeably higher inflation is not far away, even if it is taking a little longer to arrive than initially expected. In forming its judgement about the outlook, the Bank has contemplated both these possibilities. The forecast for inflation we set out in the recent Statement is one that allows for some passing on of higher costs that have already been incurred, but not by as much as historical experience would indicate. This sees inflation running at 2½ to 3 per cent for the next couple of years. The risks around this forecast could be described as balanced. It is possible that a rise in inflation in response to the cost imposts of the past few years will arrive more suddenly; but it is also possible that the international and domestic competitive forces will be strong enough for long enough that those imposts will be offset elsewhere, and never show up in prices. Given this outlook, it follows obviously that the Bank is more likely to tighten policy than to ease in the foreseeable future. An assessment of balanced risks, around a forecast of 2½ to 3 per cent inflation, means that it is more likely that a surprise will take inflation above the target of 2-3 per cent than below it. Hence, a rise in rates is more likely than a fall. That is a statement of probabilities, rather than one of near-term intent. In fact, that has been our thinking for some time. Through most of last year, we felt that inflation would probably tend to rise, and we would probably need to tighten further at some stage to limit the rise. But we also thought that the rise would be gradual, against a backdrop in which inflation expectations were pretty well anchored. Hence, we felt that in formulating our policy response, we had time on our side, a luxury previous generations of policy-makers usually did not have. We took advantage of that to wait, evaluating further information before acting. Thus far, I judge that to have been an appropriate strategy, especially given the inflation outcomes of late. Nonetheless, the Bank has to remain watchful in the face of a number of factors which obviously could push inflation higher. We will be ready to respond as needed so as to maintain low inflation. | reserve bank of australia | 2,006 | 2 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the 2006 Securities & Derivatives Industry Association conference, Melbourne, 27 May 2006. | Glenn Stevens: Risk and the macroeconomy Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the 2006 Securities & Derivatives Industry Association conference, Melbourne, 27 May 2006. * * * I am pleased to be here in Melbourne to take part in your conference. There seems no better issue to discuss with a group of securities and derivatives professionals than risk and its pricing. This is quite topical since, as you would be well aware, the extent of additional return paid to investors to take on risk seems to have been unusually low in recent years. There are several questions that naturally arise, and which I would like to address. First, how does the recent period compare historically? Compensation for risk is low compared with the 1980s and 1990s, but what can we learn from a longer-run comparison? Second, to what extent can it be claimed that the underlying economic outcomes, which presumably have a major bearing on investors’ perceptions of risk, are less “risky” or volatile than they used to be? Third, what are the odds that this apparently benign environment will persist? What factors might prompt a change? What is risk? To begin, it is perhaps important to be clear what we mean by “risk”, and how it differs from “uncertainty”, a distinction first made by Frank Knight 1 in 1921. He wrote: “The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of past experience), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique.” Risk can be priced, on the assumption that the probabilities in the future will be those inferred from the past. In Peter Bernstein’s 2 excellent book Against the Gods, the early development of thinking about risk is presented as arising from the study of games of pure chance – where the odds are precisely calculable. The classic response to the chance-like characteristics of life is insurance. Actuaries draw up tables of life expectancy for a population based on historical experience, and insurance companies, with reasonable confidence, price policies. The probability and likely cost of certain other events – fires, car accidents, etc. – is sufficiently calculable that, over time, risk can be priced. In the case of uncertainty, we don’t or can’t know the parameters of the distribution. Events that have no known parallel in recent history, where there is no basis for determining expected frequency or impact, will not easily be amenable to pricing. An avian flu pandemic, for example, could result in a frequency and severity of illnesses and a number of deaths that is outside any recent historical experience, with important implications for life and health insurance providers. In fact, many economic and financial processes produce outcomes that do not come from any known statistical distribution, because the human interactions which drive them are not like the turn of a roulette wheel or throw of a dice. In such a world, quantification and formal management of risk can go only so far; there will always be some possibilities that simply can’t be priced. These issues are quite important, and will intrude into our discussion later on. But for now, let me turn to what the quantitative evidence can offer us. Frank H. Knight (1921), Risk, Uncertainty and Profit, Houghton Mifflin Company, Boston. Peter L. Bernstein (1996), Against the Gods, John Wiley & Sons Inc., New York. Risk Pricing The place to start is with the level of long-term rates on highly rated sovereign debt. Given that the likelihood of default by such countries is remote, what is being priced here, essentially, is the rate and variability of future inflation. For those of us whose economics awareness dates from some time in the 1970s or later, it certainly seems that long-term interest rates globally have in recent years been unusually low. In the United States, 10-year Treasury note yields were below 5 per cent over several years, which stands out compared with the history of the preceding few decades. Furthermore, it is historically unusual for these rates to have been low and pretty steady at a time when the Fed is raising short-term rates. That this would coincide with a sizeable US budget deficit, and a US current account deficit of unprecedented magnitude, was certainly not anticipated by any observer I can recall. It was labelled a “conundrum” 3 , and “an intriguing financial phenomenon” 4 by successive Fed chairmen. Long-term interest rates in other major centres – Japan and Europe – have been even lower than US rates. As recently as 2003, Japan’s rates were the lowest on record anywhere that we could find over several centuries. These yields too have risen somewhat from those levels, but remain very low by standards of the past couple of decades. Because sovereign yields in major countries have been low, so have those for most private borrowers and many emerging-market sovereign borrowers in capital markets. But there has also been considerable compression in risk spreads for both corporate and emerging-market sovereign debt, which takes them back to levels that were observed in the mid 1990s. Many observers have a feeling of discomfort about all this – since, on some previous occasions, spreads this low quickly gave way to much higher pricing for risk in the face of some event, like the Asian crisis, the LTCM episode or the global downturn of 2000-01. All too often, risk has – in hindsight – been underestimated in good times and overestimated in bad times. Bond Spreads To US government bonds, duration matched Bps Bps Emerging markets sovereign US corporate ‘junk’ (B-rated) US corporate BBB-rated Sources: Bloomberg; RBA; Thomson Financial Against the backdrop of the past century, on the other hand, recent levels of long-term US interest rates do not look especially low; they look quite within the range of historical experience, especially experience when inflation was low. The 1970s and 1980s look more like the outlying period. Nor have spreads, for US corporate debt at least, been all that low when viewed from this longer perspective. There were lengthy periods in the mid part of the 20th century when spreads were as low as or lower than they are today. Greenspan, at http://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm. Bernanke, at http://www.federalreserve.gov/boarddocs/Speeches/2006/20060320/default.htm. US Corporate and Government Bond Yields Monthly % % BAA AAA A AA Treasuries 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: Global Financial Data; Moody’s US Corporate Bond Spreads Rolling 3-month average Bps Bps BAA A AA AAA 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: Global Financial Data; Moody’s It is more difficult to get consistent data for emerging market yields and spreads over history. But a study released a few years ago by the IMF suggested that, on average, emerging market spreads in the 1990s were much higher – twice as high or more – as in the period of globalisation and free capital flows leading up to World War I. 5 Now it could immediately be objected that the world of today is a vastly different place from that of these historical episodes, so that any comparison is not valid. During World War II and up to 1951, US bond rates were effectively pegged by the Fed under the monetary procedures then in place. Hence, the bond market was not really a market. 6 The US corporate debt market was not so regulated but it was a vastly reduced market in size in this period, after the extremely high rates of default in the Paolo Mauro, Nathan Sussman and Yishay Yafeh (2000), ‘Emerging Market Spreads: Then Versus Now’, IMF Working Paper, WP00/190, November (available at http://www.imf.org/external/pubs/ft/wp/2000/wp00190.pdf). This ended with the 1951 “Accord” between the Federal Reserve System and the US http://www.richmondfed.org/publications/economic_research/the_fiftieth_anniversary_of_the_treasuryfederal_reserve_accord/ for details. Treasury. See period of the Great Depression. 7 The peak number of US corporate borrowers rated by Moody’s in the mid 1920s was not surpassed until 1997. 8 So while those bonds that were in the market from the end of World War II until the early 1970s paid quite low spreads, it is not clear to what extent this provides a reasonable basis for comparison with the larger and more active market of today. On the other hand, it is a natural human tendency to think that the world we face is unprecedented in its risk and complexity compared with the past, when it probably is not. 9 It has to be said as well that the 1970s and 1980s were also, historically, rather an unusual period. This era saw a major outbreak of price inflation, which had hitherto been seen only during wars. Inflation was not only high, but highly variable, and policy-makers struggled to formulate an effective response. This was extremely disruptive for fixed-income markets, and for financial asset pricing generally. Nominal yields rose to unheard of levels. 10 The business cycle downturns of this period seemed to be much more damaging than earlier post-World War II recessions. In general, it was a period of considerable macroeconomic instability. That instability has subsided considerably since then, as I shall show in a moment. But the echoes of the 1970s and 1980s – an intellectually formative period for most of us here – took a long time to fade; just as nominal interest rates took time to recognise rising inflation, they took time to recognise what was clearly, in hindsight, a fundamental regime shift in inflation which occurred in most countries in the mid 1980s. So in assessing the level of interest rates or spreads for reasonableness, it can be difficult to find a period of history that can serve as a neutral basis for comparison. While the mid 20th century might not be ideal as a benchmark, the 1970s and 1980s are surely quite unsatisfactory. Perhaps the safest conclusion is that no historical period can be assumed unambiguously to be a good benchmark for pricing. Each period is different and we need to make efforts to understand the forces at work in economies and financial markets at the time. Economic variability That brings me to the second set of questions: is there any evidence, at a macroeconomic level, that economies are less volatile than they were in the past? The answer is clearly yes. A host of studies have documented a decline in the variability of GDP growth not only in the United States but also in a number of developed economies, even though there are still periodic recessions. 11 One authoritative study found that one-tenth of investment grade and over one-third of speculative grade corporate borrowers defaulted between the end of 1931 and the end of 1935. See W. Braddock Hickman (1958), Corporate Bond Quality and Investor Experience, Princeton University Press for National Bureau of Economic Research. David T. Hamilton, Praveen Varma, Sharon Ou and Richard Cantor (2006), ‘Default and Recovery Rates of Corporate Bond Issuers, 1920-2005’, Moody’s Investors Service. Is the world a more risky place today than it was 50 or 60 years ago? I am not sure that it is. We can point to the threat of terrorism, the impact of globalisation on various business models, avian flu and so on. But without wishing to downplay the importance of those factors, the earlier era included World War II, the Korean and Vietnam wars, the broader cold war with its threat of nuclear conflict, and intense political uncertainty and risk in various countries. In late-1940s Australia, for example, the Federal Government sought to nationalise the banking system – presumably a source of considerable risk for the owners of the time. There were also major technology changes in that era, which would have destabilised some important existing business models. For example, the development of air transport, and its acceleration (literally) with the development of the jet aircraft in the 1950s, would have changed the outlook for railroads and ocean travel dramatically. The advent of transistors was, by the 1960s, transforming the electronics sector long before the PC or the flat-panel screen arrived. Arguably the world was no less “risky”, or more precisely, a no less uncertain place in those days. Bernstein writes (op cit, pp. 334-335): “In the early 1970s, long-term interest rates rose above 5 per cent for the first time since the Civil War and have dared to remain above 5 per cent ever since”. This was written in 1996. Long-term US rates have, of course, subsequently traded as “low” as below 4 per cent and are currently about 5 per cent. This territory presumably looks much more familiar to people who remember the 1950s and 1960s. See http://www.kc.frb.org/publicat/econrev/PDF/3q05summ.pdf http://www.federalreserve.gov/pubs/feds/2005/200554/200554pap.pdf http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=5413 http://www.phil.frb.org/files/wps/2003/wp03-22.pdf http://www.nber.org/papers/w12079.pdf Much of this literature has tended to compare the period since the mid 1980s with the preceding couple of decades. But in fact, for the US at least, a decline had been under way long before then. Work conducted by one of my RBA colleagues, John Simon, 12 documents a long-term trend decline in US output volatility dating from the early 1950s, which was interrupted by the 1970s’ and early 1980s’ instability. Variability of Real GDP* 1951-69 United States OECD Australia Average growth % Standard deviation % pts Average growth % Standard deviation % pts Average growth % Standard deviation % pts 4.0 2.55 n.a. n.a. 4.5 2.37 # 3.1 2.01 1.91 # 1970-85 3.0 2.76 3.2 1986-2005 3.1 1.26 2.8 0.90 3.4 1.53 1996-2005 3.3 1.27 2.7 0.78 3.7 0.94 * Based on annual data # Data are for 1971-85 Variability of Core CPI Inflation* 1958-69 United States OECD Average rate Standard deviation Average rate Standard deviation Average rate Standard deviation 2.5 1.67 n.a. n.a. n.a. n.a. 8.7 3.16 # Australia 1.92 # 1970-85 6.7 2.91 10.1 1986-2005 3.0 1.08 4.9 2.18 3.6 2.25 1996-2005 2.2 0.43 3.2 1.10 2.4 0.46 * Based on December quarter on December quarter data # Data is 1978-85 An even more remarkable feature of the past 15 years is the trend decline in both the rate of inflation and the variability of inflation. The average rate of inflation since the mid 1990s in the US has been about one-third of what it was in the period 1970-85, while the volatility of inflation has fallen to about one-seventh of its previous value. Quite similar results have been observed in Australia. For the OECD group, the trend is similar though less pronounced. These trends are surely of great importance for financial pricing. There will always be individual businesses that fail because of technological obsolescence, flawed strategies and so on – idiosyncratic risk remains. That is why the list of firms in the Dow Jones 30 or the ASX top 50 is rather different today from a decade or two ago. 13 But insofar as the probability of default usually rises sharply in a business cycle downturn, it must matter that the size of year-to-year fluctuations in economic activity is half what it once was. And the value of re-attaining virtual price stability around the world, dramatically reducing one source of uncertainty over the future value of nominal claims, should not be underestimated. High and variable inflation is a powerful deterrent to people parting with their money for long periods. To the extent that the term premium in long-term interest rates reflects compensation for both the level and the volatility of expected future inflation, one could expect those premia to be reduced if we have returned to a world of near price stability. An alternative way to make Olivier J. Blanchard and John A. Simon (2001), ‘The Long and Large Decline in US Output Volatility’, MIT Department of Economics Working Paper 01-29, April (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=277356) For the Dow Jones 30, 15 of the current companies were present in May 1986. For the ASX 50, 18 were there in 1988. the same point is to note that a more stable world means less variation in policy interest rates, which presumably reduces premia built into longer-term rates to compensate for expected future variability in short rates. That having been said, the evidence for this greater macroeconomic stability producing less volatile returns to equity or bond investors to date is mixed. Volatility in returns to equity holders, measured by rolling standard deviations of quarterly accumulation index returns, displays pronounced cycles. But there is little obvious tendency for equity returns volatility in the US or Australia to be systematically lower since the early 1990s (though for Australia it was lower than the peak levels of the mid 1970s). Volatility in bond returns tended to remain reasonably high in the US in this period, notwithstanding the improvement in inflation stability. 14 If this indicates continuing volatility in subjective discount rates, it may have limited the extent to which volatility of equity returns could fall. 15 Were macroeconomic stability to continue, it is conceivable that long-term interest rates might also become more stable; that would presumably carry some implications for equity (and other asset) valuations. But whether that occurs or not remains to be seen. Indeed at present we seem, if anything, to be seeing something of a pick-up in short-term volatility in many asset classes. Volatility of Stock Market Returns Rolling 3-year standard deviation of monthly returns % % United States Australia Sources: Global Financial Data; RBA The data suggest that volatility of returns to holders of US Treasuries soared during the economic instability of the late 1970s and early 1980s, as the US fought and ultimately broke a serious inflation. In Australia’s case, an apparent rise in volatility in the 1980s mainly reflected the bond market becoming a real market again, rather than a captive arrangement for investors. Volatility of returns these days is comparable to the US results. On this point, see remarks by Roger Ferguson, November 2005, at http://www.federalreserve.gov/boarddocs/speeches/2005/200511152/default.htm. Strictly speaking, the volatility of equity returns is related not just to the volatilities of the flow of earnings and discount rates, but also the co-variance between earnings and discount rates. Volatility of 10-year Government Bond Returns Rolling 3-year standard deviation of monthly returns % % Australia United States Sources: Global Financial Data; RBA The evidence for enhanced stability for emerging markets is not so easy to come by. But it could be said, I think, that the fundamental position of a number of emerging-market countries has improved since the late 1990s. They have increased growth and greatly reduced inflation. The median credit rating of the countries in the JPMorgan EMBI has risen by two notches. Recent work by the IMF suggests that such factors can account for part, though not all, of the decline in spreads in recent years. 16 Of course, the fact that this has been a period of quite stable economic outcomes and low yields in developed countries, hence prompting a search for yield elsewhere, has been a big advantage to emerging-market borrowers. But a number of these countries do seem to have been using the benign conditions to strengthen their financial resilience. One of the periodic tests of that resilience appears to be under way at present. Key Indicators for Emerging Markets* GDP Growth (%) 2.7 3.8 4.1 Inflation (%) 21.4 7.0 4.1 S&P Credit Rating BB+ BB+ BBB * Median values for group of countries in JPMorgan EMBI Global Sources: Bloomberg, IMF World Economic Outlook This very brief look at some of the key facts cannot claim to be a comprehensive analysis. Nonetheless, a marked improvement in macroeconomic conditions in many countries – not just lower volatility of growth, but also a vast reduction in inflation and inflation variability – after the upheavals of the 1970s and early 1980s would seem to have been an important factor conditioning financial pricing for “risk” over recent years. That this might show up in yields and spreads, which look a bit more like they were in the 1950s and 1960s, and less like they were in the 1970s and 1980s, is not that surprising. We cannot be sure, of course, whether the extent of the change has been appropriate, but we can at least see some logic for its direction. Can it last? The final question, then, is whether this apparently benign state of affairs can persist. See ‘Main Drivers of Emerging Market Bond Spreads: Fundamentals or External Factors?’, (Box 1.5), Global Financial Stability Report, International Monetary Fund, April 2006, pp. 28-31 (available at http://www.imf.org/External/Pubs/FT/GFSR/2006/01/index.htm). In particular, given that long-term yields and spreads have recently been at levels seen for lengthy periods after World War II through until the 1960s, is it possible that the prospective environment for capitalist economies is actually like it was during that period? The post-war era was a period when there were still business cycles, but there was a long-asting and pretty robust secular expansion in economic activity and global trade, with relatively little instability. Granted, in Europe and Japan there was the rebuilding and “catch-up” after wartime devastation, which no longer needs to occur. But in its place is catch-up by China, India and a range of smaller economies which are engaging in the international economic and financial system. The openness of that system, if we are able to maintain it, arguably offers as much scope for strong growth accompanied by price stability as did the post-war world. Or is it the case that people are underestimating the likelihood of less stable times in the future? Is there, just around the corner, some event that will usher in a period of instability, triggering a wholesale reappraisal of economic and financial prospects, and hence appetite for risk? In that scenario, some of the financial exposures that were taken on in a mood of optimism over the past several years could be unwound, possibly quite disruptively. One’s answer to such questions hinges to a considerable extent on what one thinks was behind the enhanced stability of the past decade and a half. Better macroeconomic policies, better microeconomic policies, globalisation, technological advance, good luck – all of these can plausibly be argued to have played a role. People can make their own assessments of the likelihood of a continued role for such factors (presumably one should not rely much on luck!). 17 The truth, however, is that our capacity to predict even the near-term future is limited. Grappling with the question of whether we are in a new epoch – and pricing accordingly – is an even bigger ask. Following World War II, the main fear among the economics fraternity in many countries was of another depression and deflation akin to the 1930s, as the demand provided by defence expenditures tailed off and military personnel re-entered the civilian labour force. 18 In fact, partly as a result of that policy preoccupation, the economy expanded strongly through the 1950s and 1960s, and it was inflation, not deflation, that ultimately turned out to be the problem – a problem which then took quite some time (in Australia’s case, two decades) to sort out. That should, if nothing else, make us cautious about long-term prediction. But the end of the long post-war boom also highlights something else. We can see now that during that period, businesses, wage earners, industrial tribunals and policy-makers gradually adapted their behaviour as they came to assume that the long expansion could continue indefinitely. As they did, they sowed the very seeds of the expansion’s demise. The oil price rises of the mid 1970s were a shock, but the other problems on the supply side of market economies had been developing for some time. And that, perhaps, points to the relevant question to pose at present. It is possible that the world is in for another period of stability like the 1950s and 1960s. But even if it is, even if some of the “risks” of economic life, insofar as we can quantify them, are actually lower, or can be better managed, people will adjust to that. So the question is: might not the behaviour of borrowers, lenders, investors and price setters, in response to perceived lower risk, itself work to increase the probability of instability in future? This, of course, is the question posed about the tendency of households in some countries (including Australia) to take on much more debt. In enjoying – rationally, based on lengthening experience – the opportunities afforded by a more stable macroeconomic environment and a more complete and liquid set of capital markets, are they in the process gradually impairing the very resilience to economic shocks which helped to produce the stability in the first place? It is not saying anything new to note that this is a significant source of uncertainty for policy-makers: there is no historical dataset to draw on in estimating how households might respond to a macroeconomic downturn under conditions of As others have pointed out, though, improvements in these various areas do not make for continuing reductions in risk premia and rises in asset valuations – only a one-time adjustment. It is important that people understand that point, rather than just extrapolating trends. See Paul Tucker (2006), ‘Uncertainty, the Implementation of Monetary Policy and the Management of Risk’ (available at http://www.bankofengland.co.uk/publications/news/2006/056.htm). See, for example, Joseph D. Coppock (1962), International Economic Instability – The Experience After World War II, McGraw Hill, pp 1-2; Richard N. Cooper (1993), in Michael Bordo and Barry Eichengreen (eds), A Retrospective on the Bretton Woods System, University of Chicago Press, p 105. much higher leverage. Nor, for lenders, could historical rates of default on mortgages be assumed to be a good guide to the future, since that dataset is derived from an era of different behaviour. It cannot be assumed that future outcomes will be drawn from the same distribution. Questions could well extend – once again – to some corporate entities before much longer, given the re-emergence of leveraged buy-outs, which leave the cash-flow positions of the corporations more precariously balanced. At least here there is, admittedly, more historical experience as a guide to likely subsequent behaviour. Of perhaps more immediate relevance, considerable sums of money have been risked over recent years in various manifestations of the search for yield, which depended on a degree of stability and predictability in global short-term interest rates that was unlikely – even with a more stable macroeconomy – to last for a long time. While I believe central banks will continue to control inflation over the years ahead, this does require short-term rates to move: they cannot stay low and steady permanently. Market action around the world over recent weeks reflects, in part, some adjustment to previous assumptions about the likely degree of short-term rate variation in major countries which were overly sanguine. There are also some challenging questions associated with the very rapid growth seen in credit derivative markets in recent years. Generally speaking, this should be promoting the more efficient pricing of credit risk and helping to shift it away from its intrinsic origin in businesses and their bankers to a broader set of holders who really want it. From the perspective of economic and financial stability, such a trend is to be welcomed. But even leaving aside the question of whether some investors know what they are actually getting into, the amount of leverage that can be embedded in such products is a potential source of trouble. There is also considerable uncertainty about whether, under conditions of stress, liquidity in these markets will be such as to allow risk-holders to manage their positions. I have made it almost to the end of my presentation without mentioning “global imbalances”. It is time they received a mention, though not in the way you probably would expect. While there are some risks posed by the possibility of disorderly changes to interest rates, exchange rates, American consumption patterns and so on, I think the biggest risk stemming from the imbalances is of another kind. It is that the wrong conclusions will be drawn, based on partial or simply wrong analysis, with the result that structural problems in various countries will not be addressed, and/or that protectionism will flourish, under the guise of attempts to affect bilateral “imbalances”. That would undermine the global openness that has helped to produce the enhanced stability we have been enjoying. Conclusion It is frustrating that we cannot offer a definitive assessment of the adequacy or otherwise of pricing for risk. Taking a long historical perspective, it is not unreasonable to claim that risk – at least aggregate economic variability – really is lower, in some important dimensions, than it was 10 or 20 years ago. Certainly the 1970s and early 1980s – a period which deeply affected financial markets for a very long time – were themselves unusual and not a good benchmark for judging pricing. Yet notwithstanding this evidence, experienced hands almost invariably have an uneasy feeling about developments. In part, that unease reflects a conviction that the business cycle (and the cycle of greed and fear in markets) has not gone away. But it also reflects a recognition that behavioural changes are occurring, in response to the environment we face, which could elevate risks or create new ones. At some point, the financial structure emerging as a result of this behaviour will be tested. But exactly when the bell might ring to signify a new phase of the game, and what event might be the catalyst, we cannot say. In other words, life remains uncertain. That is a good reason why, as my US colleague, Tim Geithner, 19 suggested recently, thoughtful managers will surely be using the good times to strengthen resilience, and will be wary of the “late cycle” tendency for risk management and credit standards to become lax. Even if the future is pretty stable, there will still be a business cycle. Some occasional counter-cyclical behaviour gives us the best chance of continuing the stable, steady conditions – and good returns for investors – that markets seem so confidently to expect. Timothy F. Geithner (2006), “Risk Management Challenges in a Changing Financial Environment” http://www.bis.org/review/r060407a.pdf). (available at | reserve bank of australia | 2,006 | 6 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at a luncheon co-hosted by The Anika Foundation and Australian Business Economists, Sydney, 13 July 2006. | Glenn Stevens: The conduct of monetary policy Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, at a luncheon cohosted by The Anika Foundation 1 and Australian Business Economists, Sydney, 13 July 2006. * * * I am pleased to see so many of our colleagues from the financial sector here at the first public function held by The Anika Foundation. Adolescent depression and suicide are a major problem. By supporting research, The Anika Foundation can make a major contribution to effective treatment of this disease, and thereby make a difference in the lives of our children. So on behalf of the Board of the Foundation, I thank all of you for coming along. Thank you also to Citigroup for generously donating the venue, and to the Australian Business Economists for their invaluable support. I want also to pay tribute to Adrian Blundell-Wignall and his family, for their courage and generosity in conceiving and establishing The Anika Foundation. All of us who know them, or who ever met Anika, can only admire the way in which her memory is honoured by this endeavour. Adrian, Jane, Tate and Danae, we salute you for turning your own tragedy into such a fine idea; we want to help you realise it. That depressive illness should be such a widespread problem in a period of such apparent affluence reminds us, of course, that there is much more to life than the mere material. Those of us paid to work at maximising the material circumstances of our citizens through the conduct of economic policies trust, nonetheless, that prudent behaviour on our part can make a difference, and in some way help to provide the resources needed for those, ultimately more valuable, non-material pursuits. My topic is the conduct of monetary policy. It will be less a commentary on current economic conditions and prospects than an exposition of the decision process and principles that have guided our actions over recent years. Of course I can only give my own perspective, and other members of the Board, past and present, might put it a little differently. Nonetheless, I hope my remarks may help observers better to understand our decisions – even if they cannot always predict them. Process I begin with some discussion of process. For the most part, it is not much changed from the way I described it in detail in a speech about five years ago. 2 The monthly Board meeting cycle begins with staff analysis of statistical and liaison information. A large data set is monitored – a couple of thousand domestic and international data series are routinely tracked, including all the major ABS statistical releases, and at last count 16 privately compiled Australian business surveys. Following this, there is a sequence of meetings involving the most senior staff and the Governors, and the preparation of memoranda for the Board. The process culminates in the Board meeting, held on the first Tuesday of the month. 3 Papers are available to members over the preceding weekend. The meeting itself commences at 9.30 am, with presentations by the most senior staff which elaborate the main issues in the papers. These set the scene for an active discussion, following which the policy decision is taken. The Board also considers other matters, more of an internal RBA governance nature, but typically the vast bulk of the meeting’s time is taken up on monetary policy. The meeting usually concludes about 12.45 pm. The announcement of the decision is made at the beginning of the following financial trading day. The Anika Foundation was established in 2005 to raise funds for the purposes of supporting research into adolescent depression and suicide. For details, see http://www.anikafoundation.com. Glenn Stevens is a member of the Board of The Anika Foundation. Stevens, GR (2001), ‘The Monetary Policy Process at the RBA’, Reserve Bank Bulletin, October, pp 19–26. Available at http://www.rba.gov.au/Speeches/2001/sp_ag_101001.html. The meeting on the first Tuesday in November, by the way, is always in Sydney, despite assumptions made from time to time that it must be in Melbourne. We do meet once a year in Melbourne, but it is usually in the first half of the year. This is little changed from my earlier description. I would simply offer two further observations. The first is to emphasise that the RBA is a very outward-looking organisation, in the sense that we pay close attention to the world economy and financial markets. The most senior staff and the Governors meet every morning to review overnight developments around the world. This is helped by the fact that, as a participant in Australian, Japanese, European and US markets, the RBA has a strong capacity to monitor and assess developments, and ample opportunity for liaison with major market players. A substantial part of the material prepared for Board meetings is international in nature. It is not that we feel the need slavishly to follow every interest rate move of the major countries – the record shows otherwise, as I will shortly demonstrate. But the environment in which the Australian economy and financial markets operate is heavily affected by events and policies in the major regions. I have in mind here not so much short-term factors, but the lower-frequency, more persistent forces at work. Even the most casual review of the rationale for our decisions over the years would reveal a keen sense of the importance of international factors for the Australian economy. It sometimes surprises us how many local market and media commentators place rather little weight on these forces. The second observation is the value of the information of a qualitative nature gained by talking directly to firms, industry associations, State Government departments and so on. This is in addition to the insights the non-executive members of the Board bring from their other activities. The staff in our regional offices have built up a pool of over 1,500 regular contacts around the country, and visit about 100 of them each month. On the basis of those visits, they compile a comprehensive picture of trends in demand, output, labour markets, costs and prices. This is used alongside the standard analysis of the usual macroeconomic time series in forming our assessment of the economy. This material was influential, for example, in us forming the view that the economy was encountering capacity constraints in some areas over recent years. One would expect that to have been the case anyway after many years of pretty robust growth, but we did not base our assessment on that alone. We based it also on the fact that an increasing number of businesses were telling us that constraints were appearing, especially, but not only, in the labour market. This is just one example where being able to complement the dry statistical analysis by talking to firms has been very helpful. Decision-making I turn now to the more important, and altogether more subtle, process of actually coming to a policy decision, and the way in which the decision is understood in the community. Over the past decade or more, we have come a long way. The inflation targeting model is pretty well understood. The community understands that our goal is inflation control, and that low interest rates can only exist with low inflation. Thoughtful people also understand that the way to keep inflation and interest rates low on average is to be prepared to put rates up modestly, but promptly, when inflation pressures start to increase. Generally speaking, financial markets and most of the commentators apply a filter to the data, not dissimilar to the one we apply ourselves. They respond to the ebbs and flows of the economy by pricing in, with varying degrees of probability, responses by monetary policy. To the extent that this minimises unnecessary surprises, which can be costly, and even does a little bit of policy’s job for it, these adjustments are helpful. Yet reflecting on experience of the past several years, there are a few further things which can usefully be said about the proper conduct of policy under this system. Two questions in particular seem worthy of attention. First, what information is relevant to the decision? I have often been asked something along the lines of 'which particular indicator is the RBA paying most attention to at the moment?'. This is usually by people who think that, if they watch that variable too, they will get an early steer on our future behaviour. My answer to the question has always been the same: 'all the indicators'. Of course, we target a measure of price inflation – the CPI – since price stability is the main contribution that monetary policy can make in the long run. So if we could only have one statistic that would have to be the one. But since we are blessed with many data series, we can adopt a 'full information' approach: every piece of economic information we can make sense of is part of the jigsaw puzzle that is the Australian economy. Some variables are perhaps given more prominence in our public utterances from time to time – house prices, for example, a couple of years ago, or the exchange rate a few years earlier. But that is not because we have given up on the standard framework in order to 'target' that variable, as has on occasion been claimed by some market commentators. Rather, it is simply because we see something in the behaviour of those variables that seems to be having a big bearing on how the economy is travelling. So there is no single variable which is the key, and the best guide to our behaviour is going to be to look at the whole picture, to remember what policy is aiming to do – that is, to keep average inflation at 2-3 per cent, ameliorating where possible fluctuations in the real economy – and go from there. I hope, by the way, that by now it is clear that the factual information available to the Board is, with very few exceptions, available to everyone else too. The liaison information is not freely available, of course, but it cannot be at a detailed level because it is given to us in confidence. Insofar as its general tenor affects decisions, however, we try to be clear about how and why it does. While on the question of information, an assumption which seems on occasion to be made by market participants and commentators, though it is not explicit, is that each monthly decision is (or should be) based on very short-term information – even just the information arriving that month. People will then ask whether this information is enough in itself to warrant an interest rate change. But this month’s decision is not based only on this month’s information. The fact that the data available last month did not elicit a change in policy then does not mean that those data do not count in this month’s or next month’s decisions. On the contrary, the accumulation of information over many months remains relevant to each decision, and it is quite possible for a decision to move rates to be made after only a relatively small further strengthening in a case which had already been building for some time. I turn now to the second question: in deciding whether or not the evidence available warrants a change to the level of interest rates, what 'standard of proof' should the Board apply? Should it be the 'murder trial' standard – beyond reasonable doubt? Should it be a 'hair trigger' standard: the latest piece of information says that, all other things equal, inflation could deviate slightly from the target at some future horizon, hence we automatically act – knowing we will quite possibly act in the reverse direction based on next month’s data? Or should it be something else? Some popular discussion seems to assume that the 'murder trial' standard should be applied, at least to rises in rates. The presumption is that a rise in interest rates should only be contemplated when there is clearly no alternative, and no doubt that something must be done to slow the economy in order to contain inflation. You will not be surprised to hear that I think the 'murder trial' standard of proof is not the one we should apply in making monetary policy. By the time it is beyond reasonable doubt that something must be done, it is usually clear that something should already have been done – and, given the lags in policy’s effect, it probably should have been done some time ago. By delaying action, this approach would mean that action, when it comes, will almost certainly need to be more aggressive. So we should not apply this standard of proof for a rate change – it imparts too much inertia. At the same time, we obviously want to avoid the other problem, of excessive activism. We do not want a system that sees rates moving around in response to short-term trends which portend no significant change in the medium-term outlook. That would impart unnecessary instability to the economy and financial markets, and reduce the quality of the signal that policy is sending. So how do we achieve the right balance? It starts by being wary of strong conclusions drawn from short runs of data. Policy has to be more cognisant of the longer-run, usually more powerful, forces at work and not be distracted by ephemeral developments. And, of course, it is well understood that policy has to be forward looking. That means it has to use forecasts. After all, if monetary policy takes some time – several years – to have its full effect on the economy and inflation, forecasts have to be at the centre of things, don’t they? There is no doubt that the process of forming the forecast is central to the conduct of policy under an inflation target. For that matter, this is not unique to inflation targeting. Any policy system which has any degree of discretion and which recognises lags in policy’s effect shares this characteristic. But equally, we need to be wary of reducing the whole regime down to the number for the central forecast. That would give too little attention to the possible outcomes other than the central forecast. I have made this point on several other occasions but it bears repeating. Simply asking 'what’s the number?' will not be a good guide either to making policy decisions or to understanding them. For policy-makers need not only to ask their forecasters what their best guess is, but to think about how good that guess is likely to be. A portfolio manager asks not just about the expected return to a proposed strategy, but also about the range of possible outcomes. He or she asks: if the strategy were to turn out not as expected, what would be the associated costs? The manager then – we trust – makes a decision in light of those risks, seeking to contain the costs of unexpected outcomes. Likewise, policy-makers ask not just what is the central forecast, but what is the range of plausible outcomes – with associated economic costs – either side of that central estimate? Put more bluntly, they ask: what could go wrong? They then frame their policy setting accordingly, seeking to have a high probability of avoiding the most costly outcomes. That is, they too practise a form of risk management. This will mean that the setting of policy is altered on the basis of a shifting assessment of the balance of risks. This might be associated with a significant change in the central forecast, but need not be and often is not. On such occasions, those looking for a 'justification' for the policy move in a shift in the central forecast itself might not find it. There can, equally, be other periods in which the forecast is signalling that some action is likely to be required in due course, but not necessarily immediately, and where policy-makers believe that there is uncertainty about the outlook or about the effect of policy on the economy. They might perceive some benefit in waiting a little while for further information before acting, judging that, even if that turned out to be an error, it would not be a costly one. The assessment of risks is, however, inherently judgemental: there is no data series called 'balance of risks' that can be looked up, no econometric model to produce an answer. So not everyone will reach the same assessment of the balance of risks at any given time, and it would not be uncommon for a significant proportion of observers to be unable to pick the exact timing at which policy, in its efforts to manage risks, might be adjusted. Indeed, if policy is about right most of the time, incremental adjustments are highly likely to be 'on balance' decisions. There may therefore be plenty of people disagreeing with the decision on the day. That said, the RBA has not in recent years been, by international standards, what one could call an activist central bank. The evidence is that the RBA has actually been rather less likely than most of its international counterparts to move rates in any given month, having made an average of just over two rate changes per year over the past decade. The range within which the cash rate has moved has also been narrower than those of most comparable central banks. 4 Alert readers will notice that the Bank of Japan is not included above. The reason for that is that the zero lower bound for interest rates was a binding constraint in Japan – hence there was a long period of unchanged rates. Had it been feasible to lower rates further, the Bank of Japan would surely have done so. Variations in policy interest rates in selected countries July 1996–June 2006 Country Range Average number of changes per year Percentage points Australia 2.75 2.3 United States 5.50 4.0 Canada 3.75 5.1 United Kingdom 4.00 3.3 Euro area* 2.75 2.1 Sweden 4.60 3.7 New Zealand** 6.70 3.7 * German policy rate until end 1998 Prior to March 1999, the Reserve Bank of New Zealand did not announce a policy interest rate so the average number of changes is calculated only from that date: however, the range of interest rates is calculated for the whole period, using monthly average rates for the overnight cash rate for the early period Sources: Central banks; Bloomberg; RBA ** I might add that, despite occasional claims that we are insufficiently transparent, the evidence is that we are no more likely to surprise markets than other central banks that score more highly on some of the transparency tests favoured by academic studies 5 . Recent history The 'risk management' approach to decision-making I have sketched out above can be seen at work over the past several years. In the early part of this decade, the world economy slowed noticeably. The majority of G7 countries experienced mild recessions. Market interest rates declined, and policy rates in major countries fell to exceptionally low levels; in the case of the US, they fell very quickly, beginning early in 2001. These international factors, along with domestic developments, made for a marked change in the outlook for economic activity and inflation in Australia. The central forecast changed, but the assessment of the broader risks to the economy also changed. In the statement announcing the initial reduction in cash rates in early 2001 were the following words: 'The Board judged that the balance of risks to the outlook had changed sufficiently to warrant a shift in the stance of monetary policy.' Australian interest rates did not fall as far as US rates, since our economic situation was not as weak as in the major countries, but even so they fell by 200 basis points over the course of the year. By the end of 2001 they were at the lowest levels in a generation, with the weakness abroad a very important consideration. The concept of risk management was key throughout this process. Consider the following, from the September 2001 press statement announcing a reduction in cash rates: See E. Connolly and M. Kohler (2004), ‘News and Interest Rate Expectations: A Study of Six Central Banks’, in C. Kent and S. Guttmann (eds), The Future of Inflation Targeting, Reserve Bank of Australia, Sydney, pp 108–134, for an example of empirical work that studies how financial market prices respond to policy announcements and other forms of communication. Responses to RBA communications are little different to those of other central banks, suggesting that the RBA is conveying a similar amount of information to the market as other central banks. (Paper available at http://www.rba.gov.au/PublicationsAndResearch/Conferences/2004/Connolly_Kohler.pdf.) 'In reaching its decision [to lower rates], the Board carefully weighed one other factor, namely the rapid pace of borrowing by households and the associated pressure on house prices. A further reduction in interest rates runs some risk, at the margin, of unnecessarily boosting this trend in the short term. But this risk has to be set against those which would come over the medium term from not responding to the likely effects of the continuing weakness abroad. On balance, the Board’s judgement is that prospects for maintaining the economy’s good mediumterm performance will be improved by today’s action.' By the middle of 2002, with financial conditions at home and abroad quite expansionary, it seemed pretty clear that the worst of the danger of economic weakness was past. The Australian economy was in fact growing quite strongly, and global conditions were recovering. Hence the balance of risks was shifting: we were moving from a period in which it might have been a costly mistake not to let rates fall, into one where we were more likely to get into trouble by holding rates down, than by lifting them. The risk of potential problems of rates being left at generation lows was featured in the press statements announcing rate rises in May and June 2002. As we all know, the process of 'normalising' interest rates turned out to be quite a lengthy one. This was partly because there were periodic bouts of renewed pessimism about global prospects – strange as it may seem, it is only three years ago that many people were seriously talking about the possibility of deflation in the United States, a far cry from the concerns being voiced more recently. 6 Those concerns faded and were replaced by rising energy and resources prices, which history suggests can be associated with wider inflation pressures. But at the same time, ongoing declines in prices for many manufactured products, attributed to the effect of the emergence of China and other low-cost producers, have meant that inflation in most countries has, so far, been more contained than would have been expected several years ago, especially had one correctly forecast oil at US$70 per barrel. Something has been happening on the supply side of the world economy as well as on the demand side. The upshot of all this was that while we usually felt that we would most likely need to tighten further in due course, our risk assessment has prompted us to move rates only fairly infrequently, and very gradually. The fact that inflation expectations, by and large, remained pretty well anchored made that gradual approach possible. The fact that interest rates in Australia never got as low as those in the major centres also meant that we had less 'normalisation' to do than others. So we often felt we had the flexibility to wait a little longer for further information, on the basis that if waiting turned out to be a mistake, it would probably not be a costly one. That was a luxury that policy-makers in previous times often did not have. Nonetheless, at various moments through this period, the focus on assessing and responding to risks did prompt adjustments. The November 2003 press release announcing a tightening, for example, said: ' … the Board’s view is that it is no longer prudent to continue with such an expansionary policy stance. The strength of demand for credit increases the danger associated with delaying a tightening of policy that is called for on general macroeconomic grounds.' This statement shows risk management considerations to the fore once again. The same notions, though with risks stemming from other forces, were at work in the adjustments in March 2005 and May 2006. On some of these occasions, the numerical central forecasts with which we work were changing noticeably. Often, though, they were not changing that much; what was changing was the risk assessment. Since February 2001, the word 'risk', and the notion of responding to it, has featured prominently in 11 of the 12 statements announcing changes in interest rates. I believe this way of operating a medium-term inflation target has served Australia well. With the benefit of hindsight, it is remarkable how often over the past four years people could find any number of perceived downside risks to international growth – from deflation to rising oil prices to 'global imbalances'. Yet the world economy has grown with a strength not seen in three decades, and this growth has been quite expansionary for Australia’s economy. The future Let me finish with a few words about the way central banks internationally are managing the risks at present. It is apparent that the process of normalisation of short-term interest rates around the world is under way. It is most advanced, among the major regions, in the United States. It looks as though it is soon to get started in Japan (though presumably Japan has not as far to go as the US had when the fed funds rate was 1 per cent), and is presumably part way through in the euro area. It represents a response by central banks to changing conditions, and a recognition of the dangers which might otherwise have arisen with an even longer period of unusually low interest rates. Thus, the former period of very predictable short-term rates in many countries – the 'measured pace' of adjustment in the US which amounted to a rise per meeting, no change for an extended period in Japan, etc. – has given way to a period in which the future course is less obvious. That situation is actually the norm. The recognition of this is one factor that has been affecting markets in the past couple of months. Stock markets have been more volatile, bond rates have risen a little, and some emerging-market currencies have come under pressure. But this was bound to happen sooner or later, and the sooner it did the better. Yield- (and risk-) seeking trades based on an assumption of very low volatility, underpinned by virtual certainty about short-term funding costs, would hardly be a basis for sound resource allocation over the longer term. A more sober assessment of risks, while shaking out a few positions in the short term, does not appear to have done serious damage. It will probably help to lessen some of the financial risks which had been building up. If so, it will help to lengthen the global expansion. The real test of the adjustments to policies around the world will be the inflation outcomes in the next several years. The intention was that the period of very low rates would foster recovery from a global slowdown, with the stimulus to be withdrawn gradually in light of the low-inflation outcomes being experienced, but in a timely enough way so as not to contribute to a build-up in inflation longer term. There is a good chance that central banks globally will be able to claim a success in achieving that intention in due course, but it is not possible to do so yet. Careful analysis and timely responsiveness to the shifting balance of risks remain the key to good outcomes. | reserve bank of australia | 2,006 | 7 |
Opening statement by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 18 August 2006. | Ian J Macfarlane: Medium-term considerations and the curent economic situation in Australia Opening statement by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Sydney, 18 August 2006. * * * The present arrangement whereby the Reserve Bank appears before this Committee every six months was put into place by the current Treasurer ten years ago. During that period, I have appeared eighteen times, with two meetings being missed because of clashes with elections. This will be my last appearance, and I have to say I will miss this regular half-yearly event – perhaps I should come and sit in the bleachers at future meetings. I have always thought that it is a very good principle for the central bank to have to report regularly to Parliament, and to be subject to questioning by members. The practice has, I believe, been a valuable form of communication and has contributed to improving monetary policy in Australia. Since this is my last appearance, I would like to seek the Chairman's indulgence to start by covering some medium-term considerations before proceeding on to the current economic situation. As you are aware, Australia's current economic expansion is now in its fifteenth year. There is a general recognition that this is a good thing and, as a result, there has been a notable increase in the degree of optimism about Australia's economic performance. This is in marked contrast to the general pessimism that prevailed in the 1970s and 1980s and even later, when people were worried that we were falling behind other countries. After such a long expansion, it should not be surprising to discover that the economy has been experiencing some capacity constraints. But I think a lot of people are disappointed to hear this, and regard it as a bad thing. So I would like to spend a bit of time discussing this issue, which incidentally we first began raising eighteen months ago at the February 2005 meeting of this Committee. First, being at what is termed 'full capacity' is not a bad thing – it is a good thing. It means, for example, that we have low unemployment and that our incomes are higher than they might otherwise be. What would be a bad thing is if, after fifteen years of growth, we still found ourselves with significant excess capacity (that is, with significant resources of labour and capital that were not being utilised). Economies are meant to operate somewhere around the zone of full capacity, not permanently below it. Second, there is no sensible alternative monetary policy that would have prevented us from entering the zone of full capacity. The only way monetary policy could have prevented this is if it had kept the economy 'semi-comatose'. That would have meant growing so slowly on average that, even with the passage of fifteen years, it did not use up the excess capacity. Third, full capacity is not a brick wall that you suddenly hit – approaching it is something that happens in stages. It is a rather patchy process, with some sectors reaching it early and some not at all. That is why I called it the zone of full capacity. Sometimes it is an industry that becomes a bottleneck, sometimes a type of capital equipment and often it is a type of skilled labour. The situation that attracts the most attention is when it is a piece of infrastructure such as a port or a railway. But normally when the Bank talks about capacity, we are not talking about the specific pieces of infrastructure but about the economy's overall availability of labour and capital resources. It is also worth keeping in mind that it is normal for the capacity of the economy to grow over time. This is because the labour force grows and investment and economic reforms lift output per worker, or productivity. There are limits, however, to how quickly capacity can be raised, though increased investment, as is taking place at present, will boost the rate of increase. But it takes time. In the meantime, it is helpful if demand can slow sufficiently to allow capacity to 'catch up' and perhaps get ahead a little. If this fails to happen, then there is a risk of a generalised pick-up in inflation. Some rises in prices and wages in the areas where bottlenecks exist are unavoidable, but a generalised inflationary process is avoidable. This is why last year I started saying that we should get used to GDP growth with a 2 or a 3 in front of the decimal point, rather than a 3 or a 4 as we had become accustomed to throughout most of the expansion. In light of what I have just outlined, I would like to review our progress to date. The first thing to note is that over the past two years the economy has slowed from its earlier fast pace of growth. The last time we had GDP growth of over 4 per cent was in the year to June 2004. Since then, the growth rates have had a 2 or a 3 in front of the decimal point. There are a number of indications that growth has picked up again over the past six months, but our forecasts do not have it going back to the four plus rates of a few years ago. Also, domestic demand has slowed by more than GDP. If you remember it was running at about 6 per cent in 2003/04, but is now growing at about 3½ per cent. More importantly, the composition of domestic demand has changed for the better – the driving force behind demand growth for a long time was consumption spending, but that has now clearly slowed. Two years ago, consumption was growing at more than 6 per cent per annum, but over the past three quarters, it has been growing at slightly less than 3 per cent. There is some evidence to suggest that the slowing in consumption was due, in part, to the fact that household spending was no longer being stimulated by the apparent wealth increases associated with the house price boom. The gradual tightening of monetary policy, which began in 2002, no doubt also played a role. At the same time as consumption and overall demand have been slowing, investment has grown strongly. This is important because investment in plant and equipment and in construction is crucial to the process of increasing the economy's capacity to grow. Over the past three years, the Capex Survey shows that investment has grown by nearly 16 per cent at an annual rate. Much of this has been in the resource sector, but even if we take this out of the figures, the remainder has grown at 12 per cent per annum. Even in manufacturing, which many people assume has floundered, investment has grown at a similar rate, although it has been held up by resource-related activities. In the long run, this strong investment performance increases the economy's supply potential, and hence puts downward pressure on inflation. In the short run, however, it is pushing up the prices of many inputs and wages in the construction and resource sectors. The capacity constraints caused by shortages of labour are harder to remedy in the short term. Interstate movement of labour can help to provide skilled and unskilled labour to the areas that have greatest shortages, mainly in the resource sector and its supplying industries. At the same time, increased immigration has helped to expand the overall supply of skilled labour. But clearly more has to be done to attract people into the occupations where skill shortages are most acute, and to train them without unnecessary delay. I do not profess to be an expert in this important area and do not want to lecture the Federal and State Governments on this issue, which I know is already absorbing a lot of their attention. This process of slowing demand and expanding capacity has been going on for several years, but it has not prevented some general upward pressure on producer and consumer prices. This was brought home to the public with the publication of the June quarter CPI. The increase of 4 per cent over the year to the June quarter made headlines, even though many observers were quick to point out that more than half of the June quarter increase was due to petrol and bananas, the latter influence giving the cartoonists of Australia great opportunities for mirth. They were correct to downplay these two influences which, in all probability, will either reverse or revert to zero in the coming quarters. But there is also a danger in simply taking out the two fastest growing components and looking at the rest of the CPI basket. At the Bank, we tackle the problem of lumpy, and possibly one-off, price movements by looking at various measures of underlying inflation. Our preferred measures show that underlying inflation is running slightly below 3 per cent per annum. This has picked up moderately since the start of the year, after a period when it had been fairly stable at around 2½ per cent. The Bank's mandate is to keep inflation averaging 2 to 3 per cent over the medium term. This does not mean that it is never to exceed 3 per cent or fall below 2 per cent – it clearly has done both during the inflation targeting period. We need to be confident, however, that it will return to the 2 to 3 per cent range. Viewing all of the available evidence that has accrued over the six months since we last appeared before this Committee, the Board came to the view that inflation was likely to exceed earlier forecasts and that corrective action was therefore needed. As you know, the cash rate was raised by 25 basis points in May and again by the same amount earlier this month. In making these decisions, the Board was conscious that the global economy remains very strong, with output expanding at an above-average pace for the fourth year in a row. It also noted that global inflationary pressures have been rising. This is in part the consequence of the very accommodative monetary policies that the major countries ran over 2003 and 2004. While the English-speaking countries have generally returned interest rates to more normal levels, the continuing low level of interest rates in Asia and Europe means that global interest rates on average remain low. This is continuing to stimulate global economic growth and inflation. Domestically, there has been a pick-up in the pace of economic growth after a mild slowing in the second half of last year. While the pick-up has not been excessive, the general message from the growth of employment and consumer spending was that the household sector is still in good shape, and has not retreated into its shell as a result of the rises in petrol prices and the May interest rate increase. The fact that borrowing by the household and business sectors had accelerated over the past six months or so confirmed this general picture. But as indicated earlier, the most important consideration was that our forecast of underlying inflation has had to be progressively revised upwards over the past six months. Before closing and moving on to question time, I would like to thank the Committee again for the work that it has put in during the years I have been appearing before it. Not only has it kept an eye on monetary policy developments, it has also done a valuable job looking at payments system developments. The recent two-day hearing on payments system reform shows how willing the Committee has been to devote time to important issues, and how effective such public inquiries can be. I will, of course, be willing to answer any questions on the economy, monetary policy, financial system stability or payments system matters that you wish to ask. Alternatively, you may wish to look to the future and address them to the next Governor of the Reserve Bank – Glenn Stevens. I am sure he will be as forthcoming with you as I hope I have been. | reserve bank of australia | 2,006 | 8 |
Remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, in response to the Distinguished Lecture by Mr Timothy F Geithner, President and Chief Exec. Officer of the Federal Reserve Bank of New York, Hong Kong, 15 September 2006. | Glenn Stevens: Risk and the financial system Remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, in response to the Distinguished Lecture by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, co-organised by the Hong Kong Monetary Authority and the Hong Kong Association of Banks, Hong Kong, 15 September 2006. * * * It is a great pleasure to be asked to speak in response to the distinguished lecture by Tim Geithner. As always, Tim’s remarks are at once thoughtful and thought-provoking, and contain much wisdom. In charting the evolution of the US and international capital markets over the nearly a decade since the Asian financial crisis, he notes the strengthening of the core banking system in terms of profitability and capital, the growth of securitisation and the development of a plethora of derivative instruments which allow finer unbundling and re-allocation of risk. A striking feature over the past several years has also been the way in which a succession of events which might previously have triggered a significant disturbance in financial markets have been absorbed relatively easily. There is no doubt that the core of the US financial system – the commercial banks and major investment houses – have done well in strengthening their balance sheets and developing risk management over this period. I could echo this for the banks in my own country, and I suspect that in a considerable number of other places the story is similar. It ought to be recorded, as well, that the long night for Japan’s banking system seems at long last to be over. But rather than celebrating this for too long, Tim points to issues for the future which go to the heart of the functioning of financial markets and the challenges with which regulators and policy-makers grapple. One of the biggest elements of the picture is the on-going growth of lightly regulated, often highly leveraged institutions, including hedge funds. Their record of rapid growth and high reported returns on average – with the odd period of very poor returns – has attracted a lot of attention by investors. Ten years ago, hedge funds were regarded as an exotic asset class, but now they are increasingly seen as part of the main stream for pension funds, university endowments and the like. Financial institutions are also increasingly in the habit of establishing in-house vehicles to tap the appetite for hedge-fund-type investments on the part of investors. Even some large privately owned non-financial companies operate internal investment funds that are, for all intents and purposes, hedge funds. Indeed, the very term ‘hedge fund’ seems to be used rather more loosely than it used to be: we are really talking about any investment vehicle which is willing and able to take advantage of the vast array of financial products, 24-hour trading and ample liquidity to expose the funds of sophisticated investors to virtually any conceivable type of risk. The growth of such funds is an aspect of globalisation – that process in which the national barriers to trade in goods, services and capital are eroded and in which economic and financial activity is increasingly organised on a trans-national basis. But like many aspects of the modern globalisation phenomenon, hedge funds leave people with mixed feelings. We could debate the merits or otherwise of hedge funds and other HLIs at length. Here in Hong Kong it would be, I suspect, a fairly robust discussion! Their defenders claim that, by exploiting (and thereby eliminating) pricing anomalies and by being less encumbered by prudential controls than most other financial institutions, hedge funds promote efficiency in the allocation of capital by searching out returns more effectively than others. On the assumption, moreover, that those who put money into hedge funds know what risks they are taking – which might, increasingly, be a big assumption – people might take the view that what investors do with their money is their own business. Critics, on the other hand, claim that hedge funds can overwhelm and distort small markets. A tendency for herd behaviour, and application of leverage, amplifies the problem, in the view of these critics. When hedge funds decide simultaneously to get into or out of a position, they can disrupt market functioning. Small countries, including Hong Kong, have on occasion felt as though hedge funds were singling them out for rough treatment, and that the resources available to hedge funds far exceed those of a small country seeking to maintain, for macroeconomic management reasons, a particular constellation of interest rates and exchange rates. I suspect that both the supporters and the critics have, at times, overstated the arguments. But, in any event, like them or not, hedge funds and other leveraged entities are here to stay. For the most part, the entities in question are essentially those financial investment vehicles which are outside the normal prudential regulatory net. And the point is that there will always be some set of such entities. For if there is a certain degree of risk-taking behaviour that investors wish to engage in, they will find a way of doing it. If the regulatory net moves out, the activity will move beyond it. That, I believe, was a lesson hard learned in the regulated environment that prevailed in most countries for the bulk of the second half of the 20th century. It is certainly one I carry clearly in my mind from watching, early in my career, the heavily regulated Australian financial system of the time. My guess is that if hedge funds as we know them did not exist, or were regulated to behave differently, they would be invented under some other name. This has to colour the way we approach questions of regulation. Specifically, in relation to hedge funds, there are essentially two issues that regulators need to address: • The position of investors who are entrusting their money to these funds. In our view, this is essentially about ensuring there is sufficient disclosure to allow investors to make informed judgements about the risks and returns. In Australia, the regulatory authorities draw no distinction between hedge funds and other investment managers; the regulatory regime is determined by what the entity does, rather than what it is called. This ensures a level playing field. • Ensuring that the activities of investment managers which are not subject to prudential supervision do not threaten the financial viability of firms, such as banks, that are. This approach emphasises to the counterparties of hedge funds and other HLIs (that is, the prime brokers, banks and investment houses) the importance of strong risk management, collateral, knowing their customers and so on. The aim here is to preserve the prudential strength of the core part of the system in the interests of economic financial stability, while allowing the part beyond the prudential net to play its role in taking on risk. But such an approach, relying a good deal on market discipline, is not getting easier to implement. As Tim notes, the increasing complexity of the activities of various investors makes it hard for any one counterparty to know whether they really have a good understanding of their customers’ business (including with their competitors) and therefore their own exposures. Their direct exposures might be considerably smaller than the indirect ones, which will perhaps only come to light under conditions of duress. It is under abnormal conditions, when liquidity in markets is under pressure, that the leverage employed by some of the funds will be at its most damaging. It is at those moments that markets are most prone to freezing up, as all participants, wary of the unknown exposures of all others to the leveraged risk-takers, pull back. But this maintenance of liquidity and the smooth functioning of markets has become central to financial stability because even as regulated institutions have become more sound, they and other participants have come to rely more on markets for their own risk management. Hence dislocation can have serious consequences. I am sceptical, incidentally, of the argument that hedge funds and the like necessarily add to liquidity. Liquidity means being able to change a position without affecting the price, and depends on someone being prepared to make a price. Hedge fund activity adds turnover, which probably means that in good times there is more incentive for price makers. But under conditions of pressure, leveraged investors are more likely to need to use the liquidity of the market than to be able to contribute to it. On such occasions – which is when liquidity is needed most – these funds surely are liquidity takers, not providers. Additionally, there is, as Tim acknowledges quite clearly, an inherent conflict over certain time horizons between market discipline and competition for business. Precisely because hedge funds et al do add to turnover, they have considerable business to direct to financial intermediaries. When the money is flowing into the big funds, and returns have been high, they are more likely to be able to dictate the terms on which the various banks, investment banks, prime brokers and so on can get a share of that business. At those times, market discipline is likely to be eroded. In fact, this raises much broader issues of risk perception and management than hedge funds per se, and here Tim makes some very good points. In particular, the emphasis on tail events, and on the uncertainty which surrounds estimates of potential losses, is very well targeted. Risk management techniques need to extend beyond calculations of VARs and the like – as complex as such calculations already are – and to think about whether the possible size of losses associated with the one-in-a hundred event really are well described by standard distributions drawn from recent history. They need also to contemplate the possibility that the correlations between portfolios will in the future be different from those in history. This point takes on more importance, in my judgement, against the backdrop of the remarkably benign environment of the past decade in many countries. As Tim notes, a succession of financial events have been absorbed by capital markets with apparent equanimity. Simultaneously, macroeconomic performance in a number of industrial countries has been characterised by greater stability – the socalled ‘great moderation’. These two factors – macroeconomic stability and financial resilience to shocks – must surely be related, and will have been mutually reinforcing. It can plausibly be argued that risk genuinely has been lower, in some respects and to some extent, over that period. 1 But behaviour adapts to the perception that economic risk is lower, often with the result that more risk is taken on in the financial structure. Lower macroeconomic volatility has surely been one factor, for example, encouraging a marked increase in the debt that households are content to carry in many countries. This has been most marked in the US and my own country but is apparent in a number of others, and that number will grow. If it has not made its way to Asia yet, it will before long. To be sure, financial innovation and competition have also been at work here on the supply side of the capital market – which means that we have to be wary of eroding credit standards – but that macroeconomic back-drop was critical. How households will behave under conditions of greater macroeconomic stress, which surely will one day occur, we cannot yet know. It is a fair bet, though, that the historical loss experiences in these types of lending, both directly and indirectly via business portfolios, are probably not a good guide to the future. More generally, a long period of interest rates being low and fairly steady, however well justified it might apparently be by short-term macroeconomic fundamentals, also causes behaviour to change. The search for yield eventually explores some fairly remote territory – be it more pension fund or retail money going into hedge funds, the rise of private equity funds, or the use of ever more exotic strategies by various managers to generate returns. The real question here is whether investors are consciously accepting higher risk in order to keep the sorts of nominal rates of return that were characteristic of a different era, or whether they are, in fact, not cognisant of the degree of risk they are taking on. Those and other issues remain for the future. I think Tim Geithner has put the spotlight on many of the right questions. It is up to supervisors and those charged with financial stability to try to foster a climate in which the risks are managed in a way which does not quench the competitive inventiveness of markets, but still secures resilience when, inevitably, more difficult times arrive. For an elaboration of this theme, see an earlier http://www.rba.gov.au/Speeches/2006/sp_dg_270506.html. speech ‘Risk and the Macroeconomy’, available at | reserve bank of australia | 2,006 | 9 |
Remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to 'Investor Insights: ANZ Asia Pacific 2006' Seminar, Singapore, 17 September 2006. | Glenn Stevens: Capital flows and monetary policy Remarks by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to “Investor Insights: ANZ Asia Pacific 2006” Seminar, Singapore, 17 September 2006. I thank Guy Debelle and Michael Plumb for their considerable contributions to the historical part of this paper. * * * The organisers of today’s seminar have suggested the topic of Capital Flows and Monetary Policy. It seems an appropriate one in an east Asian setting. It is common to hear of the difficulties created for the conduct of domestic macroeconomic policies by capital mobility. The fact that capital flows these days are so large, and so rapid, tends to add to the perception of policy complexity. This has only grown in the wake of the Asian financial crisis of the late 1990s, though capital flows had caused serious problems for countries in Latin America and Europe on numerous occasions long before the Asian crisis occurred. Various countries in Asia are still wary of international capital flows, and even after accumulating very high levels of foreign reserves, many seem to worry more about the possibility of sudden outflow – as opposed to the very real problems associated with large inflows. Australia too has struggled on occasion with capital flows and their complicating role for the conduct of monetary policy. But Australia’s biggest problems for the conduct of monetary policy came in the days when capital flows were more restricted than they are now, but financial prices were regulated. In those days – and I refer here to the period before the decisions in the early 1980s to allow markets to set the exchange rate and yields on government debt – the problem was basically one of monetary control: policy-makers could not accurately control the amount of settlement funds available to the banking system because domestic policy actions to control these funds were often over-run by foreign operations we had to undertake to clear the foreign exchange market at the nominated exchange rate. That fundamentally impaired the Reserve Bank’s capacity to influence broader monetary conditions: we were not actually in control of the stance of monetary policy. Those days are now long gone. The market for foreign exchange clears entirely in the private sector (unless we make a choice to intervene). The Government’s financial operations are funded at market-determined interest rates, relieving the central bank of any obligation to support a particular price in the market. The result is that the Reserve Bank is able to control the total quantity of settlement funds in the system, which allows us to set, for all practical purposes, the overnight rate of interest. That does not mean that capital flows are no longer a concern, but it does change the location, and in my view the size, of the problem they present. A deeper financial system can also absorb much larger flows with less disruption. More generally, after more than 20 years of experience, the economy and financial system have shown that they can adjust to even quite large changes in the exchange rate without undue disruption. This has involved a reasonable amount of learning by doing on the part of financial markets, businesses and policymakers – and, on occasion, the learning curve was fairly steep. But there is no doubt that the present world is preferable. The story of how we got to this position is an interesting one, and it is that story I would like to tell today. Let me do this by referring to two episodes. When capital flows were a problem The first is the year 1983. At the beginning of that year, Australia’s exchange rate regime was a crawling peg to a trade-weighted basket. (This regime had been in place since 1976.) The peg was determined daily by a management committee consisting of the Governor of the Reserve Bank and the heads of the main economic government departments. 1 This group set the peg given an assessment of economic conditions, with both external and internal factors taken into consideration. The intermediate target for monetary policy was an M3 growth rate set by the Government. The The Secretaries of the Treasury and the Departments of Prime Minister and Cabinet and Finance. Reserve Bank sought to achieve this through a combination of open market operations, changes in various reserve ratios and quantitative lending guidelines. Interest rates on various financial instruments were in the process of being liberalised at that time, though some important regulations (e.g. on housing loans) remained in place. But the capacity of the Reserve Bank to control the quantity of settlements funds in the banking system, and therefore to influence broader monetary and credit conditions, was weak, because of the commitment to a particular exchange rate, even one that varied every day. An attempt to tighten conditions by withdrawing cash from the market, for example, was likely to be thwarted by the simple expedient of the private sector borrowing offshore and converting the proceeds into Australian dollars at the price nominated by the central bank. This would reverse the initial withdrawal of cash. Conversely, when private capital decided to move out, the authorities struggled to keep the system supplied with adequate liquidity. In the lead-up to the March 1983 federal election, markets were anxious about the prospect of a change of government. In the week prior to the election, capital outflow amounted to about 3 per cent of the total money stock, or about 1½ per cent of Australia’s annual GDP. This occurred in spite of capital controls that were still in place, because the distinction between current and capital transactions was blurring and market participants were becoming more adept at circumventing the controls. Exporters were by then skilled at delaying receipts when a devaluation was anticipated, while importers accelerated their payments, as did those servicing foreign currency debt. These swings caused operational difficulties in maintaining suitable conditions in the money market. As for achieving the target for M3 growth, I can well recall, as one involved in forecasting growth of the ‘money supply’ in those days, the impossibility of forecasting the size and the persistence of the capital flows, which were one of the major drivers of the growth in the community’s monetary assets. The newly elected Labor Government responded to the crisis by devaluing the Australian dollar by 10 per cent against the TWI. This was successful in reversing the flow of funds and generating capital inflow, as exporters, for example, brought onshore their pent-up receipts. But the problems were far from solved. Later in 1983, Australia’s external position was improving, due to a post-drought recovery in the rural sector, rising commodity prices and higher demand for mineral exports. The volume of capital inflow gradually mounted, further encouraged by Australia’s positive interest differential with the major countries. This again caused problems for monetary policy as the Reserve Bank had difficulty withdrawing the resulting increase in cash in the banking system. The plan that was devised to counter these problems was one of a gradual appreciation of the exchange rate (achieved through adjustment of the daily fix), lower short-term interest rates but increased sales of government securities to fund the fiscal deficit, which was likely to see longer-term yields increase. That is, it was thought that currency speculators would be deterred by the very low short-term rates, notwithstanding the higher yields on offer at the longer end. This would help achieve the M3 target by reducing the liquidity resulting from capital inflow. The exchange rate management committee also sought to add a random element to the daily movements in the exchange rate, around the general trend appreciation, to reduce the predictability in the movements in the exchange rate and thwart the speculation. As capital inflow continued to mount during November, the Reserve Bank actually devalued the Australian dollar against the TWI. 2 Attempts to frustrate the speculators were unsuccessful. Inflows continued. Finally, the exchange rate was floated on 12 December 1983 and most of the remaining capital controls were removed simultaneously. Australia was one of the few countries to have taken a decision to float when the currency was under upward pressure, because the capital inflow just could not be adequately absorbed. The decision has rightly been regarded as one of the most important ever taken by an Australian Government in the field of economic policy, for a number of reasons. Most important from the perspective of monetary policy, the system for control over the amount of settlement funds in the system became fully effective for the first time. If the Reserve Bank wanted to tighten financial conditions, by taking funds out of the system, the private sector could no longer immediately offset that by getting those funds back by selling foreign exchange to the Reserve Bank: we were no longer obliged to buy or sell foreign exchange at a given price. G. Debelle and M. Plumb (2006) ‘The evolution of exchange rate policy and capital controls in Australia’, Asian Economic Papers (forthcoming). In summary, the operation of monetary policy in the pre-float period was significantly constrained by external considerations, and was hampered by capital flows. While we had a quantitative target for monetary growth, we had no way of exerting the required control in order to achieve that outcome. Eventually, this system was overtaken by events and we had to change it. Over a number of years, we evolved towards a floating exchange rate with a medium-term inflation target. Let me now turn to the more recent episode of Australia’s experience during the Asian crisis, to illustrate how that arrangement worked. When capital flows were not quite so much of a problem At the onset of the Asian crisis in mid 1997, the Australian economy was growing at around trend rates, with domestic demand beginning to accelerate, and underlying inflation below 2 per cent. Given the inflation performance, monetary policy had been eased over the previous year as required by our 2–3 per cent inflation target. Thus, the shock hit the Australian economy at a time when it was in reasonable shape with the stance of monetary policy already relatively expansionary. Exports to east Asia accounted for around one-third of Australia’s exports at the time, so the decline in output in the east-Asian region represented a significant negative demand shock to the Australian economy. Australia’s terms of trade also fell as commodity prices declined, further exacerbating the loss of income. Reflecting this and the expected negative effect on the Australian economy, there was less demand for Australian assets (that is, ex ante, capital wanted to flow out). Twenty-five years earlier, such a situation would have resulted in a large loss of foreign exchange reserves, but under a floating exchange rate the adjustment was mostly borne by the exchange rate, with the Australian dollar depreciating by around 20 per cent. On some previous occasions, such a large depreciation of the exchange rate had led to a rise in inflation expectations and a pick-up in inflation due to higher import prices, so requiring an increase in interest rates to contain and eventually reverse the inflation impulse. In contemplating whether that policy response was appropriate on this occasion, we came to the view that, even though in the short term inflation was forecast to rise above 3 per cent for a time, as the depreciation was passed through to consumer prices, performance would most likely be consistent with the target thereafter. The forecast rise in inflation was not expected to be persistent, partly because the contractionary impulse from the decline in export demand would dampen growth. But, in addition, the credibility of the inflation target was by then quite well established, and this could be expected to help keep inflation expectations in check. The flexibility of the monetary policy framework allowed the validity of this assessment to be reassessed as time passed. In the event, inflation rose by less than was forecast, in part because of a decline in the pass-through of the exchange rate depreciation, as well as a greater-than-expected disinflationary impulse from the Asian region, which put downward pressure on foreign-currency import prices. As a result, by the end of 1998, not only had we not lifted interest rates, we actually reduced them slightly. So the flexible inflation target served as a useful framework within which to manage the effects of the Asian crisis and the policy response to the capital flow. We also used, on occasion, intervention in the foreign exchange market to counter the downward pressure on the exchange rate, but only after allowing it to move a considerable distance. The important aspect of this whole episode for the issue at hand is that allowing the exchange rate to move provided a part of the mechanism that helped the economy adapt to the Asian crisis and the changes in capital flows that it brought about. This reduced any disruption to the domestic economy and, most importantly, did not compromise the setting of monetary policy. It has often been remarked that the decline in the exchange rate was expansionary for the traded sector and that this helped the economy through that period. That is true, but in my view the much more important point is that capital flows and exchange rate changes did not compromise the conduct of monetary policy, which remained relatively expansionary, consistent with the needs of the economy at the time. Had we been in the world of fixed exchange rates, we would not have been able to set policy in that way. Broader macroeconomic considerations The change to the exchange rate regime, with its accompanying improvements to monetary control, would be expected to have an effect on the volatilities of key financial prices. In particular, it would be likely that, all other things equal, domestic interest rates would be less volatile and the exchange rate more volatile. Shocks in the form of swings in capital flows would show up more in the exchange rate and less in the level of domestic interest rates. Of course, all other things were not equal in this period. There has been a well-documented decline in macroeconomic volatility in a number of countries over the same period, the so-called Great Moderation. 3 Nonetheless, as shown in Graph 1, after the floating of the exchange rate, interest rates have been considerably less volatile, and it is highly likely, at least in the case of Australia, that the change in the exchange rate regime, along with other reforms and the establishment of consistent medium-term frameworks for monetary and fiscal policy, 4 made some contribution to the decline in macroeconomic volatility. There has been an increase in the measured volatility of the exchange rate, though perhaps not by as much as might have been expected. Prior to the float, changes in the exchange rate were infrequent but very large, as the authorities made periodic adjustments to the fixed parity in response to macroeconomic and financial developments, including some induced by capital flows as I described above. In the post-float period, the increased volatility generally reflects frequent small changes in the exchange rate, in this case determined by the market. And for significant periods in the floating era, such as the mid 1990s and the past two or three years as well, exchange rate volatility has been not very different from what it was towards the end of the managed exchange rate era in the early 1980s. Graph 1 O.J. Blanchard and J. Simon (2001) ‘The Long and Large Decline in U.S. Output Volatility’, Brookings Papers on Economic Activity, 1, pp. 135–164. D. Gruen and G. Stevens (2000), ‘Australian Macroeconomic Performance and Policies in the 1990s’, in D. Gruen and S. Shrestha (eds), The Australian Economy in the 1990s, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp. 32–72. Short-term variability of the exchange rate is not necessarily costless, of course. Some people might argue that it creates a degree of uncertainty for exporters and importers, and those allocating capital. But the share of Australia’s real economy engaged in international trade, and the extent to which Australians’ financial assets are traded internationally, have grown over the same period. No doubt this was mostly a result of the general opening up of the economy to the international system, but it is difficult to support the claim that exchange rate variability has seriously impeded these developments. On the contrary, I think that the most serious potential problem for the internationally exposed sectors is not short-term exchange rate variability, but medium-term misalignment in the exchange rate. Allowing market forces to move the exchange rate makes such an outcome much less likely. Better monetary control afforded by the flexible exchange rate, on the other hand, has been an unalloyed benefit to all sectors of the economy, traded and non-traded. Lest this sound as though we never have a care in the world about the exchange rate moving, however, it is important to add one caveat to this story. It is this: a strong monetary policy framework is essential. Indeed, there were plenty of times when the movement in the exchange rate, especially downward ones, made the Reserve Bank quite uncomfortable. Looking back, these were mostly periods when the policy framework was not as well developed, or as credible, as it is today. On occasion, it seemed that the exchange rate was moving because of a change in confidence about the conduct of economic policies, including monetary policy, in Australia. This was more a feature of the 1980s, when the medium-term inflation targeting framework was not yet in place, though some episodes in the early 1990s were also troublesome as the inflation target really did not acquire strong credibility until about 1995. In some such episodes, monetary policy did respond to changes in the exchange rate by altering interest rates. But by the advent of the Asian crisis, when the exchange rate declined a lot, both we and the financial markets had developed sufficient confidence in our monetary policy framework that we were able to allow the exchange rate to do its job. The conduct of policy through that period is generally regarded as successful. Conclusion Capital mobility can complicate the conduct of monetary policy. In Australia, we have found that the complications which arise under a floating exchange rate – while often not trivial – are not of the same order of magnitude as the monetary control problems we had when capital was less mobile but financial prices were heavily regulated. In the system we have had for some years now, the inflation target, rather than the exchange rate, is our anchor for policy. When capital flows suddenly change, the exchange rate is free to move to absorb at least part of the shock, and we are able to decide how much of the shock should show up as changed financial conditions in Australia. This seems to be a pretty durable arrangement. Of course, it took some time to get to this position. I recognise that many other countries in the region are in a different position. Many are more open, so with perhaps less scope to allow large exchange rate moves without significant first-round inflationary or deflationary effects. Others are still working to develop stronger domestic monetary policy frameworks. Hence, these countries probably tend to worry more about the flightiness of international capital flows than do we. Nonetheless, it does seem to me that Australia’s experience offers reasonable grounds for thinking that, over time, these problems can be contained sufficiently so that we can enjoy the benefits of openness to capital flows without too much cost. | reserve bank of australia | 2,006 | 9 |
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists and the Economic Society of Australia (NSW Branch) Annual Forecasting Conference Dinner, Sydney, 11 October 2006. | Glenn Stevens: Economic conditions and prospects Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists and the Economic Society of Australia (NSW Branch) Annual Forecasting Conference Dinner, Sydney, 11 October 2006. * * * It is nice to be back at an ABE-Economic Society function in a new capacity. Thank you for the invitation. Tonight I will take opportunity to make some brief remarks about the monetary policy framework, then go on to the current state of the economy and the associated issues for monetary policy. I would like to conclude briefly with a longer-term perspective. The monetary policy framework As you know, my predecessor on his appointment in 1996 reached a formal agreement with Treasurer Costello on the conduct of monetary policy. 1 This was updated in 2003 at the time of his reappointment. 2 These Statements featured a numerical inflation target, to be achieved over the medium term, for consumer price inflation, and noted an appropriate degree of flexibility in the conduct of policy over the short term. They emphasised the independence of the Reserve Bank, as provided under legislation, in the conduct of monetary policy. They provided for accountability to Parliament and provision of information to the public. And they recorded the commitment both of the Governor and of the Government to the arrangements. These arrangements have come to be well understood and widely accepted around the country, and around the world. Preserving the purchasing power of money is the most important contribution that monetary policy can make to sustainable prosperity. Having a medium-term numerical target for inflation – in our case, 2-3 per cent on average – operated by an independent central bank, remains for Australia (and many other countries) the most straightforward way of giving practical effect to that overall goal. To date, moreover, the system has worked well. For a start, the target has been satisfactorily achieved. In 1995, a colleague 3 and I wrote about Australia’s inflation target that: “…if some years from now we can look back and observe that the average rate of inflation has a ‘2’ in front of the decimal place, that will be regarded as a success.” From the vantage point of 2006, we can look back and see that the average inflation rate has indeed had a ‘2’ at the front. The number can be calculated a few different ways, but all give an answer of about 2½ per cent over the past decade. 4 Inflation has been outside the 2–3 per cent range about half the time. That degree of flexibility was always intended because inflation cannot be fine-tuned over short periods, and shocks occur that will push it away from target. But, importantly, there has been no systematic tendency for the deviation to be one way or the other. Statement on the Conduct of Monetary Policy, http://www.rba.gov.au/MonetaryPolicy/statement_on_the_conduct_of_monetary_policy_1996.html. Second Statement on the Conduct of Monetary Policy, available http://www.rba.gov.au/MonetaryPolicy/second_statement_on_the_conduct_of_monetary_policy_2003.html. available at at Stevens, G. and G. Debelle (1995), “Monetary Policy Goals for Inflation in Australia”, in A.G. Haldane (ed.), Targeting Inflation, Bank of England; also available at http://www.rba.gov.au/PublicationsAndResearch/RDP/RDP9503.html. The exact figure can be calculated as 2.56 per cent, which is the compound rate of increase in the CPI over the period from mid 1996 until mid 2006, or 2.48 per cent for the same calculation excluding the GST and interest charges (interest charges were included in the CPI until 1998), or 2.45 per cent for the Treasury underlying inflation rate until 1998 and the CPI ex GST thereafter. The logic for the latter is that the Treasury series was the original target variable until 1998, when the target became the published CPI. The wording in the Statement on the Conduct of Monetary Policy, “around the middle of the target band”, covers these minor differences quite neatly. At the same time, variability in real GDP has tended to decline. Several factors have contributed to that but it is important to state that, over the long run, controlling inflation does not harm growth; on the contrary, it leads to an improvement in growth prospects. With this record of success, the desirability of continuing the system is obvious. At times of changing personnel, moreover, it is worth stressing continuity: there was no case for a discrete change to the system just because a new Governor was being appointed. The Treasurer and I issued a new Statement on the Conduct of Monetary Policy 5 on 18 September 2006, the day my appointment became effective. The language was identical in almost every respect to the 2003 Statement. The changes were limited to those necessary to update the document and reflect a new incumbent. What this says is that the well-understood framework of inflation targeting, central bank independence and accountability will continue over the years ahead. I shall turn now to an evaluation of trends and prospects for the global and local economies in turn. The global scene It is apparent that demand in the US economy is now growing more slowly than it was a year or two ago. Recovery from the shallow 2001 recession is, by 2006, fairly mature and there has been some rise in inflation. So some slowing in demand is welcome and necessary. At the present time, the debate is over the extent of that slowing – whether it will be enough to take the pressure off prices, or whether it might in fact be too great, resulting in unduly weak economic activity. Observers have had a hard time this year deciding which of these problems was the larger concern. Early in the year, a string of biggish monthly CPI readings had everyone very worried about inflation. More recently, declining forward indicators of housing construction and softness in housing prices have seen markets and economists more concerned about a weak economy. Long-term interest rates have retraced about half their rise in the first part of the year. With the effects of a buoyant housing market thought to have been an important expansionary force in the US in earlier years, the recent change in sentiment in that market is understandably regarded as significant. Australian experience suggests, as does that of the UK, that the end of a housing price boom can have noticeable effects on aggregate demand. But those experiences also suggest that such effects are manageable. In Australia’s case, the resources boom coincided with the housing moderation and helped to dampen its effects, but that has not been the case for the UK, which has had broadly similar economic outcomes to our own. On this basis, one would think that there are reasonable prospects for moderate growth in the US economy in the period ahead. But this is obviously an area of uncertainty, and even a favourable outcome involves slower growth in US aggregate demand in the future than we have tended to see over most of the past decade. A slowing in the US economy is coinciding with a more positive picture in the euro area and Japan than we have seen over recent years. Japan looks more and more like it is finally escaping the stagnation that followed the excesses of the late 1980s and early 1990s. China has continued to grow with remarkable strength. To the extent that these and other areas are able to generate growth in domestic demand, as opposed to simply being pulled along by the US, the world economy could be expected to continue growing pretty well during 2007, though most likely below the 2006 pace. The consensus of forecasters at present seems to be that such an outcome is the most likely. Of course, forecasts can be wrong. The US might slow more than expected, perhaps because of larger dampening effects of the housing downturn. Another way it might eventually slow more than expected, as pointed out by the IMF’s recent World Economic Outlook, would be if persistent inflation pressures required further monetary tightening. The US remains sufficiently important that, if this occurred, other regions would probably find that their economies slowed too as a result. These days, we should also contemplate the outlook for China. Periodically people worry about a possible slump in China’s growth, understandably given China’s impact on the global economy over recent years. But we are also at the point where we probably should give some thought to price pressures in China. Even China must have some limit to how quickly it can grow without causing Third Statement on the Conduct of Monetary Policy, available http://www.rba.gov.au/MonetaryPolicy/third_statement_on_the_conduct_of_monetary_policy_2006.html. at inflation, and there are certainly anecdotes of rising wage costs in the major coastal industrial centres, on top of the higher costs of energy and raw materials. It appears that Chinese export prices are no longer declining. Were this trend to continue, the rest of the world, hitherto experiencing the effects of deflation in prices for various manufactures, might at some point notice some mild impact on inflation rates. No discussion of the global economy is complete without some mention of financial trends. Here the main factor at work is still, it seems to me, the search for yield. Although the Fed has more or less normalised the short-term rate structure in the US, short rates in Japan and, to a lesser extent, mainland Europe remain unusually low. Long-term rates remain on the low side as well. Appetite for risk has been a little more variable this year, but overall risk spreads remain pretty low, especially considering some of the events which have occurred over recent years. Of particular note recently has been the marked increase in leveraged buy-out activity around the world. This reflects a combination of low funding costs and high levels of confidence about the potential future productivity and profitability of corporate assets. Whether or not such confidence is well based remains to be seen. But for the past decade or more, much of the action has been in household balance sheets – with a trend towards larger gross balance sheets and higher levels of debt. If we now are moving to an era in which corporate balance sheet developments are, once again, to the fore, then economists, prudential regulators and other policymakers will need to be alert to any economic implications that would flow from such a change. The Australian economy After 15 years of more or less continuous expansion, we have an economy which is as fully employed as it has been for a long time. That’s a good thing – full employment is one of the objectives of macroeconomic policy after all, and is set down in the Reserve Bank Act. But high rates of resource utilisation affect the conduct of policy: we need to be more alert to the risk of inflation than in periods when the amount of spare capacity was much larger. The international environment is one of strong growth, and rising costs of materials. Inflation in Australia has risen, and not just because of prices of petrol and bananas. Those are likely to show declines anyway over the next couple of quarters, but measures of consumer price inflation that are not distorted by these factors have picked up. That is not surprising. Input costs have risen across a range of areas. We have a tight labour market, and despite the steadiness recently of official measures of wages growth, there is still pressure on labour costs, including the kinds that do not show up in wage statistics. At the same time, there are some puzzles in the picture painted by the various pieces of data on the Australian economy. On the one hand, real GDP growth is estimated to have declined to about 2 per cent over the 12-month period to June 2006, after having grown by just under 3 per cent in the preceding year. Growth in domestic demand has moderated from its earlier heady pace, though it still seems to have been running at 3½ to 4 per cent over the year, which is probably a bit above the economy’s sustainable capacity to increase production. Yet growth in employment has remained quite strong, and the rate of unemployment has, if anything, edged down over the past year. This sort of unemployment result would normally suggest that output growth had been at or slightly above trend, which most people would these days put at 3 per cent or a little above. Meanwhile, the rate of growth of tax revenues over the past several years has been well above what historical relationships suggest should have been expected, given the recorded growth of nominal GDP. At face value, the output and employment results suggest a marked change in the trend in productivity in Australia over the past few years. The various measures of GDP per hour worked suggest there has been approximately zero growth in productivity since the end of 2003. This compares with an average annual pace of growth of 2 per cent or more in the preceding decade. So what’s going on here? One possibility is that the level of nominal and real GDP is really higher than is being captured at the moment by the statistics. That would mean that growth over the past few years has been higher than, and productivity has not slowed by as much as, the published data suggest. Tax revenues would, in this scenario, look more in line with historical relationships. This outcome would seem more in line as well with the unemployment trends. A second possibility is that it is the labour market data that are out of line – perhaps due to lags, or sampling effects – and that they will sooner or later come back into line. If that is the story – if the economy really has grown below trend of late – we might expect some rise in the unemployment rate to emerge before much longer. But this story still needs to explain the strength of tax receipts. Or maybe both productivity and output growth really have slowed, as the published estimates suggest. The question then would be why productivity slowed so much. One hypothesis we hear from time to time is that average productivity might be reduced by adding the workers with the lowest productivity after a long expansion. Perhaps this is not altogether surprising at this stage of the cycle – and if we are now seeing employment of workers whose lesser skills and productivity kept them out of contention in the past, that in itself is to be welcomed. But this addition of less productive workers isn’t enough to explain the extent of the slowdown in overall productivity. If the figures are correct, the productivity growth for the existing workforce must also have declined noticeably. For had it continued at the pace seen over the preceding decade, the workforce that was employed two years ago could have accounted for virtually all the output growth which has occurred since. That would suggest the productivity of the additional workers employed over that period would not just be lower than average, it would actually be (approximately) zero. Surely employers would not have taken on people with productivity that low. Other hypotheses have been advanced for a slowdown in productivity growth. Among them are that higher levels of labour turnover in a tight market disrupt productivity performance across firms; or that changed regulations (e.g. new accounting standards, tougher requirements to demonstrate appropriate corporate governance and so on) are using resources without adding to output. At this point, however, these don’t seem sufficient as an explanation for a productivity slowdown of the magnitude we observe in the data. Hence it appears that, for the moment, we are left with something of a puzzle. That means that, as usual, monetary policy is being made under conditions of uncertainty. If the GDP data are correct, then the economy grew more slowly than earlier thought in the first half of 2006, potentially with some moderating impact on the outlook for inflation. (Even then, we would still have to ask the further question of whether the slowing was driven mainly by lack of supply or lack of demand. Only in the latter case would it mean that spare capacity in the economy will have been increased.) If, on the other hand, there really has been more growth than the GDP accounts suggest – more in line with the rise in employment and the trend decline in unemployment – then capacity probably remains pretty tight. In that case, upward pressure on inflation remains a distinct possibility. Alternatively, if both sets of data are correct, then productivity actually has slowed down considerably. But if that is true, unless it is a temporary phenomenon, then potential GDP growth is not 3 per cent or a bit above any more. It will be less, and our growth aspirations would have to be adjusted accordingly. In this scenario, inflation pressure in the near term could well increase and demand growth may need to be further restrained for inflation to remain under control over time. In trying to assess which of these possibilities, or which combination of them, is in operation, one of the pieces of evidence to which we will be looking for guidance is the behaviour of prices themselves. An economy with genuinely sub-potential growth over two years ought, other things equal, to start putting some downward pressure on inflation fairly soon. An inflation rate that continued to increase, on the other hand, would presumably raise questions about either the apparent rate of growth of demand and output, or of potential output or both. You do not need me to tell you, therefore, that the price data to be released over the next couple of weeks will be important in evaluating the outlook and the balance of risks facing policy. Before I leave the current state of the economy, a remark about the differences in performance by region is appropriate. As everyone is aware, spending growth is strongest in Western Australia, as resource producers seek to put in place more capacity and the income gains from the boom are partly spent. But the differences in spending overstate the differences in actual economic performance between the regions. Not all the demand generated in Western Australia is being supplied from there: some of it is being supplied from the rest of the country, and some of it from outside Australia. It is partly for that reason, presumably, that the differences in employment growth and unemployment trends across states are much smaller than the differences in spending. In fact, the extent of the differences in output growth across states, while noticeable, do not appear at present to be unusually large. They also appear to be well within the sorts of differences experienced over time by other comparable countries or regions, like the United States, Canada or the euro area. At the same time, there is some tendency for labour and capital to move to the resource-intensive areas. That is exactly what is supposed to happen in a flexible economy when relative prices change: labour and capital respond to incentives. Moreover, as the Secretary to the Treasury pointed out a couple of months ago, 6 if the current set of relative prices persists, there will be more such adjustment in the years ahead. The longer term Before concluding, it would be useful to lift our eyes from the immediate ebb and flow of the short-run data and to ask, taking a medium-term view, what will be the most important task for monetary policy over the period ahead? It should be obvious that, over the next little while, the main job is to ensure that the inflationary pressure we have been experiencing of late is successfully resisted, and that expectations of future inflation remain well anchored. That will be a key part of maintaining an average inflation performance of ‘two point something’. We could hardly overstate the importance of maintaining that general environment where, as famously characterised by Alan Greenspan, inflation is sufficiently low and stable that it does not materially affect economic decisions by firms and individuals. A stable overall price environment assists in resource allocation and preserves the value of savings. It also provides monetary policy with more scope to be flexible in the face of shocks. The past decade has seen no shortage of challenges, often of a financial nature: the Asian crisis, the LTCM episode, the dot com mania and subsequent downturn, and so on. When conditions in the real economy were threatened on those occasions by contractionary forces, central banks in a range of countries were able to respond with reductions in interest rates, or by retaining already low rates for an extended period. Some people would be inclined to argue about whether or not such actions were in every case ideal. But the more important point is that, without a background of low and steady inflation and wellanchored expectations, they would not have been feasible at all. Were the recent higher inflation rates of the past year in Australia and some other countries to persist, and to start affecting behaviour, such a degree of flexibility for monetary policy might not be present in future moments of economic difficulty. Acting as needed to keep inflation in check in the near term, on the other hand, preserves future flexibility. It is that strategic requirement to which central banks should be, and I believe are, paying close heed. As we do so, of course, we will be bearing in mind the lagged effects of the policy adjustments already made. If we can successfully see off the higher inflation of the past year or so, we will have done a lot to establish the conditions needed for ongoing growth. ‘Economic Policies to Address Global Pressures’, speech by Dr Ken Henry, Secretary to the Treasury, to the Australian Industry Group National Forum 2006, Canberra, August 2006; available at http://www.treasury.gov.au/documents/1140/PDF/AIG_August_2006.pdf. | reserve bank of australia | 2,006 | 10 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 12 December 2006. | Glenn Stevens: Finance and economic development in Australia Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 12 December 2006. * * * It is a great pleasure to be invited to address the Annual General Meeting of CEDA, continuing a long tradition of such addresses by Governors of the Reserve Bank of Australia. CEDA – the Committee for Economic Development of Australia – began in 1960, an initiative of D.B. Copland. Copland, one of Australia’s most remarkable economists of the Depression era, was a member of ‘Giblin’s Platoon’, whose history is recorded so nicely in the recent book of that name. 1 CEDA has over the years made a substantial contribution to debate in a number of fields, from trade policy to taxation policy, from indigenous affairs to infrastructure. Interestingly enough, the list of publications on CEDA’s website does not include any which are overtly financial in their focus. I do not say this as a criticism – perhaps the reason you have invited central bank governors to speak so regularly is to cover that very set of issues! But it seems appropriate, given CEDA’s core focus on economic development, to address the questions: what is the role of finance in economic development and growth? How does the financial system contribute? How can financial events sometimes be detrimental to economic growth? What can be done to ameliorate those risks? What risks do we face at present? History The growth we take for granted in the modern world is actually a fairly recent phenomenon in human history. Prior to the industrial revolution in western Europe, living standards rose, if at all, very slowly. According to Angus Maddison’s data, the real per capita GDP of the United Kingdom rose between 1500 and 1820 at an average rate of only 0.27 per cent per annum. 2 At that pace, living standards doubled about every 250 years. In other words, a person would not live all that much better than their grandparents – assuming they could discern any difference. From 1820 to 1913, the rate of increase rose to 1.15 per cent. That’s a very big change. At that pace, living standards doubled in about 60 years. In the 20th century – despite wars, the Great Depression, the Great Inflation and various other problems – growth per head rose further. Australia’s per capita growth was 1.70 per cent in the 20th century, according to the same data set, for a doubling in living standards about every 40 years. The difference between my living standards and those of my grandparents in the mid 1940s when they were as old as I am now – a trebling – is remarkable. There is a vast literature on what accounts for this growth, and there has been a long debate in economics about whether the development of financial institutions and markets followed or led the developments in the real economy. Some, such as Joseph Schumpeter, Sir John Hicks and Walter Bagehot argued that financial development actively fostered innovation and entrepreneurship. Others, including Joan Robinson, argued that finance passively followed in the wake of real-side development. 3 Surely both components were necessary, and neither alone would have been sufficient. Technological advance provided the potential for a marked acceleration in productivity. In the early age of industrialisation, the steam engine and electricity were two obvious examples. Without those opportunities, such financial capital as was available for deployment would probably have struggled to find a useful outlet. Coleman, W., S. Cornish and A. Hagger (2006), Giblin’s Platoon: The Trials and Triumph of the Economist in Australian Public Life, ANU E Press, Canberra. Maddison, A. (2003), The World Economy: Historical Statistics, OECD, Paris. For a treatment of these issues, see Levine, R. (1996), ‘Financial Development and Economic Growth: Views and Agenda’, The World Bank Policy Research Working Paper 1678. But equally, the potential technological advance would have remained just that – potential, rather than actual – had there not been a capacity to mobilise the financial resources needed to invest in the equipment embodying the new technology. The capital required for an economy based on agriculture and artisan-based manufacturing had been in the form of land, seed, basic tooling and the like. Traders needed working capital in order to purchase goods in one place and move them to another for sale, and various financial devices arose to assist this. The need to sink very big sums into large-scale machinery, however, called for capital on a different scale, and financial development was key to providing it. The economic historians suggest that a number of innovations were important. The development of the limited liability corporate structure allowed proprietors to take risk without facing complete personal ruin if the venture failed. Banking corporations efficiently pooled the resources of a large number of savers, the more so as they developed into joint-stock ownership structures, as opposed to purely private ones. These organisations also provided, before central banks developed fully, circulating monetary assets for the community, which facilitated exchange. Markets for the trading of claims against future income flows – what today we know as stock and bond markets – allowed the providers of capital to retain their wealth in a more liquid form, thus encouraging them to commit more capital to long-term ventures. In other words, the development of financial markets and institutions was an integral part of the industrial revolution. It remains a key facilitator of the growth we enjoy today. Yet such progress was not without its occasional problems, in the form of periodic panics. Commodities markets had a certain tendency towards occasional instability. Optimism and greed could push prices to extreme levels, following which a loss of confidence typically precipitated a crash. The Dutch tulip bubble of the 1630s occurred without the aid of the highly developed set of financial intermediaries that came later, though it did achieve considerable added fizz via a futures market for tulip bulbs – derivatives allow leverage, which is almost always a key element of the latter stages of speculative manias. 4 But the growth of a modern banking system in England by the late 18th century, whose liabilities were effectively financial claims against assets that could not be quickly realised if suddenly called, brought heightened risks. Banking is, after all, a business that involves leverage and liquidity and credit risks. There was always the possibility of a financial panic that could, if unchecked, threaten not only the financial institutions but also the course of the real economy. The question facing public policy, then, was how to find a set of arrangements that would allow the necessary credit extension to support capital investment in pursuit of new technological opportunities, yet provide a stable monetary standard and a financial system in which the public could have confidence. We should record that in the same era, questions of a qualitatively similar nature arose in the fledgling colonies of the Antipodes, even if they were, to begin with, at a lower level of sophistication. The Colonies needed both a system of mobilising capital and a means of making payments other than circulating paper claims over goods – be it rum or something else. We are all aware of Governor Macquarie’s ingenious attempt in 1813 at keeping metallic money in the colony of New South Wales, by making two coins out of each Spanish dollar, thus rendering them at once more useful in New South Wales and much less useful elsewhere. But Macquarie’s initiatives in granting a charter to the Bank of New South Wales in 1817, and those of Governor Darling in rescuing it from disaster in 1826, were perhaps more important milestones in the early financial development in this country. According to Trevor Sykes’ account, 5 both of these actions were contrary to the policy of the British Government. These appear to have been occasions when the lags in implementation of official policy – measured by the time taken for a request for instructions to reach London by sailing ship, be considered and then answered by return ship, too late to influence the decision – helped to produce a superior outcome! Around the world, governments groped towards a sustainable solution for combining the benefits of financial intermediation with stability. Progress was not necessarily always steadily in the right direction, 6 but one of the key developments was the gradual evolution of the institution we would today See Sykes, T. (2003), ‘Tulips from Amsterdam’, in T. Richards and T. Robinson (eds), Asset Prices and Monetary Policy, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp. 194–202. See Chapter 1 of Sykes, T. (1988), Two Centuries of Panic, Allen & Unwin, Sydney. Rondo Cameron, for example, in claiming that the British financial system contributed to the industrial revolution between th th the mid-18 and mid-19 centuries, argues that this contribution was in spite of, rather than as a result of, policy actions of recognise as the central bank. In a number of countries, these institutions had begun life as a means to finance military expeditions by governments of not altogether unquestioned creditworthiness, 7 but they gradually became central players in the efforts to foster stability in normal times, and to restore it after something went wrong. Bagehot’s classic, Lombard Street, 8 remains one of the best accounts of this in the case of the Bank of England. The notion of the lender of last resort, and the idea that the central bank should look to the interests of the system rather than any commercial interest of its own, were slowly developing. It was, of course, to be some time before the central bank had fully evolved into the current form, even in the most advanced economies. In our own case, the central bank did not really have a fully developed public policy mandate until after the 1930s, and arguably was not a purely policy institution until the separation of the Reserve Bank from the Commonwealth Bank in 1960. Through the 20th century, of course, views about the appropriate role of a central bank changed a good deal, as did views about the appropriate extent of official intervention in financial markets and institutions generally. The Great Depression of the 1930s occasioned new ideas about macroeconomic policy, which envisaged more official intervention in economic matters. This was followed by a very large increase in the government sector’s command over economic and financial resources, of necessity, to conduct the Second World War. Hence by the end of the 1940s, the landscape had changed a great deal in comparison with 1930. The financial systems of many countries found themselves subject to much more regulation, and central banks with more regulatory powers and more explicit mandates for macroeconomic stabilisation, than had previously been the case. Initially, this arrangement held great promise. The instability of the 1930s had apparently been banished. But as time went by, other problems emerged. As explained eloquently by Ian Macfarlane’s recent Boyer Lectures, macroeconomic policies became overly ambitious, and neither the policy frameworks nor the governance arrangements under which they were implemented were up to the challenges posed by the shocks of the 1970s. Nor, we might add, was the structure of financial regulation, with its emphasis on governments or central banks setting most financial prices and even seeking to decide who should and should not receive credit. Many of us here will recall the debates at the time of the Campbell Inquiry in the late 1970s. By then, the problems of the extensive regulatory regime had become all too clear. It was ineffective (or even counterproductive) at a macroeconomic level, it distorted resource allocation at a microeconomic level and it fostered the rapid development of a more dynamic financial sector operating beyond the regulatory net. This wasn’t sustainable, and something had to give. There was large-scale liberalisation of the financial sector through the 1980s, winding back many of the post-Depression, World War II era restrictions. Efforts at prudential supervision were beefed up, but these progressively became focused on ensuring adequate risk management in individual financial institutions rather than the more direct controls of the earlier era. In more recent times, financial system stability – as distinct from the solvency of individual institutions – has become more prominent as an explicit focus of central banks, many of which publish regular detailed assessments of system stability. 9 This is a natural response to the circumstances, but it is really a refocusing on one of the key original purposes of the central bank. All of that history is a backdrop to the financial trends of the past decade, to which I now turn. the British governments of the day. He writes: ‘At almost every point at which banking and monetary policy might have been used constructively to promote economic growth, the authorities either made the wrong decision or took no action at all.’ See Cameron, R. (1967), (ed.) Banking in the Early Stages of Industrialization: A Study in Comparative Economic History, Oxford University Press, New York, p. 58. For example, the Bank of England was granted its charter – establishing it as Britain’s first limited liability banking entity – in 1694 after raising £1.2 million for the Government to fund expenditure in the war with France. Bagehot, W. (1873), Lombard Street: A Description of the Money Market, Henry S. King and Co., London. It is not mere coincidence, by the way, that this came at the same time as the macroeconomic instability concerns of the 1960s, 1970s and 1980s receded. Better macroeconomic stability has coincided with, and in all probability encouraged, a dramatic increase in the size and complexity of financial activity. Financial and economic trends in Australia in the past decade The most prominent financial development of the past decade has, of course, been the change in the structure of the balance sheets of households. Much has been said about this and so any description here can be brief. The essence of the story is that in the early 1990s, two decades of chronically high inflation in Australia ended. Interest rates declined as a result. In fact, they returned to levels last seen in the low-inflation period in the 1960s. But in the intervening period, of course, the Australian financial system had changed out of all recognition, a result of liberalisation, competition and innovation. No longer was the potential borrower for housing on bended knee to a stern-faced bank manager, the way they had been in earlier periods of low rates. Now, lenders were under more competitive pressure to grow their balance sheets. Having pursued the corporate borrowers in the 1980s, with rather mixed success, they were now looking to households as a source of growth. We can all recall the advertisement for one major bank in which the formerly stern manager practises saying ‘yes’ in the mirror each morning. So by the mid 1990s, we had a household sector more able and more inclined to demand housing finance, and financial institutions more willing to supply it. It is hardly surprising that this should ultimately result in households carrying much more debt, as well as higher levels of assets, than they had before. It might have happened earlier had the course of inflation and interest rates been different. Nor is it surprising that such an expansion in finance over a relatively short period of years should be associated with higher prices for dwellings. I find persuasive the arguments that changes to planning and development regulations have raised the cost of new building – that is, the cost of adding to the dwelling stock. It is plausible that this, in turn, adds to the price of those existing dwellings that could reasonably be substitutes for new dwellings. But if we are seeking an explanation for why the prices of the 8 million existing dwellings across the country have increased so much, we surely have to give a very prominent role to the halving of the cost of debt and its easier availability. These trends also added to aggregate demand in the economy, via additional construction and renovation spending, and the generally expansionary impact of rising asset values on broader household spending. Whereas dwelling investment averaged around 5 per cent of GDP through the 1970s and 80s, it reached a peak of nearly 7 per cent of GDP in 2003/04. Households also expanded their consumption faster than their income. For a time, these trends were helpful in periods when adverse shocks from abroad were having their impact. Over the past two or three years, these effects gently faded. We have seen some decline in spending on housing, and a slowing in the growth of household borrowing and consumption spending, but these changes have been fairly modest compared with earlier episodes, partly because there are regions of the country where the resources boom has continued to boost house prices and household demand. The run-up in household borrowing has also raised, on occasion, and quite naturally, questions about how sustainable all this was, and whether there was a build-up of exposures in the household sector and the financial system that could impair financial or macroeconomic stability at some future time. Considerable attention has been given over recent years to this set of questions, both in the Reserve Bank and elsewhere. We did not believe that the rise in debt was, in itself, likely to trigger an economic downturn. That said, higher leverage would, in the event of an economic downturn that occurred for some other reason, probably make at least some households’ spending behaviour more responsive to declines in income than it would have been in the past. Precisely this set of issues has recently been addressed as part of the IMF’s Financial Sector Assessment Program (FSAP). That program was a very wide-ranging exercise, as all FSAPs are, but from our point of view a key component of it was a macroeconomic stress test. The Reserve Bank, through our Financial Stability Department headed by Keith Hall, co-ordinated this exercise, which involved the IMF team, APRA, the Australian Treasury and the risk-management areas of the five largest banks – for whose co-operation we express our thanks. The results were included in our September Financial Stability Review, and also released by the IMF as part of the FSAP report in October. In brief, the test involved a scenario featuring: a very large fall in house prices, a recession, a big rise in unemployment, a sharp depreciation of the exchange rate and a rise in the funding costs of financial institutions. This was designed specifically to test the resilience of the financial system when several of the key elements underpinning business strategies over the past decade were removed. In such a scenario, only some of the adverse effects would come directly through mortgage portfolios; a good deal of it would come through business portfolios. Faced with a loss of income, indebted households would be likely to cut back consumption sharply in order to keep up their mortgage payments. Hence, businesses supplying into discretionary consumer markets would feel the effect quite quickly. In the tests conducted, the result was an estimated decline of around 40 per cent in the banks’ aggregate profits after around 18 months, and by the end of the three-year scenario, profitability remained 25 per cent lower than its starting point. That said, the institutions remained not only well and truly solvent but with capital positions above regulatory minima. In part, this reflected the strength of business balance sheets. As the banks worked through the scenario, this strength meant that the significant cutback in household spending did not cause widespread loan defaults in the business sector. Overall, the results are, within the limitations of this type of exercise, reassuring. Before we take too much comfort from them, however, we need to enter a few caveats. For a start, while the scenario seems a demanding one at first blush, it is predicated on a recession in Australia but not in the rest of the world. That would be, if not unprecedented, at least very unusual, and a more realistic scenario in which Australia suffered a downturn simultaneously with, and largely as a result of, an international downturn could well be a more challenging environment than the one assumed for the tests. A second factor is that everyone taking part in the simulation knew that the scenario involved an economic recovery, by assumption. They could factor that into their modelling. But in a real recession, there always comes a point at which many people are not confident of recovery, and that affects their behaviour. It is not unknown for lenders to be sufficiently lacking in confidence that they are reluctant to take on the risk of new borrowers. That would feed back to the economy, deepening the decline and slowing the recovery. Thirdly, there were quite large differences in results across banks. While these differences may be partly explained by variations in the structure of individual bank balance sheets, they also appear to reflect different approaches used by the banks to model their outcomes. There is nothing wrong with that – it is not that one approach is definitely right and another wrong. But the fact that varying techniques can produce significantly different results means that there must be a fair bit of uncertainty around any individual estimate. Hence, while the results provide some comfort, we can have only limited confidence that they would be replicated in a real-world downturn. We are, however, confident that the exercise was worthwhile, and would be worth doing again at some point. The Council of Financial Regulators, a body that brings together APRA, ASIC, the Treasury and the Reserve Bank under the chairmanship of the RBA Governor, is of the view that system-wide stress testing should be conducted on a regular basis, though of course the scenario would need to change through time. This was also the view of the IMF in its FSAP report. We have indicated to the CEOs of the participating banks that we would look to do this type of stress test roughly once every two years, and I look forward to their support for this. Looking ahead, the increasing prominence of private equity and leveraged buyout activity will be a point of interest. To date, this trend has probably caused a bit more excitement than the straight numbers would suggest is warranted, since LBOs accounted for a relatively small proportion of corporate mergers and acquisitions of Australian companies in 2006. But perhaps the reason for the attention is the feeling that the trend could continue for some time. In essence, many of these transactions are based on two fundamental premises: the return on equity is high, and has in recent years been unusually stable as well; and the cost of debt is low. Those offering high prices for businesses are essentially betting that, over the next several years, they can enhance returns by increasing leverage. To some extent, they may also feel that in a private-ownership structure they can do some things to improve long-run performance of the company that current shareholders would not tolerate because of short-term damage to earnings and share prices. But mainly, the strategy is one of leverage. If this analysis is correct, then corporate leverage, and the associated exposures around the financial system, could be rather more prominent as an issue over the next five years or so than it has been for a couple of decades. Going back to the FSAP stress tests for a moment, it is likely that the results would have been more worrying had the leverage of the corporate sector been considerably higher. But we shall have to leave a more detailed discussion of such issues to another occasion. For now, it is time to conclude. Conclusion Finance and growth go together. It was no accident that the acceleration in growth in the industrial revolution was associated with the development of modern banking and capital markets. By the same token, disruption to the financial sector is costly to the real economy, as is only too clear in history. The role of public policy is to respond to these disruptions forcefully if and when they occur to preserve the stability of the system, but in the good times to work hard at fostering a climate of careful risk assessment in the relevant institutions and markets. For the past 15 years or so, the financial system in Australia has worked remarkably smoothly to assist the economy. A very large change in the household sector’s balance sheets has made households more sensitive to changes in their circumstances, but financial institutions have continued to perform strongly. The challenge remains for these institutions, and all of us, to understand how risk is changing in this new environment, and to remain aware that we may at some stage face less forgiving circumstances than we have enjoyed over the past decade. We need also to be alert to the shift in the wind in the area of corporate leverage that seems to be occurring. I suspect we will be talking about that for some time to come. In the interim, I wish all of you a merry Christmas and a happy, prosperous – and stable – new year. | reserve bank of australia | 2,006 | 12 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Perth, 21 February 2007. | Glenn Stevens: Recent economic and financial developments in Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Perth, 21 February 2007. * * * Mr Chairman, members of the Committee. My colleagues and I welcome the opportunity to appear before you today. I have attended most of these hearings since they started in their current form in May 1997, and have observed over that decade the way they have become a very important part of the monetary policy framework in Australia. I am sure that their importance will continue to grow in the years ahead, and I look forward to taking part in them. It is fitting that this hearing take place in Western Australia, where the effects of some of the profound international forces affecting the economy are perhaps clearest. I refer of course to the rise in the relative price of natural resources, which has increased shareholders’ and employees’ incomes in the resource sector, increased the flow of labour and capital into that sector, and had a flow-on effect on a range of other industries. This has all fostered a generally very expansionary set of conditions in Western Australia in particular, though the effects have spread around the country. This change in relative prices is welcome, but such events are rarely uniform in their geographical or industry impact, and this one is no exception. In the south-eastern part of the country, where direct exposure to the resources sector is smaller, the positive impact is not as strong. In addition, the other dimension of the change in relative prices to which I refer – the relative decline in prices for many manufactured products as a result of the emergence of China and other low-cost producers – is affecting local producers. Not surprisingly, those parts of the economy, while growing, are experiencing less strength than seen here in the west. Nonetheless, the rise in Australia’s terms of trade of over 30 per cent over the past three years, taking them to their highest level for 50 years, is expansionary overall. The real incomes of Australians are higher and, other things equal, this adds to demand. For macroeconomic policy, it is a matter of ensuring that the economy adjusts to the change as smoothly as possible. That task is easier today than it once was. A more flexible economic structure, a floating exchange rate and a better macroeconomic policy framework mean that the adjustment is proceeding much more smoothly than it did on some other occasions in history when the terms of trade moved by large amounts. As a result, such adjustments to monetary policy as have been required have been gradual. When we appeared before you in August last year, the economy was in the midst of a mild pick-up in inflation. This was something that we had anticipated would occur, and to which monetary policy had already begun to respond, with adjustments to interest rates in May and August. As you know, there was a further adjustment in November, taking the cash rate to 6.25 per cent, somewhat above its medium-term average. The background to the rise in inflation, and the associated adjustments to policy, is fairly well known. After a long period of solid economic growth, we have approached what for practical purposes can be called full capacity, at least for the moment. The evidence for this is quite widespread. In the labour market, we are as fully employed as we have been at any time in the past 30 years or more. The share of the working age population employed is at a record high, the rate of unemployment is at its lowest for a generation, and wider measures of ‘underemployment’ are also comparatively low. It may well be possible for these trends to go further yet, but a wide array of business enterprises the Bank talks to have been saying for some time that it is harder and more costly to find appropriate staff, and that the factor most constraining further expansion is not insufficient demand, but insufficient capacity, either of labour or capital or both. Approaching full employment is, of course, something to be welcomed. It is a goal of macroeconomic policy. If full employment is a ‘problem’, it is the one you would rather have than the problem of chronic unemployment. When we do not have full employment, it is appropriate – inflation considerations permitting – for growth in demand to be faster than normal in order to use the unemployed reserves of labour and capital. In the recovery from a business cycle downturn, that is typically what macroeconomic policies seek to achieve. But by the same token, once full employment is more or less achieved, the pace of expansion in aggregate demand that was earlier desirable will now be too fast. It has to slow a bit, to be more in line with the rate of growth of the economy’s productive capacity. Otherwise, we would face the problems of overheating, inflation and eventually another downturn. It is that adjustment to more moderate outcomes for spending and output growth which we have been seeking in Australia in recent years. That this is necessary is confirmed by the fact that inflation has picked up somewhat. CPI inflation in 2003 was 2.4 per cent. In 2004 it was 2.6 per cent, and in 2005 2.8 per cent. In mid 2006 it was nearly 4 per cent. To be sure, the Consumer Price Index was affected by the rise in oil prices, and most spectacularly, the effects of Cyclone Larry on the Queensland banana crop during March of last year. But the rise in prices was more widespread than just those items. Measures of underlying inflation, less influenced by specific price shocks, suggested a pick-up, albeit a much more modest one, from about 2½ per cent to about 3 per cent by mid 2006. A short-lived pick-up of that magnitude is not necessarily a major problem in itself. But in an economy with limited spare capacity, continuing signs of quite solid growth in demand, and experiencing a substantial external stimulus, that gradual trend rise in underlying inflation was worrisome. A continuation of this trend could have seen inflation exceeding the 2–3 per cent target over a more sustained period, even after temporary factors had disappeared. It was this risk – not banana prices or petrol prices per se – to which monetary policy had to respond. It was intended that the rise in interest rates, by restraining the growth of demand, would allow the supply side of the economy some time to catch up, and so act to contain inflationary pressures over time. How, then, do we evaluate the current situation and outlook? Most indicators suggest the economy expanded at a moderate pace through the second half of 2006. While housing construction remained a bit below average, engineering and non-residential building have been very strong. Consumer demand picked up a little pace, and at present it is being assisted further by the decline in petrol prices. At the same time, the very serious drought has strengthened its grip on the rural sector, and farm production and incomes will be sharply lower this financial year as a result. The demand for labour has remained very strong, with higher than average increases in employment and some further decline in the rate of unemployment through the turn of the year. Data on job vacancies and from business surveys suggest little moderation in this area in the near term. Looking abroad, the world economy continues to post a strong performance, led by the US and China. Many commentators have for some time pointed to the possibility of a sharper-than-expected slowdown in the US economy, due most likely to a weakening housing sector pulling down activity elsewhere, as a key downside risk. To date that risk does not seem to have materialised, and recent data suggest growth has been close to trend for the US economy, even with a weak housing sector. At the same time, recent inflation outcomes in the US show some moderation. There is little sign that China’s rapid expansion will end any time soon and recent growth in the euro area has recently been the strongest this decade. So, while forecasts made by the IMF and other institutions for the world economy have for some years been qualified by statements about downside risks, it appears that current trends are, once again, at least as strong as the forecasts. While prices for some commodities have retreated from their peaks, others have remained very high. The prevailing levels of prices will, in all likelihood, continue to prompt high levels of investment in the resource sector both in Australia and abroad. No doubt the resulting expansion in supply will, in due course, dampen prices for commodities to some extent. Even so, it appears likely that Australia’s terms of trade will be higher on average over the years ahead than they were through the 1980s and 1990s. International financial markets remain remarkably supportive of growth. Long-term interest rates are not far above their 50-year lows of a few years ago, even though short-term rates have risen in most countries to be much closer to normal levels, the main exception being Japan. Share prices have been rising steadily, appetite for risk is strong, and volatility in prices for financial instruments has been remarkably subdued. To some extent, these trends in financial pricing may well reflect a genuine decline in some dimensions of underlying risk. Variability in economic activity, and in inflation and interest rates, has clearly diminished over the past 15 years in a number of countries, including Australia. The associated prolonged period of attractive, steady returns on equity investment and low cost of long-term debt funding certainly seems to have set the stage for a return to somewhat higher leverage in the corporate sector. This is most prominent in the rise in merger and acquisition activity and the re-emergence of leveraged buy-outs around the world. Corporate leverage had been unusually low after the excesses of the 1980s, so some increase is probably manageable. Nonetheless, after more than a decade in which the main action in many countries has been in household balance sheets, this trend in corporate leverage will bear watching. For the time being, at any rate, financial conditions are providing ample support for both corporate investment and household spending around the world. Turning to the outlook for domestic demand, the very high rates of growth of business investment are now probably behind us, but the current high levels of investment are adding to the capital stock in a way that should, in time, ease capacity constraints. Governments in several states, conscious of the need for public infrastructure, are also looking to expand investment. There appears to be considerable competition for the resources needed to complete all these projects. A gradual expansion in residential construction activity will probably get under way over the next year. We expect household consumption will grow at about trend in the period ahead. In both these areas, our expectations take into account the fact that the impact of the monetary policy adjustments made last year are still working their way through the household sector. All of this should mean that domestic demand will rise at, or slightly below, trend pace over the coming year. With some export sectors expanding as additional capacity comes on line, our central forecast is for growth in non-farm GDP to pick up to about trend during the next couple of years. Total GDP growth will be lower in the near term because of the drought’s effect on the farm sector. If rainfall patterns improve in the months ahead, there would presumably be some recovery in farm production during 2007/08, though the likelihood of that, let alone its strength, is inevitably highly uncertain at this stage. So far as the outlook for inflation is concerned, at the time of our November 2006 Statement on Monetary Policy, after the three policy adjustments made last year, we believed there were grounds to think that the higher inflation outcomes observed up to that time would moderate a little in the period ahead. We were, admittedly, a little tentative in that judgement, but based on that assessment, the Board elected to leave interest rates unchanged in December. At our most recent meeting two weeks ago, we felt we could be a little more confident in that inflation forecast. We will, of course, see some large movements in CPI inflation in the next few quarters. It will probably fall noticeably below 2 per cent on an annual basis, as falling petrol and banana prices have their effect. After that, it will rise again, as those temporary factors fade, and we currently expect that CPI inflation will be around 2¾ per cent by early 2008, remaining around that rate thereafter. That is, it appears likely to be lower than recent outcomes, but closer to the top than the bottom of the 2-3 per cent target range. With that outlook, the Board decided in February to maintain the existing setting of cash rates. We will be maintaining a close watch on what incoming information tells us about the prospects for inflation. The apparent softening in underlying inflation in the December quarter was certainly very welcome, but it is not as yet clear to what extent it signals a persistent, as opposed to a temporary, phenomenon. Most of the indicators we have available still suggest a very fully employed economy. So there would be some risk of inflation remaining uncomfortably high were demand growth to be unexpectedly strong in the near term. Hence the outlook for demand, and the extent to which capacity constraints are easing in a range of sectors, must be key elements in forming a judgment about the outlook for inflation, and the appropriate stance of monetary policy. I turn now to payments policy, which I know is of interest to this Committee. You conducted a very extensive set of hearings last year into payments issues and we believe that was very useful as a way of airing the views of the various participants. In 2002, when the Payments System Board announced the credit card reforms, it committed to reviewing the outcomes after five years. We will meet that commitment with a review that will take up this year and part of next. The review will be broad in scope and will include all the Bank’s reforms to date. I know that some industry participants have expressed reservations, including to this Committee, about the Bank, rather than another body, conducting the review. I note that the Committee was not convinced by their arguments and concluded that the Bank should conduct the review. From our point of view, having publicly committed to carry out such a review, we feel we could hardly do otherwise. Moreover, it would be very odd indeed for the Payments System Board, which has been charged by the Parliament with making payments policy, to ask some other body to review its policy decisions. It is, of course, open to the Parliament, including via this Committee, to review the reforms in any way that it sees fit and to ask the Payments System Board to account for its decisions. In December last year, the Payments System Board announced the outline of the review, after inviting input from industry participants. The formal part of the review will begin mid year, when the Bank releases an issues paper, which we hope will form the basis for an initial round of consultations. As background to the review, we will also be undertaking some detailed research into costs and usage patterns of the various payments methods, including cash. This will update and broaden the study on costs carried out seven years ago. The review will be an open process, which will include a conference towards the end of this year bringing together policy-makers, specialist academics and industry practitioners. We plan to release our preliminary conclusions in the first part of 2008 and then we would again consult widely before making any changes to the current arrangements. We expect the review to be completed in late 2008. This is a lengthy process, but it has to be if the discussion is to be based on the facts, everyone with something to say heard, their views considered carefully and the PSB to undertake proper deliberation. It is important to add that while the Payments System Board’s reforms to retail payments systems have attracted a good deal of attention, the Board is concerned with a much broader set of issues, including the stability of the payments systems. The Board’s main focus here is the operation of the high-value payments systems. These systems continue to operate with a high degree of reliability and security, but continued attention and investment on the part of the principal players, including the RBA, is needed to ensure that this remains the case over the years ahead. Mr Chairman, that concludes my introductory remarks. My colleagues and I are here to respond to your questions. | reserve bank of australia | 2,007 | 2 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the QUT Business Leaders' Forum, Brisbane, 14 June 2007. | Glenn Stevens: Economic conditions and prospects Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the QUT Business Leaders’ Forum, Brisbane, 14 June 2007. Vanessa Rayner provided research assistance for this address. * * * The last time I gave a speech in Brisbane was three years ago, in June 2004. The key themes of that address were a world economy growing faster than average, rising oil prices, narrow pricing for risk in global financial markets, an Australian economy enjoying a long expansion, and a Queensland economy growing faster than the national average. You might be forgiven for saying that not much has changed in the interim. The global economy has continued to grow faster than its long-run average, oil prices have risen a lot further, compensation for risk in financial markets remains remarkably skinny, Australia’s economic expansion has continued and Queensland is still experiencing stronger economic conditions than the average for Australia. But the fact that all those things are still occurring is quite remarkable. The Australian economy is on the cusp of the seventeenth year of the expansion which began in the second half of 1991. There is, at the moment, moreover, a high degree of confidence about the future, with share prices near record highs, property markets firming again and borrowing proceeding apace. I shall begin with some remarks about the global economy, and then talk about Australia’s recent performance. I will make some observations about how the Reserve Bank Board, responsible for monetary policy, is seeking to manage the risks which we judge the economy faces. The global economy The most recent outlook released by the IMF in April forecast global GDP growth in 2007, measured on a purchasing-power-parity basis, at just under 5 per cent. This is down a little from about 5½ per cent in 2006, but that was the fastest growth for over thirty years. The projected 2007 outcome is still well above the long-run average growth rate of around 3½ per cent. Between regions, there are some important divergences under way. Europe has been enjoying an acceleration in economic activity, recording over the latest year its strongest outcomes since the beginning of this decade. This has been led by Germany, which after some years of rather indifferent performance has emerged more efficient, competitive and confident. Growth in Asia remains strong, led by the remarkable pace of China. The US economy, on the other hand, has slowed down over the past year or so. So one question for the period ahead is whether the slower US growth portends a softening elsewhere, or whether other regions are big enough and internally vibrant enough to carry on growing reasonably well in the face of the US slowdown. To a large extent this will hinge on how widely the slowing extends within the US economy itself, and how long it lasts. To date, it has been largely confined to a reduction, albeit a pretty large one, in construction of dwellings, after a period of unusually strong activity in that sector. People have been asking whether it will spread further, especially given the recent travails in the sub-prime mortgage market, which had at the peak accounted for about 15 per cent of mortgage loans made to US households. A decline in credit standards during 2006, as lenders sought to keep business growing in the face of the slowing demand for loans and a change in trend in house prices, has since resulted in a rise in loan arrears. In turn, this has resulted in a blow-out in spreads on the low-rated tranches of the securities issued by some of the US lenders active in this market, and a number of loan originators in the sub-prime space went out of business. There was understandably a concern that this sequence of events could prompt a pulling back by lenders for housing generally, which would deepen the downturn in construction. There was also a possibility that there would be a more widespread reassessment of risk and a tightening in credit across the US economy, so dampening growth more generally. But so far, the US economy and financial system seem to be absorbing the sub-prime problems pretty well. There has been a significant tightening in credit standards in the sub-prime area, as there had to be, but no widespread withdrawal by lenders more generally. While the US housing sector has yet to show much convincing sign of a pick-up in construction, the softness in the US economy does not seem to have spread to consumer spending, as incomes have been supported by ongoing gains in employment. That does not necessarily mean we have seen the last of concerns about US weakness but, at the moment at least, adjustments to the growth outlook are at the margin, rather than amounting to a wholesale re-think of economic prospects. It is also noteworthy, and very important from a global perspective, that underlying inflation appears to have come down in the US somewhat over the past six months, having drifted higher for the previous six months. Low and stable inflation has been a key underpinning of US and global economic expansion for the past decade and a half. Policy-makers around the world are rightly on alert for threats to that stability. If the US authorities have managed to turn inflation back down, then the foundations for future growth will have been strengthened. But US policy-makers themselves would still say, I think, that such remains to be seen, and we have recently seen some shift in market pricing in recognition of the fact that the risk of higher inflation has not yet disappeared. Around Asia, Japan is growing again, but the big story is of course China. According to the official figures, China’s GDP grew at about 11 per cent over the latest year, even faster than the preceding period. Just about every statistic on the Chinese economy paints a picture of dazzling growth, though there are also several areas where the Chinese authorities have expressed concern. There is more than a hint of froth in Chinese asset markets, especially the share market, which has increased by around 50 per cent this year. Rises in prices for soft commodities are also finding their way into food prices, which is a pretty big share of the cost of living in China and a number of other like countries. In response, China has tightened its macroeconomic management policies, and taken taxation measures aimed at dampening speculative excesses in the share market. We can expect, however, that China will seek to remain on a pretty rapid growth path for some time to come. To do so will require continuing efforts to find domestic sources for growth, with not quite so much emphasis on export-led growth, if only because China will be too big for the rest of the world to accommodate an export-led strategy either comfortably or willingly. It will also involve increasing attention to environmental issues, especially as Chinese living standards continue to rise towards those elsewhere. 1 But the Chinese authorities are aware of all that, and have shown an impressive capacity for economic adjustment over the years. Hence, I remain reasonably optimistic about China’s long run growth potential, and by extension the growth potential of those parts of Australia’s economy that are complementary to China’s growth needs. That said, it would be imprudent to assume that the recent consistency of exceptionally strong Chinese growth is normal. It is more likely that there will be occasional bumps along the road, and some of them could be pretty big. In the near term, were the US slowdown to become deeper and more protracted, Asia would probably be affected. It is true that direct trade linkages with the US have become relatively smaller as a share of total Asian trade in recent years. But while a larger share of Asian exports is now going to China, most of this trade is just part of the regional chain producing final goods for sale outside of the region in the major countries, a big part of which is still accounted for by the US. So higher intra-Asian trade does not of itself mean that Asia is more independent of the US. The power of linkages via financial market prices and attitudes of risk takers should not be underestimated either. Hence a bigger US slowdown would still be a big deal, if it occurred, and keeping good global growth going would increasingly depend on policy responses in other parts of the world. But provided the weakness in the US economy remains largely confined to its housing sector, as seems to have been the case to date, the spillover effects to the rest of the world through trade and financial channels are likely to remain small. There is some historical evidence in support of this point of view, 2 with other moderate US growth slowdowns in the past having had a relatively modest effect One recent study suggests that, based on the experience of most other countries which have made that transition, the number of motor vehicles owned in China would be expected to rise from 20 million in 2002 to almost 400 million by 2030. That would be equivalent to nearly 50 per cent of the vehicles in the world today. Other startling statistics can be quoted. No-one knows whether such projections will turn out to be accurate, but even a start down such a track by China surely will carry significant implications for energy and resource prices, climate change, technology and a host of other issues. Available at http://www.econ.nyu.edu/dept/courses/gately/DGS_Vehicle%20Ownership_2007.pdf. In its April 2007 World Economic Outlook, the IMF examines the global repercussions of past US recessions and mid-cycle growth slowdowns. The IMF finds that the US growth slowdowns in 1986 and 1995 had a negligible effect on growth elsewhere in the world. Specifically, the median growth decline in industrial countries was 0.1 per cent during US growth slowdowns, compared with a on world growth. This seems to be the most likely outcome as we look forward over the next year or two. The Australian economy The trends in the global economy have imparted a very large expansionary impetus to the Australian economy. The rise in resource prices (and to a lesser extent a decline in global prices for manufactures) have increased Australia’s terms of trade by about 40 per cent over the past four years, to their highest level since the 1950s. Despite the various other factors that are affecting the economy – like the drought – this is a boost of first order importance, with real national income nearly 8 per cent higher than it would otherwise have been. Some of that additional income accrues to the foreign shareholders of companies but a good deal of it stays in Australia in the form of profits and dividends, taxes, wages and so on. There are then indirect effects as that income is partly spent on domestically-produced goods and services. Assuming the change to the terms of trade is not just temporary, there are further effects as firms respond to the prospect of higher profits in future by investing in greater capacity in the relevant sectors, though investment could well decline in other sectors of the economy where relative prices look less attractive. Typically, in such episodes the exchange rate rises because capital tends to be attracted to Australia by the same prospects of profitable investment, and also because markets anticipate that the expansionary forces at work will require higher interest rates. This tends to dampen activity in some parts of the traded sector, distributes the benefits of the higher terms of trade more widely across the economy, and gives a price signal for labour and capital resources to shift, over time, to the parts of the economy with the strongest prospects. It also assists to keep inflation under control by lowering prices for tradeable goods and services. The national income accounts show the broad contours of the effects. It is usually hazardous to base a story heavily on any one quarter’s statistics, as these data can display considerable volatility over short periods. But taking the trend over the past year, growth in real GDP was around 3¾ per cent, half a percentage point higher than in the preceding twelve-month period. Business investment spending is high, suggesting a substantial increase in the nation’s capital stock is occurring. Consumer spending gathered pace, on the back of large gains in employment and disposable incomes. Final spending by governments (that is, spending that directly affects demand, as opposed to transfer payments and taxation measures) has also risen at an above-average pace over the past year. Together these pushed domestic final demand up by about 4½ per cent over the four quarters to March. Some of the growth in demand was satisfied by imports. Exports picked up on the preceding period, but were held back somewhat by the drought, and in the case of some bulk resources, continuing capacity constraints. This is a strong result considering that the effects of the drought and rising interest rates were also at work. But these data seem at present to align reasonably well with other information. Business surveys have consistently pointed to buoyant conditions. The labour market survey shows strong growth in employment, and measures of surplus labour, whether the standard unemployment rate or various measures of underemployment, have all declined further. Tax revenues, a rough cross-check on the growth of the nominal economy, have continued to be very strong. Looking ahead, there does not seem to be a high likelihood of the world economy slowing abruptly in the near term. Hence, the external forces at work will in all likelihood continue to be pretty positive. Australian households overall appear to have plenty of disposable income and the confidence to spend it. Business profits are in good shape, and firms will be well placed to continue their high levels of investment as needed. They are also displaying a strong propensity to borrow, with business credit growth at its highest for nearly two decades. Meanwhile, the number of dwellings being built looks to be below what is normally thought to be underlying demand arising from population growth and household formation. At some stage, therefore, it will probably need to pick up, adding to demand for labour in the construction sector and to demand decline of 2 per cent during US recessions. In most emerging market economies, median growth increased slightly during US growth slowdowns, but declined during US recessions. for raw materials. There are nearly a million people working in construction, broadly defined as by the ABS, a rise of about 50 per cent from six years ago. Perhaps there is some further supply of labour available, but realistically there could well be a need for other types of private construction activity to tail off, so as to release some productive resources to accommodate (no pun intended) higher rates of dwelling construction. The intended further step-up in public infrastructure projects at the State level could also put some pressure on the engineering sector, unless private infrastructure projects also tail off. That is just one manifestation of the point that we need to pay attention to the economy’s supply side, as well as to the demand side. Observers conventionally assess the outlook for growth by looking at the prospects for demand components, adding them up, and then assuming that supply will respond. Anything that stimulates demand is thought to be “good for the economy”. But over recent years, we have increasingly been reminded that it is the economy’s supply side performance – the quantity and quality of the capital stock, the availability of labour and the productivity with which both those factors are used – that ultimately determines its rate of growth over the long term. Demand management policies – monetary policy and government spending and taxation measures designed to have a broad economic impact – can usually ensure that there is adequate expenditure to use the economy’s productive resources. But while we can, in most circumstances, create additional demand, it is much harder to create additional supply. Unless additional supply is somehow forthcoming, however, expanding demand just produces overheating and inflation. Inflation did pick up in Australia during the middle years of the current decade, from 2.4 per cent in 2003, to 2.6 per cent in 2004, 2.8 per cent in 2005, and 4 per cent by mid 2006. That peak in the CPI inflation rate was affected by some temporary factors, which have now reversed. But measures of inflation designed to extract the underlying trend showed a pick-up too, from about 2½ per cent to 3 per cent during the first half of last year. The most recent data for inflation, however, showed a more welcome trend, with underlying measures of inflation running at a reduced pace and the CPI rate on its way down as well. In our Statement on Monetary Policy released about six weeks ago, our judgement was that underlying inflation would probably run at about 2½ per cent for the year 2007, which was a slight downward revision to earlier expectations. Data on labour costs received since then add credence to that forecast. Compared with what we expected a year ago, then, growth has turned out to be stronger, employment higher, but underlying inflation a little lower, and wages growth has been steady in the face of unanticipated labour market strength. This is quite a favourable set of outcomes, and should prompt us to ask how it all fits together. One possibility is that all we are observing is lags at work. Earlier national accounts showed a weakening in growth from mid 2005 through to mid 2006. Perhaps this led, with a lag, to the slowing in prices recorded in recent quarters. If this is the story, the recent apparent acceleration in growth will presumably before long lead to a noticeable renewed pick-up in inflation. While we should not completely discount this possibility, one shortcoming of this story is that the earlier slowing recorded in the GDP data was by and large not so apparent in other pieces of information, especially labour market information. The recent acceleration in GDP likewise is not so marked in other indicators, though neither is it entirely absent. But my guess at present is that at least some of the explanation for these better-than-expected outcomes probably has to do with changed behaviour in the labour market. Despite, on most counts, the tightest labour market conditions for a generation, growth in most measures of labour costs has remained well disciplined for the past two years or more, after a mild acceleration earlier. Wages are rising quickly in some areas, but quite slowly in others. That is, relative wages are changing, adjusting to the forces at work on the economy, but without, so far at least, a serious inflation of the whole economy-wide cost structure. This looks like a text-book case of adjustment. We could note as well that, even though firms have been saying for some years now that labour is hard to find, they seem in many cases to have found it nonetheless. A rise in immigration has helped to accommodate the strong demand for labour (though immigration, of course, itself also adds to demand to some extent). Rising labour force participation across a number of groups, especially among those aged over 55, has also been quite important. In economist-speak, the supply side of the labour market has recently been more “elastic” than it used to be. It is a very different environment from the one that was in place last time we had a terms of trade event of this magnitude, testimony to the host of changes to the way the labour market functions that have occurred over the past two decades or so. To this we can add globalisation, where for some products at least, the “elasticity” of the global market is available in response to short-term demand fluctuations in Australia (or any other country). Australia is open to trade, which means not only that we have recourse to imports to meet demand if domestic supply is short, but since we are small in the world economy our demand per se has relatively little effect on the world price of those goods. The rise in the exchange rate would also be acting to dampen, at the margin, the rate of inflation for tradeables. All these factors presumably help to explain the recent pattern of moderate price increases in the face of stronger demand and output growth. But it would be a mistake to rely too heavily on these influences over a long period. While domestic supply has been reasonably elastic of late, it is surely not infinitely so. And while global sources of supply are steadily becoming more important for many products, large parts of demand are still overwhelmingly supplied from domestic sources. It follows that persistent rapid growth in demand for non-tradeables would eventually start to be accompanied by more pressure on prices and wages than we have seen lately. We must, furthermore, be closer to the point where that will occur today than we were a year ago. If strong demand growth persists, risks will increase. Nor can we assume that a rising exchange rate will exert a consistent dampening force on inflation of traded goods and services over the longer term, since exchange rates do not keep rising indefinitely. The ability to supply an increasing proportion of additional demand from imports probably also has some limit, though it is hard to tell where that might be. Hence, as things currently look, inflation is more likely to rise during 2008 than to recede. This probability is something which was embodied in the medium-term part of the outlook we released six weeks ago. Data becoming available since then have given more credence to that part of the forecast. These are the considerations the Reserve Bank Board is seeking to balance as it meets month by month. On the one hand, the medium-term concerns about inflation remain, for the reasons I outlined a moment ago. That is cause enough to err on the cautious side in setting policy, and to ask whether current settings are restrictive enough. On the other hand, the somewhat lower short-term inflation outlook means that the starting point for a future pick-up in inflation is likely to be a bit lower than earlier thought. This has afforded some additional time in which to assess trends in demand and the economy’s capacity to meet them, while still leaving scope to implement a further response by monetary policy as and when needed. Weighing all this up, the Board has decided at each of its recent meetings to maintain, for the time being, the settings which have been in place since November last year. The fact that a number of timely adjustments to monetary policy had already been made gave us some confidence in adopting that approach. In fact, a lot of the work needed to keep inflation on a reasonable track was done in the period from 2002 to 2005, when unusually low interest rates, which had been appropriate for the earlier part of the decade, were gradually lifted towards normal. They were raised a bit further, to be slightly higher than normal, during 2006. Without that sequence, we would today have been in a much less comfortable position. Whether or not further instalments in that sequence will be needed is a question the Board will continue to address over the months ahead. The Board’s judgement will, as usual, be informed by all the relevant data and an assessment of the risks we face over the coming couple of years. Conclusion We are living though a period of profound change in the world economy, which is offering a rare chance to improve further the economic success Australians have enjoyed over the past decade and a half. Historically, Australia often did not manage periods of prosperity very well, as our institutional and policy structures were not sufficiently flexible and long-term in their orientation. The chances of success are much higher on this occasion, and the evidence so far is that we are doing much better, but the situation is not without risks. I trust that on some future visit to Queensland we will be able to look back and find that the risks had been effectively managed. If so, then monetary policy will have played its part in furthering the prosperity and welfare of the Australian people. | reserve bank of australia | 2,007 | 6 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to The Anika Foundation Luncheon, supported by Australian Business Economists and Macquarie Bank, Sydney, 18 July 2007. | Glenn Stevens: The Asian crisis – a retrospective Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to The Anika Foundation Luncheon, supported by Australian Business Economists and Macquarie Bank, Sydney, 18 July 2007. I thank Vanessa Rayner for assistance in preparing this address. The original speech, which contains various links to the documents mentioned, can be found on the Reserve Bank of Australia’s website. * * * Thank you all for coming out today to support the Anika Foundation. 1 Since a similar function last year the Foundation has continued to build up its capital, and this year will be making its first grants by way of scholarships, called the Anika Foundation Depression Awareness Scholarships, as a part of the NSW Premier’s Teachers Scholarship Program. These will enable teachers and counsellors in our schools to travel, study responses to adolescent depression in other countries and return to NSW to raise awareness and improve responsiveness to depression among school students. Your interest in being here today will help us to build further over the coming year, when we hope to expand this same sort of scholarship to other Australian states. 2 In time, funding permitting, we would also like to establish a PhD-level research scholarship in the field of adolescent depression. Thank you also to Macquarie Bank for providing the venue and food for today’s event, and to the Australian Business Economists for their logistical and advertising support. Ten years ago this month, the Thai baht was allowed to float. It promptly fell very sharply. There were danger signs before then, but if we were looking for one event that marked the start of the Asian financial crisis, this would be it. By the end of the year, the crisis had engulfed Thailand, Indonesia, Korea, Malaysia and the Philippines, countries with a combined population of around 400 million. It had very pronounced effects on neighbouring countries like Singapore, serious financial contagion effects on Hong Kong, and had a discernible impact on the global economy. More fundamentally, perhaps, the crisis brought to an end a period of extraordinary economic growth in Asia, and seriously deflated optimism about future growth. It has proven very difficult to recapture that sense of optimism. While that earlier ebullience may, of course, have been overdone, the scars of the crisis remain fresh in some respects even a decade later. The Anika Foundation was established in 2005 to raise funds for the purposes of supporting research into adolescent depression and suicide. For details, see http://www.anikafoundation.com. Further details about the scholarships can be found in the 2007 NSW Premier’s Teachers Scholarships handbook. Graph 1 Selected Asian Exchange Rates Against US$ June 1997 = 100 Index Index Indonesia Thailand Korea Malaysia Philippines l l l l l l l l l l l l l l l l l l l l Source: Bloomberg; IMF With the passage of time it is of some value to re-visit the crisis, to ask what has been learned, what steps have been taken to strengthen national, regional and international arrangements against a recurrence, and what remains to be done. That is the task that I shall begin today, though it is probably too big a task to finish in one session. What happened? I start with the question: what happened? There are many detailed treatments available elsewhere of what occurred, and I cannot do full justice to the literature or to the events themselves, which were fairly complex. 3 We must be mindful, too, that “Asia” is not some homogenous mass, but a group of countries and economies that have considerable variety in their historical development and their approach to some economic policies. Nonetheless, I have to generalise for the sake of brevity. Asian economies grew rapidly through the mid 1990s. Average rates of GDP growth were between 7 and 10 per cent in most cases over the decade up to 1996. Rates of investment were high, and current account positions in several cases showed substantial deficits. Put another, and more illuminating, way, there was substantial capital inflow. In the case of Thailand, capital inflow amounted to about 10 per cent of GDP per year between 1990 and 1996, though that was at the high end of the range in the region. In Indonesia’s case the Some recent articles and speeches that reflect on the Asian crisis 10 years on include: “Ten Years After the Asian Crisis: What Have We Learned or Not Learned?”, Asian Economic Policy Review, 2, 2007, pp. 1-168; Geithner, T. (2007), “Reflections on the Asian Financial Crises”, remarks at the Trends in Asian Financial Sectors Conference, Federal Reserve Bank of San Francisco, 20 June; Kuroda, H. (2007), “Asia is Moving Forward: Ten Years after the Crisis”, speech at the Asian Development Bank International Symposium, Mandaluyong City, 2 July. A large number of books covering the general topic of the Asian crisis were written shortly after the event. To name a few: Goldstein, M. (1998), The Asian Financial Crisis: Causes, Cures and Systemic Implications, Institute for International Economics, Washington DC; World Bank (1999), East Asia: The Road to Recovery, Oxford University Press, USA; Hunter, W.C., G.G. Kaufman, T.H. Krueger (eds), and The Federal Reserve Bank of Chicago and the International Monetary Fund (1999), The Asian Financial Crisis: Origins, Implications, and Solutions, Kluwer Academic Publishing, Dordrecht. corresponding figure was 3½ per cent. From an Australian viewpoint, that does not seem all that big, actually, but it had the Indonesian authorities concerned at the time. Table 1: East Asian GDP Average annual percentage growth Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand East Asia* 1987-1996 1997-1999 2000-2006 5.2 7.1 8.1 9.5 3.6 9.2 7.2 9.5 7.6 -0.8 -6.4 1.0 -0.8 1.4 2.8 5.1 -3.3 0.0 4.7 4.9 4.6 4.7 4.6 4.6 3.3 5.1 4.5 * Excluding China and Japan Source: IMF, CEIC, RBA Capital markets in the region were underdeveloped, so the capital inflow tended to be intermediated through the banking sector. Exchange rates were heavily managed, and the counterpart of the inflow was a large build-up in money and credit in the domestic financial sectors, an associated inflation of asset values and some rise in prices for goods and services. Foreign currency risks associated with these flows were large, and were being incurred by domestic entities rather than being shared around the global markets. In many instances, neither borrowers nor their bankers were managing these risks at all well, in part due to weak risk-management capacities and ineffective supervision and, in part, no doubt, because the exchange rate regimes were assumed – wrongly as it turned out – to be robust. Foreign counterparties also seemed insufficiently attuned to the likely difficulties that could be experienced by the Asian borrowers and financial institutions, and their own limited ability to exit collectively what were quite small markets in the event that things went wrong. Pressures on the Thai currency began late in 1996, with early signs of some problems in local lenders coinciding with a rise in the effective exchange rates (and hence a decline in competitiveness) of some Asian countries owing to the rise in the US dollar and a downturn in the semiconductor market, which had been an important source of growth. For a time the Thai authorities were able to resist these pressures but they had to give up by mid 1997, as foreign exchange reserves were exhausted. The baht was floated on 2 July. It fell by 13½ per cent that day and ended the month 23 per cent lower. Intense pressure quickly flowed to currencies of neighbouring countries. A period of stability following the announcement of the support program for Thailand in early August was short lived and by early October the currencies of Thailand, Malaysia, the Philippines and Indonesia were again under intense pressure. Attention then shifted to the economies of north Asia, which up until then had been only lightly affected. There was tremendous pressure on the Hong Kong dollar peg, where overnight interest rates soared and the share market slumped. As corporate and banking problems intensified in Korea, foreign lenders cut back credit lines, and in November Korea approached the IMF for assistance in meeting foreign currency obligations. Political and economic uncertainty in Indonesia became extreme in the first half of 1998, and the rupiah lost 85 per cent of its value. Even today, the rupiah trades at a 75 per cent discount to its pre-crisis level. In recent years, we have lived in an environment of unusually subdued volatility in international financial markets, so we tend to forget just how discontinuous price movements can sometimes be. But the uncertainty and financial skittishness that encompassed the global economy in 1998 were pervasive. It was not confined to emerging markets either. By August 1998, we had the Russian default, followed by the LTCM crisis in September. Around that time, the US dollar/yen exchange rate moved 30 big figures in three months, and at one point nearly 15 per cent in one day. Now that’s volatility! One observer later described the international financial system in the late 1990s as having endured perhaps its “greatest stress in the post-war period”. 4 In Asia, as the financial market prices adjusted, some of the underlying vulnerabilities came more clearly into focus. The unhedged foreign currency positions meant that the authorities in the crisis countries faced a huge dilemma: as the exchange rate fell, the borrowers or their bankers, or both, went under water owing to the valuation changes on the debts. But raising interest rates to support the currency damaged capacity to repay as well. It was this financial dimension that made the Asian crisis so costly. And costly it certainly was. Per capita real GDP fell by about 9 per cent in east Asia excluding China and Japan. The fall in Indonesia was 15 per cent. On the best available figures, non-performing loans (NPLs) reached nearly half of all loans in Indonesian and Thai banks, and NPL ratios reached double-digits in several other countries in the region. 5 The process of sorting out banking problems of this magnitude required, as it usually does, extensive public funding. The net fiscal costs of the banking crises are estimated to have been over 20 per cent of a year’s GDP in Korea, 35 per cent in Thailand and about 40 per cent in Indonesia. 6 We sometimes read that Asia quickly recovered. I am not so sure. In due course, recovery in Asia did take hold, but it was very slow in some cases. The pre-crisis peak in real per capita GDP was regained within two or three years in Korea, the Philippines, Singapore and Hong Kong. But that achievement took five years in Thailand, six years in Malaysia and seven years in Indonesia. To put that in perspective, after the 1982 recession in the United States, real per capita GDP took about two years to regain its previous peak. In Australia after the 1990-91 recession, it took about three years. As I recall, those episodes were widely seen as serious. See McDonough, W. (2001),”The Role of Financial Stability”, address at the XIII International Frankfurt Banking Evening, Frankfurt, May 2001. Available at http://www.bis.org/review/r010504a.pdf. World Bank (2007), East Asia and Pacific Update – 10 Years after the Crisis, April, p. 60. IMF (2004), Indonesia: Selected Issues, IMF, Washington DC, p. 35. Table 2: East Asian GDP per capita Change post-crisis* Per cent Years to recover Hong Kong Indonesia Korea Malaysia Philippines Singapore Thailand East Asia** -6.4 -15.0 -7.5 -9.5 -2.7 -4.6 -11.6 -8.8 Memo items: United States (1981/82)^ Australia (1990/91) -3.8 -3.8 * Taiwan did not experience a contraction in GDP ** Excluding China and Japan ^ Assumed to start in September quarter 1981, as per NBER dating committee Source: IMF, CEIC, Thomson Financial, ABS, RBA Even accepting that the pre-crisis situation was unsustainable, it is clear that the cost of the Asian crisis was enormous, and the recovery slow. In fact, the average rate of per capita GDP growth in east Asia post-crisis was a little more than half what had been seen in the decade up to 1996. What did we learn? We learned a good deal about the nature of crises from these events. This was a different sort of crisis from the ones that had often been seen in earlier periods. It was not a standard example of a currency crisis resulting from lax macroeconomic policies, in which large budget deficits (often funded from abroad), easy money, high inflation and so on lead to a loss of confidence in the policy regime and capital flight. In those cases, the standard remedy is mainly macroeconomic tightening to restore discipline and investor confidence. 7 In Asia, by contrast, fiscal and monetary policies had always been reasonably conservative. Inflation rates were low by developing country standards, budgets were reasonably controlled in most cases, and government debt levels were generally not excessive. 8 Prior to the Asian crisis, the academic literature attempted to explain currency crises as a result of unsustainable fiscal policies or self-fulfilling speculative attacks. As the Asian crisis was not able to be adequately explained under these models, a raft of new research emerged, and so called “third-generation” models were developed. For example, see Krugman, P. (1999), “Balance Sheets, the Transfer Problem, and Financial Crises”, International Tax and Public Finance, 6, pp. 459-72; Chang, R. and A. Velasco (2001), “A Model of Financial Crises in Emerging Markets”, Quarterly Journal of Economics, 116, pp. 489-517; Caballero, R. and A. Krishnamurthy (2001), “International and Domestic Collateral Constraints in a Model of Emerging Market Crises”, Journal of Monetary Economics, 48, pp. 513-548. Some have argued that in some respects the Mexican crisis was a precursor to the “new” type of crisis seen in Asia (see Ito, T. (2007), “The Asian Currency Crisis and the IMF”, Asian Economic Policy Review, 2, pp. 16-49.). There were some similarities but also important differences, not least that the Mexican crisis required restructuring of sovereign debt, whereas in Asia the problem was private debt. Nonetheless, Ito argues that important lessons that could have been drawn from the Mexican experience were not applied in the Asian crisis. Graph 2 Crisis Countries* – Policy Indicators % Fiscal balance % Ratio to nominal GDP Korea -3 Other crisis countries -3 % Gross general government debt** % Ratio to nominal GDP % Consumer prices % Year-ended percentage change -20 -20 * Includes Indonesia, Korea, Malaysia, Philippines and Thailand ** Central government debt for Indonesia and Korea. Data prior to 1996 unavailable Sources: CEIC; IMF; Thomson Financial At its heart, the Asian crisis was a banking crisis brought on by banks and their customers taking on too much foreign currency risk. No doubt macroeconomic policies were not always perfect, but the real problems were in the financial structure more than the macroeconomic settings. This is now well understood, but it was not fully appreciated at first by many outside observers, even though some Australian commentators, to their very great credit, understood it very quickly. 9 A period of learning about how this type of crisis was likely to unfold and what needed to be done was inevitable, but it delayed recovery. Macroeconomic tightening was always going to be some part of the response, but far from sufficient on its own, and if carried too far would be counterproductive. General structural reform of the economy’s supply side, moreover, however desirable from the point of view of raising long-run growth rates, was always likely to play little role in the immediate recovery from a crisis of this The early and clear analyses of these issues by Ian Macfarlane and, especially, Stephen Grenville were ahead of most in comprehending the situation. See: ”Asia and the Financial Sector”, December 1997; “The Changing Nature of Economic Crises”, December 1997; “Exchange Rates and Crises”, February 1998; “The Asian Situation: An Australian Perspective”, March 1998; and “The Asian Economic Crisis”, April 1998; “Some Thoughts on Australia’s Position in Light of Recent Events in Asia”, April 1998; “Capital Flows and Crises”, December 1998; “Recent International Developments in Perspective”, December 1998; “The Asian Crisis and Regional Co-operation”, speech at the International Seminar on East Asia Financial Crisis, Beijing, 21 April 1998; “The Asian Crisis, Capital Flows and the International Financial Architecture”, speech to Monash University Law School Foundation, Melbourne, 21 May 1998. nature, in which demand collapsed. In fact, recovery depended on addressing the financial burden of the debts as directly and quickly as possible. The biggest problem that the countries of Asia had was that they had not developed the financial infrastructure needed to provide resilience to swings in mood before becoming more open to flows of international capital. In drawing lessons, much discussion focused on the difficulty of maintaining relatively inflexible exchange rates in an environment of relatively open capital accounts. While the early tendency to conclude that only corner solutions – hard pegs or unfettered floating – were viable has softened over time, I think most observers would say that a degree of flexibility is needed, in most cases, to build resilience to swings in capital flows. But it was not just exchange rates that were the problem. The capacity of financial institutions and corporations to manage risk, and of the supervisors to enforce better management, were far too weak. The markets required to manage such risks – to hedge foreign currency exposures, for example – were small or non-existent. More generally, capital markets were underdeveloped, especially local-currency denominated ones. Hence, not only were the risks concentrated in the banking system, but when the banks could no longer extend credit there was no other channel to make up the difference. As the countries concerned and the international community came to grasp these lessons, the nature of the debate changed. We began to hear much more discussion about “capital account” crises, and the proposed responses became much more nuanced. Hitherto seldomdisputed notions about the optimality of rapid opening up to international capital flows became more widely questioned. Capital controls – anathema in the world of the early 1990s – became respectable under certain circumstances. Much more focus was placed on developing bank supervision, and also such supporting frameworks as bankruptcy laws, corporate governance standards and so on. In international circles, there was considerable discussion about the need for some sort of international counterpart to domestic commercial bankruptcy procedures – “standstills”. The countries most affected by the crisis drew their own particular conclusions too. One was that while the international financial institutions might come to their assistance, there would be a lot of strings attached, and the assistance might prove to be neither timely nor sufficient. From this judgement, whether it was correct or not, about the international mutual insurance arrangements embodied in the IMF, two things followed. First, the countries of Asia decided to self-insure, by building larger foreign currency reserves. In the face of speculative attacks in future they would be better armed. Ironically, the IMF itself encouraged this reserve buildup initially. Graph 3 East Asian Foreign Reserves Value and ratio to GDP % z China (Ratio to GDP, LHS) z US$b China (Value, RHS) z Other East Asia* (Ratio to GDP, LHS) z Other East Asia* (Value, RHS) 1 200 z z z z * Excluding Japan Sources: CEIC, IMF Second, the countries of the region re-doubled their efforts towards building regional-support arrangements. There had been much discussion of this prior to the crisis, and some largely symbolic arrangements had even been put in place. But after the crisis, there was much more activity in this space. What then has been achieved in the area of strengthening the countries concerned and the international system since the crisis? What has been achieved in Asia since the crisis? At the risk of over-generalising, several common themes emerge at the national level. First, as one would expect, there has been an even greater emphasis first on pursuit of sound macroeconomic policies. Of some note is that in several countries monetary policy frameworks have moved towards inflation targeting. This is a natural progression when the exchange rate is no longer available as an anchor for policy. Thus far this framework has been operated with a fair degree of success. Fiscal positions in most countries have been improved, after a period post-crisis when some countries showed large deficits. Countries in the region have also done a lot of work aimed at making their financial intermediaries stronger. The frameworks for dealing with impaired assets in the immediate aftermath of the crisis have, together with the economic recovery, resulted in a gradual improvement in the shape of balance sheets of the core institutions, though more progress is needed yet in some countries. One World Bank report puts the average ratio of NPLs to total loans in the five initial crisis economies at 6 per cent in 2006 – still a high figure by industrial country standards, but down from close to 30 per cent in 1998. 10 Foreign participation in local World Bank (2007), East Asia and Pacific Update – 10 Years after the Crisis, April, p. 36. financial systems has increased in several countries, which brings both capital and expertise. 11 Table 3: Non-performing Loans Per cent of total loans Indonesia Korea Malaysia Philippines Thailand At peak* 48.6 13.6 11.5 17.3 45.0 6.1 0.9 4.8 6.0 8.1 * Year of peak in brackets Source: World Bank Emphasis has been placed on beefing up bank supervision and fostering a stronger culture of risk management in the private sector. This is an area, however, where rapid progress is very difficult, and several countries still have difficulty meeting the relevant international standards. Developing and maintaining a strong supervisory apparatus is a challenge in any country at any time, no less so in the Asian region. Countries have also pursued stronger requirements for disclosure, better accounting and auditing standards and so on. That said, progress towards improving the broader regulatory and governance arrangements that condition the “investment environment” has, in the view of at least some commentators, been mixed, at best. 12 A good deal of work has also been done, particularly of a co-operative nature between countries, aimed at fostering deeper, more resilient capital markets. The Asian Bond Funds, initiated by the regional central banks, established cross-border mutual-fund type structures allowing regional investors to hold obligations issued in local currency by regional governments and quasi-government authorities. The ASEAN+3 group has encouraged the issuance of local-currency debt by the multilateral institutions. The development of securitisation and credit guarantee markets in the Asian region has been promoted through a number of regional fora, and securitisation in east Asia has grown quite rapidly since 1999, particularly in Korea, Hong Kong and Malaysia. These sorts of initiatives typically involve trying to remove the various small impediments that individual countries have (sometimes unintentionally) put in the way of investors, and progress towards the mutual recognition of regulatory frameworks in differing countries. These have been very useful examples of practical co-operation – and of how much work is involved in giving practical effect to general ideas agreed to so easily in international meetings. More ambitious ideas for mutual support have also been pursued, of which the Chiang Mai Initiative (CMI) is probably the most concrete. CMI provides for the countries in the ASEAN+3 group a series of bilateral swap lines, with the amounts committed being increased progressively. 13 Recently, an in-principle agreement was reached to make the lines multilateral rather than bilateral, which would presumably make for more efficient activation in a crisis. Ghosh, S.R. (2006), East Asian Finance: The Road to Robust Markets, World Bank, Washington DC, p. 64. See Asian Development Bank (2007), “Ten Years After the Crisis: The Facts about Investment and Growth”, in Beyond the Crisis: Emerging Trends and Challenges, pp. 1-20. Currently, the CMI involves a network of 17 Bilateral Swap Arrangements, totalling US$83 billion. The swaps are all US-dollar based, except for swaps between Japan-China, Japan-Korea and China-Philippines, which are local-currency based. As a result of these developments, I imagine that today few countries in Asia would, if they got into trouble, consider an early approach to the international financial institutions for assistance. But while the regional initiatives are all useful, they remain to be tested under less benign conditions in the global financial system. In fact, it is open to doubt whether they would necessarily prove sufficient as a defence mechanism, were really big changes in sentiment about the region to occur in international markets the way they did in 1997-98. If most countries in the region were under pressure at the same time, there would surely be questions as to whether regional counterparties could meet all the commitments for support. In any case, few financial crises are confined to one region: even those that start with a regional focus have a habit of spilling over quite quickly, as events after the Asian crisis demonstrated. So while everyone has an interest in regional crises being effectively dealt with at the regional level, we surely still need global mechanisms for dealing with crises, and preventing them as far as possible. That prompts the obvious question: what has been done since the Asian crisis to improve the global arrangements? What has been done internationally since the crisis? A good deal of effort has gone into crisis prevention. There has been a step-up in national and regional-level surveillance by the international official bodies, and an emphasis on more timely and accurate data being made available by governments. A stronger focus on financial sector soundness is another key element, with a number of countries undergoing Financial Sector Assessment Programs, in conjunction with the IMF. These and other efforts represent serious attempts to use what was learned from the Asian and other crises to reduce susceptibility, or at least to get an early warning of regional level problems, in future. But as useful as these things are, no-one could say that they will definitely prevent future crises. Hence, crisis management arrangements have still been given attention. One of the key elements is calming behaviour in capital markets once a crisis occurs. The private sector has contributed with a code of conduct, known as the Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets, which provides a flexible framework for co-operative discussion and action between private-sector creditors and emerging market sovereign debtors. A complementary initiative was the introduction of Collective Action Clauses in emerging market bond contracts. This is intended to lessen the problem of getting collective action when a debtor needs to reschedule, by preventing minority hold-outs from derailing the rescheduling. The use of such clauses is now widespread. 14,15 A more far-reaching idea is that of stand-still provisions. This is, conceptually, the international equivalent to bankruptcy proceedings, where, once a creditor cannot repay in full, there is a temporary cessation of all payments while an orderly process works out how much creditors can collectively expect to receive, rather than a disorderly and ultimately very costly rush to the exits. This idea found concrete expression in the proposed Sovereign Debt According to the IMF, all sovereigns, except two, that have issued under New York law since May 2003 have included CACs in their bonds. In 2005, more than 95 per cent of new issues, in values terms, included CACs. See IMF (2006), Global Financial Stability Report, April, Chapter 1, p. 46. The use of CACs was encouraged by advanced countries agreeing to put such clauses in their own bond contracts so as to remove any perception of stigma, and by research, including some done at the RBA, showing that there was no discernible impact of including CACs on the cost of borrowing. See Gugiatti, M. and A. Richards (2003), “Do Collective Action Clauses Influence Bond Yields? New Evidence from Emerging Markets“, Reserve Bank of Australia Research Discussion Paper 2003-02. But it was the action of Mexico in unilaterally including CACs in their bond issues that did most to encourage others to move in this direction. Restructuring Mechanism discussed at the IMF, but did not attract sufficient support from major countries and has not gone forward. 16 There has been some evolution in the architecture of international groupings over time. The formation of the G-20 had its genesis around the time of the Asian crisis. Its membership is more representative of the global economy and financial system of the 21st century, as opposed to the mid-20th century, and it has become more prominent over recent years. In parallel, the G10 seems to be diminishing in importance. With no crises of any magnitude in the past few years, the G-20 has turned its attention to other matters, including issues on the structural side. We should hope, though, that the G-20 will retain a capacity to talk frankly about urgent issues in the highly informal but effective way it did at first, should some new crisis erupt. The Financial Stability Forum (FSF) was another creation of the more crisisprone era, and is a useful body for getting key officials together regularly to identify potential threats to global stability. But while these architectural changes are helpful, the G-20 remains a work in progress, and the FSF is a consultative group, not a decision-making one. The reality is that if there is to be collective international action in the face of a crisis, international financial institutions, with formal mandates and balance sheets, will remain very important. Focus on adapting the IMF to 21st century needs has intensified in recent years. Questions of governance have been to the fore, in particular relating to representation and voting power for emerging market countries. A small but significant step was made last September with increased quota allocated to four important emerging market countries which had been under-represented. The more laborious work of getting agreement on longer-run and more far-reaching changes is now under way and has some distance to travel. But it is critically important too that resolution of the questions about the IMF’s mandate – what we want it to do – accompanies the governance reform. It will not be sufficient for the emerging world simply to expect more say in how the international financial institutions are run, without being part of a clearer shared understanding of what the institutions are seeking to achieve. That is a topic for another speech, but suffice it to say that constructive engagement by the emerging world, and especially Asia, in finding an agreement on mandate will be a key prerequisite for genuine progress. Asia’s future in the global financial system After all this, then, how would we sum up the way things have changed since July 1997? Is Asia, or the world, less vulnerable to a crisis than it was then, or not? Were we to ask policy-makers in the countries concerned, I am pretty sure they would say they remain acutely conscious of theirs being small countries in a world of large capital flows, with the attendant possibility of being overwhelmed by those flows – in both directions. Suspicion in the region of some of the larger players in international markets remains strong, as does the desire for regional co-operation in handling the financial ebbs and flows. That said, vulnerability to a 1997-style crisis must have been reduced. The build-up in reserves means that speculative outflows could now be handled more effectively. Furthermore, the fact that most exchange rates have some more flexibility now, even if they do not float completely freely, also means that the authorities would be in a much stronger position because they can allow that price to bear some of the adjustment before they intervene. The various regional initiatives have contributed to development of capital markets and stronger mutual-support arrangements. The former still has some way to go and the latter have not been tested, but certainly progress has been made. Some observers feel this issue still needs to be addressed. See Grenville, S. (2007), “Regional and Global Responses to the Asian Crisis”, Asian Economic Policy Review, 2, pp. 54-70. But maybe the question of whether Asia could withstand 1997 better if it occurred again is not the right question. A future crisis could be of quite a different nature. It is at least as likely to be truly global as to be regional, and just as likely to originate in the developed world as in the emerging world. A generalised re-assessment of risk would no doubt test the resilience of the countries of Asia, along with everywhere else. That being the case, it is in Asia’s interest that international efforts to manage risks more effectively on a global basis be continued. It would also be important therefore for Asia to be sure that Asian regionalism does not become inward-looking. Asia has mostly benefited from engagement with the global economy, and that will continue to be so. Another question is whether some aspects of the approaches being taken to avoid 1997 recurring are themselves starting to become a problem. In particular, the build-up in reserves has gone a long way past what seems sufficient for self-insurance purposes, and has surely complicated monetary policy in some cases, not least in China. The associated capital flows are big enough, moreover, to have a significant effect on global markets and potentially to rebound onto the Asian region. The rising size of sovereign wealth funds, and what risk profile they will have, is also a question that is likely to be important to countries receiving the capital flows. For the Asian crisis countries, we should ask: is it optimal for so much saving to be funding investment in the developed world when the social return to investment at home surely ought to be higher? While investment prior to the crisis may have been unsustainably high, in some of these countries it is now arguably too low. 17 Given that many changes over the past decade have been implemented to try and improve the stability of the region, do local investors still perceive the risks to be so great that they are unwilling to invest in their home countries? If so, why? Does that point to the need for further efforts at improving governance frameworks and regulatory environments, deepening capital markets and so on? A number of recent studies have argued that investment rates in East Asia are currently too low. See IMF (2007), “Investment Recovery From Financial Crises: A View from Cross-Country Experiences”, in Thailand: Selected Issues, IMF Country Report No. 07/231, June, pp. 3-23; Asian Development Bank (2007), “Ten Years After the Crisis: The Facts about Investment and Growth”, in Beyond the Crisis: Emerging Trends and Challenges, pp. 1-20. The following paper includes a summary of other research on this topic: IMF (2006), “Asia’s Investment Decline”, in Asia and Pacific Regional Economic Outlook, World Economic and Financial Surveys, Chapter 5, May, p. 35. Graph 4 East Asia* – Saving and Investment Ratio to nominal GDP % % Saving Investment * Excluding China, Hong Kong and Japan Source: World Bank The reason to address these issues has something to do with avoiding crises in future, but it has more to do with improving Asian living standards. To see how relevant that is, moreover, we need only look at the sorts of per capita growth rates post-crisis compared with the decade leading up to the crisis. They are much lower. The growth is not as easy to get as it once appeared, which puts the focus squarely back onto policy frameworks. Conclusion The Asian crisis was an extremely costly event for the countries concerned. The crisis is now a decade in the past, but those costs continue to be felt today in a number of countries. The crisis dramatically changed thinking in Asia, and around the world, about the nature of economic and financial crises, the policies appropriate to dealing with them, and the role of the various regional and global bodies charged with fostering economic and financial stability. It is important that the passage of time, and the apparently benign environment we have recently enjoyed, do not prevent us from pressing on with the as yet uncompleted regional and global efforts to develop more resilience. Were we to slacken efforts there, we would surely come to regret it. | reserve bank of australia | 2,007 | 7 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Gold Coast, 17 August 2007. | Glenn Stevens: Recent economic and financial developments in Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Finance and Public Administration, Gold Coast, 17 August 2007. * * * Mr Chairman, members of the Committee. Since we last met in Perth, economic conditions in Australia have strengthened. At the same time, financial markets globally have recently become extremely skittish and there has been a very sharp re-assessment of risk and a sudden desire for liquidity. I will come to the financial market turbulence shortly. Before I do, however, it is worth recounting how the real economy has performed over the past six months. Given the uncertainty being felt in financial markets at present, it is important to keep a clear sense of the economic fundamentals. According to the national income accounts, growth picked up sharply in the December and March quarters. Over the year to March, real GDP is estimated to have expanded by about 3¾ per cent, despite the impact of the drought. The non farm economy was reported as having grown by about 4½ per cent, equal to its fastest pace for four years. Gauging the true extent of acceleration is not straightforward given the inevitable noise in the data over short periods, but a wide range of survey evidence and other indicators also suggest that conditions picked up in the first half of 2007. Domestic spending is rising, with robust rises featured among most of the components. The exception is residential construction, where commencements remain flat at slightly below average levels. Demand for credit also appears to have firmed, most particularly among businesses. Household finances, like corporate finances, are generally in strong shape. Demand for Australian exports is rising too. Success in transporting higher volumes of resources has been mixed, varying by location and industry and according to disruptions caused by weather, efforts at adding new capacity, and port and rail delays in some cases. But the trend is upward and tonnages are set to increase over the next several years as capacity comes on line. Agricultural exports will benefit from the improved rainfall in some parts of the country. Not surprisingly in light of the above, the demand for labour has continued to expand. The recorded rate of unemployment is at its lowest for a generation. Job vacancies are high and surveys suggest that many firms see the difficulty of finding additional labour as among the biggest, or the biggest, impediment to expanding production. As yet, though, the pace of growth in labour costs overall has remained relatively contained. In thinking about why growth has picked up somewhat more than had been expected, we should not overlook the fact that the global economy has surprised, once again, by its strength. The most recent forecasts for global growth made by the IMF were revised upward only a few weeks ago, with growth now thought likely to be over 5 per cent in 2007, close to the 2006 result. The US economy has slowed but greater strength elsewhere has, to date, more than outweighed the US softening. Australia’s terms of trade have kept rising and stand at a five decade high. This has added about 1½ per cent of GDP to the annual growth in Australia’s national income over the past couple of years, which is quite an expansionary force. Some of the resulting demand spills abroad, but there is also a stimulus to spending on non tradeable goods and services arising from the income gains being experienced. The rise in property prices in Western Australia is a case in point. It would be imprudent to assume that this trend will continue indefinitely. Nonetheless, it has already gone considerably further than most observers anticipated. When we lift our gaze beyond the conventional forecasting horizon, the big picture is that the emergence of potentially very large economies like China and India, at such a rapid pace and with such consistency, is unlike anything we have lived through before. We cannot be confident, therefore, that the cyclical experience of the past few decades is necessarily a reliable guide to how things will develop. In its policy deliberations over several months, the Board has weighed conflicting trends. When we were last before you, we were observing an apparent moderation in inflation. We were, as you know, at that time still of the view that there could be a need to tighten monetary policy further at some stage. But having made three adjustments in 2006, we believed that the improving short term trend in inflation afforded us time to watch developments. Information that came in over the ensuing period suggested stronger than expected demand in the economy. This meant that the longer term risk of higher inflation was increasing, not diminishing. Hence, the likelihood that interest rates would need to be increased at some stage was rising. Moderate price and wage outcomes continued, however, for some months, suggesting that, at least temporarily, the supply side of the economy was managing to respond to stronger demand. It was doubtful that this could continue over an extended period, but taken together, the weight of evidence suggested that the best course for monetary policy was to maintain the existing setting for the time being, but to be ready to tighten should signs of a strengthening of price pressures emerge. The June quarter CPI data, available for the August meeting, showed some pick up in inflation. Together with a stronger growth outlook, this information led us to expect a somewhat higher path for inflation over the horizon of the coming one to two years. The judgement we reached was that the risk of unnecessarily damaging growth with a modest rise in interest rates was small, whereas the cost of not responding to a deterioration in the outlook for inflation could well, in the longer term, be substantial. On straightforward macroeconomic grounds, therefore, there was a clear case to make an adjustment to monetary policy. As our statement on Wednesday of last week set out, the Board considered the recent events in international credit markets in coming to our decision. Here, Mr Chairman, it is worth taking a few moments to set out some history. For some years now, many long term observers, market participants and officials have been troubled by very narrow pricing for risk. In other words, it has been easier and cheaper than had been normal in the past for risky borrowers to access funding. Investors were prepared to take more risk in pursuit of returns in a world of low global interest rates. Somewhere or other, returns were eventually bound to disappoint someone. As it turned out, the problems emerged in the US housing sector. Lenders into the so called “sub prime” market attempted to keep the pace of business up as the US housing sector slowed during last year. But they could do this only by lowering lending standards. Before long, arrears began to rise as some borrowers struggled to meet their commitments. Once this deterioration in underlying asset returns had occurred, those with exposures inevitably began to see losses. Because this type of lending was via securitised structures sold into global capital markets, losses have been coming to light right around the world. In most cases, the losses are embarrassing rather than fatal for the institution concerned. The exceptions have been where particular funds invested mainly or solely in these types of risky assets, and especially where leverage was involved. Several hedge funds have borne large losses, including some in Australia. All of this created a climate in July and early August in which investors retreated and pricing of risk started to return to levels that could be regarded as more reasonable based on historical experience. A number of capital raisings that had sought to take advantage of the earlier very generous terms were postponed. Volatility in some financial markets increased, share prices declined somewhat and a general sense of heightened uncertainty was evident. In considering the implications of all this for our decision on monetary policy, there were two questions to ask. The first was whether there was information to suggest that financial developments were likely to make a sufficient difference, over the relevant horizon for policy, to the global economy, and therefore the Australian economy and the inflation outlook, to remove the macroeconomic case for a 25 basis point adjustment to cash rates. On balance, we judged that there was not. Downside risks to the US economy do appear to have increased over recent months, but in other parts of the world the growth outlook has, if anything, been marked higher recently. The second question was whether a rise of 25 basis points in Australian cash rates would, in itself, be financially destabilising. No credible case could be made for that idea. In fact, it would probably have been more destabilising to expectations not to have carried out a policy adjustment that most people could see was needed. Accordingly, as you know, monetary policy was tightened last week, taking the cash rate to 6.5 per cent. Subsequently, towards the end of last week there was a period of stress in some major country money markets. Because the exposures to the mortgage problems in the US are still coming to light, financial institutions are uncertain over the standing of other market participants. Objectively, it is extremely unlikely that the sub prime mortgage exposures could significantly damage the core banking system in any significant country. The exposures are spread far too widely for that to occur. But precisely because they are spread widely, and because the associated financial structures are opaque, information on who is exposed and by how much is incomplete. Hence people remain wary. At times of uncertainty, market participants naturally get more cautious and want to hang on to cash, rather than lending it in the interbank market. In such circumstances, central banks typically respond by being prepared to make additional cash available, through purchases of high quality assets from market participants, in sufficient quantities to keep the cash rate at the level required by monetary policy considerations. Several major central banks made very substantial injections in this way on Thursday and Friday last week in the face of an abrupt shift in cash market conditions. While the likelihood of a significant problem of this sort arising in the Australian money market was low, last Friday the Reserve Bank as part of its normal dealing operations purchased more assets, hence adding more cash to the system, than it otherwise would have done. The intent of this was to ensure that the cash rate remained at the target level set by the Board. The market operated normally and overnight funds were available in the market at 6.50 per cent, exactly as intended, and this has remained the case subsequently. Of course, the Reserve Bank remains ready, as always, to ensure there is adequate liquidity for markets to function normally in the period ahead. The broader credit market issue is that the losses arising from the US mortgage problems are still being assessed and absorbed. That is producing a degree of uncertainty that is affecting financial markets around the world, leading to tougher borrowing conditions for the moment, and considerable volatility. The fact that the global economy has been so strong, that core financial institutions after years of strong profits are well capitalised, and that real sector corporate profitability in most countries is very sound, will be helpful in coping with tougher credit conditions if they persist. Indeed, global growth has of late been sufficiently strong that some moderating effect would be welcome. An adjustment to investor behaviour needed to occur, and was almost certainly overdue. Such adjustments often are not entirely smooth, and are frequently triggered, as in this case, by the realisation that credit terms had been too generous for too long. Sometimes, however, the ensuing retreat can go too far, resulting in a widespread withdrawal from the provision of credit that unnecessarily crimps the pace of economic expansion. We will, therefore, have to continue to watch carefully how this unfolds over the period ahead. The Statement on Monetary Policy released a few days ago contains our most recent assessment of the outlook. It takes account of the change in interest rates as well as the recent flow of data at home and abroad. There are, of course, various assumptions on which the outlook is based, and these parameters could shift over time. The credit market developments add a further degree of uncertainty about the outlook. Subject to that uncertainty, the picture is one of growth close to trend and the economy remaining close to full employment. Under such circumstances, inflation is likely to be around 3 per cent over the coming year, and near the top of the target zone in the following year. As far as risks to that forecast are concerned, the possibility that the world economy might end up being weaker than assumed, due to a persistence of credit difficulties, is one that everyone will have in mind at present. At the same time, there is also the possibility that ongoing strength of demand in a fully employed economy might leave us with inflation pressure that is harder to manage than expected. These possibilities, and other things that could come along unexpectedly, will be issues that the Board will have to assess each month. For now, my colleagues and I are here to respond to your questions. | reserve bank of australia | 2,007 | 8 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Retail Financial Services Forum, Sydney, 28 August 2007. | Ric Battellino: Central bank market operations Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Retail Financial Services Forum, Sydney, 28 August 2007. * * * Central bank market operations around the world have been in the news in recent weeks, so I thought it might be useful to take this opportunity to run through those developments. While this topic may seem somewhat distant from retail financial services, there is in fact a strong relevance to today’s conference, because much of what central banks do in financial markets eventually flows through the whole financial system, including retail services. Background The Reserve Bank has been using market operations to implement monetary policy since the 1980s. 1 Essentially, this involves dealing in markets to influence the interest rate on overnight funds in the money market – also known as the cash rate. Central banks are able to closely control the overnight interest rate because they have unlimited ability to inject funds into, or withdraw funds from, the money market. This model for implementing monetary policy is now fairly standard across the developed world. The Reserve Bank Board sets the stance of monetary policy in terms of a target for the cash rate because this rate ultimately influences the broad spectrum of interest rates in the money and capital markets and the interest rates that intermediaries charge on loans, including those in the retail market. In effect, all interest rates in the financial system are determined in one way or another relative to the cash rate. By targeting the cash rate, central banks are therefore able to exert broad influence over the overall cost of credit in the economy and, in turn, economic activity and inflation. After the Reserve Bank Board has decided the target for the cash rate each month, the Domestic Markets Department of the Bank is responsible for keeping the actual cash rate in the market as close as possible to the target over the ensuing inter-meeting period. A major determinant of the cash rate is the aggregate level of balances held by commercial banks in their exchange settlement accounts at the Reserve Bank. These are the funds that banks rely on to meet their daily settlement obligations to each other and to the Reserve Bank. If banks do not have enough of these funds, they risk failing in their payments, so a shortage of funds causes banks to bid more aggressively in the money market to try to restore their holdings. On the other hand, because these funds earn an interest rate that is below the rate that could be earned in the market (25 points below the cash rate), banks do not want to hold more than necessary. As such, a build-up in exchange settlement balances makes banks more eager to lend funds, and this pushes market interest rates down. The job of Domestic Markets Department is therefore to ensure that the aggregate supply of exchange settlement balances is sufficient for the cash market to clear each day at the target cash rate. As can be seen from Graph 1, the level of exchange settlement balances necessary to achieve this is typically around $700-800 million. However, for various reasons, there are times when banks need more, or less, cash. In these cases, the Reserve Bank responds by adjusting the amount it provides, in order to equilibrate demand and supply. It does this by buying securities to increase the supply of exchange settlement balances and selling securities to reduce the supply. These transactions may be either outright purchases or sales, or repurchase agreements which involve the sale of a security with an undertaking For details of the Reserve Bank’s market operations see www.rba.gov.au/MarketOperations/. to repurchase it at a future agreed date and at an agreed price. In recent years, the Reserve Bank’s operations have been predominantly by way of repurchase agreements. Graph 1 It is worth noting that the range of securities that the Bank is prepared to deal in has been widened over the years. Ten years ago, the Bank only dealt in Commonwealth Government securities, but in response to the diminished supply of these securities and in recognition of growing markets in other securities, the Bank over the years has added semi-government securities, bonds issued by international organisations and Australian bank bills to the list of securities in which it is prepared to deal. International practice by central banks in this regard is quite varied: some central banks take a narrower range of securities than the Reserve Bank; others take a broader range. There has, however, been a general tendency over the years for central banks to widen the range of securities in which they are prepared to deal. Over time, the Reserve Bank has also widened the range of counterparties with which it is prepared to deal. Currently, it deals with any holder of securities that is able to settle its transactions electronically through the dedicated RITS settlement system. In this regard, the Reserve Bank is at the more liberal end of the international spectrum. Many other central banks limit their dealing to banks or selected groups of primary dealers. The daily routine in market operations is fairly straightforward. The Bank’s dealing intentions are announced at 9.30 am each morning, dealing is completed over the subsequent half hour, and details of dealings are published at around 10.15 am. Second rounds of dealing may be undertaken later in the day if needed, but such circumstances have been rare. As well as these regular operations, the Bank has put in place a standing facility to allow market participants to access cash, at their discretion, in unforeseen circumstances. This facility allows banks and other holders of exchange settlement accounts to borrow overnight on a secured basis, though at a penalty of 25 basis points over the cash rate target. Banks typically use this facility only if they experience some operational difficulty or miscalculate their daily funds flows, which is rare. With banks able to borrow from the Reserve Bank at their discretion at 25 points above the cash rate, and the Reserve Bank paying interest on exchange settlement balances at 25 points under the cash rate, the rate at which cash can trade in the market is confined to a 50 point corridor around the target. In practice, the degree of fluctuation is much less than this. As shown in Graph 2, so far this year there have only been three days when the cash rate has deviated from the target, on each occasion by only one or two basis points. Graph 2 Even though each central bank around the world has its own idiosyncratic arrangements in relation to market operations, the essence of the arrangements is the same. It involves the central bank buying and selling securities in the market to supply enough funds to banks to keep the actual short-term interest rate as close as possible to the target. These operations essentially work through the banking system and rely on banks passing on funds not only to each other but also to market participants more generally. Most of the time this works seamlessly, but there are times, such as the present, when it doesn’t. Let me move therefore to these recent events. What changed in the past couple of weeks? The problems experienced in money markets in recent weeks had their origins in the credit and market-related losses incurred by investors who had bought securities collaterised by US sub-prime mortgages. Various investment funds worldwide, including in Australia, have been reporting losses on these securities for some months now. Most of these have been hedge funds, and while the losses incurred in some cases have been severe, these problems for quite some time did not seem to have any significant ramifications more generally through the financial system. That changed on 9 August, after a large European bank announced that it was freezing withdrawals from three of its investment funds due to losses incurred by those funds and the difficulty in valuing their security holdings. This seemed to trigger a shift to a much more risk-averse approach by money market participants in dealing with each other. What seemed to be worrying people was that, while the US Fed had calculated the losses in the sub-prime market as being potentially as high as US$100 billion, only a few billion of losses had been announced by investment funds. This naturally led market participants to question who was sitting on the prospective losses, and what this meant for the creditworthiness of market counterparties. Investors became much more risk-averse and banks severely curtailed their lending to each other, causing gridlock in the money market. The process spread quickly because once banks started to worry that others may stop lending to them, they in turn stopped lending to others. While there has been a widespread tightening in the availability of credit in all markets, those most affected have been the vehicles used by banks to invest in, or warehouse, mortgages. These vehicles, known variously as conduits, credit arbitrage funds or warehouses, had been set up by many banks around the world to finance mortgages off their balance sheets. The funding came from the issue of short-term securities backed by mortgages – so-called asset-backed commercial paper. Until recently, these vehicles had found it very easy and cheap to raise money. Despite the fact that hardly a day went by without some respected commentator around the globe warning that credit risk was being under-priced, investors remained enthusiastic and credit spreads if anything continued to decline. For example, the yield on US 90-day asset-backed commercial paper for much of the past year had been similar to the overnight rate on fed funds. The amount of such paper issued almost doubled over the past couple of years, to US$1 200 billion. The market for asset-backed commercial paper extended well beyond the US, as banks in most countries had set up these conduit vehicles. Many of the securities issued by these vehicles were in international markets with the funds swapped back into the relevant domestic currency. Cross-border flows were large, creating strong links between national markets. Cross-border links were also generated by the credit lines that these vehicles had established with banks in the event that the commercial paper market failed. These lines were spread across banks in a range of countries, so problems experienced by a conduit vehicle in one country affected banks in many countries. When investor attitudes to credit risk changed abruptly in early August, these links quickly spread the problems worldwide. Asset-backed commercial paper markets came to a virtual standstill, forcing the bulk of these conduit vehicles to turn to the lines of credit they had negotiated with banks. This in turn meant that banks in a wide range of countries found themselves under increased funding pressure in order to meet commitments on credit lines. The effects on markets across countries were very similar: Overnight money market rates rose above the level targeted by central banks. For example, while the US Fed is currently targeting 5.25 per cent, the actual rate in the market rose to 6 per cent on 9 August (Graph 3). Graph 3 In LIBOR and swap markets, which are further away from the direct influence of central banks because they are more internationally focussed and have a greater diversity of participants, margins widened relative to cash rates (Graph 4). Graph 4 Yields on securities issued by banks, such as short-term bankers acceptances, rose noticeably. In the US they were up by 0.25 percentage points for terms of 90 days (Graph 5). Graph 5 Yields on asset-backed commercial paper, which as noted had been at the same level as the fed funds rate for much of the past year, rose even more sharply, by about 60 basis points (Graph 6). More importantly, activity in this market dried up sharply, the effect being that for a time funding was not available at any price. Graph 6 Yields on US treasury bills fell by almost 2 percentage points, to 3.25 per cent, as investors scrambled into secure and liquid investments (Graph 7). Graph 7 There were also spillovers to other markets, including sharp falls in share prices, particularly for financial stocks, and some significant re-adjustment of exchange rates (Graph 8). Graph 8 These were all symptoms of rising risk aversion. Central banks responded to this by sharply increasing the amount of funds supplied to their banks in the money market. Among the developed economies, the European Central Bank, the US Fed, the Bank of Japan, the Bank of Canada, the Swiss National Bank, the Norges Bank, the Reserve Bank of New Zealand, as well as ourselves here in Australia, all did so to varying degrees. Some also took other measures. The Fed, for example, cut the penalty rate on its discount window from 100 points to 50 points in order to lessen the cost of emergency funding to banks. Some central banks also widened the range of securities in which they were prepared to deal. None of these measures was intended as a change in monetary policy settings and no central bank has reduced its interest rate target. Neither should these measures be seen as an attempt to “bail out” banks or markets. Rather, the measures have been technical operations aimed at breaking up the log jams in money markets and encouraging funds to flow again, in order to prevent monetary conditions becoming tighter than the settings that had been determined by the central bank monetary policy committees and boards in the various countries. The operations have restored some degree of calm to markets but conditions have not yet returned to normal. Notably, yields on asset-backed commercial paper as yet have not fallen, indicating a continuing high degree of nervousness among investors. Yields on US treasury bills have reversed some of their earlier fall, but still remain unusually low, again indicating a continuing strong risk aversion among investors. On the other hand, share markets in many countries have recovered strongly and some of the earlier exchange rate moves have also been largely reversed. The Australian situation Despite the fact that Australian banks are in very sound condition and have been experiencing minimal credit losses, they were nonetheless affected by the spread of the global money market turmoil. On the morning of 10 August, banks started telling us that they were noticing a reduced flow of funds through the market. The cost of raising funds in global markets through swaps had risen noticeably, putting more pressure on domestic funding sources. Yields on banks bills had jumped sharply overnight, and LIBOR rates by even more (Graph 9). The Reserve Bank decided to supply more than the usual $700-800 million of exchange settlement funds, so that the overnight interest rate would not rise above the target set by the Board in early August. Those operations were successful in maintaining the cash rate at the 6.5 per cent target, though other short-term market interest rates remained unusually elevated. Since then, the Bank has continued to supply whatever amounts of exchange settlement balances were necessary to keep the cash rate at the target. In the process, balances rose to a peak of $5.5 billion in the middle of last week, the highest level for some years, though some of this has been reversed recently. The Bank also skewed its market operations more towards bank bills, rather than government securities, to enhance confidence in the liquidity of highly-rated instruments in the bill market. Graph 9 The proportion of the Bank’s operations undertaken in bank bills has risen to around 80 per cent, well above the usual 30 per cent share. This has lifted the Bank’s domestic bill repo book from a little over $18 billion at the start of August to around $40 billion today (Graph 10). The term of repos has also been lengthened appreciably, from the usual average of around 20 days to over 100 days, to provide greater certainty of funding (Graph 11). Graph 10 Graph 11 These operations have held the cash rate at the target, and helped to stabilise market conditions more generally. Nonetheless, some pressures remain. Yields in the bill market remain somewhat higher than usual relative to the cash rate, and yields on asset-backed commercial paper even more so. The volume of securities issued has fallen, and the maturities have shortened. Banks have switched some of the funding of their conduits from the asset-backed commercial paper to on-balance-sheet, where it is supported by the banks’ capital. This seems appropriate. In recent days, there have been some encouraging signs of improvement in markets, both here in Australia and overseas. The Bank will continue to monitor the situation carefully. If market developments warrant, the Bank has scope to further expand the provision of liquidity. These matters are being kept under review. | reserve bank of australia | 2,007 | 8 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Asia Society AustralAsia Centre CEO Asia Update luncheon, Sydney, 18 September 2007. | Glenn Stevens: Asia, Australia and financial markets1 Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Asia Society AustralAsia Centre CEO Asia Update luncheon, Sydney, 18 September 2007. * * * As you would all be aware, 2007 is the 10th anniversary of the Asian financial crisis. The crisis is usually dated as having begun with the float of the Thai baht in July 1997, though the problems had been building for some time before that. The events of 1997 and 1998 profoundly affected the region’s economic growth. In a speech earlier this year, I reviewed the key events of the crisis. 2 Rather than go over that ground again today in detail, I will address the question of how Asia is coping with the recent distinct change in global financial market conditions, before talking about how the same events are affecting Australia. I want, then, to turn to issues for the future and, in particular, what interests the Asia-Pacific region has in the ongoing efforts to renovate the post-war official architecture of the international financial system. Recent financial events For a number of years now, many commentators have expressed concerns about the under pricing of risk in financial markets, with investors increasingly willing to purchase risky assets at high prices and often with considerable leverage. Easy credit conditions accommodated and encouraged these trends. Over the past couple of months, we have witnessed something of a reversal. The initial trigger was the deterioration in the US sub-prime mortgage sector, itself a result of declining credit standards and a slowing US housing market. Since the exposures to these risks had been spread via securitisation into global financial markets, losses are being borne in most parts of the world, including in Australia and some countries in Asia. Those losses have been coming to light only slowly, however, in part because the complex and opaque nature of some of the financial instruments in use makes valuation difficult, or even impossible under adverse conditions. In some cases, there simply is no market for, and hence no way of providing an objective valuation of, the claims in question. In the ensuing climate of uncertainty, investors rapidly have become quite risk averse, and some parts of the global capital market have suffered severe dislocation. In turn, institutions that rely heavily on wholesale capital markets, either for balance sheet funding or to securitise assets they have originated, have experienced difficulties. So-called conduits, credit arbitrage funds and various other vehicles often issued short-term commercial paper to fund their assets. This strategy, which was in some cases designed to avoid capital requirements for loans held on banks’ balance sheets, can carry significant maturity mismatch and hence funding risk. When investor attitudes changed abruptly in early August, asset-backed commercial paper markets around the world virtually came to a standstill, forcing many of these vehicles to tap lines of credit they had with banks. This, of course, transferred the funding pressures to the banks. Since there is a great deal of uncertainty about the likely demand on their own liquidity, banks have been conserving liquidity and have been reluctant to commit to lending to others for anything beyond a very I thank Vanessa Rayner for assistance in preparing this address. See “The Asian Crisis: A Retrospective”, address to The Anika Foundation, 18 July 2007. Available at http://www.rba.gov.au/Speeches/2007/index.html. short horizon. Institutional investors, which are now in a much more powerful position than a few months ago, have behaved cautiously and are demanding higher yields to accept bank paper. Hence, short-term funding rates have moved higher in a number of countries. In some cases, even overnight rates spiked sharply higher. Changes in attitude to risk also spilled over to other markets. The difficulties have spread beyond sub-prime mortgages per se to include the broader range of instruments euphemistically labelled “structured products”. As investors have looked for more secure and liquid assets, yields on government securities have declined, share prices have fallen and there has been some significant readjustment of exchange rates. Volatility across a range of markets has increased significantly. So risk is being re-priced, and strategies that looked like easy ways of making money in good times are being tested. The episode is also a reminder of the key role still played by the core banking system, despite the growth of capital markets. Banks were the first line of liquidity support when capital markets stumbled. For the time being at least, more of the flow of new credit needs to be done on, and to remain on, the balance sheets of the core intermediaries than has typically been the case over recent years. It is helpful, then, that in most countries, those core institutions are profitable and well capitalised, since there may be quite a considerable process of re-intermediation to be undertaken over the months ahead. Effects of recent developments on Asia There are several potential channels through which these events could have an impact on east Asia. Asian investors could be exposed to the underlying problem assets; Asian institutions and markets could be affected by the backwash of liquidity and funding issues in the major markets; and Asian economies could be affected by broader macroeconomic effects. Let’s consider a few of these channels. At this point, disclosed exposures of Asian financial institutions to the US sub-prime mortgage market per se have been limited and look small relative to the total assets of the institutions concerned. Actually, to digress for a moment, for most holders of such exposures, losses should be sufficiently small as not to fatally undermine the solvency of the holder, unless the holder is leveraged. The biggest problem thus far has not been that exposures are large, but that they are not transparent. The sooner they are all on the table, the sooner the uncertainty will be lessened and the sooner market participants can discriminate sensibly among their counterparts. This is not easy to achieve given the pricing issues, but at the moment, there is widespread suspicion in the absence of clear information. It would be very damaging for that lack of information to lead to a lengthy period of severely reduced credit flow to perfectly good borrowers simply because investors cannot tell who is sound and who is not. More information is needed. Against a backdrop of rising global risk aversion and increased demand for liquidity, investors sold off emerging Asian equity holdings in late July, resulting in noticeable falls in share prices. Asian currencies fell. These movements were not especially large, however, compared with numerous others seen over the past couple of decades. Graph 1 Graph 2 Asian sovereign debt spreads to US Treasuries have risen over recent weeks, though by less than the spreads on low-rated American corporate debt. Indeed, the absolute level of sovereign bond yields in Asia has changed little. Graph 3 The sharp increases in short-term money market rates in developed countries do not seem, as yet, to have been a widespread feature of emerging Asian markets. There are a couple of reasons for this. Mortgage lending via securitisation plays a relatively small role in most Asian housing finance markets, which means that the region’s banks have not had to fund warehousing of loans. 3 This, along with the fact that most banks in east Asia tend to rely less on offshore or wholesale sources of funding than many of their developed country counterparts, means that it is unlikely these banks have been under much additional funding pressure as a result of tighter global credit conditions. In fact, foreign bank claims on the 1997 crisis countries in total, as a ratio to GDP, have declined substantially over the past decade. See Chan, E., M. Davies and J. Gyntelberg (2006), “The role of government-supported housing finance agencies in Asia”, BIS Quarterly Review, December. Available at http://www.bis.org/publ/qtrpdf/r_qt0612h.htm. Graph 4 The rapid growth that we have witnessed in east Asian equity markets may pose a risk. Despite the Asian region being a net creditor, net private capital inflows have been positive over the past few years, partly reflecting strong equity inflows. If conditions in global financial markets deteriorate further and risk aversion becomes more entrenched, there is always a possibility that equity capital could flow out of the region reasonably quickly. But Asian equity market valuations are generally not that high, with solid corporate earnings keeping P/E ratios down despite the sharp rise in equity prices recorded in recent years. More generally, in my judgement, structural changes and reforms to Asia’s banking and corporate sectors over the past decade leave the region in better shape than it was a decade ago to cope with any potential problems which may occur. 4 Bank balance sheets are typically stronger, a result of improvements to the quality of supervisory oversight and risk management practices, and reduced fragmentation and government ownership in the banking sector. A range of indicators also point to a healthier corporate sector in Asia. 5 4 There is also generally more flexibility in exchange rates today. That, combined with the large build-up in foreign exchange reserves, means that capital outflows, were they to occur, could now be handled more effectively than in the past. Of course, the region could still be affected by international events through the trade channel. The ratio of exports to GDP has increased for all Asian countries over the past decade. While it is true that intra-regional trade has expanded a great deal, it remains the case that a considerable part of this activity is ultimately aimed at delivering goods to outside the region. So a major slowdown in the US economy would still be important for east Asia, the more so if the slowdown also extended to Europe. China is growing strongly, which will help the region to expand even in the face of weaker conditions elsewhere. But, the Chinese authorities are trying to slow their own economy to avoid overheating. So, Asian nations will need to assess the overall economic fall-out from the current episode in formulating their own policies. For a discussion of banking systems in east Asia since the crisis, see Turner, P. (2007), “Are Banking Systems in East Asia Stronger?”, Asian Economic Policy Review, 2, pp. 75-95. See Pomerleano, M. (2007), “Corporate Financial Restructuring in Asia: Implications for Financial Stability”, BIS Quarterly Review, September. Available at http://www.bis.org/publ/qtrpdf/r_qt0709i.pdf. In summary, the impact of the recent tightening in global credit conditions on Asian financial markets has, so far, been reasonably well contained. In comparison with the extreme volatility experienced in financial markets during the Asian crisis, recent market movements are minor. This is not surprising, really, given that the nature of the shock we are experiencing today is very different from that of a decade ago. In 1997, the epicentre was in Asia, with inability to distinguish between countries resulting in regional contagion. In contrast, the shock we are experiencing today originated in the developed world, with events in the US housing market the catalyst. The relatively lesser degree of international integration of Asian capital markets with the global system has, in this instance, probably been a blessing. It would appear from this analysis that the main risk to most of the east Asian economies lies not so much in the area of direct financial contagion, as in the ordinary macroeconomic impacts of, potentially, a slower US and world economy. Effects of recent events on Australia Australian financial markets are part of the global financial system, and have become progressively more integrated over time. This has had many benefits, not least of which has been improved access to global capital markets for Australian investors and borrowers. By the same token, when there are major events in global markets, Australian markets can expect to be affected. Recent weeks have offered a clear demonstration of that fact. As I noted earlier, international commercial paper markets have had a very difficult time over the past month. For some weeks, outstanding paper was not able to be rolled over, and it was almost impossible for many entities to issue new paper. The same was true for residential mortgage-backed securities. Some Australian entities have been significantly affected by these disruptions. The underlying asset quality in Australia is clearly sound. Loans that could be called “subprime” in Australia are about 1 per cent of the stock of total mortgages, compared with around 15 per cent in the US, and arrears rates on these loans are considerably less than those on US sub-prime loans. The securities backing these Australian loans continue to perform. For the housing loan portfolio as a whole, arrears rates remain exceptionally low by global standards; and for securitised loans in particular, arrears rates have been steady, at about 0.4 per cent, for about the past year and a half. But at times like this, investors are often unable, or unwilling, to discriminate between different underlying credit risks. In such a climate, issuers have understandably been cautious about offering new paper because of the likely higher cost involved. In other words, uncertainty on both sides led to a drying up of the flow of funds in capital markets for several weeks. In recent days, there have been some encouraging signs of new credit beginning to flow again. But conditions are still difficult and this may remain the case for a while yet. In the meantime, the same sorts of pressures on term funding costs for financial intermediaries observed elsewhere have been seen in Australia. International interbank rates for three month A$ loans have recently been about 50-60 basis points above the overnight index swap (OIS) rate (a measure of the expected cash rate). The normal margin is around 10 basis points. Bank bill rates in Australia have been as much as 40-50 basis points above OIS, compared with 5-10 basis points normally. These gaps are smaller than seen in other comparable countries but are nonetheless significant. Graph 5 It is important to note that this is not due to a shortage of overnight liquidity. The system is amply supplied and settlement balances are, in fact, much higher than normal. The RBA has supplied as much cash as the market requires for the cash rate to remain at the level set by the Board, and that rate has indeed remained within a couple of basis points of the target throughout. Other rates are determined, as they always have been, by market conditions based on participants’ expectations about how the cash rate might move as well as term, liquidity and credit premia. Sometimes, as now, those premia have been known to move. It should go without saying that loan rates are decided by the intermediaries making the loans on the basis of their costs, risk assessments and competitive considerations. The RBA does not set these rates, though we can and do take account of how the margin between these rates and the cash rate alters. As markets work to re-price risk and individual participants grapple with uncertainty about their own possible future liquidity needs, lending and borrowing have been kept very short term. The RBA has acted to assist market functioning by extending the pool of acceptable securities for repurchase agreements. The intention of this is to give market players some additional confidence that quality assets can be turned into cash if needed, so they can get on with the job of re-pricing risk. From our point of view, this means accepting a little more private credit risk in our operations, but we have been moving in that direction anyway for years, if for no other reason than that there is no longer a sufficiently large stock of government securities on issue in which we and market participants could transact in volume. Provided the transactions are conducted on proper commercial terms with appropriate margins, we judge these credit risks to be manageable. Helping financial markets to function as they undergo a re-pricing is, of course, one role of a central bank. But it is also important that we do not lose sight of our other role, of making monetary policy in pursuit of sustainable growth with price stability. From that perspective, we observe that funding costs for intermediaries have risen beyond the adjustments associated with the rise in the cash rate on 8 August. Some borrowers are being asked to recognise this higher cost in the rates they pay for their loans, a trend that will continue if the higher funding costs persist. Hence it appears, at this stage at least, that we may well observe a further tightening of financial conditions in the Australian economy in the months ahead. In assessing that prospect, the Bank will need to take note of two forces. The first is that, going into this episode, the economy was travelling very strongly, with the outlook for growth and inflation being revised higher over recent months. The data since the August decision to lift the cash rate indicate an economy at least as strong as the Board’s assessment at that time, with few signs of that momentum slowing. The second factor is that the outlook for the US economy has been weakening and will presumably be affected to some extent by the credit market events themselves. It is conceivable that some European economies could be affected as well, given the credit difficulties in those markets. To this extent, global growth, which has continually surprised by its strength in recent years, could, other things equal, turn out to be a bit weaker than expected a few months ago. Given the macroeconomic situation of the Australian economy thus far, some additional restraint would perhaps not be unwelcome. But just how much such restraint will occur as a result of a market tightening in credit conditions is not yet clear. Assessments of how much is warranted could be affected by changes in the international environment as well as by developments in the domestic economy. These are matters the Board will need to grapple with over the period ahead. Asia-Pacific in the international financial system I turn now away from recent events, as absorbing as they are, to offer a few observations about the Asia-Pacific region in the international financial system over the longer run. It is commonly observed that the “centre of gravity” of the global economy is shifting east, away from the Atlantic and towards Asia – which, for this purpose, should be defined to include India. There is naturally a discussion about how best to recognise this greater importance of Asia in the “architecture” of the international system, including in the official institutions. Some initial progress was made in the small increases in quota allocations in the IMF to four emerging countries, two of which were in Asia, late last year. The much harder task of finding agreement for more far-reaching changes over a longer timeframe is now under way. That is very important work. But the point I would like to offer here is the following. In parallel with the efforts to reform governance of the international institutions, there will need to be efforts to find agreement on mandate questions – that is, about what it is we want the IMF and other bodies actually to do, and not do. It will not suffice for Asia (or other regions in the emerging world) to expect more say in how the institutions are governed without being part of a clear consensus as to how they will use that increased influence. What is their vision of the IMF’s role? What are the limits to that role? Those who will ultimately have to cede some of their current influence to accommodate the developing countries will surely be reluctant to do so unless there is clearer mutual understanding on those sorts of questions. Asia must be prepared to contribute to this discussion. This requires meaningful engagement on the key issues such as: • how can different national policies, including exchange rate regimes, be made to coexist within the international system? • what are the respective responsibilities of the various nations to foster that compatibility? • what is the proper role for the IMF and other supra-national bodies, not just as occasional lenders to individual nations, but as custodians of the international system all the time? The recent “review” of the “1977 Exchange Rate Decision” by the IMF is a start on this discussion. It revises an agreed set of words from 30 years ago to form a more up-to-date basis for guidance to IMF members about exchange rate policies, and provides a framework for surveillance by the IMF membership of those policies. This is a good start, but only a start. The key will be the way the surveillance is actually implemented. That is in the hands not just of the IMF’s staff and management but also its membership. The membership from this region will need to be ready to play its part. By this I mean that the countries of Asia will need to be ready to defend their policies robustly, but also to work with others in understanding and mitigating unintended consequences of their policy choices. Asian countries should, of course, expect the same from other regions. It is worth adding that, in other fora, Asian countries have a potentially strong voice if they can coalesce. In the G-20, for example, China, India, Indonesia, Japan and Korea are all at the table, as is Australia. If that group of countries could speak in a united way on issues of key mutual interest, it would be a powerful force in a globally significant group. It is not easy to find a common position, of course, and it will not be possible on some issues. We need only to look to Europe – a continent that has been working at this for a long time – to see how national differences frequently limit collective regional influence. But to the extent that Asian countries can agree on some things, they have the potential to be quite influential. Conclusion Recent events are putting financial systems to the test around the world. For years people have worried about the so-called “global imbalances” leading to trouble because Asian investors might refuse to buy dollars. Others have feared some sort of repeat of the 1997style “sudden stop” crisis in the emerging world. But, in fact, it has been a domestically generated credit event in the world’s most sophisticated economy, the United States, that has triggered the recent reappraisal of risk. The resulting financial strains have been most acute in the developed, rather than the developing world. This episode may have some time to run. But the sooner the exposures to problem assets are accounted for and disclosed, the sooner markets can get back to pricing risk prudently and providing credit on sensible commercial terms. At present, without enough information, they are operating on an impossibly short timeframe, out of fear of what tomorrow might bring. Asian countries appear, to date, to be weathering the storm fairly well, as is Australia in my view. But the episode reminds us all of the importance of working to improve the resilience of our own domestic financial systems and policy frameworks, and of the task, as yet uncompleted, of building better international arrangements for the future. | reserve bank of australia | 2,007 | 9 |
Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, at the Launch of the 2007 Australian Financial Markets Report and the Invest Australia Gold Book, Sydney, 19 September 2007. | Ric Battellino: The strength of the Australian economy and financial markets Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, at the Launch of the 2007 Australian Financial Markets Report and the Invest Australia Gold Book, Sydney, 19 September 2007. * * * It’s a pleasure to take part in the launch of these two reports that highlight the strength of the Australian economy and financial markets. I would like to congratulate Invest Australia, the ASX and AFMA for putting together such comprehensive and informative documents. They are of immense benefit not only to market participants and foreign firms looking to enter the Australian market, but also to regulators, academics and students. I would also like to congratulate the three organisations more generally for the excellent job they do in supporting, promoting and helping to regulate Australian financial markets. This is important work because finance makes such a vital contribution to the Australian economy, not only directly, but also through its role in supporting other sectors of the economy. As noted in the Invest Australia report, Australia has had an extended period of strong economic growth, which is about to head into its seventeenth year. Even if we take just the past decade, real GDP has grown by a cumulative 40 per cent and nominal GDP has grown by 90 per cent. Financial markets have exhibited even faster growth over this period. The value of companies listed on the ASX has grown by 275 per cent, and the value of debt securities on issue in Australia has increased by 170 per cent. The growth of turnover in financial markets has been even more dramatic, increasing by 290 per cent over the decade. So while the nominal economy has almost doubled in size over the past ten years, turnover in financial markets has almost quadrupled. The remarkable thing is that the pace of growth shows no sign of slowing. The members of the Campbell Inquiry, who helped set Australia on the path of financial deregulation and market development, would I think be very pleased at the way the financial system has evolved over the ensuing 25 years or so. The previous speakers have outlined the highlights of the reports being launched today, so I won’t repeat them. Rather, what I would like to do is take a step back from the impressive figures contained in those reports, and consider two questions: • why do financial markets and market turnover consistently grow faster than the economy as whole? and • what does all this increase in financial activity mean for the real economy? Turnover and GDP Let me start with the first question. Financial markets play an important role in mobilising savings and allocating them to the most productive investment opportunities. There are therefore strong links from financial markets to the economy. The Australian economy would not have been able to record the strong growth that it has if there had not been such a strong expansion in financial markets. Of course, the links between markets and the economy also run strongly in the other direction: without strong economic growth, we would not have seen financial markets develop as they have. Even acknowledging these strong two-way links, however, we are still left with the question of why financial activity consistently rises faster than economic activity. Part of the answer is that the rapid growth in financial activity is due to rising private sector wealth, as this also has been rising faster than GDP. Over the past decade, for example, household financial wealth has risen by about 170 per cent, compared with the 90 per cent increase in nominal GDP noted earlier. A lot of this increase in wealth has found its way into the superannuation industry, where it is professionally managed across a wide range of markets, and this no doubt has contributed to financial market activity. But even this rapid growth in wealth still falls short of growth in financial activity. So I don’t think this is the complete answer. The other part of the answer, I think, is innovation. Innovation has been a key feature of financial markets throughout the past 25 years. This has increased the range of financial products available to savers and investors, providing them with more opportunities to adjust their assets and liabilities to fit in with their risk/return preferences. Often this has been done by breaking down financial products into their component parts. A good example is the way in which derivative products have allowed the various risks that are inherent in financial products to be separated, so that investors need only take on those risks with which they are comfortable. One only has to look at how the variety of financial products has expanded over the years, and the broad range of markets that are now listed in the AFMA report, to get a feel for how innovative and dynamic the finance industry has been. This innovation has encouraged market turnover in several ways: • First, there is the new product effect. Like all new products, new financial products typically experience very rapid growth in their early years, as users discover their advantages. • Second, innovation has provided savers and investors with more variety, giving them greater scope to adjust their portfolios. • And lastly, and perhaps more importantly, innovation has reduced costs, so the barriers to saving and investment, and to changing portfolio structures, have diminished. What does the increase in financial activity mean? Let me now move to the second question. Financial market activity is, of course, not an end in itself – at least for those people not employed in the finance sector – so the important question most people want to know is what this increase in financial activity means for the real economy. Here, I think, the answer is a very positive one. Vibrant, competitive and innovative financial markets work to increase the availability, and reduce the cost, of finance. There are some obvious examples of how this affects our day-to-day lives. Take the housing market. The development of wholesale capital markets provided funding for non-bank lenders and allowed them to compete with deposit-taking institutions in housing lending. This led to a substantial reduction in interest margins on housing lending, from about 400 basis points 15 years ago to a little over 100 basis points today. This has been a very material benefit to Australian households. The benefits of financial market development have not been restricted to households. Interest margins and the cost of borrowing have also come down for businesses, as financial intermediaries have competed with capital markets in meeting businesses’ funding needs. Fifteen years ago, the average interest margin on business loans was 570 basis points; today it is only 135 points. In short, the trading and innovation that we see in financial markets eventually flows through to reduced costs for the users of financial services. This has meant that the amount spent by households and businesses on financial services has grown much less than financial activity. For example, even though financial activity has risen by a factor of several times GDP over the past decade, the finance and insurance sector’s share of national income has risen only slightly, from around 5½ per cent to around 7 per cent. Financial innovation has also allowed households and businesses to reduce risks. Firms have been better able to structure their financing to suit the characteristics of their businesses and to manage the risks associated with their revenue flows. Foreign exchange and commodity derivatives are good examples of innovations that have helped many Australian companies in this regard. The overall effect of all this has been to make the economy more resilient and stable. The ability of the Australian economy to come through the Asian financial crisis largely unscathed owed importantly to the fact that Australian firms and financial institutions had been able to hedge a lot of the risks that caused so much damage elsewhere in Asia. The diversity and depth of Australian markets, by ensuring that avenues of financing are always available, also add to the resilience of the economy. I would also give some credit to the financial sector for contributing to the reduction in inflation volatility we have seen over the past 15 years. Part of this can be traced to the reduced pass-through to inflation of changes in the exchange rate, which, in turn, has been partly attributable to the increased use of exchange rate hedging by firms. Conclusion So let me end by saying that it is clear that the growth of financial markets and the growth of the economy are closely intertwined. Financial markets need a strong economy to thrive, and the economy needs strong, vibrant and well-regulated markets if it is to continue to expand. I think that it is fair to conclude that Australia to date has been well served by its financial markets, and I would encourage you to continue to work to maintain these high standards. | reserve bank of australia | 2,007 | 9 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Finsia-Melbourne Centre for Financial Studies, 12th Banking and Finance Conference, Melbourne, 25 September 2007. | Ric Battellino: Some observations on financial trends Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Finsia-Melbourne Centre for Financial Studies, 12th Banking and Finance Conference, Melbourne, 25 September 2007. * * * The topic I would like to talk about today is credit provided by intermediaries, or what is broadly its mirror image, the debt of the household and business sectors. In many countries – including most of the English-speaking ones – credit has been rising strongly relative to GDP for many years now. This has been an ongoing topic of discussion among the world’s central banks and financial commentators, as people try to understand whether this trend is sustainable, what it means for the performance of economies and what it means for financial stability. I would like to touch on some of these issues today, particularly as they relate to Australia. Some facts Let me start with a few facts. This first graph shows two statistics for a range of developed economies: - the orange bars are the annual average growth in credit over the past 30 years; and - the purple bars are the annual average growth in nominal GDP over the same period. In each of the 15 countries shown, credit has grown substantially faster than GDP over the past 30 years. Graph 1 The gap between the growth of credit and that of GDP has been particularly large in countries such as Ireland, Spain, Australia, the United Kingdom, New Zealand and the Netherlands. Across these six countries, credit has grown on average about 5 percentage points a year faster than nominal GDP over the period covered by this graph. It is a matter of arithmetic that if credit is growing faster than GDP, then the ratio of credit outstanding to GDP will rise. Across the 15 countries shown in Graph 1, the (unweighted) average ratio of credit to GDP has risen from about 60 per cent in 1977 to around 135 per cent today (Graph 2). Graph 2 The extent of the upward trend in this ratio, and its persistence over such an extended period, is unusual from an historical perspective, if not unprecedented. For Australia, we have data on credit going back 150 years and it is certainly the case that there is no domestic precedent for what has happened over the past 30 years (Graph 3). 1 The closest previous experiences were those in the 1880s and 1920s. In the former case, credit started to expand much more quickly than GDP in the early 1880s, but this trend lasted for less than 15 years, after which it reversed sharply. The surge in credit in the second half of the 1920s was less pronounced and shorter; it reversed after about five years. Before 1953, the series shown in the graph relates only to the credit provided by banks; after that it includes credit provided by all intermediaries. Graph 3 One of the clues as to why the recent episode of credit expansion has lasted longer is that it has been driven to an important extent by household borrowing rather than business borrowing. We have estimates of household and business credit, of varying quality, going back to the 1920s. Before that, it is possible to get some guide to the split of borrowing between businesses and households by looking at which institutions were doing the lending. For example, credit extended by trading banks traditionally has mainly gone to businesses, while that extended by savings banks has mainly gone to households. The next couple of graphs decompose the series for total credit shown in Graph 3 into its business and household components. In the case of business credit, Graph 4 shows that the ratio of business credit to GDP exhibits big cyclical and secular swings, but these have taken place around a flat trend over the 150 years shown on the graph. Periods when the financial sector has been relatively unregulated, such as the 1880s and the past couple of decades, have resulted in the ratio of business credit to GDP being elevated. The subdued credit growth in the 1950s and 1960s, a period when the financial sector was heavily regulated, also is noticeable. Graph 4 I don’t think these outcomes are surprising. In the very long run, however, there are various economic relationships at work that tend to tie down the relationship between business credit and GDP. Specifically, business profits cannot consistently rise faster or slower than GDP, and in the long run the P/E ratio also cycles around a flat trend. The combination of these two facts means that growth in the value of business equity must also be tied to GDP growth in the long run. In turn, this works to tie down the relationship between business debt and GDP, as the gearing of companies (i.e. the ratio of debt to equity) cannot consistently rise or fall. Let me now turn to household credit, as shown in Graph 5. Here the picture is very different. Up until the 1970s, households’ access to credit was very limited. Those of us over 50 years of age can remember when, in order to qualify for a housing loan, people had first to establish a long and consistent record of savings with a bank, and even then there was a tight limit on how much the bank would lend. Many borrowers had to resort to “cocktail” loans, at higher cost, to meet their needs. Graph 5 Over the past 30 years, however, deregulation and financial innovation have greatly increased the household sector’s access to credit. This has been particularly so over the past 10-15 years as many banks focused their lending on the household sector after the credit losses on business loans in the early 1990s, and as financial innovations allowed non-bank lenders to enter the market for retail finance. The securitisation of loans, the development of numerous new loan products and the emergence of mortgage brokers were particularly important. Economic circumstances have also played an important role, just as they have for business credit. The decline in inflation and the resulting fall in interest rates have reduced the cost of debt, while the strong ongoing performance of the economy has made households more comfortable in taking on debt. These and other factors contributing to the growth of household credit were examined in more detail in a couple of papers presented by some of my colleagues at the Reserve Bank’s annual economic conference last month. 2 In short, deregulation, innovation and lower inflation have simultaneously increased the supply, and reduced the cost, of finance to households, and not surprisingly households have responded by increasing their use of it. Household credit outstanding rose from 20 per cent of GDP in the 1970s to 30 per cent by 1990, and to around 100 per cent today. Household credit accounted for the bulk – 85 per cent – of the rise in overall credit to GDP over the past 15 years, and household credit now greatly exceeds business credit in terms of outstandings. While some of the rise in household credit has gone to financing consumption, most of it has been used to acquire assets. If we take the past 10 years, for example, households have borrowed in total an additional $770 billion over the period. Of this, 90 per cent was used directly to buy assets, the main components being $420 billion for houses to live in, $240 billion for houses to rent and $40 billion for shares. See Kent, C., C. Ossolinski and L. Willard (2007), “Household Indebtedness – Sustainability and Risk”, Reserve Bank of Australia Conference Paper, 20-21 August 2007; Ryan, C. and C. Thompson (2007), “Risk and the Transformation of the Australian Financial System”, Reserve Bank of Australia Conference Paper, 2021 August 2007. Available at http://www.rba.gov.au/PublicationsAndResearch/Conferences/2007/index.html. The primary effects of this borrowing were therefore on asset values, the most noticeable being the more than doubling in house prices. While there was also some spill-over into consumer spending, the expansion of household credit by and large has been a story about asset markets. Similar developments have been experienced by many other developed economies over the past decade. Looking ahead Has the expansion of household credit run its course? Will it reverse? We cannot know the answer to these questions with any certainty, but my guess is that the democratisation of finance which has underpinned this rise in household debt probably has not yet run its course. In the past, the lack of access to credit had resulted in Australian household sector finances being very conservative. Even as recently as the 1960s, the overall gearing of the household sector (taking account of all household debt and all household assets) was only about 5 per cent – that is, households owned 95 per cent of their assets, including houses, outright. This meant that the household sector had significant untapped capacity to service debt and large unencumbered holdings of assets to use as collateral for borrowings. Financial institutions recognised this and found ways to allow households to utilise this capacity. The increase in debt in recent years has lifted the ratio of household debt to assets to 17½ per cent (Graph 6) 3 . I don’t think anybody knows what the sustainable level of gearing is for the household sector in aggregate, but given that there are still large sections of the household sector with no debt, it is likely to be higher than current levels. Graph 6 Cross-sectional data show that the rise in household debt has been driven primarily by middle-aged, and higher-income, households. Thus, while the build up of household debt is Measured on the same basis as corporate gearing (i.e. the ratio of debt to equity, rather than debt to assets) household gearing is marginally higher, at 21 per cent. often portrayed as being driven by young couples trying to buy their first home, a more accurate description is that it is mainly being driven by older, higher-income households that are trading up to higher quality or better located houses, buying investment properties and taking out margin loans to buy shares. These are all signs of rising affluence, driven by a very prolonged economic expansion. Over 80 per cent of households in the top half of the income distribution have some type of debt, compared with only 30 per cent of those in the lowest decile (Graph 7). Essentially, higher-income households are the ones that have the capacity and the financial security to take on debt. It seems that debt is one of those products, like education and health, which has a high income elasticity of demand – i.e. as income rises, demand for it rises more than proportionately. It would be a mistake, therefore, to conclude that a rising ratio of debt to income is necessarily a sign of financial stress among households. Graph 7 It is the high-income groups that have had the biggest increase in debt over recent years (Graph 8 ). About three quarters of the increase in owner-occupier debt over the decade to 2005/06, for example, was attributable to households in the top half of the income distribution. If comparable figures on debt associated with investment properties and margin loans were available, they would almost certainly further skew this distribution of debt. Graph 8 Despite the rise in the debt of this group of households, their debt servicing burdens remain relatively low. For those households who are in the top half of the income distribution and who have an owner-occupied housing loan, housing loan repayments currently average a little less than 20 per cent of gross income. This has risen only marginally over the past decade, and it remains significantly lower than the figure of around 30 per cent for households in the bottom half of the income distribution. This suggests that the former group still has substantial capacity to service debt. At the aggregate level across all households with owner-occupier housing debt, the median ratio of housing loan repayments to gross income, at about 21 per cent, is only marginally higher than a decade ago (Graph 9). Graph 9 Another interesting feature emerges when the composition of debt is broken down by age group. This shows that a large contribution to the increase in household indebtedness has come from households aged 45-65. This group no doubt overlaps considerably with the high-income household group. Over the 10 years to 2006, the proportion of households aged 45-64 that are carrying owner-occupier debt increased very noticeably, from 25 per cent to 38 per cent (Graph 10). This has been encouraged by increased life expectancy, and the financial security that comes from a strong economy with low unemployment and the build up of substantial holdings of assets through superannuation. Graph 10 The trend for households increasingly to carry debt into older age may not yet have come to an end. At present, the great bulk of households still pay off all their debts by age 65, but the factors that encouraged or allowed 45 to 64-year olds to increase their debt over the past 10 years may in due course change behaviour further up the age scale. Recent financial innovations, such as so-called “reverse mortgages”, which allow older people to access equity in their houses in order to fund retirement, could be one vehicle that encourages higher debt among older households. The pool of housing equity owned by older households is very large and drawings against this by even a small proportion of this group could add substantially to household debt levels. Some implications Let me end by drawing out some implications. The first is that we may not yet have seen the end of the rise in household debt. The rise to date has been overwhelmingly driven by those households that had the greatest capacity to service it – the middle-aged, high-income group. It is not surprising, therefore, that this rise in debt has exhausted neither the collateral nor the debt servicing capacity of this group, or the household sector overall. The factors that have facilitated the rise in debt over the past couple of decades – the stability in economic conditions and the continued flow of innovations coming from a competitive and dynamic financial system – remain in place. While ever this is the case, households are likely to continue to take advantage of unused capacity to increase debt. This is not to say that there won’t be cycles when credit grows slowly for a time, or even falls, but these cycles are likely to take place around a rising trend. Eventually, household debt will reach a point where it is in some form of equilibrium relative to GDP or income, but the evidence suggests that this point is higher than current levels. It is interesting to consider what factors might change the behaviour of households. One such factor is demographics. It could be that the aging of the baby-boom generation will arrest the upward trend in household debt due to the effects of this group running down its assets and liabilities as it moves into old age. But whether this demographic effect is sufficient to offset the effects of other demographic shifts, such as the increase in longevity of the population in general, is not clear. A second factor is monetary policy. Central banks could stop the rising trend in household debt by raising interest rates to levels that exhausted households’ debt servicing capacity. But central banks around the world have generally concluded that the level of interest rates necessary to do this is higher than that needed to achieve monetary policy objectives in relation to inflation and economic growth, so this policy option has not been followed. The final point I would like to talk about is the implications of rising household debt for financial stability. There are two perspectives here. The first is from the point of view of the lenders. Has the rise in household debt left lenders exposed to excessive risk? Any number of indicators – arrears rates on loans, exposure concentrations, capital ratios and profitability – suggest that the answer to this is “no”. This was also the conclusion reached in the Financial Sector Assessment Program conducted under the auspices of the IMF last year. As explained in the September 2006 issue of the Bank’s Financial Stability Review, even under the very extreme assumptions made in that stress test, banks remained profitable. The second perspective is from the point of view of household finances. As outlined in the Financial Stability Review published yesterday, overall household sector finances remain in good shape: average real income is rising, even after interest payments; financial net worth has increased noticeably; gearing levels are not out of line with international standards; and the proportion of households experiencing financial difficulties, though higher than a couple of years ago, remains historically very low. There are some pockets of stress, but the low numbers involved – less than 20,000 of the 5,300,000 housing loans in Australia are 90 days overdue on repayments – mean that this is not a macroeconomic problem, even though it is no doubt causing distress among those households and communities directly affected. At the macro level, there are two issues that arise from the developments in household finances over the past decade or two. The first is that the rise in household debt has made the household sector more sensitive to changes in interest rates. This has meant that central banks have been able to achieve their monetary policy objectives with smaller interest rate adjustments. Second, the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities comprised by debt. This balance sheet structure is very effective in generating wealth during good economic times, but households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise. | reserve bank of australia | 2,007 | 9 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Sydney Institute, Sydney, 11 December 2007. | Glenn Stevens: Central bank communication Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Sydney Institute, Sydney, 11 December 2007. * * * This evening I would like to talk about central bank communication. There are plenty of people who probably think that “central bank” and “communication” are not expressions that are normally thought of as belonging together. Yet communication has become steadily more open, and more important, in the central banking world over the years. At one time, overnight interest rates used to be adjusted without announcement or explanation – “snugging” was a popular term of the late 1980s. The market would generally take a few days, and the general public considerably longer, to work out what was happening when monetary policy was changing. They usually had to wait longer again for an explanation of why it was changing. That is no longer the case. These days, central banks say they are moving the interest rate, and say why, very openly. This particular form of transparency was adopted quite early at the RBA, back in 1990, under Bernie Fraser. Not only do they announce policy changes in a forthright fashion, most central banks set out their detailed assessment of economic conditions in published material. In a number of cases, they publish minutes of their policy discussions. Governors and others give speeches, appear before parliamentary committees and are frequently quoted by various commentators in the media. For central banks, historically quite discreet organisations, this is quite a change. I want to examine the reasons behind that change, and the case for openness. I want also to talk about the limits of openness. Finally, I will elaborate a little on our own recently announced changes in this area. Why communicate? To begin with, it is worth asking the question: why do central banks communicate? There are at least two reasons. The first arises from the principle of accountability in an open and democratic society. The central bank is charged with some important responsibilities – maintaining the purchasing power of the nation’s currency, pursuing “full employment” and fostering stable and reliable financial and payments systems, among others. It is endowed with substantial powers – in the RBA’s case, to buy and sell financial assets, commodities, real property, to lend money and to make certain regulations – in fact, to do anything that could be thought to come within the remit of “central banking business”. It stands to reason that the central bank should expect to account for the way in which it has used its powers to pursue its statutory goals. The framers of the Reserve Bank Act 1959 nearly 50 years ago very wisely placed the Parliament squarely in the centre of accountability arrangements. In recent times, the Commonwealth Authorities and Companies Act 1997 has required annual reporting of the relevant agencies, of which the Reserve Bank is one, but from the very beginning the RBA was required to issue an annual report to Parliament. Yet the requirements for more frequent communication have grown over the years. In part this reflects the increased development of capital markets and the speed and force with which they respond to economic developments. Markets crave information, and the central bank’s assessment of the state of the economy is one part of the information set. In part, the demand for communication accompanies increased operational independence for central banks. When the central bank is making an important policy decision under an authority delegated by the Parliament, as opposed to implementing a decision made by a minister – and that is what we are doing in the case of monetary policy – there will naturally be an expectation for accountability. It also reflects the general development of the community’s expectation to be more informed about important matters. That is a natural concomitant of a more affluent, educated and mature society. As such, it is something to be welcomed. There is also the role of the media. Our political leaders are expected to answer questions from the media much more frequently, and across a much broader range of issues, than once was the case. 1 Some of this spills over onto other institutions, including corporations and central banks. The media is responding to market demand for information here, but as in any other competitive industry, media organisations are also seeking to create new markets by supplying more intensive, more frequent coverage of more issues, including economic policy. The second rationale for more communication is the desire for more effective policy. Some policy actions have as much effect through conditioning expectations as by constraining current behaviour. This is very much true in the case of monetary policy. A change in the cash rate of modest size has only a pretty small impact on the economy. But expectations about a sequence of possible future interest rate changes can often be more powerful. What a central bank says, as much as what it does, affects those expectations. Even more important are expectations of future inflation. When people expect prices to rise rapidly, they bring forward purchases, put up their own prices, demand higher wages and so on. That helps to create the very inflation they expect. On the other hand, if people are convinced that inflation will be contained – perhaps because they believe that the central bank will do whatever is required to achieve that – they behave accordingly. In that case, their price setting, wage and purchasing behaviour helps keep inflation controlled. Expectations are more likely to be helpful in fostering economic stability when the public has a clear understanding of what the central bank’s goals are, how the central bank thinks the economy works and how in general terms it is likely to respond to various events, particularly pressure on inflation. That is why most central banks spend a good deal of time talking about their objectives and their policy framework. It is why they publish exhaustive analyses of economic conditions and offer such assessments as they can about likely future developments. Of course the world is highly uncertain, so central banks cannot spell out exactly what they would do in response to every conceivable scenario. There will always be the potential for some surprises. But if people understand the framework and the goals of policy, then their own response to that knowledge will usually be helpful in achieving the policy goal. Hence, communication is an important part of the policy process. How to communicate? And how much? So much for the rationale for communication. What are the channels central banks use? There are several. Most central banks have a program of publications. Australia’s central bank has been publishing the Bulletin every month since 1937. 2 In most cases central banks publish the results of research of their staff. The views in these papers are those of the authors alone, but much of the research is part of the knowledge base available to the policy-makers and They are also expected to respond to more media questioning than their counterparts in other democracies, as far as I can see. In Australia, it was a recommendation of the 1935–1937 Royal Commission that the Commonwealth Bank publish a regular statistical bulletin. The Reserve Bank took over this obligation after “separation” in 1960. hence is usually of interest to those seeking an understanding of policy issues. The RBA has been publishing Research Discussion Papers since the late 1960s. Over the past 15 years or so, many central banks have upgraded their regular economic reporting, giving a more in depth account of economic conditions with a more analytical flavour. In some countries with formal inflation targets, these are called “inflation reports”, though they are about much more than inflation. These documents set out the factual background in a way which shows how policy makers account for economic and financial conditions in their decisions. In the process they usually reveal a good deal about how the central bank thinks the economy works – its “model”, if you will. In many, probably most, cases, these documents contain forward looking material. Forecasts for inflation (and often for other key macroeconomic variables), the assumptions on which the forecasts are based and the extent of uncertainty surrounding the forecasts are, to varying degrees, spelled out. A few central banks even publish a future interest rate path – albeit one heavily conditioned by assumptions which are almost certain not to be realised, for one reason or another. The RBA has progressively upgraded its own regular report. The Statement on Monetary Policy appears in the mid month of each quarter. This is a very comprehensive treatment of the local and global economies, financial markets and considerations for monetary policy. It contains the Bank’s inflation forecast, a sense of the risks surrounding the forecast, and a discussion of the forces conditioning the outlook for the economy. It also offers an account of the policy decisions the Board has made in the preceding period. Central bankers give public speeches on issues of the day. In our case, we typically will take questions from the floor on such occasions as well. Sometimes the questions are even about the topic of the speech! The speeches, and the answers to questions, are routinely sifted by economists, the media and others for hints about the central bank’s intentions. That is not surprising, though sometimes readers are remarkably inventive in their efforts to read between the lines. I have certainly marvelled at some accounts of what I am supposed to have said. Nonetheless, these occasions do give the central bank the opportunity to talk about the issues it thinks are important, and to signal, if necessary, any changes to its view that might occur between the formal assessments of the economy appearing on the regular timetable. Central bankers make appearances in front of Parliamentary committees. As you may know, in our case, the Governor has been appearing twice yearly in front of the House of Representatives Economics Committee for about a decade now. Other officials of the Bank appear in front of various other committees as appropriate. These hearings give elected representatives the chance to ask questions at length. They are a key part of accountability and offer a useful opportunity for communication. They can also play, if used well, an educative role, developing a better understanding of policy issues than would be achievable in many other fora. Of course, there is always the risk that in such sessions the questioning can tend to aim more at political point scoring. Public communication is, however, a two edged sword. For every occasion when there is something important to say, there is another at which a central banker finds him or herself giving a speech, or releasing a formal document, which has little new to say on the economy, in an environment in which markets and observers already have a good understanding of the central bank’s assessment. On those occasions there is always the risk that further communication will inadvertently dislodge perfectly sensible expectations – which is one reason why speeches and documents are often, quite deliberately, a little on the unexciting side. Colour and movement are not necessarily useful in the central banker’s case. It is for this reason that the RBA was, for a long time, somewhat ambivalent about the practice adopted by some other central banks of making a statement of reasons for the policy decision even when the decision is to leave rates unchanged. While a decision to change rates has for many years been accompanied by a pretty detailed explanation in our case, a decision not to change rates often meant that we had little new information to impart. We adhered to the old adage “when you have nothing to say, keep your mouth shut”. These reservations were valid. But an increasing number of other central banks have managed to construct these statements and issue them regularly, without apparently doing much harm. More importantly, while there are plenty of occasions in which no change in interest rates is widely expected, and hence perhaps needs little explanation, there are others in which a no change decision does require careful explanation. Having reflected on this for some time this year, the Reserve Bank Board came to the judgement that the downside risks of such statements no longer outweigh the likely benefits. Accordingly, we have adopted the practice of issuing a short statement after every meeting, explaining the policy decision, whether or not the cash rate is to change. The first “nochange” statement was issued last week. Last week’s decision was a good example, in fact, of one where no change to the cash rate needed explanation. The statement noted the concern the Board had about the outlook for inflation, given the recent price data and the apparent strength in demand. It also noted that the outlook for the world economy looked a little weaker, and that trends in financial market pricing, over the preceding month, were likely to result in a rise in borrowing rates for Australians. In other words, financial conditions were shifting in the right direction for containing inflation, even without a further adjustment in the cash rate. Hence the Board decided to leave the cash rate unchanged, for the time being. In a further change to communication arrangements, commencing at the February 2008 meeting, our statement will be made on the day of the meeting, at 2.30 pm, rather than the next morning. Any change in the cash rate will still take effect the following day. This schedule will inform the markets during the Australian day, but will limit the time period between the decision being taken and it being publicly announced. The previous practice of delaying the announcement until 9.30 am the following day was originally adopted for logistical reasons, but they have long since disappeared. It is much better practice, and less risky, to announce the decision as promptly as possible once it has been made. Minutes and the limits to transparency That brings me to the one remaining area of central bank accountability and communication that I would like to talk about, which is the treatment of the minutes of policy making meetings. Practices vary in this area. The United States Federal Open Market Committee has been publishing minutes for many years. It was prompted initially by Congressional pressure for more openness, but before long moved beyond minimum requirements to a fairly full set of minutes including voting records of individual members. The Bank of England’s Monetary Policy Committee (MPC) is required by statute to publish its minutes. The MPC’s culture is expressly, by intention of its creators, one of individual accountability. Hence the minutes include voting records of the members, and it is not uncommon for a significant proportion of members to differ from the majority – including two cases where the Governor was in the minority. MPC members hold a second meeting, subsequent to the policy meeting at which the interest rate decision is taken, for the purpose of approving the minutes, which are then released prior to the next policy meeting. The European Central Bank, in contrast, does not publish minutes. One of the key reasons is that the presidents/governors of national central banks sit on the Governing Council of the ECB but are required to make decisions for the euro area as a whole, as opposed to decisions that might suit the particular circumstances of their own countries. It is argued, not unreasonably, that publication of minutes and voting might prejudice the capacity of the national governors to take a euro area, rather than national, perspective. The ECB does make additional efforts at communication of other kinds, including a regular press conference. Clearly there are views on both sides of this question, which reflect the different institutional arrangements across countries. This is why we have argued over time that, in the pursuit of the optimal degree of transparency, it would not make sense to “cherry pick” the high transparency aspects of every other system and assume that they should simply be grafted onto the Australian system. The nature of the Reserve Bank Board – a majority of whom are part-time members, drawn from various parts of the Australian community, but seeking to make decisions in the national interest as opposed to any industry, geographical or sectional interest – needs to be considered when thinking about disclosure practices. It is also important, I think, to articulate the point that there are reasonable limits to transparency in any system. It is not the case that releasing more material is always, by definition, going to lead to better informed public debate or better policy decisions. In contemplating the release of minutes of meetings in particular, and the form any such release might take, we need to balance a legitimate desire for information and accountability against the need to maintain a frank, open discussion at the meeting. At many meetings I have taken part in over the years, people have considered various arguments that ultimately were found to be unconvincing, but which did need to be examined in the interests of reaching a balanced decision. People also change their minds in the course of a meeting – and one would hope that that happens occasionally, since one of the key benefits of a having meeting is to learn from and respond to the views of the other participants. It is unlikely that these dynamics of a meeting could be sustained if every utterance were disclosed. The incentive could easily arise for people to be much more cautious in what they said, and to come to the meeting with a pre-written statement, rather than to engage in a genuinely interactive discussion. That would reduce the quality of the discussion and, ultimately, of the decision. And it is the quality of the decision, after all, which we should be seeking to maximise. What all of this means is that a decision to release minutes should not be taken lightly. Such documents have to be written carefully, taking into account the institutional structure, including the nature of the Board, and the need to preserve an environment of candid discussion. RBA minutes That said, there is no reason why, with careful drafting, a set of minutes that strikes the right balance cannot be compiled. Indeed, for a while now, we have been writing the minutes in just that way. After discussion among the Board members, we recently decided that there is no longer a strong case for not being prepared to release minutes of the monetary policy discussion. Accordingly, as announced last week, we will in future release the minutes of the monetary policy meetings with a lag of two weeks. The minutes from the November meeting were released last Wednesday. The minutes from the meeting held last week will be released on December 18. In addition, with the agreement of the Board, I am releasing at this time on the website the minutes from all meetings since I have been the chairman of the Board (that is, commencing with the October 2006 meeting). Those who are interested to read these documents – which will, outside the media and economic and financial professionals, be relatively few, I expect – will find the following features. First, there is an account of the main factual material available to the Board and the issues arising from that material that came up during their discussion. There is nothing particularly startling there – the information available to the Bank is pretty much known by everyone else. The material does not cover every single indicator the Bank tracks – there are too many. So if your favourite statistic is not mentioned, that doesn’t mean we are ignoring it. Equally, those statistics that have been prominent in recent sets of minutes should not necessarily be seen as all-important for future decisions. The Board will always strive to form a comprehensive picture of the whole economy in assessing the economic outlook and the prospects for achieving the inflation objective, and in coming to its decision. Second, there is an account of the policy discussion that occurs towards the end of the meeting, which outlines the key considerations involved in the decision. Sometimes these considerations are quite straightforward. On other occasions, they may point in different directions in terms of their implications for interest rates, in which case the Board has to make an “on balance decision”. The minutes will set out as clearly as we can the logic behind the decision. Third, there is a record of what the decision was – that is, what target cash rate the Bank is to maintain in the period until the next meeting. Readers will note that comments are not attributed to individuals. The material is not a transcript – indeed we do not keep a transcript – and it is not an edited version of some other set of more detailed minutes. No other record of the monetary policy discussion exists. The minutes do not attempt to provide a “blow-by-blow” description of every comment made. But nor do the minutes released by other central banks, and it would not be sensible to do so, for the reasons I articulated a few moments ago. Readers will also observe that the pattern of votes of individuals is not recorded, only the outcome. That is a point of difference with other central banks which publish minutes. But in those cases the decision-makers are full-time appointees, in some cases in systems with expressly individual, as opposed to collective, responsibility for their decisions. That is not the system Australia operates, and our pattern of disclosure reflects the institutional arrangements. In the interests of clarity, let me also state that these minutes do not cover issues other than monetary policy. Other matters that the Board considers from time to time – such as the Bank’s accounts, audit processes, issues concerning subsidiaries and other governance questions – are not recorded in these published minutes, because there is no public policy case to do so. There is proper disclosure on these matters, but through the appropriate vehicle, which is mainly the annual report. This is in line with practice in other central banks, and with common sense. Our view is that minutes of the type we are now releasing, in combination with the regular statement after each meeting, and the large volume of other material released by the Bank, meets the legitimate claim of observers to know the basis of the Board’s policy decisions. It is consistent with arrangements that prevail in the countries to which we would look for examples of good practice. At the same time, this approach should preserve the candour of discussion at the meeting and recognises and respects the basis on which the non executive members of the Board serve. As such, it strikes the right balance. Conclusion Communication has become a more important part of the central banker’s tool kit. While we will rarely be found courting publicity, neither will we shirk the responsibility to explain what we are doing and why. That is a requirement of good governance, but also it will usually make policy decisions more effective. There are limits to transparency. More is not always better, and because the decision to disclose additional information is hard to reverse once made, it should be made with care. Nonetheless, after reflecting on our own experience and evaluating experience around the world, we recently judged that the time had come to move Australia’s arrangements to conform with normal practice elsewhere. I was very pleased to learn when I met the new Treasurer a couple of weeks ago that he supported the changes. This material will not compete too well with the best seller lists, and almost everyone will (I hope) have better things to read while on the beach over the summer than the Reserve Bank Board’s minutes. But for the professionals, this will hopefully make a modest further contribution to their understanding of the Board’s decisions. And for any of the rest of you who are having trouble getting to sleep … Whatever your preferred reading material, I wish you a pleasant festive season and a happy and prosperous New Year. | reserve bank of australia | 2,007 | 12 |
Opening remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 20th Australasian Finance and Banking Conference, Sydney, 12 December 2007. | Ric Battellino: Challenges and opportunities for the funds management industry in Australia Opening remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 20th Australasian Finance and Banking Conference, Sydney, 12 December 2007. * * * Introduction It is a pleasure to be here to open the 20th Australasian Finance and Banking Conference. Over the past twenty years, the Conference has provided a stimulating forum for discussion of a wide range of issues facing the banking and finance industry, and it has played an important role in helping to promote Australia as a major financial centre. I’m sure this year will be no exception. This morning’s Business Forum on the challenges and opportunities for the funds management industry has already generated a number of interesting points for discussion. The schedule for the next two and a half days will take the discussion into a broader range of topics in the field of banking and finance but for the moment I will focus my remarks on the funds management industry. Industry size Let me begin by recapping some facts on the size and growth of the industry. As we have heard, the funds management industry in Australia has expanded at a remarkable pace over the past couple of decades. Since 1990, the value of funds under management has grown at an annualised rate of 12½ per cent, and now stands at around $1.7 trillion. This is equivalent to about 160 per cent of GDP, up from about 50 per cent in 1990. By international standards, Australia’s funds management industry is among the largest in the world, not only as a ratio to GDP but also in absolute terms. Some reports rank Australia as the fourth largest funds management industry in the world in terms of assets under management. The data underlying this ranking are compiled by the Investment Company Institute, an industry association for US mutual funds. This measure covers investments in mutual funds and unit trusts, and therefore favours countries such as Australia where this type of investment vehicle is quite common. On the other hand, it understates the size of the funds management industry in countries that tend to use other investment structures. An alternative approach for measuring the size of the funds management industry is to add up all of the assets of pension funds, life insurance companies and other managed investments, regardless of the precise legal structure in which they reside. This provides a broader view of the funds management industry and one that is more comparable across countries. This exercise is not straightforward, however, as consistent international data are difficult to obtain. After taking into account some of these measurement issues, my colleagues at the Bank estimate that the Australian industry is among the world’s ten largest, though more likely towards the bottom of this group than in the top half. It is difficult to be more precise than this but, nonetheless, it is clear that the Australian funds management industry is large by international standards. Reasons for growth What has been behind this rapid expansion in the industry? A large part of the growth over the past couple of decades has been due to superannuation. Superannuation fund assets have grown by an average of 14½ per cent per annum since 1990, and now comprise about half the funds under management in Australia. This rise in superannuation assets reflects a number of government initiatives, such as the introduction of compulsory superannuation contributions in the early 1990s and the concessional taxation of superannuation. Other parts of the funds management industry, however, have also grown quickly, reflecting more general reasons such as the increased financial awareness of households and the associated search for higher returns than those offered by traditional investments such as bank deposits; the strength of world equity markets; and the demographic trend of “baby boomers” entering the wealth-accumulation phase of their lives. As well as investing in what might be considered to be fairly conventional financial products, it is also notable that in Australia there has been significant direct participation by retail investors in the markets for sophisticated financial products. For example, retail and high net worth investors account for about two-thirds of the assets of Australian-based hedge funds, compared with less than half globally. The available evidence for Australia also suggests a larger retail presence in the market for collateralised debt obligations than is the case in other markets. Over the past five years, retail investors are estimated to have purchased around 15 per cent of the CDOs issued in Australia. One of the reasons for this higher participation by Australian retail investors in these markets is that the regulatory regime in Australia does not restrict retail access to any financial products as long as the provider meets certain disclosure requirements. This approach has been beneficial in terms of providing investors with a greater range of wealth-generating opportunities, but it does raise some important challenges. I want to spend the rest of my time today outlining these and other challenges facing the funds management industry. Challenges One of the most important challenges raised by a disclosure-based regime is that it places a significant premium on financial literacy. This is because it relies heavily on the ability of investors to understand the information that is presented to them and make appropriate decisions based on that information. Some retail investors may not be in this position. A particularly telling statistic comes from a recent survey conducted by the Financial Literacy Foundation, in which only about a third of adult respondents indicated that they considered both risk and return when choosing an investment. The fact that some retail investors had apparently devoted the bulk of their savings to buying unsecured, high-yielding debt issued by some recently collapsed property companies also suggests that some people have difficulty understanding the financial risks of investment products. The Australian Government, through the Financial Literacy Foundation, has a number of initiatives underway to improve financial education and literacy standards. ASIC has also been active in educating retail investors about financial products, and a range of privatesector initiatives are underway to help improve financial literacy standards. One way that the financial services industry can help retail investors make better investment decisions is by providing clear and concise information about their financial products. For some time now there have been concerns about the length and complexity of product disclosure statements and prospectuses. ASIC has been trying to address some of these concerns through various initiatives. It has also recently introduced regulatory guidance to improve the quality of disclosure to retail investors in unlisted debentures. A related challenge facing the industry is financial advice, and how this is paid for. There appears to be a general reluctance on the part of retail investors to pay for financial advice on a fee-for-service basis. Instead, there has been a preference for commissionbased advice, despite the conflicts of interest that can arise in this situation. This reluctance to pay for advice upfront appears to be a form of money illusion, whereby investors may feel that they are somehow paying less for financial advice if the cost is buried in reduced earnings in the future. The regulatory environment in Australia has tried to deal with potential conflicts in commission–based advice by making it a requirement for advisors to provide their clients with a written statement of advice that sets out, among other things, the basis on which the advice is given, any potential conflicts of interest, and the dollar value of commissions they stand to receive. But the question remains as to whether full disclosure is enough to deal with the potential conflicts of interest associated with commission-based fees, or whether there is merit in the industry moving further in the direction of offering advice on a fee-for-service basis. The cost of providing investment services to retail investors is also a challenge that needs to be addressed. Recent research published by APRA compared the average net returns – that is, returns after all fees, expenses and taxes – for different types of superannuation funds. APRA found that over the decade to 2006, $1,000 invested in the average retail fund would have risen to $1,650 after fees, expenses and taxes, compared with $1,888 for an industry fund and about $2,100 for corporate and public sector funds. Of course, these figures are averages and there would have been significant variation in the returns of individual funds. While it is difficult to isolate the exact cause of the underperformance of retail funds, an important contributing factor would have been that fees and expenses on retail funds are typically higher than for industry and corporate funds. That said, I think it is encouraging that competition has been putting downward pressure on expense ratios across most categories of superannuation funds. Another issue which has received attention is what level of superannuation contributions is necessary to ensure an adequate retirement income. Determining the adequacy of contribution rates is difficult because the modelling relies on various assumptions about future investment returns, income growth, length of retirement etc. There is also a need to specify what is meant by “adequate”. Most of the recent research, however, suggests that, to ensure an adequate replacement income in retirement, the current level of superannuation guarantee contributions will need to be supplemented by the old-age pension for lower-income households, or by voluntary contributions for those households not eligible for the pension. The issues I have raised today are, I am sure, well known to those of you in the industry. There are many considerations to be taken into account in resolving them, and there will no doubt need to be a large input from the industry in doing so. Conclusion For the moment, however, let me conclude by recording that the transformation of the superannuation industry over the past couple of decades has been one of the great success stories in the Australian financial sector. While further work needs to be done, conferences such as this play an important role in raising and resolving issues. I hope that your discussions over the next couple of days prove to be both thought–provoking and rewarding. | reserve bank of australia | 2,007 | 12 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Australian Business, London, 18 January 2008. | Glenn Stevens: Economic prospects in 2008 – an Antipodean view Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Australian Business, London, 18 January 2008. * * * It is a pleasure to be here in London to speak with you today. As Australians recharge their batteries over the summer break, after a long year of coping with an economy operating at full stretch, people in this part of the world are hard at work trying to assess the outlook for the world economy. The year 2007 as a whole was another one of pretty good growth in the world economy, with the PPP weighted IMF series for global GDP thought to have risen by 4¾ per cent, compared with an average of about 4 per cent per annum since the beginning of this decade. 1 For the G7 economies the outcome was a bit below average but the emerging world continued to grow strongly. Yet as the year closed, and the fallout from the risky practices in the US housing market was becoming clearer, questions were arising over the outlook for 2008. There is no shortage of opinions on the outlook for the US economy. Hence I will be brief on that question. The question I would like to address at more length is what the implications of any change to the US outlook might be for the world economy, and for the Asian region in particular, which of course is important for Australia. I would like to conclude with some observations about inflation. The US economy In the face of the large downturn in housing construction and a fall in house prices, the US economy has in fact done remarkably well so far to keep growing. Reasonable growth in consumption, strong capital spending by businesses and a turnaround in the trade accounts have been key factors. The decline in the US dollar is presumably assisting the latter. In other words, the floating exchange rate is playing its proper role of responding to the differences in macroeconomic circumstances between the US and elsewhere. Nonetheless, it is a reasonable presumption that the US now faces a period of below average performance as the problems in the housing market are digested. The excess stock of dwellings has to be worked off; the bad loans have to be recognised and written down; and to the extent that the recognition of all this damages the balance sheets of major financial institutions (not all of which are American), repair work is in order. It has already commenced, with a number of the most significant globally active banks seeking significant capital injections from cash rich investors. Arguably, these banks are now putting in place belatedly the capital that should have been devoted to these activities all along. Even if we accept that there were some genuine advances towards more optimal risk sharing through the development of securitisation and its associated structures, it cannot be denied that there was a capital saving associated with the conduct of business through off balance sheet entities: banks had to put up less capital ex ante than the risks really warranted. That earlier business advantage is now being unwound as much of the credit risk comes back to the banks. It seems a reasonable bet that more capital will be required over the years ahead. These PPP weighted growth rates reflect the results from the recent International Comparison Program announcement on relative prices. So the US economy is in a period of adjustment, as is the banking core of the international financial system. Even with the renowned flexibility of both, and good policies, this will take a bit of time. Just how long remains uncertain. The global economy The question then is how much impact a period of US weakness will have on the global economy. I think it makes sense to think about the answer along two dimensions. The first is “spillovers” – essentially sequential causal connections whereby slower activity in a major country like the US affects its trading partners via reduced US demand for goods and services in international trade. This would, other things equal, slow economic activity in those trading partner countries, which in turn would slow their demand for goods and services, and so on. Of course, all else may not be equal – other shocks and adjustments might be occurring in the other direction in other countries. An obvious possibility is economic policy: it may be open to policy makers in those other countries to respond to weaker US demand by running more expansionary policies at home. Whether it is or not would depend on their overall macroeconomic situation and their policy regime. The second dimension is the extent of commonality in the originating event that triggers the whole adjustment to begin with. So if, for example, it were the case that a “credit crunch” occurred simultaneously in many countries, there would be a contractionary impact around the world even before any spillover effects via trade got going. Obviously, that would be a much more serious situation, since policy makers in each country would be seeking to combat declining domestic demand as well as declining foreign demand. Combating credit crunches in particular can be very difficult. I think we can take it as given that there will be trade spillovers from the weaker US economy to the developing world and to other developed countries in due course, even though there is not a lot of evidence of such an effect in the data we have as yet. The spillovers will not just be from the US either. The fact that the euro area appears to be slowing a bit, with the UK also expected to slow before long, means that the core industrial countries as a group may, over the period ahead, impart noticeably less impetus to global growth than they have in recent years. How big a difference that will ultimately make we cannot know for sure, given the apparent increased internal dynamism of much of the emerging world, and given that we do not know what policy responses those countries may make. But the bigger question is the extent to which a range of countries also experience the same shock as the US. It is in answering this question that we need to consider the financial events of the past year or so. The essential elements are well known by an audience in this city. Over some years, the availability of credit increased in many countries. In the US in particular this phenomenon saw a large extension of credit into the sub prime space in the housing market. This was all aided by the securitisation process and the search for yield, which had its genesis in the high saving rates in other parts of the world. While most of these sub prime borrowers have in fact been servicing their loans quite adequately, flaws in the process saw standards slip towards the end of this cycle. As the problems came to light, pressure came to bear on various entities. Institutions with exposure to sub prime mortgage assets, holders and intending issuers of structured products in general, SIVs, conduits and other intermediaries that relied on wholesale funding were all tested. Core banking institutions that sponsored off balance sheet entities very quickly found funding pressures transferred back to them. Doubts over asset quality, uncertainty over funding and generally reduced appetite for risk suddenly erupted last August into a scramble for liquidity. These pressures have been seen in most of the developed economies, though they have been most acute in the US, the UK, the euro area and Canada. For at least some of the G7 economies, then, these events would appear to have the characteristic of a common shock, in the form of a rise in the market cost of finance and, in some cases, perhaps, the possibility of a wider withdrawal of credit. Even though it was American borrowers who could not repay, lenders much further afield were affected. It is against this backdrop that forecasters are bringing down their growth estimates for 2008 in some of the major countries, and policy makers there are growing more concerned about downside risks to growth. Suppose then that the G7 group faces the prospect of softer growth in 2008 due at least in part to these financial factors. There will be spillovers from this via trade. But is the financial shock also common to the emerging world, and to Asia in particular – a region that has been a spur to global growth in recent years? To date, at least, it would appear not. Asian investors appear to have relatively small exposures to the sub prime loans per se. Banks in the region typically rely less than their developed country counterparts on wholesale funding, so the liquidity squeeze has been less of a problem for them. The cost of debt to Asian borrowers, as measured by sovereign bond yields, has not risen much at all. Nor has the cost of equity capital, if the levels of Asian share price indices are anything to go by. The economic growth of most of east Asia has to date remained pretty solid as well. None of that is any guarantee of plain sailing in the future. Nonetheless, it is a good start to weathering whatever the effects of slower growth in the developed world might be. If the financial shock that some of the G7 economies have experienced, and which they fear could intensify, has not been replicated in Asia, then the effects on Asia should be limited mainly to those coming through the trade channel, and perhaps via general business confidence linkages. The trade channel remains important, of course, for some key Asian countries. There has been a big rise in intra Asian trade over the past decade, but much of that trade is basically a production chain whose output is still destined for the major country markets. So developments outside the region are still very important. But some moderation in the externally generated part of growth is a manageable issue for Asian policy makers. In countries where inflation has been a little on the high side, they can allow it to reduce pressure on prices. In other cases, they would be in a position to allow more expansionary settings for domestic demand. Much hinges on events in China, an economy that now has a very prominent effect on conditions in the Asian region. Over the past couple of years the Chinese economy has continued to boom, asset prices have surged and the authorities have struggled to contain the ebullience. Some of China's growth has been courtesy of a rise in exports but, even if that contribution to growth diminished, China would still be growing very strongly as domestic spending has been rising rapidly. With very high saving rates at present, there would appear to be plenty of scope for further rises in consumption spending over time, as the Chinese people become accustomed to higher incomes. A slower pace of growth in the G7 will presumably trim this growth to some extent. But my guess is that China can cope with that. The Chinese authorities may even welcome some moderation in growth. If China does suffer a serious interruption to growth at some point – and all economies do from time to time – it is more likely, in my judgement, to be caused by some domestic problem than by the sort of events we are witnessing in the developed world at present. For Australians, it will be just as important over the years ahead to keep an eye out for imbalances in the Chinese economy as to watch the problems of the US economy. All told, it seems likely that, after several strong years, global growth will be noticeably slower in 2008. Much of this slowing will be driven by weaker outcomes in the developed world, particularly in countries facing tighter credit conditions. Some of the G7 economies are likely to experience a period of growth well below trend. It seems likely that this will affect emerging market and other economies mainly via trade linkages. At this stage, it is not clear how significant this effect will be, but it seems prudent to assume that we will be moving from a position where growth in the global economy has been well above trend to one where it will be no more than trend. Some moderation in the pace of global expansion is welcome, given the pressure on prices for energy and raw materials we have seen in recent years. But the full picture for this phase of the international cycle will become clearer only over time. Australia What then of the outlook for Australia? The continuing rise of Chinese and other incomes through those levels at which resource usage intensifies significantly has meant strong and persistent demand over recent years for the mineral resources with which Australia is abundantly blessed. At this point, there appears to be a widespread expectation that contract prices for some key resources will rise in 2008. If they do, Australia’s terms of trade, which have already risen by about 40 per cent over the past five years, would move higher still. Perhaps this general set of forces at work is behind the striking difference in confidence one encounters when travelling from the Pacific time zone to the European one. It is not as though Australian investors and borrowers have escaped completely unscathed from the turmoil abroad. While their direct exposure to the US sub prime market has been limited, we have seen additional demand for liquidity put upward pressure on term funding rates for financial institutions, though to a smaller extent than in Europe or the US and the pressures are now easing somewhat. Firms whose business models relied on short term debt funding have been tested; a couple have, for practical purposes, left the scene. Yet these events have been absorbed thus far with little disruption in the broader economy. The availability of credit to sound borrowers has not been impaired. It costs a bit more, but that is in the context of a fully employed economy struggling to meet demand. The key banking institutions are strongly capitalised, have adequate liquidity and relatively little exposure to the problems in the US housing market. Business and consumer confidence both remain high. In the local housing market over the past year, we have seen prices accelerate in several cities in the eastern states. The economy grew significantly faster than trend over the same period. As a central bank, while we have been careful to ensure ample liquidity in the money market at a time of international uncertainty and re pricing of risk, we have remained concerned about the outlook for inflation, which is likely to be uncomfortably high in the near term. Based on what we can see at present, my judgement is that the direct financial effects of the global turmoil on Australia are likely to be confined mainly to the impact on borrowing costs of the liquidity squeeze of recent months, which has pushed up the cost of wholesale finance a bit in addition to the effects of monetary policy changes. Taking into account the strength of demand, this increase in borrowing costs does not seem likely to pose a particular problem for the economy as a whole. There is no evidence, moreover, of a “credit crunch” in the domestic financial sector. On the contrary, thus far the core elements of the domestic system have stepped into the potential gap left by the capital markets. All this could change if the credit tightening abroad takes a serious turn further for the worse. But failing that, over the horizon of the next year or so, the main further impact of international events is likely to be through two channels. The first is the effects on global economic growth, and particularly the growth of China. The second channel is the potential intangible effect on business confidence, which could operate to the extent that Australian business leaders take a cue from their counterparts in the US and Europe. In both cases there is, thus far, no evidence of any significant impact, but it may be too soon to see it yet. Inflation As we consider the potential risks for economic activity over the year ahead, it is important to keep inflation in the picture too. The rapid pace of global growth in recent years has seen a pick up in some key prices. Prices for foodstuffs, energy and raw materials for industrial processes are quite high. The synchronised nature of the increases has been quite marked as well, in a fashion eerily reminiscent of the early 1970s. What is different on this occasion is the way that labour costs have behaved. In the early 1970s, labour costs exploded in many countries as inflation expectations began to rise, economic policies were too ambitious on growth, and labour unions reached the peak of their power. By and large, labour costs have been quite contained in the present episode, even in cases of tight labour markets like Australia's. This owes something to the openness of the global trading system and also to the way labour market institutions have evolved. The fact that inflation expectations have been low and pretty stable has also helped. Central banks have played a key role in anchoring expectations. One risk is that the effect on CPIs of rises in commodity prices could disturb the balance. It is customary in many parts of the developed world to strip out the effects of food and energy prices on CPIs, on the assumption that such movements are usually due to temporary supply disturbances and hence will reverse. But the predominant reason for many of the commodity price rises is demand – not just developed country demand, but that in the developing world. The demand has proved to be persistent, rather than temporary. In the event that labour costs begin to respond to the headline inflation price rises that have already occurred, it would prove more difficult to contain underlying price inflation in the industrial countries. In developing countries, moreover, where food is a big share of the basic consumption basket, the rise in food prices may present a particular challenge. While slower growth in global demand, led by the major countries, and possible supply responses may ease pressure on some commodity prices, most of them remain very high at this stage. It is conceivable, therefore, that a somewhat less favourable short term relationship between economic growth and inflation than the world enjoyed over the past decade might be experienced for a time. This outcome, were it to occur, would make for a more challenging environment for macroeconomic policy makers. It would limit the extent to which monetary policies could respond to the downside risks to economic growth in the short term without risking a rise in the trend rate of inflation and a pick up in inflation expectations. I believe that central banks everywhere are acutely conscious of this. I would venture, however, that the tolerance among some parts of the investment community for a cautious approach by policy is not high, if some of the commentary we read is any guide. This, too, adds to the delicacy of the tasks facing policy makers. But it is important to stress that, were trend inflation to rise as a result of too ambitious an approach to supporting short term growth, financial prices would actually be among those most vulnerable to adjustment as long term interest rates rose. Conclusion 2008 opens with the financial turmoil of the second half of last year fresh in our minds. Those events, and the deeper issues that triggered them, have mainly affected some of the G7 economies and have cast a shadow over their growth outlook in the near term. Emerging market economies have been less affected; in fact, in parts of Asia the main policy challenge has been to deal with the threat of overheating. Will growth performance for these different parts of the world continue to diverge? Or will they converge again – and if so, how? And how successful will we – all of us – be in containing the inflationary tendencies which have been evident up to now? These will be among the key economic questions for 2008. At the moment, we do not know the answers. One way or another, 2008 could turn out to be an interesting year. On that note, I wish all of you a happy new year and good judgement in the period ahead. | reserve bank of australia | 2,008 | 1 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Treasury Seminar Series, Canberra, 11 March 2008. | Glenn Stevens: Monetary policy and inflation – how does it work? Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Treasury Seminar Series, Canberra, 11 March 2008. * * * When I was originally approached to speak to this audience, I was asked to give a Reserve Bank perspective on the economy. That was a fairly general brief. Given the current state of affairs, it makes sense to fulfil it by talking specifically about inflation and monetary policy. There is extensive commentary around at the moment about “blunt” instruments, concerns over the effect of rising interest rates on particular indebted sections of the community and the appeal in various quarters for some other way of dealing with inflation. Hence, it seems a sensible moment to re visit just how monetary policy works. It is also important to have a realistic assessment of the extent to which other instruments are available to help in the job that monetary policy is charged with. But before tackling either of those issues, there is a prior set of questions that have to be addressed, about what is actually happening to inflation. Unless we are clear about that, then the subsequent discussion about monetary policy’s role in controlling it is not well based. If there is not actually an inflation problem, then presumably monetary policy should proceed differently than it would if there is, in fact, a problem. So the plan of these remarks is as follows. First, I will address the questions about what is happening to inflation and why. Then I will turn to questions of what monetary policy can do about it, and what other instruments can do. In both instances, the way I propose to do this is to recount some of the questions that we have seen raised in various places. In some cases, these are reasonable questions. But there are reasonable answers, and I would like to offer them. Finally, I would like to step back from this approach focused on the particular details of the current situation to give some broader historical perspective. It is important to keep that perspective in mind, not just to be clear how big the challenge is, but also to be clear how well the economy has done, so far at least, in meeting it. Arguments about inflation One argument which has been around is that there isn’t much inflation. On the face of it, this is not an unreasonable starting point. The latest CPI headline rate is, after all, only 3 per cent. If that is as high as it gets and it comes down at some point before long, then presumably there is not that much of a problem. It would, in fact, be quite consistent with the inflation targeting framework we have been operating on for well over a decade now. The average inflation rate over a run of years would still be “two point something”. Unfortunately, the situation at present is not quite as benign as that. The headline figure owes quite a bit to the unusually low result in the March quarter of 2007, which was affected by some unusual and temporary effects. When we get the March 2008 figures towards the end of April, we will most likely find that the rise over the four quarters is more like 4 per cent. That result itself will have various temporary factors affecting it, so it is not necessarily an immediate guide to how concerned we should be. To get a better feel for the component of inflation that is likely to be more persistent, we look at various measures of underlying inflation. As you know, there is more than one way of doing this, and in my judgement it is not sensible to be doctrinaire about any one underlying measure. But what is clear is that these series have all picked up, with the exact extent varying by measure. Overall, the Reserve Bank, in its February 2008 Statement on Monetary Policy, put the pace of underlying inflation over the past year at about 3½ per cent. That is no disaster as a temporary phenomenon either, but monetary policy has to be set with a view to winding that increase back within a reasonable period. Now I need to be clear about the status of these underlying measures. The target for monetary policy is set in terms of the Consumer Price Index. The objective is to achieve an average rate of CPI inflation of between 2 and 3 per cent. The “on average” specification is used precisely because the CPI is sometimes affected over short periods by factors that will not be there in a year or two’s time, when the effects of any monetary policy changes will still be coming through. For policy to chase those short term fluctuations would risk making the economy less, rather than more, stable. So we need to look ahead to where the CPI is likely to be in future, as well as where it is now. For that purpose, we employ analytical devices to help us detect what the ongoing trend in inflation is likely to be, and this is where the underlying measures are useful. They are not, themselves, the target variable. But a policy that targets future CPI inflation, using underlying inflation as an analytical tool and/or as a predictor of the headline CPI, would probably look very similar to one that was targeting underlying inflation per se. So, in this sense, if one is trying to assess what economists would call the Bank’s “reaction function” using particular price series, underlying measures would probably be more helpful than the headline rate. Another argument we hear is that inflation is higher, but that is due to a few things on the supply side that we cannot help, and that cannot be influenced by monetary policy. There are some prices that historically have been subject to large but temporary supply disturbances. Agricultural produce is a classic example – with droughts, floods or other phenomena sometimes having significant, and even large, impacts. But these effects should be expected to be only temporary – when weather conditions change, prices should revert back to trend. So there is no need for monetary policy to respond to them, and the various underlying measures help us to abstract from their effects in the short term. When Cyclone Larry devastated the banana crop in early 2006, the effect was to help push the CPI inflation rate up to 4 per cent. That impact has now been reversed. Contrary to what was asserted in some quarters, monetary policy did not respond to this event at the time, nor has it since. There are certainly some food prices that have been pushed up because of the recent drought (though others have been pushed down). It is less clear, however, that some of the other unusually large price movements currently affecting the CPI can be passed off as temporary supply disturbances. Global oil prices have certainly risen sharply, but not because the supply of oil has been reduced. In fact, the supply of oil has never been higher. The biggest reason for the rise in the price of oil (measured in US dollars) has been the rise of demand. Of course it is not Australian demand (though that has risen), but demand in Asia, and especially in China, that accounts for much of the rise in global demand. So the rise in energy prices is not “our fault”, so to speak, but nor is it temporary. Higher Chinese demand is not going to go away. So we have to adjust to higher energy prices. People have also pointed out the prominent increases in rents in the CPI as a special factor, and it is certainly true that rents are rising quickly. The reason that is happening is pretty clear too: there is strong demand for that type of accommodation, and rents as a yield to the supplier have been unusually low. Hence, rents are bound to rise. Interestingly, this shows the lengthy and rather complex connection between asset price changes and consumer price inflation. A key factor behind rental yields being very low was that the price of residential property rose so strongly – far faster than rents – in the earlier part of this decade, and has stayed high in most places in the country. While capital gains were occurring, it mattered little to many investors that rents as a running yield were low. But this was not sustainable. Once capital gains slowed, the low rental yield mattered a great deal. Low yields also prompted more demand for rental accommodation than otherwise. That combination was bound to lead to an adjustment in rents, unless property prices actually declined to restore the yield. Since, in most locations, they did not, an adjustment something like the one we now see became very likely. It seems likely to continue for a while yet, until either rental yields regain more attractive levels or some other factor raises the effective return for investors. Suppose, though, that we did take out some of the “special factors” that people nominate. Let’s, for the sake of argument, remove from the CPI rents and petrol, as well as the calculation of deposits and loan facilities. If we do that, the rate of inflation of the remaining items over the year to December 2007 is 2.1 per cent. No problem, right? Well, not exactly. To assess the trend in inflation objectively, you cannot just take out items that rise in price, which is why we typically use underlying measures, which trim both extreme rises and falls. Suppose for the current purpose, then, that we also remove fresh fruit, as a very volatile item and one that happens to have held down the CPI over the past year, due to the unwinding of the great banana episode of 2005/06. Let’s also remove the effects of the child care rebate changes, treated as a price fall in the CPI, but which we know is a one-time effect and which reduced the CPI by 0.2 per cent. If we do all that, we get a rate of inflation of 3.0 per cent over the year to December 2007. A little elementary figuring and a look at the quarterly profile, moreover, will tell you that, when this calculation is done for the year to March 2008, the answer is likely to be higher again. This is not all that far from what the statistical underlying measures, which dampen the effects of large rises and falls in a more systematic way, are telling us the trend inflation rate is now. So, unfortunately, it will not do to say that just a few items explain it all away. What is really going on is that price rises across a pretty wide range of items have picked up. About two thirds of the items in the CPI by weight have risen at more than 2½ per cent over the past year. Normally, we experience about half the price rises at that pace (which you would expect if average inflation is 2½ per cent). In essence, to explain away the rise in inflation we have seen, the list of special factors to which we have to appeal is growing rather long. At the same time, there is no question that aggregate demand in the Australian economy rose strongly through 2007, and indeed in recent years generally, at a pace well above the economy’s likely growth of potential supply. Nor is there much serious argument against the proposition that usage of capacity in the economy is very high – business surveys uniformly tell us that, as does the measured level of real GDP relative to trend, and the low unemployment rate and high level of vacancies. Firms have struggled to find the additional workers to expand their activities – that is what they tell us. In short, it is hard to avoid the conclusion that there has been genuine pressure on prices, caused not just by temporary supply shortfalls in a few areas, even though there have been some of those, but also by persistent strength in demand. The next argument that I want to address is that wages have not picked up. Some people object to our message on inflation, including references we have made to labour costs, because they seem to think that we are somehow “blaming” wage earners for inflation. We are not saying that. This episode has not been caused by some exogenous “break out” in wages. Until recently, it was, in fact, possible to say that wages growth had been remarkably steady at an aggregate level in the face of a very tight labour market, with relative wages across industries and regions doing what one would expect given the shocks hitting the economy. At one stage, I described this as a textbook case of adjustment 1 , in a labour market made much more flexible by a long sequence of reforms. Private sector wages growth may be picking up a little now, and businesses we talk to say that they are having to See Official Committee Hansard of the House of Representatives Standing Committee on Economics, Finance and Public Administration, August 2007, Gold Coast. Available at http://www.aph.gov.au/hansard/reps/commttee/R10393.pdf. find ways to raise compensation, and in ways that may not immediately be evident in the official data. But we have certainly not claimed that labour costs are leading the way. It seems to me that if labour costs are starting to accelerate, this is mainly a symptom of inflation pressure in a very strong economy. Inflation problems do not have to start with wages. Sometimes in Australia in the past they have started that way, but it should not be assumed that it will be that way on every occasion. On the other hand, should people come to expect that inflation will be higher for a long time, and wage claims and price setting start to reflect that, we will have more trouble getting inflation down again. One of the most important jobs of monetary policy is to condition expectations. To achieve that, people have to believe we will do what is required to control inflation over time. The final argument I want to tackle is that the inflation target is too low. This view accepts that inflation has increased, and that it is not just a few factors that are responsible, but argues that 3-4 per cent inflation is acceptable, and that it is unrealistic to expect to return to the 2-3 per cent standard. I do not think that the 2-3 per cent average inflation target is too ambitious. We have achieved it for the past 15 years, and we achieved average outcomes of that order for long periods in the 20th century. If we accept that the target could slide up to 3-4 per cent, to match actual inflation, how long would it be before we were debating 4-5 per cent as a goal? If the analysis of the economy that we have set out is correct – that overall demand has been growing faster than can be sustained – it would not be long. Ongoing demand growth above sustainable rates would not mean steady inflation at a higher level, it would mean a continuing increase in inflation. If that is the situation, then demand has to be curtailed to stabilise inflation at any level. Revising the target higher would provide only very temporary respite from the measures needed to control inflation, unless we were prepared to revise it higher every year. Furthermore, the argument that we could accept a higher trend inflation rate ignores how much the structure of the economy has adapted – in good ways – to “two point something” inflation. The structure of nominal interest rates, to name just one thing, has been predicated on that being the medium term anchor. If that anchor were allowed to drag, higher average interest rates in the future would be the result. This is a result amply demonstrated in history: the surest way to higher average interest rates is to accept higher inflation. To put it simply, if the community wants sustainably low interest rates, we should choose a low inflation target, not a high one. So accepting a rise in trend inflation because of the short term moderation in demand growth needed to contain a pick up in prices would be a very short sighted policy. It would very likely condemn us to a repeat of the problems of the late 1960s and 1970s, when we mistakenly thought we could live with a bit more inflation, and all the attendant difficulty we had in the 1980s in fixing the inflation problem, all over again. It is far better to resist rising inflation now. Arguments about monetary policy I turn now to arguments about monetary policy and inflation. The first one that I want to address is the assertion that monetary policy, in adjusting interest rates, is ineffective in controlling prices, because it is failing to restrain demand. More than once I have seen people state that the rises in interest rates seemed not to make much difference. But if it were really true that the sequence of adjustments that took place to raise the cash rate from its low of 4.25 per cent in 2001 to 7.25 per cent today made no difference to the economy or inflation, it would follow that we could reduce the cash rate by 300 basis points tomorrow and nothing would change. If we put it like that, surely not many people could seriously believe that the changes to interest rates have made no difference. More realistically, people might think that it is the changes in rates that matter, more than the level, and that the changes were too small. In this view, interest rate changes should perhaps have been bigger, so as to give more of a “shock” to behaviour on each occasion (though they should presumably also have been less frequent – otherwise the level of rates we would have reached would have been much higher). I suppose it is possible that a different sequence of changes, including some bigger ones, would have changed behaviour in the economy. We cannot know because that alternative scenario cannot be run, but as everyone knows, the Board has on occasion in the recent past considered larger movements. So the idea of larger changes is not absurd. Yet it is hardly as though interest rate changes were so small that no one noticed. There are few issues reported at more length than interest rates; no one could say they were unaware of what was happening. Beginning with the March 2005 rate change, moreover, the extent of coverage in the media has been far more intense than it had been prior to then, and far more intense than is the case in other comparable countries. We could debate the reasons for that, but they do not matter for present purposes. On every one of those occasions, there was no shortage of dramatic media coverage, and no shortage of predictions of serious consequences for indebted households, the economy and so on. If we were looking for announcement effects, surely they should have been at work through this period. My own view is that monetary policy is most effective when actions are seen to be consistent with the factual evidence available on the economy, a sensible assessment about future risks, and a framework that has a clear medium term objective for policy. Apart from that, we have to accept that the likely effect of any one move of 25 or even 50 basis points is, while uncertain, probably only modest. It is the combination of changes, and more particularly the level reached, that will do most of the work. A second version of the “ineffectiveness” argument holds that (1) the price rises are coming from factors beyond the control of any Australian policy, and particularly from abroad, from which it follows that (2) monetary policy cannot do anything about them. For some people, it follows that it is therefore (3) futile, and unnecessarily disruptive, to try. I have already addressed the question of whether all the price rises can be put down to a few special factors, obviously not under our control. The fact is that the price rises are broader than that. But even if all the initial impetus for higher prices comes from events abroad, we still have to decide how we will respond to that shock. In the case of energy prices, while the world price of oil in US dollars certainly is completely outside our control, it is the Australian dollar price of oil that actually matters for the Australian motorist. That price is lower at present than it might have been, because of the rise in the exchange rate. Insofar as interest rates have a bearing on the exchange rate, they can affect petrol prices, indirectly, and have done so. Looking across the economy more generally, we can all see that the main external event of recent years is the rise in the terms of trade, which is obviously completely exogenous as far as Australia is concerned. But higher resource prices generate additional income, which then affects demand for goods and services at home. That is expansionary, and puts pressure on prices for non traded goods and services. Even though monetary policy cannot stop the initial shock – of course we cannot stop the Chinese demand for resources – we can, and should, seek to condition the economy’s subsequent response to that shock, rather than simply letting domestic overheating go unchecked. Tighter policy will dampen domestic demand and contain the pick up in non traded prices as well as raising the exchange rate, which makes imports cheaper, exports less competitive and fosters a move of productive resources into the parts of the economy where more production is needed. That is an appropriate form of adjustment to such a shock, particularly if the shock is likely to be fairly persistent. So even when events beyond our control occur to put pressure on prices, we should still respond, and that response can be quite effective. Another line of argument takes quite a different tack. It argues not that monetary policy is ineffective, but in fact that it makes the problem worse by actually raising prices. The logic here is that interest payments are a cost to business activity, and that raising this cost will simply result in businesses passing it on. It is obviously true that interest is a cost, and for a business to stay solvent it has to cover that along with its other costs in its selling price. But when interest rates rise, can business just pass this cost on without losing sales? It might be possible initially, but since higher interest rates do eventually slow demand, it will get more difficult to raise prices in due course. So when some people say that higher rates will just push up prices, I think the answer is that it is the strength of demand that allows that, and the rise in interest rates will, in time, dampen demand. All the historical evidence is that monetary policy is quite effective in that regard. I turn now to other arguments, not that monetary policy is ineffective, but that it is not terribly precise. One common expression is that it is a blunt instrument. People rarely define what they mean by that term, but I think they have in mind two things. First, if inflation is rising because particular prices are moving a lot, monetary policy cannot focus precisely on exactly those particular prices, or those particular features of economic behaviour causing the price rises. It is a general, rather than specific, instrument in that sense. Second, I think that when people say “blunt”, they mean “unfair” – particularly that when interest rates rise, this affects households who owe money on a home loan. (Presumably the same argument would mean that it is equally unfair to savers to put interest rates down when the economy is weak.) As I noted before, it is not actually true that the recent rise in inflation is confined to just a few items. To that extent, the use of a general instrument would seem quite appropriate. But there are also a couple of other quite important points to make in regard to the “blunt instrument” critique. The first is that the transmission channels for monetary policy are much wider than just the impacts on households with home loans. Most businesses have debts, too. 2 Floating rate debt costs more for them to service as interest rates rise, which presumably causes some of them to reconsider some things they might have been doing or planning. So the “cash flow” channel of monetary policy affects business. Monetary policy also affects what economists would call inter temporal decision making. Incentives to save, as opposed to consume, alter. It is commonly observed that many Australians save rather little, but the household saving rate has in fact risen noticeably in recent years, largely unnoticed by conventional opinion. I do not claim that the increase is mainly due to rising interest rates, but I do not think we should assume that these incentives do not matter. Despite Australia’s extensive use of foreign saving to build up our economy, the bulk of our productive investment is financed via domestic saving of one form or another. Changes in interest rates affect asset values over time, through effects on discount rates, expected earnings growth and so on. These feed through into behaviour in several dimensions – via the cost of capital to firms, wealth effects and so on. Through complex channels, monetary policy can sometimes also affect the non price terms of credit, particularly if it manages to affect expectations about future growth, creditworthiness and risk appetite. Then there is the exchange rate, as I have already mentioned. Numerous factors affect exchange rates, and the relationships are hard to pin down. However, interest rate About 35 per cent of households owe money on their home. If we include debts of all kind, closer to 70 per cent of households carry debt of some kind, though many of these other debts are relatively small. differentials between countries do matter to exchange rates, along with expectations about how those differentials may change (a function of growth expectations), factors affecting trade positions (such as commodity prices in our case), investor risk preferences and so on. I have already discussed the case of petrol, but there is surely little doubt that the prices of tradable goods and services generally are lower today than they would have been if the exchange rate had been at its long run average level. This is the case even with much more muted short term pass through of exchange rate changes than we used to have. In other words, changes in the exchange rate alter the terms at which the rest of the world supplies goods and services to Australia in a way that is stabilising for prices. All these are channels for monetary policy’s effects. They operate at different speeds, and to differing extents in different episodes – but they are all there, and I would say that they are all working at present. The transmission of monetary policy is not just about home loan rates, as important a channel as that is. Secondly, to say monetary policy is a blunt instrument begs the question: where are the sharp instruments? It is not obvious that there are all that many. People mention supply side reforms of various kinds and unquestionably these have been extremely important over the years. To the extent that more can be done, that is all to the good for Australians’ standard of living. But they are long term. It is hard to deploy them in a hurry. And many of them are very general – “blunt” even – rather than specific. Many people will appeal, perhaps not unreasonably, to the possibility of using fiscal policy to counter inflation pressure. For some time now, fiscal policy has not been actively deployed to manage the business cycle. The focus has mainly been on achieving and then maintaining a structurally sound, long run fiscal position and, subject to that, making tax and spending decisions aimed at various other objectives that governments have. This does not preclude allowing the budget’s “automatic stabilisers” to operate over the cycle (though it might be observed that, with an elongated upswing like the one we have been having, it is getting more difficult to decide what should be thought of as a temporary rise in revenue and what can be assumed to be permanent). It strikes me that in the popular discussion about fiscal policy, many participants talk past each other because they are looking at different time dimensions. It is not unreasonable to say that if the budget is perpetually in surplus, there is no debt to speak of and no other looming large unfunded liability, taxes should probably, over some long run horizon, be lower. This, it seems to me, is the economic case for structural reductions in taxes, which some observers articulate. Others argue that such reductions should be delayed, for cyclical reasons, given that demand needs to slow to contain inflation. So there is a structural case for taxes to fall, and a cyclical case for them not to. It is no doubt difficult for any government to reconcile these two, equally valid, points of view, the more so if the same tension persists for a number of consecutive years. Leaving that aside, let us give some thought to just how effective an instrument budgetary policy is likely to be. If inflationary pressures were just due to specific, narrow issues (which, as is clear above, I doubt), precise targeting of the sources of inflationary pressure via tax and spending measures could nonetheless be exceedingly difficult at a technical level, let alone politically. If it is accepted, on the other hand, that inflation is sufficiently general that overall demand has to slow, the amount of slowing has to be the same regardless of whether it comes via monetary policy or fiscal policy. It would be somewhat differently distributed across sectors and regions, as the impact of interest rate and exchange rate effects obviously would not overlap exactly with the tax or spending measures that would occur in their place. I would hazard a guess, though, that a good many people who are today paying higher interest rates would instead pay higher taxes in a world where fiscal policy was used more actively to manage the business cycle. We are unlikely, I submit, to witness a situation where income taxes are raised only for those without home loans, or only for those living in Western Australia and Queensland, or those working in the mining sector. Then there are the time lags in implementing fiscal measures. The Budget occurs once a year, and has a very long and gruelling process in the lead up. I am not expecting to be stampeded by people in this room wishing to do that more often. The economy could conceivably look rather different in mid May when the Budget occurs than it did when the budget processes began, and different again by the time the measures actually take effect. Monetary policy has its full effects with a long lag, but we at least get to reconsider each month, and if need be we can reverse direction quickly. Don’t get me wrong. I am not arguing that fiscal policy does not matter to the cyclical outcomes, or that fiscal policy should not be made with an eye to the cycle as well as to the structural position. To the extent it can be, of course that is welcome. I am not here to offer any particular suggestion on what fiscal policy should do at present. I am simply saying that the task of fine tuning fiscal policy for stabilisation purposes, if that were thought desirable, is unlikely to be any more straightforward than that of using monetary policy. Fiscal policy, in its own way and for its own reasons, is also likely to prove a fairly blunt instrument. Inevitably, even with fiscal policy ideally calibrated for the conjunctural position, monetary policy would still have a lot of work to do managing inflation. Broader perspective The above remarks address some reservations about the conduct of monetary policy that I have seen of late. Some of these reservations are understandable, but there are reasonable responses to them. It should also be observed that it is not the first time we have seen most of these arguments: they tend to recur each time we reach the top end of the inflation cycle and monetary policy has to control it. Having said all that, it is important to keep some perspective about the situation in which we find ourselves. We have been living through one of the largest transformations in the structure of the global economy, as far as Australia is concerned, for a century. The rise in the terms of trade over the past five years is the biggest such event since the Korean War boom in the early 1950s. But while the Korean War event was a temporary one, all the indications are that the rise of China is not just a cyclical event, but a structural change of the first order. China certainly has a business cycle, like all other economies, and will slow at some point. Even so, it is highly likely that, short of some catastrophic event, China has many years of strong growth still ahead. It will not be at the 11 per cent per annum pace of the past couple of years, and there will be periods of weakness and instability. But the rise of China is not a flash in the pan of economic history. In essence, we are seeing a very large change in relative prices in the world economy, and a relative price change that is more important to Australia, in particular, than to almost any other country. These sorts of events will always produce stresses and strains, including significant divergences in performance across industries and regions (though these are often exaggerated in popular discussion). Because the event is, overall, very expansionary, it was always likely to be associated with some risk of higher inflation. But given the magnitude of the shock, when all is said and done, the economy has coped pretty well so far. Yes, inflation has risen. This is a problem, and requires a suitable response from monetary policy. But compare the outcomes on this occasion with those in the commodity price booms of the early 1950s or the mid 1970s. In the early 1950s, CPI inflation reached 25 per cent, then fell back to zero within a few years, associated with quite a pronounced recession. In the mid 1970s, inflation reached about 18 per cent, and took a very long time to come down to acceptable levels. This time, we are grappling with a peak CPI inflation rate that looks like it will be around 4 per cent in CPI terms, and trying to assess how soon it can reasonably return to 2-3 per cent. This is a far cry from the problems of yesteryear. The reason we are doing better this time around is not hard to fathom, either. As work in the Treasury has argued persuasively, a flexible exchange rate, a reformed and flexible industrial environment, better private sector management and much stronger fiscal and monetary policy frameworks have made a lot of difference. The fruits of those decades of effort of reform are an economy that, for all its strains, is doing well under the circumstances. The officers of the Treasury, past and present, have played a key role in achieving that. That legacy has been handed to you, and to all of us. Our challenge is to keep those improved structures in place and to develop them further, in the period in which we have the privilege of having some influence. | reserve bank of australia | 2,008 | 3 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Smart Capital 2008: The Euromoney Australian, Financial Markets Innovation Congress, Sydney, 27 March 2008. | Glenn Stevens: Recent financial developments Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Smart Capital 2008: The Euromoney Australian, Financial Markets Innovation Congress, Sydney, 27 March 2008. * * * Welcome to Sydney. It is a pleasure to be here to make some remarks at the opening of your conference. The opportunity this forum provides to exchange ideas and participate in vigorous discussions is undoubtedly valuable, not least at this particular juncture. The past nine months have certainly been a very challenging time in international financial markets. We have seen a significant reappraisal of certain categories of risk and considerable financial turbulence in key international markets. Economic prospects in the United States, in particular, have taken a significant turn for the worse. The extent of disengagement in some core markets, which hitherto had been thought to be extremely liquid and reliable, has been quite unsettling. The fact that your conference has a focus on innovation is apt as well. It will not have gone unnoticed that difficulties associated with some particular innovations of the past decade have been prominent in the recent period. It has been remarked by others that the complexity of some new instruments meant that they were not well enough understood by investors, and perhaps even by those promoting them. 1 Complexity is also the enemy of liquidity, which proved to be much less reliable than had been assumed. Perhaps future innovations will need to take account of the difficulty people inevitably have in grappling with complexity, and the dangers of illiquidity. In the end, though, human nature, with its propensity initially to underestimate risk in good times, then to over react when risk materialises, is probably a permanent feature of the landscape. I will organise my remarks today under three headings: How did we get here? Where are we now? And what policy issues arise for future consideration? I should be clear that my remarks are principally about global events. They are not directed towards the Australian financial system in particular. The local financial community has certainly been affected by the global turmoil but, on the whole, as the Reserve Bank’s Financial Stability Review being released later this morning sets out, is weathering the storm well. Profitability remains very strong and capital sound. There is very little direct exposure to the US sub prime problems, but the main reason for the resilience is many years of robust economic growth, sound regulatory foundations and prudent risk management. The Reserve Bank has been carefully monitoring access to funding, including offshore funding. We judge it to have been more than adequate, even if more expensive, though, of course, we will continue to watch the situation closely. But the centre of recent developments has been offshore, so my remarks today are about the global scene, not the Australian one, unless specifically noted. Background to the present international situation: how did we get here? Although the headlines of the past year have been dominated by stories about the sub prime loans in the US mortgage market, in fact the genesis of the problems was much earlier. For This observation has been made by many in the past year, including the Bank of England Governor, Mervyn King (http://www.bankofengland.co.uk/publications/speeches/2008/speech333.pdf and http://www.bankofengland.co.uk/publications/speeches/2007/speech324.pdf) and Federal Reserve Chairman, Ben Bernanke (http://www.federalreserve.gov/newsevents/speech/Bernanke20070515a.htm). much of the preceding decade, international capital markets were characterised by the search for yield. An excess of saving over investment in Asia was a feature, resulting partly from the reaction to the late 1990s crisis and the determination to avoid a repeat of it. The rapid growth of Chinese incomes and the lag between that trend and a corresponding rise in consumption was also a factor. These trends, associated as they were with a surplus of internationally tradeable goods and services, carried a degree of disinflationary impact for the rest of the world, which made strong growth in demand and low inflation easier to combine. They also lowered the marginal cost of financial capital in global markets. Somewhat later, oil rich nations also provided funds to the global economy and spurred on this search for yield, since mounting revenues from higher oil prices were invested rather than spent by governments that were now more fiscally conservative. In the major developed countries, interest rates at the short end were also lower than normal for a long period after the mild 2001 recession in some of the G7 countries, as monetary policies sought to manage the particular circumstances each country faced. This was associated with an unusually stable period for macroeconomic conditions. The “great moderation” in volatility of output and prices had been under way in the United States since the mid 1980s but it became more obvious in many other economies in the 1990s and 2000s. In my mind, there is little doubt that this lowered perceptions of risk, and indeed it is a fact that default rates on corporate debt, even sub investment grade debt, were unusually low through the past decade. They remain low even on the latest data, up to end 2007, though they will presumably rise somewhat over the next couple of years. In this environment, the search for yield continued. This saw end investors consciously begin to accept more risk in order to find the returns they were seeking. Additionally, the easy availability of credit and benign macroeconomic environment led to an increase in the use of leverage to increase returns further. It also provided the demand side backdrop for the development of new instruments. The innovative financial community obliged and provided ever more sophisticated ways of achieving the returns desired by investors. The innate complexity and, in some cases, opacity of these instruments made their properties hard to assess. With this reduced transparency, it was easy for investors to underestimate the risks that they were taking on. Observable compensation for risk declined over time, as evidenced by various market spreads, non price terms of loans and so on. This was something about which numerous prudential supervisors, central banks and private bankers commented on over some years. Eventually, something was going to occur that would trigger a reappraisal of risk. It is remarkable that this took so long. Over several years, we had a string of events that could have, and in other times surely would have, triggered a reassessment: prominent credit rating downgrades of some major US corporations to sub investment grade status; a default on foreign debt by Argentina, followed by rather rancorous negotiations over restructuring; political instability in several countries; a very large rise in the price of oil; significant tightening of US monetary policy up to 2006; the list goes on. Through all this, financial sentiment barely missed a beat. Then, in early 2007, the escalating losses on the 2006 vintage of US sub prime mortgages first started to come to light. It took some months for those losses to show up in certain hedge funds, structured investment vehicles and so on. But by July and August 2007, enough had emerged for there to be a marked change in sentiment. There is no need to give a detailed treatment here of subsequent events: they are well known, so it is enough to observe the broad outlines. As the scope of potential losses became clearer, the business models of some of the entities that were exposed came under pressure, particularly those which were reliant on short term wholesale funding and/or securitisation. Markets for asset backed commercial paper stopped the flow of new funding, and for a time were very reluctant to roll over existing funding for entities that were seen to have sub prime exposure. Much of the resulting funding pressure came back to the balance sheets of the major international banks and investment banks that had initially sponsored these entities. Essentially, they took the responsibility for funding sub prime assets. At the same time, these and other institutions found that a number of other markets had also become difficult to operate in. This saw them unable to shift loans originated from their balance sheets, even though these loans were unrelated to the US sub prime mortgage market – for example, loans associated with merger and acquisition activity. In this climate of uncertainty over both credit exposures and funding needs, funding liquidity pressures became acute on occasion during the second half of 2007. Short term market yields became much less closely connected to the overnight rates that central banks typically control. Central banks responded by expanding the scope and scale of their routine market operations, adding additional liquidity, accepting a wider range of assets in their operations and expanding the maturity of their lending facilities. There were also some internationally coordinated actions to provide foreign currency funding under swaps between some of the major central banks. Practices have continued to evolve. The current international situation: where are we now? Over the recent period, disclosures of losses associated with various credit products have continued. Financial institutions and investors have continued to be wary of what credit losses may yet be unearthed. Institutions have generally made strong efforts to disclose exposures appropriately, but there are major difficulties in valuing the relevant assets, not least because some markets have effectively ceased to operate – so no price can be observed. It appears that some very high quality assets are valued at prices that embody extremely pessimistic assumptions about returns. Key segments of credit markets remain in difficulty. There have been few, if any, issues of mortgage backed securities in recent months, though the commercial paper markets have at least stopped contracting. It appears that the most highly rated corporate names can still access capital markets, but many corporates are approaching their banks for funding. Business credit provided by the banking system has accelerated in the United States over the period since mid 2007. This process of reintermediation is a very necessary one, if the flow of credit to the major economies is not to be seriously disrupted. For the time being, and perhaps for some time ahead, the financial intermediaries need to fill some of the gap that the capital markets have suddenly left. With this comes, of course, the need for those intermediaries to have adequate funding themselves – one obvious reason for the pressure on term funding costs. They will also need sufficient capital to take on the risks inherent in the lending, since capital markets apparently no longer wish to accept those risks. This is, in fact, a key element of the whole situation: more capital needed to be carried by the big international banks to support the risks they were taking, and that capital has to be found now. In addition, the risk capital that was available from markets is no longer there to the same extent. The intermediaries have found substantial capital over recent months. By curtailing share repurchases and reducing dividends, several intermediaries have generated some of the necessary capital internally. More crucial has been the fresh capital raised though selling stakes in their businesses to individuals, institutions and governments. 2 These deals, however, have been costly, leading to a significant dilution of the interests of their existing shareholders. Irrespective of this, with both these sources of capital, intermediaries have been able to maintain, and in some cases increase, their capital ratios – even when they Sovereign wealth funds have been particularly active in providing this fresh capital. They have reportedly provided at least half of the capital injected into these intermediaries in recent times, and acquired stakes in Citigroup, Morgan Stanley, Merrill Lynch and UBS. have reported significant losses. With this being the case, they have also, at least so far, been able to step in to fill the gap in corporate funding. In addition to reintermediation and the pursuit of new capital, we are seeing a significant process of de leveraging. Entities with high leverage and/or complex structures have come under significant pressure in recent months as share markets question their resilience, and lenders seek a reduction in risk. We have seen some notable cases of this in Australia, but they are merely a reflection of what is going on in the major markets of the world. Private equity firms, hedge funds and so on, all find the environment much less accommodating than was the case a year ago. This process of balance sheet contraction has been an additional further factor disrupting markets of late, as asset sales have to be absorbed under already skittish conditions. In the meantime, real savings are still flowing into pension funds, insurance companies and other institutional investment vehicles. This is genuine capital, seeking a productive use. But these investors appear to be taking a more cautious approach to risk, given the short term uncertainty over asset valuations. It is a fair bet that they have higher positions in cash – overnight or very short term highly rated securities – than would normally be the case. This is placed largely in banking systems, so the major intermediaries are, I expect, generally flush with very short term liabilities, even though longer term funding remains difficult. This means that these intermediaries may be undertaking more maturity transformation than they would ordinarily find comfortable. Increasingly, there are good quality assets at prices that would, in normal times, be very attractive. At some point, investors who are currently on the side lines will need to summon enough confidence to take up the opportunities for profitable exposure to risk. It is impossible to say when this will occur, but we can perhaps outline what the pre conditions are. Investors will want a reasonable level of confidence that the bulk of the losses in the most important institutions have been accounted for and disclosed, that remaining “excess” leverage has been essentially sorted out, and that any remaining downside risks to asset quality stemming from slowing growth in the major countries are manageable and within the set of normal parameter variation that their portfolios can cope with. Where to from here? Issues for policy makers This financial instability presents a difficult set of challenges for policy makers around the world. First, central banks have the obligation to maintain liquidity at the core of the system. In the face of repeated system wide surges in the demand for liquidity, they have accommodated that demand. They have also been prepared to lend at longer terms than usual, and deal with a broader range of counterparties in order to foster a little more confidence in the availability of funding beyond the very short term. The Federal Reserve has also facilitated the absorption of Bear Stearns by a stronger competitor, by being prepared to use assets from its own balance sheet in a collateral swap. This is, however, not a “bail out” – the shareholders and managers of Bear Stearns have lost a great deal of money, but the system will be stabilised. Turning to the Australian setting for a moment, in the Reserve Bank’s case, we have been prepared to increase the total amount of liquidity substantially, as required. We have widened the range of eligible collateral for repurchase agreements (we already had a pretty wide range of counterparties prior to last August). We have also been prepared to enter into repurchase agreements for six months and longer on occasion, given the pressure on market funding rates at that horizon. Even with that, however, the relationship between the cash rate (or, more correctly, the expected future cash rate) and rates on high quality private paper at a three to six month term is much looser at present than it has tended to be over recent years. This means that the cost to banks of raising funds in the market has moved independently of the overnight rate. The presumption that their lending rates would and should move only in line with the cash rate, which had arisen in an earlier period when all these rates were much more closely related, has not been a realistic one in the recent environment. Of course, in setting the cash rate, the Reserve Bank has taken account of these shifting relationships, just as it does shifts in other relationships in the monetary transmission mechanism. Returning now to the global scene, central banks are continually assessing the potential impact on economic activity and inflation from these events, as they evaluate monetary policy settings. In the United States, the Federal Reserve has responded to evident weakness in economic activity, and the risks posed by the possibility of a significant disruption to credit provision, by lowering overnight rates quickly. Elsewhere, policy makers are trying to assess the potential spillovers. The weak US economy and depreciating US dollar will have some impact via reduced trade in goods and services. But that channel is less important than the possibility of financial contagion from a set of forces not confined to the United States but affecting international capital and money markets generally. What complicates matters is that policy makers have to consider that possibility at a time when they are also confronted with a troubling level of inflation in a number of cases. Longer term, a number of issues arise that are the subject of intense work in the central banking and supervisory community. Arrangements for the provision of liquidity by central banks have been changing in response to the events of the past eight months, but it is likely that there will be continued discussion about whether further refinements might be sensible. These will include how to make arrangements sufficiently flexible and adaptive, including across borders, which may be needed given the globalised nature of markets. The discussion will also need to pay due regard to the potential for other consequences of changes to practice in this area, including the possibility that private entities become so confident that liquidity risk has effectively been removed that they end up taking more risk of other types. That could leave both themselves and their central banks in an awkward position at some point down the track. So in parallel with ongoing development of liquidity arrangements by central banks, there will need to be a focus in the supervisory community and the banks themselves on liquidity management. Conclusion International financial events over the past nine months have been a source of considerable instability. Risk that was always in the economic environment has belatedly been recognised. The ensuing process of assessing and disclosing losses, finding new capital and de leveraging has been very difficult. Matters have not been helped by the opacity and complexity of some of the financial instruments involved, and the associated problems in valuing them. For market participants and policy makers alike, this environment has been challenging indeed. Those of you in the markets are dealing with heightened volatility and uncertainty. Policy makers, meanwhile, are working hard to stabilise the present international situation. In some countries, especially the US, that involves being prepared to take measures quite aggressively, in an effort to avert a cumulative spiral of declining asset values and deteriorating creditworthiness feeding back on itself and doing great damage to the economy. In other countries, where financial strains are also occurring though not always to the same extent, it has thus far involved significant changes to liquidity management, while balancing the financial risks against other macroeconomic risks in an effort to foster long run stability. In all countries, though, policy makers are also keeping an eye out for the potential low probability, but high cost, downside events that could emerge. It looks as though the environment will remain quite challenging for us all for a while but the strength of the Australian financial system is, for Australia, a good basis for meeting the challenge. | reserve bank of australia | 2,008 | 3 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 4 April 2008. | Glenn Stevens: Reviewing the Australian economy’s performance Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 4 April 2008. * * * Mr Chairman, my colleagues and I are pleased to be able to appear before this newly re formed Standing Committee. I look forward to productive sessions with you over the life of this Parliament. I shall begin by reviewing the economy’s performance over the past year or so. I will then offer some comments about the current conjuncture, and some of the issues that we face in the period ahead. All this provides some context for our discussion about monetary policy. The Australian economy recorded another very strong year in 2007. Real GDP expanded by about 4 per cent. Growth in domestic final demand was even stronger, at over 5½ per cent. The rate of unemployment declined further, in the most recent readings reaching its lowest level since the mid 1970s. Indicators of capacity utilisation reached their highest levels for two decades, and firms continued to report considerable difficulty in expanding operations, due to shortages of suitable staff. These outcomes for demand and output growth exceeded those in either of the preceding two years, and were stronger than was expected a year ago, particularly in the case of domestic demand. In explaining these trends, a noteworthy factor is that the global economy continued to offer a very supportive environment for Australia, notwithstanding the evident deterioration in the United States and the serious disturbances in international capital markets in the latter part of the year. The cumulative impact of the very large rise in Australia’s terms of trade over a number of years continued to flow through the economy. Very high levels of confidence in the business community saw robust growth, from already high levels, in capital spending. This was most pronounced in the resources sector, which is not surprising given the level of demand and the record prices being paid for its output, but the strength was not confined to that sector. To this was added the response of governments and associated enterprises to the need for upgrades to public infrastructure and other demands, which saw public final spending rise at about twice its trend pace over the course of 2007. Finally, consumer demand also rose at a pace well above average, fed by a rate of growth of real household disposable income as high as anything seen in the past 20 years. The only major expenditure aggregate that was on the soft side was dwelling investment. While there continue to be differences in the degree of overall strength of the economy by region, those differences, if anything, narrowed during 2007. Unemployment rates in the big south eastern states, for example, were at generational lows on the most recent reading. The pace of demand growth in 2007 well and truly exceeded any plausible estimate of the rate of growth of the economy’s supply potential. Under these demand conditions, inflation increased. Having apparently moderated a little late in 2006 and early 2007, it began to show higher readings around the middle of 2007 and by the end of the year had reached about 3½ per cent in underlying terms. Measured by the CPI, the year ended inflation rate was 3 per cent, but as is well understood, the next figure is likely to be around 4 per cent. Faced with this combination – very strong demand growth in what was already a pretty fully employed economy, and inflation moving higher – the Reserve Bank Board, when discharging its monetary policy duties, could draw no other conclusion than that growth in demand needed to slow. The Board had tightened monetary policy on three occasions during 2006. It then stayed its hand for a period in the first half of 2007, as inflation results available at that time suggested some moderation. But as the trends of 2007 and the likely risk they posed to longer run performance emerged, the Board tightened policy further during the second half of the year and in the early months of this year. The cash rate was raised on a total of four occasions, with the aim of achieving a moderation in demand, which is an obvious necessary condition for reducing inflation over time. In reaching these decisions, the Board naturally took careful account of the unfolding events in global financial markets. I will not recount the details of those events again now – I and many others have talked at length about them before. I am sure we will return to them in question time. As a daily participant in financial markets, the Reserve Bank was in a position to observe developments very closely. Our senior officers have been in frequent contact with all the significant financial institutions operating in Australian markets, with our colleagues at APRA and other regulatory agencies, and with our counterparts abroad. The RBA Board spent considerable time at its meetings examining market developments and considering their possible implications. The RBA responded to the unusual demand for liquidity on a number of occasions, and made early changes to its practices for open market operations to accommodate dealing in a wider range of assets and over longer terms. These market pressures were, and remain, overwhelmingly a flow on of international forces. They were not mainly a result of local factors. But it is appropriate, in our judgment, to foster confidence to the extent we can during periods of global stress such as we have been experiencing. Despite those actions, a financial system such as ours cannot be entirely insulated from these global events and, inevitably, the Australian financial system has been affected to some extent. The rise in the wholesale cost of term funding has meant that many non bank and some bank lenders have had to slow the growth of their businesses. The closure, more or less, of securitisation markets for the time being also has made life much more difficult for those lenders which relied heavily on that avenue of funding. Capital market raisings are much more difficult for some corporates as well, and many of these entities are turning to their bankers. By and large, the major banking institutions have been able to provide support for sound borrowers, and have stepped into the gap left by the withdrawal of funding from the capital markets. They have been able to do this because of their own balance sheet strength, something which is clear from the analysis in the Bank’s recently released Financial Stability Review. While some of their customers have been excluded from capital markets of late, banks have themselves been able to access segments of the capital markets in sufficient quantity to keep their balance sheets expanding. This has come at a time when wholesale funding costs have been rising by more than the official cash rate, and that has been passed on to end borrowers, while conditions on lending for some borrowers have tightened in response to higher perceived risk. But this outcome is preferable to the alternative of lending drying up. At present, the international environment remains very difficult. The US economy is experiencing very subdued conditions, as the weakness that had for some time been confined to the housing sector has spread to other areas over recent months. Losses incurred by major international financial institutions associated with previous risky lending have continued to come to light, even during this week. Valuing certain classes of assets remains very difficult and some quite sound assets appear to be priced currently at less than their likely underlying value. A process of deleveraging is continuing among hedge funds and other complex financial vehicles, as the retreat from risk by their lenders forces a winding in of positions. While all this has been occurring, participants in financial markets have understandably remained very nervous, and day to day volatility in a range of markets has been much higher than participants had become accustomed to over recent years. In the meantime, real savings are still flowing into the accounts of institutional investors – pension/superannuation funds, insurance companies and so on. Given the present level of uncertainty, those responsible for investing these funds are remaining very cautious, fearing further write offs by the large international banks and declines in asset values. Hence, they are sticking to very large positions in very short term liquid investments. There is little appetite just now to commit funds to more risky or longer term uses. The normal functioning of capital markets can really resume only when these sorts of investors regain the confidence to make those commitments. As a result, the outlook for the United States, where credit concerns are most acute, where capital markets are most important for the flow of credit, and where house prices are falling, is for weakness in the near term, and most forecasters have been revising down their numbers for 2008. Considerable stimulus has been applied by the US authorities to this situation, with policy interest rates declining sharply and a fiscal stimulus package imminent. The US Federal Reserve has also taken some forceful actions to stabilise the financial system. Growth in the euro area appears to be moderating as well, though at this point not by as much as in the US, and the euro area authorities continue to express concerns about inflation. Japan’s economy is also weakening, partly as a result of international forces but also partly due to purely domestic events. Economic conditions in the rest of Asia, on the other hand, have continued to be quite solid. Growth in industrial production and exports has been strong in the first couple of months of 2008. Weaker US conditions are affecting Asian exports to that country, but to date exports to other countries have compensated for this. The Chinese economy, with its demand for natural resources, has continued to expand strongly. The impact of the global turmoil via financial linkages has affected share markets in the region, but there does not appear, so far, to have been any noticeable effect on the capacity or willingness of Asian banks to extend credit. In fact, domestic financial conditions in Asia remain quite expansionary, which is contributing to considerable strength in domestic demand. Inflation remains a concern in many of these countries and, if anything, that concern could be said to be growing. The net effect of all these forces is such that Australia’s trading partners as a group is likely to record below average growth in 2008, reflecting weak outcomes in the developed world, and slower but still pretty good growth in Asia. But at the same time, expected higher contract prices for coal and iron ore, which are about to take effect, will, all other things equal, lift Australia’s terms of trade by perhaps a further 15 per cent, adding some 2 to 3 per cent to national income over the next year or so. This expansionary impetus comes after the earlier rise of some 40 per cent over the previous five years. So the world economy presents some considerable cross currents for Australia. The biggest terms of trade boom for 50 years is coinciding with one of the most serious malfunctions in developed country capital markets for a long time. Looking to domestic conditions, most indicators of actual economic performance for the early part of 2008 have remained quite strong. Employment has been very robust, and survey based measures of actual business conditions have remained strong, even if off their late 2007 highs. We do think, however, that demand growth in Australia is now in the process of moderating. The demand for credit by households has also been weakening over recent months. Measures of confidence have declined. While those measures can provide false signals, our assessment is that a change in trend is occurring, and we are hearing that from businesses we talk to. A tightening in financial conditions, lower share prices and heightened concerns over the global financial problems will all have played a part in this change. The likely extent and persistence of this slowing in demand is quite uncertain, as these things usually are. There remain powerful conflicting forces at work, so we can expect that difficult issues for judgment will remain with us for some time. These are issues with which the RBA Board has to grapple. At its meeting this week, the Board reached the view that, for the time being, policy settings should remain unchanged. The current rate of inflation is clearly uncomfortably high, and were expectations of high ongoing inflation to take root, it would be even more difficult to reduce inflation again. Hence, policymakers are obliged to have in place a policy setting that represents a credible response to evident inflation pressures. But the significant tightening in financial conditions that has occurred since mid 2007 is a strong response. Short term interest rates are towards the top end of the range experienced during the low inflation period. The Board is also conscious that some non price tightening of credit conditions is probably occurring at the margin. These factors should be working to slow demand. There is at least some evidence that a moderation in demand is occurring. That, if it continues, should in due course act to slow prices. We will be receiving a round of prices data in a few weeks’ time, which will afford another chance to review both recent performance and the outlook. As I noted earlier, the headline CPI rate is likely to be high. We will naturally examine the outcome for new insights about the extent of inflation currently occurring. But as well as that, it will be important to make continuing assessments of the extent both of the likely moderation in demand and its effect on inflation over time. This will by no means be an easy balance to strike. But if, by restraining demand for a while, we can secure a gradual reduction in inflation over the period ahead, then an important foundation of Australia’s good macroeconomic performance over the past decade and a half will remain in place. That, in turn, will offer the prospect of good sustainable growth into the next decade. That is the goal of monetary policy. My colleagues and I are here to respond to your questions. | reserve bank of australia | 2,008 | 4 |
Text of the Seventh Annual Sir Leslie Melville Lecture, ANU-Toyota Public Lecture Series 2008 by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Australian National University, Canberra, 15 April 2008. | Glenn Stevens: Liquidity and the lender of last resort Text of the Seventh Annual Sir Leslie Melville Lecture, ANU-Toyota Public Lecture Series 2008 by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Australian National University, Canberra, 15 April 2008. I thank Vanessa Rayner for assistance in compiling this address. The original speech, which contains various links to the documents mentioned, can be found on the Reserve Bank of Australia’s website. * * * It is a great honour to be invited to deliver the Melville Lecture. Sir Leslie Melville is one of the revered father figures of the economics profession, and of central banking, in Australia. I cannot claim to have known him, or ever met him. But it does not take long in reading about his contribution to the economic life of the nation to see what a remarkable man he was. There are a number of people who have spoken eloquently of Melville’s life, including previous speakers in this series. I cannot improve on those words. The interested reader can do no better than to consult a number of biographical essays written by Selwyn Cornish, 1 Ian Macfarlane’s Inaugural Melville Lecture in 2002, and the first hand, and rather poignant, reminiscences in Ross Garnaut’s 2004 Lecture. My topic today is one that I think Melville would have been interested in, namely, the role of central banks as providers of liquidity and as lenders of last resort in times of crisis. I say “would”, because there is nothing about it in his writings that I have been able to uncover. Perhaps this is because in the 1930s depression there were few bank failures in comparison with that in the 1890s, and other macroeconomic issues were more to the fore. 2 But there was some discussion at the Commonwealth Bank during the 1930s about supporting other institutions. Melville must have seen at least some of that discussion though it would have been very early in his time there. By the mid 1940s, moreover, Melville was intimately involved in the international discussions that led to the establishment of the IMF, which in many respects was intended to address the same issues in an international setting. Had he been working in the circumstances in which we have lived recently, I am sure Melville would have been very engaged in discussion about the role of the central bank. So it seems an appropriate occasion on which to review our thinking on this important matter. With that assertion then, let me proceed. I shall begin with the question: what do we mean by liquidity? I will then talk about the role of the central bank in supplying it. I will then go on to talk about the role of lender of last resort, why we need it, and the complications that arise in carrying out this role in the modern era. Through all this, my motivating question is: what lessons do we draw from, and what new questions are to be asked as a result of, the events of 2007 and 2008 for the central bank’s role in managing liquidity for the system, and (perhaps) supplying it to individual entities? I wish to state clearly at the outset that these remarks are prompted by what we have observed internationally over the past year, not by anything at home. The Australian financial system remains in good shape, as set out in the Reserve Bank’s recent Financial Stability Review. Nothing said here should be taken as carrying any implication to the contrary. See Cornish (1993), Cornish (1999) and Cornish (2007) for essays. In contrast to the depression of the 1890s where 54 of the 64 deposit taking financial intermediaries were forced to shut their doors, there were only three financial institutions that suspended payments during the 1930s. See Fitz Gibbon and Gizycki (2001). Liquidity The term “liquidity” is widely used but rarely defined. Until quite recently, the noun “liquidity” was often found to be preceded by the adjective “excess”. That expression – “excess liquidity” – simply became shorthand, I think, for the low structure of global interest rates, the associated ease of obtaining credit and the tendency for leverage to rise. Of course, at a global level, that process is now in reverse. For my purposes today, it is important to be more specific. There are several senses in which the word is used. Transactional liquidity is the ability to buy and sell assets without significantly affecting the price. The market for government debt in most advanced countries is usually thought to be pretty liquid in this sense. Some other markets can be rather less liquid. In the recent turmoil, such transactional liquidity as there had been for many complex financial products disappeared very quickly. A second concept is funding liquidity, which is the ability of an intermediary to raise the necessary cash to fund, or continue to fund, its chosen set of assets. This sort of liquidity can also be pretty fickle. Over recent years, some firms’ business models had been based on the assumption they could obtain liquidity easily and cheaply in wholesale funding markets. These models ended up being quite vulnerable to a disruption in market conditions. In these cases, managers needed to be very nimble, and probably a bit lucky, to re engineer their model quickly enough when conditions changed abruptly. Some were not that lucky. The past year has re affirmed, contrary to some earlier predictions, the importance of the large core banks even in a world of more developed capital markets. Banks are a key source of funding liquidity for other institutions operating in financial markets – securitisation vehicles, structured investment vehicles (the so called SIVs), conduits, non bank intermediaries and so on. Funding pressures on those vehicles were quickly transmitted back to the core banks in numerous countries. When shocks to markets occur, it is therefore doubly important that banks be able to manage their own funding needs. In many instances, this proved to be more difficult over the past nine months than bankers had anticipated. Not surprisingly, the recent turmoil has prompted many calls for the regulatory community to devote more resources to ensuring that banks strengthen their liquidity management. The reviews under way will be most useful if they address liquidity issues under conditions of market disruption, when everyone is scrambling for liquidity, not just firm specific events. Regulators will also be reviewing arrangements to facilitate the smoother functioning of markets at the national and international levels. But there is another, rather important, sense in which the word “liquidity” is used, and in which I will use it today. Here I am referring to funds at the central bank – what we in Australia call exchange settlement funds, though they have differing names in various other countries. These balances are used by banks and other participants in the payments system to settle their obligations with each other and with the Reserve Bank. Individual institutions can borrow and lend these funds in the overnight market but, for the system as a whole, the only source of these funds is the central bank itself. 3 I turn now, therefore, to a discussion of central bank liquidity operations. Central bank liquidity operations In normal times, liquidity operations are pretty straightforward. The central bank forecasts the inflows to and outflows from the system resulting from its own transactions and transactions Of course, the way the central bank conducts its own operations will have an effect on market conditions more generally. To that extent, the central bank affects ‘liquidity’ in the broader senses as described above, though its influence, while powerful, is not the only one at work. by the government, and makes arrangements to offset these flows with new dealings that meet the system’s demand for cash at the price – the interest rate – thought to be appropriate for monetary policy purposes. On occasion, however, the private sector can experience considerable mood swings insofar as its demand for liquidity is concerned. Just this sort of thing happened at the beginning of August 2007 when, around the world, concerns about creditworthiness and general uncertainty in the wake of the US sub prime problems saw participants in money markets suddenly pull back. They became, individually, much less inclined to lend to others and much more keen to borrow and hoard funds, for fear of what might eventuate tomorrow. The upshot was that the system as a whole suddenly had a much higher demand for liquidity at the central bank than it had before. In the face of a sudden flight to liquidity like this, it is the central bank’s job to supply the necessary cash to meet the demand. This is a straightforward application of Bill Poole’s (1970) result that when the shocks are predominantly to the demand for money, the central bank best stabilises the economy (admittedly a pretty simple stylised economy in the model) by meeting that demand. Technically, that is achieved by exchanging cash for other assets, through open market operations. This should, in my view, occur elastically at a constant interest rate. 4 All of this assumes, though, that the private sector has enough assets that the central bank regards as being of acceptable quality to take onto its own balance sheet in exchange for the cash the private sector desires. The question then is how big a pool of such assets the financial system (and, by extension, individual institutions) should carry in normal times, and the extent to which central banks should be prepared to widen the eligibility criteria for its own operations under unusual circumstances. There is a big philosophical issue here, and it has come more into focus as a result of the recent financial turmoil. Central banks’ liquidity operations have traditionally been in a limited range of securities, often conducted with a select group of institutions, relying on them to “distribute” the liquidity to the rest of the system as needed. But capital markets have developed in ways never contemplated when those traditional approaches were established. It is much more likely than in the past that disturbances will originate in markets and involve counterparties which are several steps removed from the central bank’s traditional sphere of direct operation. How should central banks respond in this world? One approach, which has already been adopted to some extent by many central banks, is to widen the pool of eligible assets for central bank transactions – in effect liquefying more of the assets on the balance sheets of the intermediaries with which central banks already deal. This has been complemented by being prepared to deal with a broader range of institutions (the RBA was already prepared to deal with quite a wide range of counterparties even before the recent events). A more radical step, which some people (though no current central bankers, to my knowledge) have proposed, would be for the central bank to transact directly in the markets where the problems originated, addressing them “at source”. Willem Buiter and Anne Sibert (2007), for example, have proposed that central banks might be prepared to transact in instruments like Collateralised Debt Obligations – which have been at the core of the recent questions of liquidity and asset quality – in order to provide transactional liquidity. In our arrangements, the Reserve Bank ensures that, on a daily basis, that there are enough exchange settlement funds in the system as a whole to keep the interest rate for overnight loans in the money market – the ‘cash rate’ – at the level judged by the Reserve Bank Board to be appropriate for the economy’s macroeconomic circumstances. If the system, for some reason, needs more funds than before, that will quite quickly be accommodated through our standard procedures. These ideas raise significant questions. What would be the consequences were the entire balance sheets of a large set of institutions to, in effect, become highly liquid because any of the assets could be sold to the central bank at short notice (at a market price, assuming that could be determined, and a suitable over collateralisation of course)? One view is that this would be a good thing, because, for the private sector, holding large amounts of low yielding assets in order to guard against occasional spikes in liquidity preference is costly. Arguably, this cost is unnecessary since the central bank can provide liquidity to the system on those occasions as needed, at little cost, against any asset it deems suitable. On this view, a reduction in “unnecessary” holdings of low yielding liquid assets would lower costs of intermediation and result in a higher real capital stock, raising per capita income over time. But such ready provision of liquidity would trouble many people including, I suspect, most of my central banking forebears. An asset can be illiquid for several reasons, including genuine uncertainty about its underlying value. If private institutions took on additional liquidity risk, confident that the central bank would always help them out if liquidity conditions tightened, they could easily end up taking on more of these other risks as well. This would leave both them and the central bank in an awkward position at some future time should things take a turn for the worse. And for the central bank to act as a market maker of last resort in markets for more exotic instruments would be a very big step, potentially with many unforeseeable consequences. These are pretty big questions. I suspect that they will increasingly be debated over time. My own view, given what we know at present, is that in periods of particularly unusual market duress, central banks should be prepared to move beyond the normal scope of operations to provide liquidity against a broad range of assets and over a longer maturity than might normally be considered. There are two provisos. First, the central bank has to be able to make a reasonable valuation decision about the underlying asset, and take sufficient excess collateral (a “haircut”) to protect its own position. This probably rules out exotic instruments except under the most dire of circumstances. Second, a preparedness for forceful intervention in a crisis situation has to be balanced with some thinking about ways of restraining developments in the other direction when risk appetite is high. That, needless to say, is no easy matter. The “lender of last resort” Having talked about normal liquidity operations, we must then turn our attention to the role of lender of last resort, where the central bank lends to one specific entity, when no one else will. The first question is: why do we need it? The reason is the possibility – albeit a very remote one – that a panic could put overwhelming pressure on a perfectly sound institution that, though prudently managed, cannot possibly hold enough liquid assets to withstand the pressure unaided. Some entity has to be prepared to lend in such a situation if the market will not, otherwise the panic can imperil the institution concerned, and perhaps the financial system as well. 5 The notion has quite a history. The earliest use of the term seems to have been attributed to Sir Francis Baring, who in 1797 referred to the Bank of England as “the dernier resort”, able to provide funds to an entity when all other sources had been closed off. 6 Early writings on I should be clear here that I am not talking about the narrow role where central banks routinely provide funds to an institution that has had some operational snag and found itself short of funds at the end of the day. Such standing facilities operate routinely in most countries. We are really interested here in the much more taxing situation where the standing facility is not adequate. This is where the lender of last resort really has an important decision to make, about whether to lend and, if so, on what terms. See Humphrey and Keleher (1984), p. 79. the idea came from Henry Thornton (1802) and Walter Bagehot (1873). Thornton, writing in the late 18th and early 19th centuries, saw the Old Lady of Threadneedle Street as playing a stabilising role in times of crisis, to prevent a rapid reduction in credit caused by a shrinkage of the deposit base of the banking system. Bagehot’s classic Lombard Street appeared in 1873 with what has ever since been seen as the consummate statement of the responsibility of the lender of last resort. For Bagehot, it was clear that the Bank of England should lend substantial liquid resources on a secured basis to a financial institution that had reasonable asset quality (i.e. was solvent) but which faced short term funding difficulties. Bagehot’s dictum was “Lend freely against good collateral at a high rate of interest”. It is frequently quoted still, and has been referenced more often over the past year than for a long time. 7 The question is how to put it into practice. Even leaving aside the obvious potential difficulties in assessing solvency in real time, the Bagehot formula leaves open two important questions: • what is “good” collateral? and • what is an appropriate rate of interest? The collateral involved is not necessarily going to be the standard sort of liquid assets. By definition, much of that collateral may already have been used before the bank reached the point of needing a loan of last resort. So the assets in question are likely to be some part of the bank’s loan book, or some physical asset of the bank. Presumably it is “good” if it is priced at a value that could be realised if necessary under “normal” market conditions. But for some assets, valuations are notoriously difficult, especially in periods of economic and financial distress where there is a large amount of uncertainty about where market pricing might eventually settle. As for the interest rate, Bagehot’s formula is often invoked with reference to a “penalty rate”, even though he did not actually stipulate that. 8 It is customary to motivate the need for the penalty by pointing to moral hazard: the possibility that banks may behave imprudently if they expect to be “bailed out” inexpensively should they get into trouble. That is an important point. But how does one decide how much penalty is enough? Should it, like most penalties, be related to the extent of the misdemeanour? If the bank has just been incredibly unlucky, should the penalty be lighter than if it has been imprudent? Would we always be able to distinguish between those two cases? Clearly, since the intention is to keep the bank operating, the penalty should not be so big that it leaves the bank’s interest spread between assets and liabilities negative, since that would actually hasten insolvency. 9 Some aspects of the penalty are also likely to be non pecuniary for the institution per se, but nonetheless not ineffective. The price of official In Australia’s history, since Federation, there have been few instances where last resort support has been provided. The first was to the Primary Producers Bank by the Commonwealth Bank in 1931. The Reserve Bank also provided loans to three private banks in support of those banks’ efforts to provide funds to illiquid building societies in 1974 and 1979 (see Fitz-Gibbon and Gizycki (2001)). Some commentators associate Bagehot’s dictum with the application of a ‘penalty’ rate of interest. However, as Goodhart (1999) points out, Bagehot did not state that the interest rate necessarily needs to be above the market rate prevailing after the onset of the panic. While Bagehot insisted on a ‘high’ rate of interest, it seems that the only condition was that the interest rate be above the pre panic market rate. There is a case for it being relatively small, in fact, particularly if the ‘haircut’ taken on the collateral is large enough to reduce the risk to the central bank to a trivial size. Martin (2005) is in support of central banks providing last resort support at low interest rates if required. She concludes that one of the main reasons why Bagehot insisted on a imposing a high rate of interest was because England was operating under a gold standard at the time, and the Bank of England therefore had to ration overall liquidity. With this not a concern in today’s world, Martin argues that central banks should be able to provide last resort loans at relatively low interest rates if need be. assistance may, for example, involve the departure of the CEO, some other executives and some or all of the board, and losses for shareholders. Apart from these issues, other potential complications can be noted. One is disclosure. In almost all circumstances, disclosure is highly desirable: an informed market is a fair and efficient one. But the communications surrounding emergency liquidity assistance are critical in determining the chances of success. It would appear that it was information that the Bank of England was about to offer assistance to Northern Rock – which, objectively, should have strengthened its position compared with the alternative – that precipitated the queues in the streets. Wholesale lenders to that institution would have already known that it was under pressure, but the news of official assistance told retail depositors, in effect, there was a problem and they reacted accordingly. The design of the UK deposit insurance system may also have been a contributor, in that less than full insurance and the possibility of a delay in receiving insured funds can add to the incentive for a run. In this complex situation, the UK authorities found it difficult to stabilise things, until the government issued a strong guarantee of Northern Rock’s obligations. A final issue is the re financing of the last resort loan in the private sector once the situation has stabilised. If there is ongoing general market turmoil, as in the case in question, then it can be difficult for a private firm to replace the public funding at a price that allows the bank in question to remain viable. In such an instance, the government faces the choice between providing the institution with longer term support – either a long term loan or taking ownership – subsidising a takeover or closing it. In the UK case, Northern Rock is being taken into public ownership for a time. In the US, the takeover of Bear Stearns – which, of course, is not strictly a bank – by JPMorgan Chase is being assisted by a long term facility provided by the Federal Reserve, which carries some credit risk for the Fed. In each case, there is ongoing discussion about what value the previous shareholders can reasonably expect to get from the resolution. The prospect of legal action is, of course, a potential further complication. All this illustrates that the role of lender of last resort is actually quite challenging in the modern world. Thankfully, observations in the time series of large financial near failures are few, and recent ones have been in other countries. But when they do occur, it is important to learn as much as we can from them. Central banks and supervisory authorities around the world are seeking to do just that. No doubt very thorough evaluations and recommendations will appear in due course. At this point, I would summarise the general lessons from the recent events as follows. First, well designed regular facilities that allow adequate access to central bank liquidity in times of pressure – either generalised or firm specific – are helpful in avoiding the authorities finding themselves in the position of needing to contemplate the extension of a loan of last resort. Second, if firm specific assistance beyond the normal channels is required, the central bank has to have very quickly a clear idea of the solvency of the entity concerned, and of the quality of collateral available in order for the terms of any assistance to be set. A good deal of that information has to come from the prudential supervisor. Where that is not the central bank itself, this means that an effective relationship between the central bank and the supervisor is essential. Third, the government needs to be involved early on, for several reasons. Apart from the fact that it owns the central bank and would therefore ultimately carry any risk the central bank might take on in these transactions, there is a need for clear and consistent communication by all the authorities at an early stage. Further, any decision to extend support to an insolvent institution on systemic or national interest grounds would be one properly taken by a government under advice, not a central bank itself. Fourth, if support for an institution in difficulty were to turn out to be more than just temporary, the public sector would face difficult issues of how to structure that support. Any such support should, however, come at considerable cost to the private owners and managers of the troubled entity. Public sector support should not be used to “bail out” private shareholders or those who were responsible for running the troubled institution. Conclusion Australians have been observing the major financial events of the past year mainly from the sidelines. While there have been some pressures coming through to our system, the most dramatic outcomes have been offshore. We can, nonetheless, draw some conclusions from these events. We have learned, or perhaps re learned, a good deal about the nature of liquidity, markets and the role of central banks over the past year. One key lesson is the importance of liquidity in markets and to institutions, something that perhaps had not been emphasised as much as it should have been in regulation, where the emphasis has been very much on capital. We have further learned that, under conditions of great uncertainty, liquidity pressures can erupt in markets that had seldom been affected in the past. Central banks have responded quickly and flexibly to such events, but it has proven difficult to contain the pressures fully. Some quite important questions remain for the longer run, which central banks will be considering. A second lesson is the difficulty in resolving a problem with an individual institution under strained overall conditions. Bagehot’s formula provides only the most general of guidance; making it operational requires considerable judgement. If and when such an event comes, it tends to have its own unique elements and a particular set of circumstances as backdrop. Speed and flexibility in response are essential. So is consistent and early communication, since disclosure of support, if not managed very carefully, could turn out to make the situation worse rather than better. A third lesson is that a loan of last resort is, in the end, probably simply bridging finance while a takeover or major re structure of the recipient institution is organised. The recipient would very likely see a change in its business model, management, board and ownership structure. It could well require a pretty clear statement of temporary government support. All of this would need to be organised very quickly. To be in a position to help, central banks have to keep an ear closely tuned to market developments – a sceptical one in the years of good times, and a sensitive one in periods of duress. A very good working relationship with the prudential supervisor, where that is not the central bank, is also essential. This is the case in Australia. I am not sure exactly what Sir Leslie Melville might have made of these conclusions. But we know that he responded practically and effectively to the issues of his day, which were concentrated around the role of policies in preserving economic and financial stability. I imagine he would expect those of us in the field 70 years later to be equally practical in the light of the experiences of our own time. These demonstrate all too clearly that for all its apparent sophistication, the modern financial system still needs the occasional stabilising hand of a government and/or central bank. Melville would certainly have recognised that very quickly. To meet these challenges, we will need to continue to adapt our own thinking and practices. References Australian Financial System Inquiry (1981), Australian Financial System: Final Report of the Committee of Inquiry, (J Campbell, Chairman), Australian Government Publishing Service, Canberra. Bagehot, W. (1873), Lombard Street, A Description of the Money Market. Reprint, Smith, Elder & Co, London, 1912. Buiter, W. and A. Sibert (2007), “The Central Bank as a Market Maker of Last Resort: From Lender of Last Resort to Market Maker of Last Resort”, VoxEU.org Research Column. Available at http://www.voxeu.org/index.php?q=node/459. Cornish, S. (1993), “Sir Leslie Melville: An Interview”, Economic Record, 69(207), pp. 437457. Cornish, S. (1999), “Sir Leslie Melville: Keynesian or Pragmatist?”, History of Economics Review, 30, Summer, pp. 126-150. Cornish, S. (2007), “Sir Leslie Galfreid Melville”, in J.E. King (ed.), A Biographical Dictionary of Australian and New Zealand Economists, Edward Elgar Publishing, Cheltenham, pp. 187192. Fisher, C. and C. Kent (1999), “Two Depressions, One Banking Collapse”, Reserve Bank of Australia Research Discussion Paper No 1999-06. Available at http://www.rba.gov.au/PublicationsAndResearch/RDP/RDP1999-06.html. Fitz-Gibbon, B. and M. Gizycki (2001), “A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia”, Reserve Bank of Australia Research Discussion Paper No 2001-07. Available at http://www.rba.gov.au/PublicationsAndResearch/RDP/RDP2001-07.html. Garnaut, R. (2004), “The Boom of 1989 and Now”, Remarks to the Third Sir Leslie Melville Lecture, Canberra, 3 December. Goodhart, CAE. (1999), “Myths about the Lender of Last Resort”, in C. Goodhart and G. Illing (eds) (2002), Financial Crises, Contagion, and the Lender of Last Resort: A Reader, Oxford University Press, Oxford, pp. 227–248. Goodhart, CAE. (2008), “Liquidity and Money Market Operations”, Presentation to the London School of Economics, Financial Markets Group Conference on “The Regulatory Response to the Financial Crisis”, London, January. Available at http://fmg.lse.ac.uk/events/detail.php?mainid=1&eventid=2276&ecatid=319&termcode=LT. Humphrey, TM. and RE. Keleher (1984), “The Lender of Last Resort: A Historical Perspective”, in C. Goodhart and G. Illing (eds) (2002), Financial Crises, Contagion, and the Lender of Last Resort: A Reader, Oxford University Press, Oxford, pp. 73–108. Macfarlane, IJ. (2002), “Sir Leslie Melville: His Contribution to Central Banking in Australia”, Remarks to the Inaugural Sir Leslie Melville Lecture, Canberra, 22 March. Available at http://www.rba.gov.au/Speeches/2002/sp_gov_220302.html. Martin, A. (2005), “Reconciling Bagehot with the Fed’s Response to September 11”, Federal Reserve Bank of New York Staff Report No 217. Poole, W. (1970), “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model”, The Quarterly Journal of Economics, 84(2), pp. 197–216. Thornton, H. (1802), An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, Reprint, George Allen & Unwin Ltd, London, 1939. | reserve bank of australia | 2,008 | 4 |
