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Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Financial Executives International of Australia, Sydney, 15 June 2010. | Ric Battellino: Aspects of Australia’s finances Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Financial Executives International of Australia, Sydney, 15 June 2010. * * * Given the financial orientation of this group, I thought I would focus my remarks today on some aspects of Australia’s finances. In particular, I want to deal with three questions that often come up when I talk to analysts and bankers from overseas. These are: are Australian households over-geared? does Australia have too much foreign debt? and do Australian banks rely too much on foreign wholesale funding? Before I move on to these questions, I should note that, in my experience, foreigners never ask about government debt in Australia, or corporate debt for that matter. It is not hard to understand why, as both government and corporate debt in Australia are low by international standards. Household debt Let me then start with household debt. The Reserve Bank monitors developments in household debt very closely as they have significant implications for the economy. Glenn Stevens summarised the Bank’s view on this last week when he noted that, while households had coped well with current levels of debt, it would not be wise for there to be further big increases in household indebtedness. As you know, household debt has risen significantly faster than household income since the early 1990s. At that time, households on average had debt equal to half a year’s disposable income; by 2006, debt had risen to around one and a half years’ income. Since then, however, the ratio of debt to income has stabilised (Graph 1). Most of the rise was due to housing debt, including debt used to fund investment properties. Other household debt, which includes credit card debt, car loans, margin loans and so on, has not changed much relative to income over the period. The current household debt ratio in Australia is similar to that in most developed countries (Graph 2). 1 Significant exceptions are Germany and France, where the ratios are lower, at around one year’s income, and the Netherlands, where the ratio is much higher – almost 2½ years’ income – due to the tax incentives for households to stay geared up. All countries have experienced rises in household debt ratios over recent decades. Clearly, therefore, the forces that drove the rise in household debt ratios were not unique to Australia. The two biggest contributing factors were financial deregulation and the structural decline in interest rates. One of the consequences of financial deregulation was that the availability of credit to households greatly increased. Up to the 1980s, the various controls on the financial sector meant that the ability of households to obtain credit was constrained. Even obtaining a housing loan was relatively difficult. However, after financial regulations were eased around the globe, many new financial products were developed specifically for households, and particularly relating to housing finance. Households found it was much easier to get a loan. Most loans products have worked well, though some have caused significant problems; subprime loans in the United States are the clearest example. The level of interest rates in most developed economies in the past decade has been about half that in the decade to 1995. This structural decline in interest rates has facilitated the increase in household debt ratios because it reduced debt-servicing costs (Table 1). Households have therefore found that they can now service more debt than used to be the case. Note that there is no particular reason why household debt ratios should be the same across countries. Has the rise in household debt left households over-exposed financially? In trying to judge this, there are a few considerations to take into account. First, at the same time as the household debt ratio has risen, so too have the assets held by households. Some commentators might dismiss this as simply reflecting the fact that the additional debt has been used to inflate asset values. There is some basis for this in relation to housing assets but, even if we exclude housing and focus only on households’ financial assets, the statement is still true. Financial assets held by households have risen to the equivalent of 2.75 years of household income, up from 1.75 years’ income in the early 1990s. Second, the available data suggest that the increased debt has mostly been taken on by households which are in the strongest position to service it. For example, if we look at the distribution of debt by income, we can see that the big increases in household debt over the past decade have been at the high end of the income distribution (Graph 3). Households in the top two income quintiles account for 75 per cent of all outstanding household debt (Graph 4). In contrast, households in the bottom two income quintiles account for only 10 per cent of household debt. If we look at the distribution of debt by age of household, we see that the increased debt has mainly been taken on by middle-aged households. The proportion of 35–65 year olds with debt increased significantly through to 2008, as households have been more inclined to trade up to bigger or better located houses, and to buy investment properties. Households under 35 years of age (i.e. the group that would typically encompass first-home owners), in contrast, have seen a fall in the proportion with debt (Graph 5). Another factor that has contributed to the resilience of household finances is that, by and large, the debt has not been used to increase consumption. Apart from some brief periods, household consumption has not been unusually elevated during this period of rising debt. Rather, the debt has mainly been used to acquire assets. Perhaps the best, and most direct, indicator of households’ capacity to support the increase in debt is the arrears rates on loans. This remains very low in Australia. The current arrears rate is around 0.7 per cent. This is one of the lowest rates among developed economies (Graph 6). Other data also suggest that households’ aggregate debt-servicing capacity is quite strong: in recent years more than half of owner-occupiers have been ahead of schedule on the repayments on the loan they took out to buy their property. Within this relatively benign aggregate figure, pockets of stress have emerged from time to time. We saw this clearly in the south-western suburbs of Sydney following the sharp run-up in Sydney house prices over 2002 and 2003. More recently there are some signs of increased housing stress in south-east Queensland and Western Australia, again following sharp rises in house prices in these areas. Another segment of the market that will bear close watching is first-home owners. They have accounted for an unusually high proportion of housing purchases over the past couple of years – around 40 per cent. This has reflected the incentives created by various first-home owner concessions. Most of these purchases have been funded by floating rate mortgages, and the average loan to valuation ratio is relatively high, at around 90 per cent. Clearly, this group will be very sensitive to changes in interest rates. In summary, if we look at the way the increase in household debt has been distributed, what households have done with the money, and the arrears rates on loans, it is reasonable to conclude that the household sector has the capacity to support the current level of debt. Having said that, the higher the level of debt the more vulnerable households are to shocks that might affect the economy. We at the Reserve Bank therefore welcome the fact that the household debt ratio has flattened out in recent years and, as Glenn Stevens remarked last week, there would be benefits in that stability continuing. Foreign debt Let me now turn to the question of Australia’s foreign debt. Following the floating of the exchange rate and the removal of capital controls in the early 1980s, both foreign investment in Australia and Australian investment abroad increased sharply as the Australian economy became more integrated into the global financial system (Graph 7). In net terms, capital inflows increased from around 2 per cent of GDP to around 4 per cent, and, in the latest decade, to an average of almost 5 per cent of GDP. The current account deficit widened correspondingly, since with a floating exchange rate the current account and capital account balances must be equal and offsetting, both being determined simultaneously through the interaction of a wide range of economic and financial forces. The pick-up in net capital inflow meant that the ratio of net foreign liabilities to GDP rose. From around 20 per cent in 1980, it rose to around 50 per cent by 1995. It then flattened out for a decade, but in recent years the further increase in net capital inflow has seen the foreign debt ratio rise again (Graph 8). Expressing foreign liabilities relative to GDP is, perhaps, the most common way in which people analyse them. For emerging markets, this measure has been shown to have some association with vulnerability to balance of payments crises. This is because emerging market economies often have a fixed or managed exchange rate and their foreign liabilities tend to be denominated in foreign currency, rather than domestic currency. In such instances a rise in the ratio of foreign liabilities to GDP does indicate increased vulnerability as it signals an increase in the country’s foreign exchange risk and liquidity risk. For a developed economy that can borrow overseas in its own currency, and which has a floating exchange rate, the significance of a rise in the ratio of foreign liabilities to GDP is less clear. It also needs to be kept in mind that, as economies develop, most financial variables rise relative to GDP. This seems to be a consequence of financial deepening. Expressing net foreign liabilities as a percentage of the total financing in the economy is, perhaps, more relevant, since it gives some indication of the proportion of the economy’s funding that is coming from offshore. In Australia, this ratio has remained relatively steady since the late 1980s, at a little over 20 per cent. Foreign liabilities can also be measured relative to the physical capital stock of the country, giving an indication of the proportion of the capital stock being funded by foreigners. This ratio, too, has been relatively steady in Australia since the late 1980s, at around 10 per cent. One could argue that housing assets should be excluded from this latter measure, since foreigners’ participation in the housing market is relatively limited. On that basis, the ratio rose somewhat in the early 1990s, but has been relatively steady since. In short, these measures do not suggest the build-up of any significant disequilibrium in the economy resulting from foreign liabilities. For developed economies with a floating exchange rate and the capacity to borrow offshore in their own currency, the risk from rising foreign liabilities is not that they will cause a traditional balance of payments crisis, but that they will undermine financial stability. The process by which this can happen typically starts with a country, for one or more reasons, becoming attractive to foreign investors. Capital floods in, overwhelming the capacity of the economy to use it productively. Credit is misallocated and eventually there is some form of a domestic financial crisis. This type of crisis can occur even in highly sophisticated economies, as illustrated by the recent sub-prime crisis in the United States. The policy challenge for countries in this situation is to ensure that the ready availability of offshore funds does not end up distorting or weakening the financial side of the economy. As the recipient of large amounts of offshore funds for much of the post-float period, Australia has had to remain alert to these challenges. By and large, it has been able to successfully absorb significant amounts of offshore capital over many years. There are several factors that have contributed to this: First, the country’s foreign liabilities are virtually all either in Australian dollars or hedged back to Australian dollars. 2 Australia is able to do this because foreign investors are happy to hold a certain proportion of their assets denominated in Australian dollars. This means that Australian borrowers do not face foreign exchange risk on the capital sourced from overseas. Therefore, if sentiment turns and the exchange rate falls, domestic borrowers are largely unaffected. The large swings in the exchange rate of the Australian dollar that have occurred over the past couple of decades in no way threatened the corporate and financial sectors. Second, the offshore capital that has flowed into Australia has been used essentially to fund high levels of investment. Australia uses foreign capital not because its national saving ratio is low, but because its investment ratio is high by the standards of developed economies (Table 2). In the past decade, for example, the national savings rate in Australia has averaged 22 per cent, much the same as in Europe and well above the figure of 15 per cent in the US and UK. Over the same period, the investment ratio in Australia averaged 27 per cent, whereas in most developed economies it has averaged around 20 per cent. This high ratio of investment to GDP D’Arcy P, M Shah Idil and T Davis (2009), “Foreign Currency Exposure and Hedging in Australia”, RBA Bulletin, December, pp 1–10. is, I believe, an indication that Australia is using foreign capital productively, and sustaining the capacity of the country to service that capital. Third, credit standards, by and large, have remained robust and the amount of capital wasted through bad loans has remained limited. Foreign borrowing by banks Within Australia’s total foreign liabilities, the proportion accounted for by the foreign borrowing of Australian banks has increased. Virtually all this rise took place through the decade of the 1990s. Banks accounted for a little over 20 per cent of Australia’s foreign liabilities in 1990 but, by 2001, this had risen to around 40 per cent. It has not changed much in the past decade (Graph 9). Part of this trend was the result of banks adjusting their balance sheets following financial deregulation and the growth of financial markets. These developments gave banks the opportunity to move from deposit funding to various forms of funding through markets, as a way of diversifying funding sources or reducing funding costs (Graph 10). The growth of the superannuation industry, following government decisions to promote compulsory superannuation, probably contributed to this trend. Firstly, it meant households became less inclined to hold their savings as bank deposits, and second, the pool of funds created by superannuation increased demand for securities such as bank securities. Within this trend away from deposits to funding through securities markets, there were also forces that resulted in banks increasing their use of offshore funding. As an example, a substantial proportion – about 20 per cent – of superannuation savings flow offshore, mainly into foreign equities. This reduces the pool of savings available domestically to banks and, other things equal, increases the amount of offshore funding banks need to undertake. It is also an inescapable fact that, with Australia running a current account deficit, some funding for the economy needs to come from offshore. Households, by and large, cannot borrow offshore and the government sector has not had much need for offshore funding. That leaves the corporate and the financial sectors. Of these, the financial sector has a comparative advantage in offshore borrowing, because of the relatively high credit rating of Australian banks, both compared with Australian corporations and, in recent years, with banks in other countries. Banks in Australia have therefore established a significant role in intermediating the flow of funds from overseas to Australia. Banks in countries where there are surplus savings, such as those in Europe, play a similar role, though in reverse; they channel funds from domestic savers to offshore. There is a natural tendency to believe that it is riskier for banks to borrow offshore than to lend offshore. Events over the past few years, however, have shown that one activity is not intrinsically more risky than the other. It is a matter of how the risks are managed. In the lead up to the financial crisis, for example, European banks were running very significant risks through their offshore lending, not only in terms of the credit quality of the US assets they were buying, but also in terms of the short-term nature of some of the funding transactions that supported those assets. The US dollar shortages that keep recurring in global money markets are manifestation of those funding risks. These risks were largely unrecognised and, it seems, not very well managed. The Australian banks have long recognised the risks that come from their business model, and, in my experience, are very focused on understanding those risks and managing them. This contributed to their relatively good performance through the global financial crisis. Conclusion You may have noticed that I have not given categorical answers to the three questions I listed at the start of my talk. This is because I don’t think it is possible to give simple “yes” or “no” answers to these questions. However, looking at a broad range of financial data, and considering the fact that the Australian economy and financial system have exhibited a high degree of stability over many years, despite the many global events that have tested