Background notes for opening remarks by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, to the Senate Select Committee on Housing Affordability in Australia, Melbourne, 24 April 2008. | Ric Battellino: Housing affordability in Australia Background notes for opening remarks by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, to the Senate Select Committee on Housing Affordability in Australia, Melbourne, 24 April 2008. * * * The Reserve Bank is very pleased to have been invited to participate in this inquiry into housing affordability. The terms of reference of the Committee are wide-ranging and extend well beyond the areas in which the Reserve Bank has expertise. We will therefore limit our remarks to four areas – namely house prices, housing affordability, housing loan arrears and the rental market. The key points we would like to make are as follows: 1. The increase in house prices in Australia since the mid 1990s, while very large, has been part of a broad trend evident in most other developed economies. This suggests that the main forces that have underpinned this rise have been global in nature, rather than country-specific. 2. Traditional measures of housing affordability have declined since the mid 1990s. Specifically, housing loan repayments have risen strongly relative to incomes. The overwhelming factor that has led to this is the rise in house prices; mortgage interest rates in Australia are no higher today than in the mid 1990s, when housing was at its most affordable. 3. Despite the sharp fall in traditional measures of housing affordability, arrears rates on housing loans remain low by historical standards. To some extent, this is a sign of the extraordinary commitment of Australian households to meeting their housing loan repayments, even in the face of financial pressure. It is also the case, however, that for the household sector as a whole, rising levels of income have allowed households to devote a larger share of their income to housing repayments, while maintaining or even increasing their overall living standards. This has meant that, for many households, traditional benchmarks of affordability – such as the often-quoted 30 per cent rule – may now be somewhat dated. While the picture on arrears for the household sector as a whole is quite benign, there are nonetheless significant pockets in the community where the high price of housing is causing financial distress. 4. The rental market is currently very tight, with vacancy rates at low levels and rents rising quickly. This comes after a decade when rents increased by much less than the price of houses, causing rental yields to fall to levels that discouraged increases in the supply of rental properties. It is hard to avoid the conclusion that the rental market might have substantial further adjustment to undergo before rents stabilise. 1. House prices Since the mid 1990s, the median house price in Australia has risen by 180 per cent, compared with an increase of a little over 30 per cent in the CPI. This real increase in house prices can be seen in the orange line in Chart 1. You can see that the rise in house prices has been much faster than that in construction costs, so the implication is that most of the increase in house prices has been due to increases in the price of land. Chart 2 shows that all the major cities in Australia have experienced large increases in house prices, while Chart 3 shows that the increases have been reflected in both cities and country towns. In other words, the increases have been broadly spread across the country. Chart 4 shows that Australia has not been alone in experiencing this rapid rise in house prices. With very few exceptions, most developed countries have experienced a doubling or trebling of house prices since the mid 1990s. Two common elements in the countries that experienced rapid house price increases were financial innovation (which greatly increased the access of households to finance) and relatively low interest rates (which reduced the cost of finance). The latter is true not only for the official interest rates set by central banks, but for longer-term rates set in capital markets. While there has been much discussion about the causes of the low long-term interest rates, I think it is fair to say that the majority view is that it has reflected a global excess of desired saving over desired investment – i.e. the so-called savings glut. Put another way: With the amount of money that people wanted to save running ahead of the amount that people wanted to invest in physical assets, there was a strong incentive for the financial sector to find ways to issue more financial claims against the stock of existing investment. That, of course, is a recipe for rising asset prices. In our view, the widespread nature of the increases in house prices, which, as I have noted, have encompassed most major countries and virtually all parts of Australia, makes it hard to attribute them only to factors which have localised effect – e.g. land usage policies, taxes and transport arrangements. Rather, a big part of the increases over time is due to factors affecting demand and capacity to pay, such as increased household access to finance. Supply considerations are more likely to have affected prices on the edges of urban development. These areas, of course, are important for households at the entry level of the housing market. 2. Affordability The standard measures of housing affordability essentially try to measure housing loan repayments relative to household income. There are various measures in existence. The one shown in Chart 5 is calculated by the Reserve Bank. It measures the proportion of average household disposable income needed to cover repayments on a median-priced house (assuming a 20 per cent deposit and a 25-year loan). The broad picture is that this ratio is now much higher than it was in the mid 1990s, and only a little below what it was in the late 1980s. There are three factors that drive changes in this measure: house prices; household incomes; and interest rates. Chart 6 shows how these factors have changed in recent years. The top panel of the graph shows the ratio of median house prices to average annual household income. In the mid 1990s, house prices were around 3 times average annual income; by the end of the housing boom in late 2003, this ratio had risen to about 6. It then declined for a couple of years, as house prices stabilised while incomes grew, but more recently house prices have been rising at least as fast as incomes. Mortgage interest rates are plotted in the bottom panel. They have shown a couple of cycles over the period shown in the chart, rising in the late 1990s and again in recent years, but these cycles have taken place around a flat trend. Mortgage interest rates today are much the same as they were around 1996-1997. We are therefore left with the conclusion that the decline in measures of housing affordability since the mid 1990s is almost entirely due to the rise in house prices relative to incomes. 3. Arrears Housing loan arrears are the most tangible indicator of the extent to which households are getting into difficulty with their housing loans. The series for the proportion of loans for which repayments are in arrears by more than 90 days is shown in Chart 7. The key points worth noting about this chart are that: • While arrears rates rose somewhat between 2002 and 2006, they remain relatively low by historical standards, and in fact fell through much of 2007. • The arrears rate for loans on banks’ balance sheets is about 0.3 per cent, while that for securitised loans is about 0.6 per cent in total, or 0.4 per cent for prime mortgages. We estimate that there are around 15 000 households in Australia which are 90 days or more in arrears on their housing loan repayments. An additional 30 000 or so are between 30 days and 90 days in arrears. These are quite low numbers for a country the size of Australia. From a macroeconomic perspective, there do not appear to be any major problems here. Indeed, given the historically low level of unemployment, it would be surprising if there was a widespread problem with housing loan arrears at present. How do we square the relatively benign picture on arrears with the apparent sharp decline in housing affordability such as shown in Chart 5? The explanation largely lies in the fact that real incomes of Australian households have been rising quite strongly. This has allowed households to devote a larger proportion of their income to housing, while still maintaining their living standards more generally. For example, a typical household that in 1996 was devoting 30 per cent of its disposable income to debt servicing would today be able to devote 47 per cent of its disposable income to debt servicing while still having the same standard of living in terms of being able to buy other goods and services. This, broadly speaking, is the outcome that has occurred. It is not surprising, therefore, that some commentators who use a fixed benchmark for housing stress – such as housing repayments exceeding 30 per cent of income – are finding that more and more households are exceeding the benchmark. I should also point out that the 30 per cent benchmark is sometimes applied more loosely than was intended by those who initially proposed it. The benchmark dates back to work done for the Australian Government’s 1991/92 National Housing Strategy. That work recommended that 30 per cent of income be adopted for the maximum level of housing costs for households in the bottom 40 per cent of the income distribution.1 Some commentators have since begun to apply it to all households, including those with very high levels of residual income. More generally, the rise in real incomes since the early 1990s has substantially changed the basis on which the 30 per cent benchmark was calculated. While housing loan arrears for the country as a whole are quite low, there are some regions where the financial position of households is relatively tight. The pressures seem to be particularly concentrated in suburbs of western Sydney. Various measures point to financial pressures being more intense in this area: • First, arrears rates on housing loans in western Sydney are significantly higher than those in other parts of Sydney, or Australia more generally (Chart 8). • Second, suburbs in western Sydney feature prominently in lists of Australian regions with the highest proportions of households with relatively high debt-servicing ratios. Chart 9 is published by the ABS using data from the 2006 Census. It shows the proportion of households in each of the major regions of Sydney that is paying more than 30 per cent of gross income in housing costs (including rent). While, as I noted, there are some qualifications surrounding the significance of the 30 per cent benchmark, it is nonetheless the case that the proportion of households paying more than 30 per cent in housing costs is higher in areas of western Sydney than in other parts of the city. National Housing Strategy (1991), “The Affordability of Australian Housing”, National Housing Strategy Issues Paper No.2, p.7 • Chart 10 provides more detail on this. It shows the 15 regions across Australia that in 2006 had the highest proportion of owner-occupier households paying more than 30 per cent in debt servicing. Parts of western Sydney are again over-represented in this group. In the Canterbury-Bankstown region, for example, 49 per cent of households with housing debt were paying more than 30 per cent of their income in debt servicing. This compared with about 29 per cent for the Australia-wide average. In examining why the problems of housing affordability are more severe in western Sydney than in other parts of Australia, a few key features stand out: • First, the rise in house prices and the associated increase in turnover in this region came later than in the rest of Sydney, and the increase ended up being larger (Chart 11). An implication of this is that a higher proportion of households in this region bought towards the peak of the market. • Second, incomes in this region have on average grown more slowly than elsewhere. Over the decade to 2006, for example, median household income grew by an average rate of 3.7 per cent per annum in western Sydney, compared with 4.2 per cent in Sydney overall, and 5.0 per cent in Australia. In other words, the rise in house prices in western Sydney was less well supported by income growth than elsewhere. As an illustration of this, even in 2001, at the low point in the interest rate cycle, a relatively high proportion of households in this part of Sydney had high debtservice ratios. • Third, a disproportionately large share of the housing loans in this region was sourced from non-bank lenders. This may imply that a smaller proportion of the borrowers in the region met banks’ lending guidelines and/or that some of those marketing the non-bank loans arranged loans that were inappropriate for some people. The arrears rate on loans from non-bank lenders in this part of Sydney is running at three times that for loans on the major banks’ balance sheets. That said, it is still only about 1.5 per cent. This combination of outcomes created substantial financial pressures in this region after the housing boom ended in early 2004, as evidenced by the sharp rise in the arrears rate in the region over 2005 and 2006. Having said that, the situation appears to have stabilised in the past year, most likely due to rising income levels. 4. The rental market The rental market is currently very tight right around Australia: • Vacancy rates are very low, at less than 1½ per cent on average across Australia (Chart 12); and • Rents are rising quickly. In the past year, newly negotiated rents rose by about 13 per cent, while all rents outstanding (as measured in the CPI) rose by about 7 per cent (Chart 13). Why has this happened, and why isn’t more investment in rental housing taking place? To answer these questions, we need to look back to the start of the housing boom in the mid 1990s. At that point, commonly used measures of gross yields on rental properties were in the order of 5-6 per cent. Over the subsequent decade, rents rose much less than dwelling prices, so that rental yields fell to relatively low levels – about 3 to 4 per cent (Chart 14). During this period, investment continued to flow into rental properties, as investors anticipated that capital gains would more than compensate for the low yield. However, once it became clear that dwelling prices may no longer keep rising, the rental yield by itself was not sufficiently attractive to sustain the rate of investment, and the vacancy rate started to fall. Even though rents have been rising quickly recently, over the longer term the cost of renting has risen less than the cost of buying a home (Chart 15). The price signals are therefore pushing households towards renting. On the other hand, the price signals facing investors are not conducive to increasing the supply of rental properties, as yields remain low and the prospects of capital gains uncertain. It is hard to see how equilibrium can be restored to the market until rental yields return to more normal levels. One way for this to be achieved would be for house prices to rise more slowly than incomes and rents for a period. Measures that lower the cost of adding to supply of housing, particularly low-cost housing, would be helpful in aiding the transition process. This includes initiatives, such as that announced by the Australian Government in March, to help increase the supply of rental properties by giving tax subsidies to institutions investing in rental property. | reserve bank of australia | 2,008 | 4 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Inaugural Faculty of Economics and Business Alumni Dinner, University of Sydney, Sydney, 15 May 2008. | Glenn Stevens: The Australian economy – then and now Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Inaugural Faculty of Economics and Business Alumni Dinner, University of Sydney, Sydney, 15 May 2008. I thank Clare Noone for assistance. * * * Chancellor, Vice-Chancellor, Deputy Chancellor, Deputy Vice-Chancellors, Dean of the Faculty of Economics and Business, distinguished guests, ladies and gentlemen. I think the last time I was in this Hall may have been for my graduation. If not then, it was probably for an examination. Either way, tonight’s occasion is far more convivial and I thank the University for the invitation. One of my classmates of old suggested that a good topic for this conversation might be a comparison of the Australian economy of the late 1970s, when we were students, with that of today. The more I thought about that suggestion, the better it seemed and so that comparison is exactly what I propose to offer. In the moment-by-moment focus on the economic data, and all the wiggles and ticks up and down of this indicator or that, we can often neglect to stand back and look at the big picture. So let us rectify that for the next 25 minutes or so. The approach is to use charts and tables to compare two decades – the 1970s and the 2000s – so as to offer some perspectives on how things have changed and, perhaps, on how they are similar. Economic structure Table 1 gives a comparison of the structure of the economy by industry then and now. The two most striking changes are the decline in the share of output provided by manufacturing, and the rise in financial and business services. This trend has occurred in all developed countries. Agriculture is smaller than it was then, though 2007 was a drought year, which affects that comparison. Communication services have become more important. (The mobile phone was not invented in 1977, of course. What did students do between lectures, I wonder?) Mining is larger today, though not by much. Table 1: Structure of Australia’s Economy Share of GDP (per cent) Manufacturing 16.4 10.1 Financial, property and business services 12.4 19.5 Wholesale and retail trade 11.1 10.3 Education, health and community services 9.2 10.0 Utilities and transport 6.6 6.8 Construction 6.3 6.8 Mining 5.9 6.8 Government administration and defence 4.9 3.9 Rural 3.7 2.1 Communication services 0.7 2.7 Other 22.9 21.2 Source: ABS Beyond these shifts, not all that much has changed at the broad structural level. Australia even 30 years ago had quite a substantial services sector, and still does. But the opening up of Australia to international trade, as a result of the policies of tariff reform and product market liberalisation since the mid 1980s, has been a significant change (Graph 1). The change in our trade patterns has been substantial (Table 2). In the late 1970s, over 60 per cent of Australia’s trade was conducted with the United States, major European countries and Japan. While these countries continue to be important to Australia today, their share of Australia’s trade has fallen by a third and is now eclipsed by our trade with China and emerging east Asia. This feature reflects the growing importance of China and emerging east Asia more generally – together, their share of global GDP has trebled to almost 18 per cent since the end of the 1970s. Graph 1 Trade Share of Australian GDP* Percentage % % * Exports plus imports in ratio to GDP. Source: ABS Table 2: External Environment Share of Australia’s merchandise trade (per cent) Japan 26.9 14.3 Major European countries 20.5 16.3 United States 14.4 9.9 Other east Asia 8.5 29.5 China 1.3 14.3 Notes: Data for financial years. UK included in Major European countries. Source: ABS External influences on Australia are also reflected in our terms of trade (Graph 2). A key feature of the early 1970s was the spike in our terms of trade as supply disturbances pushed up world commodity prices. Today, rising commodity prices are again a feature of the global economy. However, this time around, much of the rise in our terms of trade appears likely to be more sustained, resting as it does on the demand arising from the long-term emergence of large economies like China and India. The more open economy today also means we are more exposed to these forces. In addition, the opening of the capital account in the early 1980s has led to a degree of integration of the Australian financial system with the world in a way which offers a much larger choice set to savers and investors. Graph 2 Terms of Trade 2005/06 = 100 Index Index Sources: ABS; RBA Macroeconomic trends My next set of comparisons is of major macroeconomic aggregates. The first is growth in real non-farm GDP. I use non-farm GDP simply because farm GDP can be highly volatile due to droughts and floods. That, as rural producers know only too well, has been a constant feature of the Australian experience. On average, growth in the economy in the two periods under review was very similar, at about 3.4 per cent (Graph 3). But there was a marked change in the middle of the 1970s. After a number of years of very rapid growth, the economy encountered much more adverse circumstances from 1974 onwards. That was true for most countries, though Australia’s relative performance on some metrics deteriorated. From 1975 to 1979, the average growth rate was a full percentage point lower than in the period from 1971 to 1974. The period was also noteworthy for the close proximity of two episodes of cyclical weakness, in 1974/75 and 1977. There was also a recession in the early 1980s. Graph 3 Real Non-Farm GDP Growth* Then and now; year-ended % % 4.0% 2.9% -2 % -2 % 3.4% -2 -2 * Average annual growth based on HP-filtered trend. Sources: ABS; RBA The current decade so far has seen average growth of 3.4 per cent, though the next couple of years will probably see growth noticeably lower than that. What is quite noticeable from the chart is the relative stability of growth in recent years, something that was a feature of the second half of the 1990s as well. This pattern was observed in many economies over the same period. Of course, the 1970s makes for a flattering benchmark in that it was the most unstable period in macroeconomic terms in the entire post-War period, so even average performance will look better than that. But, in fact, the period since the mid 1990s has been very stable by any standard. Those who have looked into this in detail have posited several possible contributing factors, including better macroeconomic policy frameworks, a wide range of microeconomic reforms in labour and product markets, and luck. The weak growth of the latter 1970s was associated with an upward trend in unemployment (Graph 4). From a low of 2 per cent in the early 1970s, it rose to about 5 per cent in the mid1970s recession, and then drifted higher over the remaining part of the decade. Similar trends were observed abroad. The big rise in real wages in the mid 1970s, part of which was exogenously imposed as a result of government policy at the time, also had a fair bit to do with higher unemployment. Graph 4 Unemployment Rate Then and now % % % % Source: ABS The trend in unemployment in the most recent decade has generally been downward. Following a rise of a percentage point in the economic slowdown in 2001, it has fallen to the lowest levels since the mid 1970s. The long expansion, with occasional temporary pauses, has done a lot to foster lower unemployment. But the changes in labour market arrangements over the past 20 years or so have also been very important. Indeed, I would argue that they are a key contributor, not least because they have facilitated the longer length of economic expansions. The difference in inflation rates between the two decades is particularly striking (Graph 5). Being a central banker I suppose I would say that, but I think it is too easy to forget the corrosive effect that high inflation had on the economy in those days. Until the mid 1960s, Australia had been a low-inflation country. The seeds of the 1970s inflation were sown in the latter part of the 1960s, they took root in the early 1970s and then the events of the early and mid 1970s pushed inflation up steeply. From the end of 1970 to the end of 1979, the average rise in the CPI was 10.7 per cent a year, which meant that the value of money fell by 60 per cent over that period. The peak inflation rate in any one year was 17.6 per cent, and the lowest achieved was just under 5 per cent. Graph 5 CPI Inflation Then and now; year-ended percentage change % % 10.7% % % 3.0% Source: ABS In contrast, the current decade shows a pretty flat line for inflation when put on the same scale as the 1970s. We still have our cyclical ups and downs, but the average rate has been 3.0 per cent since the beginning of 2001. Even with the recent surge in consumer prices taking the inflation rate to a bit over 4 per cent, things are not like they were in the 1970s. That’s just as well, of course, because with entrenched high inflation would come lots of distortions and wasted resources as people in the economy adjusted their behaviour to live with high inflation. One of the adjustments would be that savers would demand higher nominal interest rates, higher than the ones we currently see, to part with their money. So the period between about 1973 and 1983, when the economists of my generation were studying and then getting their first jobs as economists, was a pretty poor one for macroeconomic performance. The past decade, in contrast, has been much better. Once again, a more favourable international environment has been a factor there, but so have better economic policies. Let me turn, then, to economic policies. Macroeconomic policies When we were students, we were taught about the four arms of economic policy, which were fiscal, monetary, exchange rate and wages policies. We still have fiscal and monetary policy, about which I will say something in a moment. But by the early 1980s, enough people had accepted that you could not really choose the exchange rate and monetary policy settings independently. You either allowed financial conditions to adjust to whatever was dictated by a given exchange rate, or you set domestic financial conditions according to the needs of the economy and let the exchange rate adjust to that. The decision to float the exchange rate, made in 1983, was a decision to do the latter. Of course, there have been subsequent occasions when, via intervention, we have sought to influence the exchange rate, but they have been confined to fairly brief periods and have become less frequent as time has passed. Wages policy was important for the wrong reasons in the 1970s, in that government pushed up minimum wages too quickly for a while. In the 1980s, wages policies negotiated in the form of the Prices and Incomes Accord between the Hawke/Keating Governments and the ACTU were effective in containing wages growth and allowing some restoration of the share of national income accruing to profits. This did a lot to generate employment and growth. It seems unlikely that such a degree of influence over wages as an instrument of macroeconomic policy will return. These days, policies over industrial matters are more structural in nature, aimed at making arrangements in the labour market reasonably flexible, balancing economic efficiency and fairness, and providing a safety net for the lowest paid. So that leaves monetary and fiscal policy. When I was a student, furious debates had long been boiling away in the halls of academia over questions like: does money matter? Was monetary or fiscal policy more effective as a stabilisation tool? Was the apparent trade-off between inflation and unemployment, which appeared so tantalisingly in the data, something that could be exploited systematically, or would it prove ephemeral? Was discretion best in the conduct of monetary policy, or should some sort of rule be employed? The 1970s and early 1980s provided important real data and experience in the resolution of these questions. Friedman and Phelps had already long argued that there was no long-run trade-off and that attempts to reduce unemployment below some structural level by accepting higher inflation would simply result in accelerating inflation and no lasting gain on unemployment. The 1970s seemed to demonstrate that this was right. More strident derivatives of the Chicago tradition, however, which insisted that there was not even any short-term trade-off, were found to be wide of the mark. Money did seem to matter, since the big rise in inflation in the 1970s had been preceded by a large increase in money growth. A lot of people not only accepted that monetary quantities were the key thing to look at, but concluded that central banks had failed to control them, so that some sort of step away from unconstrained discretion towards monetary rules was advisable. As a result, targets for those quantities were adopted, including in Australia. That was the language of discussion when I was a student and when I first started work at the Reserve Bank in 1980. 1 These days, we have inflation targeting, an arrangement that provides a measure of constrained discretion to the central bank within a medium-term framework. It emphasises the control of inflation over time, but does not seek to fine-tune inflation over short periods. That allows a reasonable accommodation for trends in economic activity and employment over periods of a year or two, about which the Reserve Bank is required to have concern by its Charter as well as by common sense, but preserves the value of the currency over the long run. In the language of trade-offs, this system accepts there is a short-term growth/inflation trade-off, but also accepts there is no long-term one. Inflation targeting does not ignore financial quantities, but does not elevate them to the status of an intermediate target and does not see them as an instrument. Inflation targeting is not perfect and, on occasion, still leaves policy-makers with some quite difficult decisions to make. It is, however, the best system that has been devised as yet. The fiscal debate of the 1970s was dominated by the budget deficits of the period, and the need to reduce them. On contemporary figuring, the Commonwealth’s budget deficit reached about 4-5 per cent of GDP in the middle years of the decade. Using figures comparable to those in use today, which measure the underlying cash balance of the Commonwealth general government sector, the deficits of the mid 1970s amounted to only about 2 per cent of GDP (Graph 6). But until 1974, the Australian general government sector had recorded more or less continual significant surpluses, so the turn to deficit in 1975/76, for the first time since the early 1950s, was substantial and, at the time, quite controversial. Reducing the deficit in the sluggish economy of the late 1970s was hard. Deficits grew much larger in the recessions of the early 1980s and early 1990s. Australia’s success in using monetary targeting was mixed, as it was in most countries. The tools to exert control over those measures of money were not really available. The liberalisation of the 1980s solved these problems but also shifted the relationships between the monetary aggregates and the economy, which meant there was no confidence that hitting a monetary target would produce the outcomes we really wanted on inflation. In this environment, policy struggled for many years to unwind the rise in inflation of the 1970s. It was not decisively brought down until 1992, which was long after monetary targeting had been discontinued. Graph 6 Commonwealth Government Budget Balance Underlying cash balance, per cent of GDP % % -1 -1 -2 -2 -3 1970/71 1972/73 1974/75 1976/77 1978/79 -3 % % -1 -1 -2 -2 -3 2000/01 2002/03 2004/05 2006/07 -3 2008/09 Sources: ABS; Treasury Since 1997/98, in contrast, the federal budget has been in surplus continually, apart from a very small deficit in one year. The government’s net debt has been retired. Gross debt on issue is maintained at a small size in order to facilitate a functioning bond market so as to allow efficient risk pricing more generally. As with monetary policy, there is a medium-term framework for fiscal policy emphasising balance over the business cycle. There is much less inclination today than there once was to use fiscal policy as a counter-cyclical stabilisation tool. Significant fiscal challenges in the long-term include health spending and responding to population ageing, as the very important work by officers of the Australian Treasury has made clear. But there would be very few countries, if any, which would not envy Australia’s fiscal position. The capacity to respond, if need be, to developments in the future is virtually without peer. This seems light years from the situation in the late 1970s. I have said little here about the changes to microeconomic policies, which do so much to determine the economy’s supply-side responsiveness. That is because my field of interest and expertise is in the macro sphere. But these microeconomic changes were equally as important as the macro ones, maybe even more important. I mentioned the change in labour market policy, but this was accompanied by a host of other changes to factor markets (like financial liberalisation) and product markets (tariff reform, competition policies and so on). It is actually these policies that have done most to improve the living standards of Australians. The contrast between the Australian economy of 1977 – heavily regulated, suffering poor productivity growth, sheltering behind high barriers to foreign competition – and the much more open and productive one of today is striking. The teaching of economics The final comparison I offer is in the teaching of economics. Of course I do not sit in lectures or tutorials, so I am unable to judge whether or not the face-to-face teaching has changed since the late 1970s. But one interesting exercise is to compare the text books used today with those in the past. 2 I understand that at the University of Sydney a popular text is the I am indebted to Clare Noone for the suggestion of conducting this comparison. Australian Edition of Ben Bernanke’s Principles of Macroeconomics (co-authored with Robert Frank, with the Australian edition adapted by Nilss Olekans). When I studied macroeconomics in 1977, the text in use was Fred R. Glahe’s Macroeconomics, published in 1973. One interesting difference that is obvious immediately is the less formal layout. I think it is fair to describe Glahe’s text as rather formidable and austere, and perhaps not a particularly inviting read. In contrast, the book by Bernanke et al is much more welcoming, challenging students with thought-provoking questions and illustrations on how economic theory relates to tangible real world events. 3 Perhaps the less formal presentation style says something about how society has changed over the past three decades, but I think it also reflects an economic force at work, and that is competition. There is a proliferation of new macroeconomic textbooks, many by highly regarded economists. This competition seems to have spurred authors to try to produce the most appealing text for students and lecturers in order to capture market share. To the extent that these texts may help to cultivate an interest in economics, this has been a positive development. On content, both include discussion of the “money multiplier”, as an introduction to the theory of fractional reserve banking. I suppose students have to learn that, and it is easy to teach, but most practitioners find it to be a pretty unsatisfactory description of how the monetary and credit system actually works. In large part, this is because it ignores the role of financial prices in the process. 4 Bernanke et al do, however, discuss some aspects of financial markets, and I note that in the most recent US edition of the text this has expanded to cover asset prices, the diversification of risk and the role financial markets play in ensuring savings are allocated to their most productive uses. In the shadow of the current dislocation in global financial markets, this is obviously a pretty valuable addition to the curriculum. Ben Bernanke has also, of course, made major contributions to academic literature in these areas over the years. The 1970s book was full of discussion about monetarists versus Keynesians, and of shortrun and long-run Phillips curves. The later book confines them to a section called Lessons from the Past. 5 Whereas Glahe’s 1970s text makes extensive use of the IS-LM framework from Sir John Hicks’ exposition of “Mr Keynes and the Classics” in the 1930s, IS-LM per se does not rate a mention in the modern undergraduate text book. But perhaps the biggest difference is in the treatment of the open economy, exchange rates and so on. In Glahe’s 1973 book, the analysis is conducted entirely in a closed economy setting. The term “exchange rate” is not one that appears in the index. Today, even the United States sees itself as an open economy, and the Bernanke et al book treats the issue carefully and even contains some international comparisons of data. What do we take from all that? At the risk of offering a set of sweeping generalisations, I would observe, first, that some of the things which so preoccupied us in the 1970s about the role of monetary policy, the nature of trade-offs, both short and long term, between inflation and growth or unemployment have been regarded by the mainstream of the profession as Missing from the Australian edition is the set of pithy cartoons illustrating simple economic truths, which is a shame. For what it is worth, I think that the Wicksellian notion of the natural rate of return on capital, the market interest rate and the dynamics set in train by the differences between those two rates is one of the more useful analytical devices for understanding the modern economy with a private credit system. Wicksell wrote about it more than a century ago. (Knut Wicksell, Geldzins und Güterpreise: Eine Untersuchung über die den Tauschwert des Geldes bestimmenden Ursachen, 1898, published in English as Interest and Prices: A Study of the Causes Regulating the Value of Money, 1936.) Neither of these books covers that idea, though to be fair I learnt about that in my honours year, rather than in intermediate undergraduate macro courses. (I trust students today are still taught this at some point.) In fact, the most recent US edition of the text makes no explicit mention of these debates at all. pretty much settled. At least, they have been as settled as things ever get. It is to be hoped, of course, that we do not have to re-learn those lessons, which is why I have been making the case to resist inflation even though that is not comfortable or convenient in the short run. Second, the theory and practice of mainstream macroeconomics has become more international in focus. This trend will surely continue, in response to the course of events. Not only have the effects of bad loans to American home buyers had reverberations much further afield, but the rapidly growing size of the emerging world is affecting economic activity and prices far beyond their own borders. I would hazard a guess that the textbooks of 30 years from now (if we are still using books) will devote large slabs of material to that emergence, and to how well the “old industrial countries” adjusted to it. They will also, no doubt, cover the economics of climate change and its abatement at some length. Conclusion That is my thumb-nail sketch of the Australian economy, and economics generally, then and now. Of course, this is not a very rigorous treatment and many things have been omitted. But this is supposed to be a relaxed occasion. Re-reading some of the material, and looking at the data, takes one back. I should not mention many particular names, but Professor Warren Hogan, still active in developing policy thinking, was one figure of importance. Peter Groenewegen’s courses in the History of Economic Thought were memorable, as was the course in Economic Classics that he taught with Colin Simkin. Those courses introduced me and others to Smith, Ricardo and Wicksell, as well as to the then-standard fare of Keynesians and monetarists. And who among the honours classes of the late 1970s will forget the aroma of coffee brewing in the corner of Prof Simkin’s study, his desk clouded in cigarette smoke, the students sitting, terrified, waiting for the interrogation ahead about the use of Kakutani’s fixed point theorem to prove the existence of general equilibrium? Some things are harder than monetary policy! It was an enormous privilege to attend the University of Sydney, to have made some very good friends (whom I have still), and to have encountered some remarkable teachers who introduced us to the study of economics. It was marvellous to have been a part, however small and fleeting, of the life of this place three decades ago, and a great honour to have resumed that association in this way tonight. References Bernanke, B. and R. Frank (2007), Principles of Macroeconomics (3rd edition), McGrawHill/Irwin, Boston. Bernanke, B., N. Olekalns and R. Frank (2005), Principles of Macroeconomics (1st Australian edition), McGraw-Hill, Australia. Glahe, F. (1973), Macroeconomics Theory and Policy, Harcourt, Brace Jovanovich, New York. Wicksell, K. (1898), Geldzins und Güterpreise: Eine Untersuchung über die den Tauschwert des Geldes bestimmenden Ursachen. Jena: Gustav Fischer (tr., 1936: Interest and Prices: A Study of the Causes Regulating the Value of Money, London: Macmillan). | reserve bank of australia | 2,008 | 5 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce in Australia Business Luncheon, Melbourne, 13 June 2008. | Glenn Stevens: Economic conditions Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce in Australia Business Luncheon, Melbourne, 13 June 2008. * * * Thank you for the invitation to address you in Melbourne today. I read that AmCham is the largest international chamber of commerce operating in Australia, and has been working to promote trade, investment and general business links between the United States and Australia since 1961. Over that period of nearly five decades, the US and Australia have enjoyed a mutually beneficial trade relationship, enshrined most recently in the Free Trade Agreement. During that time, a lot of other shifts have occurred, of significance to us both. In 1961, nearly a quarter of Australian exports went to the United Kingdom, our number one trading partner. Trade with China was of inconsequential size. Japan had become a prominent destination for exports by then, but would go on to become by far our largest trading partner by the end of that decade, due to the expansion in the mining sector. In 2007, the UK was number six as a destination. The US was number three (little changed from 40 years earlier). China equalled Japan in first place for two way trade, and will easily outstrip Japan this year. Of course, the United States is still far and away the largest economy in the world, and will remain so for quite a while. Nonetheless, the change in the trade experience of Australia – and we are hardly alone in that – is an indicator of the way the weight in the world economy is gradually shifting to the Asian region. On the financial front, in contrast, Asia remains in many respects underdeveloped, especially in terms of the prominence of its local-currency capital markets. US capital markets remain the largest, deepest and most influential, driving developments in stock, bond and money markets, and their various derivative offshoots, around the world. That contrast – the increasing economic weight of Asia and the continuing dominance of American behaviour in financial markets – is in many ways at the centre of the set of challenges facing Australia, and I suspect other countries, right now. Before coming to that, however, it is fitting to begin with some remarks about the US economy. I will then talk about the global economy more broadly, and particularly the effects of the US slowdown on the rest of the world before focusing particularly on Australia and the current challenges of economic management that we face. The United States economy As you well know, the US economy is struggling with a period of weakness at present. Growth has slowed to a very subdued pace, and confidence is well down. There continues to be debate as to whether or not what we are witnessing can be called a recession. In some respects, this is a rather silly preoccupation because there is no doubt that conditions are weak, and it is not worth spilling much ink over whether the growth rate is just above or just below zero. That said, the US economy has, thus far, done a little better than many people had feared. Of course the episode is not yet over; a period of adjustment still lies ahead. The epicentre of this adjustment is the housing sector, where deteriorating lending standards and a speculative boom in parts of the country a few years ago led to a build-up of excess physical stock and over-stretched borrowers. Subsequently, the need to work off this overhang has seen construction rates for new homes fall by half, and prices for established homes in many major cities decline for the first time in many years. Rising defaults and foreclosures are likely to dampen prices further. The non-recourse nature of mortgages in some US states is potentially a destabilising factor as well, since even people who can service a loan have an incentive to walk away once their equity falls to zero. Tighter credit conditions are a dampening factor for the US economy more generally, as lenders work to limit risk in order to repair their own balance sheets. So the real question is when the preconditions for a renewed expansion will come into place. It is perhaps a bit soon to conclude that we have reached that point. There are certainly some helpful dynamics at work: the worst fears of a serious financial collapse have abated somewhat over the past couple of months, the process of balance sheet repair for key institutions is well under way, macroeconomic policies have been put into expansionary mode and initiatives to offer some modest support to the housing market are in train. Considerable uncertainty, nonetheless, surrounds the outlook for the United States over the next year or so. The global economy What is the effect of this on the rest of the world? In a previous response to this question, 1 I suggested that there are two key channels to consider. The first is trade spillovers, as the fall in US income means that the US demands less in the way of products from other countries. The decline in the US dollar also works in this direction. The second potential channel is financial contagion, with the possibility that other countries may experience the same financial dynamics as those which have been at work in the United States. My view was that this second channel was likely to be the more important one in this episode. The trade channel certainly is working – lower US demand is being felt in weaker exports to the United States from most parts of the world. But other forces are also at work, and the strength of some other regions has meant that many export-driven economies, certainly those in Asia, have continued to record quite solid growth into the early months of 2008. Some of these countries have also developed a good deal of momentum in domestic demand. So to date, trade per se has not been the major issue. But financial exposures to the problem assets were spread around the global system. Creditrelated losses that have been disclosed by financial institutions around the world to date amount to something approaching US$400 billion, of which about half is in institutions domiciled outside the United States. More losses reside in entities outside the core financial system. So the pressure on balance sheets arising from the decline in credit standards in the middle of the current decade has extended beyond the US itself, at least to Europe and the UK. Given the integrated nature of financial markets in the developed world, moreover, pressure on term borrowing costs for banks has been seen in many places over the past nine months, even if in a less acute way than observed in the countries at the centre of the crisis. These forces are contractionary in nature, and so global growth is widely expected to be lower in 2008 than the very strong result in 2007. According to the IMF, global GDP growth will moderate to about 3¾ per cent in 2008 and 2009, with slowing concentrated among the developed economies of North America, Europe and Japan. This forecast embodies a mild US recession during 2008. But while this outcome for global growth would be well below the exceptional pace of about 5 per cent seen in 2006 and 2007, it is actually in line with the average rate of growth for the world economy over the past 15 years. And although the IMF suggested in April that the short-term risks surrounding this forecast were concentrated on the downside, with a 25 per cent chance of global recession (which it defines to be global growth at or below 3 per cent), ‘Economic Prospects in 2008: An Antipodean http://www.rba.gov.au/Speeches/2008/sp_gov_190108.html). View’, January (available at recent developments do not suggest that those risks are any more likely to be realised than was the case a couple of months ago. To date, in fact, the financial developments that have so occupied the minds of developed world policy-makers have not been as big an issue for many countries in the emerging world, at least not those most important to Australia. Banks in those cases have not had serious funding problems, perhaps in part because their own exposures to the bad assets were minimal. Capital markets, which are less important as avenues of funding than in many developed economies, have not been a source of significant disruption. Admittedly, share markets in the emerging economies have declined noticeably, but credit expansion has continued unimpeded and, as I indicated a moment ago, economic growth appears to have remained pretty solid. In fact, around much of the emerging world at the moment, the bigger problem seems to be neither the near or actual recession of the United States, nor the credit crunch about which we hear so much in the discussion of the major countries, but inflation. From Asia to Latin America to Africa, as well as in many of the industrial countries, we are hearing a lot more about inflation now. Food price rises loom large in developing countries’ consumer basket, so the big rises in grain prices over the past year have been very prominent. Several potential drivers of these increases have been nominated. One is the change towards a more protein-intensive diet as developing countries’ incomes rise, which increases demand for grain to feed animals kept for meat. This is no doubt a factor, but it is a long run trend and there is no evidence that meat consumption has exploded just in the past year. 2 Another is the diversion of some grains towards production of bio fuels, with up to half the increase in the consumption of some crops in 2006-2007 going to this source, thus constraining supply available for additional food production. 3 But while this has played a role at the margins, supply disruptions have arguably been the most important cause of big price rises in the past year. In particular, supply has been disrupted by adverse weather conditions in key production areas, for example, the drought in Australia. To the extent that those effects are temporary, it could be expected that food prices will not continue to rise at the same pace. Temporary supply factors may, at the margin, also have been at work in pushing up oil prices of late. In addition, the inflow of financial capital into energy derivatives markets as funds have expanded their asset universes to include commodities has been a source of demand. This seems to be what people have in mind when they suggest that oil prices have been subject to speculative pressure. But it is surely impossible to avoid the conclusion that most of the trend rise in oil prices over a number of years now has been due to rising demand by end users. Supply has risen too, in contrast to what occurred in the OPEC shocks of the 1970s, but it has struggled to keep pace and the cost of supplying the marginal unit has risen. The same can be said, moreover, about other resource commodities, including thermal and metallurgical coal and iron ore – commodities that are very important to Australia as a producer. Chinese demand for these resources to construct first-world standard cities has been extremely strong, and has accounted for a large share of the increase in demand over the past several years. Anyone who visits a Chinese city can see the results. Such visitors also tend, more often than not, to get a sense that this demand could continue, as a structural phenomenon, for quite a long time. Indeed, food demand in emerging economies began to increase strongly in the 1990s, long before the current run-up in prices, see IMF World Economic Outlook, October (available at: http://www.imf.org/external/pubs/ft/weo/2007/02/pdf/text.pdf). See IMF World Economic Outlook, http://www.imf.org/external/pubs/ft/weo/2008/01/pdf/text.pdf). April (available at: At present, there is a strong sense of overheating in the Chinese economy. It would be even clearer in the statistics were it not for the administrative controls over many prices. As it is, China’s official CPI is rising at close to 8 per cent per annum. The effect of China on the rest of Asia, moreover, is expansionary. Coupled with fairly easy monetary policy settings in much of the region, which tends to occur in many emerging economies when US policy rates are very low because of the importance of exchange rate considerations to Asian policy-makers, this is likely to limit downside risks to growth in the short term. It does pose the risk, though, that inflation will continue to pick up. This is not confined to Asia, either: inflation pressures are evident in much of Latin America and South Africa, both regions where higher resource prices have delivered a terms of trade gain of substantial proportions. I would venture a guess, in fact, that the number of countries where inflation is the major problem greatly exceeds, at present, the number where the predominant concern is inadequate growth. It may be that the slowing in growth in train in the major countries will lead to energy prices and some other commodity prices moderating. On the other hand, the forecast moderation in global growth is taking it back only to about average pace. With the bulk of new demand for energy and resources coming from countries which are yet to show much sign of cyclical slowdown, and whose energy intensity of demand is continuing to increase secularly, any near-term softening in these prices might only be modest. Hence the fact that the low level of interest rates in the major countries results, de facto, in the setting of monetary conditions being pretty easy in many developing countries as well, is starting to raise warning flags among observers who can see inflation pressures already building. This could pose some quite difficult choices for policy-makers, particularly in the emerging world, over the next year. Longer term, of course, the likely ongoing growth in demand for energy by developing countries will surely pose major adjustment challenges for the rest of us. The Australian economy The external environment certainly poses some big, and very immediate, challenges for an Australian economy which has experienced a long expansion and largely used up its reserves of spare capacity. The forces at work from abroad pull in different directions, to an extent seen on few occasions in the past. On the one hand, the seriousness of the sub-prime credit crisis, and the associated weak outcomes being experienced in the US, and thought to be in prospect in the UK and some parts of Europe, are well understood by Australian households and businesses. The financial turmoil of the past nine months has also seen a market-driven tightening of financial conditions in addition to that which resulted from the tightening of monetary policy. Combined, these developments are having a dampening effect on demand. Households have, over recent months, adopted a more cautious attitude to borrowing and spending, the evidence for which is a string of flat results for retail sales, and a significant decline in the flow of new loan approvals for housing. Credit approvals to businesses have also declined significantly. While this partly reflects the winding down of a process of rapid reintermediation that had been occurring as businesses turned to their banks and away from capital markets around the turn of the year, total business funding has slowed. In short, things are happening that suggest a moderation in growth in domestic demand is occurring, signs of which were beginning to appear in the national accounts data released last week. At this stage, inevitably, the extent and likely duration of the moderation remains uncertain. There is not much uncertainty, though, about the need for a moderation. Inflation increased over 2007, and in underlying terms reached the highest rate for 15 years or more. It is true that it was boosted by the international rise in oil and other commodity prices, but Australia’s inflation rate has risen more than most of those in our usual peer group when measured on a comparable basis. It is also pretty clear that strong domestic factors were at work, with growth in local demand at a pace exceeding, by a large margin, any plausible estimate of the economy’s long-run potential growth rate for output, at a time when capacity was already tight. Had not the rise in the exchange rate occurred over the past couple of years, moreover, the Australian dollar prices of energy and other raw materials (as well as other tradeable goods and services) would be even higher. So inflation has picked up, and needs, over time, to be reduced. Reductions of inflation usually require a period of slower demand growth, and this episode is no different. At the same time as we are seeking this moderation in domestic spending, the rise in resource prices that is occurring courtesy of strong demand abroad has complex effects on the Australian economy. Since Australians pay world prices for their petroleum products, the rising global oil price adds to costs for businesses and consumers. This is inflationary in its immediate impact, though it also acts as a brake on spending on other goods and services, unless people are prepared to reduce saving or borrow to sustain that other spending at previous levels. Other things equal, this brake dampens inflation impulses in those other areas. Terms of Trade - Selected Countries Percentage change, 2002-2007 _____________________________________ Chile Russia* Australia forecast for Q3 2008 Norway Argentina Canada South Africa Mexico Turkey Indonesia United Kingdom France -2 Germany -2 Italy -2 United States -6 Korea -13 Japan -22 * 2003-2007 Sources: ABS; Badan Pusat Statistik; Banco Central de Chile; INDEC; OECD; RBA; South African Reserve Bank; State Statistical Office (Russia) But other things are not equal. Australians also receive higher incomes as a result of higher resource prices. As shareholders they experience higher profits. Employees in the resource sector, as well as in the construction sector or the various areas that supply goods and services to mining, are receiving larger pay packets. Governments are receiving higher revenue flows, which in some cases they will spend, at least in part. So in net terms, this terms of trade effect is expansionary. In the normal course of events, it would add more to demand than the higher commodity prices would take out. With the rises in bulk commodity prices taking effect now, Australia’s terms of trade will rise by about 20 per cent, on top of the very substantial lift that has occurred over the past several years. Since 2002, the total rise in the terms of trade will, by the end of this year, be of the order of 65–70 per cent. Some other countries are also experiencing significant terms of trade rises. But few will have seen anything bigger than Australia’s over a five-year period. There is an obvious contrast with the United States, whose terms of trade have fallen by about 6 per cent over the same period, owing to the importance of energy imports to that country. The strongest contrast, though, is with countries such as Japan or Korea, which, unlike the US, have no significant resource endowments of their own. Turning back to Australia, the effect of the 65–70 per cent increase in the terms of trade over five years has been to lift the purchasing power of our GDP by around 13 per cent. In the terminology of the national accounts, this is the boost to real gross domestic income or real GDI. Of course, our resources sector has significant foreign ownership, so a significant part of the gains accrue to foreigners and the boost to the real income of Australian residents is not as large. Over 2008, the boost to real GDI is estimated at around 4 per cent, with the boost to national income somewhat less than this, but still substantial. The expansionary terms of trade shock occurring now obviously would have the potential, absent some other adjustment, to be seriously destabilising. By design, certain features of our macroeconomic policy framework help to handle the shock. A higher exchange rate plays a very valuable role in dampening the expansionary impact, lowering prices for traded goods and services and spilling some demand abroad. In the year ahead, the Government has said that the so-called “automatic stabilisers” in the Federal Budget, which refers to the feature that the tax system withdraws more income from the economy the faster it grows, will be allowed to operate, which is also helpful. It falls to monetary policy to play its proper restraining role as well, dampening private demand not only because inflation has already picked up, but seeking to head off further problems that could easily emerge given the expansionary effects of the terms of trade. This is why a tight monetary policy setting is essential. It is why the Reserve Bank has lifted interest rates, even as the Federal Reserve was reducing them. Not only does the overall pace of demand growth need to slow, but we are having to accept a change in its composition. There is a major process of investment going on, by businesses as well as by governments. Business investment is at very high levels relative to GDP, and businesses in aggregate say they intend to increase investment further next year. Governments at the State level intend a substantial infrastructure spend as well, though the experience of the current year is that they are having trouble implementing their plans because of the demands already being made on the engineering construction sector. In most economies, it is usually not possible, and certainly not prudent, to try to have a consumption boom at the same time as an investment boom. Of course, Australia can and does access the savings of foreigners to fund additional investment – a process of running a current account deficit – so we do not have to finance the totality of the additional investment ourselves. This is something not unknown to the US economy either (in fact, it has been a common feature of most of the Anglophone market economies over the past decade). But even so, there are probably sensible limits here. Practically speaking, domestic consumption, together with housing demand, and some areas of business investment not linked to the resource sector, is being asked to make some room, for some period of time, for the rise in other forms of investment that will sustain higher incomes and living standards in the future. Given that the economy is pretty fully employed, total investment levels are already high, the nation’s call on net capital inflow from abroad is over 6 per cent of our GDP and inflation is already 4 per cent, it is difficult to see any serious alternative to an adjustment of this nature. To try to absorb the expansionary terms of trade impact without any macroeconomic policy restraint is not really an alternative at all. In such an inflationary scenario, I expect that we would still find that the resources sector and the parts and regions of the economy that benefit most directly from its flow-on effects would attract additional labour and capital, and become proportionately larger in the national economy over time. Other sectors and regions would, proportionately, still diminish in size. The process would simply be less efficient: the price signals for resource allocation that are pretty clear at present would be more difficult to detect under conditions of higher inflation. Indeed, that is one of the problems high inflation brings. This course would also leave the rest of the economy with the legacy of embedded high inflation, commensurately higher nominal interest rates and so on. That would be harmful for living standards over time. As such, allowing it to occur would be a policy mistake. Conclusion Both the United States and Australia face significant economic challenges. For the US, dealing with the fall-out of the financial excesses of the earlier years looms large at present. This is not made any easier by the simultaneous lift in global commodity prices, which raises consumer prices but, in the US, also dampens economic activity. For Australia, the financial fall-out has been less severe, mainly because participation in the earlier excesses was so much smaller, while the very large change in prices for mineral and energy resources is the most expansionary external shock to affect the economy for 50 years or more. It has occurred at a time when the productive capacity of the economy has already been stretched by the long expansion. Hence, the prospect of inflation has presented a larger and more immediate danger to us than it has, thus far, to the US. One way or another, the near term continues to present challenges on both sides of the Pacific, as the two respective economies adjust to the shocks hitting us. But both of these economies are pretty adaptable. There is no reason why, with sensible policy frameworks, competitive and innovative firms, and capable and industrious workforces, they should not continue to prosper over the long term. | reserve bank of australia | 2,008 | 6 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Commemorate the 150th Anniversary of Bendigo Bank, at an Invitation-only Dinner, Bendigo, 9 July 2008. | Glenn Stevens: Bendigo Bank’s 150th anniversary – historical look at banking in Australia Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Commemorate the 150th Anniversary of Bendigo Bank, at an Invitation-only Dinner, Bendigo, 9 July 2008. * * * The Premier, the Hon. John Brumby; The Right Reverend Bishop Ron Stone; the Mayor of the City of Greater Bendigo, David Jones; the Chief Executive Officer of the City of Greater Bendigo, Craig Niemann; the Chairman of Bendigo and Adelaide Bank, Robert Johanson; the Managing Director of Bendigo and Adelaide Bank, Rob Hunt; Local Members of Parliament; distinguished guests; ladies and gentlemen. It is a pleasure to be here in Bendigo this evening as you celebrate the sesquicentenary of Bendigo Bank. Your city is resplendent for the occasion, and one cannot help but get a sense of the history as one moves around here. And what a history it has been – from sheep paddocks, to gold rush, to prosperous modern city. You have much to show for the past century and a half. Like so many of our fine institutions, the beginnings of Bendigo Bank were actually rather humble. In the early days following the discovery of gold in 1851, the population of this town grew rapidly. People came in search of wealth and, as always in such a search, some had success and some didn’t. The population – one in fifty Australians lived here at one stage – was rather transient. Certainly many of them were far from well housed: thousands lived in tents. The prominent citizens who had decided to make Bendigo their home permanently wanted to encourage a more stable, home owning society. The building society movement that had earlier taken root in Britain provided a model of how to go about it. And so, on 9 July 1858, the Bendigo Land and Building Society was established, with 150 or so individuals subscribing 5 pounds each in capital. This society, eventually re constituted as a permanent building society became, in combination with some other entities, the nucleus of the entity whose anniversary we celebrate today. It grew with its community and by merger and acquisition with other building societies and financial institutions, both locally and further afield. In 1995, then Australia’s oldest and Victoria’s largest building society, it took a banking licence and developed further into the institution that we know today. Following the merger with Adelaide Bank, the new entity has assets of around $50 billion, and is Australia’s 11th largest bank. 1 Though small in market share, its branch presence is considerably larger. If we were to compile a list of financial institutions of the second half of the 19th century, we would find that few of the names would be familiar ones. Not many entities of that time are still in existence today. Our major banks, of course, have a long history, in some cases dating back to the early convict era. But a great many financial institutions of the 19th century, particularly Victorian building societies, succumbed to one or other of the busts that occurred in the 1890s, the 1930s and the 1990s. The 1890s episode was a particularly severe depression in Victoria, with a collapse in land values and widespread closures of financial institutions. Nearly half the building societies Ranking based on banks’ resident assets in Australia. closed. This, as always, followed a period of extreme euphoria. Consider the way the historian Michael Cannon describes the general scene in Melbourne in the 1880s: The land mania of the 1880s took two main forms. The first was based on a plethora of building societies, whose optimistic officials believed that every family in the colony could simultaneously build their own house, keep up the payments through good times and bad, and support an army of investors who were being paid high rates of interest for the use of their money. The second form of mania was the deeply-held belief that it was impossible to lose money by “investing” in land – a belief which persists to the present day. 2 Those words, penned in 1966 about an event a century ago, carry a more than faint echo of more recent times in other parts of the world. If we may paraphrase Cannon, too many of the world’s major financial intermediaries thought that loans of dubious quality, originated by salespeople they knew little about, to borrowers whose credit standing, to the extent it was known, was very poor, could be sold in ever increasing quantities to investors looking for AAA security. One day the music stopped, as it always does, and they were left standing. The 1890s were tough for the city of Bendigo, as for most of Victoria. A number of banks in the city closed their doors. But its main building society remained sound. “The Bendigo” had not ventured as far into Melbourne real estate as others, nor was it as highly leveraged. There are some lessons there. Moreover, the fact that “The Bendigo” has endured so long being based in a town “born of gold”, as Tim Hewat put it in his history, 3 is perhaps all the more remarkable. Mining towns have their ups and downs with the inevitable cycles of discovery and depletion of ore bodies, booms and busts in commodity prices and all the associated exuberance, risk taking and inevitable subsequent disappointment for some, that goes with them. Bendigo in the gold rush days was no different. For a locally based financial institution to ride through such cycles, without itself being too swept up in events, something must have been working well. It is surely not chance – 150 years would be a rather long lucky streak. More likely, this success is remarkable testimony to generations of managers who had a good assessment of risk, plenty of common sense, a strong attachment to their core business and an ability to resist the temptation of exotic new opportunities. It sounds simple. Yet the managements and Boards of some of the world’s largest and most sophisticated financial institutions did not meet that standard during the past decade, and the fallout is now upon them (and the rest of the world). Much shareholder wealth has been destroyed and reputations of some major institutions damaged. The result has been one of the most acute withdrawals in confidence between major institutions in living memory. Inter-bank borrowing rates at term shot up, as global banks, suddenly facing pressure on their own liquidity, became more cautious about extending it to others. Because financial markets are globally integrated, these pressures were quickly transmitted across national borders. The strains on liquidity have extended, in more muted fashion, even to parts of the world where local credit quality is much higher. Australia has suffered less than the United States, Europe or the United Kingdom, but nonetheless term funding spreads increased and remain today higher than they were before the onset of the sub-prime crisis last August. Cannon, M.(1966), The Land Boomers, Melbourne University Press, Melbourne, p. 12. Hewat, T. (1992), Banking on the Bendigo, Wrightbooks Pty Ltd, Brighton, p. 1. Recent developments exposed the risks inherent in a business model involving heavy reliance on wholesale, short-term funding and securitisation of loans. For some institutions, events unfolded in devastating fashion. We saw a run on a significant British bank for the first time since the gold rush days in Bendigo. On the other hand, during this period, the virtues of a well run, straightforward business model, reliable retail funding, strong knowledge of the local market, and a suite of attractive retail banking services came once again to the fore. Soundly run institutions have seen a rise in their market positioning relative to more risky ones. Soundness, however, is only one part of the equation. Of course we need the financial system to be a safe repository for the savings of the population. But to play its full role in the economy, the financial sector needs also to mobilise those savings, putting them in the hands of investors who are in a position to make effective use of them. Banks are in the business of risk management, not complete risk avoidance. Their job is to offer a secure savings vehicle on the liability side of the balance sheet, but to take a measured degree of credit, maturity and liquidity risk – very carefully managed! – to provide finance for sound investment propositions. Those propositions range from housing, to small business, to large scale investment projects such as the ones that are happening apace at present with the commodity price boom. With capital markets struggling at present, this role is even more important than it normally is. In addition, the transaction services that banks and other authorised deposit-taking institutions offer their customers are key to facilitating the huge volume of transactions which occur every day in the modern economy. Historians point out that this function of the financial system broadly defined – the efficient mobilisation of financial capital – is critical for economic growth. As the industrialised economy took shape, markets for capital grew alongside. Had it been otherwise, brilliant technological innovations would have remained in the laboratory, entrepreneurship would have been stifled, growth would have been slower and living standards lower. Debt and equity markets, together with banks and other financial intermediaries, have been, and remain, key parts of the financial infrastructure. The history of Bendigo provides a good example of this general principle. In the early years, prospectors sought alluvial gold, which was found in or around streams and for which the requisite capital equipment was a pan and a shovel. As time passed and prospectors increasingly turned their attention to quartz-gold deposits, in some places deep underground, more physical capital was required. Steam- and air-driven equipment made men working deep underground productive enough that profit could be earned even when a great deal of rock had to be lifted to the surface and processed to find an ounce of gold. The formation of company structures, and the establishment of a local stock exchange in the 1860s, facilitated the provision of finance for all this activity. Now, of course, this was not without risk. Moreover, one could hardly claim that the exchange was not given to occasional bouts of “irrational exuberance”. Geoffrey Blainey’s account of October 1871, with trading continuing on the streets into the early hours of the morning, with even the destitute seen “pencilling [their] own share transactions”, gives the flavour. 4 Capital markets are prone to bouts of euphoria, which is why it is best if banks and other deposit-takers keep a polite distance from the riskier end of the spectrum, and avoid lending against the more speculative assets. Nonetheless, for all their occasional dislocations, the development of equity and debt markets has been important in the advance of the modern economy. Today, the Bendigo Stock Exchange, like Bendigo Bank, continues, even if in slightly less colourful fashion, providing an equity market for small- and mediumsized firms. Blainey, G. (1963), The Rush That Never Ended: A History of Australian Mining, Melbourne University Press, Melbourne, p. 75. In the period ahead, at the global level, it will obviously be critical to restore the proper functioning both of capital markets and of major international financial institutions. Losses need to be recognised, capital structures repaired where necessary, risk management processes re thought and managerial incentives more carefully structured. That process is under way, though it may have some way to go yet. The main Australian institutions are generally well placed, in my judgement, to prosper in this environment, if they continue to manage their businesses well. At the local and regional level, meanwhile, there is an ongoing role for the provision of financial services. Bendigo Bank’s community banking model, which seems to be a very successful one to date, is an innovative response to the demands of local communities for such services. The major banks tended to scale back their regional presence, in response to the cost pressures on them after the events of the early 1990s, and the changing economics of branch banking which became apparent as financial liberalisation proceeded. This withdrawal left an opportunity, but to take it, someone had to devise a business model that could cover costs at a price which the community could accept. The Bendigo model seems to meet this test. In short, though I do not say this as a supervisor of banks, this model seems to have worked pretty well. It shows that not only is there an important role for regional banks in the modern world, but that well run institutions can successfully fill that role. As we are constantly reminded, even in a globalised world, communities are still local in many important respects. So in conclusion, to the shareholders and managers of Bendigo Bank, and the broader community of Bendigo: “Happy Birthday”. I wish you many more. I am sure John Laker, the Chairman of APRA who is here this evening, would join me in exhorting you to continue your wise and prudent management so that the City of Bendigo, its bank and its people will prosper for another 150 years. | reserve bank of australia | 2,008 | 7 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon, supported by the Australian Business Economists and Macquarie Bank, Sydney, 16 July 2008. | Glenn Stevens: Challenges for economic policy Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon, supported by the Australian Business Economists and Macquarie Bank, Sydney, 16 July 2008. * * * Thank you all for coming along again to support the Anika Foundation at the third of these annual lunches. The Foundation is doing great work in supporting research and treatment of adolescent depression. 1 Your being here today will do a lot to help. Economic policies face no shortage of challenges at present. Internationally, with economic growth slowing in the major developed economies, and the problems in international credit markets still serious, but inflation rates rising in many countries, the task for monetary policies in the old industrialised world is as delicate as any seen in many years. But developing country policy-makers face some big questions too, which are rightly getting more attention. How they respond to those questions will be important for the global economy. At home, inflation has been too high after a period of very strong demand, but demand is now slowing. At the same time, the Australian economy is experiencing a gain in the terms of trade the like of which we have seldom seen before. So we have plenty of challenges of our own, and in ways that are distinctive when compared with those of the major countries. I begin with some remarks about the international scene. International challenges To date, the US economy has been more resilient than many observers had feared. Real GDP has expanded, albeit very slowly, in the first and probably the second quarters of 2008. Yet the cyclical episode is far from over, as housing activity continues to contract, housing prices fall and the labour market softens. Businesses and households now also have to absorb a recent sharp further increase in energy prices. That rise is made worse by the depreciation of the US dollar (in contrast to the case for Australians, who at least have had the benefit of a high Australian dollar in dampening the rise in oil prices). Credit market conditions are still very difficult in the aftermath of the events of the last year, and pressure remains on key institutions – as shown clearly over the past week. First quarter GDP growth in the euro area surprised by its strength. The Japanese economy also performed better than some had expected. But the run of other indicators suggests that growth is slowing in those economies. Meanwhile, CPI inflation has picked up noticeably in most of the major countries. Measures excluding food and energy have thus far remained fairly low. But, compared with last year, there is more concern about inflation prospects. Some of the price rises for Australia’s important commodities, for example, signal international pressure on steel prices and non-oil energy costs, and therefore a range of other prices. Monetary policy in the major industrialised countries taken as a group remains reasonably accommodative. There has, accordingly, been some discussion about how this sits with concerns that inflation might prove to be more persistent than earlier expected. But overall financial conditions are arguably a good deal more restrictive than suggested by policy rates, especially in the United States, where the interest rates paid by many borrowers have not For more detail, see http://www.anikafoundation.com. declined much, if at all, and lenders have toughened their standards considerably. The same is true for the United Kingdom. The bigger concerns about inflation, in any event, are in the emerging world. These concerns are twofold. First, food and energy are a bigger part of CPI baskets in these countries than in the developed economies, so the impact there of the rises in commodity prices is larger. For the same reason, the risk of second-round effects must also be higher. Second, monetary policy has generally been fairly easy in many of these countries, because of the link – explicit or implicit – that they have to the US dollar. In some of the oil-producing Gulf states, where there are explicit dollar pegs, demand growth is very strong and inflation has increased. Around much of Asia, interest rates are below inflation rates, and in several cases even below inflation measured excluding food and energy. That is to say, real interest rates are negative, whereas “natural” real rates are likely to be high, reflecting the potential growth opportunities in Asia. De facto, many of these countries have had monetary policy settings that have been influenced to a significant extent by US monetary policy, but they themselves are not experiencing US economic conditions. To be sure, slower US growth is affecting trade patterns, but to date growth has remained pretty solid in many cases, helped by firmer exports to places other than the United States and strong domestic demand. Moreover, the financial headwinds being experienced by the United States have not blown to the same extent in Asia. The danger for the countries in question is quite clear. Inflation outside of food and energy is already rising in many cases and accommodative policy settings heighten the likelihood of it remaining high on a persistent basis. But there is also a danger for the global economy. The bulk of the growth in demand for energy and natural resources is coming from the emerging world. Continuation of such expansionary policy settings in emerging countries, apart from continuing the recent tendency to overheating in those countries, would presumably foster ongoing rapid growth in demand for natural resources. That would continue to hold up CPI inflation everywhere, but also weaken growth in many industrialised countries. Policy-makers in many of the advanced countries, already facing a short-term relationship between growth and inflation that has turned much less favourable, could face some very difficult choices in framing their responses to the circumstances they face individually. What is needed is for emerging countries to adjust their policies according to their circumstances. Without that, we risk a new manifestation of the “global imbalances”, in which too much of the burden of controlling inflation would be placed on the major advanced countries, where growth is already slowing. Put another way, this is in some respects a problem of international policy co-ordination. Global monetary policy has been too easy in recent years and that is why we have seen such a major run-up in a wide range of industrial commodity prices. Any individual country might wish to treat those increases as exogenous, but they cannot be exogenous for the world as a whole if they are driven mainly by demand, which by and large they have been to date. So, as a number of commentators have been saying recently, global monetary conditions need to be tighter. But the adjustments needed really should take place more in the emerging world than in the United States or Europe or Japan. It is odd that, in such a circumstance, inflation targeting should be attracting some of the criticisms that have recently been seen, because were it used more widely it would tend to alleviate this co-ordination problem. Imagine a world in which all countries of significance had been following a medium-term, flexible target for CPI inflation, coupled with appropriate exchange rate settings. Most of them would have been tightening policy in a measured fashion in response to rises in headline inflation over the past couple of years. The result would surely have been that resource and energy prices, and CPI inflation everywhere, would now be lower than they are. Even now, the current situation could be handled quite well by widespread use of a flexible inflation-targeting approach. Regardless of the precise details of any particular framework, though, what is most important is for broadly good macroeconomic policy to be followed. At the moment, surely that involves emerging market countries playing their part in balancing global demand and supply, by responding to their own circumstances, so as to avoid prolonged and costly inflation. Compared with past episodes, this part is a larger one now – and that is surely a portent for the future. This is not an original observation – a number of commentators have made these same points over recent months. And policy-makers in a number of emerging countries are now adjusting policy settings in the required direction. In fact, the list of developing countries that have recently tightened monetary policy is now growing quite long, and includes some of the big ones – like China, India, Brazil and Indonesia. Perhaps more tightening will follow. Inevitably, growth will slow in the regions concerned as a result. But a period of more moderate growth would be a better outcome than either allowing inflation to go unchecked or expecting the major economies to do all the heavy lifting. Challenges for Australia These international challenges are considerable and, like all other countries in an interdependent world, Australia has a significant interest in how they are met. We have, in the meantime, pretty significant challenges of our own that we must meet. Even before the price rises for oil and other commodities seen this year, Australia had experienced a significant pick-up in inflation, in the mature phase of a long period of economic expansion. The rise in inflation in 2007 and into the early part of this year was not confined to food and energy, even though higher energy costs certainly were at work. Nor could it be put down mainly to “imported inflation”. In fact, the evidence is that a wide range of prices picked up speed. Acceleration in the group of prices generally classified as “nontraded” was quite pronounced. The background environment was one in which demand in Australia – which grew by over 5½ per cent in 2007 – outstripped, by a significant margin, any plausible estimate of growth in potential supply. There certainly were international forces at work, but the key one was the expansionary effect of the rise in the terms of trade. It is perhaps worth spending a few minutes on the basic analytics of this issue. For the “average” industrial country that imports much of its energy and raw materials, a persistent rise in commodity prices is a negative shock to aggregate supply. This will reduce output and push up prices. Since the higher resource prices are paid to suppliers elsewhere in the world, this also acts somewhat like a tax on spending, hence aggregate demand falls. So while CPI inflation is likely to rise initially, the net effect of these forces on the ongoing rate of inflation in the medium term is unclear, though the effect on output will be unambiguously negative. In this “average” industrial country case, monetary policy may need to be tightened to control medium-term inflation, or it may not. Much will depend on inflation expectations. Australia has some additional dimensions, because it is not the “average” country in this episode. As a commodity producer, our terms of trade have risen. Whereas for a net commodity importer a rise in commodity prices acts like a tax paid to foreigners, Australian entities are net receivers of such payments. That impact is expansionary. Just how expansionary depends on the response of the recipients of those income flows, who include local and foreign shareholders, employees and governments. But other things equal, aggregate demand will, compared with the “average” case, be stronger, and it is more likely that there will be a problem of inflation in the non-traded sector. Accordingly, it is likely that monetary policy in a country like Australia would need to be tighter than in the “average” case. That is the analytical background. We can then observe that Australia stands out among developed countries in terms both of the extent of the rise in our terms of trade, and the strength of growth of domestic demand over the past few years. It is understandable, then, that pressure on underlying inflation, particularly from domestic sources, has also been somewhat greater. Monetary policy had to respond to that. The challenge of judging how much response was necessary has been complicated by the global credit turmoil, which has had the effect of pushing up actual borrowing costs relative to the cash rate the Reserve Bank sets. In addition, banks are more careful in their lending (and businesses and households are now more cautious in general than they were six months ago). Overall, as the statements after the past five Board meetings have made clear, the sequence of changes to the cash rate, other adjustments by lenders in response to the rise in term funding costs since mid 2007 and tighter credit standards have combined to produce financial conditions that are tight. They have tightened a bit further in the past month. The effects of that will be working against the expansionary forces from the terms of trade and the broader pressures on inflation from high resource utilisation. Inevitably, there is a lot of uncertainty about how these opposing forces will net out. But the forecast we released in our May 2008 Statement on Monetary Policy was that the net result would be a significant slowing in demand and output growth this year. The evidence is pretty clear that some key components of private demand are now on a slower track. As always with such episodes, the extent of that slowing, and its duration, are uncertain. But to this point, something not unlike what was envisaged in the May outlook appears to be occurring. Moreover, it looks more likely now than it did a couple of months ago that this more moderate track for demand will continue. If it does, it will, in due course, begin to exert downward pressure on those elements of inflation that had picked up in response to strong demand. That will probably take some time and it may be too soon yet to see much of that influence on the CPI figure due next week. Indeed, on a year-ended basis, CPI inflation might rise further before it starts to come down, particularly given the recent further surge in global oil prices beyond what was assumed in our May projections. By the way, this surge in oil prices does not, in itself, amount to a rise in Australia’s terms of trade. As such, it is likely to be exerting some further restraint on non-oil demand, which would, all other things equal, tend to dampen pressure on non-energy-related prices over time. On the information available at present, we still expect inflation to fall back to 3 per cent by mid 2010, and to continue declining gradually thereafter. We will, of course, conduct a thorough review of the outlook after receiving the next CPI figure, which the Board will have available for the August meeting. The Bank will publish its outlook in the next Statement on Monetary Policy, due for release on 11 August. But for today’s discussion, I want to use the May projections as the basis for some remarks about the nature of the inflation target. As you know, since 1993 the Bank has been framing its monetary policy around a mediumterm target for inflation of 2-3 per cent, on average, “over the cycle”. The Reserve Bank remains committed to achieving that target. Apart from being consistent with the Bank’s statutory obligations, it is what has been envisaged in successive formal agreements between two Treasurers and two Governors stretching back now over a dozen years. This framework has worked well. One of the reasons it has worked well is that it has two essential ingredients. The first is the commitment to the mean inflation rate being at the target. That has been achieved, with medium-term CPI inflation rates averaging close to 2½ per cent. The second ingredient is a sensible approach to variance of inflation around that mean. The framework was designed to have the necessary flexibility to cope with the business cycle, shocks that may occur, the inevitable errors in forecasting and lags in the effects of policy decisions. The framework does not assume that inflation can be fine-tuned over short periods, nor does it require us to attempt rapidly to correct deviations from the 2-3 per cent range, which have occurred several times over the period since 1993. This flexibility was envisaged from the beginning in our approach to inflation targeting. The Reserve Bank quite deliberately eschewed the narrowly defined targets with “electric fences” that were initially favoured in some other countries and that were at one stage proposed here. We have made use of that flexibility repeatedly, and are doing so again now. The inflation outlook I have just sketched out would be a pretty long period of divergence from the target. It is important to recall, though, that we have experienced reasonably lengthy deviations before. Annual CPI inflation was below 2 per cent for 10 quarters between the middle of 1997 and the end of 1999. 2 If the May 2008 forecasts turn out to be right, then the current episode would entail nine quarters with year-ended inflation above 3 per cent. If we can achieve something like that outcome, that would still be consistent in every essential respect with the experience under inflation targeting since it began 15 years or so ago. As always, the challenge is to combine the right degree of flexibility in approach with sufficient confidence that the inflation rate will be on a declining path over time as to keep expectations anchored. This challenge is not trivial on this occasion. We are, of course, fully aware of the possibility that people may fear that this temporary period of high inflation could, in fact, turn out to be persistent. Expectations of high inflation can be self-fulfilling if individuals and businesses behave accordingly. One possible channel people have mentioned is that of higher wage claims, pursued as a result of the pick-up in CPI inflation, which then add to costs and prices, and so on. But I think it should be stated that while there are some signs of that around the edges, growth in overall wages has thus far remained contained, even though the labour market has clearly been at its tightest for a generation. Relative wages are showing noticeable variation across industries and regions, as would be expected given the events in the economy. But overall growth of wages, as measured by all the formal statistics at least, has to date been pretty well controlled. Furthermore, if the recent signs of moderation in the demand for labour continue, which could be expected if overall demand remains on a slower track, that should help to contain any over-exuberance in wage setting. So I think that our chances of keeping inflation low over the medium term are good. This outlook does involve a period of significantly slower growth in demand in Australia than we have seen over the period up to the end of 2007. The Bank has been candid about that. But controlling inflation has always involved being prepared to slow demand, for a while, when needed. Not taking adequate steps to that end would have costs. One is that were we to see inflation become established permanently at higher levels, then over time the whole structure of nominal interest rates would reflect that new reality. The mean interest rate would rise. In that world, the interest rates we see now would not look unusually high. They, or even higher rates, would look pretty common. That is what happened in the 1980s, as a result of the fact that we did not control inflation in the 1970s and early 1980s as well as we should have. Needless to say, it is that world that we are seeking to avoid. By the same token, there will be a continued pay-off to control of inflation. A stable currency is one of the foundations on which a well-functioning modern economy rests. It is a prerequisite for sustaining growth in living standards. On the interest rate front, moreover, containing and reducing inflation over time will mean that we should be able, at some point, to look back to the current period as one of higher-than-normal interest rates. Interest rates, CPI inflation excluding interest charges prior to the September quarter 1998 and adjusted for the tax changes of 1999-2000. unlike many other prices in the economy, do not always rise. Provided inflation is successfully controlled, interest rates go up and down around a fairly stable mean. Conclusion I have dwelt today on challenges facing macroeconomic policies and particularly monetary policies, both abroad and at home. These challenges look more difficult than they have been for a while. Of course, the challenges are not limited to monetary policy. There is the question of how resource allocation in the Australian economy should evolve in response to the increases in the prices of minerals in recent years, if these turn out to be persistent. Monetary policy has only a modest role to play there – other policies will be much more important, and they will be tested. There is also the question of how all that adjustment will dovetail with policies towards climate change, which are in the formative stages at present. Those charged with constructing such policies are dealing with hitherto unimagined degrees of uncertainty and the challenges seem to be of an order of magnitude bigger than the ones faced by monetary policy. It is also important to keep in perspective the very real problems that beset our society in other respects, including adolescent depression and the terrible cost it can extract on young lives, on families and on all of us. Good macroeconomic policies can, we trust, make some difference at the margin by creating a stable environment in which others can carry out the important work to understand and address these real problems. But their work needs to be resourced, which is what the Anika Foundation is all about. So, once again, thank you for coming here today. Thank you to Macquarie Bank and the ABE for your support of this function, and thank you for your support of the Anika Foundation. | reserve bank of australia | 2,008 | 7 |
Opening comments by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 14 August 2008. | Ric Battellino: Inquiry into competition in the banking and non-banking sectors Opening comments by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 14 August 2008. * * * Mr Thomson, other members of the Committee, thank you for the opportunity to appear here today. We have provided a written submission to the Committee which looks at various aspects of competition in the financial sector. I won’t take up the Committee’s time by going through that submission in detail, but it might be worth highlighting some of the key points and the conclusion. One way to analyse the competitiveness of the financial sector is to look for any signs that we would expect to see if the sector was not competitive. For example: 1. if the overall provision of financing to the economy was inadequate; 2. or if the costs paid by households and businesses for financial services was high by international standards; 3. or if the availability of new financial products in Australia was less than overseas; 4. or if the profitability of financial intermediaries was unreasonably high. When we look at the evidence in these key areas, we think it is quite reassuring: • Financial intermediation in Australia has been growing at a fast rate – on average about twice as fast as the growth of nominal GDP. This is among the highest in the developed world. There is no suggestion therefore that the Australian financial sector has been unable to provide adequate access to finance for households and businesses. • In the case of interest spreads charged by intermediaries, we find that they have declined substantially over the past 15 years, and as far as we can tell are in line with international norms. • In the case of financial innovation, we have seen a marked increase in the availability of financial products over the past 15 years, and the range of products compares favourably with the experience overseas. • When we look at bank profitability, we find that Australian banks are around the top of the international range. On the surface, this could indicate a lesser degree of competition than elsewhere. But when we look a bit deeper it seems that an important reason for the high profitability of Australian banks is their unusually low bad debt experience. Over the past decade or so, bad debts of Australian banks have been about half the long run average, and also around half the experience of overseas banks. This has been the result of the very strong domestic economy. It is also worth noting that other Australian industries have been very profitable over this period. If we adjust for the unusually low bad debts of recent years, the profitability of Australian banks falls back to around the middle of the international range. Overall, when we look at all the evidence, we think it is reasonable to conclude that the Australian financial sector is competitive, and that its performance measures up quite well across a range of international benchmarks. Some commentators have recently been concerned that the financial turmoil of the past year has lessened the degree of competition. This is because the turmoil has made it harder for lenders who fund themselves in capital markets to compete. Some have argued that this requires some type of government intervention in the market, such as setting up a government guaranteed securitisation vehicle. While it is true that lenders relying on securitisation have lost market share in recent months, it has always been the case that some phases of the economic cycle favour some forms of financing more than others. Securitisation had been strongly favoured over the previous five years of very low global interest rates; now it is at a disadvantage. Our view of recent events is that they are cyclical in nature rather than a permanent change to the structure of the market, in the sense that when market conditions settle, securitisation will pick up again. As such, it would be premature at this stage to embark on proposals such as the setting up of new government bodies to support certain forms of financial activity. The best way for the Government to promote a competitive financial sector in the long run is to ensure: • first, that regulations do not unreasonably impede new entrants (since history shows that it is new entrants that drive competitive behaviour); • second, that users of financial services have good access to information about the range and cost of services available. It is also important that this information be in a form that is easy to understand; and • third, that switching between service providers be as costless and easy as possible. I will end my opening remarks here, and Phil and I would be very pleased to answer any questions you may have. Thank you. | reserve bank of australia | 2,008 | 8 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Melbourne, 8 September 2008. | Glenn Stevens: Recent economic and financial developments in Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Melbourne, 8 September 2008. * * * Mr Chairman, thank you for the opportunity to meet again with the House Economics Committee. It might be helpful for our discussion if I begin by reviewing how things stood at the time of our last meeting, and what has changed in the interim. When the Committee met in April, monetary policy had been tightened in response to very strong growth in demand and a significant pick-up in inflation during 2007. The cash rate had been lifted by 100 basis points and financial intermediaries were facing additional increases in the cost of their funds, which they passed on to borrowers. This amounted to a significant tightening in financial conditions. That was necessary under the circumstances: if inflation was to decline over time to be consistent with the 2-3 per cent medium-term target, a precondition was to contain demand, which had run too far ahead relative to productive capacity. The fact that inflation picked up noticeably at the end of 2007, with a strong likelihood that we were in for several quarters of faster price rises, only reinforced the need for a credible and prompt response by monetary policy. In April, there was considerable uncertainty surrounding the outlook given the powerful forces at work pulling in opposite directions. On the one hand, the tightening of financial conditions, including some tightening of credit standards for more risky borrowers, was acting to dampen spending. In addition, developments in the global credit system were a likely dampener for the international and domestic outlooks. On the other hand, the rise in Australia’s terms of trade that was in train was the biggest such event for many years. It was starting to deliver a very large further boost to income and, potentially, to spending. So while there were signs in April that a slowing in demand had begun, it was unclear what the extent and duration of that slowing would be. But overall, the judgement we had reached at that time, and subsequently spelled out in the May Statement on Monetary Policy, was that growth in demand and GDP during 2008 would turn out to be considerably lower than had been recorded for 2007. This forecast was at the lower end of the range of private-sector forecasts made at that time. That in turn led us to believe that pressure would be taken off productive capacity and that inflation would, in time, abate. It was on the basis of that judgement that the Board held the cash rate steady for six months, even though inflation on both a headline and underlying basis continued to increase in the subsequent two CPI releases. The picture of moderating demand, at least on the part of households, has continued to emerge. Consumption spending grew modestly in the March quarter, then paused in the June quarter. This came after a very strong run up in the second half of 2007, when consumption had grown at an annualised pace of almost 5 per cent, well above what was sustainable. Household demand for credit has slowed, and turnover in the market for existing homes and house prices have softened, though spending on the construction of new homes and renovations has thus far continued to rise modestly. Overall, households are at present much more cautious about spending and borrowing, after a number of years in which confidence levels were very high and there had been strong rates of growth in borrowing and spending. Clearly, tight financial conditions have played an important role in slowing household demand. An additional factor, around the middle of the year, was a surge in global oil prices. Of course oil prices had risen a great deal over several years – from about US$30 per barrel in 2003 to around US$100 per barrel in early 2008. This was a large increase, but it took place over a fairly long period and against a backdrop of strong global growth, and most economies had taken it more or less in their stride. But the surge from US$100 per barrel to nearly US$150 per barrel over a matter of weeks was a very sharp increase from an already high level. Accompanied as it was by forecasts in some quarters that the price could rise much further, this affected both purchasing power and sentiment among households in many countries, including Australia. It also made business conditions more difficult for many firms, and this – together with the effects of the increases in other costs, slowing household demand and tighter credit conditions – has been reflected in the various business surveys over recent months. Confidence in international credit markets has continued to wax and wane. Following the takeover of Bear Stearns by JPMorgan Chase in mid March, sentiment improved for some weeks. But that improvement, unfortunately, did not last. Concerns about major international financial institutions re-emerged, as asset write-downs and losses related to the problems in structured products based on mortgages continued. A significant tightening of credit standards has ensued in some major countries, due to the need for banks to conserve their own – suddenly scarce – capital resources. The soundness of the two large quasi-public US mortgage agencies, which carry rather little capital, has also came into question, necessitating support from the US Government. Meanwhile the US has seen house prices falling and house construction is at its lowest for many years. The US economy continued to expand in the first half of 2008 due to solid business investment spending, the impact of the fiscal stimulus, and strong export performance, helped by the lower US dollar. In fact, the US was the strongest performing G7 economy in the June quarter, with other major developed countries showing a significant weakening. But most forecasters continue to be fairly cautious about prospects for the US economy in the second half of the year and are now also concerned about the sorts of credit losses that are routinely associated with a period of weak macroeconomic conditions. Some fairly significant changes of a financial nature are also occurring in Australia. Share prices rose in April and May, but gave back all those gains in subsequent months and at present are down by about 30 per cent since the peak in late 2007. Corporate boards are taking a more cautious approach to debt and there has been a marked reduction in business credit growth. This seems to have been more pronounced in the case of loans to large companies, though growth in credit to smaller enterprises has also slowed. Entities with complex financial structures and/or high leverage have come under pressure and are looking to de-leverage their balance sheets. But overall, what we see in the Australian financial scene is an order of magnitude less troubling than what we see abroad. This, Mr Chairman, is an important point to emphasise. The balance sheets of the bulk of corporate Australia are not over-geared. Australian financial institutions continue to present a contrasting picture to their peers in the US, Europe and the UK. They have adequate access to offshore funding – albeit at higher prices than a year ago. They have tightened credit standards for some borrowers, particularly those associated with property development, and are holding a higher proportion of their balance sheets in liquid form. Some have had to make provisions for unwise exposures that had been accumulated earlier. But even in these cases, capital, asset quality and profitability remain very sound. The money market is functioning more smoothly than it was six months ago, with short-term interbank spreads relative to official interest rates down a little. There are also signs that the securitisation market, which effectively closed late last year, is moving closer to re-opening. In summary, the Australian financial system is weathering the storm well. Furthermore, while growth in credit to business has slowed quite sharply, and surveys say that business conditions have softened to the weaker side of average, overall profitability remains pretty strong. Businesses still are maintaining high levels of fixed investment spending. Indeed, according to the most recent data released about 10 days ago, firms plan a significant further expansion of investment spending in the year ahead, at a pace as fast as anything seen in a generation. Strength in mining is exceptional, but other areas actually look robust as well. I have spoken in the past of the rise in the terms of trade adding to income and spending power. These actual and intended investments are evidence of that effect. Whether all of the planned investment will come to pass – or whether it is economically feasible for it to come to pass – is a question open to debate. Nonetheless, the strength of those intentions at this stage – a year into the global credit problems, and many months into the more conservative financial environment in Australia – is remarkable. In addition, State governments continue to look to needed infrastructure upgrades. So these areas, on the best available recent evidence, remain likely to be sources of demand growth in the Australian economy in the period ahead. This highlights again a theme that I have noted before, namely the contrast between household demand and other types of spending. Even with a pretty significant slowing in household spending, total domestic demand in the economy rose at an annualised pace of about 4 per cent in the first half of 2008. This was down from about 5½ per cent during 2007, but is still quite strong. This same picture has been pretty consistent from the liaison the Bank does with its fairly extensive list of contacts, numbering about 1,500, around the country. Those exposed to household spending are finding conditions subdued, while those exposed to the infrastructure and mining build-up are often struggling to keep pace. Some of that demand has, of course, been supplied from abroad. So at the bottom line, we come to production and capacity utilisation. At this time of the year, with two quarters of national accounts available, growth in the economy is running at a pace slower than last year, and slower than trend. Growth in real GDP in the June quarter slowed, though this was affected by a large decline in farm production because of drought, and which most forecasters expect to be reversed in the coming quarters. Abstracting from those swings, non-farm product rose by 0.5 per cent, down a little from 0.7 per cent in the preceding quarters. There was nothing in those figures to cause us to revise significantly the forecasts we published in the August Statement on Monetary Policy. The international context is one of more subdued global growth than we expected six months ago. The world economy actually expanded a little faster than we had expected into the early part of 2008, but recent data for a number of countries have been weaker, and we are assuming that weakish performance will continue in the near term. Growth in China has slowed a little, but still looks strong. Some of our other Asian trading partners, though, are facing more difficult circumstances now. Turning to the outlook for inflation, with pressures going through the system as a result of the rise in raw materials prices and strong demand over the past couple of years, headline inflation figures will remain uncomfortably high for a little while yet. It is expected that annual CPI inflation will reach a peak in the September quarter of about 5 per cent, and be similar in the December quarter. This is higher than expected six months ago. But with international oil prices below their mid-year peaks and signs that the pace of food price increases are abating, it is reasonable to expect that CPI inflation will thereafter start to fall back. With demand growth slower, capacity utilisation, while still high, is tending to decline. Trends such as this usually dampen underlying price pressures over time, and those effects should start to become apparent during 2009 and continue into 2010. This assessment hinges to no small extent on growth in overall labour costs not picking up further. Relative wages have been shifting, as would be expected given the nature of the forces affecting the economy, but overall the pace of growth in labour costs, to date, has been fairly contained given the tightness of the labour market. With pressure coming off the labour market, an assumption that this behaviour will continue appears to be a reasonable one at this point, but it is a critical one. The outlook also hinges on the expectation that demand growth will remain quite moderate in the near term, so that pressure continues to come off productive capacity. On that basis, Mr Chairman, we believe that prospects for inflation gradually returning to the 2-3 per cent target over the next couple of years are improving. An outlook like that is, of course, what the Board has been seeking to achieve with monetary policy. As that picture has gradually emerged over the past few months, the question has then arisen as to when the stance of monetary policy should be recalibrated as well. At its August meeting the Board believed, and stated, that conditions were evolving in a way that was increasing the scope to move towards a less restrictive policy setting – one that presses less firmly on the brake. At the September meeting the Board took a step in that direction. The logic of this decision was the same as the one that, some years earlier, had led the Board to begin raising rates from unusually low levels: the setting of policy designed to get the economy to change course probably will not be the right one once the change of course has occurred, and it will need to be adjusted. A further consideration was that conditions recently had actually tightened marginally as a result of rises in lenders’ interest rates, which from a macroeconomic point of view was not needed. Accordingly, the cash rate was reduced by 25 basis points last week. The decision was quite widely anticipated, and less restrictive conditions in the money market had already been in place for about a month before the Board’s decision. Since the end of July, key benchmark interest rates have fallen quite noticeably. The rate on 90-day bank bills has fallen by almost 60 basis points, while the three-year swap rate has fallen by about 80 basis points. Various rates for fixed-rate loans had already declined before the Board’s decision, while variable mortgage rates have quickly reflected the decline in the cash rate. The exchange rate has also declined. While some of this change is really a US dollar story rather than an Australian dollar story, our currency has declined somewhat against other currencies and on a tradeweighted basis. Admittedly, we are probably six months away from seeing clear evidence that inflation has begun to fall, and even then it has to fall quite some distance before it is back to rates consistent with achieving 2-3 per cent on average. A somewhat larger fall in inflation overall is required on this occasion than was the case in either 2001 or 1995, which were the comparable previous episodes, since the peak inflation rate this time is higher. Rather than trying to achieve that larger fall in inflation by pushing it down more quickly, the Board’s strategy is to seek a gradual fall, but over a longer period. This carries less risk of a sharp slump in economic activity, though it does require a longer period of restraint on demand. On the other hand, this carries the risk that a long period of high inflation could lead to expectations of inflation rising to the point where it becomes both more difficult and more costly to reduce it. Monetary policy has to balance these risks, which is why the flexible, medium-term inflation targeting system that we have been operating for 15 years now, and which has enjoyed strong bipartisan support in the Parliament, is so important. That framework will continue to guide the Board’s decision making. My colleagues and I are here to respond to your questions. | reserve bank of australia | 2,008 | 9 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Institute of Company Directors Luncheon, Sydney, 17 September 2008. | Glenn Stevens: The director’s cut – four important long-run themes Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Institute of Company Directors Luncheon, Sydney, 17 September 2008. * * * Thank you for the invitation to speak to you today. We are living through challenging times for decision-makers in both private and public roles. The past year has seen a major change in international economic and financial conditions. Global economic growth, having been well above average for a string of years, has slowed noticeably, especially in the major industrial countries – yet inflation rates remain a concern. Large losses have been incurred by major international financial institutions. Several household names in global investment banking have disappeared. Appetite for risk – which had been strong to the point of recklessness in some areas – has given way to risk aversion. Credit is harder to obtain, and more expensive. Australia has been affected by these forces, but much less than the countries at the epicentre. Our financial system is weathering the storm well. Amid all that excitement, it is useful occasionally to step back from the high-frequency detail to focus on the bigger picture. Today, I propose to talk about four low-frequency, big-picture themes – all of which are nonetheless amply demonstrated in the course of events over the past year or two. The themes are: • the emergence of China; • the economics of a fully employed economy; • the end – perhaps? – of the long period of households leveraging up their finances; and • shifting perspectives about the regulation of the financial sector in the economy. China I am not talking here about the notion of “de-coupling” and so on. That term is actually unhelpful – nothing is ever really de-coupled; everything is connected. But the connections are complex, various forces are at work and reasonable people will have differing opinions about how things will play out over a year or two. At present, China is slowing, partly as a result of the slowdown in the United States and Europe, but partly by design of domestic policy. The Chinese policy-makers have been seeking some slowing because of evident overheating, and are now in the position to be removing some of that restraint. But the emergence of China as an industrialised economy is a fundamental long-term change to the economic, financial and political landscape whose full consequences I suspect we can barely appreciate as yet. This has been happening for a couple of decades now, but the nature of its impact is gradually changing. For some years, it was too small to notice – even a country with a lot of people is small economically if their per capita incomes and productivity are very low. Then, some time in the 1990s, China became quantitatively important enough for the rest of the world to enjoy the disinflationary effects of added Chinese production capacity, as millions of low-cost workers turned out manufactures, in the process lowering global prices. More recently, we have been experiencing a new effect of that growth, namely the effect of higher Chinese living standards on the price of energy and natural resources. f course, this is not confined to China – it is happening around the developing world to a greater or lesser extent. But China is the biggest example. Commodity prices are coming off their peaks at present, though key prices for Australia are still very high. Even if this marks a cyclical turn for such prices, in the longer term this new claim on energy and other resources will not go away. Other countries are having to adapt to that. The rise in prices for energy and raw materials has made it harder for those countries to combine the steady growth and low inflation that had characterised the period from the early 1990s until about the middle of this decade. At the same time, this extraordinary increase in the demand for natural resources and energy has raised Australia’s terms of trade by close to two-thirds in the space of five years – the largest shock of its kind for five decades. So the economics of this for Australia are therefore a bit different from those for the “average” industrial country. Like others, in the energy-using parts of the economy, we find it more difficult to combine steady growth and low inflation. But in addition, we have had to absorb a massive income boost. 1 Of course, there are worse problems to have! Nonetheless, significant adjustments are occurring – to the structure of the economy, to where the population lives and how the national income is earned and distributed. Unless resource prices reverse a long way, these trends will continue. China’s emergence is surely far from complete. China, like all economies, will have cycles. But its average growth rate is likely to be pretty high for years ahead, even if not as high as it has been recently. This is an opportunity and a challenge for Australian business and policymakers, and not just in the resource sector. Economics of full employment Over recent years, the Australian labour market has been as tight as at any time seen in a generation. The rate of unemployment in the past 12 months, at about 4 per cent, has been as low as at any time since 1974. In surveys and our discussions with firms, difficulty securing labour has been a common problem. The term “capacity constraint” has been a part of the Australian economic lexicon over recent years in a way not seen for a long time. Survey measures of capacity utilisation have been very high, and fixed investment to increase capacity is running strongly. Let’s be clear that full employment is a good thing. It is one of the statutory objectives given to the Reserve Bank in our Charter (though interestingly the authors of the Act never quantified what they meant by full employment, nor for that matter, by “stability of the currency”). But the economics of full employment are different from the economics of trying to get to full employment. This is a simple point, but an important one. When the economy has too much spare capacity – say, in the aftermath of a business cycle downturn – the aim of macroeconomic policies is to push up demand so that it catches up to supply potential. There may be several years in which demand growth exceeds the normal pace as it eats into the spare capacity. Once the spare capacity has been wound in, however, actual growth in demand and output has to slow, to match the growth rate of potential supply. That growth in potential supply is given by the growth in the labour force, the capital stock and the productivity of those factors of production. Typically we think of “potential GDP” in Australia rising by something like 3 per cent a year, give or take a bit. For those of you who are interested, I have set out my views on this in an earlier address. See http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jul08/com_prices_macro_pol_aus_perspectiv e.html This, as my predecessor Ian Macfarlane remarked a few years ago, means that once the reserves of spare capacity are pretty much used up, we should expect to be accustomed to growth rates for GDP starting with a 2 or a 3. There will not be many with 4s or 5s, as we had for some years through the 1990s and earlier this decade. Periods of growth noticeably above about 3 per cent will be roughly matched in frequency and duration by periods below – as we are having now. If we set our aspirations higher than that – if we try for above-average performance all the time – we will just get inflation. That is the economics of full employment. Now you may feel that a growth rate for real GDP of something like 3 per cent on average is not that high. Is that the best we can do? Can’t we lift it? The only way the potential growth rate can be lifted is by adding more factors of production – more labour and capital – or raising the growth rate of productivity. Over the long term, the key is productivity. On that front, productivity growth does seem over the past several years to have settled at a lower average rate than we had seen since the early 1990s. This may have several causes, and the experts debate them. But over the years ahead, as a community we must be sure not to let up on our efforts to keep productivity growing. I have no specific policy prescriptions here – only general ones – trying to sustain competition, to keep markets open, to maintain flexibility and so on. But those general values are worth recounting from time to time. Household balance sheets A feature of the economic landscape of the past decade and a half has been the long gearing up of households. In the early 1990s, household gross debt in Australia was equal to about 50 per cent of average annual household disposable income. This year, it reached about 160 per cent. Households’ assets rose generally in parallel, though not quite as fast, with total assets rising from about 460 per cent of income in 1990 to over 800 per cent at the end of 2007. (Assets have fallen somewhat since then, with the decline in the share market and some softening in housing prices.) The ratio of debt to assets rose from under 10 per cent in 1990 to about 18 per cent in 2008. The ratio of housing debt to housing assets reached about 27 per cent. Very similar trends have been seen in a number of comparable countries around the world, so in thinking about the causes, we should not look exclusively for domestic causes. But in summary, the main factors behind this big increase in the size of the household sector’s balance sheet were: • the general tendency for financial activity and wealth to grow faster than income, which has been a feature of most economies since at least as far back as the 1950s; • an increased pace of financial innovation – and, in particular, a lot more credit has been available, particularly over the period since the mid 1990s, to households. In recent years around the world, anyone who was creditworthy – and some who were not – have been able to access ample amounts of credit; • the big decline in inflation. This lowered nominal interest rates dramatically. 2 This happened in all countries, though the timing differed. In Australia it was a big factor after 1992; With the fall in nominal interest rates, a big front end loading problem in servicing the conventional mortgage was eliminated. See http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_oct97/bu_1097_6.pdf. • a period of pretty low long-term interest rates globally, which encouraged borrowing around the world, though this was a bigger factor in the United States than here. This had a lot to do with the build-up of savings relative to investment in Asia; • a desire to devote a higher share of a rising income to acquiring housing services. As people’s income increases, certain goods and services will take a declining share of total spending – food, for example, or products, such as electrical goods or clothing, which have large falls in their relative prices over time. But other types of products take an increasing share of income. Housing has tended to be in that category. As we have become wealthier, our aspirations for housing in terms of position, quality and size have naturally enough increased. But for various reasons the supply is not very elastic – there is only so much well-located land, and other factors have affected the supply price of dwellings more generally. In the end, a lot more of our income is devoted to housing, acquired by servicing mortgages, than was once the case. The question is whether this long period of gearing up by households might now be approaching an end. Certainly household credit growth is much slower at present than it has been for some years, running roughly in line with income growth. Might we see this conservative approach to debt among households persist? It is hard to know the answer to this question. There is much more of the household balance sheet that could, in principle, be turned into collateral, so gearing up might resume once the current turmoil has passed. But there is also a good chance that households will for some time seek to contain and consolidate their debt, grow their consumption spending at a pace closer to income, and perhaps look to save more of their current income than in the recent past. It is possible that we are witnessing the early part of a new phase where the household spending and borrowing dynamic is different from the past decade and a half. Time will tell. But if that is the trend of the next several years, the growth opportunities for businesses and financial institutions will be different. And whereas the household balance sheet has been the big financial story of the past 15 years, some other financial trend will probably be the bigger story of the next decade. There are some developments that suggest the balance sheets of governments might well be expected to expand a good deal. The need for support of the finance sector in countries like the United States and the United Kingdom is one. The build-up in public infrastructure in Australian cities and regions may point in the same direction, though to a lesser extent. If the sudden aversion to these sorts of assets by private investors continues for any length of time, governments may have to choose whether to fund the projects themselves, or defer them. Fortunately, public balance sheets in this country are in a very much stronger starting position than those in most other countries. Financial stability and regulation All the issues surrounding the use, or not, of the government’s balance sheet to support the financial system have been on prominent display over recent months. We have seen the actions by the US Treasury to take over the running of the two large entities known as “Fannie” and “Freddie”. As Secretary Paulson commented, the ambiguity about who was bearing risk in these entities has been a problem for a long time, and it needed to be resolved. The US Government has shouldered the burden that investors always assumed it would, but has, quite appropriately, done so in a way that minimises the extent of bail-out for private shareholders who had been profiting from the risk-taking behaviour. Facing up to these problems where the entities concerned were regarded as effectively guaranteed by the government was one thing. The question of support has also arisen for entities which have always been seen as purely private, and hitherto not, at least explicitly, regarded as so central to systemic stability that failure could be costly. The events of the past few days illustrate how difficult these issues have become. In all these cases though, in the final analysis there was not enough capital behind the risks that were being taken. The sophisticated financial system of the 21st century was supposed to spread risk, but a lot of the risk ended up being concentrated on the books of highly leveraged institutions. High risk and high leverage proved to be a fatal combination. It always does. Some significant questions arise from all this. The main one, put at its broadest and simplest, is whether something can and should be done to dampen the profound cycles in financial behaviour, with associated swings in asset prices and credit, given the damage they can potentially do to an economy. This debate has been going on for quite some years. There are several points of view. One is that counter-cyclical regulatory measures using the power of the prudential regulator should be taken to dampen the so called “financial accelerator”. This is the process where confidence boosts asset prices, which then provides additional collateral for further borrowing, which then boosts asset prices further and so on – until at some point the whole process goes into reverse and there is a fall in asset values and de-leveraging, as is occurring now. Use of prudential tools to work against these tendencies would be a departure from the way prudential supervision is conducted at present, where the goal is soundness of individual institutions, rather than managing the dynamics of system stability through time. A counter view is that it is not feasible to do this, for various reasons. One is difficulties with tax and accounting rules. Another is that some of the key players are outside the regulatory net – hedge funds for example. This view holds that an effective response against the financial cycles almost certainly involves monetary policy. This would mean raising interest rates in times of booming asset and credit markets, even if goods and services price inflation was contained, in order to provide a stabilising influence over the swings in financial behaviour. Some argue that this could be reconciled with standard inflation targeting, though only if the central bank had a very long time horizon or a great deal of flexibility. A third view is that it is not possible, with policy-makers’ current state of knowledge, to know whether it is correct to lean against such booms, and that in fact it could turn out to be destabilising to try. On this view, the only thing that can be done is to respond to asset and credit collapses if and when they occur, protecting where possible the financial system and the economy generally. That is, to clean up the mess afterwards, so to speak. This has tended to be the US official view, at least up until now. This debate was quite active in the period following the collapse of the dot-com boom in the early 2000s. But those in favour of policy action aimed at moderating financial cycles did not carry the day, I think mainly because the US economy recovered pretty quickly from what was a quite mild downturn in 2001. I sense now, however, that among many thoughtful people this question is once again up for discussion. It will be fascinating to watch how the debate unfolds. Conclusion In the barrage of information with which we must all cope day by day, it is often hard to stand back and see the big forces at work. But those forces – and our responses to them – will ultimately do more to shape the course of our economy and financial system than the shortterm news. Hopefully, we can still find some time for reflection about such matters, even in the volatile conditions in which we all find ourselves at present. It is in that spirit that I offer these remarks today. Thank you. | reserve bank of australia | 2,008 | 9 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Trans-Tasman Business Circle Business Luncheon, Sydney, 21 October 2008. | Glenn Stevens: Australia, New Zealand and the international economy Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the TransTasman Business Circle Business Luncheon, Sydney, 21 October 2008. I thank Clare Noone for very able assistance in preparing this address. * * * In Les Carlyon’s Gallipoli, a conversation is recounted in which a Turkish soldier is said to have asked some New Zealand prisoners why it was that they had come so far, voluntarily, to fight a war in Europe. They apparently replied that they had expected it to be rather like playing a game of rugby. It is not recorded how Australians answered the same question (perhaps they could not decide which code of football was most apt). But they certainly also went in a spirit of optimism. That optimism was soon a casualty of war. Optimism seems also to have been a casualty of recent financial events abroad, as outcomes have been rather unlike what the sophisticated modern set of institutions and markets were supposed to have delivered. Many have observed that the world faces the most serious international financial crisis since the 1930s. The world has, of course, experienced many crises, of various kinds over the decades, not least the one to which the ANZACs responded. These were often, in terms of potential and actual human misery, far more perilous than today’s financial dislocation. Nonetheless, the situation is very serious. It is up to policy-makers and private market participants to put the system back together, without the excesses that built up over the past years, so that it can serve its proper function: facilitating trade and genuine investment flows, in the process supporting economic growth. For this audience, I had intended to talk about the Australian and New Zealand economies – noting some of their similarities and differences, and common interests. Given the circumstances, I will touch briefly on those issues, and then devote some time as well to talking about our shared interests in getting the global financial system back into shape. Australia and New Zealand It is stating the obvious that the two countries have a lot in common, dating back at least to James Cook. We share the British system of laws and custom, the historical relative geographical isolation from “old” Europe, an increasing orientation towards Asia, and generally an outward-looking mentality reflecting small economic size. Notwithstanding that Australia’s GDP is seven times that of New Zealand, we still see ourselves as small. There is a significant amount of grass-roots integration between the two countries which has occurred fairly naturally. Apart from the relative ease of population flows – which facilitates labour mobility – one is struck by the number of Australia-New Zealand Associations and Societies of one kind or another. Try an on-line search of the words “Australia, New Zealand, association and society” to see what I mean. The industry structures of the two economies differ somewhat, reflecting natural resource endowments (Table 1). Australia has more mining, but less manufacturing and farming, as a share of GDP, than New Zealand. But on the whole, the differences are perhaps not as striking as the similarities. Table 1: Economic Structure Percentage share of GDP, 2007/08 Australia New Zealand Manufacturing 10.1 14.1 Mining 6.8 1.2 Agriculture, forestry and fishing 2.3 5.8 Total of above 19.2 21.1 Finance, property and business services 19.4 20.9 Health, education and community services* 13.4 11.9 Wholesale and retail trade** 12.3 15.4 Construction 6.8 4.6 Utilities and transport 6.8 6.5 Government administration and defence 3.8 4.6 Communication services 2.7 6.1 Other 15.5 8.8 * includes cultural, recreational and personal services ** includes accommodation, restaurants, cafes and bars Note: Data are not strictly comparable as industry value-added in Australia is measured at basic prices and in New Zealand at producers’ prices Sources: ABS; Statistics New Zealand The two countries do a good deal of bilateral trade, helped by the Australia New Zealand Closer Economic Relations Trade Agreement (CER) of 1983, 1 and Australia is easily New Zealand’s largest trading partner. Interestingly enough, though, while growth in trans-Tasman trade has been faster than growth in trade with Japan, the United Kingdom or the United States, traditionally big trading partners, it is not especially fast. The most striking thing is that growth in trade with China and other east Asian economies has been much faster for both Further information on the Australia New Zealand Closer Economic Relations Trade Agreement is available at: http://www.austrade.gov.au/ANZCERTA/default.aspx. countries than growth in trade with each other, despite the CER. I am neither arguing that the CER restrains trade nor that it might not be amenable to improvement to facilitate further trade. I simply observe that the massive increase in the prominence of Asia in the global economy over the past 25 years provided both countries with opportunities. We are both able to take those opportunities because of the open approach we have taken to trade generally. 2 Both economies have a high export rate of commodities – relatively more minerals for Australia and more agricultural products for New Zealand. Not surprisingly therefore, both countries have had very significant changes in our terms of trade over the past several years. New Zealand is a more open economy than Australia, so a rise in the terms of trade of any given percentage has a larger effect on incomes there. But the sheer magnitude of the terms of trade gain for Australia means that the gain in real domestic income over the past five years was roughly double the size of the impact in New Zealand. In both cases, the terms of trade look like they are now starting to moderate. The two countries share structural policy features: • floating currencies and central banks with a medium-term, flexible inflation-targeting approach to monetary policy. New Zealand was, along with Canada, a pioneer of inflation targeting; and • a history of governments, of varying political persuasions, which have maintained a general commitment to market-opening, liberalising policies over the past generation, including financial liberalisation. The two countries also share the same major banking groups, with the large four Australian banks having New Zealand subsidiaries and branches. The operations of these entities account for 90 per cent of the market for bank deposits and loans in New Zealand. For that reason, Australia and New Zealand have a common interest in sound functioning of the international financial system being restored. Our financial systems, like those of most countries these days, are connected to global markets and our large financial institutions are active in international markets. So there are impacts on our systems of the extreme dislocation in international markets, even though the Australian banks have strong balance sheets with good asset quality. Moreover, these same disturbances are in the process of slowing down major economies and hence global growth, which obviously will have some impact on our own economies. It is time therefore that I turned to say something about those issues. Recent events The genesis of the problems – the search for yield in a lengthy period of low global interest rates, the associated disregard for growing risk, structural flaws in the “originate and distribute” model of financing, the deterioration in lending standards – have been discussed at length over the past year. For today, it suffices to say that a lot of new risk was created and, far from being widely dispersed, a good deal of it ended up on the balance sheets of the most leveraged parts of the international financial system – banks and investment banks. The problems of counterparty risk aversion and reluctance to lend at term – that is, a breakdown in trust – first erupted in August last year. Term borrowing rates rose sharply Some research results imply that Australia and New Zealand both do significantly more international trade than would be implied by empirical models of international trade. See Guttman, S and A. Richards (2006), “Trade Openness: An Australian Perspective”, Australian Economic Papers, 45(3), pp. 188-203. Those authors also note that our two economies are the most “economically remote” countries in the world, in terms of average distance to potential trading partners. However, that relative disadvantage is falling somewhat with the growth of Asia relative to the economies of the North Atlantic. relative to overnight rates. This intensified through to the end of each calendar quarter as bank accounting dates approached, and lessened thereafter. This cycle was repeated several times through to the middle of 2008. While that was going on, a number of major international institutions accepted write-downs of their exposures to US mortgages, which were often via complex structured products whose prices proved to be very volatile – when they could be measured at all. They simultaneously sought new capital, though as fast as they received it, capital was being burned up in losses. Things proceeded in this way for over a year, without getting noticeably worse, but not getting noticeably better. Then during the months of September and October 2008, in a sequence of events historians will study at length for decades ahead, the international financial landscape changed dramatically. In the space of six weeks: • the remaining four large American investment banks disappeared – into bankruptcy, merger or by taking a banking licence, which gets them closer to the support of the Federal Reserve; • one of the world’s largest insurance companies, hit by a wave of margin calls on credit default insurance contracts it had written, had to take a loan from the Federal Reserve and is effectively in public ownership; • the largest participants in the US mortgage market, which had always been seen as implicitly government guaranteed, were explicitly nationalised; • the US Treasury brought forward a plan to purchase assets from lenders’ balance sheets for a sum of up to 5 per cent of US GDP. A version of this plan was approved on the second attempt, after several anxious days in which confidence was further eroded; • a number of European banks faced failure, including some quite large ones, and needed government support or were nationalised; and • governments in a number of countries felt the need to guarantee some or all of the deposit obligations of their banks. While this was occurring, global markets for equities, currencies and commodities saw extraordinary price movements, while yields on many short-term government securities fell sharply. Volatility in daily prices increased significantly. Interbank and commercial paper markets, which had already been under pressure, effectively closed in a number of countries. (It is worth noting that most key markets in Australia have continued to function through this period, even if under some pressure.) The extreme counterparty risk aversion in markets saw the shortage of US dollar liquidity in the European and Asian time zone worsen seriously, to the point that the effective cost of borrowing US dollars via swap in the Asian time zone reached well into double digits in mid September, and on some days the market was, for all intents and purposes, not available. The fall in commodity prices brought pressure to some emerging market countries, which saw falls in currencies and share prices, and which in some cases closed share markets. Since late September, many currencies have come under downward pressure against currencies like the yen, which was a favoured funding currency for various positions in higher-yielding currencies. The Australian dollar fell particularly sharply, in part because of the changes in interest rate expectations and commodity prices, and partly because its relatively liquid market sees it used by many managers as a device to change quickly their exposures to some other currencies and commodity-based strategies. In summary, what appeared for the preceding year to be a serious, but containable, problem of liquidity and concerns over creditworthiness turned suddenly into a very fast-moving crisis of confidence in key players in the international financial system, where questions of solvency came much more to the fore. It has presented financiers, and policy-makers, with the most difficult set of challenges of its kind for generations. What should be done? The question, then, is how to restore confidence and stability to these important markets and institutions. The first thing is to continue to provide liquidity. This requires central banks to expand their balance sheets if necessary, so that the private financial sector can continue to fund its existing asset book for the time being, and so that the broader process of de-leveraging can be accommodated with as little disruption as possible. Central banks have stepped up their liquidity efforts in a major way, with a number of them providing much more in the way of own-currency funding against a wider range of collateral. But the most visible impact is on the Federal Reserve’s balance sheet, where assets have nearly doubled in the past six weeks as a result of increases in the Fed’s various facilities. An increase in swap lines with other central banks, which allows the supply of dollar liquidity in Asian and European time zones, has been one large contributor to the expansion (and the RBA has participated in these lines). The most recent development has seen this liquidity operate on tap in several major countries – at a fixed price, in any amount market participants require, for terms extending out to three months. As a result, there is a now a huge amount of US dollar liquidity in the system. But while liquidity provision helps, it can, at best, ameliorate the impact of counterparty risk. It cannot eliminate it. The second thing that is needed is a restoration of confidence in the key financial institutions. Because the lack of confidence is, ultimately, about solvency, re-capitalisation of the relevant institutions is required. The lesson of past banking crises, moreover, is that when there are really serious problems in private balance sheets, capital may be available in sufficient quantity only from the public purse. This should of course come with appropriate conditions – private shareholders should absorb the losses from past problems, governments that put in new capital should share in the upside and guarantees that are offered should be priced. Governments should plan to divest their holdings in banks in due course. The UK Government’s plan announced a couple of weeks ago, which seems to have become something of a template for these sorts of intervention, appears to have the key elements needed to restore health to the key international institutions. It increases further the supply of liquidity for the short term. It also provides for an increase in the capital of key UK institutions, from the public sector if needed, via the government underwriting capital raising. And it provides some confidence for term funding markets by offering a guarantee of the debt obligations of the relevant banks for a period of time. This guarantee is not free to the banks – they will pay for it on commercial terms, which in the current environment are unlikely to be cheap. The intention is not to subsidise the price of borrowing but, by promoting confidence of repayment, to allow the market to find an appropriate price, which of late it has had trouble doing. The Australian response has taken careful note of the elements of this plan which are pertinent to our situation. The RBA’s liquidity facilities had already been further expanded, to allow our counterparties to bring to us internally securitised mortgages as collateral, to get funding for out to a year. This is available at market prices every day. The additional eligible collateral available to the Australian system as a result of the most recent changes can support over $50 billion of additional liquidity (after allowing for haircuts), if needed. The Australian Government has announced a general guarantee of deposits, as a precaution to allay any public anxiety over security of their savings. It has also decided to offer to guarantee wholesale debt obligations of Australian authorised deposit-takers and authorised Australian subsidiaries of foreign banks, on commercial terms. This will ensure that Australian institutions, some of which are among the highest rated of the world’s banks, are able to retain adequate access to term funding in an environment where banks of other countries are able, in effect, to use the rating of their governments when borrowing. Steps in these directions, in the context of what other countries were doing, were sensible and the Reserve Bank supported them. As is also the case in other countries, the design features of the various guarantees will be important. Little detail is available from other countries yet. Meanwhile, the Reserve Bank is working with our colleagues in the Treasury on the details of the Australian arrangements, including on how to maintain continued healthy functioning of Australia’s short-term money markets. The element of the UK plan Australia has not sought to emulate is public underwriting of capital injections. The Australian banks have strong capital positions and profits, so they should be able to approach the market on normal commercial terms if they desire additional capital. Where to from here? At moments like this, it is hazardous to make predictions. However, it seems to me that the key elements of dealing with the root issues in the crisis are starting to come into place. Policy-makers in the major countries do “get it”. The plans are not precisely uniform across countries – that is never achievable anyway – but we can, I think, see the shape of a broad common outline. It addresses the issues of liquidity, capital and confidence. There is much more work to be done yet on the design details, and one area in which further international co-operation would be helpful is in the area of making these various guarantee arrangements broadly consistent. But the world is, it seems to me, getting on to a better path. As a result, the likelihood of a global catastrophe has in fact declined over the past couple of weeks. The question of the appropriate macroeconomic policy settings to help economies through this period will also be receiving attention around the world. In those countries where previous settings have been prudent, and where inflation prospects permit, policies can be eased to counteract some of the contractionary forces set in train by the deterioration in global growth prospects resulting from the credit turmoil. Central banks in major countries, recognising weaker demand and the likelihood of easing pressures on prices, reduced interest rates in October. In Australia, the Reserve Bank made a substantial cut to the cash rate at its October meeting, bringing forward reductions that might ordinarily have taken place over several months. CPI inflation is likely to remain high in the period immediately ahead, and yesterday’s PPI data illustrate the concerns that the Bank has long expressed about inflation. But looking forward to next year, forces seem now to be building that will start to dampen pressures on prices – even though we won’t have evidence for that for a good six months. The Board sought, as always, to respond to the medium-term outlook for prices, not just the current data. The Australian Government has made a significant change to the fiscal stance which will flow through the demand side of the economy during the summer. The decline in the Australian dollar by about 20 per cent against a trade-weighted basket also amounts to a significant change for the trade-exposed sectors of the economy, though at the cost of some temporarily higher price rises. These changes will act to lessen the extent of the likely slowdown in Australia’s economy, even as global forces work the other way. The Reserve Bank will publish its next update on the economic outlook on 10 November, so I will not say any more about that today. I shall finish with the question of what trends will be of importance beyond that horizon. As I have said before, the emergence of China is not complete and has many years to run. Right now, China’s economy is slowing. This is a reminder that China’s economy has cycles, like economies everywhere. But even if it slows a lot, it will pick up again in due course and will probably grow pretty strongly, on average, over many years. In countries like Australia, perhaps the long period of household debt build-up is now giving way to a period in which balance sheets will see some consolidation. If so, household credit growth will not be as fast as it was for the past decade and a half. Perhaps we will need also to get better at turning borrowing for housing into more dwellings rather than just higher house prices. Perhaps the finance sector globally will return to fulfilling something more like its historical role of being “the handmaiden of industry”, with a bit less in the way of exotic innovation of its own. In such a world, a renewed focus on the processes in the real economy which generate growth in productivity could also be apt. In the case of Australia at least, it is now hard to avoid the conclusion that underlying growth in productivity has slowed over the past five years, compared with what was seen through most of the 1990s and the early part of this decade. Of course, these things are notoriously hard to measure and there will be various opinions about the extent of the slowing, why it occurred and what might be done about it. Nonetheless, once the immediate crisis has passed, that might be a conversation worth having. | reserve bank of australia | 2,008 | 10 |
Speech by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, at the 7th ITSA Bankruptcy Congress, Sydney, 30 October 2008. | Ric Battellino: An update on household finances Speech by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, at the 7th ITSA Bankruptcy Congress, Sydney, 30 October 2008. * * * The extraordinary developments in global financial markets over the past couple of months have, understandably, undermined households’ confidence in their finances. This has occurred around the world. • Households have seen incredible volatility in financial prices. Daily movements in share prices of several percentage points have become the norm. • Share prices have fallen sharply around the globe. In Australia, the share market is down about 40 per cent in 2008, resulting in negative returns in most individuals’ superannuation funds. • The difficulties in global interbank markets which had existed since August 2007 took a dramatic turn for the worse last month. The crisis, which had until then been largely confined to wholesale markets, spilled over into a severe loss of confidence among retail investors in financial institutions. Governments around the world have been forced to offer wide-ranging guarantees on banks’ liabilities. • And, to top it off, some commentators are predicting sharp falls in house prices here in Australia. Given the daily barrage of gloom and doom, it is easy for households to lose perspective, so I thought it would be useful to take an objective look at the state of household finances. In doing so, I will focus on three key areas: • household income; • household balance sheets; and • the housing market – in particular, is the Australian housing market going to go the same way as the US market? Household income The first thing to say about household income is that the past five years have been an extraordinarily favourable period. Real disposable income of the household sector grew on average by 6.1 per cent per year, resulting in a cumulative increase over the five years of more than 30 per cent. One has to go back more than thirty years to find a bigger increase over a five-year period. Table 1: Real Household Disposable Income Average annual percentage change Before interest After interest 1963-1968 4.6 4.5 1968-1973 5.8 5.6 1973-1978 3.1 2.7 1978-1983 2.6 2.2 1983-1988 1.8 1988-1993 1.7 2.1 1993-1998 3.1 1998-2003 3.2 2.9 2003-2008 6.1 4.8 Deflated using the household consumption deflator; dates refer to financial years. Source: ABS Periods of strong income growth tend to be periods of strong spending and it is the job of central banks to try to keep a lid on this, to prevent excessive inflation. The past five years were therefore also a period of rising interest rates. Some commentators would have us believe that this had a crippling effect on the finances of the household sector. While some households were no doubt severely affected, the facts show that this was not the case for the sector as a whole. Even after allowing for higher interest payments, real household disposable income over the five years still increased by more than 25 per cent. This increase, too, was the largest since the early 1970s. Put another way, over the past five years, the amount of money that Australian households had left over to spend, after paying taxes and interest on all their loans, grew in real terms at the fastest rate in over 30 years. What contributed to this surge in incomes? As usual, there were a number of factors at work: • wage and salary income grew strongly, at about 7½ per cent per annum on average; • income from investments grew by 17 per cent per annum on average. This was due to high dividends on shares and interest on deposits. This figure does not include the very strong capital gains on shares, which I will come to later; • taxes payable grew less than income because we were given a series of tax cuts. This meant that disposable income grew more quickly than gross income (8.3 per cent per annum on average); and • inflation (as measured by the consumption deflator) ate up 2.2 per cent per annum of this income growth, leaving growth in real disposable income at the figure of 6.1 per cent mentioned earlier. This growth in household incomes in Australia greatly exceeded that in any other developed economy. In the US, for example, growth in real household disposable income was only about half that in Australia. It is also interesting to note that the growth in income in Australia was fairly evenly distributed through the household sector. The percentage increase in real income was very similar across all the income quintiles. In short, the boom in income in Australia was very strong by world standards and a high proportion of Australian households shared it. These facts help us to understand how we got to where we are, but the more relevant question for households is: where are we heading over the coming five years? I think it is now widely accepted that growth in real incomes over the next year or two will be more subdued than over the past five years. How subdued will depend importantly on the effects of the financial turmoil. Nobody knows how significant they will turn out to be but it would be reasonable to assume that income growth for the household sector will be noticeably below average over the next year or two. Beyond the next couple of years, the future is harder to predict, but there is no reason at this stage to doubt that past patterns will be repeated and that growth will pick up again. Australia remains, after all, a very dynamic economy. The outcomes in Australia will, as usual, be influenced to some degree by global developments. At present, the major developed economies seem to be moving into recession, as they tend to do every seven to ten years. The last such recession was in 2001, so the one that is emerging at present seems to be pretty much on cue. The Bank has been factoring weaker global economic growth into its policy assessment for much of this year. Throughout this period, we have been forecasting lower growth than the major international forecasters. Even so, the events of the past couple of months have caused us to revise our forecasts down further. Australia managed to sidestep the 2001 global recession. Can it do that again? That is certainly what we are aiming for, and there is nothing in the data to date to suggest that we are off track. But the economy is being affected by powerful forces from different directions, and it is unclear what the net effect will be. The impact of global developments is particularly uncertain. We also have to recognise that the task of managing the economy this time will be more difficult than in 2001 because we are starting with a bigger inflation overhang. The Bank has for some time thought that inflation would peak in the second half of 2008 and then fall; accordingly, we have acted pre-emptively in reducing interest rates. Nonetheless, there is still a big task ahead to bring inflation down and this could limit room for manoeuvre on monetary policy. Many people will be disappointed and unhappy with a year or two of below-average economic performance. But the truth is that the economy cannot always grow above average and it certainly cannot maintain the pace of the past five years. If we attempted to make it do so, we would be repeating the mistakes of our predecessors in the 1960s, whose attempts to maintain a never-ending boom laid the foundations for the subsequent two decades of severe economic difficulties. One of the factors that helped keep Australia from following the developed economies into recession in 2001 was our increasing links to Asia, and China in particular. These links have strengthened further since 2001, with China now Australia’s largest trading partner. It would be naïve to assume that China will not experience an economic cycle, so we should expect its demand for our resources to fluctuate. However, China’s strong long-term growth potential must be a source of optimism about our own long-term prosperity, given our role as one of its most important suppliers of raw materials. Household balance sheets I would like to turn now to household balance sheets. Australian households have much bigger holdings of financial assets than financial liabilities. Financial assets at 30 June averaged around $275,000 per household while liabilities averaged $150,000 per household. Since then, we estimate that average assets have fallen to around $245,000 per household, though this is still quite a strong position. Graph 1 The composition of assets and liabilities is very different. • The liabilities consist mainly of borrowings from banks and other lenders where the value is fixed and on which regular interest has to be paid. • Household financial assets, however, consist mainly of market-linked investments. This balance sheet structure is very favourable in terms of maximising long-run accumulation of wealth, because the return on these assets over long terms exceeds the cost of debt by a substantial margin. The returns do not, however, accumulate evenly from year to year. Some years produce very strong returns while others produce negative returns. We are currently going through one of those periods of negative returns. As I mentioned, the Australian share market has fallen sharply this year. Largely because of this, the typical balanced superannuation fund experienced a negative return of about 8 per cent last financial year. Returns are again negative so far this financial year. Naturally, people find this very distressing. But it is not the first time this has happened. Over the past 100 years, the share market on average has had negative returns every 5 years. Graph 2 While the sharp fall in share prices since late last year is confronting, the thing that needs to be kept in mind is that it was preceded by four years of extremely strong returns. As such, even after this year’s fall, anybody who has held shares over the past five years would still have earned 8 per cent a year on average. That is still more than the return on government bonds or bank deposits over the period. Graph 3 The uneven pattern in share market returns partly reflects the economic cycle and partly reflects the influence of human behaviour. As investors, we find it difficult to distinguish the cycle from the trend. In particular, after a few years, a cyclical upswing starts to look like a trend and more of us try to jump aboard. Eventually this pushes asset prices to levels that are higher than can be justified by the income produced by the asset, and prices correct down. Investments in shares tend to compensate the holder for the short-run volatility in returns by producing higher returns over the long run. If they did not, nobody would invest in them. These higher returns can compound to very large amounts over time. Graph 4 As an illustration of this, assume somebody had $100 (in today’s money) to invest 100 years ago: • If they put this in government bonds, and assuming all the interest was re-invested in bonds along the way, the investment would today be worth about $800. This is an annual real return of 2 per cent. • If they put it in the Australian share market, and again assuming that all dividends were re-invested in shares, it would today be worth about $130,000. This is an annual real return of 7 per cent. The difference between these two rates of return – 5 percentage points per year – is the risk premium that investors have received for investing in the share market. At present, the risk premium is higher than this because investors have become very nervous. The increase in the risk premium demanded by investors has been an important factor causing share prices to fall in recent months. The one-year forward earnings yield on Australian shares has risen to 11 per cent, well above the long-run average. This is a very attractive yield. When the yield has risen to these levels in the past, the return on shares over the subsequent 10 years has almost always been well above average. The housing market Finally, I would like to make a few comments about the housing market. Some commentators who have looked at the US housing market feel they have seen the future for the Australian market. In some ways, this is understandable because economic developments in Australia have in the past often mirrored those in the US. As you know, the ratio of housing costs to income has been unusually high in recent years and it is not unreasonable to expect that it will decline over time. But this ratio can adjust in several ways: lower house prices, rising incomes or falling interest rates. In the US, falls in house prices have been a big part of the adjustment. I think there are reasons, however, to believe that the Australian housing market will not follow the US market to the same degree. Let me run through some of these reasons. First, the cycle in the Australian housing market, rather than following the US market, is in fact at a more advanced stage; it is probably leading the US market by three years or so. The Australian housing market was at its hottest in 2003, whereas the US market peaked in 2006. To understand how this came about, it is necessary to look back to the second half of the 1990s. The tremendous shift in the global savings/investment balance that followed the Asian crisis generated a surplus of funds in global markets. The financial sectors in the English-speaking countries, being more dynamic and responsive than in many other countries, were quick to take advantage of this. In the US, the early part of this period coincided with a surge in technological innovation, and the initial wave of money in that country went to the technology sector. This resulted in the “tech” bubble, which eventually collapsed in 2000. Australia did not have much of a technology-producing sector so our financial institutions sought out other investment opportunities. What Australia did have was a conservative household sector with relatively low gearing. As such, the financial sector saw opportunities for financial innovation aimed at encouraging households to make greater use of their borrowing capacity. Most of this was focused on housing lending. The result was that the boom in housing in Australia got underway well before that in the US the latter did not really get going until after the tech bubble collapsed. A second difference relates to the dynamics of the housing markets in the two countries. In the US, the rise in house prices elicited a very strong supply response so that, by the end of 2007, there was almost one-year’s supply of newly built unsold houses overhanging the market. US house prices stopped rising essentially because the supply of houses overtook demand. Graph 5 Here in Australia the rise in house prices did not elicit such a strong supply response. There were pockets of overdevelopment in apartments in 2003/04 but, by and large, there was never a serious oversupply of unsold new houses in Australia. In fact, the consensus is that there is currently a shortage of dwellings. The Australian housing boom ended because prices rose to levels that severely strained the financial capacity of buyers to pay higher prices, not because too many houses were built, as in the US. The overhang of unsold houses in the US has created downward pressure on house prices as builders and developers have been forced to sell. This is absent in Australia. Rather, the shortage of housing here means that there are buyers waiting for better circumstances – e.g. lower interest rates or rising incomes – to facilitate their entry to the market. This latent underlying demand for housing is a factor that will support the market. A third important difference between Australia and the US is in the groups that the lenders targeted, and in the loan terms on offer. In Australia, the lending boom was concentrated on existing home owners who traded up to bigger and better houses and bought investment properties. Many of these were people in their 40s and 50s who previously had low levels of debt. At the end of the boom, the home ownership rate in Australia was no different to that at the start; in both cases about 70 per cent. While one could argue that no socially productive purpose was served by this increased lending to middle-aged existing home owners, it did mean that the loans largely went to those who had a strong capacity to service and repay them. As a result, whereas most other countries with housing booms have experienced a strong rise in arrears on housing loans once the boom ended, in Australia the arrears rate is today no higher than it was at the start of the boom in the mid 1990s. And, of course, it is low by international standards. Graph 6 In the US, in contrast, a lot of the lending found its way to more marginal borrowers who previously could not afford a loan, or it took the form of aggressively structured mortgages which allowed people to borrow much more than they previously could. The home ownership rate in the US continued to rise during the first years of the boom. One could argue that this was a good thing, but one consequence was that a significant proportion of this group ended up having trouble servicing their loans; hence, the sharp rise we have seen in US loan delinquencies. In setting out these differences, I don’t want to leave the impression that the Australian housing market is without its problems. There is no denying that there is a significant number of people who are facing difficulties with housing loan repayments, especially in western Sydney where arrears rates are significantly higher than in other parts of Australia. While lending standards in Australia did not deteriorate to anywhere near the same extent as in the US, loans sourced from new, non-traditional lenders have ended up with higher rates of arrears than those of traditional lenders. The arrears, even on prime, full-doc loans made by this new group of lenders are three times higher than those on similar loans sourced from the major banks. In addition, a higher proportion of loans granted by these lenders were lowdoc or non-conforming, the arrears rates on which are significantly higher than those on prime loans. One can only conclude that these lenders had lower credit standards than traditional lenders, and while this may have benefited some borrowers, it has ended up causing significant hardship for others. Graph 7 One of the issues that has been highlighted by events in the US is the importance of having adequate regulation of lending and loan brokers. In Australia, all lenders were covered by the Uniform Consumer Credit Code but loan brokers were much more lightly regulated, until very recently. The Council of Australian Governments earlier this year recognised that regulation needed to be strengthened and agreed to transfer responsibility for the regulation of all consumer credit to the Commonwealth. This is due to take effect by the middle of next year and should ensure that regulation of this very important financial activity is put on an even sounder footing. Conclusion We are going through some uncertain financial times at present, which is leading some to question whether the period of prosperity that has been running for almost two decades has come to an end. While nobody can predict accurately all that lies ahead, it is important not to become too pessimistic because, fundamentally, household finances and the economy more generally remain in good shape. The main problem that had built up – inflation – is manageable and is being dealt with. The next couple of years will be noticeably more subdued than the past five. We should not be surprised by this as the income and wealth generated over the past five years were simply extraordinary. By definition, the economy must grow at a below-average pace for some of the time. These periods provide the economy with the breathing space to sustain the expansion. There is no reason to assume that the next year or two will not do the same. | reserve bank of australia | 2,008 | 10 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to CEDA Annual Dinner, Melbourne, 19 November 2008. | Glenn Stevens: The economic situation Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to CEDA Annual Dinner, Melbourne, 19 November 2008. * * * Thank you for the invitation to renew my association with CEDA, which goes back many years. CEDA has, for half a century, sought to promote informed discussion and balanced development of the Australian economy. That long-run perspective is never more important than at times like the present, when a cyclical event is under way and confidence tends, understandably, to wane. The global economy is at an important juncture. After a number of years of very strong growth, the latter part of 2008 and 2009 look almost certain to be characterised by the weakest international economic conditions for many years. Of course, global growth had already been slowing, after several years of very heady expansion that had stretched the limits of resource availability and pushed up commodity prices sharply. Inevitably, the slowing was initially uneven and some countries – notably the United States – had been battling economic weakness longer than others. But global growth prospects have been marked down significantly further in the space of just a couple of months, with the weaker picture led by the United States but by no means confined to it. The proximate trigger for the sudden deterioration in people’s assessment of the outlook was a sequence of financial events. It was not that these events initiated the slowdown, but they have led people to think that it will turn out to be a bigger event than hitherto expected. What had been for over a year a serious dislocation in international financial markets, but one which seemed to be being managed, turned quite suddenly into a very serious crisis during the weeks following the failure of Lehman Brothers on 15 September. In a breathtaking turn of events, the financial landscape changed dramatically, with the failure or rescue and effective nationalisation of a number of systemically important financial institutions in the United States, the United Kingdom and continental Europe. Share markets slumped, currencies moved abruptly, commodity prices continued their sharp decline and investors’ appetite for risk contracted further. Not only that, but the constraints on credit that periodically had been flaring up over the preceding year became more widespread, and are likely, if they persist, to have significant effects on economic activity in many countries and on trade between them. Until September, while the cost of borrowing for banks and low-rated corporates had increased, it had been the case that the most highly rated corporations had not experienced a significant rise in borrowing costs. That has now changed, with spreads for even AAA-rated corporates rising sharply. Likewise, spreads for emerging market sovereigns have increased significantly, for the first time in this episode. It is not surprising, then, that formal forecasts made by bodies such as the IMF have been in a state of almost continual revision. Their latest incarnation, as released for the annual meeting of G-20 finance ministers and central bank governors recently in Brazil, is for the weakest performance in the G7 group of countries for many years. In addition, emerging market countries, including China, are also being affected more now, and talk of “decoupling” has gone away. Actually, this was a very unhelpful term anyway, carrying as it did the implication than economies are either mechanically “coupled” or not. Reality is more complex – everything is connected, but the effects across national borders depend on the nature and severity of the originating shock and what else is going on in the other countries around the globe at the time. Given a big enough shock, everyone ultimately is affected. What then is needed to address the situation? In facing the financial problems themselves, the most important steps have already been taken by countries at the epicentre of the crisis. Those steps address issues of liquidity, capital and confidence. In the area of liquidity, central banks have taken unprecedented steps over the past year, and especially the past few months, to add funds to their respective financial systems. This has culminated, through co-operative swap lines between many of the central banks, in the provision of virtually unlimited amounts of US dollar cash, against a wide variety of localcurrency collateral, across multiple time zones. This liquidity is on tap at a fixed (low) price: no quantitative limit has been set by the US Federal Reserve. As a result of this, and the expansion of other facilities, the Fed’s balance sheet assets have more than doubled in the space of a few months. In the area of capital, the lessons from earlier crises have been heeded, chief among which is that when a country faces a system-wide question of solvency, the only source of sufficient new capital may be the public purse. Hence, governments in the United Kingdom, the United States, Germany, France, Spain, Portugal, Sweden, Switzerland, the Netherlands, Belgium, Luxembourg and Iceland are offering to take, or have taken, equity stakes in key financial institutions, up to and including full nationalisation in some cases. As far as confidence is concerned, measures have been taken by a number of governments to secure retail deposits by a guarantee, and to offer a guarantee of eligible wholesale obligations of banks willing to pay for it. This ought to alleviate concerns about riskiness of the institutions concerned, allowing them access to term funding. These measures are bearing some fruit. Markets are beginning to thaw. Spreads between expected central bank policy rates and term funding costs have come in from the extraordinary levels seen in September and October, though they remain high by historical standards. The actions taken to inject equity are stabilising a situation on solvency that could otherwise have unravelled quickly. There have been substantial issues of wholesale securities using the priced guarantee, mainly by UK banks, suggesting that term markets are opening again. What is needed now is for policy-makers everywhere to specify as quickly as possible the parameters of their various guarantees so that market participants have a degree of certainty about how things will work – while retaining, within reason, the capacity to adjust the parameters in the light of experience. So a good deal has been done already towards addressing the financial problems themselves. These measures cannot avert a significant slowing in the global economy – it is fairly clear that a recession in the major country group, the G7, is under way. That, in turn, means that credit losses will be incurred by the lenders in those countries as typically happens in a business cycle downturn. But the measures averted, in my judgment, potential systemic collapses that would have had massive repercussions throughout the world. That leaves an international business cycle event to be addressed. So what are the ingredients for doing that? The slower growth in demand occurring now, and likely to be seen over the coming year, has had the effect of lowering the most flexible set of prices, namely those for raw materials and energy. The price of crude oil has fallen, measured in US dollars, from nearly US$150 a barrel at mid year to under US$60 today. Prices for metals and soft commodities have also declined considerably. It now looks as though prices for iron ore and coal, critical cost components for steel and electricity, are declining too. Other prices around the global economy are typically slower to respond to the shifting balance between demand and potential supply, but with global output expected by the IMF to be growing during 2009 at its slowest pace for two decades or more, spare capacity is likely to be increasing, so we could expect these slower-moving prices to moderate over the next couple of years. This outlook has increased the scope for many central banks to reduce interest rates. Until quite recently, concerns about inflation saw a majority of central banks tightening monetary policy. Through to the September quarter of this year, those central banks raising interest rates had consistently outnumbered those reducing them, by a significant margin. There is now, however, a preponderance of reductions, in expectation of falling inflation. Some of the reductions have been quite large. So monetary policy is easing. In circumstances where the financial markets are seriously impaired, of course, the central bank reducing the overnight interest rate may not make much difference to the price of credit to ultimate borrowers. This is not a major problem in Australia, but in the United States rates paid by many borrowers have not fallen much, if at all, over the past year. It is also possible in some countries that, even at lower interest rates, neither the demand for credit nor the willingness of banks to supply it will be increased as much as would normally be the case. This does not mean that monetary policy in those countries has become completely ineffective – in many cases, it may simply lead policy-makers to lower overnight rates by more than usual. Nonetheless, it is handy in such circumstances to have an additional channel – namely, fiscal policy – that can affect aggregate demand if needed. Moreover, as the private sector in many countries is seeking to conserve wealth in the face of weakening incomes and lower asset values, it will presumably attempt to save more of its current income; this might be particularly so for households. The problem is that, for the economy as a whole, if everyone attempts this change simultaneously, the “paradox of thrift” says that the economy will contract. So if that were indeed the situation that some countries faced, the stabilising policy would be for the government sector to decrease its saving, so as to accommodate the rise in saving by the household sector. So, in addition to monetary policy easing, fiscal policy adjustments are being made or contemplated in a number of countries. The question is how much scope the relevant governments have for such actions, before encountering the potential limits to credibility of their own balance sheets. Those who already had largish deficits – which will get bigger as economic activity weakens – and/or who had high levels of public debt, presumably have less scope for fiscal action. Calls for fiscal expansion around the world are accordingly being accompanied by calls for credible statements of how the long-run soundness of public finances will be maintained. There is an important point to make here, which generalises to monetary policy as well. It is that those countries which went into this episode having practised disciplined macroeconomic policies over many years, and I would include Australia in this group, will tend to be the ones which find themselves with the most scope to move in an expansionary direction, should they need to do so. And that, of course, is the whole point of the earlier discipline. That said, it is still important for fiscal measures to pass the “good policy” test. Poor public policy proposals should not be accepted simply because they are presented as boosting short-term aggregate demand. One of the countries of most importance to Australia is China. It has been said that the full emergence of China is a structural phenomenon that has many years to run and which is profoundly changing the world economy. I still believe that to be true. Nonetheless, as I have remarked before, the Chinese economy has a business cycle, like all economies, and it is apparent that this cycle is in the down-phase at present. While it is very difficult to get a full economic picture of China, it appears that the slowing may be much more pronounced than most people, including the Chinese authorities, expected. That change in trend has had major effects on prices for commodities, including ones important for Australia. But the Chinese authorities have now responded quite forcefully to the emerging weakening in their economy. Details of the recent fiscal package are still difficult to assess, but new demand may be as much as 2 per cent of GDP or more in each of the next two years; and monetary settings have been eased noticeably over the past two months. So I suspect that, while China is weakening at present, it will be strengthening a year from now. These various policy responses are acting to limit the downside risks attached to the outlook over the next couple of years. It will be six to nine months before their effects begin to be seen in the statistics. Whether enough has been done adequately to restore conditions for sustainable growth, it is too soon to know yet. But if not, it is a safe bet that more will be done before long, if the recent comments by the authorities in various countries are any guide. What then of the outlook for Australia? Thus far most indicators have suggested that the economy has been slowing, after a period of excessively strong growth in demand that had pushed up inflation. Absent the sudden recent deterioration in the global outlook, I think we would in due course have looked back and seen that the slowing had been similar to that observed in 2001, albeit with differences by sector. But with recent international economic and financial events, the economy will probably now experience a more significant slowing than was otherwise going to occur. That is barely detectable yet in some of the key official datasets. Employment, for example, remained quite solid, and unemployment very low, through into October, consistent with the gradually moderating growth of mid year, but not yet showing the effects of the more cautious mood in the business community that is now taking effect. Nonetheless, in the period just ahead, we are likely to see, for a time, growth at quite a slow pace. That is the outlook embodied in the Reserve Bank’s Statement on Monetary Policy released last week. This means that, over time, the extent of capacity utilisation will decline and pressure on prices will abate, though that could take some time to be apparent. The lower exchange rate will tend to push up prices for traded goods, though the weak global environment may mean this effect could be muted somewhat. Lower raw material prices will also be of considerable assistance in slowing manufactured prices – again subject to the exchange rate. Of course, many of the items pushing up inflation in Australia of late have been in the services sector, but the likely moderating trend in labour cost growth over the next couple of years should help here. Overall, our view is that after a fairly extended period of above-target inflation, we will see the CPI inflation rate moving back to its target over the next two to three years. Should demand in the economy weaken further than we expect, that would be likely to be accompanied by a downward revision to the inflation outlook. Given this outlook, the Reserve Bank has been lowering the cash rate. We have chosen to do so quite quickly, well before a decline in inflation is evident in the data, in recognition that the international circumstances had changed quite sharply, which have increased the risk of a more abrupt slowing in demand. That is, we have been pursuing the inflation target in a forward-looking way, and paying due account to economic activity considerations. In the period ahead, we shall be seeking to strike the right balance between, on the one hand, the need to have inflation come back down, albeit slowly, and on the other hand, the desire to avoid as far as possible an unnecessary weakening in demand. Looking beyond the near term, what needs to be done to make future growth less likely to be disrupted by the sorts of financial problems we have seen emerge over the past 15 months? Every episode of crisis provides some new lessons and these can be incorporated into regulatory and supervisory practice as appropriate. Various proposed reforms in the area of financial regulation are on the table, many of them developed under the auspices of the Financial Stability Forum. 1 These include likely adjustments to the Basel II arrangements for Established in 1999, the Financial Stability Forum brings together senior representatives from international financial institutions, international groupings of regulators and supervisors, committees of central bank experts and national authorities responsible for financial stability to promote international financial stability through enhanced information exchange and co-operation in financial supervision and surveillance. the capital requirements of banks, including efforts to make them more anti-cyclical; more focus on liquidity risk management; attention to the conduct of credit rating agencies; the increased use of central counterparties to control the risks in some derivatives markets; and the establishment of cross-border supervisory “colleges” for the largest internationally active banks. Much work remains to be done, and if past experience on finding international agreement on regulation is any guide, it will be hard, slow, grinding work. But the call of global leaders last weekend in Washington for this work to be expedited gives it an important additional impetus and a greatly strengthened focus. But we need to approach the task of reform with realism. The cycle of greed and fear cannot be regulated away. To assume that unrealistic optimism will not again, at some point, overwhelm the more sober instincts of investors, bankers, commentators and others would be a triumph of hope over experience. Regulation can be improved, but there will always be an unregulated part of the system, the more so the tighter regulations are; there will always be those who put at risk some of their capital in that sector; there will always be a business cycle, and there will always be some who take excessive risk near the peak of the cycle and get caught out. The genius of the market economic system is that so much of the risk that is prudently taken, much of the time, turns out to reward the risk-taker, and indeed all of us, with the profitable deployment of capital, jobs, more choice, higher productivity and better living standards. It will be important not to forget that in the next year or two. Nor is it realistic to assume that regulators and central bankers will always have the wisdom and prescience, or even the scope, to deploy their few instruments such as to ensure that an ideal combination of financial stability and high growth can be achieved consistently. The world will never be that perfect. Nevertheless, in addition to the many useful steps being planned by regulators, perhaps we could pay more attention to the low-frequency swings in asset prices and leverage (even if that means less attempt to fine-tune short-period swings in the real economy); we could have a more conservative attitude to debt build-up; and we could exhibit a little more scepticism about the trade-off between risks and rewards in rapid financial innovation. This would constitute a useful mindset for us all to take from this episode. To conclude, we face difficult circumstances. Policy-makers and regulators both here and abroad will need to stand ready to act promptly to provide any necessary support for the financial system and sustainable economic activity. In doing so, though, we need not, and should not, abandon the well-established and tested policy frameworks that are in place. In fact, it is these that have given Australia, in particular, ample scope to do what is needed in the current situation. Given that we have that scope, and given the underlying strengths of the economy, about the biggest mistake we could make would be to talk ourselves into unnecessary economic weakness. Yes, the situation is serious. But, as I suspect CEDA members know well, the long-run prospects for the Australian economy have not deteriorated to the extent that might be suggested by the extent of some of the gloomy talk that is around. If businesses remain focused on the long-term opportunities; if markets and commentators do the same; if banks remain willing to lend on reasonable terms for good proposals; if governments are able to so order their affairs as to continue supporting worthwhile – and I emphasise worthwhile – public investment (even if that involves some prudent borrowing); then Australia will come through the present period. We ought to go forward with some quiet confidence in our own abilities and in the opportunities that are on offer. I wish you all well in that endeavour. | reserve bank of australia | 2,008 | 11 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 9 December 2008. | Glenn Stevens: Interesting times Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 9 December 2008. * * * It is a pleasure once again to address the Australian Business Economists. It was to this group that I gave my first speech as Governor, in October 2006. Tonight is my 23rd speech since then. Between the two occasions, quite a lot has changed, globally and domestically (though I doubt the speeches have become any more exciting). Many people have said to me recently that the times are “interesting”. My response has been that they are, perhaps, a little too interesting. I need not remind this audience of the international financial turmoil through which we have lived over the past almost year and a half, nor of the intensity of the events since mid September this year, in particular. I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a “tail” outcome – the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it. In that spirit, I shall set out a few features of this episode that make it “interesting”. The most obvious one is the prominence of financial events and particularly financial sector impairment in key countries. There have been other episodes where individual financial institutions or sectors, or even the whole banking systems of small countries, have needed recapitalisation. But the scale of capital needed, the number of countries where it is needed and the extent of counterparty risk aversion because of concerns over solvency have been outside the range of experience of the past half century. In the near term, financial stress brings the obvious concern about the ability of the financial system to provide credit to the economies in question. As one measure of this concern, the number of loans approved for housing in the United Kingdom in October was 65 per cent lower than a year earlier, and about 50 per cent lower than during the downturn of the early 1990s. The immediate need is to keep ample liquidity, strengthen banks’ balance sheets by adding capital and to help confidence, including by lending the strength of the sovereign’s credit rating where necessary. All this has been occurring. What may still be needed internationally is attention to the remaining problem assets, since if their prices continue to decline, the capital position of the banks will continue to deteriorate. So while the UK solution has emphasised new capital and the initial US approach emphasised excising the “troubled” assets, the Swiss solution has been to do both: to recapitalise the banks, while getting the worst of the bad assets off their balance sheets. The United States has moved in this direction also more recently. Continued efforts to provide clarity on the state of balance sheets is also important. Surely the lingering counterparty risk aversion reflects uncertainty on this score. Longer term, some of the implications of the past year’s events will be seen in the regulatory environment. In those countries where the public purse has had to be used to support bank solvency, it can be expected that there will be significant regulatory reform – and rightly so. The real trick, however, will be to make sure that the reforms are not just knee jerk reactions to the symptoms of financial excess – as clear as they are – but well considered, durable and tractable changes that appropriately contain, but do not crush, the financial system’s capacity and appetite to take risk. Certainly, over the past five or so years, too much risk was taken, of the wrong sort. The danger in the next several years, however, will not be too much risk taking, but too little. Regulators will want to avoid compounding that. While the prominence of financial events has been clear, there has also been a set of “interesting” events in the real economy unfolding at the same time. The fortunes of the Chinese economy are increasingly important, particularly for Australia and other countries in our time zone. The most striking real economic fact of the past several months is not continued US economic weakness, but that China’s economy has slowed much more quickly than anyone had forecast. Our own estimates suggest that Chinese industrial production probably declined over the four months to October. Some of this might be attributable to the effects of the Olympics but surely not much. Some of it reflects the weakening in Chinese exports to major countries. But more than that seems to have been occurring. I am not sure that many economic forecasters have fully appreciated this yet. There is every chance that the rate of growth of China’s GDP is currently noticeably below the 8 per cent pace that is embodied in various forecasts for 2009. The Chinese authorities, having sought a slowing of their economy after it was clearly overheating, are now moving policies quickly in an expansionary direction. So there is a good chance that China’s economy will be looking stronger in a year’s time than it does today. It is important, though, that this is done in the right way – specifically by boosting domestic demand. China’s slowing may be part of a third striking fact, namely, the simultaneity of the weakening in economic activity around the world during recent months. When this occurs, one is naturally led to look for a common shock. The noticeable slowing in many economies in the June quarter seemed at the time to be attributable to the sharp run up in oil prices. That rise has now been more than reversed, but the slowing has, if anything, intensified during the past several months. The more recent weakening might be the result of more widespread and intense tightening of credit conditions that has occurred in some of the major countries. But the state of domestic financial sectors differs across countries. In Australia or Japan or much of east Asia or Canada, while credit conditions have become more difficult, the banks are in much stronger condition than in the United States or Europe or the United Kingdom. One thing that stands out as closely related across countries, however, is the fall in share markets. These changes are to some extent themselves a reflection of a weaker set of expected economic outcomes. But with closely linked financial markets and rapid communication, changes in sentiment are transmitted very quickly across countries and it appears that those changes in sentiment are themselves affecting behaviour. People have, understandably, become very uncertain about the outlook and are correspondingly more cautious in their spending behaviour. In essence, we are now in a period when the essential nature of events is not so much a crisis in the financial system. It is a crisis of confidence on the part of households and businesses, and it is global in nature. Hence the need for actions that are internationally consistent to deal with the situation. On that score, a fourth “interesting” feature is the speed with which official institutions seem to be reacting to the economic fallout now unfolding. To take one example, IMF forecasts, and associated policy advice, are being revised more often and faster than I can recall in the past. Perhaps this is simply because of the greater number of international meetings at which the Fund is asked for its view, but my sense is that international official bodies and their domestic counterparts are shifting their assessments unusually quickly as they attempt to grapple with the unfolding situation. Monetary policy is being eased aggressively around the world. So is fiscal policy. One of the striking features of the recent G 20 meetings was the way the need for fiscal stimulus, where debt levels permitted, was readily agreed between participants, and actively encouraged by the IMF. Of course, agreeing to things in general at a meeting is only the first, and the easiest, step. Actual policies have to be delivered and in a timely and effective – and hopefully consistent – way. I use the word “consistent” because it is preferable, in my judgment, for action to be broadly consistent and timely, than for it to be precisely co ordinated but delayed. It also remains to calibrate the extent of the measures appropriately for the circumstances, which is no easy matter. Nonetheless, it seems to me that all this is happening faster than on previous occasions. It would not be realistic to suggest that this response has been, or ever could be, so fast and so well targeted that significant near term weakness in the global economy can be avoided. The data coming in by the day confirm that there is an international downturn taking place, and that it shows every sign of being a deeper one than the rather shallow affair of 2001. The question is whether we have reasonable grounds to expect that the combination of private and public efforts to address the financial problems, a subsidence of the sheer panic in financial markets and the use of macroeconomic policy to provide stimulus to weak economies will establish sound foundations for a renewed period of expansion beginning some time in 2009. The inauguration of a new US Administration is a key opportunity. The economic downturn has been deepening during the transition period. But if the new team can announce credible plans to accommodate the required adjustments in the US economy, confidence in medium term prospects can be re built. This would assist both the US economic recovery and conditions elsewhere. Thinking ahead, the next international expansion will no doubt have some different characteristics from the previous one. It cannot be based on a continual gearing up by consumers in developed countries and associated asset price escalation. For that reason, neither can it be characterised by the continued large build up of balance of payments surpluses by the emerging world. The secular increase in living standards in emerging countries ought to play a bigger role in driving global demand – and that will depend on appropriate policies in both those countries and the developed world. It looks like there will be a fairly prominent role in the near term, in many advanced countries, for the government sector through the recapitalisation and/or guarantees of banks, or fiscal expansion, or both. But for sustained growth, there will also need to be a role for innovation and prudent risk taking in the private sector – even though, at present, that is in retreat. Turning closer to home, the Australian economy has seen a significant change in circumstances over the past six months. The biggest terms of trade boom in half a century is over, and has partly unwound. I still think that China’s emergence is far from complete and that, as a result, the terms of trade will be higher on average than they were until a few years ago. But over the next year they will be well below their peak. Our households, like those elsewhere, have observed financial turmoil and a decline in share prices and have become more cautious. Consumer spending, which slowed significantly in the period from about February to June as interest rates and petrol prices rose, has remained slow since, even as interest rates and petrol prices have fallen significantly. I think we can expect that households will be more cautious about debt over the next couple of years. Business investment and government spending have remained pretty strong – so that domestic demand was still 4 per cent higher in the latest data than a year earlier. But businesses are currently in the process of scaling back plans for investment and hiring. This is partly in response to slower consumer demand, but the dramatic change of view about international conditions and the general uncertainty reflected in financial market prices are surely playing a major role. So in the period ahead, private demand could look weaker than it has for some years. What then do we need to be doing to ensure as far as we can that the period of weakness is brief, and that prospects for longer-term sustainable growth are maintained? Of course, we cannot change the course of the world economy. But we can keep our own house in order to maximise our chances of good performance. On this score, as I have remarked before, Australia has scope to use macroeconomic policy to support the economy in the weak part of the cycle. That scope was earned by being prepared to run budget surpluses and run down public debt when revenues were strong, and by raising interest rates to contain inflation when the economy overheated. The scope to ease policies is now being used. On the fiscal side, the “automatic stabilisers” will reduce the budget surplus as the economy weakens, cushioning the economy in the process. That is what they are designed to do. There has also been a front loaded, discretionary easing that is starting to arrive in recipients’ bank accounts this week. Of course, a good deal of this may be saved, but even if it is, that presumably takes the place of private saving that would otherwise have been done over a longer period, so it brings forward the point at which households become confident enough to lift spending. Also on the fiscal front, there is no reason why worthwhile public investment decisions that are currently planned should not proceed, as long as they really are worthwhile. On the monetary front, interest rates right across the spectrum have fallen. Some fairly elementary calculations suggest that, as a result of the decline in interest rates that has occurred already, the fall in the household sector’s gross debt-servicing burden will be almost 3 per cent of household income. This is roughly equal to that seen in the early 1990s, when the cash rate fell from 18 per cent to 4.75 per cent. But on that occasion it took two and a half years; this time it will take place over about four or five months. The decline in borrowing costs for businesses has generally been smaller and slower to appear, but there has been some faster pass through of the most recent reduction in the cash rate. These transmission channels of monetary policy are still operating in Australia, unlike in some other countries. In addition, the exchange rate is playing its normal role of adjusting to changed circumstances in a way that stabilises the economy. It has declined by about 25 per cent in trade weighted terms since mid year, just about the largest movement we have seen in such a short period. These are quite big changes. They will take time to have their full effect, but they will be making a significant difference to conditions over the next year. There is scope to do more with macroeconomic policy settings, if needed, given the strength of the public accounts at the federal level, and the outlook for declining inflation. In assessing whether more is needed, and if so, how much, we will naturally need both to maintain a close watch on the data and to remember the extent of stimulus that is still in the pipeline as a result of past actions. Other supportive factors include the state of the financial system. This has been said many times but bears repeating. Of course credit conditions for some sectors, notably property, have tightened. And overall, credit to business is rising much more slowly now than a year ago. But even so, over the three months to October, credit provided by intermediaries rose at an annualised pace of about 12-13 per cent. On a broader definition, which includes capital market raisings, the pace was about 9 per cent. Both numbers are actually a bit higher than they were around mid year. In most developed countries, this would be considered a very satisfactory pace (if not a little fast). Credit growth to households has recently been very slow, by historical standards, at about 4 to 5 per cent. Margin loans in particular are contracting quickly as people reduce their leverage. Lending for housing is starting to pick up now, however, from the early impact of interest rate reductions. Australian banks, having raised very large quantities of deposits in the past couple of months, are now turning back to offshore markets, making use of the government guarantee. They do not appear to have had much trouble raising capital from private markets when they wanted it. Overall, while not without its difficulties, this situation remains a much better one than seen in a number of other countries. These are the key elements of handling the cyclical episode. Longer term, performance will depend on the quality of investment, both public and private, on productivity increasing innovation and reform, and on getting the right balance on regulation. All that is hard, but at various times over the past couple of decades, Australia has made considerable progress in these areas, and has a pretty good record overall of responding to the need for change, especially in times of adversity. There is no reason we should not maintain that record. As I said at the outset, we are indeed living through “interesting” times. They are tough times, for businesses, financial markets, households and policy makers. Given the global situation, we have a very difficult period to negotiate. But we can negotiate it. The long run prospects for the Australian economy have not deteriorated to the extent that some people may presently be feeling. We do have reasonable grounds for some quiet confidence about the future, however bad the storm at present may be. A period of reflection and recharging of batteries over the break will be helpful. At the conclusion of a hectic year, therefore, I wish all of you a Merry Christmas – and a much less interesting 2009. | reserve bank of australia | 2,008 | 12 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Central Bank of Malaysia's High Level Conference 2009 "Central Banking in the 21st Century: Implications of Economic and Financial Globalisation", Kuala Lumpur, 10 February 2009. | Glenn Stevens: Financial system developments and their implications for the conduct of monetary policy Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Central Bank of Malaysia’s High Level Conference 2009 “Central Banking in the 21st Century: Implications of Economic and Financial Globalisation”, Kuala Lumpur, 10 February 2009. I thank Kathryn Ford for assistance in compiling this address. * * * It is a great pleasure to be here in Kuala Lumpur at this celebration of Bank Negara Malaysia’s 50th Anniversary. The two central banks actually have something of a shared history. In the late 1950s, the Commonwealth Bank of Australia, as Australia’s central bank was then known, seconded officers to assist with the establishment of Bank Negara. One of them, Tan Sri W.H. Wilcock, became Bank Negara’s first Governor in 1959. So it is a pleasure indeed to be renewing the relationship in this way here today. The subject for this session is “The Nexus between Monetary and Financial Stability”. It is certainly a topical one. The global financial system has changed dramatically since Bank Negara’s early days, both in size and complexity. Yet for all its supposed sophistication, the system is still characterised by cycles – as is the case with so much of human behaviour. Periods of strong growth, rising asset prices and investor optimism are still followed by sharp increases in risk aversion, falls in asset prices, investor pessimism and weak economic conditions. What is perhaps novel in recent experience is the scale with which risk appetite could be accommodated by the global financial system and, equally, the scale of the damage wrought by the ensuing shift to risk aversion. All of this has, of course, complicated the operation of monetary and other policies and, in some cases, threatened to overwhelm them. With the benefit of this experience, policy makers everywhere are working on strengthening their frameworks. In doing so, however, we all need to keep in mind that our capacity to predict how financial behaviour will change in response to events, and to policy initiatives, will always be imperfect, as will be our capacity to keep pace with the latest innovations. Therefore, we need policy regimes that are robust enough to be effective despite this limited knowledge. These are the issues I will be discussing today. I wish to make clear at the outset that my remarks are about the general international issues, not specifically about either Malaysia or Australia. Financial system complexity and its role in the financial crisis In the current cycle, it has been argued that complexity obscured risks that were embedded in certain financial instruments and activities. So what do we mean by financial system complexity? Three key aspects come to mind: • the complex financial instruments that have played such a prominent role in the current financial turmoil; • the interactions between financial markets and institutions; and • the speed and virulence with which problems spread across national borders. Each of these elements has been important over the past two years. Financial innovation saw the development of a number of complex products, from asset backed securities (ABS), to structured credit products such as collateralised debt obligations (CDOs) based on portfolios of ABS, and CDO squareds (CDOs of ABS that hold CDOs as collateral) and credit derivatives. Only too late was it understood that the prices of these instruments move in a highly non linear fashion in response to falling credit quality in the tranches underlying the securities. When that began to happen, moreover, there was little or no liquidity in markets where these instruments were traded. Opacity was also a problem insofar as the banking system was concerned because such instruments were often not accounted for on balance sheet but were issued indirectly through special purpose vehicles. At the same time, the activities of financial institutions became much more closely intertwined with financial markets. There was a blurring of distinctions between different types of institutions and a shift in their relative sizes within the financial system. Banks moved beyond their traditional role as deposit takers and lenders to offer a much broader range of financial products, including funds management and insurance. The growth of securitisation markets (until recently) enabled non bank financial institutions to play a greater role in credit provision, and fostered the expansion of the so-called “shadow banking system”. Financial institutions also became much more reliant on markets for their own risk management and funding, and in some cases found that disruptions in financial markets had a serious impact on their ability to operate. For example, in the United Kingdom, Northern Rock’s heavy reliance on securitisation, and its inability to find an alternative source of funding when this market closed, was instrumental in its need for official support and subsequent nationalisation. Similarly, disruptions to markets for credit default swaps, or even simple foreign currency swaps, had a significant impact on the operations of institutions that relied on these markets to hedge their exposures and manage funding. Globalisation has also been important, with much economic and financial activity increasingly organised on a transnational basis. Hence, there is much greater interdependence between national financial systems – and one of the remarkable features of the recent global turmoil has been the speed at which problems have spread across borders at critical moments. This is true not only of financial difficulties, by the way, but also of the effects on the real economy. Modern management of inventories and shipments has probably transmitted weaker demand back up through the production chain, across countries, all the way to the raw materials sector faster than in the past. (This should, of course, be stabilising in the sense that it prevents the old fashioned inventory cycle amplifying the effects of the swings in demand.) The slump in trade has also been exacerbated by dislocation in trade credit, which is but another manifestation of counterparty risk. But something more than just the usual effect of lower US demand via trade channels has been at work. The ubiquity of access to instantaneous “news” – from globalised news organisations and via the screens on our desks, CNN and so on – and the pace at which households and businesses adjusted their expectations and behaviour based on this new information was surely a big part of the explanation for the highly synchronised slump in demand around the world during the final few months of 2008. I suspect that economists will debate for years ahead the nature of what has clearly been a common shock to all countries. My reading of the episode is that the extraordinary financial events of September and October 2008 – several large financial failures, large scale rescues of major institutions, enough incipient systemic concerns about banking systems to lead governments to issue guarantees, investor panic on share markets – were all observed in real time by households and businesses right around the world. This caused a collapse of confidence, a disengagement from financial and business activity and a much more cautious attitude to spending. It has had very large effects on the real economies of most countries. Recent challenges for the operation of monetary policy How then has all this affected the task of conducting national monetary policies? Here I will take some liberties and define monetary policy more broadly than just the setting of the overnight interest rate, and include the full gamut of central bank operations in markets. The first point to note is the international spillovers of the crisis, stemming from the cross border integration I mentioned earlier. The earliest evidence of this was the way higher term funding spreads in money markets were observed in many countries, even those whose exposures to the problem assets were trivially small (I include in this group my own country and some others in this time zone). In many short term money markets, the spreads between overnight rates and 90- or 180-day rates rose significantly, even though not as much as in the United States, the United Kingdom or the euro area. These spreads reached extremes in most cases during September and October 2008, in the midst of the turmoil following Lehman’s failure. In some cases, turnover in money markets dropped sharply, almost to zero, for anything other than overnight maturities. An important dimension of this phenomenon was the shortage of dollar liquidity for non US entities trying to fund their US asset positions. The pressure this placed upon swap markets ultimately saw them effectively close for a couple of weeks during September. In response to these spillovers, central banks did two things. First, they adapted their own domestic policies for provision of liquidity, responding to the unusual term spreads by widening the classes of assets in which they would transact, being prepared to push the amount of cash in the system higher than normal, lending on a collateralised basis at longer terms and in some instances providing foreign currency from their reserves to swap markets. Second, central banks stepped up their collaboration in recognition of the mutual dependence of national financial systems. The Federal Reserve co operated with central banks in a number of countries to provide US dollar funding against local currency collateral, with the central banks in effect acting as intermediaries. This alleviated the US dollar liquidity problems. Subsequent further expansions of these facilities in the United States and Europe have, for all practical purposes, made the dollar liquidity shortage a thing of the past. (Of course, counterparty risk aversion remains to some extent, which would explain the fact that term spreads remain higher than prior to the crisis – but that reflects questions over the perceived riskiness of the major institutions, rather than liquidity per se.) On top of this, there was also the co ordinated interest rate reduction by the G10 central banks in October. And in Asia, there have been further developments of bilateral and multilateral swap agreements. The second complication for several countries is that some of the transmission channels of monetary policy are not working normally. In the boom, optimism and the search for yield pushed down the risk premia that were built into the interest rates offered to borrowers, and this may have diluted the effect of any increases in policy rates on the ultimate cost of funds. But lately, this dynamic has worked powerfully in the reverse direction, with sharply rising risk premia diluting the effect of lower policy rates. The most damaging instances of this have been in the United States and the United Kingdom, where despite quite aggressive reductions in the interest rates set by the central banks, rates paid by many borrowers have not fallen very much until quite recently. In addition, even where interest rates have declined, many banks display an individually understandable, but systemically damaging, reluctance to lend. Perhaps these impairments of the transmission process could be offset, to some extent at least, simply by pushing the policy rate further than would otherwise have been the case. But by now, the zero bound problem, which had been a theoretical curiosum until Japan’s experiences over the past decade, is being faced also by the United States and Switzerland, and prospectively perhaps by one or two other countries. For this reason, so called “unconventional” policy instruments are starting to come into view in some countries. These essentially amount to direct purchases of assets by the central bank, so as directly to affect the price of that asset and/or the balance sheet of the counterparty, or to act as “intermediator of last resort”. A third general issue is that the sheer interconnectedness of all of the major institutions and markets makes the framing of particular policy interventions aimed at fostering stability much more difficult. Because every linkage cannot possibly be known beforehand, the effect of any particular measure is almost impossible to predict with much accuracy. The broader issue The current financial crisis has highlighted some of the risks associated with this financial system complexity – and the complications they bring for monetary policy are far from the only ones. Those charged with designing and implementing policies for prudential supervision, market conduct and deposit insurance, among others, are thinking hard about how to refine them. Obviously, each episode has its unique elements. In this one, the very low interest rates and macroeconomic stability of the past decade or so led investors to lower their perceptions of risk and allowed a greater range of borrowers much easier access to finance than before. Investor optimism and the search for yield provided the demand side background that was associated with the development of complex financial products. These products, in turn, facilitated the build-up in leverage that allowed investors to achieve higher returns. The complexity and opacity of certain financial products and financial institutions’ activities made it difficult for investors to develop a good understanding of their counterparties’ business and their own exposures. There were no long time series of historical relationships that investors could use to estimate the probability of default associated with new instruments. Further, the new products and changes in the structure of the financial system resulted in a tight web of interconnections between institutions and markets that made it more difficult to determine the correlation of default probabilities across institutions. Information asymmetries were also associated with incentive and agency problems. The difficulties of assessing potential losses and limited transparency, in the presence of competition and investors’ search for yield, may have encouraged some managers to take on greater risks than would have otherwise been the case. Rewards systems based on short term performance added to these incentive problems. The difficulties involved in measuring risk meant that, during the buoyant conditions prior to mid 2007, investors were content to outsource risk measurement to credit rating agencies. Even then, investors did not fully understand the differences between different products with the same rating. But as important as all the new instruments and the various interactions between them, markets and institutions have been, it would be a mistake to conclude that fancy new instruments alone were the root cause of the crisis. Complexity was responsible for obscuring the risks associated with certain financial instruments, but many investors, if they were honest, would have to admit that they knew that they did not fully understand the instruments, yet they were not deterred from investing. In the end, the question remains: why were investors willing, eager even, to invest in such complex products they must have known they did not fully understand? Why did some financial institutions allow their business model to become so dependent on particular forms of market funding? Yes, the complexity obscured risk. But investors and institutions were not deterred by that. The simple point, surely, was that there was too much optimism combined with too much leverage. That is neither new, nor particularly complicated. I am prepared to assert that it will, periodically, recur. Policy makers across a range of endeavours will need to keep that very much in view in the future. The challenge for the future Turning to the implications for the future conduct of monetary policy, we have seen that financial system complexity and the financial cycle have affected both the overall environment in which monetary policy operates and the transmission channels through which it affects the economy. In response, policy makers clearly have to work hard at understanding the effects of changes in economic and financial behaviour and the way they affect the transmission channels. They need to monitor a wide range of indicators to assess both financial conditions and the impact of their decisions on the economy. It is also important to monitor closely and respond to developments around the globe, as recent events have demonstrated that these can be rapidly transmitted across borders. In addition, monetary policy authorities need to work in collaboration with regulators and those responsible for financial stability to build their understanding of the financial system. In the short term, the situation requires flexibility and a degree of innovation on the part of central banks, and on occasion not a little boldness. I think most central banks have been prepared to embrace those principles, without abandoning the long term foundations on which credible policy making must rest. As challenging as the current environment is, however, some big challenges loom for the longer term, once the emergency has been dealt with. Complexity and uncertainty have always been defining characteristics of the economy. Economic behaviour and the structure of the financial system and economy are continually evolving. It will never be possible for central banks or others to work with full information, nor to predict exactly how their actions will be passed through the financial system, nor how they will affect the economy. The financial crisis may lead to a certain simplification of the financial sector for a time, with the closure of markets for many complex products, banks moving towards more narrow, traditional business models and the disappearance of some highly leveraged institutions with complex business structures. But the global nature of financial activity and the importance of markets to financial institutions are likely to remain, and the cycle of risk taking will eventually turn. We certainly want this to be the case, in my view. The problem in the next couple of years will not be too many cross border capital flows, but too few; not too much risk taking, but too little. A retreat into financial autarky and wholesale shunning of risk would be even more damaging than what we have seen to date. So the challenge in the longer term is to construct a policy regime that handles all the complexity and cyclicality of the system. We need a robust policy regime that can operate effectively, on the assumption that we will never have the full picture of the workings of the financial system and the real economy. We need policies that can be effective on the assumption that private financial systems are periodically prone to “irrational exuberance” – but without being predicated on the fallacious assumption that regulators will always know best. We need policies that steer away from a retreat to the financial repression of the 1940s and 1950s, but that have a more sceptical view of the latest financial innovations, and in particular maintain a much greater degree of distrust of leverage, in all its forms. And we need a system that is more robust in the face of occasional financial failures. This is a challenge, of course, for financial institutions, prudential supervisors and those responsible for seeking to maintain overall system stability alike. Indeed, these two perspectives have to be married more effectively than they have been to date. Assumptions reasonably made at the level of the individual institution when assessing prudential strength – say, about the availability and liquidity of various markets – may turn out to be collectively invalid. In the case of central banks, surely we cannot avoid another look at the question of monetary policy, asset prices and leverage. This has been a long running debate – going at least as far back as the early 1990s, in my memory. Distinguished scholars have disagreed on the extent to which monetary policy should respond to movements in asset prices over and above their estimated impact on inflation via wealth channels, etc. Some argue in favour of “leaning into the wind” of asset price swings, 1 while others eschew that on various grounds, in favour of dealing with the aftermath of asset price busts if and when they occur. Several chapters have been written in the story, the most recently completed one being in the early 2000s after the “dot.com” boom and bust. I think it could be said that, at that time, those advocating leaning into the wind did not get enough traction – I suspect mainly because growth in the United States was fairly easily restarted after the shallow recession of 2001 that followed the “dot.com” bust. In the aftermath of the excesses of the subsequent period, a new chapter is now being written in this discussion. Knowing the next speaker, Bill White, as I do, there will probably be food for thought on the topic here today. See SG Cecchetti, H Genberg, J Lipsky and SB Wadhwani (2000), Asset Prices and Central Bank Policy, Geneva Reports on the World Economy No 2, International Center for Monetary and Banking Studies and Centre for Economic Policy Research, Geneva. | reserve bank of australia | 2,009 | 2 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 20 February 2009. | Glenn Stevens: Financial crisis developments – impact on the Australian economy Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 20 February 2009. * * * Mr Chairman, thank you for the opportunity to meet again with the House Economics Committee. Shortly after the Committee last met, the global financial system took a serious turn for the worse. On 15 September 2008, the American firm Lehman Brothers filed for bankruptcy. It was the biggest actual failure of a major American financial institution for many years. While it had been widely known that Lehmans was under immense pressure, when it came the event was still a shock. It triggered a massive re-appraisal of risk, and ushered in a period of the most intense financial turmoil seen in decades. The worst of the turmoil was actually fairly short-lived – a matter of weeks. But in that time a number of events occurred that have had a significant bearing on the outlook for the global economy. These included the incipient failure and/or public support of a number of major financial institutions in the United States, the United Kingdom and continental Europe, effective closure of many important capital markets and a worldwide decline in equity values of a quarter, leaving them around 50 per cent lower than their peak. I believe that the extraordinary actions of governments and central banks in that period – in supporting key institutions, supplying huge quantities of liquidity and offering guarantees on various obligations of banks – helped to stabilise what could have been a catastrophic loss of confidence in the global financial system. This remains a work in progress, and sentiment in financial markets remains fragile. Nonetheless, since October we have seen term spreads in money markets decline (back towards the pre-Lehman, though still elevated, levels). We have seen long-term markets re-open to banks (by virtue of the guarantees), public confidence in the security of the banking system maintained and the exceptional volatility abate somewhat. Inevitably, however, the turmoil of September and October took a large toll on household and business confidence around the world. Observing those events in real time, people everywhere understandably became much more cautious. We are now seeing the effects. Consumers have pulled back their discretionary spending sharply, are more inclined to save and are looking to repay debt. Businesses have seen the fall in demand, and have responded very quickly to cut production and costs, as well as putting on hold plans for expansion. Nowhere is this more evident than in the automobile sector, where global demand has fallen by around 20 per cent since August and production has declined equally sharply. Global trade has fallen away, driven by these trends in demand and also a significant disruption in trade finance. For many of the world’s largest economies, the contraction in output in the last quarter of 2008 was the sharpest in decades. Nor is the weakness confined to the major economies. Emerging economies around the world, relatively little affected by the problems in the major economies until September, are now suffering the effects of both the weaker demand in the developed world and the shock to domestic demand as their own citizens respond in the same way to the financial turmoil. Many indicators for Asian economies stepped down abruptly in the last few months of 2008. China’s economy recorded little GDP growth in the last quarter, and industrial production declined for several months. There are some tentative indications of a turn for the better in China in some of the most recent data, though it is too soon to know yet whether this will continue. It is all this news that bodies such as the IMF have factored into their growth forecasts for 2009, which put global GDP growth at just half of 1 per cent, which would be a very weak outcome. As recently as October, the forecast was 3 per cent. Needless to say, this amounts to a very major change in the international environment for Australia. As one metric, our terms of trade, which rose by 65 per cent over five years, look like they will fall by up to 20 per cent during the next year. That would still leave them historically high, and several important commodity prices have stabilised over the past couple of months after steep falls. At these levels, the stronger mining companies will still earn good profits. But the confidence seen in mid 2008 has given way to a much more sober outlook, at least for the near term. Internationally, the availability of risk capital has declined. Local businesses are anticipating tougher times ahead. Measures of business confidence have diminished sharply. Firms are altering their strategies quite quickly, looking to conserve cash, pay down debt and reduce costs. They are also experiencing tougher credit conditions. Indications are that investment plans, which had been exceptionally strong in the middle of last year, are being quickly curtailed. Households, for their part, are affected by a significant loss of wealth, especially over the latter part of last year, and are understandably tending to save more and, in many cases, looking to get their debt levels down. That said, measures of consumer confidence and consumer spending in Australia have held up much better than in many other countries over recent months. Six months ago, our judgment was that Australia was experiencing an economic slowdown that would turn out to be not unlike that of 2001 in magnitude, and that inflation would gradually decline. Absent the events of September and October, that would still have been a reasonable expectation. But the financial turmoil, and the real economic impacts that have flowed from it, altered the balance of risks for the world and Australian economies significantly. The Board quickly came to the judgment that the gradual easing of monetary policy that appeared to be in prospect six months ago should be accelerated. It moved to reduce the cash rate quite aggressively. The total decline of 400 basis points since August – as rapid an easing as any in Australia’s history – takes monetary policy to a clearly expansionary setting. The Government has also implemented a major discretionary easing of fiscal policy, and the exchange rate is significantly lower. The deterioration in international economic conditions was so rapid that no policy response could prevent a period of near-term weakness in the Australian economy. We are being affected by the global downturn, and cannot realistically expect other than weak conditions in the first part of 2009. But the very large reduction in interest rates, the lower exchange rate and the major fiscal initiatives will work to support demand, increasingly so as the year goes on. Inflation is likely to continue its moderation that began in the December quarter, and to do so faster than expected six months ago. Compared with the sorts of growth we enjoyed until fairly recently, this is a weak near-term outlook. But if the outcomes we see turn out to be even close to these, Australia will have done well in comparison with most other countries. We have claimed all along that Australia was better positioned than many countries to ride out the international difficulties. Credit standards do seem to have tightened further over recent months and banks are seeing the inevitable increase in bad debts as the economy slows. But our major financial institutions are still in a strong condition, have access to debt and equity markets, are still earning good profits, and are in a position to lend for sound proposals. Our housing sector is not overbuilt; instead there is considerable pent-up demand, and affordability is improving quickly. Most of the corporate sector is not over-geared. Going into this episode, the scope to use macroeconomic stimulus was bigger than for most countries – and that scope is being used. Moreover, our transmission channels are still working: interest rates paid by borrowers have fallen when the cash rate has been reduced. In contrast, mortgage rates in the United Kingdom and the United States did not fall through much of 2008, as margins rose by about as much as the central banks cut their policy rates. Only quite recently have UK and US mortgage rates begun to decline. So there are reasonable grounds at this stage to think that the Australian economy will come through this very difficult episode – certainly not unscathed, but well placed to benefit from a renewed expansion. Things will be difficult over the next year. But as I have said before, the long-run prospects for Australia have not deteriorated by as much as we may all be feeling just now. China’s emergence, for example, has not finished. It has years to run and Australia will benefit from it. We should not lose sight of that or other positives. We can have confidence in our long-run future and in our demonstrated ability to adapt to changing circumstances. If we retain that, there is no reason for any downturn to be a deep one. The Board is, of course, continually assessing whether the stance of policy is the right one to foster a durable expansion, consistent with the inflation target. A very large easing of policy has been put in place, on the basis of the anticipated effects of the global downturn and more risk-averse behaviour at home. Those effects are yet to be seen in many of the figures, though they are being felt in businesses around the country. The effects of the policy adjustments are only beginning. So in evaluating the information we receive in the months ahead, our task will be to distinguish between that which confirms the anticipated trends to which we have already responded, and that which tells us something genuinely new about the prospects for demand and prices over the medium term. Our objective, however, remains the same: sustainable growth and low inflation. Perhaps I should also make one or two comments about payments matters, given the impending changes to arrangements for ATMs. The new arrangements seek to remove several undesirable features of the existing system. In particular, fees paid between banks when their customers use each others’ ATMs – “interchange” fees – are not transparent, and are not clearly related to costs; fees paid by customers using ATMs other than those owned by their own banks – so-called “foreign” fees – are not always properly disclosed (and in many cases are higher than necessary); the earnings stream for owners of independent ATMs – about half the ATMs in Australia – are limited to the interchange fees paid by banks, which are of course their competitors; and access by new entrants is difficult, potentially limiting competition. Under the new arrangements, there will be no interchange fees. An ATM owner will be able to charge the customer directly a fee for the use of the machine, but must disclose the fee prior to the transaction. Banks will probably continue to allow fee-free withdrawals by their customers at their own machines, because they expect to cover those costs with the revenue earned across the entire customer relationship. Use of another bank’s ATMs will presumably attract a fee by that other bank to cover the costs. But the only cost to a cardholder’s bank associated with use of a “foreign” ATM is the cost of processing the transaction electronically – a matter of no more than 10 cents. Given this, we cannot see any strong case for a “foreign” fee. Independent ATM owners will charge for the use of their machines, but that will maintain an incentive to grow their network. Otherwise, it is likely that the independents as a source of competition would diminish over time, reducing consumer choice. Access to the system will be governed by a code, which caps the price of connections, so that new competitors cannot be unduly hampered by the incumbent players over-charging to connect. The essence of the changes is simple. People have always been paying, one way or another, to use ATMs. ATMs do have a cost of operation and somehow that cost has to be covered. Even where no explicit charge is levied, somewhere or other the financial institution is making up that cost. They do not provide services for free. Now people will know exactly what the price of an ATM transaction is, and they will know it before completing the transaction. There should be no “foreign” fees of any significance. And competition will be maintained, by allowing the independent ATM owners to remain viable and new competitors to enter more easily. That is, in our judgment, an improvement over the arrangements of the past and is the best way of keeping costs down in the long run. My colleagues and I now look forward to your questions. | reserve bank of australia | 2,009 | 2 |
Text by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, of the Third Annual Ian Little Memorial Lecture, Melbourne, 25 March 2009. | Glenn Stevens: Public policy and the payments system Text by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, of the Third Annual Ian Little Memorial Lecture, Melbourne, 25 March 2009. * * * Introduction It is a great pleasure to be here in Melbourne to deliver the Ian Little Memorial Lecture. I worked with Ian when we were both young recruits in the Research Department of the Reserve Bank in the early 1980s. I remember an easygoing young man with a cheerful disposition, and a mop of curly dark hair. Even then, Ian was a clear thinker with a strong commitment to good public policy. So it was not really surprising that, having left the Reserve Bank in the late 1980s and succeeded in the private sector, he returned to public service in the Victorian Department of Treasury. In that role, as many of you here know better than I do, he shone. I would occasionally run into Ian at conferences and he would always impress on me, a macroeconomist working in the central bank, the need to acknowledge the importance of microeconomic policy reforms in bettering economic performance. It is a simple, but important, point. While macroeconomic policies are to the fore right now around the world, as governments and central banks seek to foster recovery from recession, in the long term our living standards depend more on innovation and productivity, and less on the manipulation of interest rates or aggregate spending decisions by governments, than common discussion often admits. Real prosperity depends critically on the supply side of the economy – the realm of microeconomic policies. It is in that spirit that I wish to speak today about something that I have not addressed in public before, namely, the payments system. Although the Reserve Bank is best known for its macroeconomic policy responsibilities, it has, in fact, an important microeconomic responsibility, namely, the competitiveness and efficiency of the payments system, including at the retail level. This obligation was given to the Payments System Board of the Reserve Bank, as a result of the Wallis Committee process in the mid 1990s – hence, my topic this evening. Motivation We might begin by asking: why is an efficient payments system important? The answer is that the payments system facilitates all economic and financial activity, whether it be the day-to-day payments that you and I make, payments between businesses or transactions in financial assets. There are around 18 million transactions in Australia every day, with a value of around $230 billion. With so many payments, even relatively small inefficiencies can potentially have significant implications for the costs of the payments system. Part of the Reserve Bank’s job, therefore, is to promote efficient arrangements in the payment system in the interest of the broader economy. Earlier reforms to the high-value payment system improved efficiency and safety, but in the retail payment area, progress has been slower. In fulfilling its responsibilities over the past 10 years, the Reserve Bank has in some fairly high-profile instances ultimately resorted to regulation. This has not been because we have had a strong predilection for regulatory solutions. On the contrary, the Reserve Bank has usually first sought to achieve improvements in competition and efficiency without direct regulation. In particular, it has sought to encourage the players in the payments space to identify potential improvements and to undertake reforms to achieve these. But such industry-led reforms have sometimes been difficult to achieve, and so the Reserve Bank has ultimately been required to take a stronger role, including by regulating. I want to examine why this is the case, both at a general level and by reference to a recent example. These observations are framed by the particular challenges the Reserve Bank has faced in promoting competition and efficiency in the payments system, but the conclusions apply to a number of other areas where regulators are working to spur improvements in efficiency and productivity. Co-operation and competition in networks In payment systems, as with other networks, a certain amount of co-operation between participants is needed to ensure that the system provides benefits to users. For example, when you or I purchase something at a retailer, it should not matter with whom the retailer banks, or with whom you or I bank. We expect to be able to rely on the banking system to transfer money from us to the retailer. We expect that, when we pull out our debit or credit card to pay, it just works. That requires a detailed set of co-operative arrangements between financial institutions to accommodate payments between each other’s customers. These same institutions are also competing with each other, however, to attract customers. A common way to compete is to offer products or features not offered by one’s competitors. But if the ability to offer that new product relies on competitors making changes to their systems, innovation may be stymied. Why would other banks be willing to incur the costs of developing the relevant systems in order to help customers of their competitors? The tension between these two separate dynamics – the need for co-operation and the impulse to competition – means that the industry may have difficulty taking decisions in the interests of the system as a whole, and of the community more broadly. In such circumstances, someone – an industry group or a regulator – may need to play a co ordinating role, to encourage improvements in the common infrastructure that benefit all, while still allowing competitive forces between the banks to ensure that the new products are priced competitively and packaged to meet customers’ needs. Of course, these issues are neither new nor unique to the payments industry. It is well accepted in the economic literature that in industries that rely on networks of infrastructure (so-called “network industries”) there is an incentive to co-operate in order to gain efficiencies, but a socially optimal level of co-operation might not be achieved. One illustration of this point which has been cited in the network literature is the development of the rail network in the United States in the 19th century. 1 The early US railway system consisted of a large number of individual links between pairs of destinations, often on different track gauges and designs. There was a clear public (and private) benefit in linking these “networks” to allow goods or passengers to cross efficiently from one railway to another. But, nonetheless, railways were often designed to be incompatible, so as to prevent competitors from siphoning off traffic. Eventually, the commercial logic for some degree of co-operation was sufficient to ensure that standardisation occurred and this brought with it large productivity gains. For instance, in the space of a decade, the time for shipment of goods by rail from Philadelphia to Chicago was reduced from nine weeks to three days. 2 Despite these pay offs, standardisation was Carlton DW and JM Klamer (1983), “The Need for Coordination among Firms, with Special Reference to Network Industries”, The University of Chicago Law Review, 50(2), pp 446-465. See Carlton and Klamer (1983), p 455. still not complete. In fact, the only way railways could reach an optimal level of standardisation was horizontal integration – merging competing railways. While all this sounds a million miles away from Australia’s payments system in the 21st century, the parallels are quite strong. For example, like the linking of the railways, the realisation that a single, interconnected EFTPOS system was more valuable than a number of individual EFTPOS systems that could not talk to one another drove co operation and standardisation quite early in the development of that system. But despite the benefits that brought, co operation, standardisation and innovation in Australia’s EFTPOS system have not progressed as far as is desirable. The EFTPOS system has essentially remained unchanged since its establishment in the 1980s. The fact that the system is built on bilateral links between all the major participants means that there is no one standardised communications protocol between the participants. Furthermore, co operative efforts to innovate or upgrade the system are complicated because they require all bilateral relationships to be renegotiated. This is, in fact, a difficulty with many of Australia’s payment systems – they are based on bilateral links, with no established mechanism to foster improvements and expansion in the network. So left to their own devices, networks may stop short of an efficient level of co-operation. Incomplete standardisation may result, and innovation or movement from one standard to a superior one may be difficult because of co-ordination problems, even where the benefits to society outweigh the costs. The literature points to several reasons for this potential outcome, some of which are evident from the example I have already given. The first is the classic economic externality. Firms within the network may be concerned that if they agree a common standard with a competitor, that competitor may be able to capture some of the benefits of moving to that standard. Why would I pay all the cost of converting my railway line to a gauge that can connect with another railway, when my competitor will gain as much of my rail traffic as I will of his? The implication is that competitors in a network might not individually make decisions that are optimal for the network as a whole. The second is the ineffectiveness of voluntary strategies for achieving co-operation in a network industry owned by competing firms. Establishment of industry bodies to agree standards is a common approach, but the success of these bodies has been mixed. Agreement tends to be delayed where there are vested interests and, in some cases, non standardisation is used as a barrier to entry by competitors. 3 Third, there is often a tendency towards “excess inertia” in standards. 4 Problems with coordinating the movement from an old standard to a superior standard (such as the movement to new system architecture in a payment system) may mean that the movement does not occur, or occurs very slowly, even where the benefits to society outweigh the costs of switching. These co ordination problems may be caused by an uneven distribution of the costs and benefits of switching standards, or by uncertainty regarding the movement of rival firms to the new standard. 5 For example, see David P and S Greenstein (1990), “The Economics of Compatibility Standards: An Introduction to Recent Research”, Economics of Innovation and New Technology, 1(1), pp 3-41; Farrel J and P Klemperer (2007), “Co-ordination and Lock-in: Competition with Switching Costs and Network Effects”, in M Armstrong and R Porter (eds), Handbook of Industrial Organization, Elsevier, Amsterdam, pp 1967-2072; and for the Australian context, Lowe P (2005), “Innovation and Governance of Payment Systems”, Address to Banktech.05 Conference, Sydney, 16 September. For example, see Farrel and Klemperer (2007). There can also be, in some cases, a tendency towards overly rapid changes in standards (so called “excess momentum”), which can lead to the premature adoption of a new standard that is less efficient than the old standard. Further, those who benefit disproportionately from a change to a new standard will fail to consider A recent Australian example From first principles, therefore, we might expect that achieving agreement among Australian financial institutions on development of the payments system might not be easy. So it has proved. There are a number of examples of this, but a recent one is the efforts by the industry at reform of the ATM system. As you may be aware, there have recently been some changes to the way ATM transactions at machines not owned by your bank are priced and paid for. Instead of paying a relatively obscure “foreign ATM fee”, that was charged to your bank account at the end of the month, people are now presented with the cost of the transaction in real time. These changes will, in our view, allow competitive forces to come into play in a way that was previously impossible. But it is the process of achieving the reforms, more than the likely benefits, on which I want to focus this evening. In particular, it required changes in the bilateral links between all the major players in the system. In this sense, the problems were akin to those of the US railway system – how do we get all the competitors to agree to change their bilateral links in a standardised way? Work by the industry on the reforms started as long ago as 2001. While some progress was made over the next few years, participants ultimately could not agree and asked the Payments System Board for guidance on the way forward. Finally, after much cajoling by the Reserve Bank, the new arrangements were implemented earlier this month – some eight years after discussions on the issue commenced. Ironically, the package implemented differs very little from the proposal put forward by the industry group itself in 2004, which was subsequently abandoned owing to irreconcilable differences between some of the parties. Moreover, despite a firm desire by the industry to implement the new arrangements without Reserve Bank intervention, the industry ultimately asked the Reserve Bank to use its powers to help finalise the process. This is not a unique example. Reforms to most of Australia’s payment systems including cheques, direct entry and EFTPOS faced similar challenges. As we have seen, this is not altogether surprising given the network nature of the payments system and the number of players which must co-operate, but also compete. The bilateral architecture that I have already mentioned is also a difficulty. Every large bank has an agreement with every other large bank about how to handle payments from one another’s customers. The more banks there are, the more agreements are necessary and the more complicated the system becomes. To use the railway line analogy, the more customised tracks are built, the more difficult the task of ultimately converting all tracks to a standard gauge. This has two implications. First, while these bilateral agreements can be helpful in getting a system started initially, and may subsequently work well for those already in the system, potential new entrants face the prospect of negotiating numerous different connections. This can act as a barrier to entry, inhibiting competition. Second, because upgrading the network requires participants to agree, since they all must make changes, each participant therefore can effectively veto, or at least delay, any decisions affecting the network. Because different participants have different technology cycles and different strategic interests, there is a high probability that some participants will be unwilling to proceed at any given point in time. If a participant thinks a particular change may provide another participant with a potential competitive advantage, it will probably attempt to delay. Indeed, if one participant sees a potential competitive advantage in a the loss of network benefits to those who are reluctant or late to change, and these participants may end up remaining on the old standard with a reduced network. See Farrel and Klemperer (2007). change, it is almost guaranteed that another will see a disadvantage and, therefore, seek to block the change. This results in a significant co ordination problem for the industry. The result is that, in the underlying architecture of the Australian payments system, very little has changed over the past 20 or 30 years, even though technology has evolved in the quarter of a century since the technology underlying the ATM and EFTPOS systems was first established. So while the payments system infrastructure has served Australia well, pressures for change are building. The network structure needs to be updated and services to customers are starting to fall behind those available in other countries. In the past, the Reserve Bank has identified real-time internet payments, business-to-business payments and online payment mechanisms as examples where progress has been made overseas but not, to date, in Australia. The resulting co-ordination challenges were very evident in the process of reform in the ATM system. With each of the parties having different objectives, consensus was hard to achieve. For example, small institutions would only consider a system that allowed them to form feefree networks among themselves – otherwise they would be at a competitive disadvantage to the big banks with their large ATM networks. But larger institutions saw an opportunity to obtain a competitive advantage if smaller institutions could not form larger fee-free networks. There was also reluctance to liberalise access to the system. While improved access would serve to increase the benefits of the system as a whole and therefore the participants collectively, each bank tended to focus on the costs it would bear individually as well as the competition it would face. In short, there were problems because there was no participant in the system thinking of the benefit to the system as a whole with the power to effect change. Now in many countries, this role is handled by a single private sector entity that manages a system or systems. For example, the credit card schemes have a central body responsible for governance, innovation and promotion. Their incentive is to do things that expand the network, making its use easier and more attractive and increasing the number of participants. They have, in effect, internalised some of the externalities inherent in the network. While the credit card systems have had other elements that unduly limited competition in some respects, the centralised approach is arguably superior for network innovation and growth. That central body can determine standards and co-ordinate change. These arrangements are also more access-friendly in that a new entrant need only establish one, standardised connection to the system. Some private payment systems in other countries have such an entity – for example, LINK which manages the ATM system in the United Kingdom, Interac which manages the equivalent of the EFTPOS and ATM systems in Canada, and Paymark which manages New Zealand’s EFTPOS network. But that entity is missing in Australian payment systems. What role for public policy? These considerations all suggest that there is an important potential role for public policy in promoting change in the payments system. While the academic literature is divided generally on the role of regulation in network industries, there seems to be support for careful regulatory intervention in industries with competing network components where sufficient standardisation or a move between standards cannot be achieved in a timely manner. There also seems to be considerable sense in having an entity with responsibility to consider the interests of the system (and society) as a whole and the power to achieve reform to that end. Indeed, the need to have a body responsible for promoting the public interest through competition and efficiency in the payments system was recognised by the Wallis Committee over a decade ago. It led directly to the establishment of the Payments System Board at the Reserve Bank and the granting of its current statutory goals and powers. The fact that the central bank fulfils this oversight role in Australia is unusual internationally – in many countries, issues of competition in, and efficiency of, payment systems fall to competition authorities. But it is nevertheless common to find structures in place in network industries to assist in promoting access and the efficient setting of standards – whether this is a body that merely assists with co-ordination or one that has powers to enforce or perhaps set standards. We see this in network industries in Australia, such as telecommunications, electricity and ports, where there is frequently some sort of public body with oversight of the network, perhaps operating in conjunction with an industry body or bodies. Of course, such bodies should not take a decision to regulate hastily. In most cases, a graduated approach to regulation in these areas is pursued, reflecting a reluctance to assume that a regulatory solution is necessarily superior, or that the government would necessarily be able to choose the best standard, particularly in a highly technical or rapidly changing field. The typical approach of network regulators is to prefer a co operative industry approach to standard setting, to provide some suasion where this process is unsuccessful, but ultimately to set standards if necessary. Where intervention is required, the academic literature suggests that we might look first of all to ensure compatibility between competing standards – for instance, by rules governing access and interconnection between competing networks – before setting detailed standards themselves. So there is not a presumption that a black-letter regulatory solution will be adopted. In fact, at the time that the current regulatory arrangements for Australia’s payment systems were established, there was an expectation that a co-regulatory model would be followed. In this view, industry would progress reform for the most part and the Reserve Bank’s powers would be used only occasionally, as a last resort, where reform could not otherwise be achieved. As it has turned out, however, the Reserve Bank’s powers have had to be used more often than I suspect was initially imagined. The Reserve Bank always explores ways that its statutory goals of competition and efficiency in the payments system can be achieved without resorting to its direct regulatory powers. But the history of the ATM reforms demonstrates how difficult it is for pure industry-based reform to move ahead without at least some push from a public policy body. Possible approaches Reflecting on that experience then, and looking to the future, the question is how best to strike the balance and to facilitate reform most effectively. There are a few possible approaches – each one more interventionist than the previous one. First, the Reserve Bank could agree targets and timelines with the industry, but without any explicit regulation or penalty for failure to meet those targets. This approach is similar to the approach that the existing industry payments body, the Australian Payments Clearing Association (APCA), takes with many of its projects. Provided agreement on the need for change can be reached (no small achievement), APCA plays a co-ordinating role in organising a project plan, providing some resources and setting timelines and targets, though in the past these projects have tended to focus on technical issues rather than strategic directions. In the absence of agreement on the need for change, however, industry-based projects – which, after all, rely on mutual agreement – tend not to proceed sufficiently quickly. That observation leads to the second option – the possibility of the Reserve Bank using overt regulation may be enough to forge agreement among industry participants. This is the path that was predominantly followed in progressing reform of the ATM system, and in a number of other reforms to the payments system. Where industry agreement on an issue was not forthcoming, the Reserve Bank has engaged the various sides to seek a solution with the clear possibility that it might regulate if agreement could not be reached. This approach was essentially behind the establishment of the Payments Council in the United Kingdom, and the development of the UK’s “Faster Payments” 6 – both of these initiatives were undertaken with the knowledge that, were something not done, there would be official intervention. While this can work, and emphasises the co ordination role that the Reserve Bank can play in the industry, the experience with the ATM system suggests that it still may be a drawn-out process. Individual participants with a preference for the status quo have no incentive to push the plan along and so it relies on the Reserve Bank setting a timetable for agreement and implementation – a timetable that is invariably argued to be “challenging”. A third, more intrusive, option is for the Reserve Bank to set explicit standards – what may be viewed as more traditional regulation. This is the approach that was taken when dealing with the credit card schemes, where the Reserve Bank set a number of standards dealing with the level of interchange fees and the imposition of surcharges. This approach could, however, also be used to achieve industry co-ordination around technical issues. For example, the Reserve Bank could set technical standards where the industry has been unable to agree on a common standard itself. Such an approach may yet become relevant in Australia’s electronic payments system, especially where co-ordination problems are inhibiting innovation. As an example, some have suggested that the Reserve Bank could play a role in the further development of the EFTPOS system. The system was designed originally to transfer money from consumer accounts to merchant accounts. These transfers are initiated when an EFTPOS card is swiped through a merchant’s terminal and the impact on the customer’s account is immediate. In recent years, however, there has been demand to use the system in a different way, to send payments into consumers’ accounts in real time. These demands flowed initially from the government looking to ensure benefit payments reach recipients as quickly as possible – for example, when providing emergency funds after a natural disaster. The EFTPOS system at present can accommodate these sorts of payments only in a limited way. While some participants in the industry have seen benefit in expanding the EFTPOS message format to enable such transactions, there has been limited progress. A requirement by the Reserve Bank that all participants in the industry be able to accept instructions conforming to a common message standard would facilitate access by new entrants, and thus competition. If the Reserve Bank chose to require use of an international standard, that could also facilitate more competition from overseas providers of payment related services. A mandate from the Reserve Bank that EFTPOS message formats must be able to support credit transactions might likewise lay the foundation for innovation in the EFTPOS system based on these transactions more quickly than the industry might be able to achieve by itself. Notwithstanding its regulations with respect to card payment systems, the Reserve Bank has in the past preferred the first two of the above options. This is particularly the case with respect to issues relating to technical standards and system architecture, where the Reserve Bank has on occasion raised the issues but left the industry to drive reforms. We remain conscious of the risks that public intervention itself may be an impediment to innovation. As we have said a number of times, our hope is that the industry will deal with these issues itself. But we also know that if the industry fails to push ahead with improvements to the system, Australians will be denied the full benefits of a modern retail payments system. To a large extent, the future approach of the Payments System Board depends on the behaviour of industry participants. If industry agreement on further reforms can be reached relatively quickly, then the need for the Reserve Bank’s co-ordinating role to be interventionist is limited. On the other hand, if, as on some past occasions, the industry is unable to carry forward reform and innovation by itself, the Reserve Bank would consider making more extensive use of the tools at its disposal. “Faster Payments” is a system to allow internet banking payments to be made in close to real time. Conclusion The economics of networks are complex, and the role of public policy is a delicate one. The aim is to ensure, as far as we can, that the correct balance is struck between the need for cooperation and the benefits of competition. Co-operation is required in order to ensure that the benefits of an extensive, and reasonably standardised, network can be enjoyed by the public, raising economic welfare. Competition is vital in the long run to make sure that costs are minimised and the incentive to respond to changing consumer preferences maximised. Policy has to recognise and fulfil its role in dealing with the externalities inherent in the set of decisions made by private market participants, while also respecting and maintaining the competitive dynamic. We recognise that the roles of the industry participants and the regulator are mutually interdependent. We trust that the industry does too. The Payments System Board is content to confine itself to encouraging industry solutions and being the occasional catalyst for agreement among the parties, where that achieves the goals the Board has been given. But it is and must be also prepared, if needed, to use regulatory powers more forcefully. In judging which approach is preferred, we will respond to the industry’s behaviour, just as they respond to ours. The approach we adopt in any instance has to be tailored to the circumstances and we will ourselves on occasion need to innovate. What will be constant is the set of statutory goals given to the Payments System Board – controlling risk, and promoting competition and efficiency in the payments system. The Payments System Board is committed to those objectives and will be pragmatic, but determined, in pursuing them. We look forward to effective engagement with the industry in the process. | reserve bank of australia | 2,009 | 3 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Urban Development Institute of Australia, National Congress 2009, Brisbane, 31 March 2009. | Ric Battellino: An update on the economy and financial developments Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Urban Development Institute of Australia, National Congress 2009, Brisbane, 31 March 2009. * * * Introduction The past six months have certainly proved that we live in a globalised world. Last September, the US investment bank, Lehman Brothers, collapsed and several other major US financial institutions came under immense stress. These events transformed what was a difficult but manageable situation in global markets into a full-blown financial crisis. The consequences for the global economy have been severe. Up until these events, most forecasters had been predicting that the major economies would have a relatively mild slowdown in 2009, and that Asia would be largely unaffected. Those predictions have since been replaced by forecasts of a major global downturn, with all significant countries affected. Australia entered this difficult period in much better shape than many other countries. Disciplined monetary and fiscal policies in earlier years, sound regulation and a prudent approach to lending by our banks meant that the country was largely free of major problems. It is not surprising therefore that, so far, we have weathered this global downturn better than most. We have had more scope than others to move policies in the expansionary direction and our banks, being largely free of problem assets, are in a position to keep supplying credit to the economy. Having said that, no amount of good economic management can totally shield us from what is happening in the global economy. In my talk today I would like to review how the global economy is evolving; update you on how we are seeing the domestic economy; and say a few words about household sector finances and the housing market. The global economy We all know by now that the global economy is going through a recession. In itself, this is not unusual; the world economy has tended to experience a downturn every 7-10 years. The current global downturn is, however, more severe than we have experienced for a long time. This is because in some important countries a banking sector crisis has been overlaid on the regular economic cycle. This has added to the severity of the downturn because: • it has undermined the confidence of the community; and • it has led to a sharp slowdown in the availability of credit. This cycle is also highly synchronised, with every significant country in the world affected. Household and business confidence collapsed simultaneously in every country late last year, as we all reacted in the same way to the dramatic news being transmitted around the world. The events of the past six months have resulted in big changes in the forecasts for the global economy. Mid last year, official international bodies were generally forecasting that the world economy would grow by around 4 per cent in 2009, only a little below average. Now they are forecasting that global GDP will fall by around 1 per cent in 2009, the weakest outcome in the post-war period. It is widely accepted that a precondition for economic recovery is the restoration of financial stability. Markets have at times been frustrated at how long it has taken countries with banking problems to implement measures to restore the health of their financial institutions. But these are very complex problems and it takes time for consensus to build about the solution. Another complication is that, not surprisingly, a common initial reaction is to want retribution from the financial institutions that are seen as having caused the problem. While this is understandable, it makes it difficult for the political process to support making public funds available to stabilise the financial system. These issues are not new and, by the standards of some past banking crises, the US, the country at the heart of the current crisis, is making reasonable progress. The US authorities last week announced further plans to restore the health of their financial sector. These were followed by a solid rise in share prices, particularly for banking stocks, though market sentiment is clearly still fragile. On the real economy, we are starting to notice the odd positive economic indicator in the run of US monthly data, in contrast to the universally negative outcomes a few months ago. Let’s hope this continues. From Australia’s perspective, no discussion of the global economy is complete without reference to China. Like other countries, China experienced a sharp slowdown in the second half of last year, after a couple of years of extraordinary boom in which output growth increased to around 12 per cent per year. The downturn in China has been of great significance to Australia, given that China is now our largest trading partner. My guess is that the Chinese authorities, like everybody else, were caught by surprise at the suddenness of the downturn. But they have since reacted with great speed and vigour in implementing monetary and fiscal measures to stimulate their economy. There are some signs that these measures are starting to work. While China is not going to return to a 12 per cent growth rate any time soon, it is quite possible that the past six months will turn out to have been the period of maximum weakness in the Chinese economy. Of course, it will be a while before we know one way or another. The Australian economy Like all other economies, the Australian economy was very much affected by the extraordinary events of last September. As in other countries, confidence was severely eroded by the spectacle of large US financial institutions either collapsing or coming under immense financial strain. Concerns began to arise about the safety of our own financial institutions, even though they were in a very strong position. The Australian Government therefore elected, as did governments in other countries, to guarantee the debts of banks. In addition to these adverse confidence effects, the Australian economy was also affected by the collapse of commodity prices. Mid last year, commodity prices were at boom levels; six months later, many had broadly halved. This has resulted in a large loss of real income to the economy. The fall in commodity prices has also caused businesses to revise down sharply their investment plans in the year ahead. Households have also become much more cautious, cutting back on spending and increasing saving. All this meant that there was a sharp change in the outlook for the economy in the closing months of last year. The Reserve Bank responded to this with a very substantial lowering of interest rates: between September last year and February this year the cash rate was reduced from 7¼ per cent to 3¼ per cent. Other central banks have also cut official interest rates sharply, but in many cases, because of problems in their banking sectors, this did not flow through to any great extent to interest rates faced by households and businesses. In essence, the monetary policy transmission mechanism in many countries has become severely impaired, which is why some central banks have resorted to non-traditional monetary measures. This problem has not arisen in Australia. The monetary policy transmission process has been effective and there remains scope to ease policy further if circumstances require. The 400 basis point reduction in the cash rate since last September has reduced the overall cost of funds to banks by 340 basis points, after taking into account movements in interest rates in global capital markets. On average banks have cut interest rates on loans by the same amount – i.e. they have on average fully passed on the fall in their cost of funds to borrowers. Interest rates on housing loans have fallen by more, while interest rates on some consumer and business loans have fallen by less. As a result of the reductions that have occurred, both housing interest rates and business lending rates are at historically low levels. In the case of housing, this has produced a very quick response in terms of the pick up in loan demand. Housing loan approvals are up 20 per cent since their low point in July. This has been concentrated almost entirely among owner occupiers. It is not hard to understand why demand for housing loans has responded so quickly. With interest rates on housing loans around 5½ per cent, the cash payments involved in servicing a housing loan are now not much more than those involved in renting. Combined with the First Home Owner Grant, this has attracted a lot of first home buyers into the market. Governments are also supporting the economy with increased spending. Perhaps the best single measure of this is the change in their fiscal position. Across all levels of Australian governments, last financial year there was a fiscal surplus of 1½ per cent of GDP. This year, it is estimated there will be a deficit of 2½ per cent of GDP. This turnaround – about 4 per cent of GDP – is the largest in the post war period. These measures will go a long way to offsetting the negative influences on the economy coming from abroad, but the reality is that we cannot fully insulate ourselves from what is happening elsewhere in the world. As such, GDP is likely to fall in 2009. Even so, Australia will remain one of the better performing economies in the developed world and be well placed to benefit from the renewed global expansion when it comes. Household finances and housing As I am sure you are all acutely aware, households have experienced a large reduction in wealth over the past year or so. Mainly this is the result of the fall in the share market. As incomes have grown, we have accumulated more financial assets and an increasing proportion is held in market-linked investments such as equities and unit trusts. This is the natural outcome of financial development and is generally beneficial. It does mean, however, that there is more variability in the returns on our investments. Many people regard a fall in the share market as an aberration but the reality is that share markets produce negative returns every few years. This should be factored into our return expectations. If we don’t, we will be over-estimating the long-run rate of return that can be achieved on savings. It is important that we be realistic in our expectations about returns if we are to achieve our financial goals. Assumptions about investment returns have a big impact on decisions about how much we need to save out of income, and for how long we need to work, in order to accumulate a given amount of money. As a rule of thumb, for every one percentage point reduction in the long-run average return on savings, households would need to increase the proportion of income saved over their working lives by 3 per cent in order to accumulate a given amount of assets. Alternatively they would need to work for an additional 3 years. It is interesting that, over the past year, as the share market has fallen, the household saving rate has increased substantially and more older workers are either remaining in, or returning to, the workforce. Even after the large fall in wealth over the past year, the household sector is still in a relatively sound position. If we look at household balance sheets, we see that, on the liabilities side, households on average have debt equal to about one and a half year’s income. On the assets side, they have a property valued about 4 years’ income and financial assets equal to 2½ years’ income. Let me end with a few words on the housing market. This market was fairly subdued in 2008, with prices falling on average by 3 per cent across Australia. Some states – such as Western Australia which had a late boom – are now experiencing larger falls than average. Prices at the top end of the market have also been softer than other segments, no doubt reflecting the deleveraging that is taking place among high income households following the global financial crisis. Overall, however, the housing market in Australia has held up pretty well compared with that in countries such as the US and the UK, where prices have fallen in the order of 20 per cent. We continue to believe that the market here will hold up better than overseas. There are a number of reasons why this is likely to be so, but perhaps the most important is that we did not have the same deterioration in lending standards that occurred elsewhere. By and large, the great bulk of Australians who took out housing loans have been able to afford the repayments. Notwithstanding some rise over the past year, the 90 day arrears rate on housing loans is only 0.5 per cent, which is broadly in line with its long run average and well below that in countries such as the US and UK. In the period ahead, there will be forces pulling the arrears rate in opposite directions. On the one hand, as unemployment rises, more households will have difficulty continuing to service their housing loans. On the other hand, the very large reduction in interest rates has greatly reduced the debt servicing burden of households. On an average-sized mortgage, loan repayments are now $7,000 a year less than they were six months ago. This is a very large reduction, equal to about 8 per cent of average household income. The majority of households have chosen not to spend the money that has been freed up. Rather, they have maintained high repayments and are therefore moving ahead of schedule in repaying their loans. This will give them breathing space if they do subsequently find themselves in circumstances where their repayments are interrupted. Conclusion Let me sum up by saying that the past six months have been a very difficult time for the world economy. There are some tentative signs of improvement, but in reality it is going to take quite some time for the world to recover from the financial shock that has occurred. While the Australian economy has also weakened, it has held up better than most during this difficult period, helped by earlier disciplined policies and prudent financial behaviour. However, there are limits on how much we can insulate ourselves from what is happening abroad, and therefore there are probably still some difficult times ahead. Nonetheless, the underpinnings of the Australian economy are sound so we are well placed to benefit from the global economic recovery when it comes. | reserve bank of australia | 2,009 | 3 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Institute of Company Directors, Directors Luncheon, Adelaide, 21 April 2009. | Glenn Stevens: The road to recovery Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Institute of Company Directors, Directors Luncheon, Adelaide, 21 April 2009. * * * The global economy is in recession. Virtually all of Australia’s trading partners are contracting. In fact almost every country with which we would normally make comparisons is in recession, and for many of them it is a bad one. It is very rare for Australia to escape an international downturn and there is no precedent for avoiding one of this size. We, like most countries, have trade and financial linkages to the rest of the world. We are all aware of what happens abroad, and our own expectations and economic behaviour cannot but be affected by those events. Whether or not the next GDP statistic, due in early June, shows another decline, I think the reasonable person, looking at all the information available now, would come to the conclusion that the Australian economy, too, is in recession. 