their resilience, is, I think, grounds for confidence that the economic and financial structure that has evolved in Australia is sustainable. | reserve bank of australia | 2,010 | 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, 20 July 2010. | Glenn Stevens: Some longer-run consequences of the financial crisis 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, 20 July 2010. * * * I thank George Gardner for assistance in preparing this address. Thank you for coming along today in support of The Anika Foundation’s work supporting research into adolescent depression. This is the fifth such occasion and it is very gratifying indeed to see such a strong response from the financial community. I want also to record my thanks to the Australian Business Economists for their support and to Macquarie Bank for their sponsorship of today’s event. My subject is the consequences of the financial crisis. We are all aware of the immediate and short-term impacts the crisis had on the international financial system and the world economy. I won’t repeat them. The initial phase of the recovery has been underway for over a year now. Global GDP started rising in mid 2009. When all the figures are in we will probably find that it rose by close to 5 per cent over the year to June 2010, though the pace has been uneven between regions and with some of the leading Asian economies seeking to slow down to a more sustainable pace, and European nations tightening fiscal policy, there is a bit more uncertainty just now about prospects for 2011. The bulk of financial institutions most affected by the crisis have returned to profit, while estimates of the total losses to be absorbed from the whole episode have tended to decline somewhat lately (though they are still very large). Financial market dislocation has gradually eased, albeit with sporadic episodes of renewed doubts and instability. But what of the longer-run consequences of the crisis? I want to offer some remarks under three headings, though with no claim this is an exhaustive list. These remarks are about the general international situation, not Australia in particular, unless otherwise noted. Fiscal issues The first lasting consequence is the fiscal burden taken on by countries at the centre of, or close to, the crisis. There are three components to this. First, some governments took on bank ownership in order to ensure the replenishment of capital that had been too thin to start with and that was depleted by the losses on securities and loans. Table 1 shows public capital injections to the financial sector for several key economies. The amounts in mainland Europe could quite possibly grow soon as a result of the forthcoming stress tests. Note that this is not necessarily a permanent burden since, if carried out successfully, the ownership stake can be sold again in due course. In fact about 70 per cent of the funds invested by the United States in banks have been repaid, and the US Government expects to make an overall profit from these capital injections. 1 Nonetheless for a period of time governments are carrying a little more debt than otherwise as a result of the provision of support to the banking system. Of course the United States retains the stake in the insurer AIG. Fannie Mae and Freddie Mac also remain in government ownership though that perhaps might be seen simply as final recognition on the US Government’s balance sheet of an obligation everyone always assumed it would meet. Second, the depth of the downturn saw recourse to discretionary fiscal packages. As the table shows, while there was a lot of national variation, for some countries this spending was quite significant relative to the normal pace of annual growth in GDP. To the extent that the packages had measures that increased spending for a finite period but not permanently, the result is a rise in debt of a finite magnitude, but not an ever-escalating path of debt. But it is the third factor – namely the magnitude of the downturn itself and the initial slowness of recovery – that is having by far the biggest effect on debt ratios. According to the IMF, for the group of advanced economies in the G-20, the ratio of public debt to GDP will rise by almost 40 percentage points from its 2008 level by 2015. Fiscal stimulus and financial support packages will account for about 12 percentage points of this. Close to 20 percentage points are accounted for by the effects of the recessions and sluggish recoveries. Another 7 percentage points comes from the unfavourable dynamics of economic growth rates being so much lower than interest rates for a couple of years. Now it is somewhat inaccurate to attribute the economic downturn effects entirely to the financial crisis because there would probably have been some sort of slowdown even without a crisis. There will always be a business cycle, after all, and deficits and debt rise when downturns occur. As a comparison, the rise in the debt ratio of the G7 from 2000 to 2005 associated with the previous cyclical downturn – which was not an especially deep one – was around 12 percentage points. Nonetheless the recent downturn was a bad one in many countries, and that is because it was associated with a financial crisis. For this reason, together with the other factors I have already mentioned, the major countries generally are going to have significantly higher public debt relative to GDP after the crisis than before, and the debt ratios will continue to rise for several more years. This was largely unavoidable. To a considerable extent, the fiscal legacy can be seen as one manifestation of a broader legacy of lost output (and hence weaker budgetary positions through “automatic stabilisers”) over a period of several years. Generally speaking, the public balance sheet has played the role of a temporary shock absorber as private balance sheets contracted. But the servicing of the resulting debt is an ongoing cost to the citizens of the countries concerned. At present that additional cost is, in some countries, reduced compared with what it might have been due to the low level of interest rates on government debt that we see. Moreover had the debt not been taken on it could well be that the economic outcomes would have been much worse, so increasing fiscal and other costs. Nonetheless this lasting debt servicing burden is a real cost. More importantly, the pace of the rise in public debt has increased focus on the question of fiscal sustainability. This is especially so in those countries where debt burdens were already considerable before the crisis. The difficulty is that “sustainability” is so hard to assess. It is more complex than simply the ratio of debt to GDP. In any number of countries, including our own, public debt ratios have on some past occasions been much higher than 100 per cent. Many countries found themselves with such a situation in the aftermath of World War II. Those ratios thereafter came down steadily though it took until the 1960s in our case, or longer in some others, for them to reach levels like 50 or 60 per cent that today is often regarded as a sort of benchmark. 2 That reduction occurred for a combination of reasons. The big deficits of the war years really were temporary in most cases; economies recorded good average rates of output growth in the long post-war boom with strong growth in both population and productivity; in the same period, business cycle downturns were not especially deep or protracted; interest rates were low – so the comparison of the growth rate of GDP and the interest rate on the debt was favourable; and lastly, significant inflation raised the denominator of the ratio – in some cases in the late 1940s and early 1950s, and more widely in the 1970s. So high or even very high debt ratios per se have not necessarily been an insurmountable problem in the past. On the other hand, that earlier decline in debt ratios may not be easy to replicate in the future. In some countries demographics are working the wrong way, with population growing more slowly or even declining. Other things equal, future growth of nominal GDP will thus be lower than in the past. A period of rapid catch-up growth in income, which helped Europe and Japan in the couple of decades after 1950, is more likely in the future to occur in the emerging world than in the parts of the developed world where most of the debt is. In fact it might be argued that the fiscal position of a number of countries has been increasingly vulnerable for quite some years. Perhaps what the crisis has done is to act as a catalyst to bring forward a set of pressures for long-term budgetary reform that were bound to emerge anyway. This has placed some governments in a very difficult bind, since the heightened focus on sustainability has increased the pressure for fiscal consolidation at a time when aggregate demand remains weak. The “least-damage path” through the various competing concerns has become harder to tread. A public debt to GDP ratio of 60 per cent was one criterion in assessing eligibility for the European monetary union and was a benchmark in the Stability and Growth Pact (a Pact perhaps more often honoured in the breach). Public intervention in finance The second long-run implication of the crisis is that government intervention in the financial sector has become much more pervasive. I have already mentioned governments taking major stakes in banks in key countries, which was virtually unthinkable, certainly for an American or British government, only three years ago. But the intervention was broader than just a temporary period of public ownership – as massive an event as that has been. Take guarantees. Once the Irish Government guaranteed its banks, governments all over the world felt bound to follow suit in some form or other – expanding or (as in our case) introducing deposit insurance, and guaranteeing wholesale obligations (for a fee). The feeling was probably most acute in countries whose citizens could shift funds to a bank guaranteed by a neighbouring country without much effort. In circumstances of incipient or actual panic, or potential complete market closure, measures along such lines had to be taken. The simple truth is that, given a big enough shock, the public backstop to the financial system has to be used. But the backstop having been used so forcefully on this occasion, it is desirable not to use it again soon. The real question is how, having set the precedent, governments avoid too easy recourse to such measures in the future. They will want to get to a position where in future periods of financial turmoil, they are standing well in the background, not in the foreground. Meanwhile there is a growing debate, at a very high level, about what the financial sector should do, and what it should not do. The number of inquiries, commissions, conferences, papers and ideas about the desirable shape of the system in the future is growing. This is a growth industry with, I should think, pretty good prospects over the next few years. Another characteristic of public intervention is the expansion of central bank balance sheets. During a panic, the central bank’s job is to be prepared to liquefy quality assets, with a suitable combination of hair-cuts and penalty rates, to the extent necessary to meet the demand for cash. Once the panic is over, the additional liquidity shouldn’t need to remain in place, and indeed some particular facilities established by central banks had design features which saw their usage automatically decline as conditions improved. But overall it has proven difficult, so far, for the major central banks to start the process of winding down the sizes of their balance sheets. In effect central banks have been replacing markets. They had to. If counterparties feel they cannot trust each other and flows between them are cut off, with everyone preferring to keep large liquid balances with the central bank, the central bank has to replace the market to ensure that everyone has the cash they need each day (against suitable collateral of course). Central bank purchases have also acted to reduce credit spreads and yields. I am not arguing that this policy is macro-economically wrong. But consider the implications of persisting with it over a long period. One doesn’t have to believe that markets can solve all problems to accept that well-functioning markets have a value. A cost of the zero or near zero interest rate and a greatly expanded role for the central bank’s balance sheet is that some markets tend to atrophy – as Japan has found over a decade. Moreover some central banks have had to accept a degree of risk on their own balance sheets that is considerably larger than historical norms. Of course since the governments are ultimately the owners of the central banks, that is where the risk really resides. From a purely financial point of view, the risk of a rise in yields on bonds held by central banks, but issued by their own governments, is actually no risk at all once the central bank is consolidated with the government. On the other hand, to the extent that central banks are really exposed, or are exposing their governments, to private credit risk or to the risk of other sovereigns, those are genuine risks. So some central banks, like their governments, have found themselves in very unusual terrain. It is terrain: in which the relationship between the central bank and the government is subtly changed; where the distinction between fiscal and monetary policy is less clear; from which it may be hard to exit in the near term; and a side effect of which may be wastage, over time, in some elements of market capability. Regulation Of course I have not yet mentioned the other significant public intervention in finance which is the major regulatory agenda being pursued by the international community. This is being pushed by the G-20 process and by the Financial Stability Board. The “perimeter” of regulation is being extended to include hedge funds and rating agencies. Governments are demanding a say in the pay of bankers and talking of specific taxes on banks’ activities. The climate is more difficult for bankers these days, it seems, especially in countries where the public purse had to be used to save banks. But the core work on regulatory reform is being done by the Basel Committee on Banking Supervision. I am not sure who first began to talk of this as “Basel III” but the label seems to be starting to stick. Basel II came in only about two years ago for many countries, 20 years after Basel I. The gap between Basel II and Basel III looks like being a lot shorter. Warning: that pace of acceleration in devising new standards is unsustainable! You would all be well aware of the essence of the proposals. In a nutshell, what regulators are pushing toward is a global banking system characterised by more capital and lower leverage, bigger holdings of liquid assets and undertaking less maturity transformation. It is hoped that this system will display greater resilience to adverse developments than the one that grew up during the 1990s and 2000s. What will be the implications of the various changes? Put simply, the customers of banks around the world, and especially of large internationally active banks, will generally be paying more for intermediation services, in the form of higher spreads between rates paid by banks and rates charged by them. The reason is that capital is not free and it typically costs more than debt. The spread between a bank’s own cost of debt, both deposits and bonds etc, and the rate it charges its borrowers has to cover operating costs, expected credit and other losses and the required cost of equity capital. Assuming the costs of equity and debt do not change, the more capital intensive the financial structure is, the higher that spread has to be. A requirement to hold more high quality liquid assets and/or to lengthen the maturity of debt has a similar effect. Of course the costs of equity and debt may not be, and actually should not be, constant as banking leverage declines. The cost of wholesale debt should fall over time if the equity buffer, which protects unsecured creditors against losses, is larger. In time, the cost of equity may even fall with lower leverage if the required equity risk premium declines to reflect a less variable flow of returns to equity holders. All of that assumes of course that the perceived riskiness of the underlying assets is unchanged. Still, such effects would take some time to emerge. Most observers appear to agree that even allowing for some possible pricing changes over time, spreads between banks’ borrowing and lending rates will be wider in the new equilibrium after the regulatory changes have been fully implemented. 