1 These are periods of hardship for significant parts of the community. People lose jobs, businesses fail, loans go bad, and plans are unfulfilled. As such, they are to be avoided if possible and at least ameliorated when they occur. It is for the latter reason that most countries today have extensive social safety nets, so that when recessions do occur, we can avoid the extent of outright misery seen in episodes like the 1930s. Policy-makers also seek to cushion such downturns with macroeconomic policy. They are usually more successful if they have managed to restrain the preceding boom. But no country’s policy-makers have been able to eliminate the business cycle, much as they have all tried. Cyclical behaviour has always been a feature of market economies. It always will be. Should you see, at some future time, a claim to the contrary, it would be advisable to treat it with great scepticism and, indeed, as a possible indication that a cyclical turning point is in the offing. Most of the time, economic activity expands, as population growth, increasing wealth and aspirations to higher living standards lead to more demand, while a growing workforce, higher productivity and technological innovation push up supply capacity. That is the normal situation for an economy. But every so often – on average about once every seven or eight years, but not regularly enough to predict with accuracy – a set of conditions arises that sees demand weaken for a while, output decline and unemployment rise. That is a recession. Usually, though not always, inflation tends to fall as a result of such episodes. Modern Australia has experienced a number of recessions – in the early 1950s, the early 1960s, the mid 1970s, the early 1980s, the early 1990s, and now in 2008/09. There were also events that could reasonably be labelled brief recessions in 1957 and 1977. On that count, the current episode will be the eighth recession since World War II. Most of these events have been associated with international business cycles. Perhaps it is useful to be clear what we mean by the term “recession”. The original definition is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators”. This is the working definition of the National Bureau of Economic Research (NBER), and is based on Burns AF and WC Mitchell (1946), Measuring Business Cycles, NBER, New York. There were significant mid-cycle slowdowns, which did not develop into recessions, in the mid 1960s and very early 1970s 2 , the mid 1980s, the mid 1990s and 2000/01. In each of these periods, output slowed or even fell very briefly, the rate of unemployment stopped falling and/or rose, and inflation moderated. The 2000/01 episode was notable in that it coincided with a downturn in the major countries. It was very unusual for Australia not to have a recession in such circumstances, though as it was, the rate of unemployment rose by about a percentage point in the space of a year. One aspect that helped us on that occasion was that the downturn in many of the major countries was not an especially deep one. Another was the continuing strength in some other key trading partners, not least China. This time, the state of the global economy is much worse. The extent of that weakness was unexpected. Until the financial crisis escalated so dramatically last September, it appeared that some of the major countries would have downturns, but that the emerging world, including Asia, would not slow as much as on some other occasions. Although affected by weaker demand from the industrialised world, many of these countries appeared largely to be free both of the financial problems in the major countries and of the sorts of problems they themselves had experienced in past episodes. The growth of China seemed to be on a strong medium-term path, albeit with a cycle like every other economy. This was not “de-coupling”, simply the assessment that the net of competing forces would produce a significant slowdown, but not a slump. Hence, global growth was generally expected to slow to below average, after several years in which it had been unsustainably high. Then, things took a serious turn for the worse. The financial turmoil following the Lehman collapse was the most intense in generations. It was contained within about six weeks, and indeed over the past few months conditions have been gradually improving in financial markets, in several respects. But we are now seeing the fallout in the rest of the economy from that financial turmoil. The weakened ability of the financial institutions to provide credit to industry is one of the factors at work, but in my judgment a bigger one is the decline in confidence, and the sudden and widespread aversion to risk, among firms and households all over the world. It seems that everyone, everywhere, having seen the instability in financial systems in September and October 2008, and consequently feeling poorer and fearing bad times ahead, simultaneously decided to pull back their own spending, curtail their expansion plans and reduce their debt. It was, of course, entirely rational, at the individual level, for firms and households to behave in a more precautionary way. But the collective sum of those decisions created, over the ensuing six months, an international slump in demand for consumer durables and investment goods that was sharper, and more synchronised, than any seen for decades. The result is that the world’s gross product is now thought likely to decline in 2009, the first time that has happened for many decades. Australians shared in this more cautious behaviour, particularly in the business world. A range of business surveys indicates that a trend moderation in business confidence that had been occurring for some months turned abruptly much weaker in October, and remained weak thereafter (Graph 1). There was some recovery in March. (The behaviour of Australian household confidence surveys has not been as weak, as I shall come to later.) While official data are yet to show it, it is likely that business investment spending is in the process of declining sharply. Hiring intentions have been scaled back quickly. Residential investment and exports have fallen. In both those cases, by the way, if we applied the “two negative growth quarters” definition, they would be labelled recessions. No-one remembers them as recessions, though, which perhaps illustrates why that definition is not very useful. Graph 1 The net result is that the Australian economy has been contracting, though on the best information we have, not at the pace seen in a number of other countries, where quarterly declines in real GDP of 3, 4 or even 5 per cent have been observed in the last quarter of 2008 and are likely to have occurred in the first quarter of 2009. A key dimension through which Australia experiences the global business cycle is the terms of trade, a gauge of the income gains or losses that international relative price changes impart to Australia. Over the five years to 2008, a period of exceptional strength in the global economy, the terms of trade rose by about 60 per cent, equivalent to about 12 per cent of a year’s GDP – about $140 billion – in additional annual income. It was the biggest such gain in half a century. Now, the terms of trade are falling, reversing part, though so far only part, of that earlier gain. I would like to make two points, however, about those terms of trade swings. The first is that, in earlier episodes such as in the early 1950s, and the mid and late 1970s, very large terms of trade movements seriously destabilised the economy. On this occasion, there have been plenty of adjustment challenges – generally coming under the heading of the so-called “two speed economy”, where the resource-intensive regions and industries grew quickly and others slowed. But for all that, a floating exchange rate, a much more flexible labour market and better macroeconomic policy frameworks have helped the economy adapt to the terms of trade swings without the degree of instability seen in the past. That is a testament to the arrangements that are now in place. The second point is that, at this stage, the fall in the terms of trade that is occurring does not seem to be reversing all of the previous rise. Even with the large falls in prospect for contract prices for bulk commodities, Australia’s terms of trade look like they could, at the end of this year, still be about 40 per cent higher than the average for the period from 1980 to 2000. Perhaps that will not persist. Alternatively, perhaps what commodities markets are telling us is that some factors beneficial to Australia – foremost the continued likely emergence of China – remain in place. It is probably not entirely coincidental that the clearest signs of a turning point in economic activity appear to be accumulating in China, though not exclusively there. That is a quick description of where we are, and some of the background of how we got here. I will not speak here of the broader background of the financial excesses that helped to create the situation, because that has been covered in detail before. Instead, I want to devote some attention to the question: how do we get on the road to recovery? History shows that recessions come, but also that they end. Can we speed that process? And to the extent that we have some capacity to shape the next expansion, how might we use it? Since this is essentially an international episode, and not really an Australia-specific one, much depends on what happens abroad. This neither means we are helpless to affect our own future, nor absolves us of the responsibility to pursue sensible policies to promote recovery here. I shall come to that, but first, a few words about the conditions for a durable global recovery. I take it as given that we all agree that a better financial regulatory architecture is needed and there is a lot of work under way on that. But that is about avoiding a repeat crisis. What about steps to get out of this one? There are several necessary elements. The first, as many have said, is to sort out the mess in the financial system, especially in the United States, the United Kingdom and Europe. It is not an easy problem to solve. But quite a lot is known from previous episodes, including in the United States itself, of the main principles that must be observed in this process. The first step is an honest accounting of the situation. Then, the “legacy” assets have to be quarantined so that the potential for further erosion of their quality, and uncertainty over their value, does not lead to further loss of bank capital and associated confidence problems. The relevant institutions must then be recapitalised if need be, so that, freed of the problem loans, they can resume normal commercial activity – lending for sound proposals. It may be that, appropriately cleaned up, banks can attract new private capital. If not, then public funds have to be made available to recapitalise them where needed. Everyone understands these principles. The question is how to implement them. There are a few ways to go about it, all of which are on the table at present. One is to hive off the problem assets into a “bad bank” or some other like vehicle, which is then managed and gradually wound down. The assets have to be transferred at some price, and the process of striking that price has to protect the interests of taxpayers, who should not over-pay for the bad assets and thereby give a windfall to shareholders. At the same time, there has to be pressure on the institutions concerned actually to get on with the clean up, as opposed to just waiting for something to turn up. The plan being implemented in the United States is designed to induce private capital to take part in the asset management vehicles, which helps to sort out the pricing question. Another approach is to leave the assets on the banks’ balance sheets, but have the government insure them, for a price, to limit further downside. This is the essence of the UK approach. Yet another approach is to nationalise the relevant institutions, which obviates any pricing issues for the assets per se and automatically provides enough capital, but introduces new questions in dealing with shareholders. This approach is the traditional one, though it has mostly been used in smaller countries or, where used in major countries, for smaller institutions. The economics of all these approaches is essentially the same: recognising losses that have occurred, reducing the riskiness of bank balance sheets and finding new capital to restart the credit process. Which technique to choose is a matter of judgment. The politics may be harder than the economics. Ordinary people resent, not surprisingly, taxpayer funds being used to fix problems that arose, in part at least, because of seriously misaligned incentives that rewarded financiers for taking too much risk. But it has to be done, otherwise economies will suffer for longer. The political leaderships of the United States, the United Kingdom and some other countries have the unenviable task of persuading their citizens to accept the need for these initiatives. A second near-term condition for recovery is macroeconomic support for aggregate demand, in an environment in which private spending has weakened sharply, owing to loss of confidence and strained credit markets. That is coming into place as a result of easier monetary policy, and easier fiscal policy also in many countries. Internationally, the role of fiscal policy is more prominent on this occasion than has been the case for many years, since the impaired credit system makes monetary policy less effective than it would normally be in many countries. The reason official interest rates are approaching zero in a growing list of countries is not because central banks think it is a good idea to make credit available for free. It is because the flow-through from official rates to the rates that matter most in these economies – those paid by businesses and households – has not been working very well. Third, with these near-term policy requirements – repairing the financial system and macroeconomic stimulus – come associated medium-term requirements, which fall under the heading of “exit strategies”. For those countries where governments end up owning part or all of banks, there will need to be a plan to divest that holding when conditions improve. The same can be said of the various guarantees under which banks globally are raising money at present. This was an important step to help the system through a period of severe dislocation, but it is surely not desirable as a permanent state of affairs. At some point, it will be prudent to start weaning banks, or more to the point investors, off those guarantees. Perhaps co-ordinating such a departure across countries would be a useful role for the Financial Stability Board. The other international exit strategy needed will be on macroeconomic policies. The size of the downturn, the extent of fiscal stimulus and the cost of the financial restructuring packages have placed a very large burden on government finances in a number of countries. I am not arguing against the measures. But they will need to be accompanied by a credible story about how governments will keep their own finances on a sustainable footing over time. Taxpayers, markets and creditors will lose, rather than gain, confidence if they cannot see that path back to sustainability. And, at this point, confidence is what it is all about. The same issues will arise for the exceptional monetary policy measures. The fourth condition for a durable new international expansion is to avoid perpetuating the so-called “global imbalances”. The excess of saving over investment in the emerging world, especially Asia, was one part of the story of how the search for yield led to excessive risktaking. This is not to blame Asia for the crisis, but simply to state the obvious: that for people to misuse abundant capital as they did, there has to be a fair bit of it around to begin with. As it has turned out, there was more of it than the United States and some other developed countries were able to use wisely. So to the extent that strong global growth relied on advanced country consumers lowering their saving rates, absorbing the export surpluses of the emerging world, and accepting higher debt burdens, the model is broken. Of course, the most important matter in the immediate term is for the US economy to resume growth. But even when it does, the reality is that for some time ahead, advanced country households will be looking to lower their debt burdens and save more of their income. They will not be the same spur to consumption growth as they were. This will mean that global growth will be, for a while at least, lower on average than we saw for most of the past decade. How much lower will depend in part on the extent to which the economies in the emerging world are able to foster more demand at home. For them to feel safe in doing that, and perhaps to return to their traditional position as capital importers, there will be other conditions – not least confidence on their part that the rules of international engagement are not just skewed to the advantage of the advanced countries. In the end, though, durable growth will have to be more balanced than the growth we had over the past decade. To the above, I should add that maintaining openness to trade and capital flows is critical – lest the mistakes of the 1930s be repeated. This should hardly need saying, yet times of serious recession are often times when protectionist sentiments grow stronger. That is all I have to say today on the global conditions for recovery. Turning closer to home, Australians cannot do a great deal to make these improved international conditions come to pass. But we can maximise our chances of benefiting from a new international expansion. The first thing is to maintain some confidence in ourselves and the prospects for our country over time. We cannot achieve effortless prosperity either on the back of ever-escalating mineral prices or simply by bidding up the prices of our houses. It is as well to realise that. But as I have said on previous occasions, Australia’s genuine long-term economic prospects remain good, and there remain good grounds to think that we will continue to weather the storm better than most. It is noteworthy that in measures of confidence taken from surveys, household confidence has fallen in Australia relative to the ebullient levels of a year ago, but it remains much more resilient to date than comparable results in major countries (Graph 2). While households expect unemployment to be much higher in a year’s time, their stated expectations about economic conditions five years from now have barely diminished at all from what we have seen consistently over a number of years (Graph 3). So notwithstanding their evident caution at present, people remain essentially optimistic about the long term. Graph 2 Graph 3 Consumer demand in Australia, while weak compared with recent years, is actually at the stronger end of international comparisons among advanced countries. This presumably owes something to the stimulatory effects of fiscal measures and lower interest rates for borrowers (though savers are feeling the pinch). But perhaps it also shows the inherently optimistic view Australians take in the future. Optimism, combined with an awareness of risk, is a fundamental strength. It is to be hoped that this will be matched by a recovery in business confidence over the months ahead. That remains to be seen, though there have been some encouraging signs recently. What can policy-makers do to help? Unfortunately, there is no lever marked “confidence” that policy-makers can take hold of. Our task is very much one of seeking to behave, across the board, in ways that will foster, rather than erode, confidence. Over the past six months, that has, of course, involved the rapid deployment of both fiscal and monetary measures, to support demand. The effects of those measures will still be coming through for some time yet. Measures to sustain confidence in the financial sector and to keep key markets functioning were also important. Perhaps there is also some value in articulating a view of where we want to get to when the cyclical downturn ends, as it will, and recovery takes hold. What sort of country does Australia want to be, economically, during the next expansion? How do we want to be positioned in the global marketplace for capital, in an environment in which markets will have absorbed a lot of government debt and will be evaluating opportunities for other uses of capital? I suggest that Australia has a very good chance of offering an economic setting in which the following conditions hold. First, political stability remains assured – something becoming a bit less common. Second, the Government does not own, and has not had to give direct financial support to, the banking system. Australia will be free of the difficult governance and exit strategy issues that such support is raising in a number of countries. Third, public finances remain in very sound shape, with modest debt levels and a mediumterm path for the budget back towards balance. Without the massive obligations arising from bank rescues that will inevitably narrow the options available to governments in other countries, Australia should be able to articulate such a path more effectively than most. Fourth, sensible policy frameworks – both macroeconomic and microeconomic – remain in place; the financial regulatory system is strong and tested. Fifth, we remain open for trade and investment, and have a capacity to deploy both our own and other people’s capital carefully and profitably. Finally, there is an exposure to, and an engagement with, an Asian region that still has the most dynamic growth potential in the world, where hundreds of millions of people will for decades to come be seeking rising living standards. There are rather few countries that have the potential to offer so attractive a proposition to international capital, and to their own citizens, over the years ahead. It is a proposition that, if pursued sensibly and consistently, offers the most secure basis for confidence in Australia’s future. It is such confidence that, more than anything else, will help to drive us along the road to recovery. | reserve bank of australia | 2,009 | 4 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Canadian Australian Chamber of Commerce, Canada-Australia Breakfast, Sydney, 19 May 2009. | Glenn Stevens: Australia and Canada – comparing notes on recent experiences1 Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Canadian Australian Chamber of Commerce, Canada-Australia Breakfast, Sydney, 19 May 2009. * * * Thank you for the invitation to be here. As a one-time temporary resident of Canada and graduate of a Canadian university, it is pleasing for me to see the Canadian Australian Chamber of Commerce contributing to economic interaction between the two countries. It is surprising that Australians and Canadians do not spend more time comparing notes, given the things we have in common. Apart from a shared heritage as members of the British Commonwealth (though Canada, of course, has the French-speaking heritage as well),2 we are both federal states and constitutional monarchies. Both nations have relatively small populations that occupy physically large continents. We are both commodities producers. Our economies are open, and free flows of trade and capital are very important to us. There are some interesting similarities, and the occasional informative difference, in experiences, and examining these is helpful for Australians to understand better the way the past six or seven years have evolved. I propose to look at some of those today. Looking to the future, both our countries have reason to believe that we will come through this episode in reasonable shape. We also have important shared interests in the way the international economic and financial system evolves over the years ahead. In canvassing some of these issues, I am mindful that David Dodge, the former Governor of the Bank of Canada, spoke to this group only a few years ago, concerning many of the same questions.3 I find myself agreeing with the sentiments he expressed then, and repeating many of them today. Similarities, differences and recent developments Australia and Canada have similar levels of GDP per capita (based on purchasing power parity, nominal GDP per capita was around US$37 000 for Australia and US$39 000 for Canada in 2008). Since 1990, Australia’s growth in real GDP per capita has been a little higher than Canada’s. In terms of economic structure, the primary production sectors, combined, are of similar size in the two countries (Table 1). Australia has less manufacturing, but more mining than Canada. There are also some notable differences in the composition of our mining sectors. Both these turn out to have been of some importance over recent years, as I shall point out shortly. But, overall, the economic structures of the two countries at a very broad level are reasonably similar and, beyond the resource sector concentration, not all that different from the “norm” among industrialised economies. I thank Kathryn Ford and Jennie Cassidy for assistance in preparing these remarks. Canada is, of course, famously bilingual. In both countries, Chinese languages (that is, Cantonese, Mandarin and other Chinese languages) are the most commonly spoken languages after English (and after French in Canada). Dodge D (2006), “Prospering in Today’s Global Economy: Challenges for Open Economies such as Australia and Canada”, address to the Sydney Institute and the Canadian Australian Chamber of Commerce, 6 November. Trade and financial flows between Australia and Canada are small – Canada accounted for around 1 per cent of Australia’s merchandise exports and imports in 2008, and around 1 per cent of foreign investment received by Australia. But trade overall is very important to Australia, and even more so to Canada. Exports of goods and services amounted to just under a quarter of Australian GDP in 2008 and more than a third of Canadian GDP. Commodities make up a significant share of the value of merchandise exports in both countries, although they are rather more important to Australia, as Canada also has sizeable exports of machinery, equipment and cars (Table 2). The composition of the two countries’ commodity exports differs somewhat – Canada’s exports include a larger share of crude oil, natural gas and forestry products, while Australia has a larger share of exports in coal, iron ore and many metals. Commodity prices tend to vary quite a bit, of course, driven largely by the ebb and flow of the world business cycle. This means that fluctuations in the terms of trade have long been an important feature of both countries’ economic experiences. For many years, the movements seemed to be quite similar – at least until the international downturn of 2001 (Graph 1). Graph 1 In the subsequent global upswing, while both countries saw their terms of trade increase, Australia’s terms of trade began to pull ahead of Canada’s. Between the beginning of 2002 and the middle of last year, the Canadian terms of trade had risen by more than 30 per cent. But over the same period, the Australian terms of trade rose by over 60 per cent. Why the difference? The answer is that the more rapid rise for Australia reflected the fact that our exports have a higher share of commodities, and within that, a higher weighting towards the commodities that had experienced the largest price increases (Table 3). That said, since Canada’s trade share of the economy is considerably larger than Australia’s, the smaller size of the terms of trade rise in Canada still imparted a pretty significant boost to national income. Income gains driven by the terms of trade are generally expansionary. The boost would be expected, other things equal, to result in stronger growth in demand and output relative to capacity, more risk of inflation, higher interest rates and a rise in the exchange rate, relative to countries that did not share the shock. So it seemed to turn out. In the phase of the terms of trade upswing, both our countries saw growth above average, interest and exchange rates rising and some upward pressure on inflation. There were, nonetheless, some differences. The Australian dollar did not rise as much as the Canadian dollar, which is a bit surprising given Australia’s greater rise in the terms of trade. Australia also saw somewhat higher growth in demand on average during the 2002 to 2008 period than Canada. Associated with those trends was a more pronounced rise in inflation at the end of the upswing, which saw us deviate further from our inflation target than Canada (Graph 2). Graph 2 That said, Australia coped with the terms of trade upswing better this time than in some past episodes. An inflation peak at around 5 per cent in 2008 compares to around 25 per cent in the commodities boom of the early 1950s and 18 per cent during the boom in the mid 1970s (Graph 3). Several economic reforms contributed to this improvement – including the floating exchange rate, more flexible labour market and stronger monetary policy framework. Graph 3 More recently, the impetus from the global economy has reversed direction for both countries as a result of the global recession. Canadians would have sensed the change first, reflecting Canada’s very close ties with the United States – which absorbs around three-quarters of Canada’s merchandise exports, equivalent to around a quarter of its GDP. The economic weakness in the United States began to take root as problems in its housing sector and financial system emerged in 2007, reducing demand for Canadian exports and weighing on growth, even with the booming terms of trade. In Australia’s case, exports are not as large a share of the economy, as noted, and the destinations are both more diverse and more oriented to Asia (China and Korea account for more than a fifth of the value of Australian merchandise exports, and Japan accounts for another fifth). Overall, Asia was initially relatively little affected by the problems in the major economies. It was really only in the second half of 2008, as the financial turmoil led to a sharp drop in confidence among households and firms around the world, that a reassessment about Asia’s prospects began. Even then, Australia’s export volumes have not weakened to date as much as those of many other countries (Table 4). One reason is that the slump in global trade was initially concentrated heavily in manufactures, which is a smaller share of exports for Australia than others. Another is the stronger linkage of key commodity exports to China, which appears to have seen a pick-up in growth this year. Chinese industrial output fell for four months between July and November, but has since recovered all those losses. A similar pattern has been seen in Korea, where industrial output suffered a sharp decline around year end but apparently made up about half of that over February and March. Looking ahead, with commodity prices at present levels, Canada’s terms of trade look like they are still somewhat above the average for the preceding couple of decades. Australian resource producers have accepted lower prices for the year ahead, and this is likely to contribute to a decline in the terms of trade by the end of 2009 of about 25 per cent from the peak, as shown in the chart. Yet even with that, at this stage Australia’s terms of trade over the coming year look like they will still be around 40 per cent above the two-decade average up to 2000. So in some important respects, not only did the economic upswing that ended during 2008 provide a bit more impetus to Australia than Canada, but the ensuing global economic downturn has not, to date at least, hit Australia as hard as it has Canada. On a comparison of these two countries, the effects of export volume losses in slowing overall demand in the economy have been less important in Australia. As for inflation, it has moderated. The headline figures overstate the fall in inflation in both countries because of the decline in petrol prices, but measures of core or underlying inflation are trending lower. Of course in Australia, inflation has further to fall than in Canada, since it reached a higher peak. Key strengths One important feature that our two countries share at present is the relative resilience of our banking sectors.4 Notwithstanding the global credit crisis, Canadian and Australian banks continue to be profitable and are well capitalised by private investors – something that many advanced countries cannot claim. For the 2008 reporting period, the return on equity for the five largest Australian banks was 17 per cent, and it was 14½ per cent for Canada’s major banks. This was lower than in the preceding few years, which had been ones of exceptional profits for banks around the world – and years during which, in retrospect, risk was increasing – but still very solid. It is noteworthy that equity market valuations of the two banking systems display more confidence in asset quality and potential future earnings than for US, European or UK banks, as judged by the market premium over book value (Graph 4). Graph 4 The solid performance of these banks reflects a number of factors. Firstly, holdings of the complex securities at the centre of the crisis were modest by international standards. Secondly, banks in Australia and Canada had more conservative lending practices in their home markets than their counterparts in the United States and the United Kingdom. While sub-prime mortgages accounted for around 13 per cent of the US mortgage market in mid 2007, the closest equivalents in Australia and Canada accounted for around 1 per cent and less than 5 per cent of their mortgage markets, respectively. The six largest Canadian banks account for around 90 per cent of Canadian banking system assets. Following recent mergers, the four largest Australian banks account for around 70 per cent of Australian banking system assets. Both countries have had regional booms in housing markets in the past few years, associated with the run-up in commodity prices and the associated effects of the shift in productive resources to those industries and regions that were enjoying the boom. Hence, house prices in Alberta and in Western Australia had a large run-up compared with most other regions in the respective countries (Graph 5). More recently, dwelling prices generally have tended to soften. In Australia’s case, the ratio of the median dwelling price to average household income has declined quite noticeably since 2003, without a very large absolute decline in housing prices (Graph 6). This is evidence for at least the possibility that these adjustments can take place over reasonably lengthy periods and without being terribly disruptive to the economy. Graph 5 Graph 6 Of course, with the economy contracting at present, banks in both countries are seeing some pick-up in mortgage arrears. Overall, though, Australian and Canadian households appear to be having much less trouble servicing their debt than is the case in the United States and the United Kingdom, as shown by their relatively low rates of non-performing housing loans (Graph 7). This reflects the better lending decisions in earlier years. Graph 7 Our common external interests Of course, good domestic policies can do only so much to ameliorate the impacts of very adverse international developments. Both economies have slipped into recession as international forces have taken hold, albeit through differing chains of causation. But for the reasons articulated above, there are good grounds to think that both countries should be in a relatively good position and well placed to take part in a renewed international expansion. It is too soon to say this is beginning yet, though developments over recent months are certainly consistent with the view that a recovery will get under way towards the end of the year. That said, most observers think that the early part of any new global expansion will be characterised by pretty slow growth. Even with the uncertainty over the near-term global outlook, however, it makes sense to look forward. So in the final part of this address, I should like to talk about the common interests we have at stake in the way the international community responds to the crisis and shapes the next expansion. First among these is the openness of trade and capital flows. The extent to which trade flows slumped late last year perhaps gives a sense of what could happen were trade barriers to go up. Everyone would suffer, and badly. This is fully understood at an intellectual level around the world. Yet we know that in times of domestic economic difficulty, the pressures for protectionism increase. Countries like ours need to keep making the point that trade is not a zero-sum game; it is collectively a positive-sum process that stimulates innovation and productivity, increases global growth and raises living standards. Secondly, the continued development of many emerging economies will enrich the opportunities for firms and individuals in economies like ours over time. But it will be sensible for emerging countries to have strategies that rely less on the absorption of consumer products by the developed world, at least for some years. That will involve, roughly speaking, more consumption and investment at home, lower trade surpluses and a step back from very large outflows of capital to the developed world. This is actually a rational choice for emerging market countries. But a lesson many countries took from the Asian crisis was that a strategy such as that was dangerous, because the rules of international engagement did not provide adequate protection in times of difficulty. Their response was the build-up of reserve assets in the period since 1998 – a costly form of international self-insurance, involving sending hard-saved capital from developing economies to the rich world. It was very much a second-best option but was pursued because first-best seemed unachievable. So it is in the interests of many developing countries to alter their growth strategy, but to do so they need confidence in the international system – its rules, governance, safety nets and so on. At the same time, the countries that have dominated the governance arrangements hitherto, and which will have to accommodate the emerging countries, will want to have some confidence that we are all – emerging markets and developed countries alike – reading from the same page about the role and responsibilities of the international financial institutions and their member states. Australia and Canada have a shared interest in fostering progress on these fronts, which will involve encouraging both emerging countries and highly developed countries to move in ways that accommodate each other. I know my Canadian counterparts have worked assiduously on these issues for many years. We support those efforts. Thirdly, much work is being done on the lessons we can learn from this episode for financial regulation and structure. As countries whose financial and regulatory systems have performed pretty well in this episode, and which are largely free of serious problems, Australia and Canada are perhaps uniquely placed to contribute to the discussion. I think we could hope to bring a sense of emotional detachment, balance and perspective to the international discussions on regulatory reform, which can be quite heated at times. Conclusion The “great white north” and the “great south land” have much in common, as well as some very informative differences. Sound policy frameworks and robust business sectors are being tested at present, but they can meet the test. We both certainly have, at this juncture, much at stake in the global economy recovering to a path of balanced growth, with open markets and sustainable policy settings. There is plenty we can do together to promote our common interests in the world, as well as our own interaction. Part of this sharing of ideas and co-operation will be spurred on by forums such as this one. I wish you every success. | reserve bank of australia | 2,009 | 5 |
Address by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, to 2009 Securities & Derivatives Industry Association Conference, Sydney, 28 May 2009. | Ric Battelino: Global monetary developments Address by Mr Ric Battelino, Deputy Governor of the Reserve Bank of Australia, to 2009 Securities & Derivatives Industry Association Conference, Sydney, 28 May 2009. I would like to thank Chris Becker for his extensive assistance with this talk. * * * Introduction Over the past eight months, many central banks have reduced interest rates to unusually low levels. Some have also undertaken unconventional measures to implement monetary policy, such as: • giving commitments about the future path of interest rates; • greatly expanding their balance sheets; and • shifting the composition of their assets from securities that are short-term and relatively risk-free to those that are longer-term and somewhat riskier. Given the unprecedented nature of these measures, many people are asking what they mean for the world economy, and particularly for inflation. Debate about these issues will no doubt continue for a long time yet, and I certainly don’t pretend to have the answers. In my talk today I will set out what various central banks have been doing, and offer a perspective on how these actions could be interpreted. Monetary policy implementation Until recently, the majority of the world’s central banks followed a fairly standard model when it came to implementing monetary policy: • first, a monetary policy committee or board set a target for a short-term interest rate, taking into account the central bank’s objectives; • second, central banks then undertook operations in financial markets to adjust the supply of funds in the market to a level consistent with the targeted short-term interest rate; and • third, changes in short-term interest rates fed through to a wide range of other interest rates in the economy. An important channel through which this approach to monetary policy works is by influencing the demand for credit. The supply of credit is assumed to adjust to demand, which in a world of deregulated financial systems and stable, well functioning markets, is a reasonable assumption. When markets are disrupted, however, the normal transmission mechanism can break down at several points: • first, the relationship between the amount of funds supplied through market operations and the overnight interest rate can become unstable. For example, if banks start to hoard liquidity, more funds need to be supplied to keep the overnight rate at the target; • second, even if the target rate is achieved, the flow-through to other interest rates in the economy may become impaired. If, for example, risk aversion in markets increases, interest rates for term funds rise relative to the overnight rate, and premiums for credit risk also rise. Reductions in the overnight rate targeted by central banks, therefore, may not flow through to the same extent as usual to interest rates charged on loans; and • third, if banks become capital constrained, their willingness and capacity to lend at any interest rate will be diminished. As you know, over the past year, many countries have found that the normal monetary transmission mechanism has become less effective. Interest rates As I noted, many central banks have responded to this by reducing official interest rates to abnormally low levels, in some cases close to zero. Most of this has happened since September last year. Up until then, monetary policy settings around the globe had been following a relatively normal path, guided mainly by inflationary pressures. Global monetary policy entered a tightening phase around 2004 and the majority of central banks continued to tighten policy into 2008. Of the 35 largest countries or monetary areas, 23 had higher interest rates at September 2008 than at the start of the year, seven had unchanged rates and five had lower rates (see Table 1). This is not surprising because global inflationary pressures were still rising in the middle of 2008. Commodity markets did not peak until July 2008, and indicators of pressure on global capacity – such as prices charged on shipping contracts – were at extreme levels. Table 1: Changes in Monetary Policy Change from 1 Jan Change from 1 Sep level to Sep 08 08 to present Current (basis points) (basis points) (per cent) Developed markets United States ↓ ↓ 0.125 Euro area ↑ ↓ 1.00 ↓ 0.10 Japan United Kingdom ↓ ↓ 0.50 Canada ↓ ↓ 0.25 Australia ↑ ↓ 3.00 Sweden ↑ ↓ 0.50 ↓ 0.25 Switzerland Norway ↑ ↓ 1.50 Denmark ↑ ↓ 1.65 New Zealand ↓ ↓ 2.50 ↓ 5.31 Emerging Asia China South Korea ↑ ↓ 2.00 India ↑ ↓ 4.75 Taiwan ↑ ↓ 1.25 Indonesia ↑ ↓ 7.25 Thailand ↑ ↓ 1.25 Hong Kong ↓ ↓ 0.50 ↓ 2.00 ↑ ↑ 14.00 ↑ ↓ 4.50 ↑ ↑ 12.00 Turkey ↑ ↓ 9.25 Poland ↑ ↓ 3.75 ↓ 1.50 ↑ ↓ 9.50 Brazil ↑ ↓ 10.25 Mexico ↑ ↓ 5.25 Chile ↑ ↓ 1.25 Colombia ↑ ↓ 6.00 Peru ↑ ↓ 4.00 Malaysia Pakistan * Philippines Emerging Europe Russia ** Czech Republic Romania Latin America Other Saudi Arabia South Africa ↑ Israel Iceland *** ↑ ↓ 2.00 ↓ 8.50 ↓ 0.05 ↓ 13.00 Sources: Bloomberg; central banks * After raising its policy rate by 200 basis points in November 2008, Pakistan's central bank lowered its policy rate by 100 basis points in April 2009. ** Russia's central bank increased its policy rate by a cumulative 200 basis points during November 2008 in moves aimed at stemming capital outflows and mitigating the downward pressure on the ruble. *** After initially lowering rates by 350 basis points in mid October 2008, the Icelandic central bank increased its policy rate by 600 basis points two weeks later as part of the conditions of the IMF's rescue package. Subsequent easings have amounted to 500 basis points. The unusual period of monetary policy began in September 2008, after the failure of Lehman Brothers dramatically escalated the financial crisis. This in turn led to a collapse of household and business confidence around the world. Official interest rates have since been cut very sharply across virtually all countries due to the highly synchronised nature of the current economic cycle. The average reduction in interest rates has been 330 basis points in the developed economies and about 300 basis points in emerging economies. Among the developed economies, only four – Australia, New Zealand, Denmark and Norway – still have official interest rates above 1 per cent. Official interest rates have never been this low in the developed world in the 150-year period for which we have data (Graph 1). Graph 1 The reason why official interest rates have been reduced to such extreme levels is that frictions in markets had made interest rates on loans to households and businesses less responsive to cuts in official rates. In the case of the US, for example, even though the Fed had reduced official rates by 325 basis points by September 2008, the standard mortgage rate had hardly changed (Graph 2). Bigger cuts in official rates were therefore needed in order to bring about a given fall in interest rates on loans. Graph 2 Table 2: Mortgage Rates on New Housing Loans* Predominant Mortgage Type Current Rate 10-year Average Rate Deviation from Average Australia Standard variable 5.16 6.85 -1.70 United States 30-year fixed 4.63 6.42 -1.79 Canada 5-year fixed 3.89 5.65 -1.76 United Kingdom Standard variable 3.83 6.5 -2.67 United Kingdom 3-year fixed 4.33 5.58 -1.25 New Zealand 2-year fixed 6.19 7.79 -1.60 Germany Fixed (>10 years) 4.49 5.33 -0.84 Sweden Variable 2.16 4.18 -2.02 ** ** Sources: Bloomberg; Thomson Reuters; national data * Data: to April for Australia, US and Canada; to March for UK and NZ; and to February for Germany. ** In the UK, variable rate and 1–5 year fixed-rate loans account for approximately the same proportion of the market. In assessing the level of global interest rates, it is important to look not just at official rates, but at a broader spectrum of rates faced by borrowers. We don’t have data on housing rates going back 150 years, but it is clear that they are not at the very low levels of official rates. In most countries, including Australia, they are around 1½-2 percentage points below their decade averages – that is, low, but not at extremes (Table 2). For corporate borrowers, interest rates are not unusually low. In fact, in most developed economies, interest rates faced by corporations in capital markets are, if anything, still a little above decade averages, due to the large increase in risk premiums (Table 3). Table 3: Non-financial Corporate Bond Yields* Maturity 10-year Average Current Rate Rate Deviation from Average Australia 1-5 years 7.29 6.62 0.67 United States 5-10 years 6.59 6.26 0.34 Canada 1-10 years 5.37 5.75 -0.38 United Kingdom 5-10 years 7.04 6.43 0.61 Euro area 7-10 years 6.00 5.50 0.50 New Zealand 10 year** 8.66 7.84 0.83 * Industrial corporates ** A-rated bonds Sources: Bloomberg; Merrill Lynch Other monetary measures Let me now turn to the other unconventional measures central banks have undertaken. These are often grouped in the popular press under the generic title of “quantitative easing” or “printing money”, but they really fall into three distinct categories: • measures to add to banks’ reserve balances; • measures to reduce the term structure of interest rates; and • measures to support specific credit markets and/or take credit risk onto central bank balance sheets. The US Fed has coined the term “credit easing” 1 to cover such policies. All these measures involve changes in either the composition or the size of central bank balance sheets. While all are aimed at sustaining the flow of credit in the economy, some do so by working on credit demand, while others aim to stimulate the supply of credit. The measures are not mutually exclusive, but can be mixed in different combinations to best suit See Bernanke, B (2009), “The Crisis and the Policy Response”, at the Stamp Lecture, London School of Economics, London, 13 January. the circumstances of the country. Indeed, it can make sense, in terms of maximising their impact, for policies to combine elements of each of the above measures. Measures to increase bank reserves Measures designed to increase the supply of bank reserves can, I think, be accurately referred to as “quantitative easing”. They involve the central bank increasing the size of its balance sheet by increasing its purchases of securities from the market and crediting the payments to banks’ reserve balances at the central bank. These measures differ from routine market operations both in their scale and their intent. They involve operations on a much larger scale than normal. Some central banks have expanded the supply of reserves by several percentage points of GDP (Graph 3). Graph 3 Perhaps more importantly, the objectives underpinning quantitative easing are different. Whereas routine operations are working through interest rates to influence the demand for credit, quantitative easing seeks to influence the supply of credit. The aim is to provide more reserves than banks wish to hold, with the intention that they will try to dispose of these excess reserves by increasing their lending. This type of activity is usually undertaken only when interest rates have fallen to zero or near-zero levels. While, theoretically, a central bank could undertake quantitative easing at any level of interest rates, in practice it is difficult to do so, as large-scale provision of excess reserves forces the interest rate to zero. The central bank could stop this from happening by paying a market-based interest rate on reserve holdings, but this would undermine the purpose of the exercise by reducing the incentive for banks to lend their reserves. Measures to flatten the yield curve As I noted earlier, monetary policy settings in most countries are normally defined in terms of a target for a short-term interest rate. The precise relationship between official interest rates and the interest rates faced by borrowers varies from country to country. In some countries, such as Australia, where the bulk of banks’ loans to customers are at floating rates, the relationship is usually relatively close. In countries where banks mainly lend to customers at longer-term fixed rates, the relationship between official rates and loan rates is more complex, and therefore more prone to being unsettled when market conditions deteriorate. As such, loan rates in these countries can become quite insensitive to changes in the shortterm rate, reducing the effectiveness of monetary policy. Because of the limited flow-through from short rates to long rates, a number of central banks have recently taken direct measures to reduce longer-term rates. One way they have done this is by giving commitments to keep short-term rates low for a long time. Central banks in the US, UK, Canada, New Zealand and Sweden have done this. By signalling such a commitment, forward interest rate expectations are lowered, resulting in lower longer-term yields. The success of this measure in lowering term rates will naturally depend on how credible the commitments are. A second set of measures involves the central bank buying a large amount of long-term assets. Such measures work mainly through a portfolio balance effect, increasing demand for these securities above what it would otherwise have been, thereby lowering their yields. There are, of course, also flow-on effects to other asset prices. Purchases of long-term securities can be undertaken in association with, or independently of, quantitative easing. In the former case, the central bank would buy long-term bonds and pay for them by adding to banks’ reserves. In the latter, it would buy long-term bonds but pay for them by selling some of its existing holdings of short-term securities, or by issuing its own securities, thereby leaving reserve balances unchanged. Purchases of long-term securities can also contain an element of credit easing, if the securities being purchased carry credit risk. Credit easing At their most basic, credit easing measures might involve simply expanding the range of collateral that central banks will accept in their repo operations. Most central banks in the world have done this over the past couple of years and so can be thought of as having engaged in some limited form of credit easing. But the term is normally understood to apply to more forceful measures, such as: • providing long-term central bank funding to vehicles set up to acquire private securities or loans; • outright purchases by central banks of securities carrying credit risk; and • guaranteeing some part of the assets held by commercial banks. These measures involve decisions about the allocation of credit between specific institutions and sectors of the economy. This is usually a funtion of fiscal policy, whereas monetary policy is normally general in its application. The measures therefore start to blur the distinction between monetary and fiscal policy. The effectiveness of various measures As with normal monetary policy, the impact of these various unconventional measures is likely to take quite some time to become apparent. This is particularly the case for measures involving bank reserves. Given the relatively limited time that most of these measures have been in place, it is therefore premature at this stage to draw any firm conclusions about their effectiveness. Also, as most of these measures were undertaken relatively simultaneously, only their combined effects can be judged. So far, their main impact seems to have been on market pricing, which is starting to return to more normal levels. One guide to the effectiveness of these measures may come from past episodes, such as that in Japan in the early part of this decade. Of course, circumstances differ greatly from country to country so there are limits on the extent to which one country’s past experiences are relevant to others. The Japanese episode was very prolonged. The economy started to stagnate following the collapse of property prices and the stock market in the late 1980s. The interaction of macroeconomic weakness and instability in the banking system exacerbated the downturn. Through the 1990s the Bank of Japan responded to this by lowering interest rates but, by 1999, the policy rate had been reduced to zero. In 2001, the Bank of Japan switched from targeting an interest rate to an explicit target for banks’ reserve balances. The target was initially set at ¥5 trillion and then subsequently raised several times to peak at ¥35 trillion (Graph 4). Relative to GDP, this increase in reserves was not dissimilar to increases recently experienced by other major central banks. Graph 4 During the quantitative easing period, base money expanded rapidly due to the increase in banks’ deposits with the Bank of Japan (Graph 5). While one can never know what the counterfactual would have been in the absence of this policy, the evidence available indicates that the expansion in the money base did little to boost broader money aggregates or bank lending. Instead, banks appear to have hoarded the additional liquidity. Bank lending had been contracting since the late 1990s and continued to do so through to 2006. Research conducted by the Bank of Japan concluded that the ability of quantitative easing to impact on aggregate demand and prices was limited. 2 Ugai, H (2006), “Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses”, Bank of Japan Working Paper Series, No. 06-E-10, July. Graph 5 The Bank of Japan’s experience also provides some evidence in relation to yield curve measures. Its quantitative easing was implemented by buying long-term government bonds and it also gave a commitment to maintain official interest rates at zero for a long time. In effect, therefore, the quantitative easing undertaken by the Bank of Japan was combined with measures to flatten the yield curve. The evidence suggests that these measures were effective in lowering the yield curve in Japan, particularly the medium-term point of the curve. Conclusions Let me conclude. With central banks doing unconventional things, it is not surprising that there is considerable debate about the effectiveness and consequences of the various measures. On the one hand, some argue that the measures will be ineffective. On the other side of the debate, others argue that they will eventually result in higher inflation. Those of the former view point to the experience of Japan over the past decade as supporting their case. The conclusion they draw from that experience is that, if the household and corporate sectors are seeking to consolidate their balance sheets, and banks remain risk averse and capital constrained, simply adding to banks’ reserves at the central bank may not result in any generalised expansion of money and credit. The other side of the debate – that the measures will result in higher inflation – implicitly assumes that the measures will be effective in stimulating the economy, since money does not miraculously transform into inflation without affecting economic and financial activity. Rather, their argument is that central banks will be too slow to reverse the various measures. As there are no technical factors that would prevent or slow the reversal of recent measures – they can be reversed simultaneously or in any sequence – the argument must rest on central banks making incorrect policy judgments. This is always a possibility. But, the high state of awareness that currently exists about the risk of being too slow to reverse recent exceptional measures should limit the probability of such a mistake being made. | reserve bank of australia | 2,009 | 6 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to James Cook University's Business Excellence Series in the Tropics (BEST) Luncheon, Townsville, 4 June 2009. | Glenn Stevens: Economic update Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to James Cook University’s Business Excellence Series in the Tropics (BEST) Luncheon, Townsville, 4 June 2009. * * * Thank you to James Cook University for organising this occasion and for the invitation to take part. Townsville and the surrounding region boast a significant set of industries. Townsville provides a port and refining capacity for important parts of the mining sector. It is an export point for the live cattle industry, sugar and a range of other rural industries. For the tourist industry, it is an access point to the Great Barrier Reef and home to research into the marine environment. It is the base for an important part of Australia’s defence capability. Of course, the University is also a strong centre for higher education. A number of the University’s graduates in economics have become prominent in the world of finance and business. So it is a pleasure to be here, to talk about how economic conditions are unfolding, including in countries and industries in which this region has more than a passing interest. About a month ago, the Reserve Bank released its May Statement on Monetary Policy. I want to give an update on that material, though developments have not caused us greatly to change our views. I will start with the international economy. The current global recession is being widely referred to as the most significant of the postWar period. There is, by now, little debate about that description. It is not necessarily the case, however, that it will be the biggest recession for all individual economies. It will be for many, but quite a few have seen larger recessions at some point in the previous six decades than they appear to be experiencing now. For some countries in Asia and Latin America, other episodes, with other causes, were more damaging than what has been observed, at least so far, this time. I do not think it will be the biggest recession of the post-War period in Australia either, though of course we will not know for sure for a while yet. Rather, it is the exceptional synchronicity of the international downturn that has been so remarkable. It is well known, of course, that the financial crisis had its genesis in lax lending in some of the major economies, and cheap credit generally, earlier in this decade. This has been well covered before, so I will not go over it today. Rather, I would like to focus on the sharp deterioration in global demand for goods and services that occurred late in 2008 and early this year. There are some important features of this event that help us to understand both our own experiences in Australia and those of other countries. Historians will study this episode for years to come. They may find additional nuances, but one very clear trigger for the sharp collapse in demand was the heightening of stress in financial markets. A sequence of extraordinary events occurred in September and October last year. These included: • the US Government taking over the two largest housing finance entities; • the bankruptcy of one of the four remaining large US investment banks, which people had presumed was “too big to fail”; • the US Government taking over one of the world’s largest insurance companies; and • in short order, pressure on systemically important institutions across the United States and Europe. Combined, this previously almost-unthinkable sequence resulted in a sharp increase in perceived systemic risk in financial markets and systems everywhere. Stock prices fell sharply around the world. Risk spreads on all sorts of debt instruments blew out, and capital markets for issuing (or rolling over) debt and equity essentially closed. It was the most turbulent period in international finance any current banker, economist, market trader or policy-maker has lived through or, we hope, ever will. Unlike most previous financial crises, moreover, the news about this set of events reached people all over the world very quickly. They did not learn about it the way they once might have: sequentially, with varying lags, via delayed print media, word of mouth, high-brow publications and so on. Instead, they learned about it simultaneously, via the 24-hour news cycle, in every country, more or less in real time. Not surprisingly, people everywhere suddenly became much more fearful of the future. In the face of this acute uncertainty, firms and households across the world did what you would expect. They acted in a precautionary way. They postponed discretionary purchases, shelved expansion plans and did what they could to consolidate their balance sheets. The result was a highly synchronised slump in demand especially for consumer durables and investment goods. Production and consumption of more “everyday” non-durable goods and services did fall, but by much less than for those products that could easily be purchased tomorrow rather than today (Graph 1). Graph 1 The nature of this slump helps us to understand both the relative performance of various national economies and the subsequent behaviour of production generally. It has become much clearer over the past month or two, for example, that the countries hardest hit have been those that are most involved in the production and export of these high-value goods (Graph 2). Among the major economies, Japan and Germany have seen the biggest falls in output. Among emerging market countries, some of the biggest contractions were among the Asian nations that are an integral part of the production chain for consumer durables. Graph 2 If the fall in global demand in late 2008 was rapid, the cut in production was even more aggressive as firms sought to reduce inventories. In many countries, these had tended to rise a little going into the crisis. As demand fell away, firms were faced with further increases in stocks of unsold items, at a time when the cost of funding them was moving up. Hence, they sought to get inventories down quickly as part of their strategy of surviving the downturn. To achieve a reduction in inventories, firms must cut production by more than demand, so that the level of production falls below the level of demand for a time. This is indeed what seems to have occurred in many cases. Once inventories are back under control, production will rise, back up to the level of demand. This is what we seem to be seeing now in some countries, particularly around Asia. Industrial production has risen quite sharply over the past few months, and in some cases has retraced a good deal of the earlier fall. The clearest signs of growth are in China, where our estimates are that industrial production had recovered all the losses by March. China does not publish quarterly GDP growth rates, but our best estimates are that the March quarter growth rate picked up relative to the weak outcome in the December quarter. The improvement in conditions in other emerging economies in Asia may be partly related to the pick-up in China. Quite a marked bounce in industrial output has occurred in Korea and Taiwan, and a similar pattern looks to be emerging in several other countries in the region. Even Japan’s production now seems to be rising, though from extremely weak levels. Across the leading industrial economies, the best we can say at present is that while the contraction in overall output in the March quarter was broadly similar to that in the December quarter, recent data suggest that the rate of contraction in the June quarter will be significantly smaller. Now while the initial pick-up in output is coming from this inventory cycle running its course, that only lifts production to the level of demand, which remains lower than it was before. An ongoing rise in output will depend on demand starting to increase. Again, the clearest indication of stronger demand is in some of the emerging economies, particularly China. The improvement in China’s growth does not seem to be coming from Chinese exports to the developed world, but from stronger demand at home. The reversal of earlier restrictive policies designed to slow the Chinese economy because of inflation concerns, together with a government spending package that by any standards has been very large, have both contributed. To date, the recovery has been led by increased spending on infrastructure. What is not yet clear is the extent to which Chinese private-sector demand is accelerating. A pick-up in China is relatively beneficial to Australia, as I will discuss in a moment. For the world economy, it will also be beneficial if the emerging world relies more on domestic demand for growth than it has in the past decade. A durable expansion will be one that is more balanced than the last one. That said, prospects for demand in the developed world obviously remain very important because of the still very large size of those economies. Most observers expect that demand in the United States and Europe (including the United Kingdom) will be quite subdued for a few years. One might, of course, ask whether the striking speed and simultaneity of the downturn could be seen again in the upswing. The reason people think such an outcome is unlikely is that the loss of wealth during 2008 and the need for private-sector balance sheets to be deleveraged are thought likely to constrain both household demand and the ability of the banking sector to expand credit, for some time. This is a reasonable reading of the history of most financial crises, and underpins the consensus forecast that global growth, when it resumes, will be pretty modest initially. Yet the speed and size of the responses to the downturn by policy-makers around the world is just as unprecedented as the speed and size of the downturn itself. If there were an upside surprise on global growth, it would most likely be because the collective effects of all those policy responses turned out to be bigger than expected, perhaps because those expectations were formed by looking at a history where such simultaneous responses rarely occurred. Having said that, the size of the build-up in government debt in some of the major economies will surely become much more of a constraint on their fiscal room for manoeuvre over the next decade. Let me be clear that I am not talking about Australia here; rather, I have in mind countries where public debt could approach 100 per cent of annual GDP over the next few years. It is not that these magnitudes are completely unmanageable, but they will constrain choices to an extent these countries have not been accustomed to for a long time. For example, their capacity to cushion the impact of another downturn, were one to occur in six or seven years’ time, would be limited. The developments in the world economy over the past year have had a significant effect on our economy. One key channel has been the impact on commodity markets, where prices fell sharply in the second half of last year. It has been apparent for some time from developments in markets for coal and iron ore that there would be large downward adjustments to the contract prices for those commodities when they were renegotiated this year. Those falls have now largely been realised, broadly in line with what was expected. Compared with last year, there will be a lot less revenue coming in. But it is important to remember that commodity prices remain high by historical standards. Even with falls of 45-60 per cent for coal and around 35 per cent for iron ore, the 2009/10 prices are the second highest on record in US dollar terms. Five or six years ago, these sorts of prices would have seemed extraordinary. As the outlook for resources demand becomes clearer, and the uncertainty in financial markets continues to lift, it would not be surprising if plans for new mining projects that are being deferred at present were re-activated at some point, though this, even if it occurred, would presumably take some time to flow through into actual spending. The volume of Australian exports, moreover, has so far held up remarkably well, especially compared with those of some other countries (Table 1). Even people who were relatively optimistic, as I was, have been a bit surprised by this strength. Part of the relative strength may reflect supply-side factors: a larger wheat crop in 2008 and the commencement of operation of an additional LNG compression train have both added to supply. There are, however, some particularly interesting developments in the pattern of demand for coal and iron ore. A large proportion of Australian iron ore goes to China and very little goes to Europe. Chinese demand has actually increased as infrastructure spending has picked up, whereas in Europe demand has fallen sharply. In the coal market, Australia’s exports have traditionally gone to Japan, Korea and Taiwan, where demand has softened. But increased demand in China (which traditionally imported very little coal) has partly offset the falls elsewhere. Indeed, in the past year, China’s share of Australia’s merchandise exports has risen sharply, and is approaching that of Japan (Graph 3). Part of the increased demand from China can be explained by the construction-intensive activity taking place there, and part by reduced Chinese production of iron ore and coal, as the fall in prices has seen some of the high-cost mines in China being closed. For both iron ore and coal, Australian companies are among the lowest-cost producers and so gain when higher-cost firms exit the scene. Factors such as this have kept Australian exports doing relatively well so far, and would seem to offer significant long-term opportunities, including for this region. Graph 3 The Australian economy has, nonetheless, been affected by the global recession, with real GDP, on the latest estimates, posting a small net decline over the past couple of quarters. The major driver of the slowdown has been weaker private domestic demand, most prominently a sharp decline in business investment spending, with a fall off in housing construction. The fall in investment is best seen as the same understandable precautionary behaviour by Australian businesses as displayed by their counterparts around the world. A decline in business investment spending of about 8 to 10 per cent in the December quarter seems to have been a pretty standard result around the world. Macroeconomic policies have not been able to prevent an economic downturn. They rarely can, especially in the face of a global recession of this magnitude. Indeed, attempts to do so have as often as not run into trouble by stoking up bigger problems a few years down the track. But it is reasonable to think that policies can have the effect of making the downturn shallower than would otherwise have been the case, and that they can help to establish conditions conducive to recovery. The scope to implement such policy changes has to be earned during the expansion phase of the cycle. But Australia did earn that scope, and has been prepared to use it during the last six months. What has the Reserve Bank been doing? The Bank made a number of changes to its operations in financial markets to help keep them functioning through the worst of the crisis. Measures the Government took in this sphere were also important for confidence and access to funding. The Board also moved quickly to ease monetary policy after the events of mid September, with interest rates being reduced significantly. At 3 per cent, the overnight rate is at the lowest level seen since the early 1960s. This has fed through into significant declines in the rates paid by borrowers, especially, but not only, households. The debt servicing costs of households have fallen faster and further than in previous cyclical episodes. The Board has not felt the need to cut our policy rate to the very low levels – effectively zero – seen in some other countries. There are two reasons. The first is that the situation we face is not as dire. The second is that the reduction in interest rates we have implemented has had a more direct effect on borrowers than in many other countries. The combined impact of the easing of fiscal and monetary policy is likely to be substantial. Quantification of the effects is very much a matter of informed judgement. The fact that Australia is experiencing, so far, a smaller downturn than most countries reflects in part the relatively smaller extent of the sort of financial excesses that have been the problem in some other countries, as well as the good fortune of our position in relation to China. But significant macroeconomic policy responses will have also played a role. Fiscal initiatives were not only sizeable by global standards, but implemented quickly. The impact of monetary policy easing in terms of reducing debt servicing burdens for borrowers has been greater than in the major northern hemisphere countries. The relevant question now is: what are the prospects for a durable expansion? It is likely that activity has remained subdued in the June quarter. The rapid decline in business investment is almost certainly continuing. While consumer spending has held up quite well so far, it may be weaker over the next few months, as the one-off government payments pass and rising unemployment starts to weigh on incomes and willingness to spend. On the other hand, we are likely to see significant growth in public spending over the year ahead, reflecting fiscal policy decisions. Moreover, while it will be a while yet before the effects of lower interest rates and the boost to grants to first-home buyers are seen in data on construction work done, the pick-up in borrowing for housing that we have been seeing for about six months is what would be expected if an upturn in residential investment spending is to begin later in the year. Overall, then, our expectation remains that the economy will be well placed for expansion towards the end of this year. Initially it will be fairly gradual, in part because of the global factors to which I referred earlier. If so, the degree of spare capacity in the economy will tend to be increasing for a while, and inflation will most likely continue to decline for some time. That in turn means, as the statement following this week’s Board meeting indicated, that some scope remains to ease monetary policy further, if that were to be helpful to securing a durable upswing. The emphasis on “durable” is important. It is the intention of current monetary policy settings to lower debt-servicing costs, assist efforts to reduce leverage and support demand. It would be counterproductive, though, if further reductions in interest rates induced a large number of marginal borrowers into debts they could service only at unusually low interest rates. This is a reason for care, both by the Reserve Bank and private lenders, and I note that lenders are being a bit more conservative on non-price loan conditions for households. Picking cyclical turning points is notoriously hard – even in hindsight, let alone ahead of time. But I think Australia is as well positioned as any country, and better than most, to enjoy a new expansion. Longer term, there also is plenty to be positive about. There are good grounds to think that we can emerge from the current global recession with our economy largely free of the problems in the financial sector, the stresses on public finances and the general disillusionment facing a number of other economies. Keeping to prudent policy frameworks and settings, maintaining flexibility, focusing on productivity and pursuing the opportunities arising from the growing engagement with the Asian region will all be part of a prosperous future. This part of Australia is as well placed as any to play its part in that future. | reserve bank of australia | 2,009 | 6 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to The Anika Foundation Luncheon, supported by Australian Business Economists and Macquarie Bank, Sydney, 28 July 2009. | Glenn Stevens: Challenges for economic policy Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to The Anika Foundation Luncheon, supported by Australian Business Economists and Macquarie Bank, Sydney, 28 July 2009. I thank Kathryn Ford for assistance in preparing this address. The original speech, which contains various links to the documents mentioned, can be found on the Reserve Bank of Australia’s website. * * * Thank you all for coming today, and thank you to Macquarie Bank for their financial support, and the Australian Business Economists for their logistical support for today’s function. Those of you who were here at last year’s Anika Foundation lunch may have noticed that I have selected the same title today.1 The challenges have changed in nature, but there are no fewer of them. The first part of my remarks will be about the general set of issues confronting policymakers in key economies. They are not about Australia, unless specifically noted. I will devote time to Australia-specific issues in the second part. Global challenges A year ago, the international financial crisis was unfolding, but had not, at that point, spun out of control. The global economy had reached the peak of a long, strong upswing, which had stretched capacity and seen a wide range of raw materials and energy prices reach very high levels. Strange as it may now seem in light of subsequent events, a wave of concern about inflation swept financial markets in the middle of last year. Many countries were grappling with the lift in oil prices, which were reaching their peak last July. That was starting to reduce growth but also push up the general level of consumer prices in the advanced countries. In many emerging economies, strong growth had pushed up inflation significantly, even apart from food and energy prices. Australia was experiencing high inflation too, a result of the expansionary impact of a oncein-fifty-years terms-of-trade rise in an economy already close to full employment. We were also being affected by the dampening forces of the financial events, though by less than countries whose banks were closely involved in the problem lending areas. Since then, inflation rates have trended down in most countries. One thing that helped this was that the rapid final lift in oil prices during the first half of 2008 was reversed by the end of the year. Much of the cumulative increase that had occurred over the preceding five years, however, remains in place. Broadly parallel trends can be seen in other resource prices. All of that suggests a significant structural rise in demand for energy and resources has occurred, as a result of the cumulative growth of the emerging world. This seems more likely to be a feature of the international economy for some time than to go away. If so, it has to be accommodated by the advanced industrial countries that, hitherto, have had access to those resources on favourable terms. Such an accommodation can be made, over time, via responses to higher prices in terms of efficiency gains, structural change in economies and so on. But it is as well to recognise that an adjustment has to be made. This could well remain something of a medium-term challenge for economic policies in the relevant countries. The Anika Foundation was established in 2005 to raise funds for the purposes of supporting research into adolescent depression and suicide. For details, see http://www.anikafoundation.com. At a cyclical frequency, the global economic downturn has taken the pressure off prices for goods and services for the time being. Most likely, inflation rates in the developed world will continue to be low for a while. Some observers worry about deflation. For the past nine months or so, the key imperative has been to stabilise financial systems, and to support demand during a process of de-leveraging, so as to halt an incipient downward spiral of falling asset prices, contracting credit, slumping spending, further deflationary pressure on prices, and so on. Probably in some of the most important countries, this support will need to remain in place for a while yet. Once demand is on a self-sustaining path of expansion, the support can be removed. At a longer frequency, on the other hand, the aggressive, and in places unconventional, policy responses to the contraction in demand are seen by some observers as increasing the risk of inflation. The essential reasons for such concerns boil down to some fairly basic fiscal and monetary notions. Fiscal deficits are very large in some countries now, and look like remaining so for some years. Public debt is rising quickly in many countries. For the G7 countries, gross public debt will probably exceed 100 per cent of GDP within the next year. Some major central banks have expanded their balance sheets dramatically, purchasing government debt and/or private securities in order to give additional impetus to efforts to support financial systems and aggregate demand. It is not that the fiscal burdens are unprecedented: there are periods in history in which deficits and debts were this large, or even much larger. They were mostly, however, war-time precedents, and wars have tended to be inflationary for the combatants. Likewise, largescale expansions of central bank balance sheets have usually been seen as a fairly sure way of debasing the value of a currency. So at present, we have the unusual situation where some, who look at the prospective deficits and debt burdens, combined with ‘unconventional’ monetary policy measures, worry about high inflation down the road, even as others worry about the possibility of deflation over a shorter time horizon, as a result of large-scale overcapacity. Logically, subject to one or two important assumptions, there must exist a path that avoids both these unpalatable alternatives – deflation and inflation. Finding that path is the challenge for policymakers around the world over the next several years. Faced with a large downturn like this, it was the right thing to do to allow budgets to go into deficit. Over time, though, there will obviously need to be fiscal consolidation. This will be easiest where the fiscal measures taken were temporary: it would be a matter mainly of not repeating the measures. Where more permanent measures were enacted, it will be more of a hard grind to get onto the path of sustainability. In some countries, moreover, the legacy of the excesses of the earlier part of this decade, and of the steps needed to cope with their subsequent unwinding, is likely to be quite persistent. Some major country governments have assumed, one way or another, a significant part of the obligations associated with earlier poor decisions by lenders and investors. Moreover, the level of potential output in some economies may have taken a step down, which will make the path back to fiscal sustainability more difficult to reach. In the countries concerned, there was no alternative to these actions; inaction would have been more costly. Nonetheless, all of this suggests that, in those countries, constraints on economic policy are likely to last for some time. The higher debt burdens will limit the extent to which worthwhile structural spending levels can be maintained for other things – like in health, education, urban infrastructure and so on. Moreover, the capacity to respond with fiscal policy to another economic downturn, should there be one, would be much more limited. Over time, these constraints will tend to become more apparent. Of course they might be disguised for a while under conditions of higher inflation. Indeed, the potential attraction of the ‘inflation tax’ as a fiscal device is precisely why some worry about inflation, given the size of budget deficits in some countries. The main safeguard that stands between debt holders and that outcome is the agreed framework for monetary policy, which is, with some differences in detail, in place pretty much everywhere. Its key components are a strong focus on medium-term price stability and sufficient operational independence for central banks to pursue that goal. This framework will require central banks to remove the exceptional accommodation being supplied at present, in due course. Getting the timing of that right will not be easy. In the major countries, the calibration of even conventional policies has probably been dislodged by the sequence of events, not to mention the almost total lack of comparable history against which to calibrate the unconventional measures. But while achieving a successful ‘exit’ will be quite a challenge, the chances will be maximised under the sorts of policy frameworks currently in place in most countries. For a key assumption behind the notion that the ideal path between deflation and inflation can even be found is that inflation expectations remain anchored. Were they to start to drift upwards, policymakers could be presented with an unenviable situation of gathering inflation and ongoing weakness in real economic activity. Their choices would be very bleak indeed in that world. So, expectations remain key. It would, therefore, be a mistake to weaken commitments to clearly understood goals for inflation, of either the explicit or implicit type. Assuming the present set of monetary frameworks remains in place, then, the real constraints will have to be faced squarely. This only reinforces the importance of maximising productivity growth. The households of the Western world are currently feeling that they can no longer consume as they did, in part because the earlier spending is now seen to have been based on an unrealistic set of assumptions about long-run income and wealth. To that extent, there is no real way around a period of adjustment involving lower consumption for a while. But the adjustment could nonetheless be eased if a better foundation for optimism about future income could reasonably be established. Productivity is the key to that. In fact it is the only real basis for it. Of course, finding more productivity is easier said than done. But one key element will be to maintain open and competitive markets for goods and services, since they are most likely to spur the innovation that raises productivity. It is a bit disturbing, in this context, that the World Trade Organization reports a pick-up in trade-restricting decisions by governments in recent times. The challenge for governments is to resist these tendencies. That, of course, is not a new challenge, but it is as important as ever. Part of the way ahead will, at some point, involve winding back the extensive government guarantees (and in some cases extensive public ownership) of financial institutions around the world. These measures were necessary last October in the extreme uncertainty of the time, and played a critical role in stabilising confidence in the core of the financial system, and re-opening key capital markets. But they are undesirable as a permanent feature of the landscape. Countries that issued very generous or even unlimited guarantees of deposits will want to make sure such steps truly were emergency measures, by scaling them back to a more sustainable set of deposit insurance arrangements. Likewise, it would be desirable that guarantees for wholesale raisings in capital markets lapse into disuse as conditions improve. To date, in excess of US$800 billion of government-guaranteed debt has been issued in public markets by banks around the world. An unknown additional sum has been placed into private hands directly. Taking account of the additional debt governments are issuing for regular fiscal purposes, plus the funding for bank rescue packages, the shape of global capital markets is changing significantly. Government and government-guaranteed debt of one form or another is rapidly increasing globally. This has been accommodated so far because it has, by and large, matched investors’ shifting risk preferences. Certainly people will worry, longer term, about increases in long-term interest rates potentially ‘crowding out’ private borrowers. To date, though, long-term rates remain historically pretty low for public borrowers, despite the prospect of very large debt issuance. They have increased somewhat, but this is best understood as an unwinding of the extreme risk aversion of 2008 and early 2009. But the longer-term question is whether, even without adverse effects on borrowing costs, we would really want to keep moving in the direction of a world where the bulk of debt is government-issued or government-guaranteed. It seems to me that that could easily be a world in which investors end up being no more discerning about risk and return than the buyers of CDOs a few years ago, and in which banks themselves ultimately rely on the guarantees to an inappropriate or even dangerous extent. More generally, while some countries do need significant regulatory reforms in the financial sector, do we want to throw away the genuine advances of risk management and globalisation of the past generation? Surely the better world for the decades ahead is one where a global financial system, having been stabilised at a time of crisis by public intervention (at major cost to shareholders and incumbent managers as well as taxpayers), plays its proper role of capital allocation and risk management. To be sure, it failed to perform as promised in the recent past. But it would be preferable, in my judgement, to work at making the system more effective in doing that job, than to retreat into the financial repression of an earlier state of the world. Finding a way to combine efficiency and stability in the way we need is a major challenge. The regulatory arbitrages and skewed incentives of the past need to be corrected. The likely pro-cyclicality of the regulatory standards needs moderation. Work is well under way on those fronts. Most importantly, the global policymaking community will have to grapple more effectively with the problem of entities that are ‘too big to fail’, but potentially ‘too big to save’, especially where their activities cross national borders. This is probably the most taxing financial regulatory problem of our time. For their part, banks will need to reduce their reliance on the extended guarantees and stand on their own feet before too much longer. The banks of the United States and Europe are starting down this path on their wholesale issuance, having recognised that it is in their own interests to do so. It would make sense for Australian banks, which have accounted for 10 per cent of global issuance of government-guaranteed bank debt over the past nine months, to step up their efforts to do likewise. Australian challenges Since I have now mentioned the Australian situation, I will go on to talk about challenges for economic policies at home. The flexibility to use macroeconomic policies, and other measures such as guarantees for deposit-taking institutions, has been used to support demand and maintain confidence, through the period of maximum global economic contraction. To date, because of those actions, earlier sensible management (public and private) and a degree of good fortune, the Australian economy and our financial system have been travelling rather better than those of most of our peers through the crisis and the initial economic aftermath. Six months ago, my own view was that the biggest risk to the Australian economy was an unwarranted loss of confidence in our medium-term prospects. Late last year, survey after survey pointed to a major battening down of the hatches by businesses across the country. This was quite understandable, and in some respects eminently logical at the level of the individual enterprise. But the risk was that these actions, in bringing on the very weakness that everyone feared, could set off a cycle of further weakening in demand and output. Now, however, it looks like confidence has recovered some ground. Economic conditions remain very difficult in some sectors. But surveys now suggest that many businesses have found that the worst has not occurred, and are perhaps thinking about their medium-term strategies for the next expansion. They are tending to try to hang on to employees who were recruited and trained at some expense and who will be needed in the future under conditions of stronger demand. Many listed companies are taking the opportunity to raise new equity, strengthening balance sheets. The fact that they can tap the markets for those funds, by the way, says something about the underlying resilience of the system. Consumer confidence has also recovered a lot of ground. In fact in recent readings it has been at or above long-term averages. This should not be entirely surprising. Households have seen significant gains from the various fiscal packages as well as declining petrol prices. For indebted households, there has been a very large reduction in debt servicing costs as a result of easier monetary policy. Against that, unemployment has been rising, and a great deal of prominence has been given in public discussion to forecasts that it will rise further, with associated predictions that this will weaken confidence and demand and so on. To date, however, the rise in unemployment has been a little slower than earlier feared, and the effect of the more positive factors for households has, so far, outweighed fears of unemployment. In addition, the decline in interest rates, together with the additional grants for first-home buyers, has seen a significant pick-up in demand for housing finance. The value of loan approvals has risen by about a third since the low point in the middle of 2008. In contrast to developments in so many other countries, house prices are tending, if anything, to rise, and arrears rates on the bulk of mortgages remain very low by historical and international standards. In fact, across some portfolios arrears rates have declined in recent months. We cannot claim that Australia has avoided any downturn at all. It appears at this stage, however, that the downturn we are having may turn out not to be one of the more serious ones of the post-War era, in contrast to the experiences of so many other countries. It is becoming more common for Australians to see the glass as half full than as half empty. Put another way, we can much more easily imagine upside risks to the outlook, to balance out the downside ones, than was the case six months ago. So far, so good. But what challenges lie ahead? And how should we respond to them? Just as it would have been a mistake nine months ago to write-off our long-term economic prospects at the height of the financial turmoil, it would be a mistake now to lapse into the comfortable assumption that easy prosperity will come our way. The pace of global growth, and the easy availability of credit, seen in the period up to 2007 was not the norm. It is unlikely to be seen again any time soon. The path to economic health for the major countries of the world will still be a difficult one, because the legacy of the crisis will cast a shadow for some time. Major international banks will remain diminished in stature and balance sheet capability, and will be required to devote more capital to their strategies in the future. If global regulators have their way, the world will be characterised by less leverage, and scarcer and more expensive credit, than in the earlier period. We here in Australia have to accept that fact and accommodate it in our thinking. One thing this presumably means is that the prominence of household demand in driving the expansion from the mid 1990s to the mid 2000s should not be expected to recur in the next upswing. The rise in household leverage, the much lower rate of saving out of current income, and the rise in asset values we saw since the mid 1990s, are far more likely to have been features of a one-time adjustment, albeit a fairly drawn-out one, than of a permanent trend. Moreover the risks associated with those trends going too far are apparent from events in other countries. These risks have been reasonably contained so far in Australia – but it would be prudent not to push our luck here. A very real challenge in the near term is the following: how to ensure that the ready availability and low cost of housing finance is translated into more dwellings, not just higher prices. Given the circumstances – the economy moving to a position of less than full employment, with labour shortages lessening and reduced pressure on prices for raw material inputs – this ought to be the time when we can add to the dwelling stock without a major run-up in prices. If we fail to do that – if all we end up with is higher prices and not many more dwellings – then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track. Over the medium term, the emergence of China (and other countries such as India) will continue, and will offer opportunities for Australia. Plenty of observers, the RBA among them, have been saying this for years. But China’s emergence also presents challenges. If commodity prices do stay at their current relatively high levels on the back of strong emerging world demand, the mineral extraction sector and all those parts of the Australian economy that service it and feel its flow-on effects, will expand. Other sectors will, relatively, contract over time. That is to say, the structural adjustment issues that faced us a year and a half ago, and which have received less attention since then, would resume. These sorts of adjustment in the economy have industrial, geographical and social dimensions. Moreover, if we are more integrated into China’s expansion, we will be similarly more exposed to the consequences of whatever might go wrong in that country. So our understanding of how the Chinese economy works, and of what risks may be accumulating there, will need continual work. To conclude, challenges abound for policymakers, for private firms and for individuals. The fact that we have managed to get through the past nine months in reasonable shape ought to give us some quiet confidence in our capacity to meet the current set of ‘crisis’-related issues. But many years of careful work is the price of being able to ride out crises and benefit from the ensuing period of growth. We will need to re-invest in all that over the years ahead. Thank you once again for coming today, and for your support of the Anika Foundation. | reserve bank of australia | 2,009 | 7 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 14 August 2009. | Glenn Stevens: Recent economic and financial developments in Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 14 August 2009. * * * Mr Chairman, Thank you for the opportunity to meet once again with the House Economics Committee. When we last met with you in February, international financial markets were stabilising after the extreme turmoil of September and October 2008. But the fallout of the financial events for demand, production and trade flows in the global economy was only then starting to become apparent in hard data. Household and business confidence around the world had been severely damaged. Households had sharply pulled back their discretionary spending, were tending to try to save more and were looking to pay down debts. Businesses had responded very quickly to a fall in demand by cutting production and costs, as well as shelving their plans for expansion. It was already fairly clear by February that the resulting contraction in economic activity in the December quarter was severe in many countries, and that global growth had suffered its biggest setback in decades. Global trade was falling rapidly. Central banks had eased monetary policy aggressively, including taking short-term interest rates to near zero in several cases, and some were considering or implementing “unconventional” measures to deliver additional stimulus. Governments were putting in place fiscal stimulus packages. But these measures would take time to have their effect. In the short term, we worried that the March quarter outcomes for the global economy would be just as bad as occurred in the December quarter. For some months, the news from abroad indeed continued to be very poor and global demand contracted further in the March quarter. Given the speed of the global deterioration, we believed that it would not be possible to avoid a period of weakness in the Australian economy. We thought that Australia had several advantages – a sound financial system, an absence of the worst of the problems afflicting some other countries, exposure to an emerging China, and scope to use macroeconomic policies to cushion the downturn. The exchange rate had declined, which would also assist in adapting to weak global conditions and lower commodity prices. So we could reasonably have expected to have a smaller downturn than others. But it is very rare for Australia to escape an international downturn altogether, and it seemed quite unlikely that we could avoid one of this size completely, despite the advantages we had. For confidence here too had suffered a serious setback. This was clear in equity prices, in numerous surveys of sentiment and in the feedback we were receiving directly from firms. Australia was being affected through our trade, financial and business linkages with the rest of the world. Australia was doing better than most countries, as had been anticipated. But for a few months it was not clear how much comfort we should take from that, because the economic news from abroad seemed to be so dire. As one metric, the IMF’s forecasts for global output in 2009 as at last February were for growth of ½ per cent. That was already a marked reduction from a few months earlier. Subsequently they were cut further, and when released in late April showed an expected contraction of over 1 per cent, which would be the weakest outcome for at least six decades. Forecasts for Australia were inevitably marked down as well. The time of our May Statement on Monetary Policy was when the outlook for the local economy seemed weakest. In this environment, the possibility that we would need to ease monetary policy further was obviously canvassed. Financial markets expected as much, at one point pricing in a decline in the cash rate to less than 2 per cent. Yet the Board had already aggressively eased monetary policy, delivering the largest reduction in debt servicing costs to households in modern times. Interest rates were low, or in some cases very low, by historical standards. Substantial fiscal stimulus was also in train. These could be expected to provide significant support for demand. So even as activity abroad continued to contract, the Board had to be mindful of how much action had already been taken in anticipation of serious economic weakness. Those measures would take time to have their full effect. But that lag could not be shortened by increasing the dosage. Accordingly, while keeping open the option of further easing, the Board kept a fairly steady setting through this period. There was one further small decline in the cash rate in April. Apart from that, official interest rates have been unchanged since we last met, in contrast to the very sharp falls from September through to February. Where then do we stand at present? Things abroad hardly look rosy, but they look distinctly better than they did a few months ago. Conditions in international financial markets have continued to improve. There have been occasional reversals, but each time the improving trend has resumed. Extreme risk aversion has abated; spreads have narrowed; capital markets have continued to thaw, though in some overseas cases this has relied heavily on central bank financing activities. Financial institutions in the United States and Europe have recorded better earnings. Global equity markets have risen to be nearly 50 per cent above the lows in early March this year. There has been substantial new issuance of debt and equity. Spot commodity prices have picked up. In addition, it appears that the really large contractions in major countries’ GDP are now behind us and that global output is levelling out. International trade and global industrial production have even recorded small gains over recent months. Of course there is a long way to go and there are notable differences in economic activity across regions. While the United States and Europe only now seem to be at or near a turning point, there has already been a marked improvement in economic activity in much of east Asia and India. This reflects significant stimulus put in place by governments in Asia, the dynamics of the inventory cycle, the healthier state of their financial systems and, in all likelihood, the inherently better secular growth prospects for these sorts of economies. The improvement has been most pronounced in China, but it is not confined to China. Korea, an important trading partner for Australia, recorded a significant bounce in GDP in the June quarter. There are also some signs that the Japanese economy has begun to grow. The IMF has recently raised its outlook for world growth in 2010. These forecasts are actually still for pretty lacklustre growth overall. But it is the first time we have seen upward revisions for quite a while. The Australian economy has been resilient, with economic activity looking stronger than expected a few months ago. Both foreign and local factors have been at work. Exports have been remarkably strong. For Australia, they grew over the six months to March, whereas for most countries exports fell sharply over that period. Further growth appears to have occurred in the June quarter. This reflects the strength of Chinese resource demand, as well as some other factors. The strength in demand from China has also been associated with the continuation of attractive prices for many commodities. Australia’s terms of trade are likely to be around 20 per cent lower than their peak last year. But they are about 45 per cent higher than the average for the two decades up to 2000. Domestic demand has likewise held up pretty well, with retail sales posting a solid increase in the first half of the year. Demand for housing credit is up, as are house prices, and purchases of some investment goods by firms rose mid year. Some of this strength is likely to be temporary, the result of fiscal measures that have a finite life. We are assuming, for example, that consumer demand, and first home buyer demand for finance, will be softer in the second half of the year. Nonetheless, the retreat from the extreme risk aversion of nine months ago, the partial recovery of household net worth and the impact of low interest rates will offer support to private demand over the period ahead. Survey measures of business confidence have lifted from the very low levels seen at the beginning of the year to be close to their long run average. Capacity utilisation has stopped its sharp decline. Business credit has been falling, but this has been more than offset by increases in non intermediated sources of funding, such as equity raisings and corporate bond issuance. Overall business external funding has remained positive, at rates similar to those seen in the 2001 slowdown. For their part, financial institutions remain profitable, even though they are absorbing higher loan impairments. Business investment has been an area of expected weakness in forecasts for the Australian economy. This is still likely to be true, though recent liaison suggests that some firms may be re-thinking the size of their planned cuts to investment spending. Differences across sectors remain. The commercial property sector, for example, is part way through a difficult period of adjustment to valuation and leverage, even as parts of the mining sector are back to producing at full tilt to supply Chinese demand for resources. The labour market has seen considerably softer conditions, but there has been little decline in overall employment, and the rise in unemployment, to date, looks smaller than had been feared a few months ago. As several commentators have pointed out, there has been a significant fall in hours worked, as there usually is in downturns. This may be a more reliable gauge of the extent of labour market weakening than employment or unemployment. Compared with some earlier cycles, the reduction in hours has occurred via a reduction in working hours across more people, rather than being concentrated among a group of unemployed. At this point, the fall in hours worked looks larger than what occurred in 2001, but not as large as in 1991. In fact, that is probably a reasonable characterisation of this downturn in general. On the basis of the information to hand at present, this may well turn out to be one of the shallower recessions Australia has experienced. Inflation, meanwhile, has been easing. CPI inflation has recorded its lowest outcome in a decade, of 1½ per cent over the year to June. This compares with a peak of 5 per cent in September last year. The size of this decline overstates the real extent of the slowing in prices, just as the peak figure overstated the real extent of inflation. Measures of underlying inflation remain a good deal higher, at around 3¾ per cent over the year, but they too are gradually declining. We believe that decline has further to go, though in the medium term inflation on either a CPI or underlying basis does not look like it will fall as far as we thought a few months ago. Looking ahead, some of the recent strength in private demand might, as I noted earlier, prove to be temporary. But at the same time, the contribution of public spending to growth in demand is likely to increase over the year ahead. More generally, there has been enough genuine strength in the run of recent indicators, sufficient further improvement in financial conditions and enough recovery in sentiment such that forecasters are starting to lift their numbers for overall growth in both 2009 and 2010. As always, there are risks. The global economy could suffer another setback of some kind. The likelihood of that has declined in our view, but the possibility remains. Perhaps the growth in China’s demand will falter. Certainly the pace of China’s growth seen in the June quarter, which was extraordinary, cannot continue for long, and may be moderating now. We need to keep an eye out for potential imbalances in China. That said, though, sceptics about the growth of China thus far may have underestimated the determination of the Chinese policy makers to grow their economy over the medium term. I doubt that determination has lessened. Some of the pick up in global industrial output is clearly due to the cessation of inventory run down, and prospects for final demand will be important in determining the pace of ongoing growth. On that score, the process of balance sheet consolidation for both the private and public sectors in some major countries will probably weigh on growth in demand there for some time. (I am not talking about Australia here.) On the other hand, performances of both Australia and some of our key trading partners have exceeded expectations in the recent past; that could continue, particularly if rising confidence were to feed further demand, thus increasing income, and so on. That, after all, is the way most recoveries proceed, in cases where there is no strong headwind from financial restructuring. Moreover, just as the severity and simultaneity of the global downturn was unprecedented, so was the speed and strength of the policy response. Six months ago the possibility of concerted global policy action delivering a surprise on the upside for global growth was noted by some, but it seemed perhaps rather theoretical at that point. It is a bit easier to imagine now. The forecasts outlined in the recent Statement on Monetary Policy give our best assessment of the most likely outcomes for Australia, contingent on these and other factors. Considerable uncertainty inevitably surrounds these numbers. Nonetheless if things continue to look like they will turn out in that fashion, there will come a time when the exceptional monetary stimulus in place at present will no longer be needed. It will then be appropriate for the Board to do what it has done on past such occasions, namely to start adjusting interest rates back towards normal levels. The timing and pace of those adjustments, if and when they come, will be a matter of careful consideration, taking into account all the relevant factors, including what might be happening with market interest rates. Mr Chairman, last time we met, I said that there were reasonable grounds to think that the Australian economy would come through this very difficult episode as well placed as any to benefit from renewed expansion. That remains my view. The economy appears to be weathering a very large storm pretty well, and the community’s confidence about the future has improved commensurately. No doubt the future will pose its own challenges, but we are well placed to meet them. My colleagues and I now look forward to your questions. | reserve bank of australia | 2,009 | 8 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Senate Economics References Committee, Sydney, 28 September 2009. | Glenn Stevens: Recent economic and financial developments in Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Senate Economics References Committee, Sydney, 28 September 2009. * * * Thank you Mr Chairman. I have just a few opening remarks. Economic conditions in Australia were generally quite subdued in the second half of 2008 and the first part of 2009. Output was sluggish, hours worked in the economy declined, unemployment rose and inflation started to abate. By the standards of past recessions, however, this was a mild downturn. Although the evidence is as yet incomplete, this episode has been much less serious than those in the mid 1970s, the early 1980s and the early 1990s. It also has been very mild indeed in comparison with recent outcomes in many other countries, where deep recessions have been experienced. For the G7 group of advanced countries, for example, a cumulative contraction in real GDP of nearly 5 per cent was experienced over the four quarters to June this year. The Australian economy recorded a small net expansion in GDP over the same interval. So I think it is reasonable to conclude, against the benchmarks of historical and international experience, that Australia has done quite well on this occasion. Why was that so? The key factors have been articulated before, but it may help to frame our discussion here today if I recount them. First, our financial system was in better shape to begin with, being relatively free of the serious problems the Americans, British and Europeans have encountered. Lenders have some problem loans, as always occurs during a downturn, but these are manageable. The banking system has continued to earn a positive return on its capital, unlike those in some key countries. The system has been affected by the spillovers from the global crisis, through tighter borrowing conditions in international markets, higher spreads and so on. But these too have been manageable and various policy responses have helped the system to cope. The Reserve Bank was prepared to expand its balance sheet to assist in maintaining liquidity and the government guarantees were important in shoring up confidence and maintaining access to wholesale funding. Second, some key trading partners for Australia have proven to be relatively resilient through this episode. The Chinese economy did slow sharply in the latter part of 2008, but quickly resumed very strong growth. China will easily achieve her 8 per cent growth target this year, led by domestic demand. Many of our other Asian trading partners have also returned to growth recently. Ongoing strength in demand for resources has kept Australian exports expanding. Australia’s terms of trade, even though well off their peak, remain high by historical standards. Confidence about the future for the resources sector is building quite strongly. Finally, Australia had ample scope for macroeconomic policy action to support demand as global economic conditions rapidly deteriorated, and that scope was used. The Commonwealth budget was in surplus and there was no debt, which meant expansionary fiscal policy measures could be afforded. In addition, monetary policy could be eased significantly, without taking interest rates to zero or engaging in the highly unconventional policies that have been necessary in some other countries. I have maintained throughout that Australia’s medium-term prospects remained good and that we should not lose confidence. More people seem to be taking that same view. Measures of business and household confidence have shown a very substantial pick-up from the low points reached earlier this year. Share prices have risen by almost half. House prices have risen rather than fallen, though commercial property prices have fallen. People are realising that, though things have been tough, the worst has not occurred and the future is looking brighter. Earlier plans for drastic cuts to capital spending look like they are being reconsidered. Economic growth forecasts are being revised up. A straightforward reading of the economic outcomes would suggest that the various policy measures have been effective in supporting demand. In due course, both fiscal and monetary support will need to be unwound as private demand increases. In the case of the fiscal measures, this was built into their design. The peak effect of these measures on the rate of growth of demand has probably already passed. The extent of support will tend to tail off further over the next year. In the case of monetary policy, the Bank has already signalled that interest rates can be expected, at some point, to move off their current unusually low levels, as recovery proceeds. These adjustments back towards more normal settings for both types of macroeconomic policy are what should be expected during the recovery phase of a business cycle. Our most recently released set of forecasts assumes they occur. Such an outcome would mean that fiscal and monetary policy would be acting broadly consistently, as they did when they were moved in the expansionary direction when the economy was slowing. In both cases a degree of policy discipline will be needed. Policy frameworks will be valuable in enforcing that discipline. On the fiscal side, the forward estimates provide an indication of the restraint needed to move the budget back towards balance and eventual surplus over time, as required by the Government’s medium-term fiscal commitment. On the monetary side, the inflation targeting framework the Reserve Bank has been following for a decade and a half will guide adjustments to interest rates. These will be timely and ahead of a build-up of imbalances that would occur if interest rates were kept low for too long. These frameworks will, in other words, prompt the needed adjustments. It was the preparedness to make those adjustments in the past, guided by these very frameworks, that contained the build-up of imbalances in the upswing and which in turn earned us the scope to take bold measures to support demand when a recession loomed. A continuation of that approach into the future will serve us well. | reserve bank of australia | 2,009 | 10 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to The John Curtin Institute of Public Policy and the Financial Services Institute of Australasia Public Policy Breakfast Forum, Perth, 15 October 2009. | Glenn Stevens: The conduct of monetary policy in crisis and recovery Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to The John Curtin Institute of Public Policy and the Financial Services Institute of Australasia Public Policy Breakfast Forum, Perth, 15 October 2009. * * * With economic prospects improving, people’s thoughts naturally turn to the question “what next for monetary policy?” Financial markets were the first to ask this question. Virtually as soon as the cash rate stopped falling, the pundits started to speculate about the timing of the first increase. Initially, this change in market tone seemed a little premature. But it is now a year since the dramatic financial events of September and October 2008 dictated a sharp change of course for monetary policy. The question of how monetary policy will be conducted during the next phase is therefore a reasonable one. It is understandable if it is also a rather prominent one, following last week’s decision by the Board to lift the cash rate by one quarter of 1 per cent. The Bank has already conveyed a good deal of its general thinking, through its regular statements after each Board meeting, the subsequent minutes, other written material and remarks I have offered previously. Nonetheless, this is an appropriate juncture at which to try to bring all this together. So this morning, I intend to elaborate a little about the sorts of issues that have been important for the conduct of policy in the past year and those that look like they will be relevant in the period ahead. First, however, it is worth recounting the framework for policy, the process that we go through each month in reaching the decision, and the way that decision is implemented. The policy framework The centrepiece of the framework for monetary policy is a medium-term target for inflation. This framework combines two important principles that both theory and practical experience about monetary matters have taught us. The first is that, in the long run, monetary policy is about the value of money – that is, prices. Over long horizons, the size of the economy and its average rate of growth will be driven by developments on the supply side – such as the availability of land and labour, the extent of accumulation of real capital, technology, and the efficiency with which we use all those factors. Monetary policy can’t make those factors grow faster. The second is that, in the short term, monetary policy changes do affect the real economy, because they affect aggregate demand. If trend inflation has risen, for example, getting it down again usually requires a period of slower growth in demand. But we don’t want that period of slower growth to be any longer or more pronounced than necessary. By the same token, if as a result of some shock demand falls below potential supply capacity, the resulting downward pressure on inflation may provide scope for monetary policy to be easier for a time, which will help to limit the cyclical weakness in economic activity. Our objective of keeping consumer price inflation to 2-3 per cent, on average over time, strikes a good balance between these short-term and long-term considerations. The “on average” specification allows deviations from the target in the short term, which are often unavoidable anyway, but still embodies a commitment that those deviations will be reversed in a reasonable period of time. It allows the economy’s growth potential, determined by productivity, labour force growth and so on, to be realised. At the same time, the explicit numerical goal for inflation helps to anchor expectations of inflation and works to preserve the value of money. As such, it is in our view fully consistent with, and gives practical expression to, the objectives given to the Bank in legislation: the stability of the currency (that is, its purchasing power); full employment; and the economic prosperity and welfare of the people of Australia. It has bi-partisan support in the Parliament. It has also been, in practice, over the 15 years we have been using it, the most effective framework for monetary policy Australia has had so far. The target is expressed in terms of the Consumer Price Index (CPI). This is, of course, only one of a number of price indexes. But the CPI was chosen because: it is the best known and accepted published price index; it is pretty reliable; and it presents fewer analytical problems for this purpose than other measures of prices. I now turn to the decision process. The decision process The Bank is continually examining a vast amount of statistical and survey information. There are thousands of individual data series monitored by the staff in the Bank’s Economic Group, covering Australia and a number of other countries. An array of financial information from all the major markets around the world as well as in Australia, is monitored on a daily basis. This work is complemented by an extensive program of business liaison. A lengthy list of contacts is maintained; about 100 organisations are spoken with in any given month. The Financial Markets Group also maintains close contact with financial market participants in Australia and elsewhere, and the Reserve Bank gains valuable intelligence as a participant in both local and offshore markets. In the lead-up to the Board’s meeting, all this material is carefully evaluated. At a meeting of the most senior officers in the week preceding the Board meeting, discussion occurs about what should be recommended to the Board. Papers for the Board containing the factual information available, the staff’s judgements about issues of interpretation in the data, the outlook and any topics of special interest are prepared. A four to five page paper, containing a high-level summation of the issues for policy and the recommendation, is completed on the Thursday afternoon ahead of the meeting. Board members receive the papers on the Friday. At the Board meeting, the most senior staff present the key messages from the papers. There is extensive discussion, and plenty of questions from the members about the material. The Board, I can assure you, is no rubber stamp and its members are no group of shrinking violets. They come from a diverse set of backgrounds. They bring their own experiences and their own independently gleaned pieces of information about what is going on. The analysis and arguments put by the staff and management of the Bank are well and truly tested. Any weaknesses will quickly become pretty clear. This discussion usually takes about three hours. It is, I would think, the most intense regular discussion of the state of the economy that occurs anywhere in the country, as of course it should be. At the end of the discussion, the Governor, as Chairman of the Board, will sum up and introduce the policy question. Each member has an opportunity to give their view and their reasoning on the decision at hand. Typically, a consensus emerges, and the decision is then taken. It then remains to issue a statement. The Board meeting is not a drafting session – the members are usually content to leave the precise wording to the Chairman, on the understanding that the statement will be consistent with the discussion at the meeting. The statement is then released at 2.30pm and the community is thereby informed very quickly what the decision is and why we have taken it. Subsequently, the draft minutes of the meeting are prepared. These are finalised after members have the opportunity to comment on the draft during the following week, and are released publicly on the Tuesday two weeks after the meeting. A few days after this, the whole sequence begins over again. In addition to all the above, every three months the Bank publishes an extensive analysis of the economy, financial markets and the issues for monetary policy. This document, the Statement on Monetary Policy, typically runs to about 70 pages. All of this is already known. The point of recounting it is to reassure people that there is a very careful, detailed and extensive process involved both in making the monetary policy decision and in explaining it. The transmission process A lot of effort goes into the policy decision, as I have just described. But that only establishes one interest rate in the economy – and a very specialised one at that. (For today’s purposes only, I am leaving aside the other channels through which monetary policy affects the economy, such as the exchange rate, inflation expectations, the supply of credit and so on. These remain important, but today it is the interest rate channel on which I want to focus.) The “cash rate” is the rate for borrowing large parcels of cash, or settlement funds that are held in banks’ accounts at the RBA, overnight. This is a very active market, but only a very small proportion of borrowing in the economy is actually conducted in this market. To have its broader effect, monetary policy relies on changes in the cash rate affecting other interest rates. Both today’s cash rate and its expected value over the next six months to 12 months form the anchor for the spectrum of interest rates in the economy. But there are other factors at work as well. Term premia – the additional return that must be paid when money is tied up for longer periods – and compensation for risk also can affect the official yield curve and the structure of private interest rates. For some years, these other factors were reasonably stable. Compensation for risk actually tended to decline gradually, as a result of a very strong “search for yield” by investors and heightened competition among intermediaries to lend. Hence in net terms loan rates slowly fell, relative to the cash rate. On the whole, though, changes in the cash rate came to be seen as driving most of the important rate changes in the economy quite precisely. This was, historically speaking, somewhat unusual. In the past 18 months or so, in contrast, a sharp reappraisal by investors around the world has seen compensation demanded for accepting risk increase. As a result, the various market interest rates that intermediaries have to pay to raise funds have, on occasion, moved independently of the cash rate. The Bank has published an analysis of funding costs, which provides a useful framework for thinking about these issues, so I won’t go into them in detail. 1 I will simply make a couple of observations. First, during the easing phase, interest rates for most borrowers still came down quite significantly, because the cash rate changes were so large. For mortgages, floating rates in the past year reached their lowest level since 1964. At the margin, the cash rate cuts were larger than otherwise because the Board could see that spreads between intermediaries’ rates and the cash rate were tending to widen. Likewise in future decisions, the Board will take careful note of any tendency for spreads to change. Davies M, C Naughtin and A Wong (2009), ‘The Impact of the Capital Market Turbulence on Banks’ Funding Costs’, RBA Bulletin, June, pp 1–13. Available at <http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jun09/impact-cap-mkt-turb.html> Second, in Australia, housing loan rates came down much more than has been the case in many countries. This was partly because of the prevalence of floating rate housing debt here, but also because spreads on housing loans (relative to the policy rate) widened by less in Australia than other countries. That is to say, monetary policy still works pretty effectively in Australia. The conduct of policy during the crisis Going into the crisis, the global economy had been growing strongly. Global GDP expanded by 5 per cent in 2007, which capped off several years of well above average performance. The US economy had been slowing for a while as concerns mounted over the financial problems, but even into the first quarter of 2008 global GDP was still expanding at 4 per cent. Prices for most commodities were still rising; oil prices would not reach their peak until July that year. Our economy was operating at full stretch, with our terms of trade showing their largest rise in 50 years and delivering a very large income gain to the community. Confidence was high; firms routinely complained of labour shortages; inflation was tending to rise, worryingly so in the second half of 2007; and demand for credit was strong. In this environment, the Board was running tight monetary policy to contain inflation. We now know (but could not know for sure at the time) that CPI inflation was on its way to 5 per cent. Measures of underlying inflation, which seek to look through temporary factors, reached over 4½ per cent. These outcomes were well above our target, and it could not be credibly claimed that they were just due to temporary or imported factors. In fact, in late 2009, we are still to see whether inflation will be consistently back to target over a period of time. We think it will be, but, as yet, that remains a forecast. The big rise in energy prices in the first half of 2008 crimped growth in advanced and emerging countries alike, and most showed a significant softening in the June quarter of that year. By then it was starting to emerge that demand in Australia was in the process of moderating – though it is worth noting that domestic final spending still rose by 1 per cent in the June quarter of 2008 and 5 per cent over the year to June, both very robust outcomes. The Board was then in a position to start thinking about when it might be time to begin to ease monetary policy, in anticipation of inflation starting to decline – even though at that stage it had yet to reach its peak. The easing phase began in early September. About two weeks later, the simmering financial tensions in the northern hemisphere erupted into the most dramatic sequence of financial events we are ever likely to see. The failure of Lehman Brothers is usually taken to be the signal event. That is a reasonable assessment, even though the US Government takeover of Fannie Mae and Freddie Mac actually preceded the Lehman collapse. The ensuing sequence of crashing share markets, the huge financial strains, the need for governments to support struggling banks, and so on, had a massive effect on confidence around the world. As a result demand for goods slumped everywhere. Most economies went into recession; in a number of cases these were severe ones. This required a change in monetary policy thinking in Australia. Instead of the gradual easing of policy that we had been expecting would occur, as inflation gently subsided, the Board concluded last October that it needed to be more aggressive in lowering rates. Australian households and businesses, understandably, began to react to events abroad. This meant that there was likely to be a much weaker outcome for demand and output – and hence a greater prospect of falling inflation – than had been expected up to that time. This change to the outlook was reflected in revisions to the central forecasts prepared in the Bank. But the Board responded to more than just those forecast changes. It responded also to the risk that, in an environment of acute global financial strain and deleveraging, there could easily be a much weaker outcome for economic activity even than the one embodied in the reduced forecast. Accordingly, the cash rate was reduced by a total of 300 basis points in the four months leading up to the end of 2008. It was lowered further in the early part of 2009. This “risk-management” approach, in which policy responds quickly to a situation where there is an increased risk of a very adverse outcome, is fully consistent with the flexible inflation-targeting framework. Admittedly, a more conventional approach might have seen the Board ease policy more slowly, waiting for more evidence of economic weakness and moderation of inflation. Such an approach would have been defensible, particularly given how high inflation became during 2008. But the loss in economic activity would probably have been greater, and the risk of an even larger contraction would have been unaddressed. Inflation might well have fallen not only faster, but ultimately further, than we needed it to. The Board’s view was that we should move to limit the downside risks to economic activity, to the extent it was feasible to do so while remaining consistent with the inflation target. The Board had some earlier analysis available to it that proved to be helpful in coming to that decision. A year earlier, for the September 2007 meeting, the staff had prepared some scenarios for discussion. One of those was a sketch of what might occur if the financial crisis escalated badly and the global downturn turned out to be much more severe than then expected. The message from that work was that such an event, if it occurred, would probably require a very rapid response from monetary policy, in the direction of lower interest rates. That event did not occur for another year, but when it ultimately did, we were a bit better prepared than otherwise might have been the case. The conduct of policy in recovery Along with the fiscal measures taken by the Government, the recovery in China, and assisted by Australia’s better starting point across several dimensions, this approach has had some success in heading off the worst effects of a very serious international recession. Australia has had an experience that, even if labelled a recession, was a pretty mild one. That is, clearly, a good outcome in the circumstances. Now that the risks of really serious economic weakness have abated, however, the question arises as to how to configure monetary policy for the recovery. We have said that, over time, interest rates will need to be adjusted towards a more normal setting as the economy recovers. A step in that direction was taken last week. Of course, there are still important matters of judgement in the timing and pace of how that is done. The global outlook remains uncertain and the Board is very conscious of that. The Board is also conscious, though, that a risk-management approach requires policy to be recalibrated as circumstances change. If we were prepared to cut rates rapidly, to a very low level, in response to a threat but then were too timid to lessen that stimulus in a timely way when the threat had passed, we would have a bias in our monetary policy framework. Experience here and elsewhere counsels against that approach. None of this is to say that the economy is, at this moment, “too strong”. It isn’t. The point is, rather, that the very low interest rate settings were designed for a weaker economy than we are in fact facing. Plainly, the downside risks to which the Board was responding earlier have not materialised. This is not a problem. In fact, it is a very desirable situation. It is a welcome contrast to the experience of a number of other countries. It is simply something we need to recognise in setting monetary policy – which means not holding interest rates at very low levels when that is no longer needed. Conclusion The period of greatest weakness in the Australian economy is probably past. Barring another serious international setback, the economy is likely to continue on a path of gradual expansion during 2010. That being so, those of us involved in monetary policy must turn our thoughts to encouraging the sustainability of that expansion. This is particularly the case for monetary policy given the lags in its impact. In conducting monetary policy during this expansion, our objectives will be the same as they were in the previous one: to keep inflation low; to react in a measured but prompt fashion to changes in the risks facing the economy; and, in so doing, to play our part in fostering a long, sustainable period of growth. Australia faces many challenges in the future, but we can have confidence that these can be met. A sound monetary framework is one of the foundations for doing so. | reserve bank of australia | 2,009 | 10 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the 2009 Economic and Social Outlook Conference Dinner, The Melbourne Institute and The Australian, Melbourne, 5 November 2009. | Glenn Stevens: The road to prosperity Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the 2009 Economic and Social Outlook Conference Dinner, The Melbourne Institute and The Australian, Melbourne, 5 November 2009. * * * When I spoke in April about “The Road to Recovery”, the issue was how to get onto that road. 1 It was clear then that the global financial system had been stabilised by the extraordinary interventions of policy-makers during the December quarter last year. The system was, very gradually, mending. But it was also clear that the major countries had experienced a very sharp contraction in demand in the December and March quarters. It wasn’t yet clear, at that time, whether that slump had been arrested – though we now know that it was bottoming out. Reputable observers were talking about the worst global recession since the 1930s. For some of the individual major countries at least, there seemed to be a good deal of evidence for such a view (and there still does). It was widely anticipated that the Australian economy would be affected by these developments. Even if one was optimistic about the Australian economy in a relative sense, it seemed pretty unlikely that we could escape a significant impact from such an international downturn. To say that we would outperform other countries, while accurate, didn’t necessarily reassure people a great deal, because things in a number of those countries seemed to be so bad. As it turns out, in April we were pretty much at the nadir of sentiment about the Australian economy. Six or seven months later, even most of the optimists are a little surprised, I suspect, at the economy’s performance. So the title of this conference is particularly apt. But the issue before us now is not, in fact, how to get onto the road to recovery: we are already on it. The question, rather, is how to make sure that the road to recovery will connect to the road to prosperity. To make that connection, I suggest that we need to do two things. First, we need to draw the right lessons from our experience of the past couple of years. There are no doubt many lessons that might be mentioned. I will list just a few that I think are important. Second, we need to apply those lessons in the right way to the challenges that are likely to confront us over the years ahead. I will offer a few observations about some of those. Lessons from the crisis The first lesson is that the business cycle still exists and that financial behaviour matters, sometimes a lot, to how that cycle unfolds. We need to have a broad definition of the term “business cycle” in mind. There is more than just the cycle in the “real” economy of GDP, employment, consumer price inflation and so on. These remain important, but it is just as important to recognise the cycles in risk-taking behaviour and finance. Failing to do that is precisely what has got some countries into trouble this time. For some years we heard talk of the “great moderation”, a reference to a period of unusually low macroeconomic volatility for the major industrial countries from the mid 1980s until the mid 2000s. During this period, the United States had a couple of recessions – in 1990 and 2001 – but they were shallow ones compared with those in the mid 1970s or early 1980s. Available at http://www.rba.gov.au/Speeches/2009/sp_gov_210409.html. Inflation in most countries was low and pretty stable. So were interest rates. Australia shared in this experience from about the mid 1990s onwards, with an unusually long expansion. Compared with the instability of the 1970s and early 1980s, this was a remarkably good period for macroeconomic performance. It was also very positive, for quite some time, for investment returns. But the problem with this apparently benign environment was that it made things seem just a little too easy. As the period of stability grew longer, so compensation for risk tended to diminish as investors continued their “search for yield”. In the end that search explored some fairly remote territory, including complex structured products, exotic derivatives and so on. Key sectors of important economies accumulated a considerable degree of leverage along the way – in households, or financial institutions or both. In other words, as the macroeconomic environment seemed less risky, people changed their behaviour. The macroeconomic stability provided scope, it seems, for some financial trends to run further than they might otherwise have done, and further than they really should have done. Ultimately, this re-introduced risk through another channel: the financial structure of economies changed in a way that was more likely to amplify certain types of shock once they occurred. The great moderation has ended for many of the world’s most advanced economies. They have become re-acquainted with the business cycle, in its most unstable and unpredictable form, where financial shocks and real economic activity become highly, or even dangerously, connected, through balance sheets. It’s an old lesson, but worth re-stating. No country has managed to eliminate the business cycle. No country ever will, because the cycle is driven by human psychology, which finds expression in financial behaviour as well as “real” behaviour. We are seemingly just made – “hardwired”, as some would put it – in a way that makes us prone to bouts of optimism and pessimism. Occasionally, we are prone to periods of myopic disregard for risk followed, in short order, by an almost complete unwillingness to accept risk. We could search for perfect policies that will eliminate, or completely offset, these tendencies, but that search would most likely be frustrating, and ultimately, I fear, fruitless. Realistically, what we need are policy frameworks that recognise the cycle – in its inevitability, yet unforecastability – and help us cope with it. They will do that, in large part, by limiting the build-up of excesses in the good times. Australia’s policy frameworks have withstood the test pretty well during this period. Nonetheless, they will need ongoing investment if they are to continue to work well in the future. And even the best policy frameworks will not make the cycle go away. We need a parallel development in the general public discussion of economic and financial cycles. We might start with a more balanced discourse about recessions. We are still debating whether or not the events of late last year and early this year should be labelled a recession. The fact that we are still debating says something about the episode’s severity. Perhaps we should just let the students of business cycles decide what label to apply and focus on the broader issue. If it was a recession, it was the eighth one since World War II. It certainly will not be the last one. Recessions are cyclical events that occur periodically, but not with sufficient regularity to be forecastable as to timing. They will occur in the future. If one’s business or personal or policy strategy depends heavily on there not being a cyclical downturn, it is a risky one. The road to prosperity is not a road without cyclical ups and downs. But the second lesson we ought to draw from recent experience is that while downturns will inevitably occur, we are not helpless to do anything about their severity. We can make a difference. When a downturn came this time to Australia, there were certainly casualties. Risky business strategies (in most cases related to financial structure) were exposed, and those involved sustained losses of income, wealth and reputation. Other firms and individuals suffered much more difficult circumstances too. But on the best reading of all the available information, this appears to have been one of the mildest downturns we have had. Furthermore, it is likely that recovery is already under way. That’s the next lesson: when downturns come, we can recover. Now the relative resilience of the Australian economy in this cycle warrants some discussion. Unless we are prepared to accept it has all been an incredible coincidence, we have to ask why things turned out that way. It wasn’t just that China returned quickly to growth. That certainly was important in sustaining export volumes, and in re-establishing confidence in the outlook for the resources sector, which did wobble for a few months. But China’s importance may be greater for future outcomes than recent past ones. Equally important recently were other factors, including the relative strength of the financial sector, the economy’s flexibility and the willingness and scope to change macroeconomic policy. Those things were not accidents. Financial resilience resulted from sensible management by financial institutions themselves, and careful regulation on the part of the prudential supervisor. For the most part, the non-financial corporate sector was also fairly conservatively managed in respect of balance sheets – largely because enough corporate managers and directors today remember a time when that was not so. Moreover, businesses took a far-sighted view about employment decisions. Given the preceding difficulties in securing labour, they found ways of keeping people on payrolls, even if on reduced hours. They clearly had not only the good sense, but also the requisite degree of institutional flexibility, to do that, which must say something about the progress that has been made in labour market arrangements over the past couple of decades. And finally, long-term investments in prudent fiscal and monetary frameworks paid off. A whole generation of policy-makers painstakingly worked to build credibility by taking decisions with a long-run perspective. The return was in the form of a capacity to respond credibly to the downturn before it gathered much pace. The lesson here, then, is that all those investments were worthwhile. So I think this episode offers us an opportunity to re-visit our national script about recessions and recoveries, financial behaviour and policy frameworks. Recessions will occur, as they always have. Financial behaviour matters greatly and can, if we are not careful, contribute to instability. In our thinking about the future, we all need to remember that. But if we do, and act with due prudence during the upswings, recessions need not be bad ones and, when they come, we can recover. Signposts to that effect ought to be erected along the road to prosperity. Applying the lessons The task before us now is to manage a new expansion. Of course, we are still in that period when we cannot be absolutely certain that the expansion will gain full momentum. Every upswing starts with that uncertainty. The conduct of macroeconomic policies in the near term must grapple with that uncertainty, as it always must do. Even so, it is not too early to think about issues of a medium-term nature. The key question is: having had a fairly shallow downturn, how do we make the upswing long and stable, and relatively free of serious imbalances? At least part of the answer is that we will need to re-invest in the same policy discipline, and the same careful private-sector management, that paid dividends in the recent episode. That means keeping tested frameworks in place, amended as necessary in the light of experience. It means unwinding temporary measures as appropriate. It means keeping a focus on flexibility. And perhaps most of all, it means resisting the temptation to assume prosperity is easily achieved, or easily managed. In that spirit, let me offer three observations. First, we start this upswing with less spare capacity than some previous ones. After a big recession, it usually takes some years for well-above-trend growth in demand to use up the spare capacity created by the recession. This time that process will not take as long. Most measures of capacity utilisation, unemployment and underemployment are much more like what we saw after the slowdown in 2001, than what we saw after the recession in the early 1990s. This is not a problem. In fact, it is good. It is a goal of macroeconomic policy to try to keep the economy not too far from full employment. And some spare capacity does exist, and will do so for a little while, which is why we think underlying inflation will probably come down a little more in the period ahead. But it does underline the importance of adding to supply, not just to demand, over the medium term, and of maximising the productivity of the factors of production that we have, if we are to have the sort of growth that genuinely brings prosperity. Second, and following on the theme of potential supply, others have noted that the rate of population growth at present is the highest since the 1960s. On one hand, this may help alleviate capacity constraints, insofar as certain types of labour are concerned. On the other hand, immigrants need to house themselves and need access to various goods and services as well. That is, they add to demand as well as to supply. It follows that the demand for additional dwellings, among other things, is likely to remain strong. Corresponding effects will flow on to urban infrastructure requirements and so on. So the question of whether enough is being done to make the supply side of the housing sector more responsive to these demands will remain on the agenda. Adequate financial resources will of course also be needed. In that regard, the current issue is not the cost of borrowing for end buyers, which remains low, but the availability and terms of credit for developers. Perceptions by lenders of the riskiness of development in some cases are probably overdone just at the moment, given the strength of the underlying fundamentals on the demand side for accommodation. That will probably not be a permanent problem though; the more persistent difficulties look like they may be in the areas of land supply, zoning and approval. Third, the likely build-up in resources sector investment over the years ahead carries significant implications for the medium-term performance and structure of the economy. Even if a number of the proposed projects do not go ahead, the ratio of mining investment to GDP for Australia, which is already very high, will probably go higher still over the next several years. A sizeable share of the physical input will be sourced from abroad (through imported equipment) but the domestic spend will still be significant. So, other things equal, the investments will be expansionary for the economy. The financial capital to fund this build-up will mostly come from abroad. That is to say, absent some offsetting changes elsewhere, Australia’s current account deficit could be considerably larger for some years than the 4 to 5 per cent of GDP we have seen on average for the past generation, which itself was a good deal bigger than seen in the generation before that. Now of course the current account position we have had turns out, contrary to what most would have expected 25 years ago, to have been manageable and sustainable. A temporarily larger one would probably be so as well, provided it involved a relatively modest amount of currency mismatch, and a rise in investment as opposed to a reduction in saving – and that seems to be the likely shape of things. In fact a temporarily sizeable current account deficit, if characterised by equity-type capital inflow, may well be optimal, because it would mean that a good deal of the risk of the projects was being shared with foreign investors, and that makes sense. Why would Australians alone take on all the risk of these massive projects? It is probably more sensible to share the risks with global capital markets and global companies. But these trends will take some explaining, not least to foreign and international organisations, many of which have a more traditional view of current account positions. Our explanation to our own citizens will also be important, and not just about capital flows. Over time, if the resources sector is to grow as a share of the economy, as seems likely, other areas will by definition shrink. This does not necessarily mean that they will shrink in absolute terms, particularly given the population is growing quickly, but certainly their growth prospects would be weaker than in an alternative state of the world in which the resources sector was to remain at its historical size. It follows that adjustment challenges will arise, with industrial and geographical implications. The “two-speed economy” debate of a few years ago was really only a preview of what we could see if the resources sector build-up goes ahead. A further implication is that the economy’s trade patterns could end up becoming less diversified than they have been in recent years. Such concentration would not be unprecedented and may well be worth accepting if the returns from doing so were high enough, as it appears they might be. But we might also think about how to manage the risks associated with any concentration. The emergence of China and India is a benefit to Australia, but we stand to have a heightened exposure to anything going seriously wrong in those countries. How then to manage an income flow that is higher on average, over a long period, but potentially more volatile? The answer to that question is beyond my brief today but presumably involves thinking about the extent and form of saving by the community. Conclusion As we look forward to a new expansion, Australia has many advantages. The financial sector remains in pretty good shape. The Government does not own, and has not had to give direct support to, any financial institution. Australia, therefore, will be relatively free of the difficult governance and exit strategy challenges that such support is raising in some countries. Public finances remain in good shape, with a medium-term path for the budget back towards balance, and without the large debt burdens that will inevitably narrow the options available to governments in other countries. Sensible policy frameworks – both macroeconomic and microeconomic – remain in place, and they have worked. The financial regulatory system is strong and tested. We remain open for trade and investment, with an exposure to Asia, which still has the most dynamic growth potential in the world over the next several decades. These advantages are already paying dividends. Properly exploited, they will pay many more. But there is no such thing as effortless, or riskless, prosperity. There is still a business cycle, and we do well to remember that even if we have been spared the worst of the recent downturn. We will need to continue investing in all the things that helped us get through the recent episode. And we will need to accept and manage various changes that will probably confront us over the years ahead. The road to prosperity will have some bumps, twists and turns. But it is the road to the right destination. | reserve bank of australia | 2,009 | 11 |
Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 3rd Annual Australian Parliamentary Conference, Perth, 6 November 2009. | Ric Battellino: Australia’s foreign trade and investment relationships Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 3rd Annual Australian Parliamentary Conference, Perth, 6 November 2009. * * * Thank you for the invitation to take part in this panel discussion. Given the international focus of this session, I thought I would make some observations about the changes taking place in Australia’s trade and investment relationships with other countries and what they mean for the domestic economy. 1. Facts on international trade Let me start with some facts on international trade. After a period of relative stability in the 1980s and early 1990s, Australia’s trade relationships have changed significantly in the past decade. This has been driven by the rise of China and, more recently, India. • China has now become Australia’s largest export market, taking almost one quarter of our exports; 10 years ago, less than 5 per cent of our exports went to China; • India has gone from being a relatively insignificant export market 10 years ago to taking 7 per cent of our exports now. Interestingly, the rise in the share of exports going to China and India has not come at the expense of our other large markets in Asia – Japan and Korea. Rather, the offsetting decline has been in exports to the United States, New Zealand, South America and Africa. The result is that the share of our exports going to the Asian region, which was already high, has risen further, to around 70 per cent. Many people have noted that, with China and India still at early phases of their economic development, it is likely that they will continue to grow strongly for many years yet, and so will their demand for resources. It is hard to argue with that conclusion, though we should keep in mind that, like all countries, China and India will experience economic cycles around this trend. In the case of our imports, China has also increased its share sharply over the past decade, from 6 per cent to 17 per cent. While Europe as a whole, and the countries of South East Asia as a group, have larger shares, China is the single largest individual country supplying goods to Australia. China’s growing share of Australian imports in recent years has mainly been at the expense of the United States and Japan, though part of this change in shares has been due to United States and Japanese companies relocating some manufacturing plants to China. In short, over the past decade there has been a very significant refocusing of Australia’s international trade towards China and, more recently, towards India. 2. Facts on foreign investment In the public consciousness, China has also figured prominently when it comes to foreign investment. The facts, however, show that, even though Chinese investment in Australia has increased in recent years, it currently accounts for only a very small share of foreign capital invested in Australia. Australian Bureau of Statistics (ABS) data indicate that, at the end of 2008, Australian assets owned by Chinese entities stood at around $8 billion. This is less than half of one per cent of total foreign investment in Australia, and puts China a long way down the list in terms of importance as a source of investment. Looked at from China’s perspective, Australia accounts for an even smaller share of its total offshore investment – less than one quarter of one per cent. Furthermore, this share has not changed much in recent years suggesting that China’s investment in Australia has grown in line with its accumulation of foreign assets globally. This would indicate that China does not have a particularly strong bias towards Australian investments. The ABS figures probably understate the true level of Chinese investment in Australia, because they do not identify as Chinese any investment from China that was channelled through custodial accounts held in third countries (typically those in major financial centres like London). Any such investment, however, would be of a portfolio nature rather than direct investment resulting in the control of companies. One of the reasons why China may be getting a higher public profile in the area of foreign investment is that in the past couple of years it has accounted for a large share of the proposals put to the Foreign Investment Review Board (FIRB). In 2007/08, for example, over 20 per cent of the number of investments approved by FIRB were from China. However, most of these entailed only small projects and, by value, the share was less than 5 per cent. The figures for 2008/09, while not yet available, are likely to be higher due to the approval of Chinalco’s intended investment in Rio Tinto, though in the end that investment did not proceed. When it comes to foreign investment, Australia’s main relationships are still very much with traditional partners such as the United Kingdom and the United States. The largest holding of foreign investment in Australia is by the United Kingdom, reflecting a history of over 200 years of investment and the fact that, as a major financial centre, a lot of investment coming to Australia from other parts of the world is channelled here via UK funds managers. The United Kingdom accounts for 25 per cent of the outstanding value of foreign investment in Australia. The United States is not far behind, at 24 per cent. In terms of the flow of new investment, the United States has been by far the largest source over the past decade. Investment in Australia by Asian countries, whether measured in terms of the stock outstanding or the flow of new investment, remains small in comparison. Japan is by far the largest Asian investor in Australia, with a share of 5 per cent; other Asian countries’ investments in Australia are noticeably smaller. If we look at Australian investment overseas, the relationship is even more skewed to the United States; over the past decade almost half of all the foreign investment by Australians went to the United States. Europe was the next largest destination for our savings, while the amounts going to Asia were relatively small. As a broad summary, the conclusion I would draw from these figures is that while Australia is very much linked into Asia (and particularly China) in respect of trade flows, in terms of investment flows it is mainly linked to the United Kingdom and the United States. 3. What does this mean for the Australian economy and Australian markets? Let me start with financial markets. One does not have to follow financial markets too closely to know that developments in US financial markets have a big influence on our markets here in Australia. The correlation between the Australian and US stock markets, and between the Australian and US bond markets, is very high. Most mornings, one can get a pretty good idea of how the Australian share market will open simply by looking at what happened to US share markets overnight. Similarly, US news has an important influence on the Australian dollar exchange rate and on the price of many of the resources that Australia sells. It used to be the case that the US economy also had a big influence on Australia’s real economy. For much of my working life at the Reserve Bank, if one was able to pick what was happening to the US economy, one had a pretty good indication of what was going to happen to the Australian economy. Correlations between Australian and US GDP growth used to be very high. US news still dominates the daily flow of economic and financial information from overseas, and so still plays a dominant role in shaping perceptions about what is happening in the world economy. But the correlation between the United States and the Australian economies has nonetheless declined noticeably over the past decade. In particular, the United States has had two recessions – one in 2001 and the current one – which have had a relatively muted impact on Australia. There are no doubt many factors that have contributed to this. One of them is that the growing trade linkages between Australia and China are increasingly pulling the Australian economy away from the United States towards China. China is our largest export market, and Australia is the largest supplier of bulk commodities to China, so our economies are becoming very intertwined. Various people, including Glenn Stevens and Phil Lowe from the Reserve Bank and Ken Henry from the Treasury, have recently spoken about the implications of this for the Australian economy in the medium term. This topic is also attracting considerable attention in the media. Three themes emerge when people look at these issues. The first is that Australia will most likely face an extended period of prosperity in the years ahead. Some of this will come about through strong real economic growth, due, for example, to increased investment and higher export volumes. Some of it could also come via high commodity prices. If, as has occurred over the past five years, the supply chain involved in the production of resources in Australia (and elsewhere) struggles to keep up with rising Chinese demand, commodity prices will remain high. The fact that commodity prices are still at a level that is historically high, despite the severity of the global recession, indicates that the demand/supply balance in commodity markets remains fairly tight. It could tighten further as the global economic recovery gets under way. A second theme is that this prosperity could put strains on the economy, and not all sectors may share in it. It is possible, for example, that some sectors of the economy will suffer as labour and capital are competed away by the faster-growing sectors. In general, workers are likely to be in short supply, leading to strong demand for skilled migrants and therefore fast population growth. This, in turn, will have flowon effects for housing markets. Investment, which is already high by the standards of developed economies, will need to rise further. A large part of this is likely to be imported. Similarly, the financing of this investment will most likely require increased capital inflow. We could therefore see a widening in the current account deficit, possibly to higher levels than previously experienced, matched by increased capital inflow. The third theme is that the forces affecting the economy could pose a number of policy challenges. Glenn Stevens dealt with these at some length in his talk last night, so I won’t go over that ground again here. It is worth keeping in mind, however, that these challenges are about the medium term, not the immediate future. There is also no reason why they should be beyond our capacity to handle. | reserve bank of australia | 2,009 | 11 |
Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 6th National Housing Conference, Melbourne, 25 November 2009. | Ric Battellino: Housing and the economy Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 6th National Housing Conference, Melbourne, 25 November 2009. * * * I have been asked to focus my comments on the economic aspects of housing. In keeping with this, I will start with a few words on the economy and then discuss the implications for the housing market. In the course of that, I would like to look at three specific questions: • are we building enough dwellings? • is there enough housing finance? and • why are dwelling prices in Australia high relative to income? The economic context The Reserve Bank has published a lot of material on the global and Australian economies recently, including the November Statement on Monetary Policy, the minutes of Board meetings and various speeches. I won’t go over that material in detail, but it is worth drawing out a few highlights. The first point is that the global economy is clearly growing again after some very sharp falls in activity late last year and early this year (Graph 1). Virtually all economies recorded growth in the September quarter, and the information available so far for the December quarter indicates that the expansion has since continued Graph 1 Industrial Production* January 2008 = 100 Index North Atlantic countries** Emerging Asia*** Index * Weighted using GDP at market exchange rates ** Canada, Denmark, euro area, Norway, Sweden, UK and US *** China, Korea, India, Malaysia, Philippines, Singapore, Taiwan and Thailand Sources: CEIC; RBA; Thomson Reuters It is also clear that the economies of the North Atlantic are lagging behind those in other parts of the world, particularly those in Asia where the economic recovery has been quite rapid. It is not surprising that the North Atlantic economies are lagging, as they were at the centre of the financial crisis. Many of the banks in that region are still at the early stages of balance sheet repair, which is limiting their capacity to lend. Banks elsewhere are in much better shape. While they were caught up in the squeeze on global money markets that flowed from the events in the United States late last year, they generally did not experience severe credit losses. Once the liquidity pressures passed, financial intermediation in these countries has tended to normalise. This is certainly the case in the Asian region. More generally, economies in the Asian region have responded well to accommodative macroeconomic policies and economic activity has rebounded. This is positive for Australia as Asian countries are our major trading partners. While the world economy as a whole is forecast to remain relatively sluggish next year, economic growth for the group of countries that comprise our major trading partners is expected to recover to a relatively normal pace. Some commentators question the capacity of Asia to continue to grow if the developed economies of the North Atlantic remain weak. While there is no doubt that weakness in the developed economies would have an adverse effect on Asia’s growth prospects, we should not lose sight of the fact that most of the growth in the larger Asian economies comes from their own domestic demand. In the case of China, for example, domestic demand contributed on average close to 9 percentage points per annum to growth over the past decade, while net exports contributed about 1 percentage point (see Table 1). Importantly, the authorities in most of these countries have plenty of scope to pursue policies that sustain domestic demand. Table 1: Average Economic Growth* Annual Average Growth 1999–2008 (%) Japan China India Korea Indonesia Taiwan Singapore 1.3 9.7 7.1 5.2 4.7 3.8 5.6 Contribution from: Domestic demand (% points) Net exports (% points) 0.9 8.7 7.5 4.5 4.1 1.6 4.6 0.4 1.1 –0.4 0.7 0.6 2.3 1.4 * This calculation abstracts from the fact that some of the growth of domestic demand has come from increased export income. Sources: CEIC; Thomson Reuters; RBA. The Australian economy in 2009 has held up much better than had been expected earlier in the year. Australia is the only developed economy where year-ended growth in GDP has remained positive during the past year. It is now 18 years since Australia has experienced a negative in year-ended GDP growth, a very prolonged economic expansion (Graph 2). With the economy having only recently entered a new upswing, it is reasonable to assume that we will see this growth extended for a few more years yet. Graph 2 Over the next few years, Australia is also expected to see a further expansion of the resources sector, including the development of some very large gas projects. Mining investment, which is already at record levels as a share of GDP, could rise substantially further in the next five years or so (Graph 3). Graph 3 If this scenario eventuates, it will have powerful and broad-ranging implications for the economy. Glenn Stevens and Ken Henry have addressed these recently. I won’t go over all that ground again today but, as far as the housing market is concerned, the key implications are that: • the rate of growth in the population, which has already picked up in recent years, is likely to remain strong, as demand for labour will encourage continued high immigration; • household incomes are likely to rise solidly, which will help underpin the demand for housing; and • the construction industry is likely to face substantial competition for workers from the mining sector. While this suggests a generally positive environment for the housing sector, it will not be without its challenges. Are we building enough dwellings? As Glenn Stevens mentioned recently, one of the key challenges will be to ensure that the supply of housing is able to respond adequately to the increased demand for accommodation. There is a broad consensus that in recent years Australia has not built enough dwellings. A good indication of this is the very low vacancy rates in rental markets. This shortfall in housing, however, is not because, as a nation, we have cut back on investment in dwellings. In fact, the opposite is true: over the past decade dwelling investment has been higher – around 6 per cent of GDP – than it has typically been in the past (Graph 4). Graph 4 Private Dwelling Investment Five year averages, current prices, per cent of GDP* % % New dwellings Alterations and additions * Last observation uses data to June 2009 Source: ABS So how do we square up the seemingly contradictory evidence that overall investment in housing is relatively high, yet there seems to be a shortage of dwellings? I think four factors help to explain this contradiction. • First, Australians are on average spending a lot more on each new dwelling. Real expenditure on each new dwelling built is now 60 per cent higher than it was around 15 years ago (Graph 5). This is due to improvements in quality and increases in size. • Second, a high proportion of dwelling investment is in the form of alterations and additions – i.e. upgrading existing houses rather than building new ones. Almost half of all dwelling investment has been accounted for by alterations and additions in recent years. • Third, a higher proportion of the new houses built are simply replacing existing houses that have been demolished. We estimate that between 2001 and 2006, around 15 per cent of new houses built replaced houses that had been demolished; 10–15 years earlier, that figure was less than 10 per cent. Graph 5 • Fourth, a significant proportion of dwelling investment appears to have gone into holiday homes or second homes. Census data show that the number of dwellings built has exceeded the increase in the number of households by a large margin. As a result, the ratio of the number of dwellings to the number of households has been rising over time; as at 2006, there were 8 per cent more dwellings in Australia than there were households. Presumably, most of this surplus reflects holiday houses and second houses (Graph 6). Graph 6 In short, the apparent contradiction between the shortage of dwellings and the high investment in dwellings arises because a high proportion of dwelling investment is going into improving the quality of existing dwellings and building accommodation additional to primary residences. If as a nation we want to continue to do this, while at the same time providing enough dwellings for the growing population, the overall amount of dwelling investment undertaken will need to increase relative to GDP. That would raise important challenges for the housing industry in terms of its capacity to meet that demand. It would, of course, also raise the question of which of the other expenditure components of GDP should bear the offsetting fall in share. Is there enough housing finance? Let me now turn to the question of housing finance. Over the past couple of years, there has been a significant change in the structure of the housing finance market, with lenders that were funding themselves through securitisation cutting back substantially on their new lending. Increases in the cost of funds for these lenders made it largely uneconomic for them to lend. Their declining market share has been picked up by the major banks, which now account for about 80 per cent of all new housing loans. These developments have led to concerns that borrowers may not have sufficient access to loans or that the cost of new loans may increase. However, to date at least, the evidence does not suggest that we should be overly concerned. On the question of cost, margins on standard housing loans have, if anything, narrowed a little over the past couple of years, even for the major banks. Two years ago, the interest rates charged by the major banks on new variable-rate housing loans were about 190 basis points above their cost of funds. The margin today is slightly narrower. To the extent that there has been a widening in banks’ margins it has been on their business lending. So far, it appears that there is still sufficient competition in the housing loan market for lenders not to have been able to widen their margins. The Government has helped to sustain that competition by putting in place arrangements to encourage the continued securitisation of housing loans. The Australian Office of Financial Management (AOFM) has been buying mortgage-backed securities from these lenders at yields that, during the crisis, were well below those in the secondary market (though still very attractive in absolute terms). This helped keep the cost of funds to these firms at levels that allowed them to continue lending, albeit at a much reduced rate from that of earlier years. The Government has recently announced an expansion in the AOFM program. At the same time, issuers of mortgage-backed securities are finding that, with market spreads having narrowed substantially in recent months, it is again becoming economic to issue securities into the market. As my colleague, Guy Debelle, said last week, the Australian securitisation market, like securitisation markets everywhere, has suffered reputational damage from the events in the United States. However, Australian mortgage-backed securities have not experienced credit problems. I am confident that this fundamental point will eventually see the local securitisation market return to being an important source of funding for housing loans. In the meantime, increased lending by banks means that total new loan approvals are relatively high. In fact, new loan approvals are at levels which indicate a degree of homebuyer activity that has typically been associated with rising house prices (Graph 7). At the same time, however, existing borrowers are continuing to take advantage of the low level of interest rates to make accelerated loan repayments, which is restraining the overall growth of housing credit. Even so, housing credit is growing at an annual rate of 7–8 per cent, a pace which is more than adequate to fund the new investment in housing that is needed. Graph 7 Housing Loan Approvals and Prices % % Year-ended housing price growth (LHS) 2.0 1.8 1.6 1.4 1.2 Housing loan approvals* (RHS) -5 -10 1.0 0.8 * As a share of the value of the dwelling stock; excludes owner-occupier refinancing and investor approvals for new construction and by ‘others’ Sources: ABS; APM; RBA Why are dwelling prices high in Australia relative to income? There is a common perception that house prices relative to household income in Australia are high both compared with other countries and with our own history. It is certainly the case that the ratio of house prices to income in Australia is higher now than it was 20 years ago. However, this is largely explained by the fact that the fall in inflation over that period has allowed nominal interest rates to cycle around a lower average level now than was the case earlier. That is, lower interest rates have allowed households to take out bigger home loans, without increasing housing loan repayments (Graph 8). In turn this has given households more buying capacity in the housing market, which has been reflected in house prices. Graph 8 Housing Loan Repayments* As a percentage of household income % % * Housing loan repayments calculated as the required repayment on a new 80 per cent LVR loan for the median-priced home; household disposable income is before interest payments. RBA estimate for September quarter 2009. Sources: ABS; RBA; REIA International comparisons of the relativity between house prices and income have been the subject of considerable research over the years. One of the complications faced by people working on this topic is to ensure consistency in the data that underlie the comparisons. Do the figures relate to capital city prices, or the prices across the whole country? Do they cover all dwellings or just detached houses? Is income measured as average weekly earnings or average household income? It is not always possible to get entirely consistent data across countries, so we need to be careful in interpreting the results of these comparisons. Most people do agree, however, that the ratio of house prices to incomes in Australia is higher than in the United States. One explanation that has been put forward for this is that the Australian population is more concentrated in a few large cities, where house prices are higher, even relative to income. This seems like a plausible explanation, but there must also be a financial explanation, otherwise we would expect to observe that housing stress among Australians was higher than in the United States, and this is clearly not the case. Arrears rates on housing loans in Australia have typically been lower than those in the United States, despite the higher ratio of house prices to income. There are a couple of reasons why Australian households seem to be able to sustain a higher ratio of house prices to incomes. First, Australians seem to spend less of their income on non-housing consumption than is the case for US households, with a significant part of this difference explained by lower health costs in Australia. Australian households therefore have greater capacity to service housing loans. Second, the level of gearing in the United States housing market is noticeably higher than in Australia. This may reflect the fact that Australian households are more active in paying down their loans after buying a home, possibly because owner-occupied mortgage interest rates are not tax deductible here as they are in the United States. The faster pay-down of mortgage debt in Australia reduces the risk of borrowers subsequently getting into financial difficulty. Overall, the experience of the last few years suggests that the Australian household sector as a whole appears to have the financial capacity to sustain a relatively high ratio of housing prices to income. That capacity may not, however, be evenly distributed through the population. Many 50–60 year olds, having benefited from the prolonged economic expansion over almost 20 years and the accumulation of superannuation savings, are in a strong financial position. This has encouraged a change in financial behaviour, with many households in this group being more inclined to stay geared up later in life, using the funds to upgrade or expand dwelling investments. It is likely that this changed behaviour has been a significant factor in the housing developments we have seen over the past 10–15 years. In contrast, the typical first-home owner cohort – those under 35 years of age – has experienced a noticeable decline in home ownership over the past 10–15 years (Graph 9). It may be that this is being driven by demographic factors – such as the fact that young people are staying in education longer and delaying the formation of new households – but it may also be financially driven. Graph 9 Home Ownership Rates in Australia % % Total Under 35 years Source: ABS Survey of Income and Housing (SIH) A particular problem for first-home owners is that the rise in the ratio of house prices to income has substantially increased the deposit needed to get into the market. On plausible assumptions, the deposit needed by first-home owners may now be around one and a quarter years’ income, almost twice what it was 15 years ago. At one stage, lenders were responding to this by lowering the deposit requirement, but this carried the risk of buyers subsequently getting into difficulty. Also, various governments have sought to provide concessions to first-home owners through grants or tax relief. However, while these measures assist the first wave of buyers who are able to take advantage of them, the benefits diminish over time to the extent that these concessions become capitalised into higher house prices. Conclusion I am conscious that I have raised a lot of issues and provided very few answers. Nonetheless, I will stop here, and leave it for your discussions over the next couple of days to resolve some of these issues. | reserve bank of australia | 2,009 | 12 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Annual Dinner of the Australian Business Economists, Sydney, 8 December 2009. | Glenn Stevens: Developments in financial regulations Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Annual Dinner of the Australian Business Economists, Sydney, 8 December 2009. * * * The financial crisis that engulfed global capital markets and brought a number of important international banks close to the brink last year has been followed by a good deal of soul searching among the regulatory community. In several countries, though not in Australia, regulatory structures and/or practices have been seen as inadequate. Work is proceeding to try to establish better arrangements so as to prevent the next crisis, or, more realistically, at least make it less costly – all the while seeking to avoid doing things that make it harder to recover from this one. I propose to offer today some information and some observations about these developments and the associated issues. I won’t go into the causes of the crisis per se; these have been covered at length before. The material offered is set in a global context, rather than an Australia-specific one. Just to be clear, if in the following paragraphs I am saying something about Australia, I will make that explicit. Lessons from the crisis What conclusions have governments and regulators around the world drawn from this episode? There are many. But the most important ones can be organised under five relevant headings. First, capital: there was not enough. In the case of global banks’ trading books, a lot of risk accumulated and was not well measured. Capital held against complex structured products in particular was seriously insufficient. A good deal of risk was also supposed to be “off balance sheet”, but returned very quickly to major institutions once liquidity dried up. Moreover, some instruments were considered to be “capital” but could not really absorb losses, at least while a bank remained operating. Second, liquidity: not enough attention had been paid to the risk that, in the event of some market shock, funding liquidity could become much more difficult. Comfortable assumptions that markets for some instruments would remain liquid proved to be unfounded. Third, the so-called “shadow banking system”: there were systemically important activities going on outside the “regulatory perimeter”. This included the activities of investment banks, hedge funds, finance companies, money market mutual funds and institutions that often had close ties to banks, such as special purpose vehicles (SPVs), structured investment vehicles (SIVs) and conduits. These entities were typically less closely supervised or unregulated, but in some cases their risk-taking behaviour and subsequent travails had systemically significant impacts on the core financial system. Fourth, cross-border arrangements: globally active banks and other entities operated apparently seamlessly across national borders and legal jurisdictions. But the structures to allow that were actually quite complex, and legal, supervisory and crisis-management arrangements remained nationally based. So when it came time to manage the process of deleveraging and winding up of some institutions, the degree of complexity was increased by the cross-border nature of the issues. Finally, pro-cyclicality: the episode demonstrated – again – that the financial system imparts its own dynamic that reinforces the natural cyclical tendency in an economy. In good times, lenders and investors tend to be confident and act with less caution. Standards decline and banks come under pressure either to use “surplus” capital or return it to shareholders. Backward-looking risk metrics present risk as low just when it is reaching dangerous levels and very high when everyone has already become much more risk averse. This all serves to fuel the boom and bust. Many commentators have argued that accounting standards contributed to pro-cyclicality. Fair-value accounting and buoyant markets make for strong valuations that can boost recorded profit, but problems emerge when banks have to mark-to-market securities whose markets have effectively ceased to function. The incurred-loss basis for provisions – where an event has to occur before a provision can be made – promotes transparency in one sense. But it arguably inhibits the build-up of buffers in the good times to cushion against future losses, and prompts more provisioning during the turmoil, further harming profitability and confidence. Other incentives have also been seen as adding to cyclical behaviour. Remuneration packages for some financial institutions’ executives and employees appear to have been structured in a way that may have encouraged traders and managers to take excessive risks in activities that appeared profitable in the short term but led to large losses later on. People have also pointed to the role of earlier regulatory changes, credit ratings, the complexity of instruments and weaknesses in market infrastructure, not to mention the long period of low global interest rates, the “global imbalances” and so on as all playing a role. I don’t want to underplay those factors, but the five above are the big themes on which I want to focus today. What is being done? Much has already been done, or is underway, to respond to these weaknesses by the various standard-setters, the Financial Stability Board and within the G20 process. Many of the responses can be organised under the same five headings. First among them is capital regulation. Now it is worth pointing out, before going on, that it is something of a stretch to suggest, as some commentators have, that the so-called Basel II framework was to blame for the crisis. In fact the build-up to the crisis occurred under the old Basel I capital rules: most global banks did not even implement Basel II until after the crisis had begun. US banks are still not using it. Basel II is not perfect but it addresses some of the shortcomings of Basel I that were identified by the financial crisis. It allows, for example, greater differentiation between different types of risk, introduces capital charges for offbalance sheet exposures to structured investment vehicles and conduits, and creates more neutral incentives between holding assets on balance sheet and securitising them. Had Basel II been in place, it might not have prevented the crisis but it would probably have helped matters. Nonetheless, Basel II can be improved in the light of experience during the crisis. The Basel Committee on Bank Supervision is in the process of implementing numerous changes, which essentially require more capital and higher-quality capital. It has already finalised changes to risk weights on certain exposures related to securitisation, and issued new supervisory guidance on compensation, governance, risk management and concentrations of risk. 1 It has changed rules around disclosure and valuation practices, which will come into effect at the end of next year. The Committee is currently rethinking the amount of high-quality capital banks should hold, specifying what instruments should be included in that definition, and developing a non-risk-weighted simple leverage ratio as a supplement to the risk-weighted capital adequacy measures. The Committee intends to finalise this latter set of new capital Specifically these relate to: securitisation exposures in the trading book; sponsorship of off-balance sheet vehicles; re-securitisation exposures; and pipeline and warehousing risks with regard to securitisation exposures. 163/2009 rules by the end of this year and calibrate them in 2010 with a detailed “quantitative impact assessment” to gauge their effects. Second, efforts to bolster liquidity management are underway, with the Basel Committee planning to introduce a new global standard for funding liquidity soon. This is likely to require financial institutions to focus on adequate funding liquidity over longer time horizons, as well as resilience to more demanding stress scenarios. In line with this, APRA has recently released for consultation proposals to enhance liquidity risk management by authorised deposit-taking institutions in Australia. Third, the regulatory perimeter is being extended. Some of the relatively less supervised institutions that were problematic prior to the crisis no longer exist – for example, US investment banks failed, or were converted into, or assumed by, regulated banks. But other institutions whose actions could on occasion be of systemic importance, such as hedge funds, are being subjected to more oversight. Fourth, attempts are being made to help the cross-border issues with the creation of supervisory “colleges” for large institutions. These are designed to promote better sharing of information across countries. Agencies on the Financial Stability Board are also working on protocols for cross-border crisis management. Regarding pro-cyclicality, proposals are being developed for the use of capital regulations that would require banks to increase capital in the good times that can then be run down during a crisis. The proposals involve introducing target counter-cyclical capital buffers, above the re-designed minimum capital requirements. The Basel Committee is also working to promote the use of more forward-looking provisioning policies based on expected losses, rather than current arrangements that base provisions on losses already incurred. Accounting standard-setters are continuing their work on international convergence and clarity in regulation. They have issued guidance emphasising the need for judgement in valuing mark-to-market assets when markets for those assets are inactive, are working to simplify the valuation rules for financial instruments, and are seeking to close loopholes that generated incentives for off-balance sheet activities. Some observations All of this is worthwhile work. It forms part of a comprehensive set of responses to the conclusions drawn from the crisis. Implementing it presents a very demanding schedule for regulators. I want to offer a few observations about what we might realistically expect over time. These are not criticisms, but rather nuances that are, in my view, worth noting. The first is that the right balance needs to be struck between more regulation and more effective enforcement of existing regulation. There is no doubt that regulation can be improved after an event like this. Yet some jurisdictions ended up with very serious problems, while others did not, even though they were all, more or less, operating on the same internationally agreed framework for bank supervision. Why that was so remains a question of interest. Secondly, on the assumption that most of these regulatory changes go ahead, one effect will presumably be to make the process of financial intermediation more costly. The intention, after all, is that lenders will operate with more capital against the risks they are taking. But capital is not free; shareholders have to be induced to supply it, and it will have to be paid for. High-quality liquid assets typically carry lower yields too, so mandating higher liquidity will have some (modest) cost as well. Admittedly it can be argued that shareholders of financial institutions will have a less risky investment and so should be prepared to accept lower returns. But customers of financial institutions – depositors and borrowers – will also pay via higher spreads between what lenders pay for funds and what they charge for loans. That is, they will pay more ex ante to use a safer financial system, as opposed to taxpayers having to pay large costs ex post to re-capitalise a riskier system that runs into trouble. Now of course protecting the interests of taxpayers is very important, and there is no doubt that certain types of behaviour need to be backed with much more capital, if not severely curtailed or even stopped altogether. It is appropriate that pricing play a role in achieving that. We should try to ensure, however, that the cost is no more than necessary. The most egregious behaviour was mainly that of 30 to 40 large, globally active banks. They have imposed very large costs on their own banking systems, economies and taxpayers, and on the global economy. But there are thousands of other banks in the world whose risk appetite did not get out of control, that have remained solvent, and that have not needed public capital injections. So it will be sensible to ensure, as far as we can, that the proposed measures act effectively to constrain the worst excesses of the former without unnecessarily shackling the latter. I am personally not persuaded of the intellectual basis of the simple overall leverage ratio. It goes against the whole thrust of the idea that capital should be allocated against economic risk – after all, the Basel risk weights are a sophisticated leverage ratio already. I have not seen persuasive evidence that the banks of countries that had a leverage ratio in place have systematically outperformed those that did not. Nonetheless, it had already been agreed, before Australian officials joined the Basel Committee, that such a device would be introduced as a “back-stop” to prevent extreme leverage in instances where the Basel rules, for some reason, may not. Provided that it is suitably calibrated, the leverage ratio will probably not do any great harm. That is, however, a very important provision. Were it to be calibrated in a way that unnecessarily constrains the common or garden variety commercial bank, it could be unduly costly. So the calibration is important and in this regard it is critical that adequate time be allowed for the completion of the technical work in assessing the quantitative impact of this measure. That will take at least another year. As far as the proposed counter-cyclical capital buffers are concerned, this is an appealing idea, based on the notion that it is precisely at the moment when capital appears to be abundant, profits high and the economy booming that true risk is approaching its peak. Requiring more capital to be put aside at that time, which can then support balance sheets after the cycle turns, sounds very desirable. But we should not think it will be easy to achieve. The proposals appear to involve balancing a degree of mechanical linkage to particular variables – such as credit – with an appropriate degree of short-term flexibility. Those familiar with the old debates about rules versus discretion in monetary policy might notice an echo here. Based on experience in monetary policy, I am sceptical about the durability of hard rules, but all too familiar with how difficult it can be to deliver genuinely counter-cyclical policy. There is no reason to think it will really be easier when using prudential tools for “macro-prudential” purposes. That is not to say that we can’t devise a framework combining certain rule-like behaviour with a sensible degree of discretion, but it might take a while. In the case of monetary policy, it took a couple of decades or more. 2 If one is inclined to place a good deal of importance on quality supervisory judgement – as I think we have to – as much may be achieved by adjustments to accounting arrangements for We ended up with a form of constrained discretion: a reasonably clear medium-term objective combined with short-term operational flexibility, and independence of the decision maker from the day-to-day political process (with accountability to legislatures). The counterpart framework for counter-cyclical capital management will, if it is to be successful, require similar elements, including the independence of the relevant decision-maker – from both the political process and the markets and institutions affected by the decisions. 163/2009 provisions as by a complex set of variable capital ratios. What is needed is to allow banks more easily to make more forward-looking provisions when either they or the supervisor thinks they should. This is an important area of work for regulators. One should also be realistic that while using balance sheet regulation as a macro-prudential tool may have attractions, it is no panacea. Of course there may be occasions when the setting of monetary policy is about right for most of the economy but there is a desire to calm down some over-exuberant borrowing behaviour in a particular sector. In such cases, some kind of temporary regulatory measure may well be useful. But as those with any recollection of Australian experience of the 1960s and 1970s will know, if the fundamental problem is actually that financial conditions are just too easy – that is, interest rates are too low – balance sheet regulation won’t ultimately constrain credit growth. Over time, private markets will find a way of doing the business outside of the regulated sector. Then the authorities face the question of whether or not to expand the scope of regulation to more sectors – just as we did in the 1970s. A possible outcome is that, the harder we regulate a set of institutions as a result of the last crisis, the more likely it becomes that the next crisis occurs in the hitherto unregulated part, perhaps even among institutions that do not yet exist. If the conditions are such that people want to take risk and gear up, they will find a way. Of course, that is acceptable provided the relevant private parties can be allowed to fail without bringing down the core part of the system. Caveat emptor can apply outside of the regulated net if there are few spillovers. But if risk-taking activity goes on long enough, then sufficient leverage may well accumulate somewhere to make the ensuing deleveraging generally disruptive, placing policy-makers once again in a very awkward situation. Too big to fail And that brings us to the most difficult of all the issues, namely that of the too-big-to-fail institution. Here the term “big” might mean a large balance sheet, or refer to interconnectedness or complexity. Or all three of the above. In some countries, the debate on this issue is now quite active. One potential response is a tax on size: much higher capital requirements for “systemic” institutions so as to lower greatly the probability of a failure of a really large firm, either by making large firms much less risky, or giving them an incentive to no longer be large. Another approach would simply be much more intensive – and intrusive – supervision of such entities. Either of these measures could be complemented by the requirement that a large firm compile a “living will”, in which it writes its own break-up/winddown plan ahead of time – in the process, hopefully, highlighting those bits of complexity that ought to be removed while it is still alive. Before regulators even got to any of those possibilities, they would have to grapple with the practical difficulties of setting the threshold as to what constitutes “systemic”. Expect furious lobbying by the finance sector on that. Nor is this issue just domestic in nature. It goes to the heart of what it means to have a globalised financial system. In the absence of clearly articulated rules about burden sharing, a potential failure of one of these institutions is further complicated because the frameworks for global governance and crisis resolution have not kept up with the process of globalisation itself. It is very hard for them to do so. Even in a region such as Europe where there has been six decades of continuous effort in building collective structures, the resolution of problems at entities like Fortis has, by all accounts, been very difficult. One response to that would be to unwind the globalisation of the financial institutions and go back to having local banks just doing local business. That seems absurdly costly, though – in general, capital flows have been a tremendous force for higher living standards over the long run. It would surely be a retrograde step to shut them off. A less radical response would be subsidiarisation – where foreign banks have a presence in the form of locally capitalised and governed structures, in which local authorities could intervene in the event of a shock in another country affecting the viability of the parent. That still entails some costs in terms of efficiency, albeit ones that countries might now be prepared to tolerate. To succeed in this approach, a country would need to have the capability and resources to ensure the viability of a local subsidiary of a failed major global institution, taking control of it if necessary. This would be at a time of tremendous damage to the relevant global brand. For many small countries this might be a big ask. In the crisis itself, the too-big-to-fail issue presented simply as an imperative for a number of governments to prevent failures. But as the crisis recedes, and the global financial system is gradually nursed back to health, it is this issue that is going to leave the biggest lingering challenge. The Financial Stability Board will be directing particular attention to it over the coming year. It is not likely to be amenable to simple solutions, or easy ones. In the mean time, enormous moral hazard, perhaps greater than ever before, exists in the global financial system as a result of the actions – albeit essential ones in the circumstances – of 2008. Conclusion A year ago, I wished this audience a much less interesting 2009. That wish was partly fulfilled in that 2009 was less “interesting” than 2008, though still not quite boring enough in my view. As 2009 draws to a close, things in the global financial system look much less worrying than they did a year ago. With the sense of immediate crisis much reduced, regulators can devote more focus to the job of designing and implementing changes to regulatory frameworks – work that is better done outside a period of crisis anyway. Realistically, the task is to reconfigure regulatory frameworks to lower the probability, and the cost, of future crises while assisting recovery from the recent one. That is every bit as difficult a challenge as getting through the immediate crisis itself. It will require very careful judgment to strike the right balance between costs and benefits of revised regulatory structures and practices, and due regard to the possibility of unintended consequences. It will also take a great deal of determination on the part of regulators to enforce arrangements adequately in future booms. And there is little doubt such booms will occur because, ultimately, the cycle of greed and fear itself cannot be regulated away. To assume that unrealistic optimism will not again, at some point, overwhelm the more sober instincts of investors, bankers, commentators and others would be a triumph of hope over experience. But it can’t be beyond us to achieve some worthwhile reforms in this area and 2010 is a year in which we can hope to make some progress. I wish all of you a Merry Christmas and a prosperous and stable new year. 163/2009 | reserve bank of australia | 2,009 | 12 |
Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 22nd Australasian Finance & Banking Conference, Sydney,16 December 2009. | Ric Battellino: Some comments on bank funding Remarks by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 22nd Australasian Finance & Banking Conference, Sydney,16 December 2009. * * * I would like to thank Michael Davies, Anna Brown and Tegan Hanrick, who undertook the research for this talk. One of the widely drawn lessons from the financial crisis is that banks should source more of their funding from deposits and less from short-term debt markets. I want to spend some time today talking about this, focusing in particular on: • how significant are the benefits of such a shift? • how feasible is it for banks to shift their funding sources? • what is the impact on banks’ cost of funds? and • what are the implications for the level of interest rates? Bank funding Banks in Australia have reasonably diverse funding bases: deposits account for 43 per cent of funding, split fairly evenly between households and businesses; domestic capital markets provide a further 19 per cent of funding; and foreign capital markets 28 per cent. Securitisation and equity account for 3 per cent and 7 per cent of funding respectively (Graph 1). Graph 1 Since mid 2007, the share of banks’ funding that has come from deposits has risen by 5 percentage points, with increases in both household and business deposits. Banks have used these funds to replace some of their short-term capital market debt. The increased use of deposit funding has been evident in both the major banks and in the regional banks. The foreign-owned banks, in contrast, have experienced a fall in the proportion of funding coming from domestic deposits (Graph 2). Graph 2 How stable are bank deposits? Assessing the relative stability of banks’ various funding sources is not straightforward, as there can be significant variation even within each category of funding. For example, government-guaranteed deposits are “stickier” than non-guaranteed deposits, household deposits tend to be stickier than corporate and institutional deposits, while internet deposits are less stable than other at-call deposits. Deposits from corporates and other financial institutions are unlikely to be much more stable than short-term debt, particularly in a crisis. Offshore capital market funding can be less stable than domestic capital market funding, as during crises investors often have a strong home bias. The behavioural maturity of a given funding source can also be very different from the contractual maturity, especially during financial crises. It is the behavioural maturity that matters most, and during a severe crisis this can shorten significantly for many funding sources. This is because banks can come under pressure to allow term deposits to be redeemed early and to buy back short-term capital market debt. While a bank could try to enforce the contractual maturity on its funding, the reality is that, unless the bank is already in great difficulty, this could draw attention to itself and accentuate its problems. Another issue is that the behaviour of new depositors attracted through more competitive pricing may also be very different from that of existing depositors. These new deposits are likely to be more price sensitive and less stable. The benefit, in terms of funding stability, which comes from increasing deposits through competitive pricing, may therefore be somewhat illusory. How do Australian banks compare internationally? There is a common perception that banks in Australia make less use of deposits to fund themselves than do banks in other countries. However, the difference between Australian banks and their overseas peers is sometimes exaggerated by inconsistencies in the data across countries. Table 1 contains some data the Reserve Bank has put together on deposit funding for the major banks in Australia, Canada, Germany, Japan, the United Kingdom and the United States. We have tried to make the data as consistent as possible although they are probably still a long way from being fully consistent. The data show that, contrary to popular perception, the share of funding from deposits for the major banks in Australia is similar to that for the major banks in Germany, Japan, the United Kingdom and the United States. 1 Table 1 Share of domestic and foreign deposits in total funding1 December 2008, per cent Major banks Australia Canada Germany Japan United Kingdom United States Data based on the major banks in each country. Deposits include CDs. Total funding equals total liabilities, excluding derivative liabilities. Sources: central banks, national statistical agencies, banks’ financial statements, Standard and Poor’s, RBA. Another commonly quoted metric used to support the case that Australian banks are underweight deposits is the relatively high ratio of loans to deposits in Australia. The ratio for the major banks in Australia is around 130 per cent, whereas in most overseas countries the ratio varies between 80 per cent and 100 per cent (Table 2). However, as I have noted, this is not due to Australian banks having lower deposit funding. The high ratio of loans to deposits reflects differences in asset composition. Banks in Australia mainly have loans on the asset side of their balance sheet, whereas banks overseas often have large holdings of debt securities. This results in a higher ratio of loans to deposits in Australia. But, rather than being a weakness, I would regard this as a strength of the Australian banks, as events of the past couple of years have shown that holdings of securities can be more risky than loans. Table 2 Ratio of loans to deposits1 December 2008, per cent Major banks Australia Canada Germany Japan United Kingdom United States Data based on the major banks in each country. Foreign and domestic loans and deposits (including CDs). Sources: central banks, national statistical agencies, banks’ financial statements, Standard and Poor’s, RBA. The figures for deposit shares in the table are higher than the figures quoted earlier in this talk because of definitional differences. To allow international comparisons, the figures for deposits in the table include CDs and are for the banking group, and hence include overseas as well as domestic operations. The denominator used to measure total funding is on-balance sheet liabilities (excluding derivatives) rather than total funding including equity and securitisation. How far can banks lift their deposit ratios? An individual bank has a large amount of discretion in the way it funds itself, as it can bid more aggressively for the type of funds it wants and compete them away from other banks. The banking sector as a whole, however, has much less flexibility. For the banking sector as a whole to increase its use of deposit funding, it needs to be able to induce a shift in the structure of the financial system away from financing through capital markets to on-balance sheet funding through the banking sector. Put another way, for the banking system as a whole, the share of deposits in total funding can increase only to the extent that investors reduce their holdings of securities and place the proceeds on deposit with banks. There are limits to the extent this can happen since there are a range of structural, economic and cultural factors that shape the composition of a financial system, and these do not change quickly. In fact, the trend in most economies is for savings over time to move away from simple instruments such as bank deposits towards debt securities and equities. To try to shift savings back to deposits would require a reversal of these trends, and there must be doubts about how feasible that would be. There is also the question of whether it would be sensible from the point of view of the overall functioning of the economy and the financial system. As I noted earlier, over the past year Australian banks as a whole have managed to increase the share of their funding that comes from deposits. However, the bulk of this occurred during the period of high risk aversion late last year and early this year, when investor perceptions were that bank deposits were safer than debt securities and unit trusts. Over the past six months, as risk appetite among investors has returned, the deposit funding share of banks has stopped rising. It would seem that banks have largely exhausted the available opportunities to induce investors to increase their holdings of bank deposits. The so-called “deposit war” among banks is producing very attractive interest rates for depositors but little net benefit for the banking system as a whole in terms of increasing deposit funding. What is happening to the cost of deposits? The increased competition by banks for deposits has added substantially to their cost of funds. It used to be the case that on average banks paid about 125 basis points less than the cash rate on deposits. Now they are paying interest rates that are on average in line with the cash rate (Graph 3). In the case of term deposit “specials”, which are the main vehicle through which banks are currently competing for deposits, interest rates can be as much as several hundred points above the cash rate. Graph 3 Table 3 shows how the cost of various types of funding for the major banks has changed, relative to the cash rate, since the start of the financial crisis in mid 2007. It shows that the cost of new deposits has risen on average by 147 basis points relative to the cash rate over that period. This rise was mainly driven by an increase of about 250 basis points in the relative cost of term deposits. The cost of short-term debt relative to the cash rate has not changed much over the period, while the cost of new long-term debt has risen by 173 basis points relative to the cash rate. Table 3 Estimated change in cost of new funds relative to the cash rate – major banks Since July 2007 Basis points Deposits – transactions – savings – term Short-term debt (incl CDs) Long-term debt Total Source: RBA. The table indicates that the push by banks to increase the share of their funding that comes from deposits has added substantially to their costs. At the same time, the cost of long-term debt has risen sharply relative to the cash rate because of the global crisis. These changes in banks’ cost of funds relative to the cash rate have meant that the relationship between bank lending rates and the cash rate has also become looser. It is difficult for banks to adjust their lending rates in line with changes in the cash rate when the cost of their funds is rising substantially relative to the cash rate. We estimate that if banks had not adjusted their lending interest rates to reflect their higher cost of funds over the past couple of years, they would now be incurring losses (Graph 4). That would have threatened their ability to keep raising funds and, in turn, their capacity to lend. In the event, early in the financial crisis, banks did not pass on all of the increase in their cost of funds, but recently increases in lending rates have run ahead of the cost of funds. Banks’ margins are now a little wider than at the start of the crisis, and therefore are adding to profits. Graph 4 The margin between the cash rate and banks’ lending rates receives considerable public attention. This is understandable because changes in it are very visible. This margin, however, can change for many reasons, so it is difficult to interpret. A widening in it might be due to banks making unjustified increases in their lending rates, or it might reflect market developments that have pushed up banks’ cost of funds relative to the cash rate. Some have argued that variability in this margin means that monetary policy is less effective. This, however, misses the very important point that the Reserve Bank takes account of the changing relativities between the cash rate and other interest rates when setting the cash rate. Other things equal, if interest rates in the economy are rising relative to the cash rate, there is less need for the cash rate to rise. The more relevant margin is that between the average interest rate on bank loans and the average cost of the funds used by banks to finance their loans. This is usually referred to as banks’ net interest margin. Between 2000 and 2007, the net interest margin on the major banks’ Australian operations had narrowed by about 100 basis points (Graph 5). This was driven by competition, and was made possible by sizeable reductions in banks’ operating costs over that period, which allowed banks to continue operating profitably despite falling margins. Graph 5 As I mentioned, early in the financial crisis, the banks’ net interest margin was squeezed further, as the cost of funds rose sharply and banks did not fully pass this on to interest rates on loans. Over the past year or so, however, margins have widened again, and they are now about 20 basis points above pre-crisis levels. This recent widening in the net interest margin has been largely due to wider margins on banks’ business lending. The margin on variable housing loans is much the same today as it was at the start of the crisis; it had fallen until recently and the increase in home loan interest rates in December restored it to around its pre-crisis level. Margins on business loans, however, are now substantially higher than they were immediately before the crisis. This comes after a prolonged period when margins on business loans had narrowed. Margins on business loans tend to vary over the economic cycle, reflecting changes in perceptions of risk by banks. During periods of a strong economy, banks tend to cut their margins as they see business loans as being less risky. In contrast, when the economic and business outlook is uncertain and loan losses are rising, as has been the case over the past couple of years, banks see loans as being more risky and margins widen. With the economy and business climate now improving, the economic justification for wider margins on loans is becoming less compelling, so it would be reasonable to assume that, in a competitive banking sector, we should see margins level out soon. Over the past couple of months, there have been some signs that this is starting to occur. What does this mean for monetary policy? As I have noted, over the past couple of years, the interest rates that matter in the economy – the rates on housing and business loans and the rates on deposits and debt securities – have all risen relative to the cash rate (Graph 6). The Reserve Bank has taken these changing relativities into account in its monetary policy decisions. Graph 6 One of the implications of doing so, however, is that it has altered the relativity of the cash rate compared with its historical ranges. I want to end with a few words on this, and what it means for the interpretation of monetary policy settings. As you know, the cash rate is currently 3.75 per cent. This is still 50 basis points below the previous cyclical low of 4.25 per cent in 2001. On the surface this might suggest that the cash rate is still unusually low. However, with other interest rates in the economy having risen by at least 100 basis points relative to the cash rate over the past couple of years, they are now above their previous cyclical lows. Another way to think about this is that the current level of deposit rates, housing loan rates and business loan rates would have been consistent, before the crisis, with a cash rate of at least 4.75 per cent. Taking these considerations into account, it would be reasonable to conclude that the overall stance of monetary policy is now back in the normal range, though in the expansionary segment of that range. The appropriateness of this will be monitored by the Reserve Bank over the months ahead in the light of the data becoming available on economic activity and inflation. | reserve bank of australia | 2,009 | 12 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 19 February 2010. | Glenn Stevens: Overview of the Australian economy and future challenges Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 19 February 2010. * * * Since we last met the global economy has continued an expansion that started around the middle of 2009. It appears that world GDP grew at an annualised pace of about 4 per cent in the second half of last year. Many forecasters now expect a similar result in 2010. International financial markets have generally continued to thaw, with most capital markets functioning again and the use by banks of exceptional support from central banks and government guarantees being wound down. These are, needless to say, very welcome developments. Having said that, the situation is not without some challenges. I will mention just two. The first is the two-speed nature of the global recovery. Normally after a sharp downturn, the ensuing upswing is correspondingly strong. This has been the case among a number of Asia-Pacific economies, which take half of Australia’s exports. The strength is not confined to China: India, Korea, Singapore, Taiwan and others have all seen a significant pick-up in production and trade. In several of these instances the term “v-shaped recovery” would be apt. Around the region, secularly rising incomes, generally healthy banking systems and relatively low public debt levels allow considerable room for confidence of a sustained expansion in demand. In fact in some cases the issue of overheating is arising and the authorities in both China and India have begun to tighten their policy settings. In the large industrial countries, on the other hand, the rebound has been more tentative, and driven more by the turn in the inventory cycle and temporary policy measures than a strong pick-up in private demand. It is not unusual, at this point of the recovery, for the inventory dynamics to be playing a prominent role in pushing up output. Nonetheless, the question is the extent to which a durable upswing in private final demand in the various countries will become established. Most observers expect this to be a fairly gradual process, given the lingering effect of the strain on banking systems and ongoing de-leveraging, not to mention the need, at some point, to begin the process of fiscal consolidation. Growth in these cases is therefore expected to remain modest and, as a result, these economies are likely to be characterised by a lot of spare capacity and ongoing high unemployment. So the historic shift in the centre of economic gravity to the Asian region is continuing, and if anything it has been highlighted by the different performances during the crisis and initial recovery. The differences in speed of recovery between the emerging world and the advanced world, and the likely persistent differences in growth trajectories into the future, will increase the pressure on exchange rate arrangements in the region. The second challenge is the increasing focus on sovereign creditworthiness. We saw a brief period of turmoil regarding Dubai late last year, and more recently the public finances of Greece have been under the spotlight, with some other European countries just in the background. Going beyond just these instances, government balance sheets in numerous countries have taken on considerable burdens as a result of the crisis, and markets are beginning to focus on issues of sustainability. It will be a very delicate balancing act for those governments to strengthen their fiscal positions without undermining the upturn in their economies. Happily, in both these areas, Australia is relatively well-placed. We are located in the part of the world that is seeing the most growth. And in terms of fiscal sustainability, Australia’s position is, by any measure, very strong indeed. Turning to Australia, we think on the basis of available data that real GDP grew by about 2 per cent through 2009. We expect that it will grow by a bit over 3 per cent for 2010 and about 3½ per cent in 2011 and 2012. Notwithstanding reports of patchy retail sales through the Christmas period, we judge consumption to have held up reasonably well after the various fiscal boosts faded. But in the future consumption is unlikely to be a leading driver of growth to the extent it was a few years ago. Households seem to be adopting a more cautious position regarding saving and borrowing, which is appropriate. A turnaround in private housing construction is under way. The effect of the temporary firsthome buyers’ boost is fading, but underlying demand is solid as a result of population growth and there is something of an “underhang” of earlier low construction to work off. Credit costs and availability are adequate for households. While for developers credit remains quite difficult to access, it looks like we have seen a turning point in approvals for multi-unit construction. Housing prices have been rising quite smartly over the past year. Government spending is having an impact on demand, holding both residential and nonresidential construction at higher levels than would have resulted from private spending alone. This effect will gradually diminish over the next year. At the same time, a large buildup in energy and resource sector investment is under way, prompted by optimism about long-run prospects for resource demand. The terms of trade are rising after last year’s sharp fall, as the strength of demand has pushed up key commodity prices. In 2010 they could once again reach a very high level, exceeded in modern times only by the extraordinary level reached in 2008. Inflation has been falling, in line with recent forecasts. It is important to remember that inflation reached 5 per cent in 2008, or just over 4½ per cent in underlying terms. This was much too high. The earlier period of tight monetary policy, and the weakening in demand in late 2008 associated with the escalation of the financial crisis, has seen inflation come down. Over the past year, it was about 2 per cent on a CPI basis and about 3¼ per cent in underlying terms. Over the past six months, underlying inflation ran at an annualised pace of under 3 per cent. We think it will be about 2½ per cent in 2010. It is normal, given the lags in these processes, for inflation to keep declining for a while after the economy begins to firm. With the economy having had only quite a mild downturn, however, we start the new upswing with less spare capacity than would typically be the case after a recession. One measure of this is that the rate of unemployment peaked at less than 6 per cent, much lower than we or most others forecast. Only a few years ago, unemployment rates like this would have been seen as a good outcome in strong times, let alone in times of economic weakness. The general flexibility in the labour market, including the ability of firms and employees to adjust hours of work, limited the rise in numbers unemployed. But the overall size of the downturn in economic activity also proved to be considerably smaller than thought likely a year ago. This is of course a very good outcome. But it also means that there is less scope for robust demand growth without inflation starting to rise again down the track. Monetary policy must therefore be careful not to overstay a very expansionary setting. This situation is quite different from those faced by the major countries. Whereas many of them had their worst recession since World War II, Australia probably had its smallest. As such, it should not be surprising that Australia was among the first countries to begin to raise interest rates, once it was clear that the danger of a really serious contraction in economic activity had passed. The Board lifted the cash rate in October, November and December. Most lenders raised borrowing rates by a little more than the cash rate. Allowing for these margin changes, borrowing rates are still below average but not by as much as the cash rate. We have taken careful note also of non-price credit conditions. For large firms, access to capital market funding, both debt and equity, has been good. For some other business borrowers, access to credit has remained difficult, though we have some suggestions in our liaison now that this may be starting to ease. Furthermore it appears that the rate at which lenders are having to make provisions for bad loans has slowed noticeably, which is not surprising given that economic conditions have been improving. Given that, it is reasonable to expect that lenders will become more willing to lend over the coming year. That said, it seems unlikely that we will return to the easy credit conditions of three years ago. The world has changed, for a while at least. Moreover, the likely course of international standards for regulation over the next few years will probably, at the margin, act to raise the cost of intermediation by requiring banks to hold additional capital and liquidity. If economic conditions evolve roughly as we expect, further adjustments to monetary policy will probably be needed over time to ensure that inflation remains consistent with the target over the medium term. This is a normal experience in an economic expansion: as economic activity normalises interest rates do the same – though of course it is the interest rates borrowers actually pay, and that savers receive, that are important rather than the cash rate per se. The Board sets the cash rate with that in mind. Mr Chairman, I have previously said that Australia would come through the global crisis well placed to benefit from renewed expansion. For a time, the challenge was to sustain confidence, and to support the economy and financial system through some exceptionally demanding circumstances. By and large those efforts were successful. Now we must turn our attention to the challenges of managing an economic expansion. Issues of capacity, productivity, flexibility, adaptation to structural change and so on will once again come to centre stage, as they should. For our community to tackle those challenges successfully, monetary and financial stability are important conditions. The Reserve Bank will do all that it can to secure them. I look forward to your questions. | reserve bank of australia | 2,010 | 2 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to The Sydney Institute, Sydney, 23 February 2010. | Ric Battellino: Mining booms and the Australian economy Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to The Sydney Institute, Sydney, 23 February 2010. * * * Introduction The topic of my talk tonight is “Mining Booms and the Australian Economy”. I have chosen this topic because the Australian economy is currently experiencing a surge in mining activity, one of a sequence of mining booms since the European settlement of Australia. These have been a powerful force in shaping the Australian economy. Tonight I want to review the effects of these booms. Of particular interest is the question of whether there are recurring themes from which we can draw lessons on how to manage the current episode. My talk is based on research by a couple of my colleagues from the Bank which draws on the work of several economic historians. 1 I won’t take time to list these references now, but they are shown at the end of the version of my talk on the Bank’s website. Mining booms in Australia The distinguishing features of a mining boom are significant increases in mining investment or mining output, usually both, which go on to have important macroeconomic consequences. On this basis, I think we can identify five major mining booms during the past two hundred years or so. These are: the 1850s gold rush; the late 19th century mineral boom; the 1960s/early 1970s mineral and energy boom; the late 1970s/early 1980s energy boom; and the current episode, which is again both a mineral and energy boom. I would like to thank Ellis Connolly and Christine Lewis for this work. The data underlying the graphs in this speech are drawn from multiple data sources, which may affect the comparability of series over time. There have also been quite a number of other mini booms in mining activity, but given the time available I am going to limit myself to the five episodes I have just noted. I will start with a brief summary of the causes, characteristics and consequences of each of the booms, and then provide a more general assessment of their macroeconomic implications. (a) The 1850s gold rush The 1850s gold rush was the first major mining boom in Australia. Economic historians note that the timing of these gold discoveries may have been related to international developments such as the California gold rush of the late 1840s, which had heightened general interest in gold exploration and mining. The first well publicised find of gold in Australia, near Bathurst in New South Wales, was by a veteran of the California gold rush. Domestic economic developments may also have influenced the timing, as the continuing effects of the 1840s recession meant that labour in Australia was abundant and mobile, and therefore more likely to become involved in prospecting. 2 This boom ended up being mainly centred on the gold fields of Victoria. It was atypical compared with later booms in that it was not accompanied by a large increase in mining investment. At that stage, large amounts of capital were not readily available and, in any case, the form of mining that was taking place – surface alluvial mining – was well suited to large inputs of labour and little input of capital. The boom lasted for about a decade and a half; by the mid 1860s, the gold rushes of Victoria had largely faded. Measured in terms of value added to GDP, this boom greatly exceeded all subsequent mining booms. At its peak in 1852, mining comprised about 35 per cent of GDP. 3 This created tremendous upheavals in the economy at the time. The value of exports from New South Wales and Victoria rose by a factor of six in three years, and exports of gold exceeded wool exports for the following 18 years. 4 See Blainey (1963), p12; Blainey (1970). See Butlin (1985). See Maddock and McLean (1984); Doran (1984). Labour flowed strongly to the gold states, particularly Victoria, and Melbourne became the largest city in Australia. Some of this flow of labour came from other states. For example, the male populations of South Australia and Tasmania fell by 3 per cent and 17 per cent respectively in 1852. But a large amount of labour also came from sharply increased immigration; the Australian population almost trebled during a 10-year period. 5 Wages rose sharply, at first in mining, then across the country as labour flowed to the diggings. Between 1850 and 1853, wages in Victoria rose by 250 per cent. 6 Colonial governments had no powers over the money supply or the exchange rate. 7 The money supply trebled in the space of a couple of years. All the adjustment in the economy took place via inflation. The rise in inflation meant that by the middle of the boom the real exchange rate was about 50 per cent higher than at the start. There was evidence of what we now call the “Dutch disease” – i.e. damage to some nonmining industries because of the difficulty of retaining labour, increased costs and the high real exchange rate. 8 For example, shepherds’ wages doubled between 1850 and 1853, creating difficulty for the wool industry and wool exports grew at much reduced rates. Also, according to one data source, the number of manufacturing establishments in New South Wales fell from 165 in 1850 to 140 a couple of years later. 9 The overall impact on economic activity was, however, highly positive. Confidence was high, the flow of immigration greatly boosted demand for goods and services, and industries servicing the mines – e.g. sawmilling, brick-making and transport – all boomed. Parts of agriculture also benefited from greatly increased demand for food. The infrastructure provided to service the mines – such as extensive road-building – went on to have many positive effects in terms of opening up agricultural land. GDP growth remained very strong for a decade after the boom peaked. 10 Despite having a new source of tax and licence revenue, governments faced pressures in their finances, both because of strong demand for infrastructure spending and sharply rising costs of providing it. In 1853, for example, the Victorian Government spent £520 000 on roads, compared with £11 000 two years earlier. 11 Governments therefore resorted to borrowing, which they did through London markets. They found this relatively easy to do, as the discovery of gold had made the colonies more creditworthy. (b) The late 19th century mineral boom The second boom was that in the late 19th century. This boom was driven by the discovery and development of new gold and metal mines across the country, but particularly in Western Australia, Queensland and western New South Wales. Partly this was the natural consequence of the spread of the population to more remote areas, but partly it reflected capital market developments. There was ample capital available in London to fund exploration activities as the recession in the early 1890s had led to a fall in investment opportunities. Also the development of the “no-liability” See Blainey (1963) p62; Maddock and McLean (1984). See Maddock and McLean (1984). See Maddock and McLean (1984). Gregory (1976). See Maddock and McLean (1984). See Blainey (1963) p62; Butlin (1986); Doran (1984); Maddock and McLean (1984). See Doran (1984). company made it much easier to access this capital. In 1894, 94 Western Australian companies had been floated in London; two years later there were 690. 12 Sadly for the British investors, much of this money was never repaid in dividends, an indication of the risks that can be involved in mining investment. The main part of this boom took place against a very subdued economic background, both in Australia and in the major economies. The financial collapses that occurred after the bursting of the 1880s property bubble had led to a global depression with very large falls in output and high unemployment. The continuing effects of that financial collapse meant that this boom, somewhat unusually, was not accompanied by a sharp acceleration in money supply growth. Similarly, the large amount of spare capacity in the economy meant that there was significant deflation at the start of the boom, which limited the subsequent peak in inflation. There were some pressures on wages as the unemployment rate fell sharply from the very high levels of the early 1890s, and there were signs of rising industrial disputation. The real exchange rate, however, did not move much through this episode. 13 The current account, which had moved to a very large deficit during the 1880s property bubble (13 per cent of GDP) moved back to a more normal small deficit in the 1890s, and eventually into surplus when the mining boom ended and the economy slowed in the early 1900s. 14 The inter-regional effects of the boom, as in the 1850s, were very powerful. There were strong flows of labour to the new mine sites. The population of Western Australia increased from 48 000 to 180 000 during the 1890s; and the population of Broken Hill grew from 6 000 in 1888 to almost 20 000 in 1891. Charters Towers had its own stock exchange. 15 There were also significant shifts in industrial composition. Exports of wool and grains stagnated and metals took over as Australia’s leading export. 16 Eventually, the combination of rising costs and falling profits meant that capital dried up, investment fell, and the boom ended. Some of the policy actions taken at that time – such as the imposition of tariffs to protect urban industries – had powerful long-run influences. 17 (c) The 1960s/early 1970s boom The third boom was that in the 1960s/early 1970s. This boom was quite broadly based, but the key parts were sharp increases in mining of coal and iron ore, and the development of oil and bauxite discoveries. The background to this boom was that both the global and domestic economies were becoming increasingly stretched, with rising commodity prices and rising inflation more generally. Particularly important for Australia during this period was the economic development of Japan. As well as adding to the global demand for resources, this had particular significance for Australia because Japan’s proximity lowered transport costs and made certain mineral discoveries economically viable. See Blainey (1963) pp187, 190. See Blainey (1963) p303; McKenzie See Belkar, Cockerell and Kent (2007). See Blainey (1963) p194; Doran (1984); Withers et al (1985). See Blainey, (1963), p248. See Blainey, (1963), p289. This boom differed from the episodes in the 19th century in that it was more capital intensive. Partly this reflected supply factors, as global capital markets had developed significantly since the turn of the century. Partly it was also technological, as some of the resources could only be developed with large-scale investment. Mining investment rose from about ½ per cent of GDP in 1960 to a peak of almost 3 per cent in the early 1970s. Export prices rose strongly, particularly in the early 1970s, resulting in a large swing in income towards exporters. The current account of the balance of payments moved to surplus, an outcome that has not been repeated since. Employment grew strongly in the second half of the 1960s, by close to 3 per cent per annum, due to large-scale immigration and increased female participation. Wages rose strongly, and the centralised wage fixing system spread the increases widely through the community. The nominal exchange rate remained relatively fixed until towards the end of the boom, the eventual appreciation of the exchange rate in the early 1970s coming too late to benefit the economy. Money supply growth picked up to over 20 per cent per annum in the early 1970s and fiscal policy also became expansionary. Inflation rose sharply. Tariff cuts were introduced in 1973 to help control inflation, but the benefit of this was later offset by the imposition of import quotas to try to protect manufacturing jobs. By the mid 1970s, both the Australian economy and the global economy were experiencing severe difficulties, primarily flowing from the adverse consequences of very high inflation. The boom therefore ended; mining investment fell to low levels, and commodity prices stagnated. (d) The late 1970s/early 1980s boom The fourth major boom was in the late 1970s/early 1980s. This boom was largely driven by the energy sector, in particular steaming coal, oil and gas. This followed the second of the oil price shocks in the late 1970s. In addition, the increased cost of energy made Australia an attractive place for energy-intensive activities such as aluminium smelting. Investment in mining started to pick up in the late 1970s and increased sharply in 1981 and 1982. This mining boom led to a sense of euphoria about Australia’s future which was accompanied by a resurgence of wage demands and rising inflation. Monetary and fiscal policies were tightened but did not succeed in keeping the economy in check. The exchange rate system at that time involved management of the Australian dollar against a trade-weighted index of currencies. The authorities followed a policy of appreciating the exchange rate, but, with the benefit of hindsight, the rate of appreciation was relatively mild and did little to insulate the Australian economy from rising inflationary pressures. The boom was relatively short-lived. The downturn in the global economy in 1981, following the oil price shock, meant that demand for energy ended up being much less than had been expected; this was reflected in both the volume and the prices of exports. At the same time, the distortions caused by high wage growth and inflation, and the resulting tight policies, meant that by 1982/83 the domestic economy had followed the global economy into a severe recession. (e) The current boom This brings me to the surge in mining investment that is currently under way. This is again very broad based across a range of resources, but the core part centres on the large expansion in the iron ore, coal and gas industries. It has been, to a large degree, driven by demand for resources by emerging economies, with China being the most significant. Judged by the pattern in mining investment and commodity prices, the start of this boom can be dated from around 2005. By 2007 and early 2008, it was severely testing the productive capacity and flexibility of the economy. That all changed in the second half of 2008, as the effects of the mining boon were offset by the impact of the global financial crisis. However, now that this has passed, the underlying dynamics of the resource boom are starting to reappear. Many of the characteristics of this episode have been similar to those of earlier booms, but there are a few key differences worth noting: First, mining investment as a share of GDP has been significantly higher than recorded in previous booms and is thought likely to rise further. In terms of additions to output, the contribution of mining this time has been larger than that during the booms of the 1960s and 1970s, but still below that of the late 19th century and much lower than that in the 1850s. Second, the terms of trade have risen much more than they did in earlier mining booms. The current level of the terms of trade rivals the sharp peaks that were associated with rises in wool prices following the First World War and during the Korean War. The current mining boom has seen both the volume and the price of resource exports rise strongly. Third, this is the first boom during which the exchange rate has been floating, and in which a significant rise in the nominal exchange rate has been an important part of the economic adjustment. This has added an important degree of flexibility to the economy, by allowing the real exchange rate to rise through a means other than inflation. How long the current surge in mining activity will continue is uncertain. Past booms do not seem to have lasted more than about 15 years before resource depletion, or international or domestic developments, acted to slow economic activity and bring the boom to an end. On this occasion, the growth potential of countries such as China and India suggests that the expansion in resource demand could continue for an extended period, though this will depend at least to some extent on the economic management skills of the authorities in these countries, not to mention our own. Assessment The booms that I have described took place over a period of about 160 years, and against very different backgrounds. Yet, some similarities come through. The first point that stands out is the important role played by global events in causing mining booms in Australia. In some cases this was due to the effect on prospecting activity (e.g. the impact of the California gold rush in the 1850s boom and the availability of international capital to fund the 1890s boom); in some cases it was due to a change in the relative prices of commodities on global markets (e.g. the late 1970s boom); and in others due to the emergence of powerful new trading partners (e.g. the development of Japan in the 1960s and the development of China and India recently). The second point is that the overall impact of each boom was to strengthen the economy. Increased investment in mining, higher income from mining activities, and the need for increased infrastructure to service the mines all worked in this direction. Also, each boom had high, or increasing, population growth in its early years which added to the economic momentum. Not everybody benefited from that economic pick-up and some industries went into decline due to the difficulty in competing for workers with the newly expanding sectors. The third point that seems clear from history is that every mining boom was accompanied by increased inflationary pressure. Sometimes this was part of a global story, sometimes it was due to wage behaviour, but the general factor was pressure on the productive resources of the economy due to the expansion of economic activity. Leaving aside the current episode, only in the 1890s boom, which began when the economy had large-scale spare capacity, was the rise in inflation contained to single digits. One interesting issue is the role of the exchange rate in these booms. Theory suggests that part of the adjustment process for an economy experiencing a mining boom is a rise in the real exchange rate in order to facilitate the flow of real resources that is needed. In all the previous booms, however, the nominal exchange rate was either fixed or managed very tightly. The real exchange rate could therefore only adjust through inflation. In the current episode, with a floating rate, the behaviour of the nominal exchange rate has been very different from the past. It has risen early in the boom and by a large amount. This has been an important factor helping to dissipate inflationary pressures. Conclusion Let me conclude. History tells us that mining booms are periods of significant economic change and that they can pose complex challenges for policy makers. Key among these is the need to ensure flexibility in the economy and maintain disciplined macroeconomic policies in order to contain the inflationary forces generated by the boom. History also shows that, in the past, these challenges proved to be quite difficult to deal with. However, in the 30 years since the previous boom, the Australian economy has developed in ways that should make it better able to accommodate the surge in mining activity that is currently under way. The floating exchange rate is a key difference, but goods and labour markets are also more flexible, and the monetary and fiscal policy frameworks are now more soundly based. This gives grounds for confidence that we can do better this time, but the task will not be without challenges. References Blainey G (1963), The Rush That Never Ended, Melbourne University Press, Melbourne. Blainey G (1970), “A Theory of Mineral Discovery: Australia in the Nineteenth Century”, The Economic History Review, 23(2), pp298–313. Belkar R, L Cockerell and C Kent (2007), “Current Account Deficits: The Australian Debate”, Central Bank of Chile Working Paper No 450. Butlin NG (1964), Investment in Australian Economic Development 1861–1900, Cambridge University Press, London. Butlin NG (1985), “Australian National Accounts: 1788–1983”, Australian National University Source Papers in Economic History, 6. Butlin NG (1986), “Contours of the Australian Economy 1788–1860”, Australian Economic History Review, 26(2), pp96–125. Butlin MW (1977), “A preliminary annual database 1900/01 to 1973/74”, Reserve Bank of Australia Research Discussion Paper No 7701. Doran CR (1984), “An Historical Perspective on Mining and Economic Change”, in LH Cook and MG Porter (eds), The Minerals Sector and the Australian Economy, George Allen & Unwin Australia, Sydney, pp37–84. Eichengreen B and I McLean (1994), “The Supply of Gold under the Pre-1914 Gold Standard”, The Economic History Review, 47(2), pp288–309. Foster RA (1996), “Australian Economic Statistics 1949–50 to 1994–95”, Reserve Bank of Australia Occasional Paper No 8, revised. Freebairn J (1987), “Natural Resource Industries”, in R Maddock & I McLean (eds), The Australian Economy in the Long Run, Cambridge University Press, Melbourne, pp133–164. Gregory R (1976), “Some Implications of the Growth of the Mineral Sector”, The Australian Journal of Agricultural Economics, 20(2), pp71–91. Gregory R (1978), “Some Observations on the Relationship Between the Mining Industry and the Rest of the Economy”, CEDA Policy Forum “Dollars for Minerals and Energy”, 8/11/78. Gillitzer C and J Kearns (2005), “Long-term patterns in Australia’s terms of trade”, Reserve Bank of Australia Research Discussion Paper No. 2005–01. Haig B (2001), “New Estimates of Australian GDP: 1861–1948/49”, Australian Economic History Review, 41(1), pp1–34. McKenzie I (1986), “Australia’s real exchange rate during the twentieth century”, The Economic Record, 1986 Supplement, pp69–78. Maddock R & I McLean (1984), “Supply-Side Shocks: The Case of Australian Gold”, The Journal of Economic History, 44(4), pp1047–1067. Pagan A (1987), “The End of the Long Boom”, in R Maddock & I McLean (eds), The Australian Economy in the Long Run, Cambridge University Press, Melbourne, pp106–132. Pope D (1986), “Australian Money and Banking Statistics”, Australian National University Source Papers in Economic History, 11. Smith B (1989), “The Impact and Management of Minerals Development”, in B Chapman (ed), Australian Economic Growth, Macmillan, South Melbourne, pp210–239. Vamplew W (ed) (1987), Australians: Historical Statistics, Fairfax, Syme and Weldon Associates, Sydney. Withers G, T Endres, and L Perry (1985), “Australian Historical Statistics: Labour Statistics”, Australian National University Source Papers in Economic History, 7. | reserve bank of australia | 2,010 | 2 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Reserve Bank of Australia's 50th Anniversary Gala Dinner, Sydney, 8 February 2010. | Glenn Stevens: Brief history of the Reserve Bank of Australia Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Reserve Bank of Australia’s 50th Anniversary Gala Dinner, Sydney, 8 February 2010. * * * Treasurer, Shadow Treasurer, former Prime Ministers, former Treasurers, distinguished guests, ladies and gentlemen, colleagues and friends, welcome. I welcome former Reserve Bank Governors Bob Johnston, Bernie Fraser and Ian Macfarlane; former Deputy Governors; and current and past members of the Reserve Bank Board and the Payments System Board. I welcome also the Governors, Deputy Governors and other representatives of 30 central banks from the Asia-Pacific region and around the world; our colleagues from the Bank for International Settlements; and past and present friends and colleagues from the public and private sectors. It is a very great pleasure indeed to welcome you all to Sydney and to this occasion. Fifty years ago, the Reserve Bank of Australia commenced operations as Australia’s central bank. That occasion, though, was the end of a long journey. The history of the RBA actually began much earlier. Not many people realise that the RBA is, by a different name, in fact the entity that opened its doors for business in Melbourne on 15 July 1912, as the Commonwealth Bank of Australia. Conceived as a publicly owned commercial bank that would compete with the private banks, but act in a more stable fashion, the Commonwealth Bank quickly became a significant force in the banking landscape. The story of how central banking evolved in Australia in the 20th century is told in the monograph prepared specially for this occasion by Professor Selwyn Cornish of the Australian National University. The early part of the story is bound up with the history of the young Federation, itself dating only from 1901. At that time, Australia had no central bank. Notes issued by private banks circulated, and reserve balances were held in sterling accounts in London. The financial system serving the Australian colonies had been notoriously unstable during the 1890s. After a speculative property boom rivalling anything we have seen in recent times, the ensuing collapse saw more than half of the deposit-taking institutions close their doors. With Federation, the new Federal Parliament gained constitutional power over currency and banking matters. The Australian Labor Party’s platform included a pledge to establish a “Commonwealth Bank” to be “a bank of issue, deposit, exchange and reserve”. When the ALP won office in 1910, the Government duly brought forward a bill to establish the new Bank. Indeed, Prime Minister Andrew Fisher opened the first savings account. Initially, the functions were limited to commercial ones. Over many years, the Commonwealth Bank slowly acquired central banking functions. As with many central banks, war financing brought the Bank to prominence in the 1914–18 conflict. The note issue, initially a function of the Treasury, was transferred to the Bank in the 1920s. In the 1920s and early 1930s, further legislative attempts were made to strengthen the Commonwealth’s role as central bank. At least one Federal Treasurer (Theodore) made the case for a pure “central reserve bank”. But major progress was not made until an inquiry after the Great Depression outlined the intellectual foundations for the conduct of the modern central bank. The 1937 Royal Commission’s findings led in due course to major legislative change, culminating in the Commonwealth Bank being given explicit macroeconomic policy goals in the 1945 Act. The charter given to the Commonwealth Bank in that Act obliged it to conduct policies as to best contribute to: a. the stability of the currency of Australia; b. the maintenance of full employment in Australia; and c. the economic prosperity and welfare of the people of Australia. They are the same words that are set in stone in the foyer at 65 Martin Place today. The same legislation, I might add, abolished the Bank’s Board, in favour of a system that effectively made the Governor the sole decision-maker. The Board was re-instituted in 1951 and today’s Board in fact is the continuation of that Board, with the same mix of internal and external members. Yet the Commonwealth Bank was still also a commercial bank. Various arguments were made, including by the Governor of the day, as to why it was acceptable, even desirable, for the central bank both to regulate, and to compete with, the private banks. But by the late 1950s, the opposition of the private banks was intense, and our position as poacher and gamekeeper was no longer tenable. And so, at least 30 years after the discussion began about the merits of having a separate institution dedicated solely to central banking, the Reserve Bank of Australia was established to continue the central banking activities, while the commercial functions were placed in the Commonwealth Banking Corporation. Interestingly enough, whereas in the 1930s the Labor Party was inclined to move ahead with developing central banking and the conservative parties had resisted it, in 1959 it was a conservative government that introduced legislation to create the Reserve Bank and the Labor opposition voted against it. So, both parties have been on both sides of this debate! And no-one could say that Australia rushed into the decision. The Reserve Bank opened for business on 14 January 1960. It had the same policy charter as the Commonwealth Bank had had, and an almost identical Board, including the Governor, who had been appointed to the post in 1949, and was eventually to retire in 1968 after a tenure of almost 19 years – longer even than Alan Greenspan. I confidently predict that this record will never be equalled in Australia. While the early leaders of the RBA sought to make it a distinctive institution, they also stressed the continuity of the central banking functions that had carried over from the Commonwealth Bank. One legacy of that history is that we not only have some old silver teapots carrying the CBA inscription, we also hold many of the very valuable archives of the early Commonwealth Bank. Some items from those archives – which date back to the convict era – are being shown this year for the first time in a modest display in our Currency Museum at head office. Over 50 years, the RBA has been present at, and part of, some of the great ups and downs of the Australian economy and the financial system. It has engaged in many arguments about public policy within its sphere of responsibility and competence. It won some of those arguments, and lost others. It has had its share of critics, and still does. Through all that it sought to call things as it saw them, even if it tended to put its views a little obliquely at times. It has always had a Board a majority of whose members have been drawn from outside the organisation, from commerce, academia and the broader community. A part-time Board with the decision-making power over monetary policy is unusual among central banks – I can think of no other major country with that structure. Yet that broader representation has given the Bank a degree of legitimacy that we might otherwise have struggled to achieve in Australian society. And I can say that in the 140 or so meetings of the Board in which I have participated, the members have always carefully set aside sectional and personal interest to act in the national interest. There are still some with us – even some here tonight – who were present at the creation in 1960. They and others worked hard over the years to establish and nurture a culture and an institution. Many others here have had a connection with the Bank in some way – political leaders, professional colleagues in government, counterparts in the financial sector, or colleagues from abroad. All of you have played a part in creating an institution. Some of you won’t have agreed with things we have said or done at one time or another! But you nonetheless sustained support for the Bank as an institution and for the arrangements under which we operate. Whatever success we may have had over the years owes a lot to the support and trust that the financial sector, the political leadership and our community – whom we serve – have been prepared to give us, even on occasions when they didn’t agree with us. We have also benefited greatly from the support of our international colleagues. Thank you for that support. We shall continue to do our utmost to be worthy of it. Thank you all for coming to be part of this celebration. Please enjoy your evening. | reserve bank of australia | 2,010 | 3 |
Speech by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, at the Urban Development Institute of Australia (UDIA) 2010 National Congress, Sydney, 10 March 2010. | Philip Lowe: Some challenges for the future Speech by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, at the Urban Development Institute of Australia (UDIA) 2010 National Congress, Sydney, 10 March 2010. * * * As is now well known, the Australian economy has come through the worst global downturn since at least World War II better than expected, and in sounder shape than most other advanced economies. As a result, many of the economic challenges that we are likely to face over the next few years look to be quite different from those facing most of the other advanced economies. This morning, I would first like to talk about how we found ourselves in this relatively favourable position, and in particular about the importance of flexibility. I would then like to touch on three of the broad challenges that are likely to lie ahead. The first of these is the need to expand the supply side of the economy. The second is the need to increase the supply of housing for a growing population. And the third is the need to ensure that inflation remains low and stable. The importance of flexibility Before I look to the future though, it is useful to understand how we got to where we are now. The various factors that have contributed to Australia’s relatively good economic performance are now well understood. They include: the substantial and early easing of both monetary and fiscal policy; the healthy state of our banking system; the rapid rebound in Asia, and in particular China; the depreciation of the Australian dollar in 2008; and the relatively high rate of population growth. Collectively, these factors helped us get through an extremely difficult period in the world economy. We should not lose sight, though, of the fact that they didn’t insulate us completely from the global recession; the clearest example of this is the fall in GDP of almost a full percentage point in the final quarter of 2008. But overall, it is fair to say that we have come through this downturn in much better shape than was widely expected. The latest evidence of this was in the GDP figures last week, which showed that the economy expanded by 2¾ per cent over 2009. There are various lessons that one can draw from the experience of the past 18 months, but the one that I want to highlight today is the importance of flexibility. Here, there are two aspects that are important: the first is the general flexibility of the economy to adjust to changes in the external environment; and the second is the flexibility that economic policy had to respond to changes in this environment. Without both of these aspects, the recent economic history of Australia would have been quite different. This flexibility, though, did not just materialise out of thin air. Instead, it was the result of many years of policy reform and hard work by governments and business. What we have seen recently is the dividend of that hard work, with the economic outcomes over the past year or so reflecting not just the decisions made since late 2008, but also the decisions made in the two to three decades before that. I would like to touch on a few aspects of this flexibility. The first is the flexibility of the exchange rate. This has been one of the great success stories of economic policy making in Australia. Without it, we would have seen bigger booms and busts and more variable and, probably, higher inflation. As Ric Battellino, the RBA’s Deputy Governor, discussed in a speech a couple of weeks ago, the floating exchange rate has helped the economy adjust more smoothly to the current boom in the resources sector than was the case in previous resources booms, which always ended in high inflation. It also helped the economy in 2008 when global risk aversion was at its peak, and during both the Asian financial crisis in the mid to late 1990s and the bursting of the tech bubble in the United States a decade ago. The second area is labour market flexibility. Over the past year, the unemployment rate rose by considerably less than was expected. While this was partly the result of the surprising strength in the economy, it also highlighted the increased flexibility of the labour market. When demand weakened, many firms and their employees agreed to reduce working hours as a way of preserving jobs. And in other cases, wage rises were reduced or delayed as a way of avoiding lay offs. These responses helped limit the rise in the unemployment rate. In turn, this helped support incomes and the general level of confidence in the community, and ultimately the level of economic activity. The third area is the flexibility in macroeconomic policy. When the world economy took a sharp turn for the worse, fiscal policy in Australia responded quickly and on a significant scale. It was able to do this without raising the fiscal sustainability concerns that have come to the fore in a number of other countries. While there will always be differences of opinion about the merits of specific measures, there is little disagreement with the idea that Australia’s history of sound fiscal policy provided the government with the scope to act quickly, and on a significant scale, when the outlook deteriorated. One of the obvious benefits of keeping your house in order over a long period of time is that you can more easily respond to changing circumstances if you judge that to be the correct thing to do. Right now, there are a number of other countries that would clearly value that flexibility, but that do not have it because of decisions on fiscal policy running back over the past couple of decades. Monetary policy was also able to respond rapidly when the outlook turned for the worse, with the cash rate being reduced by 4¼ percentage points over a seven month period. Importantly, we were able to do this without causing inflation expectations and long-term interest rates to rise. The main reason for this is that the monetary policy framework in Australia is seen as credible in ensuring that the inflation rate averages between 2 and 3 per cent over time. But again, the credibility of the framework did not rise out of thin air. Instead, it is the result of nearly two decades of having delivered low and stable inflation. So in each of these areas – the exchange rate, the labour market, fiscal policy and monetary policy – the decisions that were made over a long period of time helped us get through the global downturn. Looking forward, it is important that we do not lose sight of this. As the Bank has set out a number of times recently, our central scenario for the Australian economy is a reasonably favourable one. In this central scenario, we are likely to face a twospeed global economy for some time. While most of the advanced economies are expected to experience only a subdued recovery, weighed down by balance-sheet problems, Asia is expected to grow solidly, with domestic demand in the region playing a greater role than in the past. If this is indeed how things play out, Australia should be well placed, particularly given its strong trade links with Asia and the generally bright outlook for the resources sector. But it is important to remember that this is only the central scenario. As we know, the global economy has a habit of throwing us surprises and there are clearly risks in both directions. Over recent months, the economic data for a number of countries have been better than expected and it is possible that this could continue. On the other hand, it is also possible that financial events in the advanced economies could again derail the global economy, and growth in Asia could disappoint. We clearly cannot control global outcomes, but what we can do is preserve the flexibility that the economy has, and enhance that flexibility wherever we can. Ultimately, this is the best insurance that we can take out against the uncertain world in which we live. I would now like to turn to the three issues that I mentioned at the start: expanding the supply side of the economy, housing, and inflation. In each of these areas, the situation in Australia is different from that in most of the other developed economies. Expanding the supply side Australia starts the current expansion with considerably less spare capacity than earlier thought likely, and with less than at the starting points of previous expansions. This is clear from surveys of capacity utilisation by businesses. It is also clear from the labour market data, with the unemployment rate peaking at around 5¾ per cent, which was around the trough in the previous two cycles (Graph 1). These outcomes put Australia in quite a different spot from that of most other advanced economies. In both the United States and Europe the unemployment rate is around 10 per cent, and both economies are estimated to be operating at around 5 per cent below their potential. The issues we face are therefore quite different from those confronting most of the other advanced economies. Elsewhere, the challenge is to get private demand to grow on a sustainable basis so that it can catch up with the supply potential of the economy. In contrast, for Australia, the main task is to expand the supply side of the economy so that demand can grow solidly without causing inflation to rise. This is unambiguously a better position to be in, but it does pose some challenges. The obvious keys to improving the supply side of the economy are investment and productivity growth. In terms of investment we are doing well, with Australia having become a high investment country over recent times. Currently, business investment is equivalent to around 16 per cent of GDP – not far below its peak level in the past four decades – and is expected to rise a little further over the next couple of years (Graph 2). Investment in the resources sector has been particularly strong, and this is now starting to bear fruit, with resource exports rising recently following a number of years where there was little growth (Graph 3). Over the years ahead, further significant increases in resource exports are expected. The high overall rate of investment means that the capital stock is increasing at a faster pace than over recent decades, and this should underpin continued growth in the supply potential of the Australian economy. In contrast, in a number of other advanced economies, including the United States, there is currently little net growth in the capital stock, with the investment that is taking place barely enough to offset depreciation. The fact that investment is high in Australia reflects the high expected return on capital, particularly in the resources sector. Given that countries with relatively high returns on capital typically have relatively high real interest rates, it should not be surprising that interest rates in Australia are above those in other countries where the return on capital is currently much lower. In terms of productivity, the story is not as positive, although, as always, measurement issues cloud the picture. According to the Australian Bureau of Statistics (ABS) data, since the mid 2000s, almost all the increase in output in Australia has been accounted for by a rise in hours worked and an increase in the capital stock. Or put another way, there has been very little underlying productivity growth over this period (Graph 4). The reasons for this are not particularly clear. Some slowing in productivity growth might have been expected in the mature stage of the business cycle, as the economy was operating against its capacity limits and skill shortages emerged. A second possibility, relating to the mining sector, is that high commodity prices allowed lower grade resources to be mined. The lag between the construction and production phases of large resource projects may also have lowered measured productivity growth, at least until these projects come on line. More generally though, it is important to remember that one of the least productive things that a society can do is to leave large numbers of people sitting at home who actually want to work. From this perspective, the productivity performance over the past decade looks to be quite a lot better. The Australian economy has done well at bringing in to paid employment those who actually want to work and the unemployment rate has fallen significantly. While one side effect of this may have been to contain productivity growth as conventionally measured, from a broader perspective it represents a considerable success. As we go forward, if we are to grow strongly on a sustainable basis we will need to ensure that both our capital and our workforce are used as efficiently as possible. Returning to my earlier theme, maintaining flexibility in the economy is important here. Under the central scenario that I sketched earlier, the economy is likely to undergo considerable structural change, particularly as the resources sector expands. How well we deal with this change will have a significant impact on how the overall economy performs. Housing Now to the second issue, that of housing. Here again Australia finds itself in quite a different position from that of many of the other advanced economies, both in terms of the construction cycle and prices. One challenge we face is to satisfy the increase in the demand for housing from a growing population, particularly given that we start the current upswing in the economy with a tight housing market. Unlike a number of other countries – most notably the United States and Spain – Australia did not have an unsustainable surge in dwelling investment in the middle years of the 2000s that resulted in over-supply of housing (Graph 5). Indeed, over recent years, the rate of increase in the number of dwellings has been below the average of the past 50 years (Graph 6). In contrast, the rate of increase in the population has been around the fastest in 50 years. Consistent with this, rental vacancy rates in Australia are low by historical standards, although they have increased a little over the past year. There has also been a reversal of the decades-long trend of fewer people living in each dwelling. While demographic factors have been important here, including a rise in the birth rate and the increase in the number of students undertaking post-secondary education, the increase in the cost of housing has also played a role. With population growth above average, and growth in the housing stock below average, it is not surprising that there has been upward pressure on housing costs as part of the process of balancing supply and demand, with the higher housing costs leading to people economising on housing services. Obvious examples of this are the trend towards young adults staying in the parental home longer, and a rise in the number of people sharing accommodation. Interestingly, the relatively slow growth in the number of dwellings does not reflect historically low levels of dwelling investment. In fact, the share of GDP devoted to the construction of dwellings over recent years is above the average of the past five decades (Graph 7). However, within total dwelling investment, renovation activity now accounts for a higher share than was the case historically, and the average size and quality of new dwellings has also increased substantially. The result of these developments is that for a given share of GDP devoted to housing investment, there is a smaller increase in the number of dwellings than was the case previously. In a sense, as a society there has been a trade-off between quality and quantity; in particular, we have implicitly chosen to build bigger and betterappointed dwellings, rather than more dwellings. Looking forward, if population growth were to remain strong for an extended period, and we do not change the mix of housing that is being constructed, it is likely that we will need to devote a higher share of GDP to housing than has been the case historically. If this does not happen, further adjustment in housing prices and rents is likely to occur to balance supply and demand. This raises two important issues that we need to think about. The first is the constraints that exist on increasing the supply of dwellings. If we are to build more dwellings, we need to ensure that planning guidelines and infrastructure provision can accommodate this. This will pose challenges for all levels of government. And the second issue is the capacity of the economy to deal with an increase in dwelling construction at a time when investment elsewhere in the economy is also very high. If housing construction is very strong at the same time that the resources sector is expanding, there will be competing demands for a range of skilled workers and specialised services. Managing these competing demands and ensuring the adequate supply of workers with appropriate skills will be a challenge. Inflation The third issue is inflation. In all of the advanced economies, inflation – in both headline and core terms – has fallen and, in most cases, is currently below the relevant target or medium-term average. Given the considerable excess capacity that currently exists, most of these countries are likely to continue experiencing disinflationary pressures for some time yet, and have inflation rates that are below target. In Australia, inflation has also fallen, but unlike for most of the other advanced economies, it is not expected to be below target for an extended period of time. In the December quarter, underlying inflation was running at an annualised rate of around 2½ per cent – right at the mid point of the target range. In annual terms, underlying inflation was higher than this, reflecting the higher quarterly outcomes in the early part of 2009. Looking forward, we expect broadly similar outcomes over the next year or so to that recorded in the December quarter, as the lagged effects of the slowdown in wage growth last year and the appreciation of the exchange rate work their way through. As set out in our latest Statement on Monetary Policy, we expect inflation in both headline and underlying terms to be around 2½ per cent in 2010, and just a little higher in 2011. Recently, there has been some discussion, prompted by senior staff at the International Monetary Fund (IMF), that central banks might aim for high inflation – say 4 per cent – as a way of giving them more scope to reduce official interest rates in future downturns. This idea does not seem particularly sensible. As history has taught us, inflation distorts decisionmaking in the economy, discourages saving, and increases uncertainty about the future. None of this is helpful for expanding the supply side of the economy, and ultimately higher inflation means higher nominal interest rates. Equally importantly, a global shift to allow higher inflation would run the very real risk of undermining trust in central banks and their commitment to price stability. The public might rightly wonder whether inflation targets might shift up again at some future point as other problems arose. If this loss of trust were to occur, we would have given up the hard-won credibility of the monetary policy frameworks that has been built up over the past couple of decades. Conclusion The central scenario for the Australian economy is a positive one, with growth over the next couple of years at, or above, average, a relatively strong labour market, and inflation consistent with the medium-term target. There are, however, risks around this central scenario that we will need to watch carefully. Recent experience has reminded us of the importance of flexibility of both the economy and macroeconomic policy in managing these risks. As we look forward, if something like the central scenario were to eventuate, we will need to keep a strong focus on improving the supply side of the economy so that demand can grow solidly without putting upward pressure on inflation. We also face the significant challenge of increasing the supply of housing at a time when business investment is also very high. While meeting these challenges will require hard work by both governments and businesses, they are surely better ones to face than those being confronted by other advanced economies. | reserve bank of australia | 2,010 | 3 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the 15th annual conference "Cards & Payments Australasia 2010", Sydney, 15 March 2010. | Malcolm Edey: Competition and regulation in the card payments market Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the 15th annual conference “Cards & Payments Australasia 2010”, Sydney, 15 March 2010. * * * It’s a pleasure to join you today for this 15th annual conference of Cards and Payments Australasia. As a newcomer to this event, I want to take the opportunity to talk about the economics of the card payments industry, how it differs from other markets, and also about the Reserve Bank’s approach to card payments regulation. Card payments are an important part of the infrastructure of a modern economy. All of us here today, I’m sure, appreciate the convenience of being able to pay by plastic. More to the point, card payments account for a big slice of spending in the retail economy. There are currently roughly 40 million debit cards on issue in Australia, and around 20 million credit and charge cards. On those cards, nearly 10 million transactions are made every day, with a daily value of around one billion dollars. To put this in some sort of perspective, the value of spending on personal cards is about half the size of household consumption. Card payments are a big proportion of the number of non-cash payments in the economy, but only a small proportion of their value. More card payments are made in Australia than the other main means of non-cash payments – that is, direct debits and credits, BPAY and cheques – combined. And yet, in terms of value, they make up less than three per cent of the total. This illustrates that, while card payments have few implications for the overall stability of the financial system, they have significant implications for its efficiency. In this context, efficiency includes not just the efficiency of the processes by which payments are made, but also the way in which price signals function to allocate resources and guide decisions. The RBA has a mandate to use its regulatory powers, where needed, to promote that broader efficiency goal through its Payments System Board. I’ll talk more about the Board’s activities in a moment. But let me start with some observations about the economics. One of the first things I learned when I started to work on card payments is that the economics of this industry are not simple. In the simplest markets, we can think of supply and demand as being determined by a set of independent decisions made by producers and consumers. People will base their decisions on factors like price, quality and the cost of production. If it’s a competitive market, we’d expect it to have certain characteristics, such as that: other things equal, a lower price means more demand; producers compete to offer the product at the lowest price they can; and the price mechanism promotes efficiency by guiding resources to their best use. In practice, no market will meet those conditions perfectly. But the card-payments market has some particular qualities that make it very different from the stylised description I’ve just given. First, the card payments market is subject to network externalities, which is another way of saying that the cost-benefit decisions made by the various players are highly interdependent. The value of the service I get from being part of a card network depends, in part, on the size of the network. Cardholders value having a particular card in their wallet because they know the card is widely accepted. And merchants value the capacity to accept a card because it’s widely held. This aspect of the market adds a level of complexity to the pricing strategy, because the suppliers of card services will want to take those externalities into account. They have an incentive to adopt pricing strategies that promote the size of their networks. The second difference is that card payments services are a joint product. The purchaser of the service, in any given transaction, is not the only one who benefits from it. When a card is used to make a payment, it delivers a service jointly to both the payer and the receiver of the funds. Thirdly, the card payments market, particularly in the credit cards space, has evolved in such a way as to have a very unusual characteristic. That is, that the decision-maker in a transaction – the person who decides which payment method to use – is generally not the person who is on the receiving end of the price signal. To be specific, it is typically the purchaser who decides whether to use a card (and which card to use), but it’s the merchant who, in the first instance, pays the fee associated with that decision. So, in a world where cards are widely held and widely accepted, the effective demand for the service is determined mainly by the cardholders, while the price is charged to the merchants. This is where, in the four-party card schemes, interchange fees play a key role, because they are typically passed on to the merchant, and they therefore set the base for the merchant service fee. It’s this third characteristic that, to my mind, most clearly distinguishes card payments from other markets. We can think of examples of other markets with complex network effects, or of other markets where there are jointly-produced outputs. But I can’t think of any example of a market where the separation of decision-making power from the price signal is such an integral part of the structure – the cardholder makes the decision, but the merchant pays the fee. And, in the pre-reform days, they were restricted from passing on that fee to the customer making the decision. It remains true, of course, that merchants do have some decision-making power of their own. They can, for example, choose not to accept a card – that is, to stay outside a card network if they think it’s too expensive. But this is where a fourth characteristic of the market comes into play. The card market is highly concentrated. In credit cards, for example, the two major schemes in Australia have a combined market share of more than 80 per cent of transactions. They have high levels of penetration of the potential cardholder market, and high rates of acceptance among merchants. These conditions can make it very unattractive for an individual merchant to stay outside a given card network, particularly in a world where the merchant doesn’t know which cards a customer might be carrying. I don’t say any of that as a criticism of the card schemes – it wouldn’t be fair to blame them just for being successful – but it is an important feature of the market that has a bearing on competition and efficiency. One of the consequences of the industry structure that I’ve just described is that competitive discipline on interchange fees has been weak. As I said before, in conventional markets, competition puts downward pressure on prices, because if you raise your price you will lose market share. But in card payments, there are significant pressures going the other way – a rise in the interchange fees charged to acquirers can allow issuers to increase their reward points to cardholders, thereby encouraging use of the card. 1 In other words, a rise in price can lead to an increase, rather than a decrease, in the effective demand for the service. Again, I can’t think of any other significant market where that is the case. This principle creates a natural tendency for average interchange fees to drift upwards over time. Within each scheme, there are multiple cards with differing interchange fees, and market share tends to shift towards those cards with the higher fees. It’s an illustration of the The acquirer is the bank that services the merchant. The issuer is the bank that issued the credit card to the cardholder. In a typical credit card transaction, the acquiring bank pays an interchange fee to the issuer. principle that, in these rather unique conditions, competition for market share tends to push the average price up rather than down. What I’ve just set out is obviously not a complete description of the cards market. But I think it captures those features that are particularly distinctive, and which raise at least the potential for concerns about efficiency and the adequacy of competition. With that background, I’ll turn now to the RBA’s involvement in card payments regulation. The origin of that involvement was the decision by the Federal Government, in 1997, to implement the Wallis recommendations by giving regulatory oversight of the Australian payments system to the RBA. The Act set up a Payments System Board of the Reserve Bank, with responsibility for payments-system efficiency and stability. Among other things, the Act gives the Board the power to designate a payments system and, where a system has been designated, to set regulatory standards with respect to such things as fees and operating rules. The Board’s first major study in this area was conducted jointly with the ACCC, and was released in October 2000. That study raised a number of concerns about market practices in the industry, particularly the setting of scheme interchange fees and a range of other matters related to competition and the efficiency of price signals. Since industry attempts to address ACCC concerns about interchange fees had failed, and given that the Payments System Board had a clear mandate in this area, the Board then moved into a process of reform, starting with the credit card schemes. After a period of consultation, the first package of credit card reforms was announced in August 2002. That package had three main elements, which were: A cost-based standard on interchange fees; Disallowance of no-surcharge rules; and Rules to expand access to the network. But the Bank was always of the view that reform of the payments system needed to be holistic. So over the next few years, the reform process added a number of other elements, which covered both credit and debit cards. Some of the key ones were: A restriction on the honour-all-cards rule to allow merchants to make separate decisions for credit and debit cards; A cap on Visa debit interchange (which was also voluntarily adopted by MasterCard); A reduction in interchange fees for EFTPOS; Agreement by the three-party schemes to remove no-steering rules; Access regimes for a number of card-payment systems; and Increased transparency of interchange fees and merchant service fees. Taken together, this expanded package of reforms was in place by the beginning of 2007. These developments have been closely watched both by regulators and market participants around the world, because Australia was the first major country to begin reforms in this area. Subsequently, a number of other countries have taken steps of a similar nature, and some are considering the case to do so. The sequence of reforms I’ve just outlined obviously has a lot of detailed elements to it. But, at a strategic level, it can be thought of as addressing the concerns about efficiency in two ways. In the first place, the Board took the view that, left to itself, the market was delivering interchange fees that were too high. Hence they took direct action to regulate them lower. As a result, average credit card interchange fees have fallen from around 95 basis points before the reforms to around 50 basis points now. Merchant service fees associated with the large credit card schemes have correspondingly fallen (in fact by more than the reduction in interchange fees), and this in turn has put downward pressure on fees for the three-party schemes. Interchange fees for scheme debit and EFTPOS have also been reduced by direct regulation. Secondly, the various other elements of the reform package can be thought of as working to improve the alignment between price signals and decision-making power – the issue that I spoke about earlier. One very important aspect of that is the disallowance of no-surcharge rules. It’s important to be clear on the rationale for that. We’re not saying that surcharging is an end in itself, or that it’s going to be right for all circumstances. But rules against surcharging represent a restriction on the flow of price signals to the main decision-maker, and so the option to surcharge needs to be there. And where surcharging reflects the costs incurred in the provision of the payment service, it should contribute to efficient outcomes. Another way of improving this alignment has been to remove restrictions on the ability of merchants to influence the choice of payment method at the point of sale. Examples of such measures were the regulation to allow separate acceptance choices on scheme debit and credit, and the dropping of no-steering rules. These things give the fee-payer greater scope to respond to the relative prices that are being charged. Finally, moves to increase transparency have helped to provide more information to merchants and make them aware of the costs of accepting payment instruments. This transparency has supported the other elements of the reforms that have provided merchants with more competitive leverage. I don’t claim that perfection can be achieved on any of these fronts, but these were all areas where improvements needed to be made. The general principle is that, if you’re paying a fee, there should be some commensurate degree of influence over the decision to incur that fee. Without that, price signals will be ineffective, and competitive pressure to keep fees down will be weak. I’ve gone through that history in order to convey the overall sweep of card-payments regulation, and the general economic basis for it. Having done that, let me move on to look at the current position. The immediate background at this point is the review of card-payments reforms that the Board undertook in 2007–2008. In thinking about the approach taken in that review, it’s worth keeping in mind that the Reserve Bank has described itself as a reluctant regulator. Our general mandate with respect to the payments system is to promote efficiency and stability. For reasons that I’ve already described, that includes taking measures to stop fees from rising too far above efficient levels. But our preference is to do that, when we can, by promoting competition rather than by direct regulation of fees. The results of the Board’s review were presented in September 2008. What did it find? First of all, it found that the reforms to date had delivered clear benefits, in the form of lower costs to merchants and increased competition. In addition, it found that price signals had been strengthened, transparency enhanced, access improved, and that the competitive environment was more soundly based than it had been five years earlier. But the Board also concluded that more needed to be done. Specifically, it concluded that: at 50 basis points, credit card interchange fees were still too high; it also concluded that, even with the various reforms to date, competitive pressures were still not strong enough to put downward pressure on those fees if the regulation were removed. Against that background, the Board set out two possible approaches for the next stage of its regulatory strategy. The first possible approach would be to step back from interchange-fee regulation, if it could be reasonably satisfied that this was not going to result in the fees going back up again. Within that broad approach, the Board saw two ways that this objective might be met through action by the payments industry. Those were: by strengthening competition from alternative payment methods, particularly through development of industry-based EFTPOS and online payments schemes, coupled with further changes to honour-all-cards rules and increased transparency of scheme fees; and by voluntary undertakings from the credit card schemes that interchange fees would not rise. The second possible approach put forward in the 2008 review was to maintain interchange regulation on credit card schemes, and to make a further reduction to 30 basis points. The Board indicated it would follow this path if progress on the first track was unsatisfactory. As you know, the Board undertook to make an assessment of that in August 2009. As you also know, the decision at that point was deferred. The Board took the view that good progress was being made by the industry, but that it wasn’t yet enough to provide sufficient confidence that fees would be held down in the absence of direct regulation. So the decision was to allow some further time to assess developments. In the meantime, the Board did make one further change of a more limited nature, which was needed to put the new EFTPOS scheme on a comparable regulatory footing to scheme debit. That announcement was made in November. I know that many of you involved in the industry would like me to give some predictions or clues about what the Board’s next decision on these matters might be. I’m not in a position to make that kind of prediction today, but I hope I’ve conveyed some of the principles that are important. To reiterate: The Reserve Bank is a reluctant regulator. We’d prefer to see fees being held down by competition than by direct regulation. We believe there’s been good progress in promoting competition over recent years. But it’s not yet clear whether that will be sufficient. And hence, the Board’s announcement in August last year explicitly left on the table both of the two broad approaches that I outlined earlier. Let me conclude on a somewhat different note. I’ve talked mainly today about the Payments System Board’s regulatory approach. But obviously there’s more to the card payments industry than just interchange fees and regulation. This is an industry that’s rapidly innovating, developing new ways to offer services, and also facing continuing challenges like fraud and security. I expect you’ll be focusing mainly on those wider issues over the next few days and I wish you every success with the rest of the conference. | reserve bank of australia | 2,010 | 3 |