3 What will be the broader economic effects of these higher costs of intermediation? By the way, in those countries that choose to impose “levies” of some kind or other on banks, we shouldn’t assume that the banks’ shareholders will ultimately bear such costs: it is fairly likely that the costs of this tax will fall mainly on the customers. The conclusion most people are reaching is that economic activity will, to some extent and over some horizon, be lower than otherwise. The question is, by how much and for how long? There are various ways of approaching that question. Researchers are putting it to various macroeconomic models. The answers will vary, depending on the models and particularly according to the degree of detail in models’ financial sectors. Overall, these techniques are likely to show moderate but nonetheless non-zero effects on economic activity of the regulatory changes over an adjustment period of several years. Some other analyses, often by banks themselves, find much larger adverse effects. This is usually because they find that credit to the private sector must be reduced in order to meet the various standards, particularly liquidity standards, because it is assumed there will be quantity limits on the availability of funding in the form necessary. It is further assumed that a mechanical relationship between credit and GDP exists, which in turn results in big adverse impacts on GDP. To a fair extent these differences come down to a discussion about what economists would call elasticities: for the non-bank private sector to respond to a desire for banks to be funded differently, how big a change in the price is required – a little, or a lot? Some of the industry estimates appear (to me anyway) to assume elasticity pessimism. Official sector estimates are likely to be based on less pessimism. In truth, it is impossible to know for sure exactly how big these effects will be. That is a reason to proceed carefully, and to allow time for the new rules to be phased in. Clearly, we wish the new rules to be constraining risk taking and leverage as the next boom approaches its peak, but that will probably be some years away, so we have time to implement strong standards and allow an appropriate period of transition. That said, there are three broad observations that I would like to offer. First, I think we ought to be wary of the assumption of a mechanical relationship between credit and GDP. Of course a sudden serious impairment in lenders’ ability to extend credit almost certainly amounts to a negative shock for growth in the short term. But did the steady rise in leverage over many years actually help growth by all that much? Some would argue that its biggest effects were to help asset values rise, and to increase risk in the banking system, without doing all that much for growth and certainly not much for the sustainability of growth in major countries. Some gradual decline in the ratio of credit to GDP over a number of years, relative to some (unobservable) baseline, without large scale losses in output may be difficult to achieve but I don’t think we should assume it is impossible. Secondly, even accepting that there will probably be some effect of the reforms in lowering growth over some period of time, relative to baseline, we have to remember that there is a potential benefit on offer too: a global financial system that is more stable and therefore less likely to be a source of adverse shocks to the global economy in the future. So we have a cost-benefit calculation to make. Quantifying all this is very difficult, but then that is often the case when deciding policies. Thirdly, however, the reforms do need to be carefully calibrated with an eye to potential unintended consequences. One such consequence, obviously, would be unnecessarily to crimp growth if the reforms are not well designed and/or implementation not well handled. Another could be that very restrictive regulation on one part of the financial sector could easily result in some activities migrating to the unregulated or less regulated parts of the system. Financiers will be very inventive in working out how to do this. If the general market conditions are conducive to risk taking and rising leverage (which, sooner or later, they will be if the cost of short-term money remains at zero), people will ultimately find a way to do it. Of course while ever the unregulated or less-regulated entities could be allowed to fail without endangering the financial system or the economy, caveat emptor could apply and we could view this tendency simply as lessening any undue cost to the economy of stronger regulation of banks. But if such behaviour went on long enough, and the exposures in the unregulated sector grew large enough, policymakers could, at some point, once again face difficult choices. Conclusion The financial turbulence we have lived through over recent years has had profound effects. The most dramatic ones in the short term have been all too apparent. But big events echo for many years. My argument today has been that the full ramifications are still in train, insofar as impacts on governments’ finances, governments’ role in the financial sector and the trend in regulation are concerned. It will be important, as these reverberations continue, for there to be a balanced approach blending strong commitment to sensible long-run principles with pragmatism in implementation. In Australia we have been spared the worst impacts of serious economic recession in terms of lost jobs, much as we will be spared the prospect of higher taxes that face so many in the developed world. These are factors that support our native optimism, at least about economic conditions. Nonetheless depression still ranks as a serious, and underestimated, problem in our community including among our young people. That is why the work of the Anika Foundation, working alongside other bodies seeking to combat depression, is so important, and why I thank you all very much for coming along today. | reserve bank of australia | 2,010 | 7 |
Shann Memorial Lecture by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the University of Western Australia, Perth, 17 August 2010. | Glenn Stevens: The role of finance Shann Memorial Lecture by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the University of Western Australia, Perth, 17 August 2010. * * * I would like to thank Paul Bloxham for his extensive research assistance in preparing this address. Thank you for the invitation to deliver the 2010 Shann Lecture. It is an honour. People are shaped by formative events, and Edward Owen Giblin Shann was no exception. Born in Hobart in 1884, his family moved to Melbourne a few years later. Growing up in the Depression of the 1890s – an episode that hit Melbourne particularly hard – Shann saw firsthand the effect that financial crises could have on peoples’ lives. Those memories stayed with him and motivated much of his career’s work. 1 In his early adult life Shann exhibited some Fabian tendencies – and a flirtation with the Left would be a not uncommon response by a later generation of intellectuals as a result of the sense that capitalism had failed in the 1930s. But by the time he had become prominent as an economist, his views had shifted in a direction that we would probably today call Libertarian. One of his most noted works was a short pamphlet, published in 1927, that described the lead-up to and crash of the early 1890s. It was prescient in drawing parallels with the financial developments in the 1920s that preceded the 1930s depression. 2 The 1880s were characterised by rapid population growth and increased urbanisation which fostered an investment boom dominated by construction. There was a spirit of optimism, which saw international capital flow in and asset prices – particularly land prices – increase. Leverage rose and lending standards fell. As Shann’s monograph noted, financial regulation at the time abetted the excesses, including an “untimely amendment” of the Victorian Banking Act in 1888, which allowed borrowing against a wider range of collateral. In the 1920s, when Shann was applying this experience to contemporary issues, the problem was not so much excessive private debt or poor regulation. 3 This time the problem Shann saw was too much public borrowing. He viewed the extensive public works popular with State governments in the 1920s as not only increasing debt but also lowering productivity. So it would come as no surprise that, after Australia’s terms of trade collapsed in the late 1920s and international capital markets made new borrowing much more difficult, Shann was among the group that argued that the standard of living that could feasibly be associated with full employment was noticeably below that to which people had become accustomed in the boom. The Premiers’ Plan of 1931, which Shann had a hand in producing, sought to recognise this, and to spread the associated decline in incomes across the different sectors of society. 4 These two episodes had some important differences, but in a deeper sense both stories were rather similar, and all too familiar. The sequence goes as follows. Some genuine improvement in economic conditions leads to more optimism. It may be a resource discovery (including the opening up of new productive land), or a technological change, or a rise in the terms of trade, or even just greater confidence in economic policy’s capacity to solve Snooks (1993). Shann (1927). In the 1890s more than half the note-issuing banks had suspended payment – one third never re-opened (Cornish 2010, Kent forthcoming). By comparison, only three minor banks failed in the 1930s’ Depression. Shann and Copland (1931). problems. Human nature being what it is, people (or governments) are inclined to project into the future with undue confidence and insufficient assessment of risk. They often decide to invest more in ventures that are marginal, or even speculative, borrowing to do so. Because their assessment of permanent income is that it has increased, they also decide to consume more now (either privately or in the form of public services). Financial markets and institutions – which are populated by human beings after all – help them do both these by making capital available. Then, at some point, an event causes people suddenly to realise they have been too optimistic. Maybe the “new paradigm” disappoints in some way or the terms of trade decline again. The cycle then goes into reverse, usually painfully. This pattern is fresh in our minds after the events of the past several years. But Shann was writing about it 75 years ago, and of course he wasn’t the first. Narratives like these are peppered throughout history. The thought that “It’s Different This Time” springs eternal in the human psyche, and is a fitting title to the recent work by Rogoff and Reinhart covering eight centuries of financial delusions. Moreover, financial instruments, markets and institutions are always central to the way these cycles play out. So it is fitting, given Shann’s own work, to ask the question: what is the proper role of finance? In particular, I will take up four questions: 1. What are the desirable functions of the financial system, and how did they evolve? 2. What problems are inherent in finance, and what issues do they raise for policymakers? 3. What questions arise from the growth and change of the financial system over the past couple of decades? And finally, 4. What are the challenges as we look ahead? The functions of the financial system and its origins What is it that we need the financial system to do? I think we can outline five key functions. We want it to provide: i. a reliable way of making payments (that is, exchanging value); ii. a means for pricing and pooling certain types of risks; iii. a way of transferring resources from savers to borrowers; iv. a way of transferring the returns back again, which requires that the savers’ money is not lost and which, in turn, requires monitoring of borrowers and managers; and v. liquidity. These are very valuable things for a community to have. The modern economy could not have developed without these capabilities arising in the financial system. We tend to think of financial activity and innovation as very recent, but in fact the history is a long one. There is not time to do justice to that history here, and there are some fascinating books on the subject which repay the reader generously for the investment of their time. 5 But it is clear that borrowing and lending is almost as old as civilisation itself. Evidence of such transactions, some of them remarkably codified, go back at least to eighteenth century BC One of the most accessible recent treatments is Ferguson (2008). Babylonian records. 6 Some scholars suggest that the records of the Greek and then Roman ages show considerable evidence of several activities we would associate with banking, including taking deposits, making loans and facilitating transactions. 7 Developments seemed to accelerate during the Renaissance, particularly in Italy. Bills of exchange were by then in common use as a means to facilitate trade and also to circumvent usury laws. Traders were able to take a deposit in one city, make a loan to someone transporting goods to another city and then take repayment at the destination (possibly in a different currency) – with a suitable addition to the price in lieu of interest. This activity would appear to be a forerunner – by seven centuries – of an instrument that in our terminology would combine elements of a zero coupon or discount security, trade credit and a sort of foreign currency swap. The most noted bankers of that era were of course the Medici family of Florence, who went further than their predecessors and contemporaries in the pooling of credit risk, by having a branch network with partners who were remunerated with a profit share. 8 The development of double-entry bookkeeping, in Genoa in the 1340s, also helped banking assume more modern features: the receipt of deposits, maintenance of current accounts, provision of loans and management of payments. 9 This form of banking in Italy later became a model for Holland, Sweden and England, to which further innovations were added. In Amsterdam, the Wisselbank, which was the first exchange bank in Northern Europe, pioneered a system of cheques and direct debits circumventing problems with different currencies. 10 The Swedish Riksbank, formed in 1656 and the oldest institution recognised today as a central bank, is credited by some as having pioneered fractional reserve banking. 11 Other key innovations were joint-stock ownership and limited liability. These allowed more capital to find its way into banking and further reduced the costs of intermediation. The Bank of England, established in 1694, was for many years the only bank in England allowed to operate on a joint-stock ownership basis. Walter Bagehot devotes a chapter in Lombard Street to the virtues of joint-stock ownership, noting that while these sorts of companies “had a chequered history”, in general the joint-stock banks of Britain were “a most remarkable success”. 12 The same innovations helped to develop equity markets more generally. Meanwhile bond markets had also developed. Again the earliest forms were in Renaissance Italy, where wealthy citizens were able to buy bonds and thereby invest their savings in one of the few activities that was seen as providing a significant return: war. Such instruments allowed governments (and later large corporations) to raise funds from a broader set of sources. In time, the formation of secondary markets for these securities meant that risk had Banking activities were sufficiently important in Babylonia that there were written standards of practice that were part of the Code of Hammurabi, the earliest known formal laws (Davies 1994). These were carved on tablets of stone, including details of how loans, interest and guarantees would operate according to a set of standardised procedures. Temin (2004). See de Roover (1946). The Medici family may have learned from earlier failures of the Peruzzi and Bardi families’ banks in Florence in 1348 owing to defaults on payments when King Edward III failed to repay borrowings taken in the beginning of the Hundred Years’ War (Kindleberger 1993). As an aside, it is from this era that we receive the term “bank”, which derives from the merchant’s bench, or banco, in the market places of medieval Italy (particularly Lombardy; Lombard Street in the City of London is named after this region of Italy, as King Edward I granted this piece of land to the goldsmiths of Lombardy). Quinn and Roberds (2005). Ferguson (2008). Bagehot (1873). a price set by a market. These innovations also spread to Northern Europe and, by the mideighteenth century, London had a well-developed bond market. 13 It was trading in the bond market that made the Rothschild family wealthy and for most of the nineteenth century its bank was the largest in the world. 14 So by the middle of the nineteenth century a quite sophisticated financial system had arisen in major western economies. It included banks and other financial intermediaries, stock and bond markets and insurance. It allowed transactions to be made, and mobilised pools of savings for investment in enterprise while offering a degree of liquidity to savers. It pooled certain risks, and served in a fashion to monitor borrowers. It allowed payments to be made and funds invested across national borders. In the process, it facilitated the industrial revolution, which resulted in the biggest transformation in living standards seen in the history of western civilisation. This system did just about all the things we would want a financial system to do today, albeit with less technological efficiency. Arguably the biggest change a financier from much earlier times would notice today would not be the new instruments – nor the crises! – but the effects of the silicon chip and fibre optics on the way finance is conducted. Incidentally, the difficulties that accompanied having only a rudimentary financial system were nowhere better illustrated than in the early Australian colonies, as one of Shann’s other works, An Economic History of Australia, makes clear. The most commonly used means of exchange for many years was rum. 15 Indeed, he reports that in Sydney “George Street between Brickfield Hill and Bridge Street cost four hundred gallons” of rum to build (p 49). In today’s prices for rum, this amounts to about $80,000. It is doubtful that a road of that length could be constructed for that sum today, such has been the increase in the price of labour in terms of rum (and indeed other commodities). The colonists began to issue “notes” or “cards”, which were forms of IOUs and which circulated as currency, although this system soon became unworkable partly because the quality of such IOUs varied greatly and tended to decline over time. Governor Macquarie famously sought to end the shortage of metallic currency by punching holes in a consignment of Spanish dollar coins, giving the “ring” and “dump” different values, and also rendering them less useful elsewhere, thereby retaining this currency in the new colony. However, the need for credit facilities, for pastoral expansion and short-term financing for local and overseas trade, still required the development of a banking system. In 1817, Macquarie granted a charter to a group of leading traders and officials to form the Bank of New South Wales, with responsibility to issue a paper currency. As Shann points out, the stock holders were given limited liability in the operations of the Bank of New South Wales, which at the time in England was still an exclusive privilege of the Bank of England, and was not granted to other British banks until 1858. 16 So despite a somewhat shaky start, Australia’s own financial system was able to catch up rapidly on the other developed economies by adopting their technologies. The more market-oriented approach of British finance stood in contrast to mainland Europe, which was more bank-oriented (and remains so today). Both approaches provide different ways of achieving the functions listed above. The contrast between systems has spurred much debate about their effectiveness. Some suggest a key role in the development of German industry in the nineteenth century, for example, was the large size and scope of the universal banks of Germany, which allowed them to develop a close relationship with industry (Gerschenkron 1962). Others suggest that markets provide the discipline required and also led to a superior allocation of capital. Ferguson (2008). Shann (1930). Shann (1930) and Newton (2010). The problems of finance and development of regulation As banking had developed, it had become more leveraged. No longer was it a case of a few wealthy individuals risking their own money in enterprises akin to venture capital funds – accepting the risk and illiquidity that went with it. In their more developed form, banks raised deposits from the public – redeemable at their face value, at notice or at call. Leverage changes the dynamics of any business. Expected returns are higher but management needs to be on its game – which is an oft-quoted argument for having some debt in a corporation. In the case of banks, it meant that the business of banking became even more focused on monitoring, information gathering and risk management. Of course the depositors had some protection in that the capital of the proprietors was at risk before deposits. But banks also undertook maturity transformation. They offered depositors liquidity, but held only a fraction of their own assets in liquid form – enough for normal day-today operations. The whole thing depended on confidence – if depositors wanted their funds back en masse, a bank could not provide them because its assets were not all in cash. If there was a loss of confidence for some reason, the bank would be under pressure: there could be a run. So banks themselves needed access to liquidity in situations of stress; that is, they needed to be able to liquify assets when a shock to confidence occurred. When such a shock was idiosyncratic, a bank might seek funding in the market. Other institutions, mindful of the possibility of contagion if a run got going, might support one of their competitors provided there was a reasonably held expectation of solvency. But if the confidence shock was more systemic in nature the question was how the whole system could be supported. This came to be seen as the proper role of a central bank and was ultimately encapsulated in Bagehot’s famous (if widely misquoted) maxim that the central bank should be prepared to “lend freely, against good collateral at a high rate of interest”. 17 Of course central banking was at that time embryonic at best: the central banks in existence in Bagehot’s day mainly had been established to help sovereigns raise war finance; their stability functions evolved later, over time. 18 But while the provision of liquidity in crises left the system less vulnerable to runs, it was no real solution to simple bad lending. Even if all the good assets can be liquified to meet a run, if not all the assets are good, failure may still occur. Failures of individual institutions could be allowed provided they did not damage confidence in others, but it is always difficult to know just how small or large a failure might cross the threshold. Inevitably, since there could be spillovers from failures, and since banks and others would accept funds from the general public, there would end up being a degree of regulation. And so the history of banking and finance is not just a history of financial innovation, it is also a history of regulatory response. That regulatory response has had its own quite pronounced cycles. Moreover, regulation prompts further innovation, and so on. From the 1930s, regulation became much more intrusive. In the United States, fear of the “money power” saw some large institutions (J.P. Morgan for example) broken up, much as occurred in some other industries at the time. Yet simultaneously, competition between banks was intentionally curtailed in some respects, for fear of irrational behaviour. Regulatory intervention extended to interest rates, requirements for reserves, prohibitions on certain types of business, and even lending guidelines and quotas. In the 1940s this all became part of the war-time apparatus that essentially sought to run economies via direct intervention I spoke at length about the role of a central bank as lender of last resort in the Melville Lecture at ANU in 2008, so will not cover it here in further detail (Stevens 2008). Most central banks in existence today were established in the twentieth century. The price stability mandate typically came later – since until the 1930s countries were typically on some sort of link to gold and the problem of continual inflation was not expected to arise in such a world. rather than by relying on the price mechanism. However, it persisted in finance for many years after the war had ended, perhaps in part to keep low the costs of servicing large war debts. It was only really in the 1980s and 1990s that this regulatory approach had finally passed, allowing banks to compete vigorously for all lines of business and allowing pricing to be driven by market forces. We can trace many of these trends in Australia. The 1937 Royal Commission argued for greater control and regulation of the Australian monetary and banking systems, motivated by the perceived failings of the financial system through the depressions. Legislation on many of the recommendations from the Commission was enacted in 1945 and continued the tight controls placed on banks during the Second World War. The focus immediately after the war was on stability with little regard given to the efficiency of the financial system. This was consistent with extensive government intervention and regulations in other markets. As a result, in the early post-war period, the Australian banking system was highly constrained. There were tight controls on interest rates for bank lending and borrowing, on terms to maturity of different types of deposits and loans, and quantitative and qualitative controls on banks loans in aggregate and to particular types of borrowers. These were introduced to guard against excessive risk-taking by banks with depositors’ savings and also were regarded as serving the needs of macroeconomic policy. Given the pervasive and restrictive nature of these controls, it is perhaps not surprising that the banking system was very stable. In the almost five decades from the early 1930s until the problems of the Bank of Adelaide in 1979 no Australian bank failed or even faced serious financial problems. 19 This was in a very real sense a result of the terrible 1890s depression which had been so influential on the young Shann. As Selwyn Cornish points out, that episode had a significant effect on the nature and form of much of Australian economic policy throughout most of the twentieth century, including financial regulation and central banking. 20 But the constrained banking system left a gap into which others stepped. 21 As early as the 1960s, new, less regulated, financial institutions began to arise. The banks’ share of financial intermediation in the Australian economy steadily declined from the mid 1960s, reaching a little over half at its lowest point in the early 1980s (Graph 1). Macfarlane (2006). Cornish (2010). This “regulatory arbitrage” has antecedents, in the Medici example I used earlier, and descendents in the form of the recent North Atlantic financial crisis. In the recent case, as we all know, a great deal of financial activity moved outside the regulatory net, via the so-called shadow banking system which enabled the creation of a whole array of off-balance sheet vehicles, for example SPVs and conduits, to circumvent capital requirements. Graph 1 The increasing size and complexity of the system and the rise of non-bank financial institutions made the regulatory architecture increasingly less effective. By the late 1970s, the philosophical tide was turning against intervention as efficiency costs became more apparent – a trend not confined to finance. Eventually these inefficiencies led to calls for financial liberalisation and so, around 40 years after the Royal Commission, the Campbell Inquiry laid the foundations for the intellectual and practical shift towards liberalisation and the current system. In addition to freeing up banks, the floating of the currency and the opening up of capital markets, a range of technological advancements – as well as economic development and policy changes affecting other sectors in the economy – also were important drivers of change in the financial system. Questions arising from the growth of finance The past 20 years has seen a major increase in the size and breadth of activity of the financial sector in most economies, as well as an acceleration in the globalisation of finance. Statistics abound to demonstrate this: the turnover in various markets, the real value of assets, the amount of gross derivative positions outstanding; all have grown considerably faster than the size of overall economic activity. Again some of these same trends are seen in Australia. Total assets of financial institutions relative to the size of the economy have increased from the equivalent of around 100 per cent of annual GDP in the early 1980s to almost 350 per cent in recent years (Graph 2). Graph 2 Noteworthy in some countries has also been a significant increase in the share of financial activity in the economy’s value added and the proportion of people employed in the financial sector. It is widely assumed that financial deregulation played a major role in this increase, and the timing seems to fit. Now, in the aftermath of the crisis, there is a more questioning tone about whether all this growth was actually a good idea: maybe finance had become too big (and too risky). This question is certainly a live one in the United Kingdom, where the City of London was very prominent in the economic success of the country since the mid 1980s. 22 There are at least two potential problems in a world where the finance sector becomes “too big”. If it is accepted that finance has its own cycle – of risk appetite, leverage, crisis and then de-leveraging – then a bigger financial system compared with the economy, unless accompanied by much more capital (and it wasn’t in the case of the big international banks – the reverse was true), risks de-stabilisation of the whole economy. Because crises can be costly, moreover, calls are inevitably placed on the public purse for support. These are very difficult to resist. In the current episode, the direct costs to the public purse of restoring financial stability in some of the North Atlantic countries are non-trivial. But the cost of lost revenue in the lengthy periods of economic weakness that seem invariably to follow financial crises is an order of magnitude larger. It is this factor really that has unleashed the recent round of concerns about public finances in the affected countries. Secondly, as well as making incomes and activity less stable, an overly large financial sector, if characterised by perverse incentives that can drive extraordinary remuneration for individuals, may draw in too many resources that could otherwise be employed at a higher social return. To put it in practical language, too many PhD physicists, mathematicians and engineers working on options pricing and designing structured products could lower, rather than increase, the productive capacity of the economy. See for example the recent conference on The Future of Finance at <http://www.futureoffinance.org.uk>, and particularly the papers by Turner (2010) and Haldane (2010). For finance is not, for the community, an end in itself. It is a means to an end. Ultimately it is about mobilising and allocating resources and managing risk and so on – providing the five outputs I listed earlier. Yet people have become suspicious of the way much of the activity in the financial system amounts to the production of “intermediate” financial services, delivered to others within the same sector: the “slicing and dicing” of risk, re-allocating it around the system to those who are most willing and best able to bear it (or, sometimes perhaps, and much more troublingly, to those who least understand it). Some commentators – among them the chair of the UK Financial Services Authority – have openly questioned the social usefulness of much of this activity. In essence people are asking whether the rising size and pace of transactions of the finance sector is actually a sign of higher economic prosperity, or of something wrong. They are also questioning implicitly whether the thrust of financial liberalisation in the 1980s and 1990s was correct, or at least may have gone too far, if it helped to produce these outcomes. These questions are likely to be debated intensely over the next several years. This will be a growth sector of the conference and consulting industry. It is therefore premature to draw strong conclusions, but a few observations may be useful. First, a small point of measurement. In most modern economies, the share of GDP accounted for by services generally has long been growing as agriculture and manufacturing get (relatively) smaller. It would not be surprising for the finance sector to be part of that. So it might make more sense to measure the financial sector as a share of the services sector, rather than as a share of total GDP. On this basis it will still have shown a distinct rise, but not quite as much. In Australia’s case, by the way, the finance sector’s share of services sector employment peaked around 1990, thereafter declined somewhat and has changed little for a decade. Second, a fair bit of the growth in financial sector activity was surely bound to happen in view of changes in technology. These dramatically lowered costs, so that the provision of news and information became instantaneous and ubiquitous, as did the ability to respond to news. The capacity to monitor and manage a portfolio more actively is likely a “superior good”: people will want more of it as their affluence increases. The increasing development of financial management techniques and new instruments – another kind of technology, if you will – also led to a lot more gross activity. For example the conceptually simple process of keeping to a benchmark drives a good deal of transaction volume. So surely some of the growth in the finance sector has been genuinely useful, and the technological changes mean that much of it has been accommodated without much in the way of real resources being used. That is not to deny that there is a very important set of questions about the price the general public is paying for some of the services and about whether the capacity to respond to every piece of “news” is resulting in an excessively short-term focus in management. The latter is, of course, a question that extends much more widely than just the finance sector. Third, the increasing integration of the global economy – itself assisted by financial development – brought the savings of literally hundreds of millions of Asians into the global capital market. This meant that differences between countries’ policies and saving and investment appetites became more likely to affect financial trends and market prices. These factors were certainly one reason that interest rates, including long-term rates set in markets, not just the ones set by central banks, were so low in the middle of last decade. Surely this had a major bearing on the pace of growth of intermediation and, ultimately, the appetite for risk in the global system. Fourth, we need to be careful how much blame we ascribe to changes in regulation for everything that went wrong. Of course it cannot be denied that the regulations had shortcomings. But while all significant countries were operating on more or less the same minimum standards for bank supervision, some countries had serious financial crises, but many – in fact most – did not. Moreover, a significant part of the problems arose in the “shadow banks” – more lightly regulated institutions which were not banks (though some of them became banks subsequently when there was a regulatory advantage to doing so). Many observers have concluded that in the major countries, allowing large regular commercial banks to engage in more “shadow banking” type activity without more capital was a mistake. But all this says that supervisory practice is as important as the formal regulations. Moreover, if those freedoms were granted in response to the demand by the commercial banks to get in on the action