Speech by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Industry Group 10th Annual Economic Forum, Sydney, 25 March 2010. | Philip Lowe: Recent developments in the global and Australian economies Speech by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Industry Group 10th Annual Economic Forum, Sydney, 25 March 2010. * * * Thank you for the invitation to speak this morning. I am very pleased to be able to continue the long-standing relationship between the Reserve Bank of Australia and the Australian Industry Group. Over the years, we have found this relationship very valuable and I hope and trust that this will continue. This morning, I would like to talk about some of the recent developments in both the world and Australian economies and the implications of these developments for the outlook for the Australian economy. The world economy The world economy is gradually recovering from the worst downturn since World War II. This recovery though is occurring on two different tracks (Graph 1). As a group, the G7 countries are experiencing only relatively weak growth, especially when viewed against the very large contraction in output that occurred. In contrast, the picture in Asia is quite different, with many of the economies in the region having had near V-shaped recoveries. There has also been a reasonably solid bounce back in some other parts of the world with, for example, Brazil growing quite strongly over the past year. Graph 1 World GDP Growth Per cent, weighted using GDP at PPP exchange rates % G7 economies Asia excluding Japan % Year-ended Quarterly -3 -3 -6 -6 Sources: CEIC; RBA; Thomson Reuters This two-speed world is evident not just in the GDP data but also in the unemployment and inflation data. Unemployment rates in both the United States and the euro area are around 10 per cent and a sustained reduction still looks some time off (Graph 2). In contrast, unemployment rates are now clearly falling in Asia and are much lower than in the major advanced economies. Graph 2 Unemployment Rate % % Euro area US Higher-income Asian economies Sources: CEIC; Thomson Reuters In terms of inflation, in both the United States and the euro area, core measures are still trending down, and they are likely to continue doing so for some time yet (Graph 3). Again, in contrast, core rates have clearly bottomed in Asia and now look to be rising in a number of countries in the region. Graph 3 Core Consumer Price Inflation Six-month-ended annualised % % US Euro area % % Other east Asia (excluding Japan) China -3 -3 -6 -6 Sources: CEIC; RBA; Thomson Reuters Rather than run through more of the recent economic data, I would like to touch on three broad issues that are likely to play a major role in shaping how the world economy evolves over the next few years. The first of these is the need for the advanced economies to consolidate their public finances. The second is the realignment of capital flows, given the likelihood of an extended period of low interest rates in the advanced economies. And the third is the challenge of increasing domestic demand in Asia. (i) Public finances Of these three issues, the one that has attracted the most attention recently is public finances. This is partly the result of what has been going on in Greece but, more broadly, it reflects the difficult fiscal positions in which many advanced economies currently find themselves. In the United States, the federal budget deficit for 2009 was around 10 per cent of GDP. In Japan, the deficit was almost as large, and for the euro area as a whole it was around 6 per cent, with some euro area countries having much larger deficits than this average. Furthermore, these large deficits come after three decades over which the ratio of public debt to GDP for the G7 economies as a whole trended higher (Graph 4). They also come at a time when there will be significant medium-term budget pressures due to the ageing of the population. Graph 4 G7 – Net Public Debt Per cent of GDP % % Source: IMF Over coming years, many governments will need to take significant steps to improve their public finances. The flexibility that they have to determine the timing and size of these steps is limited by the fact that they went into the current downturn with already high levels of debt. As a result of the poor starting points, many are now treading a fairly narrow path. On the one hand, tightening fiscal policy in the very near term risks derailing the recovery, while not doing so risks a damaging loss of confidence. How these risks are managed is likely to have a major effect on how the world economy evolves over the next few years. Presumably, what is required is for the affected countries to have credible medium-term fiscal consolidation strategies. While this is easier to say than to do, ensuring the confidence of investors is an important ingredient if the recovery is to be sustained. (ii) Capital flows This brings me to the second, but related, issue – that of capital flows. Most of the advanced economies are currently operating well below full capacity and, given the subdued nature of the recovery, it is likely to be some time before this excess capacity is wound back. One consequence is that, provided inflation expectations remain well anchored, official interest rates in these economies – which are currently at historically low levels – are likely to remain below average for a considerable period of time (Graph 5). In contrast, elsewhere, including in Asia and Australia where growth is stronger, interest rates are likely to be relatively higher. This interest differential is likely to lead to a flow of capital from the major advanced economies to Asia and other better-performing areas of the world. Graph 5 G7 – Average Policy Rate % % Sources: Federal Reserve Bank of New York; Global Financial Data; Thomson Reuters In Asia, concerns are already emerging about the implications of this. In particular, some countries are worried about the potential for volatile capital flows to be destabilising for their economies. The concern is that capital inflows in the near term will later turn into capital outflows when interest rates in the advanced economies do eventually normalise, and that this could be disruptive. As a way of insuring themselves against this risk, some central banks continue to accumulate foreign reserves. A number of countries in the region are also concerned about the effects of capital inflows on their domestic banking systems, with some having taken steps to rein in bank lending growth, particularly in cases where property prices are increasing strongly. A related consideration is the effect of these capital flows on exchange rates in the region. In general, there is considerably less tolerance for large movements in exchange rates in many of these countries than there is in Australia. In our own case, movements in the value of the Australian dollar are largely seen to be a stabilising force for the economy. There is also a general acceptance of the view that, over the next few years, our real exchange rate is likely to be higher than the average over the past decade or so. In contrast, in much of Asia, where international trade shares are considerably higher than in Australia, movements in exchange rates tend to be viewed with more concern, particularly when they are seen to be driven by speculative capital flows. One other related consideration is the impact on asset markets around the world of an extended period of low official interest rates in the major advanced economies. When the global economy was in this situation around five years ago things did not work out well. While the current environment is very different from that in the middle of the 2000s, this earlier experience suggests that we need to watch the financial side of the global economy very carefully, particularly when interest rates are unusually low. (iii) Domestic demand in Asia The third issue I would like to touch on is the growth of domestic demand in Asia. For some decades, many countries in Asia have had a growth strategy focused on exports. Given the strong growth in consumption in the major western economies, this strategy worked. However, many of the countries in Asia recognise that given the subdued outlook for the advanced economies, there will now need to be a stronger emphasis on growth in domestic demand than has been the case in the past. China provides a good example here. Over the past two decades, the share of household consumption in Chinese GDP has declined from just under 50 per cent to 35 per cent – a very low level by international standards. This decline reflects two broad developments. The first is a reduction in the share of national income going to households; in the early 1990s, this share stood at nearly 70 per cent, but by late 2008, it had fallen to less than 60 per cent (Graph 6). The second factor is an increase in the household saving rate; in the early 1990s, around 30 per cent of household income was saved, while today this share is close to 40 per cent. Graph 6 China – Household Income and Saving % % Disposable income Saving ratio Share of nominal GDP Share of disposable income Sources: CEIC; RBA In China, as in many parts of Asia, there is now a recognition that policies to promote consumption are likely to play a more important role than was previously the case. In the past, strong consumption growth was often seen as something that would follow strong exports, rather than be a driver of the economy itself. This view is gradually changing and this is leading to an increased focus on structural reforms to increase the share of national income going to the household sector and to reduce the household saving rate. While reforms in these areas can be difficult, they are important if Asia, as a whole, is to continue to grow strongly in the face of subdued demand for exports from the region. How things play out in each of these three areas – public-sector debt, capital flows and structural policies in Asia – will have a significant impact on the global environment in which the Australian economy finds itself over the year ahead. As the Reserve Bank has spelt out a number of times recently, our central scenario is a relatively positive one. The economies in Asia are expected to continue growing reasonably solidly, while the advanced economies are expected to have only a subdued recovery, weighed down by the need to consolidate balance sheets in both the household and public sectors. Around this central scenario there are, however, clearly risks, particularly associated with the three issues that I have just touched on. Given these risks, one question is how should policy be set? The Reserve Bank’s general approach has been to proceed on the basis of the central scenario, but be prepared to respond if things turn out differently, as we did in late 2008 when the global outlook took a marked turn for the worse. The alternative of waiting to see how the myriad of risks evolves before adjusting policy runs the significant downside of moving too late, particularly given that the economy is starting this upswing with less spare capacity than in previous upswings. Fortunately, in Australia we have had the policy flexibility to respond to changing events as they have occurred and this has served us well. The Australian economy I would now like to turn more specifically to the Australian economy, where the run of data over the past few months has tended to be on the firm side. Employment growth has been robust, business and consumer confidence is above average, the housing market has been strong, and there are signs that the period of business deleveraging is coming to an end (Graph 7). Collectively, these outcomes provide us with some confidence that the economy is now in a reasonably solid upswing. Graph 7 Unemployment and Business Confidence % % Unemployment rate % % Business confidence* -15 -15 -30 -30 -45 -45 * Net balance; deviation from long-run average Sources: ABS; NAB; RBA Over the course of this year, the nature of this upswing is, however, likely to change somewhat. Recently, the overall level of spending in Australia has been supported by strong growth in public-sector demand. This has occurred at a time when growth in private-sector demand has been relatively weak (Graph 8). As we move into the second half of 2010, this configuration is likely to change. Public-sector investment is projected to decline, particularly as spending on the Federal Government’s school building program tails off. But moving in the other direction, private-sector business investment is expected to strengthen further, particularly in the resources sector. Graph 8 Domestic Final Demand Growth* Financial years % % Private Public -2 97/98 00/01 03/04 06/07 09/10 -2 * Adjusted for transfers between the private and other sectors and the privatisation of Telstra; 2009/10 based on financial year to date. Sources: ABS; RBA This expected rise in business investment is underpinned by the strong outlook for the terms of trade. Recently, the spot prices of iron ore and coal have risen, and the prices that exporters will receive over the next year look likely to be substantially higher than those received over the past year (Graph 9). As a result, a significant rise in the terms of trade is expected over the year ahead. While movements in the terms of trade do not get the same high-frequency attention as many of the monthly economic indicators, history suggests that they have a large influence on how the overall economy performs. Among other things, they can affect the investment climate, the government’s budget position, asset values, overall confidence in the economy and the growth of domestic incomes. Graph 9 Bulk Commodity Spot Prices US$ per tonne Iron ore* US$ US$ US$ US$ Coking coal US$ US$ Thermal coal l l l l l l l * Calculated using the spot import price in China less the spot freight rate from Australia to China Sources: Bloomberg; Citigroup; Macquarie; RBA In contrast to the terms of trade, one area that does get high-frequency attention is the property market. Over recent times, most indicators of conditions in the established housing market have been very buoyant. Auction clearance rates have been high and nationwide measures of housing prices have been increasing by around 1 per cent a month, with prices in Melbourne rising at an even faster pace (Graph 10). The rental market also remains quite tight, with rents having risen firmly and vacancy rates low. Graph 10 Capital City Housing Prices 2005 = 100 Index Index RP Data-Rismark APM Sources: APM; RBA; RP Data-Rismark There are, however, a few contrary signs to this generally strong picture. Total housing loan approvals declined in October, November, December and January, with the declines broader than just for first-home buyers following the scaling back of the additional grants (Graph 11). Some lenders have also tightened terms and conditions, including by further reducing maximum loan-to-valuation ratios (LVRs). And in the lower-priced suburbs of the capital cities, housing prices have broadly moved sideways since October, after earlier significant rises. Graph 11 Housing Loan Approvals* $b $b Non-FHB owner-occupiers Investors First home buyers * Excludes owner-occupier refinancing, alterations and additions and investor approvals for new construction and by ‘others’ Sources: ABS; RBA Looking forward, it is too early to tell whether these contrary signs indicate that some cooling in the property market is in prospect. It is, however, clearly desirable to avoid significant imbalances developing in the housing market, both in terms of the supply-demand situation and the price and financing dynamics. The pick-up in dwelling construction that is occurring will be helpful here, although further increases are likely to be needed over the medium term. On the financing side, we are currently not seeing the type of financial developments that caused concern in 2002 and 2003 when maximum LVRs were being raised, loan servicing requirements were being eased, new types of mortgage products were being introduced, and risk spreads were being compressed. This is good news, as it would obviously be unhelpful if a speculative cycle were to emerge on the back of the recent strength in housing prices. This is an area that lenders and current and prospective home owners will need to watch carefully over the months ahead. The final topic that I would like to touch on briefly is inflation. Here things have proceeded pretty much as expected. In underlying terms, inflation has moderated significantly, and the year-ended rate is expected to decline from its current rate of around 3¼ per cent to around 2½ per cent over the course of 2010. This decline is being underpinned by the sharp slowing in wage growth in the private sector that we saw over the past year and the appreciation of the exchange rate. In addition, the Reserve Bank’s liaison with retailers suggests that there has been significant discounting recently, and business surveys point to below average price increases. As we move forward, we need to ensure that inflation pressures remain contained and that inflation expectations remain well anchored. Expansion of the supply side of the economy is obviously important here. So too is addressing potential bottlenecks and ensuring that our labour and capital markets are sufficiently flexible so that resources are able to move to where they are most productive. In addition, as the Bank has noted a number of times, with the economy having relatively limited spare capacity, it is likely that interest rates will need to continue their gradual move towards more normal levels. Conclusion In summary then, our central scenario is for the world economy to grow at around an average pace over the next couple of years, with strong growth in a number of our major trading partners in Asia. However, around this central scenario there are significant risks as the flow-on effects of the events of the past 18 months continue to reverberate around the global economy. While we need to watch these flow-on effects carefully, the outlook for Australia appears to be considerably brighter than that for most other advanced economies. Thank you. | reserve bank of australia | 2,010 | 3 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to ACI2010 49th World Congress, Sydney, 26 March 2010. | Glenn Stevens: Recent financial developments Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to ACI2010 49th World Congress, Sydney, 26 March 2010. * * * Welcome back to Sydney. The last time that this body met here was in 1992. At that time the Australian economy was in the early phase of a recovery from a deep recession. Pessimism about the future was deeply rooted. The financial system was under considerable strain. Unemployment was in double digits and still rising. Inflation had fallen significantly, but many people thought this was a temporary impact of the downturn. They thought that if we did get a recovery – and some despaired of that – we would return to our old bad habits of high inflation. People worried a lot about Australia’s substantial current account deficit. There were relatively few optimists. You might notice some of that sort of thinking today, in some other countries. I imagine that among the participants of that 1992 meeting one could have gotten some pretty long odds against Australia having a long upswing, with inflation averaging “two point something”, surviving the financial crisis and ensuing global downturn with one of the mildest domestic downturns we have seen, and facing the future with a fair degree of confidence. This shows how hard it is to forecast, of course. But perhaps it also demonstrates that with time, effort, discipline, good policies and a bit of luck, economies can be returned to health and their citizens to prosperity. Financial market recovery To that end, it is helpful that the global financial system is gradually recovering its poise, after a near-death experience eighteen months ago. Perhaps like a patient that has suffered an acute cardiac event, there has been some lasting tissue damage, but quick intervention avoided something much worse. A period of emergency life-support has been followed by a period of recuperation, with some ongoing medication, during which the patient has been able gradually to resume normal activities. Certainly the functioning of money markets has improved substantially. Extreme counterparty risk aversion has abated and spreads of LIBOR rates to equivalent maturity OIS rates have come down to about the lowest levels since mid 2007. The dramatic expansion in the balance sheets of central banks in major economies has largely ended, though policy interest rates remain at 50-year lows. Australia’s situation is more advanced in this regard. The expansion in the RBA’s balance sheet was unwound nearly a year ago and the policy rate has been increased somewhat, reflecting the very different circumstances facing the Australian economy. But we are not the only country seeking to manage the “return to normality”. An increasing number of countries outside those most directly affected by the crisis have begun this process – though the speed of adjustment naturally depends on national conditions. Capital markets have also improved, with spreads to sovereign bond yields for private borrowers across most of the risk spectrum back to “pre-Lehman” levels, and for the best rated borrowers back almost to mid-2007 levels. They are not quite back to pre-crisis levels, but then, they probably should not have been at such low levels anyway. Similarly, spreads for emerging market sovereigns are well down from their peaks. In fact overall borrowing costs for quality corporates and emerging market sovereigns are similar to or slightly below what they were in 2006. This finer pricing is being accompanied by a gradual pick-up in debt issuance. Appetite for risk has increased significantly since the end of 2008, albeit with some occasional setbacks. Of course we should expect that it would have increased, since September and October 2008 were characterised by sheer panic – there is no other word – and a flight from virtually any risk at all. Once the global financial system did not actually go over the precipice, there was going to be some re-appraisal. Hence, even as evidence continued to emerge in the first half of 2009 of the dramatic fall in demand for goods and services, share prices and spot commodity prices began to recover. Share prices are now about 60 per cent higher than the “priced for disaster” low point, while commodity price indexes have increased by a third. Some individual commodity prices have risen by much more. Similarly, we have seen a preparedness to take foreign currency risk, and flows into emerging markets involving both foreign currency and credit risk have increased. Again, risk appetite has not returned to the heady days of the mid 2000s, but nor should it. Even the flows we have seen have begun to raise concerns among policy makers in some of the emerging countries about potential risks of asset market excesses and eventual capital flow reversal. The banking sector For major financial institutions, the picture has also improved. The general decline in risk aversion has eased funding problems, and some countries have been able to terminate or scale back their government guarantee programs as banks are increasingly able to access term funding markets under their own names. Share prices for those financial institutions that are still privately owned have generally increased by more than the broader market. A number of large American and European banks that accepted public-sector capital injections during the crisis have moved to repay them. The challenges that remain ahead for the banking system in major countries nonetheless remain considerable. The outlook for some of the remaining government ownership stakes remains unclear. While losses coming from write-downs of securities slowed some time back, losses are still occurring in lending books as a result of the normal effects of big recessions, not least in the area of commercial property. This will continue for a while. In addition, banks, particularly large internationally active banks with big trading operations, will require additional capital over time under proposed changes to global prudential standards. There is a considerable contrast between that picture and the one for banks in most other countries. It is important to note that the majority of countries have not had a banking crisis as such. Everyone was affected by the seizing up of markets in late 2008, but most were not afflicted with the sorts of asset quality and capital issues that so bedevilled large US, UK and continental European banks. This in turn meant that once the panic had subsided, the banks in most countries were able to continue to carry out their functions – albeit under more difficult circumstances and facing much more subdued demand for credit, particularly from corporations. Australia is a good example of this, though not the only one. The lowest rate of return on equity earned among the major banks here over the past two years was about 10 per cent in underlying terms; among smaller banks the lowest was 3 per cent. When markets for securitisation closed the major banks stepped into the gap by increasing their rate of housing lending, albeit at higher prices. These banks were able to support some business customers – again at a price – that in previous cycles they might have chosen to cut. The rate of provisioning for bad loans has stopped rising for several banks, and non-performing loans are likely to peak at a considerably lower share of loans than earlier expected. This general picture, even if not the exact numbers, would, I suspect, be replicated across much of Asia. These differences in experience are an important backdrop for the international work on regulatory reforms. There is no question that there must be some significant reform. To use the medical analogy again, the recovering patient is usually advised to consider some dietary and lifestyle changes, and perhaps to submit to some ongoing monitoring, in order to avoid further emergency procedures. These changes involve: removing the scope for taking on excessive leverage via regulatory arbitrage; making sure that adequate capital is held against risk that is being incurred; ensuring better management of funding liquidity; countering, to the extent possible, the inherent tendencies in both human nature and regulation to form assessments of risk in a pro-cyclical way; and improving resolution processes to ensure orderly and rapid crisis management and to help manage the issue of “too-big-to-fail” institutions. These are all very important goals. The Australian authorities support them. But as we have said before, the really serious problems were generated in a relatively small number of very large, internationally active banks. They did not stem from the thousands of other banks around the world which have not needed to be “bailed out” and whose capital resources have, in most cases, proved adequate to cover normal losses in a cyclical downswing. Hence it is important not to shackle unnecessarily the latter group in our efforts to constrain the relatively small number which caused much of the problem. Challenges from sovereign debt Turning from banks to markets more generally, a recent development has been the increasing focus on sovereign debt and creditworthiness. The initial manifestation of this was late last year when Dubai World requested a six-month standstill agreement on its debt repayments. More recently, the focus has been on Greece, after it was revealed that the Greek Government’s current borrowing requirement was much larger than had been previously disclosed. Greece is a small country – accounting for only half of one per cent of the world’s GDP. The significance of Greece is that it is a euro area country, which means two things. First, its adjustment to its predicament cannot involve currency depreciation (unless it were to leave the single currency). The only way it can grow out of the problem is by gaining competitiveness against other European economies via domestic deflation, which will be a difficult and lengthy process. A very large fiscal consolidation is an unavoidable part of this path. Second, the euro area has an interest in this effort succeeding, which is why there has been intense discussion about whether, and in what form, European assistance might be forthcoming. Any assistance would of course have to pass the test of credibility more generally in Europe, and would need to be applicable under similar terms to other euro area countries if needed. This is obviously a difficult problem, on which the policymakers concerned are continuing to work. Perhaps the broader significance is that the difficulties facing Greece, while unusually stark, are a reminder of the challenges facing many governments in Europe, and for that matter the United States and Britain, over the long haul. Ratios of debt to GDP are rising quite significantly in all these cases. There are several reasons. The first is the size of the recessions being experienced, which obviously reduces revenues and adds to some categories of spending – the so-called “automatic stabilisers”. This effect is relatively larger in some European countries but it occurs everywhere to some extent. The second factor is the discretionary budgetary decisions aimed at stimulating demand and injecting capital into banks. In the circumstances, the former was understandable; the latter was unavoidable. The “automatic stabilisers” will presumably “automatically” move budget positions in the right direction as economies recover. The costs of stimulus and bank rescue measures, while one-off in nature, do leave debt permanently higher. But without such measures, economies might have suffered much deeper downturns and so the extent of budget deterioration could have been much greater, itself leaving an even bigger debt legacy. If that was the end of the story, we would not want to get too worked-up over debt ratios. Unfortunately, though, there is more to the story. For several important countries there was a trend increase in debt-to-GDP ratios going on before the crisis occurred. For the domestic audience, let me be clear that Australia has been a conspicuous exception. Particularly in mainland Europe, the pattern has tended to be for debt ratios to rise quickly in periods of recession, then to stabilise for some years, before rising again in the next recession. No doubt multiple factors are at work but the interaction of changing demographics and generous welfare, health and retirement systems is prominent. The same factors also work, other things equal, to lessen future potential economic growth. It is certainly not unprecedented for countries to have debt stocks much larger than their annual GDPs. This has usually been seen when they faced the requirements of fighting wars. Those ratios subsequently came down over time. But the situation now is different. The decline in debt ratios seen after the Second World War, for example, driven by rapid growth in output as population expanded and productivity surged, will not easily be repeated in many of the major countries. It is these more deep-seated trends, which were in place before the crisis, that are really the greater cause for concern; the crisis has brought them more sharply into focus. The demographic drivers will continue for the foreseeable future, while the unwillingness or inability to tackle the structural trends in earlier “good times” has significantly reduced future flexibility. So a number of advanced industrial countries face some difficult fiscal decisions over the years ahead. At some point, significant discretionary tightening will be required. Of course policymakers need to get recoveries well entrenched, which is why many observers warn against attempting an early fiscal consolidation. But unless a credible path to fiscal sustainability can also be set out, growth could easily be stunted by rising risk premia built into interest rates as markets worry about long-run solvency. This is not happening as yet; long-term rates in many of the major advanced countries remain quite low. That provides a window within which to plan the eventual consolidation. Since markets can be fickle and things can change, governments will surely want to use the window. Economic recovery In the mean time differences persist in the pace of economic recovery across regions. In the United States growth spurred by a swing in the inventory cycle is thought to have marked the turning point in the second half of 2009, but most observers still expect only moderate growth this year. In Europe, the momentum of the recovery has been less certain. In both cases the old forecasting cliché about uncertainty applies in spades. In contrast, it is apparent that the letter “v” is a reasonable description of the trajectory, to date, of important emerging countries like China, India, Brazil and a number of smaller east Asian countries. We should expect to see some moderation in the pace of growth of production in some of these cases this year. This is usually the case in “v-shaped” recoveries, since the initial pace of expansion is considerably higher than the long run sustainable growth rate. The question of what happens to demand in these countries is of course distinct from that of what happens to production. Full employment in parts of the emerging world will probably be reached before full employment in North America or Europe. Productive capacity therefore would remain to meet further demand from the emerging world, via imports of goods and services from the “old world”. That is, emerging Asia and some other parts of the world could see their living standards rise a bit faster than the increase in their own productivity, for a time, if they were prepared to meet some demand through imports. Facilitating this most efficiently would of course involve, among other things, allowing exchange rates to change. The alternative approach would be to seek to slow growth in demand in the emerging world as production there approaches full capacity, so as to maintain internal balance at a given set of exchange rates. But that would leave unused capacity in the industrial countries and emerging world living standards lower than they could be. These are polar cases – it would of course be open to policymakers to steer some path in between. Among Asian policy makers many factors go into thinking about exchange rates and trade and capital flows. They have a degree of suspicion of rapid capital flows and large movements in exchange rates, which is understandable after the experiences of the late 1990s. It is also understandable that the smaller economies, some of which are extremely open, with trade shares of more than 100 per cent of GDP, do not wish to see volatile exchange rates because it is disruptive for their economies. Moreover, the issue goes well beyond just exchange rates per se; it involves saving and investment patterns, and national policy approaches to growth, the speed with which these can be adjusted and so on. The point, nonetheless, is that the current and prospective differences in economic circumstances between significant parts of the world are likely to put strains on the relative settings of macroeconomic policies and exchange rate arrangements. This will need careful management, by all concerned, over the next few years. Conclusion The stabilisation of financial markets and banking systems over the past year or more is a welcome development for all of us. There are still difficulties to overcome for financial institutions in some key countries as a result of the depth of recessions, and these will be the subject of attention over the coming year. Looking ahead, the differences in the speed of economic recovery are starting to present challenges of their own, showing up as they do in capital flows, asset valuations and exchange rates. When we add to all that the looming longterm requirement for fiscal consolidation in a number of major countries, there is plenty for markets and policy makers alike to think about. I’m sure your conference will take up these issues with great energy. I wish you every success in doing so. | reserve bank of australia | 2,010 | 3 |
Address by Mr Guy Debelle, Assistant Governor of the Reserve Bank of Australia, at the Mortgage Innovation Conference, Sydney, 30 March 2010. | Guy Debelle: The state of the mortgage market Address by Mr Guy Debelle, Assistant Governor of the Reserve Bank of Australia, at the Mortgage Innovation Conference, Sydney, 30 March 2010. * * * I thank Michael Davies, Dan Fabbro, Megan Garner and Jennifer Pitman for their help in preparing this talk. Thank you for the opportunity to address this forum. Today, I intend to talk about the past, present and future of the mortgage market in Australia. It is useful to recount some of the history of the mortgage market to put the current state of the market in to better context and provide a basis for thinking about how the market might evolve in the period ahead. History In the 1960s and early 1970s, the Australian financial system was heavily regulated. 1 There was a number of wide-ranging controls including: The interest rates that banks could charge on their loans and pay on their deposits were controlled. Banks were subject to reserve ratios and liquidity ratios. There were directives on the overall quantity of loans banks should make, as well as moral suasion on who they should lend to. Institutions were specialised – trading banks lent to businesses, savings banks held large quantities of Government debt and lent to households (almost entirely for housing), and finance companies lent for more risky property loans and consumer credit. These regulatory controls on the banks reduced their capacity to adjust to changing conditions and imposed a cost disadvantage on them. As a result they lost market share to the unregulated financial sector, primarily building societies. The banks’ share of total financial intermediary assets declined from nearly 90 per cent in the early 1950s to 70 per cent in 1970. The banks’ share of housing credit was just below 60 per cent in 1976 with much of the rest of the mortgage market being provided by credit unions and building societies. Finance companies, which were generally associated with the banks, often provided top-up funding to bank mortgages but were not a particularly large share of the overall market. This draws on Battellino R (2007), “Australia’s Experience with Financial Deregulation”, Address to China Australia Governance Program, 16 July, Melbourne. Graph 1 Financial deregulation in Australia began slowly in the 1970s, before accelerating sharply in the early 1980s. It affected the quantity of credit provided, the pricing and the structure of the mortgage market (Graph 1). The main developments were the reduction of the prescribed assets ratio which was the minimum share of total assets that savings banks were required to invest in Government debt. As this was gradually reduced from 70 per cent to 40 per cent between 1963 and 1978, savings banks could correspondingly increase the share of housing lending in their assets. On the pricing front, the interest rate ceiling on large housing loans was removed in the early 1970s and then in April 1986, the interest rate ceiling on all new housing loans, 13½ per cent at the time, was removed. (Existing loans remained subject to the 13½ per cent cap until they were discharged.) In terms of the structure of the market, the distinction between savings banks and trading banks was removed in 1989. Prior to that, in the mid 1980s, 15 foreign banks were given licences to operate in the Australian market. However, the foreign banks, in the main, focussed on lending to businesses rather than lending to households, in large part because they did not have a branch network which would enable them to compete effectively against the local banks. Further financial innovation which would have facilitated their ability to compete without a branch network was still nearly a decade away. The major change in market structure was that a number of building societies and credit unions converted to banks through the 1980s and early 1990s. Becoming a bank allowed these institutions a greater capacity to expand their capital base. More generally, in the first few years after deregulation, business lending grew much more quickly than housing lending. Between January 1985 and December 1988 business lending grew at an average annual pace of 30 per cent, while housing lending grew by 22 per cent. 2 As a result, the share of business loans in banks’ total lending rose from 54 per cent to 62 per cent over this period. These are nominal growth rates. Inflation during this period averaged 8 per cent. However, in the early 1990s, a number of factors contributed to the banking system shifting its focus from lending to business towards housing: First, the banks suffered large losses on their business loan portfolios during the early 1990s recession. In contrast, the losses on their housing loans were relatively mild, notwithstanding the fact that the unemployment rate rose to about 11 per cent and mortgage rates reached as high as 17 per cent. Second, demand for credit from the corporate sector declined as the sector underwent a period of deleveraging. Third, the introduction of the (first) Basel Capital Accord saw a change in the risk weighting in favour of housing assets. In August 1988, the Reserve Bank of Australia (which was then the banking sector regulator) issued guidelines for a riskbased measurement of banks’ capital adequacy, broadly consistent with the Basel proposals. Prior to this, Australia used a capital-to-total assets ratio for measuring the capital adequacy of banks, which gave banks an incentive to invest in riskier, but higher yielding assets. 3 Under the new risk-based approach, housing loans were given a risk weight of 50 per cent, whereas business and personal loans had a risk weight of 100 per cent. Banks were required to satisfy the new capital adequacy requirements by 1992, but as early as 1990 they had taken steps to increase their capital bases to the required levels. As a result of these factors, between 1991 and 1995 the share of business loans in banks’ total lending fell by 15 percentage points to 48 per cent, while the share of housing lending rose by 16 percentage points to 46 per cent. Since then, this trend has continued, reinforced by the continuing strong performance of housing loans and, in terms of demand for credit, the shift downwards in the nominal interest rate structure as the low inflation environment was achieved and maintained. Currently, the share of housing loans in banks’ total lending stands at 58 per cent, while the share of business lending is about 35 per cent. Rise of the wholesale lenders The next development which had a material effect on the structure and pricing of the mortgage market was the rise of the wholesale lenders. As nominal interest rates came down in the early 1990s, mortgage rates declined more slowly such that the spreads on banks’ housing loans increased. In 1993, the spread between the variable mortgage rate and the cash rate was about 430 basis points (Graph 2). The reduction in inflation and nominal interest rates eroded the banks’ funding advantage obtained from interest-free deposits. These factors, together with the lower level of money market rates (and their increased stability), provided the opportunity for wholesale lenders to enter the market. These new institutions competed aggressively for market share by undercutting banks’ mortgage rates and by introducing new mortgage products such as home equity loans, interest only loans and low documentation loans (see below). The wholesale lenders’ share of housing loan approvals rose quickly from 2 per cent in 1993 to 8 per cent in 1996 (Graph 3). The banks responded to this increased competition by reducing their spreads, such that by 1997, the spread over the cash rate on their indicator housing rates had decreased to about 175 basis points. The ability of the wholesale lenders to compete effectively was considerably enhanced by the growth of the residential mortgage backed securities (RMBS) market. This provided a source See: Lewis MK and RH Wallace (eds) (1997), The Australian Financial System: Evolution, Policy and Practice, Addison Wesley Longman, Melbourne; RBA (1988), “Supervision of Capital Adequacy of Banks”, Bulletin, February, pp 14–26; RBA (1998), “Capital Adequacy of Banks”, Bulletin, September, pp 11–16. of funds to these lenders which did not have the deposit base of the financial institutions. These lenders had no balance sheet, little capital and no branch structure and hence were low cost operations with a large degree of flexibility. In subsequent years, the regional banks, along with credit unions and building societies, also made significant use of securitisation as a relatively cheap source of funding. The major banks also issued RMBS to diversify their funding base but it was never a large part of their funding. Graph 2 Graph 3 In a further response to the competition from the wholesale lenders, in the early 2000s, banks began increasing the discount offered on the standard mortgage rate to new borrowers. This enabled banks to slow the repricing of their loan books because only new or refinancing borrowers benefited from the discounts, whereas changes to their standard variable rate immediately flowed through to all borrowers. Initially banks did not publicise these discounts, but since the mid 2000s, they have been quite open about them, and now the vast majority of new borrowers pay an interest rate that is below the standard variable rate. The discount has grown over time and has spread to most borrowers. Currently the average borrower is receiving a discount of around 60 basis points on the standard variable rate. This discounting saw the spread between the cash rate and the actual mortgage rate paid narrow further over the decade to 2007. As I mentioned earlier, the foreign banks focussed primarily on the corporate market when they first began business in the mid 1980s, but from the beginning of this decade, they have increased their focus on retail banking, including housing lending. Their share of housing loan approvals increased from about 1 per cent in 2000 to a peak of about 15 per cent in 2008 (Graph 4). Two related factors have contributed to the foreign banks’ increased market share. First, starting off with a small portfolio of mortgages meant that the foreign-owned banks were able to advertise lower interest rates without adversely affecting the profitability of a large stock of loans to existing customers. Second, the wider acceptance on the part of customers of applying for loans over the internet and the use of the broker network has increased the ability of these banks to reach new borrowers without establishing a costly branch network. 4 During late 2008 and 2009 however, the foreign banks’ market share fell significantly, in large part because of the reduction in lending by Bank-West. Graph 4 More generally, the emergence of mortgage brokers, who act as intermediaries between lenders and borrowers and make it easier for borrowers to compare the costs and features of different loans, has contributed to the increase in competition between lenders in the Australian mortgage market. Mortgage brokers’ share of total mortgage settlements is about one-third of all loans. See RBA (2007), “Box C: Foreign-Owned Banks in Australia”, Financial Stability Review, March, pp 47–49. Product innovation Through the late 1990s and first half of the 2000s, there was considerable product innovation in the Australian mortgage market. Lenders sought to cater for a wider range of potential borrowers and found new ways to assess their borrowing capacity. Some of this innovation has resulted in an easing in lending standards and an increase in risk for both borrowers and lenders, but its overwhelming effect has been to widen the range of households who can access finance. 5 Moreover, when the lending was more risky, lenders charged a larger spread on these loans to take account of the greater risk and required lower loan to valuation ratios (LVRs) for these loans. Lenders introduced home-equity loans, redraw facilities and reverse mortgages, all of which allowed households to borrow against the equity they have built up in their homes. Lenders also introduced interest-only loans and shared-equity loans, which made it easier for households, particularly first home buyers, to purchase their home. Loan products that better meet the needs of certain types of borrowers, such as those with irregular income streams or those who do not meet the standard lending criteria, were also introduced. Low-doc loans, for which borrowers self-certify their income in the application process, accounted for about 10 per cent of newly approved housing loans in 2006, compared with less than ½ per cent in 2000 (Table 1). There was also an increase in non-conforming loans for borrowers who do not meet the standard lending criteria of mainstream lenders. These borrowers typically have poor credit or payment histories. In 2006, non-conforming loans comprised 2 per cent of new loan approvals, compared with less than ½ per cent in 2000. Table 1 Housing loans Lending standards and arrears Fortunately, lending standards in Australia did not loosen as much as in some offshore markets. There was very little sub-prime lending of the form more common in the United States for example, where loans were provided to those with poor credit histories. The non-conforming loan market, which was the closest equivalent in Australia, never reached more than 2 per cent of new loans, and is currently less than 1 per cent of loans outstanding. Only a few fringe institutions were involved in the market. There are almost no nonconforming loans being issued at the moment, with the providers of such loans having exited or gone into extended hibernation. See APRA (Australian Prudential Regulation Authority) and RBA (2007), “Joint RBA-APRA submission to the Inquiry into Home Lending Practices and Processes”, August, and RBA (2008), “RBA Submission to the Inquiry into Competition in the Banking and Non-Banking Sectors”, 10 July. Consistent with this, and the stronger underlying economic conditions in Australia, the share of non-performing housing loans in Australia has remained very low (Graph 5). In December 2009, the share was 0.6 per cent in Australia, much the same as it was 15 years ago. Compared with other countries, this is only a little above the 0.4 per cent in Canada and well below the 2½–3 per cent in the UK and Spain and 8 per cent in the US. Graph 5 Looking at the Australian data in more detail, the proportion of banks’ on-balance sheet housing loans that were in arrears or impaired in December 2009 was 0.6 per cent. This is up from the very low levels in 2002–2003, but still low in absolute terms. The arrears rate has tended to be relatively stable in recent months. Australian residential mortgage backed securities have continued to perform very well. This is reflected in data from a lenders’ mortgage insurance provider and the RMBS market, which show that annual losses on insured prime housing loans averaged 4 basis points between 1980 and 2010, with the highest loss in any one year being 10 basis points. 6 As a result, even the holders of lower rated tranches of RMBS have not suffered any losses, as the insurance, together with the subordination embodied in the RMBS, has provided a more than adequate buffer. The effect of the financial crisis The financial crisis has had a material affect on pricing and structure in the Australian mortgage market but has not had a particularly marked impact on the quantity of housing credit provided. RBA (2006), “The Performance of Australian Residential Mortgage-Backed Securities”, Financial Stability Review, March, pp 63–68. Beginning around the middle of 2007, there was a widespread reappraisal of the risks associated with investing in structured credit products. Securitisation started to suffer severe brand damage as primarily US RMBS incurred significant credit problems as delinquency rates began to rise. 7 Initially, the problems were most evident in the sub-prime mortgage market, but they later spread to prime mortgages in the US as well. Combined with the decline in house prices, these delinquency rates have led to large losses for investors in US RMBS. The Australian RMBS market was significantly affected, even though (as already discussed) lending standards were much better in Australia, and the RMBS continued to perform well. Issuance dried up markedly (Graph 6). Most of the issuance during late 2008 and the first half of 2009 was purchased by the Australian Government through the Australian Office of Financial Management. Offshore SIVs, which had been large buyers of Australian RMBS prior to the financial crisis, were forced to liquidate their portfolios as they were no longer able to fund themselves. These sales into the secondary market drove spreads from about 15 basis points (over the bank bill swap rate) pre-crisis to a peak of over 400 basis points in early 2009. This very wide secondary market spreads also deterred new issuance. Graph 6 The crisis also had a material effect on the funding costs of all providers in the mortgage market. In addition to the effect on RMBS funding described above, wholesale (and particularly recently) retail funding costs have risen relative to the cash rate. 8 In response to the rise in funding costs, all institutions have raised their mortgage rates relative to the cash rate. Interestingly, while the standard variable rate has been increased, there is little sign of any reduction in the discounts offered on new loans. The average rate on variable rate housing loans has increased by around 110 basis points relative to the cash rate since mid 2007 (Graph 7). 9 This increase, relative to the cash rate, is below the See Debelle G (2009), “Whither Securitisation?”, speech given to the Australian Securitisation Conference 2009, Sydney 18 November. See Brown A, M Davies, D Fabbro and T Hanrick (2010), “Recent Developments in Banks’ Funding Costs and Lending Rates”, RBA Bulletin, March Quarter, pp 35–44. The average rates on all outstanding housing loans has increased by around 145 basis points over this period, as rates on the major banks’ new 3- and 5-year fixed-rate housing loans have risen by 170–180 basis points estimated 130 to 140 basis point rise in banks’ overall funding costs over this period. In contrast, banks’ business and personal loans have increased by even more relative to the cash rate and by more than the rise in funding costs. Because the funding costs of the smaller participants have tended to rise by more, their profit margins have been squeezed more and in some cases, their capacity to provide new loans has also been curtailed. Some participants have been able to remain competitive and profitable only by cross-subsidising their new issuance using the large spread they are earning on their back book of mortgages. These mortgages were funded pre-crisis, so that the subsequent upward repricing of the whole mortgage book has resulted in the older loans now earning a wide margin. Graph 7 The pressure on funding during the crisis, together with the near closure of the RMBS market, changed the competitive dynamics in the mortgage market. The market share of wholesale lenders (who relied almost exclusively on securitisation) fell from about 13 per cent in mid 2007 to about 2 per cent by early 2009. Several of the larger wholesale lenders were acquired by the major banks (CBA bought into Aussie and Aussie bought Wizard; Westpac bought RAMS distribution business; NAB bought Challenger’s mortgage business). The share of housing loan approvals by smaller banks, credit unions and building societies also declined, though not as sharply. The major banks’ combined market share rose from 60 per cent to over 80 per cent over this period. Nevertheless, housing finance has been readily available throughout the crisis period, with housing credit growing at about 8 per cent a year. The larger banks have filled the gap left by the decline of the wholesale lenders, so that there has not been a material constraint on the quantity of housing credit available in Australia throughout the crisis. There has, however, been some tightening in lending standards, with several banks reducing their maximum LVRs on prime, full-doc loans for new borrowers from 95–97 per cent to relative to equivalent maturity swap rates (and by more relative to the cash rate because of the current slope of the yield curve). about 90 per cent during 2009. Banks have also raised their interest rate buffers and increased their “genuine savings” requirements. Low-doc and non-conforming loans have become much harder to obtain. This has seen a decline in the share of new owner-occupier housing loans with a LVR above 90 per cent, from a peak of 27 per cent in the March quarter 2009 to 17 per cent by the end of the year. The share of low-doc loans has declined to about 7 per cent. There has been a decrease in the shares of new investor loans that are being written with higher loan-to-valuation ratios (LVRs) or lower documentation standards. There has also been a decline in the share of interest-only loans, though it is still the case that close to half of all new investor housing borrowers are opting to not make any principal repayments, reflecting the tax advantages of this funding strategy. The future Looking forward, the competitive state of the current market is reflected in the fact that home lending rates have not risen by as much as funding costs. Moreover, the outlook for the smaller lenders has improved since mid 2009. The securitisation market is starting to recover, with the volume of issuance to non-AOFM investors picking up and secondary market spreads decreasing. Securitisation is once again becoming a more viable funding source for lenders, with spreads on newly issued RMBS – around 130 to 135 basis points over one-month bank bills for nonAOFM supported deals – a little below our estimated break-even spread of around 160 basis points. However, our estimate of the break-even spread, and hence the profitability of the issue, does not take into account different degrees of subordination across issues. To the extent that that the degree of subordination required by investors is greater than it was previously, the overall profitability of the issue will be lower. This is because a greater share of the security is retained on the book of the issuer, or sold at a higher cost to another investor, reducing the return from the deal. (However, this effect on overall profitability is much smaller than the increase in spreads since the crisis.) The cost of long-term and short-term wholesale funding has also decreased since mid 2009, though the cost of deposits remains high. Consistent with this, the smaller lenders’ market shares have risen slightly over recent months, though they are unlikely to return to pre-crisis levels any time soon. The pre-crisis level of RMBS activity, which these institutions relied more heavily on, was supported by demand from offshore SIVs which is no longer there. But as the major banks have increased their lending rates to recoup increased funding costs, and as funding costs for securitisation have fallen, the smaller participants have become increasingly more competitive. While interest rates on mortgages have increased relative to the cash rate, the Reserve Bank is able to take account of those changes in its policy deliberations. The cash rate determined by the Reserve Bank is still the major determinant of the interest rate structure in Australia, including that of mortgage rates. With the securitisation market showing greater vitality in recent months, the housing loan market remains contestable. Any widening in margins is likely to attract new competitors into the market. Already, the improvement in securitisation has encouraged some of the smaller lenders back into the market and encouraged some brokers to again look to increase their own mortgage lending. With these developments, the provision of mortgage credit in Australia is likely to continue to be adequate in a competitive marketplace. | reserve bank of australia | 2,010 | 4 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Regional Business Leaders Forum, University of Southern Queensland and Toowoomba Chamber of Commerce and Industry, Toowoomba, 23 April 2010. | Glenn Stevens: Economic conditions and prospects Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Regional Business Leaders Forum, University of Southern Queensland and Toowoomba Chamber of Commerce and Industry, Toowoomba, 23 April 2010. * * * Thank you for the invitation to visit Toowoomba. In my remarks today I would like to provide an update on economic conditions and prospects. This will be from a national perspective, and set in an international context. In so doing, I am mindful that next week we will receive some important data on prices. We, and everyone else, will have an opportunity to update our thinking on the current and likely future course of inflation. So my remarks today will be subject to that caveat. The Bank will publish a detailed overall analysis of the economy early next month. The global economy The latter part of 2008 and the first few months of 2009 saw what has come to be regarded as the most serious international recession in decades. Global growth has since resumed, but with a rather uneven pattern: it is being led, in the first instance, by the emerging world. It’s worth asking why that pattern exists. At least part of the answer lies in the nature of the downturn and in the policy responses to it. It is frequently claimed that the downturn was the worst since the 1930s. In the financial sectors of some major countries that seems clear, but for economic activity it is actually less clear than you might think. For several important countries individually, the increase in unemployment and loss of real output was certainly equal to those in the most severe postWar recessions, but not significantly greater. Some respected scholars of US business cycles have suggested recently that it may be a bit soon to judge whether the recent period qualifies for the term “great recession”, at least in the US case. In east Asia, in most cases, the latest episode has turned out to be far less traumatic than the 1997–98 Asian financial crisis. What was striking about the recent downturn was the simultaneity of the collapse in demand for durable goods around the world at the end of 2008. Suddenly, everyone, everywhere, felt much more risk averse – understandably so, as they watched governments have to save major financial institutions in a number of countries. This affected consumption and saving decisions, firms’ investment plans, hiring intentions and so on. But equally remarkable was the simultaneity of the policy responses. There was a degree of formal co-ordination – for example, most G10 central banks reduced their interest rates by 50 basis points on 8 October 2008. Beyond that there was a fairly consistent set of responses stemming from a common assessment of the seriousness of the potential threat. So the global downturn could have been much worse than it eventually was, but policy makers everywhere supported financial systems where needed, eased monetary policy and eased fiscal policy, to support demand. The responses, by and large, were quite quick. In the countries at the centre of the crisis, these policy efforts have borne fruit. But they have been working against the powerful headwinds of private sector de-leveraging. Hence in those cases the recovery thus far has been quite hesitant. Economic activity remains well below the peak level seen in 2007 or 2008, and in some of these economies it may not regain that level for another year or two. It is in this sense, actually, that the downturn in parts of the advanced world may well turn out to be the most costly in generations: the forecast slowness of the recovery implies a very large cumulative amount of lost income in some cases. In other episodes of serious recession, once conditions for recoveries were in place, they proceeded quite strongly. People are not confident of those sorts of outcomes this time (indeed many forecasters and financial markets will be seriously wrong-footed if a rapid recovery in the crisis-hit countries does occur). Observers in some countries even wonder whether their trend growth rate may have been impaired for a lengthy period by what has occurred. But most countries did not have a bank solvency crisis. They had an acute liquidity crisis for a couple of months in September and October 2008 when the global financial system went into cardiac arrest, but thereafter those problems began to ease – mainly due, it must be said, to actions of governments and central banks in the major countries. Since in most countries banking systems were generally sound, the headwinds have not been blowing as strongly in Asia or Latin America as in some other regions. Accordingly, the policy stimulus applied in these countries appears to have been pretty effective in supporting demand. Once money markets and trade finance began to thaw, recovery proceeded at a very strong clip. In east Asia outside Japan and China, industrial production is now a little above its previous peak. In China, it surpassed the 2008 peak in the middle of last year and kept rising, while in India it never really fell. Despite the slow growth of Asia’s traditional export destinations – North America, Europe and Japan – trade in the region has bounced back remarkably strongly after a precipitous fall in late 2008. A large part of this rebound has been an increase in intra-region exports of final products, particularly to China. This suggests that demand within the region is playing a bigger role in this upswing, though Asian exports to the United States and Europe are recovering too. Corresponding differences show up in other areas. Inflation in the euro area and United States is still trending downwards, and spare capacity could be expected to dampen price changes for some time yet, though rising commodity prices will work the other way. For much of Asia, on the other hand, the period of disinflation caused by the downturn may be past. Asset values also have moved up most quickly in these countries. Perhaps this is not altogether surprising given that no countries in the region have had seriously impaired banking systems, but most have had very expansionary monetary policy. Australia and the “great recession” While several major countries have had one of their most, if not their most, serious recessions in the post-War period, Australia had arguably one of its mildest. We had a relatively sharp but very brief downturn in aggregate demand and economic activity late in 2008, and then returned to a path of expansion during the first half of 2009. As most recently estimated by the ABS, real GDP grew by 2¾ per cent through last year – a bit below average, but much higher than for most other high-income economies. This was supported by monetary and fiscal stimulus, the recovery in Asia, and a sound financial system. The sorts of things that typically accompany downturns – such as higher unemployment, increased loan losses for intermediaries, a fall in asset values – did happen to some extent. But because the downturn was brief, these deteriorations were rather mild, which meant that they did not then become part of a major feedback loop back to aggregate demand and output. That in turn meant that the economy was able to get onto the recovery path more quickly. And so on. As a result, the rate of unemployment, at about 5¼ per cent, is more than 2 percentage points lower than we forecast a year ago. The level of employment is 3½ per cent, or some 350,000 jobs, higher than we expected a year ago. GDP growth of 2¾ per cent through 2009 compares with our forecast a year ago of –1 per cent. That is, the level of real GDP today is nearly 4 per cent higher than had been anticipated. For 2009 as a whole, we estimate that nominal GDP was about $45 billion higher than our forecast a year ago. Measures of business confidence and conditions in most of the surveys carried out by private organisations have for some time been at levels that are suggestive of something like average rates of economic growth. The Reserve Bank is of course aware that the picture is not uniform across every region or industry. Moreover, the upswing is likely to have particular features that mean that differences across sectors and regions may widen. Not everyone will feel its benefits in the same way or to the same extent, though this is true of all economic cycles. But it does not in any way diminish those concerns to say that there has been a good outcome for the national economy in a difficult international environment. Managing the upswing Our task now is one of trying to ensure, so far as we can, that the new economic upswing turns out to be durable and stable. There are many factors about which we can do little. The speed and composition of global economic growth for example, or the behaviour of international financial markets as they grapple with uncertainty and risk – these and other factors may turn out to our benefit or detriment. We cannot change them; we can only try to be alert to them, and maintain some capacity to respond to them. For the time being, at least, the global economy is growing again. Forecasters expect an outcome something like trend global growth in 2010 and 2011, which is much better than 2009 but not as strong as 2006 or 2007. Those were exceptional years for growth and that pace could not have been sustained for long, even absent the crisis. In the region to which the Australian economy is closely linked, growth has been very strong over the past year. Almost certainly it will need to slow somewhat in the coming year. Demand for natural resources has returned and prices for those products are rising. We have all read of the recent developments in contract prices for iron ore. As a result of those and other developments, Australia’s terms of trade will, it now appears, probably return during 2010 to something pretty close to the 50-year peak seen in 2008. As usual with these things, we cannot know to what extent this change is permanent, as opposed to being a temporary cyclical event. However, the fact that we will have reached that level twice in the space of three years suggests there is something more than just a temporary blip at work. Financial markets have made a pretty good recovery from their cardiac arrest 18 months ago. Despite large budget deficits in major countries, long-term rates of interest remain remarkably low. Since risk spreads for most borrowers have also declined this means that overall borrowing costs for rated borrowers, corporate and most governments, are low by the standards of the past few decades. This has to be advantageous for well-run companies and countries looking to invest. Of course, risks to this outlook do remain. In the middle of the crisis, the international focus was on private creditworthiness. Now it is more on sovereign creditworthiness. The euro area is working on a response to the problems of Greece, but we can expect that a focus on sovereign risk will be a feature for some time yet. Periodic surges in concern are likely to be a recurring theme, and not just about the sovereigns themselves but about banks that might have exposures to them. A credible path needs to be outlined for fiscal consolidation and debt stabilisation in the North Atlantic economies over the years ahead. In the meantime, banks in the countries with weak economies are absorbing the normal sorts of losses associated with recessions. A different challenge for countries in other regions is managing the flows of capital that result from, on the one hand, the very low interest rates in major economies and, on the other, the solid growth performance in Asia and parts of Latin America. Setting monetary policy and managing exchange rates will be no easy task. More countries in the Asian region are starting to change policy settings to be less expansionary: at last count central banks in India, Malaysia, Singapore and China had all begun this process. Having said all that, what sort of outcome might be expected for the Australian economy? If the outlook involves a combination of solid-to-strong growth overall among trading partners, a high level of the terms of trade pushing up national income, reasonably confident firms and households and strong population increase, we are not likely to see persistently weak economic growth. This big picture view is why we expect that, short of something serious going wrong in the global economy, Australian growth in 2010 will be a bit faster than in 2009 – at something close to trend. The reason I say “a bit faster” is that while some factors are building up in an expansionary direction, and might be quite powerful, at the same time the impact of earlier expansionary policy measures is starting to unwind. So what happens to growth depends on the net effect of the two sets of forces. It is noteworthy that, although measures of consumer and business confidence suggest that people are essentially quite optimistic about the future, a degree of caution still characterises consumer spending decisions. Some areas of retail sales are quite soft. In the period ahead, moreover, we might expect to see households inclined to save a higher share of current income, and perhaps to be more cautious about the amount of debt they take on, than in the preceding upswing. On the whole, taking a longer-term perspective, this is probably not a bad thing. A similar caution is in evidence, at this stage, in some firms’ investment intentions, though overall investment as a share of GDP remained fairly high through the downturn. But of course there is also a once-in-a-century build-up in resource sector investment, which could see that investment, already high, rise by another 1–2 percentage points of GDP over the next four or five years. There are also high levels of public sector infrastructure investment planned in coming quarters and the housing needs of a rapidly growing population are likely to see demand for new dwellings remain quite strong over time. So the outlook for demand seems likely to be driven more by investment, both private and public, and less by consumption than in some previous periods. Even before the downturn, the relative share of consumer spending in total demand was tending to diminish and that of investment spending to increase. There will presumably be corresponding shifts in the industry composition and geographical location of output and employment. Such effects could well be seen in and around Toowoomba itself, depending on the outcomes of proposed gas and coal projects in the region. The key will be, and not just in Toowoomba, to retain flexibility in the face of such changes. Let me now make some observations about inflation and monetary policy. Inflation has fallen from its peak of 5 per cent in 2008. Measured on a CPI basis it fell to about 2 per cent in 2009, but that figure flatters us a bit as it was partly a result of some temporary factors. Underlying inflation ran at around 3¼ per cent for the year, and at an annualised pace of about 2¾ per cent in the second half of the year. Our forecast a few months ago for 2010 was that inflation, measured either in headline or underlying terms, would be in line with our 2–3 per cent target. Next week’s figure will provide an insight into how things are tracking relative to that forecast. A year ago, when we thought we might be going into a significant recession, there seemed to be the possibility that inflation could fall noticeably below the target. That doesn’t seem very likely now, though, with a recovering economy, rising raw material prices, the labour market having stabilised and with some firms even beginning to worry again about skill shortages. Given all of the above, one would not expect the setting of interest rates to be unusually low. If the economy is growing close to trend, and inflation is close to target, one would expect interest rates to be pretty close to average. The Reserve Bank has moved early to raise the cash rate to levels that deliver interest rates for borrowers and depositors more like those that have been the average experience over the past 10 to 12 years. Those interest rates are now pretty close to that average. These increases have been fairly close together but then so were the preceding reductions. It is important to recall that the cash rate was reduced by 75 or 100 basis points at each meeting of the Board in late 2008 and early 2009, for a total of 375 basis points in five months after the Lehman failure in September. This was the biggest proportional decline in interest rates, delivering the biggest reduction in the debt servicing burden of the household sector, seen in Australia’s modern history. It was an appropriate response to the situation. These changes were newsworthy, as interest rate changes always are. But as I have said before, while the changes in interest rates make the news, it is the level of interest rates that matters most for economic behaviour. Eighteen months ago, the Board moved quickly to establish a much lower level of interest rates in the face of a serious threat to economic activity. But interest rates couldn’t stay at those “emergency” lows if the threat did not materialise. The aggressive reduction in interest rates needed to be complemented by timely movement in the other direction, once the emergency had passed, to establish a general level of interest rates more in keeping with the better economic outlook. Hence the cash rate has risen by 125 basis points over seven months – which is still only about a third the pace of the earlier declines. The Board’s reasoning for those decisions has been set out in the various statements, minutes and so on. The question of what happens from here, of course, remains an open one, as it always must. The Board’s focus will be on doing our part to secure a durable expansion and on achieving the medium-term target for inflation of 2–3 per cent on average. Conclusion Australia has survived what some have labelled “the great recession” in the global economy. So, as it turns out, have a number of countries that are of importance to us in our region. The common ingredient seems to have been reasonably healthy financial systems accompanied by liberal doses of policy stimulus. Our task, and theirs, is now to manage a new economic upswing. This will be just as challenging, in its own way, as managing the downturn. But it’s a challenge plenty of other countries would like to have. | reserve bank of australia | 2,010 | 4 |
Keynote speech by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, at the Colonial First State Investment Forum, Sydney, 13 May 2010. | Philip Lowe: Recent economic developments Keynote speech by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, at the Colonial First State Investment Forum, Sydney, 13 May 2010. * * * I would like to thank Colonial First State for the invitation to speak at today’s Investment Forum. It is a pleasure to be here this morning. Last Friday, the Reserve Bank released its latest quarterly Statement on Monetary Policy. What I would like to do this morning is to pick up on three of the interrelated themes of that Statement. The first is the nature of the recovery in the global economy. The second is the outlook for the Australian economy and the expected increase in Australia’s terms of trade. And the third is recent developments in inflation, particularly the divergent trends in the prices of tradable and non-tradable goods and services. The global economy The week since the Statement was finalised has been a turbulent one on global financial markets due to concerns about the fiscal situation in Europe. When these concerns first arose, the focus was on public finances in Greece and there were limited flow-on effects outside of Europe. While the problems continue to be focused on Europe, more recently there were signs of a rise in risk aversion globally. This saw equity markets fall and strains re-emerge in many money markets. There were also safe-haven capital flows into the US dollar and the yen, as well as into government bonds in the United States and Germany. Left unchecked, these events had the potential to lead to a widespread retreat from risk-taking by investors, damaging the recovery in the world economy. In the face of this escalation in market instability, recent measures by the European Union and its member states, the IMF, and the ECB and other central banks have provided investors with some confidence that the underlying issues are being addressed, and that support mechanisms are in place. Restoring confidence is clearly a necessary step in what will be a very difficult road ahead for a number of countries. These events again remind us of the very hard choices that countries can be forced to make if prudent policies are not implemented in the good times. In a number of European countries, governments are being forced to cut back at the same time that private demand is declining. The obvious result is a very weak economy. In these countries, the capacity to use countercyclical fiscal policy to support aggregate demand has been diminished because of the lack of fiscal discipline in more tranquil times. While financial markets have been turbulent, the recent data on economic activity suggest that the global economy is continuing to recover from the sharp downturn in late 2008 and early 2009. In its latest update, the IMF is forecasting that the world economy will expand by 4¼ per cent in 2010 (Graph 1). This is a much better outcome than was expected 12 months ago, when the IMF was forecasting growth of just 2 per cent. At the time, the outcomes that we have seen recently were viewed as a possible “upside risk”, although most observers thought the likelihood of this risk materialising was quite low. The main focus at the time, as it has been over the past week, was on the possible downside risks which were seen to be both very real and very serious. Graph 1 We now know that the various policy measures that were taken did help arrest the collapse of confidence following the failure of Lehman Brothers. These measures on the fiscal, monetary and financial fronts provided reassurance that policymakers would not stand on the sidelines. In doing so, they helped reduce the extreme risk aversion that was evident at the time. They also had the more traditional effect of directly supporting spending in the economy when many people were reluctant to spend. While the global economy is recovering, the recovery has been quite uneven to date. In Asia, it has been V-shaped, but in the countries of the North Atlantic, particularly those in Europe, it has been subdued (Graph 2). Output remains below the level it reached in 2008 and, in many countries, it will still be some time before that earlier peak is reached again. Graph 2 China continues to be at the forefront of the recovery. Growth over the first few months of 2010 was strong, and recent indicators suggest that this momentum has continued. Investment in the manufacturing sector and in infrastructure has, if anything, surprised on the upside (Graph 3). The main issue continues to be the potential for the Chinese economy to run too hot, putting upward pressures on the prices of goods and services and on housing prices. Recently, the Chinese authorities have been responding to this risk, especially through steps to rein in the property market. Graph 3 The picture is broadly similar elsewhere in Asia, where there has been a sharp recovery in industrial production and exports (Graph 4). Policy settings in the region remain stimulatory, particularly when viewed against the V-shaped recovery. Over the past month or so, a number of countries – including India, Malaysia and Singapore – have taken steps to withdraw some of this stimulus. These are welcome developments given that one risk that has been getting some attention is the possibility that stimulatory policy settings remain in place for too long causing inflation pressures to build in Asia. If this risk were to materialise, a more pronounced tightening of policy, and perhaps a sharper slowdown in growth, would be likely to occur over the medium term. In the economies of the North Atlantic the challenges are very different. In many countries, financial systems have not returned to full health, consumer confidence is still low, housing markets are yet to show sustainable signs of recovery and governments face very significant medium-term fiscal challenges. Conditions in Europe, in particular, remain weak, with domestic final demand still not growing (Graph 5). In contrast, in the United States, domestic demand is now growing again, and recent economic data have generally been a bit better than earlier expected. Both consumption and spending on plant and equipment by businesses have increased, surveys suggest that business conditions have improved, and employment is growing again. However, as in Europe, the recovery in the United States remains dependent on stimulatory settings of both fiscal and monetary policy, and fiscal issues cloud the medium-term outlook. Graph 4 Graph 5 This international environment is clearly a mixed one. Australia’s major export partners are growing strongly, and there are reasonable prospects that they will continue to do so. This is a positive for Australia. There are, however, downside risks. Despite the recent announcements having stabilised confidence in Europe, concerns about public finances could build again. If they did, it would weigh on growth prospects for the countries directly concerned, and it could also weigh on prospects in Asia, particularly if it were associated with a marked increase in risk aversion globally. At the same time, one cannot rule out further positive growth surprises for the global economy, particularly if confidence in Europe holds up and policy remains stimulatory in Asia. As usual, the Reserve Bank will be watching carefully over the weeks and months ahead to assess how the balance of these risks is evolving. The Australian economy and the terms of trade I would now like to turn to the Australian economy, which continues to improve from the relatively mild downturn a year or so ago. As is the case for the world economy, the recovery in Australia has been stronger than expected. In a very real sense, our experience has been much closer to that of many of our major trading partners in Asia, than it has been to that of the other advanced economies of the world. As a result, we are operating closer to full capacity than other developed countries, and the challenges we face are quite different to the ones that they face. In the Statement last week, the Bank published its updated forecasts for the next few years. The central forecast is for the Australian economy to expand by around 3¼ per cent over 2010, before growth picks up to be in the 3¾–4 per cent range over the next couple of years (Graph 6). The forecast for 2010 is unchanged from that of three months ago, while the forecasts for the following years have been revised up a little to above-average growth, partly reflecting above-average growth in both the labour force and the capital stock. Graph 6 An important factor underpinning this positive outlook is the lift in Australia’s terms of trade, which are expected to regain their peak of a couple of years ago. This would bring them back to around the very high level they reached in the early 1950s when wool prices spiked at the time of the Korean War (Graph 7). Over the past six months, the prices of most commodities have increased, although it is the prices of iron ore and coking coal that have risen particularly strongly. These commodities share the common feature that they are inputs into the production of steel. Looking back in time, global steel production grew strongly in the 1960s and early 1970s when Japan was industrialising, but then was relatively flat for about a quarter of a century (Graph 8). Over the past decade, growth in global steel production has again been very strong, running well ahead of that in global industrial production. This strength largely reflects the very strong growth in manufacturing and infrastructure investment in China, both of which have been quite intensive in their use of steel. Graph 7 Graph 8 If the industrialisation experience of the United States and Japan is any guide, strong growth in Chinese demand for steel could be expected for quite a few years yet. And over a slightly longer horizon, Indian demand for steel – which currently is relatively low – could also be expected to grow strongly. Of course, over time, a significant global supply response is likely to lead to less pressure on raw materials prices than is currently the case. Notwithstanding this, Australia does look to be well placed to benefit from strong global demand for the main inputs into the production of steel. The outlook for the LNG sector also remains very positive. This boost in the terms of trade this year will add significantly to national income. In putting together the Reserve Bank’s forecasts it has been assumed that more of this boost to income is saved than was the case in the earlier boom in the terms of trade. This reflects two factors. The first is the different position of the Federal budget and the second is the more cautious approach to spending currently being displayed by the household sector. If this lift in saving does not occur, then demand in the economy could well be stronger than forecast, and this would put additional pressure on capacity. At the moment though, with the economy still emerging from the earlier downturn, there is still some spare capacity and conditions clearly differ across sectors. Retail spending remains subdued following the large increase last year, and commercial construction is weak outside of the boost from public-sector infrastructure spending. In contrast, dwelling construction continues to pick up, the period of business-sector deleveraging looks like it has come to an end, and investment in the resources sector is at very high levels. The Bank will continue to monitor these differences carefully. Overall though, the central scenario for Australia remains a positive one. Our major trading partners are growing solidly, commodity prices are high and domestic income is likely to grow strongly over the year ahead. If this central scenario were to eventuate, a major challenge will be to expand the supply side of the economy so that demand can grow solidly without adding to inflation. At the same time, we need to be aware that circumstances can change quickly. If they do, Australia is in the fortunate position, as are a number of countries in Asia, of having the policy flexibility to be able to respond. Inflation The third issue I would like to talk about is recent trends in inflation in Australia. The March quarter CPI confirmed that inflation pressures have moderated significantly (Graph 9). In mid 2008, underlying inflation was running at a little above 4½ per cent, a level that was clearly too high, with the economy pushing up against capacity constraints. In contrast, over the past 12 months, the various measures of underlying inflation all suggest that it is now running at around 3 per cent – a marked reduction from rates two years ago. Graph 9 This decline reflects two broad developments – the earlier slowdown in demand growth and the appreciation of the exchange rate. The downturn in the economy in late 2008, together with the elevated degree of uncertainty at the time, led to a considerable slowing in wage growth in the private sector. Weak demand growth also put downward pressure on firms’ margins, and the appreciation of the exchange rate has recently led to price reductions for many imported goods. Given the inevitable lags, these factors are likely to see underlying inflation in year-ended terms come down a bit more in the near term. Notwithstanding this, the outcome for the March quarter was slightly higher than we, and most market observers, had been expecting. One clearly needs to be cautious in interpreting a single figure. However, this outcome is consistent with the idea that the disinflationary forces in the economy are not quite as strong as previously expected, largely because the economy has performed better than previously expected. One other aspect of the recent data on inflation worth noting is the divergent trends in the prices of tradable and non-tradable items. Over long periods of time, the prices of nontradables – which are mostly services – have tended to rise more quickly than the prices of tradables – which are mostly goods. For example, over the past decade the average annual increase in the prices of non-tradables was 3¾ per cent, while the average increase in the prices of tradables (excluding food and fuel) was much lower, at just ¾ per cent. The primary reason for this difference is the faster rate of productivity growth in the production of goods than in services. Looking at the recent inflation data, we can see that this difference is currently quite large (Graph 10). One very concrete example of this can be seen in divergent movement in the price of health services – a non-tradable – which has increased by 6 per cent over the past year, and the price of clothing – a tradable – which has fallen by 3 per cent over the same period. Graph 10 The recent decline in the prices of tradables reflects the appreciation of the exchange rate that I noted earlier, as well as tariff cuts at the beginning of 2010, and discounting by retailers in the face of subdued growth in retail sales over the past year. Looking ahead, these factors are likely to continue to contribute to low rates of tradables inflation for some time yet. For non-tradables, the picture is somewhat different, with year-ended rates of inflation picking up recently. This is partly explained by a number of specific factors that have affected the prices of individual services. But, more generally, it would appear that demand for a range of services has been strong relative to the economy’s current capacity to supply them. This pressure on capacity is, in turn, putting pressure on prices. One obvious example here is housing, with the rate of population growth recently exceeding the rate of increase in the number of dwellings for the first time in many decades. One result of this is that rental vacancy rates are generally low and rents are rising solidly, although recent rates of increase are below the pace of a year ago. Another example is utilities, where prices have been rising very strongly recently (Graph 11). Over the past year, the price of electricity is up by 18 per cent, the price of gas is up by 9 per cent and the price of water is up by 14 per cent. These large increases follow an extended period in the 1990s when utilities prices increased by considerably less than the general rate of inflation, and the level of investment in infrastructure was relatively low. Recently, there has been strong growth in demand for electricity, especially in the peak periods, and this is requiring further expansion of infrastructure to expand supply capability and ensure the reliability of the network in these peak periods. To fund this supply expansion, as well as in response to higher raw material costs, the industry regulators have approved large price increases. Looking ahead, above-average price increases are likely to continue for some years, although below the current rate of increase. Graph 11 Overall, the Reserve Bank’s central forecast is that underlying inflation will trough at around 2¾ per cent later this year, before gradually picking up over the next couple of years. The inflation rate as measured by the CPI is expected to be higher than the underlying rate over 2010, partly reflecting the recent increase in the excise on tobacco which is likely to add around 0.4 percentage points to CPI inflation. Over the past couple of decades, low and stable inflation has clearly been one of the critical elements in Australia’s good economic performance. We need to make sure this continues. Sustaining low rates of inflation requires inflation expectations to be well anchored and growth in demand not to outpace the expansion of supply. With aggregate demand likely to be supported by strong commodity prices over the next few years, there needs to be a strong emphasis on improving the supply side of the economy. Here, well-targeted investment and improvements to productivity are obviously the keys. While on the topic of inflation, I would like to touch on one final issue. You may be aware that the Australian Bureau of Statistics (ABS) is currently undertaking one of its regular reviews of the CPI. In its submission to the review, the Reserve Bank has argued that there is a case to move to a monthly CPI. While the current CPI provides a comprehensive and reliable measure of consumer price inflation in Australia, more frequent data on prices would be helpful in assessing trends in inflation. This is particularly so around turning points and when unusual factors are affecting the aggregate CPI. The Bank welcomes the open and transparent manner in which the current review is being undertaken and looks forward to its completion. Conclusion We continue to live in turbulent times. Recently, concerns about the quality of public-sector balance sheets in some countries have overtaken concerns about the quality of privatesector balance sheets. While recent announcements have alleviated these concerns somewhat, the path ahead is likely to be a difficult one for many of the advanced economies. In Asia, the outlook is more promising, although challenges also lie ahead, particularly in judging the appropriate timing to move to less expansionary policy. For Australia, while the international environment continues to be a challenging one, the central scenario for the domestic economy remains quite positive. Importantly, Australia has the flexibility to respond to changing circumstances and is well placed to benefit from the strong growth in Asia. Thank you for your time this morning. | reserve bank of australia | 2,010 | 5 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Australian Retail Deposits Conference 2010, Sydney, 19 May 2010. | Malcolm Edey: Competition in the deposit market Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Australian Retail Deposits Conference 2010, Sydney, 19 May 2010. * * * Introduction The theme for this session is Pricing and Competition in the Deposit Market. It’s a highly topical subject, because we have been seeing some very strong competition in this area in the recent period. To give one summary indicator: the average interest rate banks have been offering on their term-deposit “specials” recently have been around 6 per cent, or about 100 basis points above the bill rate. A few years ago they were typically about 50 points below the bill rate – so there’s been a price movement, in relative terms, of around 150 basis points. That’s a significant shift although, to keep it in perspective, we have to remember that this is not the whole market – it’s just the part where competition has been most intense. Other rates are not as high. Nonetheless, across the board, spreads between deposit rates and wholesale rates have generally shifted in the same direction over the past couple of years. Obviously this is good news for depositors. It means that, if you have funds to invest, and you’re prepared to shop around, now is a very good time to find a favourable rate. Of course, from the point of view of deposit-takers 1 and the people they lend to, it mightn’t seem particularly good news, because this is one of the factors that have been adding to the relative cost of funds, and therefore adding to the cost of lending. I’ve been asked to talk today about what’s driving this competition in the deposit market, and how it might develop from here. I’m going to stick to that brief, but I also want to place it in a broader context by looking at how competition has evolved over a longer period. Evolution of competition in the post-deregulation period I’ll take as a starting point a snapshot of the aggregate balance sheet of the banking system in 1980 – just before the main sweep of financial deregulation got under way (Table 1). Banks’ balance sheets back then looked rather different from the way they do now. Roughly speaking, the liabilities side of the balance sheet consisted of close to 90 per cent deposits. On the asset side, loans were around 60 per cent of the total, and much of the rest consisted of government securities, which were held under the “captive market” arrangements that were then in place. In this talk I focus mainly on banks, though much of what I have to say applies to the deposit-taking sector in general. In simplified terms, we can think of the banks’ core business in that environment as being a mix of three main elements – namely, deposit-taking, lending, and providing transactional services. Banks’ net interest margins were quite a bit wider than they are now. That was partly because their (non-interest) costs were higher. But in a deeper sense, it’s also a reflection of the way competition has evolved in the meantime. In the regulated environment, banks generally faced a situation of excess demand for their loans. As a result, competition within the banking sector was not very strong, and banks faced relatively weak pressure to contain costs. These conditions affected not just the intensity of competition, but also its focal point. In the regulated environment, competition within banking tended to take place at the whole-of-bank level, rather than at the level of the individual product. There was no point competing to offer lower lending rates when the market was in structural excess demand. Instead, the banks competed to offer their full mix of services on terms that would be attractive as a package. Typically the pricing structure that this type of competition generated involved significant elements of cross-subsidy. In particular, the net interest margin tended to cross-subsidise transaction services and other activities (such as the maintenance of branch networks) to a much greater extent than is the case today. This is the business model that used to be referred to, only half jokingly, as 3–6–3 banking – borrow at 3 per cent, lend at 6 per cent and be on the golf course by 3 o’clock – although even then the joke was probably well past its use-by date. Obviously, a great deal has changed in the banking industry since then. Banks have become much more diversified, both in their funding sources and in the range of businesses they engage in. But for the purpose of today’s subject, the thing I particularly want to focus on is the change in the way they compete. Post-deregulation, competition has been both more intense, and increasingly directed at the level of the individual product. That’s been true of both the competition between banks, and the competition provided by specialist institutions that targeted the banks’ most profitable product lines. One early example of that, on the deposit side, was the introduction of cash management trusts, which came in as providers of what were effectively stand-alone deposit-taking services. The effect was to put upward pressure on deposit interest rates relative to wholesale rates – in other words, to give depositors a better deal. Specialist mortgage originators later did a similar thing on the lending side. Over time, these sorts of developments had the side-effect of reducing the amount of net interest margin available for banks to cross-subsidise their other activities. In addition, technological improvements like internet banking have contributed to the intensity of product-level competition, by making it easier for customers to shop around on a product-by-product basis. The results of all this can be seen in some summary indicators of the banking sectors’ aggregate performance. Let’s start by looking at the relativities between deposit and loan rates and interest rates in the wholesale market (Graph 1). For much of the 1980s, the 90-day bill rate was actually higher than the average rate that banks charged on loans, a result of regulations that held lending rates much lower than they would otherwise have been. 2 Of course, that didn’t mean that borrowers were on average getting a favourable deal. It just meant they were being rationed for funds and may have had to go outside the regulated sector where rates were much higher. Graph 1 In the post-deregulation environment, from the 1990s onwards, the whole interest rate structure was much lower because of the fall in inflation that occurred at that time, but wholesale rates fell significantly further than both deposit and lending rates. This restored the structure to a more logical configuration where average lending rates were usually above the wholesale rate and deposit rates below it. Interest rate regulations on deposits and loans were progressively removed during the 1980s. The last major control to be removed was the ceiling on housing loan interest rates. This was removed for new loans in 1986, but since existing loans were grandfathered, it continued to affect the average rate on loans outstanding through the remainder of the decade. An important driver of the fall in banks’ intermediation margins on the liabilities side has been the declining share of deposits bearing either zero or very low interest (Graph 2). That was partly a regulatory effect, since before 1984 banks were prohibited from paying interest on current accounts. But it was also a consequence of stronger competition. In 1980, around a third of bank deposits were either in interest-free current accounts or in low-interest passbook accounts. Twenty years later, that proportion was down to around 5 per cent. Not only did this proportion decline, but the relative benefit to banks from any given amount of low-interest deposits has fallen substantially, as the overall interest-rate structure has come down. Graph 2 Another important development on the liabilities side, which I alluded to earlier, was that an increasing proportion of banks’ funding was coming from wholesale sources. That was a partly a consequence of the growth of the superannuation system as a recipient of household funds, some of which were then channelled into bank securities; it was also partly a result of the banks’ diversification into offshore funding sources. We see, then, that a combination of structural factors, regulatory changes and increased competition has been working to narrow average margins on the liabilities side for quite some time. A similar thing happened on the lending side: after the initial reconfiguration of interest rates that occurred in the early 1990s, competition over the subsequent decade put substantial downward pressure on most lending rates relative to wholesale funding costs. The result of all this is that the major banks’ net interest margins in the period since deregulation have been trending downwards (Graph 3). They roughly halved, from an average of around 4½ per cent in 1980 to a bit over 2 per cent in the latest period. Notwithstanding its most recent uptick, the average margin now is well below where it was a few years ago. Graph 3 To complete the story, the downward trend in net interest margins hasn’t resulted in any structural decline in banks’ overall profitability (Graph 4). In broad terms it has been offset by two factors – namely, reduced non-interest costs, and increased non-interest income as banks diversified their business models and reduced cross-subsidies. The net effect is that banks’ combined income from all sources has been declining in relation to assets, but this has been broadly matched by a downward trend in the cost-to-assets ratio. Graph 4 Probably much of this is familiar territory. My reason for going through it is to make the point that a trend towards increased competition in the deposit market, and an increased relative cost of deposits, is not something new. It has been an ongoing consequence of the way market forces have evolved in a deregulated environment. Effects of the crisis on the deposit market Having made that point, it’s also clear that the trend has been amplified by factors flowing specifically from the financial crisis. Let me turn to that part of the story now. For some time, banks have tended to operate with a two-tier pricing structure on their term deposits, offering significantly higher-than-average rates at certain points on the maturity spectrum. Often these are at non-standard terms like four or seven months. These “specials” have been the part of the market where banks competed most vigorously for price-sensitive customers. The average rates on these specials are shown in the accompanying chart (Graph 5). In the years just prior to the crisis, the pricing of these term-deposit specials was fairly stable. They were typically priced at about 50 basis points below the bill rate. As I noted at the outset, that margin has now shifted to around 100 points above. Graph 5 Another indication of more intense competition is that institutions have become more active in offering special rates at terms of longer than a year, and often out to as much as five years. They have also begun to offer higher rates in other parts of the market. Rates on “nonspecial” term deposits have tended to move up closer to the specials, and margins on at-call deposits have moved in the same direction, though by a lesser amount. So, clearly the intensity of competition has stepped up. This has been a consequence of two factors associated broadly with the crisis and with the post-crisis environment. First, the crisis has focused the attention of investors, regulators, rating agencies and, not least, the banks themselves, on the need for stable sources of funding. What constitutes stable funding is, of course, a good question. There is some tendency for analysis in this area to be overly simplistic, and in particular to assume that deposits are unambiguously more sticky than various forms of wholesale funding. That might not always be the case. Within short-term wholesale funding, for example, holdings of bank paper by domestic super funds are actually likely to be quite stable. Conversely, those types of deposits designed specifically to appeal to price-sensitive customers will be less stable than others. So in analysing funding stability, it is important to focus on the specific characteristics of each instrument, and not just to rely on broad summary measures like aggregate deposit ratios. That said, markets have clearly been taking a general view that banks should source more of their funding from deposits rather than from short-term wholesale liabilities, and there is no doubt that this has been a factor in market pricing in the post-crisis environment. It’s also clear that prospective regulatory developments are going to put more emphasis on stable deposit funding, although there are many details of this still to be worked out. A second factor is that the crisis made non-deposit sources of funding more expensive, or in some cases more difficult for lending institutions to obtain, than was previously the case. In this environment, it is to be expected that deposit rates would be bid up. One element of the change in funding conditions was the drying up of the RMBS market early in the crisis period. That was a factor that disproportionately affected the smaller lenders and induced them to compete more vigorously for deposits as an alternative source of funding. These factors are of course not unique to Australia. There are, however, some arguments that it may be more difficult for banks to attract deposit funding in Australia than elsewhere, because a structurally higher share of their funding comes from non-deposit sources – particularly from international markets and from domestic super funds. These funding patterns may be hard to change quickly, although we certainly shouldn’t think of them as being immutable. How far these Australia-specific factors might be adding to competitive pressure on deposit markets is hard to judge. But it’s notable that significant shifts in deposit margins have been occurring in a number of other economies besides Australia (Graph 6). Although strictly comparable data are hard to come by, term deposit margins in the UK look to have risen by more than those in Australia. In the euro area, average margins rose initially by a similar amount to those in the UK, though they have since retraced some of that. So, on the face of it, it seems likely that a good deal of the recent pressure on deposit rates has reflected common international forces, not just conditions specific to Australia. Graph 6 Assessment and outlook Let me conclude with a few more general remarks about what all this means and how things might develop from here. My first remark is that we shouldn’t talk as though competition in this market is a bad thing in itself. The point of financial deregulation was to deliver efficiency gains through increased competition. Among other things, that should mean a better deal for banks’ customers. The particular customer we’ve been talking about today is the depositor, someone who is often neglected in these sorts of discussions. As I said at the outset, if you’re a depositor who is prepared to shop around, now is a very good time to find favourable rates. It’s also important to put these things in a longer-term context. The tendency for competition to put downward pressure on banks’ net interest margins is not new – it’s been going on for a couple of decades, to the benefit of both borrowers and depositors. Having said all that, there’s a legitimate question as to how far the most recent step-up in competition for deposits will prove to be sustainable. There do seem to have been some instances of anomalously high deposit rates being offered on occasion. It seems likely that, over time, banks and other deposit-takers will get better at managing these more competitive conditions and avoiding paying rates that are unnecessarily high relative to the market. There are other reasons to think that the factors giving rise to the current wave of competitive pressure might prove to be partly transitory. In particular, conditions in alternative funding markets have been improving. A further recovery in securitisation markets, for example, would help lenders to diversify their funding sources and probably help to take some pressure off the deposit market. Similarly, any further narrowing of risk spreads in other wholesale funding markets would work in the same direction. Possibly reflecting some of these factors, there does seem to have been some easing in deposit margins recently. On the other hand, we should expect the increased emphasis on stable funding sources to continue. It is also possible that the recent wave of competition has itself helped to make depositors more price-sensitive. With the availability of special rates being more widely advertised, households may be learning to be more active, and more sophisticated, in seeking out the most favourable rates. If so, then we would expect this to have an ongoing impact on the dynamics of the market. In a nutshell then, a good deal of what is happening in deposit markets is not new, but is actually a continuation of existing trends. Some of what is new might prove to be temporary, but some of it is likely to persist. To me, that sounds like an environment where competitive pressure in the deposit market is going to remain strong, even if some of the recent intensity has been somewhat overdone. | reserve bank of australia | 2,010 | 5 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Western Sydney Business Connection, Sydney, 9 June 2010. | Glenn Stevens: Recent developments Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Western Sydney Business Connection, Sydney, 9 June 2010. * * * Thank you for the invitation to be here today in western Sydney, a region which accounts for about one in every 15 people employed in Australia. Of course events far from western Sydney can affect all of us here, through various channels. In view of the developments in recent weeks in Europe, it seems sensible to devote some time to what has occurred, and to what it may mean for Europe itself, for the global economy and of course for Australia. I should stress at the outset though that any assessment is very much preliminary at this stage. To begin, let me sketch some background on the global economy. We estimate that world GDP grew by around 1 per cent, or perhaps a little more, in the March quarter of this year. This was the third consecutive quarter of growth of about that pace after the contraction in the first half of 2009. Note that this occurred with very little contribution from the euro area, a region in which domestic demand contracted over the past two quarters. Many respectable forecasters have pencilled in a growth rate for 2010 as a whole of 4 per cent or a bit more – that is, they have expected that the sort of the growth already seen for the past nine months or so would continue for the rest of this year. This would be close to, or slightly above, the average pace of growth for the global economy over the ten years up to 2008. This is not just the Reserve Bank’s forecast – though we broadly concur with it at this stage. The IMF, the OECD and various private forecasters have numbers like this. There are some who are more pessimistic, though there have also been others somewhat more optimistic. It is worth noting, by the way, that this outcome would be noticeably better than what was expected a year ago. For most of the intervening period the bulk of commentators seem to have been worried by “downside risks” – that is the possibility that things could turn out worse than expected. But it was the “upside” risks that, in fact, materialised over that period. One reason for that may be that all countries responded to the events of late 2008 by moving their macroeconomic policies in an expansionary direction. Just as the downturn in October 2008 was highly synchronised, so was the policy reaction. In countries that have not had an impaired banking system, those policy reactions have had a considerable effect. They were, amplified by the spill-overs that occurred because the stimulus took place in all countries more or less at the same time. Yet the upswing is uneven. It has been very strong in Asia and Latin America, moderate so far in the US and weak overall in Europe (which itself has quite a mix of growth performances across countries). Of importance to Australia is that the strongest growth in demand has been nearby. Apart from Japan most of the economies in the east Asian region have experienced a “v-shaped recovery”. While some of this recovery reflects the process of re-stocking of durable goods around the world, it also reflects strong demand within the region. Commodity prices generally rose somewhat after the very large falls in late 2008. But of significance for Australia, prices for those resources which serve as the raw materials for steel production in particular have been exceptionally strong. Prices for iron ore and coal rebounded very sharply during 2009 and early 2010. Contract prices for iron ore in the current period are double those of a year ago; until recently spot prices were well above even that level though they have retreated somewhat of late. In short, global growth, while uneven, has been recovering in the places and in the form that was most likely to deliver a boost to Australia’s terms of trade. It looks like our terms of trade this year will again reach the 50-year high seen two years ago. It could, of course, be that some of this recent increase in prices turns out not to be permanent. Some economies in Asia will probably, one way or another, experience a moderation in the pace of expansion over the coming year, because the pace of growth over the past year can’t be sustained without problems arising. The Chinese authorities have been seeking for some months to take the steam out of certain sectors of their economy, particularly housing prices. They may be having some success. For this and other reasons, we and other forecasters are assuming that this peak in the terms of trade won’t be sustained. But to reach that 50-year high twice in three years would appear to signal that something pretty important has been going on – something more than just temporary cyclical events. It is increasingly apparent that the Asian region is becoming large enough that it has a tangible independent impact on the global economy and on Australia in particular. China and nonJapan east Asia together accounted for around 9 per cent of the world economy in 1990. By 2000, their share was around 14 per cent. In 2010, it is likely to be about 20 per cent. China is already the world’s largest steel producer and the second largest user of oil after the United States. China’s share of global GDP 1 could exceed that of the euro area within another five years. This confluence of events is likely to see an acceleration in the shift in perceptions about the shape of the global economy and financial system. The prominence of Asian views, and the weight accorded to them, are likely to grow accordingly. What Asian policy makers do and say increasingly matters. Turning then to the recent events in Europe, it is worth asking at the outset how these countries arrived at their current position. The story has many nuances by country but broadly, the public debt relative to GDP has long tended to be on the high side in Europe. It generally ratcheted up in successive economic downturns over the past three or four decades and efforts to get it down in the good times had only modest success. For some countries that joined the euro area the substantial fall in borrowing costs they enjoyed masked a degree of vulnerability, in that their fiscal sustainability depended partly on being able to continue borrowing cheaply. Demographic trends – pronounced in Europe, with some countries already experiencing declining populations – further highlight the problem. A high debt burden is much more easily managed in countries with higher potential growth prospects, one driver of which is population growth. This problem was slowly but steadily accumulating over many years. Then the financial crisis occurred. There was a deep recession from which recovery is not yet entrenched. Budget deficits rose sharply as a result – reaching 10 per cent of annual GDP or more in a number of instances. The prospect of adding that much to the debt stock each year for even just a few years can make a difference to assessments of sustainability even for strong countries. For the not-quite-so-strong cases, markets began to signal unease. Borrowing costs rose for those countries, which of course makes the fiscal situation worse. And so on. Initially the effect of these developments on financial markets was very much confined to Europe. Wider effects were observed in May as global investors became more cautious. Uncertainty over the nature of the policy response, and fears that it could be un-coordinated Measured on a Purchasing-Power-Parity basis. across countries, saw a marked increase in volatility in share prices and exchange rates. Our own markets have been affected along with everyone else’s. Qualitatively, some of the market events had a little of the flavour of September and October 2008 about them. Quantitatively, however, they have, at this point, been nothing like as pronounced. Indicators of stress in markets have not, to date, signalled anything like the problems of late 2008 when interbank and capital markets seized up. But of course the episode is not yet over, and the issues will continue to need careful handling by all concerned and close monitoring by the rest of us. European authorities have responded by assembling a large support package, which covers Greece but, if needed, other countries too. It has several elements. It provides European level financing for individual governments – so relieving them of the need to go to private capital markets – for a period of time, subject to conditions. The European Central Bank is undertaking some operations to stabilise dysfunctional bond markets and is ensuring abundant liquidity in money markets. The IMF has also committed to make funds available and will play a role in ensuring conditionality requirements are met. The final element is that governments are committing to reduce budget deficits and thus control the future rise of debt, though debt will keep increasing for a few years. Of course much detail remains to be set out as to how the mechanics of the package will work. At this stage any assessment about the impact of these events on the economies of Europe and on those further afield is very preliminary. One might expect some effect on business and household confidence, but it is too early to see much evidence of that yet. Looking ahead, we would have to expect that the planned fiscal contractions will dampen European demand as they occur, which in some cases will be over a number of years. Now some such effects should already have been embodied in existing projections since fiscal consolidation has been planned all along. But with some euro area countries now intending to do more consolidation in the near term than they had earlier planned, the dampening effects will occur sooner than earlier assumed (though this presumably improves growth prospects in a few years’ time compared with the earlier forecast). The alternative path of less fiscal action would carry less risk of near-term weakness in demand. However in the current climate it could also have an attendant risk of loss of fiscal credibility. If the latter occurred, it could be followed in short order by a serious crisis that would push up borrowing costs sharply for both governments and private borrowers, so damaging growth. So a path involving a credible fiscal consolidation has to be found that steers between these two possible bad outcomes. That task has become more difficult. Over the horizon of a couple of years it is hard to see how euro area demand won’t be weakened. All other things equal, that would lessen global growth in 2011 compared with earlier projections (although it must be said that those projections have not relied all that much on growth in the euro area). Of course, all other things won’t be equal. Financial markets and, perhaps, policymakers will respond to these events. The decline in long-term interest rates in the core European countries and many other countries around the world that has occurred may work, if it is sustained, to lessen the adverse impact on growth in those countries. If policymakers in other regions responded to the potential euro area weakness by leaving policies easier than they would otherwise have been, this too would have some offsetting impact, though possibly at the cost of more unbalanced growth. As to the effects on Australia, the euro area takes only about 5 per cent of Australia’s exports. Those exports have been declining over the past few years anyway because the euro area has been weak for a while. So that direct effect doesn’t seem likely to be all that large. It is usually the case, however, that the most important impacts on Australia from these sorts of events are not the direct export effects but those that come through the broader global channels – the impact on world and Asian growth, on resource prices and on the cost and availability of global capital. How big those effects may turn out to be remains to be seen. But one thing we can say is that one of the most important advantages in coping with episodes such as this is a good starting point. There is an old joke about the best way to get somewhere involving “not starting from here”. We are not starting from the same place as Europe. In particular, Australia’s budgetary position is very different from those in Europe and, for that matter, most countries. Public debt is low and budget deficits are under control and already scheduled to decline. The banking system is in good shape with little exposure to the European sovereigns having the biggest problems, and asset quality is generally better than had been expected. The flexibility afforded by our floating currency, coupled with credible monetary and fiscal policies, are all advantages in periods of global uncertainty. This doesn’t mean there will be no effects. But these factors put us in the best position to ride through this particular event, even if it does get worse. Stepping back from the immediate issues, a final question worth posing is: what lessons might we take away from watching the travails in Europe? One is that vulnerabilities can remain latent for a long time, then materialise very rapidly. Markets can happily tolerate something for an extended period without much reaction, then suddenly react very strongly as some trigger brings the issue into clearer focus. There were certainly significant revelations about the true financial position in Greece that occasioned additional concern, but more generally in Europe it can’t really have been news that the state of public finances was an issue: it had been so for years. But governments didn’t come under gradually increasing market pressure to fix the problem – the pressure was minimal for a long time, then it suddenly became intense after a trigger event, in this case an economic downturn. It follows that potential vulnerabilities need to be addressed in good times, even when markets are not signalling unease, because by the time markets take notice and start responding seriously – which will usually be in bad times – the problem may have become pretty big. How is this relevant to Australia? Australia does not have a problem with public debt, as I have already said. Nor do we have a problem with corporate debt. Some highly leveraged entities foundered over the past couple of years but most of the corporate sector had pretty strong balance sheets going into the downturn and they are even stronger now. The big rise in debt in the past couple of decades has been in the household sector. There have been many reasons for that and, overwhelmingly, households have serviced the higher debt levels very well. The arrears rates on mortgages, for example, remain very low by global standards. As a result the asset quality of financial institutions has remained very good. So, to be clear, my message is not that this has been a terrible thing. But that doesn’t mean it would be wise for that build-up in household leverage to continue unabated over the years ahead. One would have to think that, however well households have coped with the events of recent years, further big increases in indebtedness could increase their vulnerability to shocks – such as a fall in income – to a greater extent than would be prudent. It may be that many households have sensed this. We see at present a certain caution in their behaviour: even though unemployment is low, and measures of confidence have been quite high, consumer spending has seen only modest growth. This may be partly attributable to the fact that the stimulus measures of late 2008 and early 2009 resulted in a bringing forward of spending on durables into that period from the current period (though purchases of motor vehicles by households – a different kind of durable – have increased strongly over recent months). But the long downward trend in the saving rate seems to have turned around and I think we are witnessing, at least just now, more caution in borrowing behaviour. Of course this will have been affected by the recent increase in interest rates but the level of rates is not actually high by the standards of the past decade or two. We can’t rule out something more fundamental at work. We can’t know whether this apparent change will turn out to be durable. But if it did persist, and if that meant that we avoided a further significant increase in household leverage in this business cycle, it might be no bad thing. Moreover if a period of modest growth in consumer spending helped to make room for the build-up in investment activity that seems likely, perhaps that would be no bad thing either. These sorts of trends would surely increase the medium-term resilience of household finances and accommodate the resource boom and the rise in other forms of investment with less pressure on labour markets and prices than otherwise. The world economy has to date staged a stronger recovery than most thought likely a year ago, albeit one that is uneven across regions. Looking ahead, it has to be expected that the unfolding situation in Europe, which is going to result in earlier fiscal tightening than had been assumed by forecasters until now, will weigh somewhat on global growth in 2011. But the overall outcome will depend on what else happens and judgements about all that at this stage can only be preliminary. It cannot be denied that the potential for further financial turmoil exists, but to date the stresses have not been of the order of magnitude we saw a year and a half ago. Much still hinges, however, on the way European policy makers craft their ongoing response to a complex problem. We in Australia must naturally keep a careful watch on all this. It will be just as important, though, to keep a close watch on developments in the Asian region. Asia will be affected by events in Europe, but also by domestic forces. The experience of the past few years is that those domestic factors – good or bad – can loom just as large as ones further afield when it comes to Asia’s economic performance and, therefore, our own. In the final analysis, sensible and credible policies at home, the strength of our financial institutions and the resilience and adaptability of the businesses and employees that make up the Australian economy, will continue to be our greatest assets. | reserve bank of australia | 2,010 | 6 |
Subsets and Splits