happening elsewhere, that points to the general environment as a big part of the story. As we know from our own history, if there is an incentive for risk-taking activity to occur (like low interest rates, for example), it will eventually occur even if it has to migrate to markets and institutions where fewer regulatory impediments are in place. To put this point at its most extreme, it could be argued that that the overall environment dictates the appetite for risk-taking financial activity, and that the nature of regulation simply determines the location of the activity. That is, as I say, extreme, but there is some truth to it. Looking ahead Where then does this leave us? The regulatory cycle has come fully around. After two or three decades of liberalisation and allowing markets and private agents in the financial sector more sway, the international debate has of late been consumed with issues of financial regulation: how to re-design it, and generally increase it. This is understandable, and it is entirely appropriate that these questions be posed in the light of the events of the past decade. My point is simply that we have been here before. If we think far enough back in history, there are things to learn about regulation and its cycle, just as there would have been – had people been more inclined to look – about the nature of private finance and its cycle. The objective shouldn’t be to suppress finance again to the extent it was for so long in the past. There would be a cost to the economy in attempting this, and in any event the financiers will be quicker to figure out the avoidance techniques than they used to be. The objective should, rather, be to foster arrangements that preserve the genuine benefits of an efficient and dynamic financial system, but restrain, or punish, the really reckless behaviour that sows the seeds of serious instability. Such arrangements surely have to include allowing badly run institutions to fail, which must in turn have implications for how large and complex they are allowed to become. There is a large reform effort under way at the international level. I have spoken about this before on several occasions and so I will not revisit the regulation issue here. I would only say that while no doubt regulations can always be improved – and who would say otherwise? – it is unlikely that regulation per se, becoming more and more complex and widespread as it is, will be the full answer. A big part of the answer must come from practice, not just blackletter law. The finance industry, certainly at the level of the very large internationally active institutions, needs to seek to be less exciting, less ambitious for growth, less complex, more conscious of risk and more responsible about where those risks end up, than we saw for the past decade or two. And, of course, it does have to be better capitalised. Equally, surely regulators and supervisors in some jurisdictions need to be more intrusive and assertive, to be prepared to go beyond minimum standards and to be a little less concerned about the competitive position of their own banks, than they have been in the past. It has been not uncommon, for example, for Australian bankers to complain about APRA’s relatively strict rules on definition of capital for regulatory purposes, where other jurisdictions were more lenient. But the international supervisory community is at this moment in heated debate about what can and cannot be counted as capital, and it is moving, belatedly, in APRA’s direction. But to be effective, supervisors need support from their legislatures and executive government – in having strong legislation, adequate funding, and a high degree of operational independence from the political process in the conduct of their duties. In several countries legislatures are working now, in the aftermath of the crisis, to strengthen supervisory arrangements. That is good, but the most important time to have this support is in the boom period – when a cashed up private sector, which would much prefer the party to keep heating up, can bid quality staff from regulatory agencies and is not averse to looking for other ways of tilting the playing field in the direction of short-term profits. It is precisely then that capable, well-resourced and well-supported regulators need to be able to say “no”. Conclusion Edward Shann died tragically in 1935. He did not live to see the full recovery from the Great Depression, nor the long post-war prosperity. He could not take part in the subsequent debate about financial regulation in its ebbs and flows. But were he to have been able to observe the past fifteen years in the global economy and financial system, I think he would have recognised many of the features. Finance matters. Its conduct can make a massive difference to economic development and to ordinary lives – for good or ill. Moreover, finance has its own cycle – of risk appetite, innovation and occasional crisis. That won’t change. Shann understood that and so must we. The sort of financial system we should want is what was once described as “the hand-maid of industry”: 23 reliably facilitating transactions, fostering trade, bringing savers and investors together, pooling risk and so on. We don’t actually want too many of the financiers to be “masters of the universe”. There will always be a risky fringe, but it should stay at the fringe, not be at the core. But the man we remember tonight would not want the financial system to be simply an arm of the state either, subject entirely to bureaucratic or political direction. We shouldn’t be looking to go back to the 1940s and 1950s. So we have to find the right balance involving regulation, supervision and financial industry practice. That is the task that lies before us. Bibliography Lombard Street: A Description of the Money Market, Henry S. King and Co., London. Cornish S (2010), The Evolution of Central Banking in Australia, Reserve Bank of Australia, Sydney. Davies G (1994), A History of Money: From Ancient Times to the Present Day, University of Wales Press, Cardiff. de Roover R (1946), “The Medici Bank Organization and Management”, Journal of Economic History, 6 (1), May, pp 24–52. Ferguson N (2008), The Ascent of Money: A Financial History of the World, Allen Lane, London. Gerschenkron A (1962), Economic Backwardness in Historical Perspective, Harvard University Press, Cambridge. I first heard this phrase in remarks by Ed Frydl at a conference many years ago – about a previous financial crisis. I have several times tried to find its origins. To my knowledge Withers (1916) was the first to use the phrase. Haldane A (2010), “What is the Contribution of the Financial Sector: Miracle or Mirage?”, in The Future of Finance: The LSE Report. Available at <http://www.futureoffinance.org.uk>. Kent C (forthcoming), “Two Depressions, One Banking Collapse: Lessons from Australia”, Journal of Financial Stability. Kindleberger C (1993), A Financial History of Western Europe, Second Edition, Oxford University Press. Macfarlane IJ (2006), The Search for Stability, Boyer Lectures 2006, ABC Books, Sydney. Newton L (2010), “The Birth of Joint-Stock Banking: England and New England Compared”, Business History Review, 84 (1), pp 27–52. Quinn S and W Roberds (2005), “The Big Problem of Large Bills: The Bank of Amsterdam and the Origins of Central Banking”, Federal Reserve Bank of Atlanta, Working Paper 2005-16. Reinhart CM and KS Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton. Shann EOG (1927), The Boom of 1890 – And Now, 2nd edn, Cornstalk Publishing Company, Sydney. Shann EOG (1930), An Economic History of Australia, Cambridge University Press, Cambridge. Shann EOG and DB Copland (1931), The Battle of the Plans: Documents Relating to the Premiers’ Conference, May 25th to June 11th, 1931, Angus and Robertson, Sydney. Snooks G (1993), “Bond or Free? The Life, Work, and Times of Edward Shann, 1884–1935”, in MAB Siddique (ed), A Decade of Shann Memorial Lectures 1981–1990, Academic Press International. Stevens G (2008), “Liquidity and the Lender of Last Resort”, Seventh Annual Sir Leslie Melville Lecture, RBA Bulletin, May, pp 83–91. Temin P (2004), “Financial Intermediation in the Early Roman Empire”, Journal of Economic History, 64(3), September, pp 705–733. Turner A (2010), “What do Banks do? Why do Credit Booms and Busts Occur and What can Public Policy do About it?” in The Future of Finance: The LSE Report. Available at <http://www.futureoffinance.org.uk>. Withers H (1916), International Finance, Smith, Elder and Co., London. | reserve bank of australia | 2,010 | 8 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Moreton Bay Regional Council, Redcliffe, Queensland, 20 August 2010. | Ric Battellino: Twenty years of economic growth Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Moreton Bay Regional Council, Redcliffe, Queensland, 20 August 2010. * * * I would like to thank my colleagues in the Bank’s Economic Group for their assistance with this talk, particularly Susan Black and Cathie Close. 1. Introduction The Australian economy has started what will be its twentieth year of economic growth. This has been a remarkable performance – one that is unprecedented both in Australia’s economic history and among other developed economies over this period. It raises a number of interesting questions: why was Australia able to record such a good performance; were we just lucky, or were there economic policy decisions that contributed to it? how has this growth been distributed across the nation? and what is the likelihood of it continuing? I would like to focus on these issues in my talk today, but, before I do, it might be useful if I set out some facts and figures. 2. Historical and international comparisons Following the recession in the early 1990s, the Australian economy began to grow again in the September quarter 1991 (Graph 1). In the period since, the economy has grown in every quarter except three. Graph 1 There were a couple of periods when economic growth slowed noticeably, but at no time did year-ended growth turn negative. The lowest rate that year-ended growth fell to was 0.7 per cent. That was in the year to the March quarter 2009. The other slowdown was in 2000–2001, when growth slowed to 1.4 per cent. I should note that, while growth remained positive, both these slowdowns in economic activity did cause a noticeable rise in unemployment. The period since 1991 is the longest period of growth that Australia has recorded for at least the past century. The next longest period during which year-ended growth remained positive was the 13 years between 1961 and 1974. 1 In the 1970s and 1980s, growth phases typically lasted only seven or eight years before another recession hit. As I mentioned, no other developed economy has experienced uninterrupted growth over the past 20 years. In fact, many developed economies have experienced two episodes of negative growth during that period: one in 2001 following the collapse of the dot-com bubble; and one in 2008 following the collapse of the US sub-prime housing bubble. Even among the fast-growing emerging economies, such an extended period of growth is rare, as most of these countries were affected at some point by the various crises that occurred over that period. Australia’s performance, therefore, is quite unusual and I think it is worth spending some time thinking about how it was achieved. 3. Factors contributing to this performance Part of the growth came, of course, from the fact that the population grew strongly over the period, particularly in recent years. Some people might also say that Australia was just lucky: that it was well-placed to take advantage of the emergence of China, both in terms of its location and the composition of its exports. I think these factors have played a role, but they are only a small part of the explanation. The China story has been significant only over the past five years; most of its significance still lies ahead. Remember, too, that the country that was our main export market, Japan, has experienced very subdued economic growth over the past 20 years, and that several other of our Asian trading partners experienced a very severe economic crisis in the 1990s. I would therefore conclude that our luck has been somewhat mixed, and we need to look to other factors to explain Australia’s good growth performance. I won’t pretend to be able to provide a detailed analysis of these factors in the short time available today, but I do want to highlight a couple of factors I think have been important. These are the increased flexibility of the Australian economy and the pursuit of prudent and disciplined financial policies. The Australian economy over the past 20 years has shown a greater degree of flexibility than was the case in the 1970s and 1980s. This has made it more resilient to the various external shocks that have been experienced over the period: the Asian crisis; the collapse of the dot-com bubble; and the recent collapse of the US sub-prime credit bubble, to name some of the more severe. One of the key elements in that flexibility has been the floating exchange rate. The Australian dollar has played an important countercyclical role by rising and falling in response to various external events that otherwise might have had the potential to destabilise the domestic economy. This was evident both during the Asian crisis and the dot-com bubble, when the Australian dollar fell sharply in response to deteriorating economic conditions abroad, helping to insulate the domestic economy. That period, however, was broken by consecutive quarters of negative growth in December 1971 and March 1972. Evidence of the role played by the exchange rate in stabilising the economy can also be seen in recent years. The Australian dollar rose strongly between 2006 and 2008 as commodity prices rose, which helped to dissipate pressures that would otherwise have caused the economy to overheat. Conversely, the temporary, but sharp, fall in the exchange rate during the recent financial crisis helped cushion the economy on the downside. Given the consistent way in which the exchange rate has moved to insulate the economy from various external shocks, I would have to conclude that the decision to float the exchange rate in 1983 ranks among the most important economic reforms, if not the most important reform, of the past 30 years. But other reforms have also clearly played a role: a wide range of reforms to competition and industry policy, implemented over many years, have seen the business sector become more outward-looking and competitive; labour market reforms, some extending back to the late 1980s, gave the labour market increased flexibility to respond to changing economic conditions without producing large swings in unemployment or unsustainable pressures on wages; and various reforms of the financial system gave it greater capacity to meet the financing needs of the economy and made Australia more attractive to foreign investors. In total, these reforms contributed to a substantial pick-up in productivity in the 1990s. The Bank estimates that, during that decade, Australia was able to produce an extra 1½ per cent of output per year simply by using capital and labour more efficiently (Table 1). Table 1 Output growth All industries Contributions to GDP growth (percentage points)* GDP growth Average annual percentage change Labour Capital Multifactor productivity 1990/91 to 2000/01 3.6 0.8 1.3 1.5 2000/01 to 2008/09 3.2 1.0 1.8 0.4 1990/91 to 2008/09 3.4 0.9 1.5 1.0 * Estimates based on a Cobb-Douglas production function. Sources: ABS; RBA. Unfortunately, this growth in productivity appears to have slowed substantially more recently. Perhaps this is partly a measurement problem, since the large shifts we have seen in the composition and pricing of output in recent years may have complicated the measurement task. Some of the slowdown in productivity is also a reflection of the economy being relatively fully employed in recent years. It is also possible, however, that the slowing in productivity growth is due to the fading effects of the earlier economic reforms. Output growth has not slowed as much as productivity in recent years, because businesses have been applying increased amounts of labour, and particularly capital, to production. Business investment in recent years has risen to a very high level relative to GDP, one of the highest among the developed economies (Graph 2). Employment growth has also been strong. Nonetheless, the slowdown in productivity growth has meant that GDP growth in the latest decade was not as fast as in the previous decade. Graph 2 Disciplined economic policies also contributed to the good economic performance of the past 20 years. They have prevented the build-up of imbalances that might otherwise have threatened the economy, as occurred frequently in the 1970s and 1980s. Government budget finances were greatly improved during the period. Budget surpluses were recorded in 10 of the 19 years since 1991. Government debt was reduced sharply, leaving Australia as one of the best positioned developed economies in terms of government finances. Monetary policy helped keep inflation low, providing a stable environment in which businesses and households could plan and undertake their economic activities. Since inflation targeting began in 1993, inflation has averaged 2.7 per cent, a little above the midpoint of the target range (Graph 3). Graph 3 4. How has this growth been distributed through the economy? Economic growth is important because it allows living standards to rise and more people to find work. The benefits that have flowed to Australians in this respect over the past couple of decades have been impressive. Since June 1991, 3.5 million new jobs have been created and income per household has risen by a cumulative 30 per cent in real terms (Graphs 4 and 5). Graph 4 Graph 5 The increase in jobs, which represented a rise of 2 per cent per year on average, was faster than the growth in the population, and was met partly by an increase in the proportion of the working-age population that is in the workforce, and partly by a decline in unemployment. Over the period, the unemployment rate fell from 9 per cent to a little over 5 per cent. One question of interest is how the benefits of this growth were distributed through the community. There are various ways to look at this: one is across the states; another is across the income distribution; and a third is across industries. Let me start with a comparison of the states. The key point that stands out is that all the states shared in the growth over the period, though Queensland and Western Australia grew faster than the others. As can be seen in Table 2, growth in gross state product in Queensland averaged 4.8 per cent per year, and that in Western Australia, 4.5 per cent. The other states averaged between 2.8 per cent and 3.7 per cent. Population shifts explain most of this gap, however, and on a per-capita basis growth in gross state product was more uniform. Table 2 State economic indicators 1991/92 to 2008/09; annual average growth, per cent NSW VIC QLD WA SA TAS Gross state product 2.8 3.7 4.8 4.5 2.9 2.9 Population 1.0 1.2 2.2 1.8 0.6 0.4 Gross state product per capita 1.8 2.5 2.6 2.7 2.3 2.5 Source: ABS. All the states also experienced large falls in unemployment over the past couple of decades (Table 3). In fact, the states with the highest unemployment rates in 1991 generally experienced larger falls. At present, the rate of unemployment is fairly uniform across the states, with the exceptions of Western Australia, where it is below average, and Tasmania, where it is above average. Table 3 Unemployment rates by state Seasonally adjusted, per cent NSW VIC QLD WA SA TAS September 1991 9.4 10.3 9.4 10.6 10.4 10.6 Current (July 2010) 5.6 5.5 5.6 4.4 5.1 6.5 Source: ABS. The benefits of growth were also spread fairly widely across households at different points of the income distribution. Income relativities across the bulk of the population did not change much over the period, though the relative position of households in the top 10 per cent of the income distribution improved somewhat, and that of households in the lowest 10 per cent deteriorated (Graph 6). Graph 6 Table 4 GDP by industry* Per cent of total Industry 2008/09 1991/92 Difference Financial & insurance services 10.8 7.0 3.8 Education, health & social assistance 10.4 10.8 –0.4 Retail & wholesale trade 9.6 10.2 –0.6 Manufacturing 9.4 14.0 –4.6 Ownership of dwellings 8.0 8.9 –0.9 Administrative (including public administration & safety) 8.0 7.9 0.1 Mining 7.7 5.0 2.7 Construction 7.4 6.3 1.1 Professional, scientific & technical services 6.1 4.3 1.8 Transport, postal & warehousing 5.8 5.6 0.2 Utilities, accommodation & food services 5.0 6.4 –1.4 Information media & telecommunications 3.4 4.1 –0.7 Rental, hiring & real estate services 3.0 3.1 –0.1 Arts, recreation and other services 2.8 3.1 –0.3 Agriculture, forestry & fishing 2.6 3.3 –0.7 100.0 100.0 Total * GDP excludes taxes, subsidies, and the statistical discrepancy. Sources: ABS, RBA. One area where there have been sizeable differences in growth performance has been across industries. The output of the mining, financial services and professional services industries grew at a much faster rate than average, while the output of the manufacturing sector increased by less than average (Table 4). Around three-quarters of the economy now involves the production of services rather than goods, and the financial sector has replaced manufacturing as the largest single industry in the economy. While many people lament the small share of manufacturing sector in the Australian economy, the low exposure to manufacturing may have been one reason why the economy has fared relatively well over the past couple of decades. It meant that Australia was less affected than many other countries by the global shift of manufacturing to emerging markets, particularly Asia, that took place over that period. 5. Current conditions Let me turn now to the current state of the economy, and the prospects for the next few years. As you know, the Australian economy recovered relatively quickly from the slowdown that followed the global financial crisis. It is currently growing at around its trend rate, in part due to a large increase in government spending. Consumer spending remains relatively restrained, even though consumer confidence is high. It seems that households have become more cautious in their financial habits, borrowing less and saving more. The household saving rate has risen back to around 4 per cent over the past year, after being close to zero in the early part of the decade (Graph 7). Investment in new housing is also growing at only a modest pace, despite fast growth in the population. This is because of the relatively high cost of housing, rigidities in the housing supply process and difficulties for developers in obtaining finance. Graph 7 Business investment, however, is at very high levels. It did decline somewhat during the financial crisis, but it is expected to increase strongly again over the period ahead, driven importantly by the mining sector. Exports are also increasing at a solid pace at present, as earlier increases in mining capacity are coming on stream. Together with much higher export prices, this has meant that the trade account of the balance of payments has moved strongly back into surplus, an unusual situation for Australia. Employment has been growing strongly, in fact more strongly than would normally be associated with recent rates of increase in GDP, and the unemployment rate has fallen significantly since mid 2009, to around 5¼ per cent (Graph 8). Graph 8 As I mentioned earlier, over the past couple of decades the typical pattern had been for growth in the resource-rich states of Queensland and Western Australia to be faster than the average of the other states. Currently, however, that is not the case. Queensland is lagging the other states, with relatively weak growth in retail sales and consumption, and particularly business investment (Table 5). Over the past year, Queensland has experienced little growth in final demand, whereas in the rest of Australia demand grew by close to its highs of the past decade (Graph 9). Part of the problem is that Queensland seems to be suffering from an overhang in the property market after a period of exuberance in the lead-up to the financial crisis. Apartment building outside Brisbane is especially weak, as is commercial building. The high exchange rate is, of course, also affecting the tourism industry in Queensland, as Australians are taking advantage of cheaper foreign holidays. Graph 9 Table 5 State economic indicators Percentage change over past 12 months* NSW VIC QLD WA SA TAS 4.7 6.4 0.3 6.1 5.2 3.1 Consumption 2.8 3.3 1.8 5.9 3.3 3.0 Dwelling investment 0.1 0.6 1.3 5.0 –8.1 6.8 Business investment 1.9 10.4 –17.8 0.6 –0.7 –24.3 Government 13.4 12.8 10.6 14.5 17.7 15.8 Per cent 1.4 3.6 2.9 5.2 2.2 –0.1 Number (‘000) State final demand (sa, per cent) Employment (sa) * State final demand data are over the year to the March quarter 2010; employment data are over the year to July 2010. Source: ABS. 6. Outlook Our expectation is that economic growth in Australia will continue for at least the next couple of years, the period for which the Bank typically prepares forecasts. Our latest forecasts, which were published earlier this month, show growth in the Australian economy continuing at a solid pace over this period. This view is partly based on the expectation that the world economy will continue the expansion that began in 2009. World economic growth is estimated at about 4½ per cent for this year, which is above average – in other words, quite a healthy outcome. Growth in our major trading partners, a group that is more heavily weighted to the fastgrowing economies of Asia, is expected to be even stronger this year. Despite the good performance of the past year, there has been considerable discussion in recent months about whether the global economy can continue to grow solidly in the face of the financial problems it has been experiencing, particularly the overhang of government debt in many countries. However, while official forecasters around the world all acknowledge that this is a potential risk to growth, they are nonetheless forecasting that the global economy will grow at a reasonable pace over the next couple of years. This is the Reserve Bank’s view as well. The strong growth of the global economy over the past year or so has again pushed up the prices of commodities that Australia produces. They have returned to the high peaks reached before the onset of the global financial crisis in 2008. Relative to prices of our imports, export prices are at their highest level in 60 years (Graph 10). This is generating a large increase in income for the country: we are forecasting that Australia’s gross income (in nominal terms) will rise by about 10 per cent this year. Graph 10 We expect that export prices will ease back somewhat over the next couple of years, as more supply comes on stream and as economic growth in our trading partners slows to a more sustainable rate. Nevertheless, by historical standards, prices will still be very high. This creates a very favourable environment for the Australian economy. Household income will most likely rise quite solidly, which should underpin consumption even if households maintain their recent higher rate of savings. Most importantly, however, we think that economic growth will be driven by strong business investment. This will be concentrated in the mining and gas industries, including some large projects that are planned here in Queensland. Mining investment typically runs at about 1¾ per cent of GDP, and in past mining booms it has reached up to 3 per cent of GDP (Graph 11). In the current boom, it has already risen to 4¼ per cent and, even on conservative assumptions, is expected to rise significantly in the years ahead. That will provide a major impetus to growth. Graph 11 Even outside mining, investment is likely to rise, given that capacity constraints exist in many parts of the economy. This expansion in business investment is expected to outweigh the planned scaling back of government spending. In this environment, we see further growth in employment, probably continuing to run ahead of growth in the labour force, so that unemployment will continue on a downward trend. One issue is whether the strength of the economy will have implications for inflation. At present, underlying inflation has fallen back into the top half of the target range after rising noticeably over the second half of 2007 and 2008. We expect that it will stay around its current rate for the next year or so but, after that, upward pressure on inflation is again likely to emerge with a strongly growing economy. History tells us that inflation can be a problem during resources booms, and while there are grounds for thinking it will be less of a problem this time than in the past, we need to remain alert to the risks. While Australia will, most likely, continue to do well over the next few years, it would be a mistake to assume that the economic cycle has been eliminated. We also need to recognise that it is difficult to foresee what will happen in the future, and that there are risks regarding the future path of the economy. It is possible, for example, that growth in the world economy will lose momentum, creating a significantly less favourable environment for Australia than is currently assumed. Both the volume and price of our exports would be weaker and external financing might also be more difficult. On the other hand, it could also turn out that inflationary pressures build more quickly than assumed. 7. Conclusion Let me conclude. Australia has delivered a very good growth performance over the past couple of decades. That was the benefit that flowed from a long process of economic reform and the adoption of prudent and disciplined economic policies. Even though there was significant variation in growth across industries, the benefits of growth were spread relatively widely across the states and across the income distribution of the population. It is reasonable to expect that further growth lies ahead. However, with the economy now operating close to its capacity, it will take further improvement in productivity and disciplined policies for this growth to be sustained. | reserve bank of australia | 2,010 | 8 |
Address by Mr Guy Debelle, Assistant Governor of the Reserve Bank of Australia, at the Risk Australia Conference, Sydney, 31 August 2010. | Guy Debelle: On risk and uncertainty Address by Mr Guy Debelle, Assistant Governor of the Reserve Bank of Australia, at the Risk Australia Conference, Sydney, 31 August 2010. * * * “The future’s uncertain and the end is always near” – Jim Morrison Today I want to talk about the role of risk and uncertainty in the financial crisis. The primary reason why I want to do that is that I believe risk assessment, or more precisely, misassessment has been one of the key elements of the crisis. While that is undoubtedly true in any crisis, I think it has played a more central role in the current episode than in the past. Risk was mis-assessed by financial institutions, risk managers, investors and regulators. There was a false comfort taken from a misplaced belief that risk was being accurately and appropriately measured. To some extent, the technology provided risk managers with a false sense of security. Risk may well have been accurately measured for the particular regime that the economy and financial markets were operating in. But the risk assessment was not robust to a regime change that took the models out of their historical comfort zone. Not enough account was taken of uncertainty. One of the messages I want to leave you with is that risk measurement based on historical models can only take you so far. Judgement must play an important role. Ultimately, the future is uncertain, in the sense that it cannot be quantified. The goal should be to design systems that are as robust as possible to this uncertainty. A system with less leverage is one obvious means of enhancing robustness. Risk versus uncertainty In discussing risk, I would like to highlight the key distinction between risk and uncertainty: risk is quantifiable, uncertainty is not. This is a distinction with a long tradition. Keynes made much of it, 1 as did Frank Knight who lends his name to “Knightian” uncertainty, on which he elaborated in Risk, Uncertainty and Profit in 1921. 2 Knightian uncertainty arises when you don’t know the underlying probability distribution, which makes quantifying the risks impossible. More recently, this distinction has been given prominence by Donald Rumsfeld with his knowns and unknowns, as well as by Satyajit Das in Traders, Guns and Money and Nassim Taleb in The Black Swan. In addition to the distinction between risk and uncertainty in terms of measurability, Keynes made the similar distinction between cardinal and ordinal probability. Indeed his Treatise on Probability has this as one of its central concepts. Cardinal probability is quantifiable: the probability of heads in a coin flip is 50 per cent. Ordinal probability is qualitative: for example, (as much as it pains me to say it), Collingwood are more likely to win the premiership this year than Carlton. How much more likely they are to win, I couldn’t tell you exactly. Modelbased risk management handles cardinal probability a lot better than ordinal probability. In the period prior to the onset of the crisis, hubris developed in parts of the financial sector, and in the investor community more generally, that everything could be precisely measured and priced. In particular, that risk was always quantifiable. To some extent, in the narrow See Skidelsky’s discussion in Keynes, The Return of the Master. See Cagliarini and Heath (2000) on the effect of Knightian uncertainty on monetary policy. sense, that is correct because, as just described, I see measurability as the key distinction between risk and uncertainty. But risk assessment needs to take account of both risk and uncertainty. I am not saying that the quest for improved measurability was misplaced. There was a lot of progress made in better understanding the way financial markets operate and enhancing the technology of risk assessment. The problem was that the management of risk proved to be too narrow. The focus tended to be on things that were quantifiable (cardinal probabilities) to the exclusion of those which were not. Some risks were treated as cardinal even though they were actually ordinal. Some risks, such as liquidity risk and roll-over risk were neglected. Moreover, the risk assessment was often based on too short a history that did not include a set of observations relevant to the events that were unfolding. Comfort was taken in the precision of the measurement without thinking enough beyond the measurement. That is, not enough judgement was exercised. Indeed, it seems to have often been turned off. A key question to ask is: could it have included a relevant set of observations, or were the events of the past three years unpredictable, too uncertain? That is a question I will come back to shortly. I don’t want to get too Rumsfeldian here, but an important element of risk management is to know what you don’t know. 3 (Although Mark Twain might beg to differ: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”) But unfortunately even that is not good enough. From a risk point of view, ultimately you need to be able to measure what you don’t know. That, I believe, is inherently impossible. Because it is impossible, we should make society as robust as possible to uncertainty, while realising that it is not possible to insulate it completely from uncertainty. I do not believe that “the Truth is out there” waiting to be discovered. The Quant faction in financial markets, to some extent, is on a quest to find “the Truth”, the data-generating process that is at the root of financial markets. 4 While a valiant quest, with much knowledge to be gained in its pursuit, like Lancelot’s quest for the Holy Grail, it is likely to be in vain. (This is of course, itself, a qualitatively probabilistic statement about an uncertain event!) A critical issue is: how important is all of this? The answer is that it depends on the circumstances. In the good times, not being able to quantify the risk of the unknowable downside, or take into account the uncertainties, is not that important while ever the good times last. Indeed, there is little to be gained from doing so. Every once in a while, however, it becomes the main game. The “Great Moderation” of the 1990s and 2000s lulled investors and risk managers into a false sense of security. The decline in volatility led many to conclude that a new, more stable, regime had been established. Let me make it clear that I am not saying that the stable macroeconomic environment of this period was a bad thing. Far from it. The improvement in welfare generated by the low unemployment rates, stable growth and low inflation was large and welcome. I do not subscribe to the somewhat Austrian view that the stability and decline in volatility sowed the seeds of its own destruction. Models could do a good job of measuring what was taking place during the Great Moderation. The models were also doing a good job of out-of-sample prediction because the future was unfolding broadly in line with the samples used to estimate the models. When shocks occurred, they were still consistent with the error distribution that underpinned the models and hence provided further validation to the models. Models were continually refined, Actually, to give credit where credit is due, this should be attributable to Confucius, and then Thoreau, before we get to Rumsfeld. See Scott Patterson’s The Quants. but this was not too difficult. They may have become more complex, taking advantage of the improvement in computing power to analyse price movements and discrepancies at a higher and higher frequency. But the underlying data were still assumed to come from the one stable Data Generating Process. The problem came when the future unfolded in a way that was no longer consistent with the history used to develop these models. This raises the question of whether things would have been different if a more appropriate history had been used in the estimation, or is that simply a pipedream? What is the right history? Is it different this time? This time is different. As Reinhart and Rogoff point out, this is the excuse which is always used when there is a major shock to the status quo. However, a careful reading of Reinhart and Rogoff shows that while the general themes often repeat themselves, unfortunately history doesn’t repeat exactly. 5 Things are different enough to matter. History can inform, but ultimately it is only a guide. History is not a forecast. History plays a prominent role in risk assessment. History shapes the models used as well as the data underpinning them. But what is the relevant history that should be taken into account in the risk assessment? I will answer this question using value-at-risk (VaR) models as an example. I am not meaning to single these out (although I do have some particular misgivings about VaR and its application), as the same issues arise with all models. VaR models draw observations from a defined period of time which is generally not all that long. As observations are realised, the model is further refined. If observations start to be realised which lie outside the distribution of the VaR, it is updated to take account of that, imparting a procyclicality to the process. If the short time period used to estimate the model is an unrepresentative guide to what is about to unfold, then VaR has a serious problem. But in an era of reduced volatility like the Great Moderation, the shortness of the time period was not so much the issue. Indeed a longer data sample would still have generated similar outcomes, as long as it lay within the period of the Great Moderation. Rather the problem was the misplaced expectation that volatility was permanently reduced. This was then combined with the belief that the distinction between uncertainty and risk was no longer particularly relevant. That is, the belief was that while the future was still unknowable, it was still likely to lie within the distribution of the recent past. This was believed to be so because there supposedly had been a regime change which meant that the earlier, more volatile, period of history was no longer relevant. But how much history should be relevant? That is a difficult question to answer, although it a question which should always be asked. When one is looking at financial market pricing, should one include observations from the 1920s, when the structure of financial markets were markedly different? Or when the policy reaction function today is completely different to that in the 1920s? In that regard, it is interesting to read Lords of Finance and gain an insight into the mindset of the policy makers at the time. We would like to think we have learned from that history and hence that the policy responses today have been conditioned by those lessons. 6 Given that, the 1920s may I recall this point often being made by the late Rudi Dornbusch, of whom Rogoff was a student. One could argue that given the Germans experienced hyperinflation and the Americans, the Great Depression, the lessons policy makers in those two countries have drawn may be somewhat different. not be relevant to model estimation today because there has been a major structural change. So perhaps history can be too long, as well as too short. To use another example, if one is assessing the distribution of possible outcomes for Brazilian interest rates, should one include observations from the periods of hyperinflation? It would seem a more reasonable assumption that there has been a regime shift and hence that earlier period is no longer relevant. Similar arguments can be brought to bear on stress tests, which can be used to assess the robustness of a model, or a risk management regime, to a set of outcomes that lie outside the data history of the model. Stress testing can go beyond out-of-sample forecasting in that one can conceive of a scenario which is not completely model-consistent. Nevertheless, a similar question can be asked: what is the universe of events that should be considered? To take an extreme, should I stress test my model against the prospect of nuclear Armageddon. It would seem extreme to do so now, but maybe in the 1950s it wouldn’t have been perceived as such a tail event. To take perhaps a more relevant recent example: in the US, financial institutions, credit rating agencies and investors stress tested their mortgage portfolios and mortgage-backed securities. However, the stress test was derived from the history of house prices in the US. That history suggested that cities in the US had their own price cycles and that the correlations across markets were not particularly strong. Periods of large house price decline were confined to a few idiosyncratic events in a few cities. One could obviously have stressed the mortgages assuming some moderate nationwide house price decline. 7 And indeed a number of the AAA-rated securities would not have maintained their rating under that scenario. But given the history prior to 2007, would a stress test of a nationwide 20 per cent decline in house prices have been considered plausible? To illustrate this point one last time, consider Bear Stearns. With the benefit of hindsight, it would seem sensible that Bear should have stress tested their funding resilience to a significant reduction in funding from the repo market. But how significant a reduction should have been stressed? A 10 per cent reduction, a 50 per cent reduction or a complete closure of the repo market? 8 In the event, the latter was obviously what occurred. But there had not been such an event in that market before, so it may well have been difficult to have even conceived of it or believed it to be a plausible stress. In terms of risk assessment, one could only have expressed it qualitatively not quantitatively. I could have told you that a closure of the repo market was an extremely unlikely event, but I could not have assigned a probability to it. For a stress test, the ability to only assign an ordinal rather than a cardinal probability is not necessarily a problem, but it is a problem in then assessing the market value of financial instruments issued by Bear, or determining the appropriate risk mitigation strategy that Bear should have adopted. However, post-Bear, a complete closure of the repo market to a particular institution is now a conceivable event, and maybe I could even begin to assign a cardinal probability to it. And to some extent the market did in its re-pricing of CDS premia of various financial institutions. But from a stress test point of view, it would appear that Lehman Brothers did not adequately factor this event into its set of scenarios. There is the possibly apocryphal story recounted in Michael Lewis’ “The Big Short” that a house price model used by a rating agency could not accept a negative number. See William Cohan (2009) for a detailed account of the effect of the closure of the repo market on Bear Stearns. Now, having seen that history, banks stress test their resilience to a closure of short-term funding markets, because it is an event that is in the recent experience. But what heretofore unconceived event will they be vulnerable to in the future? The answer, of course, is that is impossible to tell. So an important part of the solution from a regulatory point of view is to make the system as robust as possible to such events. Obviously one cannot make the system impregnable, nor would it be optimal to do so. So let me now turn to some issues surrounding the design of a system that can be more robust to uncertainty. Towards a robust system A primary step in making the system more robust is to be using the right models. Using a number of models at the same time is probably going to be helpful too. But the point I have been trying to make is that while that is a commendable objective, what is right in one set of circumstances may not be right in another. A healthy dose of judgement needs to be added to the model-based analysis. We might be comfortable in having an overall framework that is robust to these changes in circumstance, but it may well not be possible to distil that framework down to a set of quantifiable models that can be useful in practice. Hence the aim is to make the system robust, whatever the right model. As my colleague at the Bank of England, Andy Haldane, has highlighted, leverage is a critical factor in making the financial system less robust to uncertainty. 9 Andy shows that leverage played the major role in translating events which would have been somewhat damaging, but survivable, into events which were fatal. Leverage increases the returns to bets which pay off, but simultaneously increases the losses from bets that do not. Financial institutions had (by and large) made the assessment that the leverage that they were carrying was not fatal. Their models told them that it was not, unless there were draws from the extreme tails of the model’s distribution. Unfortunately, as David Viniar, CFO of Goldman Sachs, put it, we were “seeing things that were 25 standard deviation moves, several days in a row”. He said this in August 2007. The tails continued to get fatter and fatter for at least the next year. The light-touch regulatory approach applied in some jurisdictions (although not in Australia) also unfortunately assumed that the models were doing an adequate job. At this point, the Efficient Markets Hypothesis (EMH) is generally dragged out and beaten. But I think that is somewhat of a straw man. The main message I take from the EMH is that there are no gains left on the table, not that (financial) economics had reached a bliss point where the world could be fully encapsulated by a utility-maximising representative-agent model. The goal of making the financial system more robust to uncertainty is one of the key motivations behind the reforms being finalised in Basel at the moment. It is worthwhile to note that the Basel reforms are primarily focussed at the institutional level. That is, the idea is to help make the system robust to an idiosyncratic institutional shock (although measures addressing the system as a whole are also being considered). This includes measures designed to limit the leverage of financial institutions, deliver a more robust funding structure and enhance their capital buffers. While these measures work to increase the robustness at an institutional level, in the event of a system-wide event, such as took place in 2008, a different set of considerations come into play. Once a systemic shock of that nature occurs, it requires a systemic response, which ultimately must come from the public sector, including the central bank, which has the capacity to respond. The institutional framework determines the point at which the public See Haldane (2009a,b). sector needs to be called on. But in terms of insurance of the system as a whole, at some point, it has to be provided by the public sector. I do not believe it is socially optimal for the individual entity to fully insure itself. It would be excessively costly for the financial sector to hold enough capital and liquidity to enable it to survive a freezing of capital markets of the type that occurred in 2008. At some point, it is not even affordable. As Ricardo Caballero puts it, the presence of “Knightian uncertainty [means] that scarce capital is wasted insuring against impossible events”. 10 Financial services are a key intermediary input into the production process. A severe curtailment of those services has a material impact on the capital accumulation process, unemployment and the long-run growth prospects of the economy. It is in the interests of society to ensure that the public sector provides a backstop in such circumstances to mitigate the externality caused by the individually rational risk-aversion of financial sector participants. Finally, the financial innovation of the decade or so prior to 2007 saw the development of a large number of derivative products whose goal was to disperse risk around the financial system. This was done, in part, to enhance the robustness of the system to any idiosyncratic shock and to ensure that the core process of financial intermediation was not significantly compromised when the shock hit. This worked up to a point, in that the situation, as bad as it was, may have been even worse if all the losses resided on the books of financial intermediaries rather than also on the books of pension funds etc, where the immediate effect of the losses was diffused somewhat (although less of it turned out to be diffused than originally thought). Whether this is true or not will be an interesting research question in the years ahead. Conclusion The argument I have been seeking to make today is that the mis-assessment of risk has been a key element of the financial crisis. One of the contributing factors to this misassessment was an over-reliance on a model-based approach to risk management, which focussed too much on measurable risk without taking full enough account of unmeasurable uncertainty. Taking account of uncertainty is not easy, after all, it is uncertain! But at least a focus on ordinal as well as cardinal probabilities, in part by stress testing with scenarios that fall outside the model’s history, would surely be beneficial. But stress testing and the assessment of uncertainty is still constrained by the difficult decision as to what is the relevant set of stresses that the framework should be subjected and what is the relevant history. A healthy dose of judgement needs to be brought to bear on these decisions. Given these difficulties, it is important to try to make the system as robust as possible to the inherent irreducible uncertainty. One key element of this is restraining leverage, which can limit the number of illnesses that turn into fatalities. Bibliography Ahamed L (2009), Lords of Finance: The Bankers who Broke the World, Penguin, New York. Caballero RJ (2010), “Crisis and Reform: Managing Systemic Risk”, XI Angelo Costa Lecture, Rome, 23 March. See Caballero (2010). Cagliarini A and A Heath (2000), Monetary Policy in the Presence of Knightian Uncertainty, RBA Research Discussion Paper 2000-10. Cohan WD (2009), House of Cards: How Wall Street’s Gamblers Broke Capitalism, Allen Lane, Great Britain. Das S (2006), Traders Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives, Prentice Hall, Great Britain. Haldane AG (2009a), “Small Lessons from a Big Crisis”, Remarks at the Federal Reserve Bank of Chicago 45th Annual Conference “Reforming Financial Regulation”, 8 May. Haldane AG (2009b), “Why Banks Failed the Stress Test”, speech given at the MarcusEvans Conference on Stress-Testing, 13 February. Lewis M (2010), The Big Short: Inside the Doomsday Machine, W.W. Norton & Company, Inc, New York. Patterson S (2010), The Quants: How a New Breed of Maths Whizzes Conquered Wall Street and Nearly Destroyed It, Crown Business, New York. Reinhart CM and K Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton. Skidelsky RJA (2009), Keynes: The Return of the Master, Allen Lane, United Kingdom. Taleb NN (2007), The Black Swan: The Impact of the Highly Improbable, Random House, New York. | reserve bank of australia | 2,010 | 9 |
Speech by Mr Guy Debelle, Assistant Governor Financial Markets of the Reserve Bank of Australia, at the Westpac Macro Strategy Forum, Sydney, 9 September 2010. | Guy Debelle: The financial situation three years on Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Westpac Macro Strategy Forum, Sydney, 9 September 2010. * * * Thanks to Patrick D’Arcy, Megan Garner, Crystal Ossolinski and Andrew Zurawski for their help. It is now a little over three years since the onset of the financial crisis in August 2007. Since that time, financial markets have varied substantially in terms of pricing, volumes and functioning. Conditions in global markets now are markedly improved from their dire position in the last quarter of 2008. Markets have not returned to their pre-2007 state, but that is generally a good thing as those conditions were not sustainable (as indeed they proved not to be). Notwithstanding this, conditions in some markets remain somewhat fragile, reflected in still elevated volatility. In part, I think this is because the events of 2008 are a recent memory and practitioners now know how to retreat rapidly, instead of this process taking over a year as occurred between August 2007 and September 2008. We saw some evidence of this back in May this year. What I intend to do today is talk about the state of play in financial markets, focussing primarily on the foreign exchange market and the domestic bond market. I will focus on structure and functioning and how these have changed over the past three years. Throughout the period, Australian financial markets have generally operated with less dislocation than those in other parts of the world and that remains true today. Foreign exchange The foreign exchange market has been amongst the most resilient of markets throughout the financial crisis. Indeed, its resilience and the increasing attractiveness of foreign exchange as an asset class have seen many financial institutions expand their staffing in this area, even while they have been shrinking elsewhere. The most recent data published by the foreign exchange committees in the major markets confirm this view. Turnover in these markets has increased by 30 per cent from the lows of early 2009, to be above its pre-crisis levels (Graph 1). The same picture can be gleaned from the just-released BIS Triennial Survey which shows global turnover averaged US$4 trillion a day in April 2010, 20 per cent higher than in April 2007. By market, this growth has been broad-based. The UK, which is the largest market, experienced slightly above-average growth while market share declined in the rest of Europe. The Australian market’s relative position was little changed, remaining the seventh largest market. There was more variation in growth rates by currency. Among the major currencies, the Canadian dollar and the Australian dollar experienced the fastest growth, with turnover increasing 50 per cent and 40 per cent respectively. The Australian dollar became the fifth most traded currency, overtaking the Swiss franc in which growth was subdued. The AUD/USD remains the fourth most traded currency pair. Turnover involving the US dollar grew slightly less than the average. However, it still maintains its dominant role in foreign exchange markets, being involved in 85 per cent of all transactions. Graph 1 While turnover in all instruments has grown over the past year, growth has been faster in spot and forward instruments than foreign exchange swaps (Graph 2). Spot and forwards turnover has rebounded by 40 per cent since early 2009 and volumes are now above those seen in 2007. In contrast, turnover in swaps has grown by around 20 per cent over the past year and remains about 10 per cent below its peak. Graph 2 This difference reflects the varied uses of these instruments. There is a strong correlation between growth in spot and forwards turnover and international trade. In these markets, trade has increased by more than 30 per cent since its trough in March 2009, driving the rebound in spot and forwards turnover (Graph 3). Graph 3 The recovery in cross-border capital flows has also contributed to the pick-up in spot and forwards turnover. Foreign banking flows, foreign direct investment and portfolio investment all contracted earlier and faster than international trade during the crisis. These capital flows have recovered of late, supporting spot and forwards turnover in 2010. However, the recovery in cross-border capital flows has been more muted than that in trade; capital flows in G3 countries remain at much lower levels than seen prior to the crisis. These lower flows are likely to be part of the explanation for the slower growth in swaps turnover, which are more dependent on financial activity than are spot and forwards. Along with the rebound in turnover, liquidity in the foreign exchange market has also improved. As I noted when I last addressed this forum, 1 liquidity and turnover, while related, are not necessarily the same thing. The bid-ask spread is one potential measure of liquidity and it shows the steady improvement in market conditions (Graph 4). The bid-ask spread widened appreciably in May of this year but the deterioration in conditions was short-lived and significantly less than in late 2008. Graph 4 See “The Australian Foreign Exchange Market in the Recovery”, address to Westpac Forum, 10 December 2009. While turnover has recovered, the pricing of foreign exchange swaps has been affected by the events of the financial crisis in a more long-lasting way. Historically, the implicit cost of borrowing US dollars through the swap market was the same as borrowing directly in the US dollar money market, that is, US dollar LIBOR. Covered interest parity held and there was no implicit basis in the foreign exchange swap market. However, during the crisis the basis in the swap market widened considerably implying a large premium for borrowing US dollars under swap (Graph 5): the pricing indicated it was considerably cheaper to borrow US dollars directly in the interbank market than under swap. This basis has narrowed significantly from its peak in late 2008, but remains positive at around 50 basis points. Graph 5 The origin of this positive basis is the dislocation in money markets that emerged through 2007 and 2008. 2 Prior to the crisis, banks outside the United States – mostly in Europe – built up large US dollar asset positions which were funded in part by rolling short-term US dollar borrowing. There was a large maturity mismatch between their short-term funding and their long-term asset positions. In the second half of 2007, the supply of US dollars in the money markets tightened considerably and these banks found it increasingly difficult to borrow the US dollars they needed directly. Nor could they sell the assets because of their illiquidity. Following the collapse of Lehman Brothers the situation worsened as general counterparty concerns saw the supply of US dollars in the unsecured money market largely disappear. In response, non-US banks increasingly sought to obtain US dollars via the foreign exchange swap market, but supply of US dollars here was also tight. This saw the basis spike sharply higher in October 2008. Under normal conditions, market forces would ensure any price discrepancy would be arbitraged away. However, there were a number of constraints on the ability to arbitrage over this period. Increased risk aversion, counterparty concerns and balance sheet losses restricted potential arbitrage activity. Further, US institutions with access to US dollar borrowing tended to hold additional precautionary balances to ensure their own liquidity rather than lending in the market. For more analysis of this, see CGFS (Committee on the Global Financial System) (2010), “The Functioning and Resilience of Cross-border Funding Markets”, CGFS Publication No. 37. Counterparty concerns generated significant credit tiering in the market for US dollars. In late 2008 and early 2009, few banks were actually able to access unsecured funding at LIBOR. The eurodollar rate, which is a broader measure of US dollar borrowing costs, indicates that for many banks, funding costs were considerably higher than US dollar LIBOR. When we account for credit tiering by calculating the basis using the eurodollar rate, the apparent deviation from covered interest parity through 2008 is smaller. 3 Action by policymakers, in particular the central bank swap lines set up with the US Federal Reserve, acted to ease supply constraints in the market. However, the basis has not returned to zero and remains sensitive to counterparty concerns. This was highlighted earlier this year in May, when concerns about European sovereign debt saw the basis increase again. Unlike the earlier episode, it appears that credit tiering in May was isolated to a smaller group of European banks. While the swap lines were reactivated by the major central banks, their usage has been extremely small this time around. Turning to the Australian foreign exchange market, turnover has rebounded from its lows of early 2009 by 60 per cent (Graph 6), a much greater increase than in other major markets. Somewhat in contrast to other markets, swaps turnover in Australia has outpaced growth in other instruments and turnover is now higher than prior to the crisis, while spot and forwards turnover was unchanged from October 2009. Graph 6 The growth in foreign exchange swaps is likely to be related to the improvement in risk appetite and appreciation of the Australian dollar over the past year. As in the pre-crisis period, market yields remain high in Australia relative to the rest of the world and as markets have stabilised there has been renewed interest in the Australian dollar carry trade. One way for the investor to generate a carry return is to hold an open forward position in the Australian dollar. These positions are typically short-term and rolled frequently using foreign exchange swaps. Data on CME investors’ and Japanese retail investors’ net positions show high levels of net long Australian dollar positions (Graph 7). In fact, Japanese retail investors’ net long positions are even larger than prior to the crisis. The pick-up in options turnover seen in the previous graph would also be consistent with a pick up in carry trade activity, as options are used to limit the potential losses on the trade. For more detail, see Ossolinski C and A Zurawski (2010), “The Financial Crisis through the Lens of Foreign Exchange Swap Markets”, RBA Bulletin, June. Graph 7 I talked about the improvement in liquidity in the local foreign exchange market earlier. Volatility in the Australian dollar has also declined significantly from its peak in October 2008 but remains well above its pre-crisis level (Graph 8). The spike in volatility in May is evident. Graph 8 The Australian cross-currency swap market has also experienced strong growth with turnover now close to its previous peak. The market is particularly important in Australia as Australian banks make use of cross-currency swaps to hedge the exchange rate risk associated with their foreign currency bond issuance. Australia has a large share of the cross-currency swap market and this share has grown over the past three years, from 5 per cent in 2007 to 11 per cent in 2010. The increasing share reflects the fact that Australian institutions accounted for a larger share of global foreign currency bond issuance in 2009. The increased share resulted as much from the very low issuance globally as it from the fact that the Australian banks maintained their access to bond markets due to their strong balance sheets, high credit rating and, for a period, the government guarantee (see below). The premium to obtain Australian dollars under swap has risen compared to the pre-crisis period. Historically, Australian institutions paid a small premium to swap foreign currency into Australian dollars. The premium arises because domestic issuers tend to issue a greater value of foreign currency bonds than foreigners issue of Kangaroo and other Australian dollar bonds. The crisis saw this balance shift even further toward Australian issuers as Kangaroo issuance slowed to a halt, resulting in a higher basis (Graph 9). Kangaroo issuers have since begun responding to the favourable pricing, with $8 billion of Kangaroo issuance over the past three months. As a result, the basis has moderated from its peak but remains higher than in the pre-crisis period. Graph 9 The Australian non-government bond market 4 Turning to the local bond market, one important point to emphasise is that holders of Australian bonds have seen relatively little deterioration in asset quality. Nevertheless, heightened global risk aversion significantly affected pricing, and while spreads have narrowed over the past year, relative pricing has changed, and consequently so has the structure of the market. Graph 10 This is discussed in detail in Black S, A Brassil and M Hack (2010), “The Impact of the Financial Crisis on the Bond Market”, RBA Bulletin, June. The Australian non-government bond market had grown significantly over the decade prior to 2007, as unsecured issuance by financials and corporates expanded (Graph 10). There was particularly rapid growth in asset-backed issuance in the form of RMBS such that by mid2007, RMBS accounted for around 40 per cent of issuance in the non-government bond market. The onset of the financial crisis in mid 2007 altered these issuance patterns (Graph 11). There was large selling of existing RMBS by foreign investors, particularly SIVs. The selling occurred because the SIVs were forced to liquidate portfolios, not because of any issue with the security itself. The resultant overhang of supply in the secondary market generated a large increase in RMBS spreads such that issuance was not economic for most lenders. As a result, issuance in 2008 and 2009 was only a fraction of the issuance prior to the crisis. Graph 11 At the same time, the rise in risk aversion also saw many corporates turn to the banks for funding. The reintermediation on both the housing and business side saw banks’ balance sheets grow. The banks retained access to the bond market and, supported by their strong balance sheets (reflected in the major banks retaining their AA ratings) and, for a time, the Government Guarantee Scheme, were able to issue significantly more in 2009 than in previous years. While the pace of new issuance by banks in 2010 has slowed compared with last year, issuance this year has been almost entirely in their own name, with the banks making very little use of the guarantee in the run up to the termination of the scheme in April. Despite all these classes continuing to perform well from a credit perspective, spreads widened during the financial crisis to historical highs and, as noted above, most dramatically for RMBS (Graph 12). As investor risk aversion has eased, spreads have narrowed from these highs, but still remain well above pre-crisis levels. Perhaps more importantly for the structure of the market, relative pricing has changed significantly compared with early 2007: the relative cost of bond market funding has declined for the higher rated banks compared with RMBS issuers and corporates. Graph 12 In the RMBS market, primary and secondary market spreads have broadly converged, with AOFM supporting new issuance at tighter spreads. Although RMBS spreads remain high by historical standards, recent issues, including those without AOFM support, have been cost effective for the issuers. Nevertheless, the shift in relative pricing noted earlier suggests that the asset-backed segment is, and is likely to remain, a smaller share of the market than it was prior to the crisis. The decline in AAA asset-backed issuance has only had a modest effect on the credit composition of the market, being offset by strong AAA Kangaroo issuance. Conclusion Conditions in financial markets have fluctuated through a wide range over the past three years. Recently, conditions have been somewhat fragile but considerably improved from late 2008 and early 2009. The foreign exchange market has been one of the most resilient markets and has expanded rapidly over the past year. In that market, unlike a number of others, conditions have generally returned to those before 2007. In other markets, it is unlikely that the pre-crisis conditions will prevail again anytime soon. Throughout the past three years, Australian financial markets have been less affected than other markets. However, there has been a marked effect on the structure and pricing of the Australian bond market. An increase in paper issued by financial institutions has offset the decline in asset-backed issuance. Risk margins across all asset classes have tightened over the past year but remain noticeably higher than in 2007. | reserve bank of australia | 2,010 | 9 |
Speech by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, NatStats 2010 Conference, Sydney, 16 September 2010. | Philip Lowe: The development of Asia – risk and returns for Australia Speech by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, NatStats 2010 Conference, Sydney, 16 September 2010. * * * I would like to thank Adam Cagliarini for his assistance in preparing this talk. It is a pleasure for me to be able to support the work of the Australian Bureau of Statistics (ABS) by participating in this year’s NatStats Conference. The conference itself is evidence of the ABS’s commitment to high-quality statistics. It is also evidence of the Bureau’s commitment to making sure that its statistics remain relevant as the economy evolves over the years ahead. Today, I would like to talk about that expected evolution and some of the issues that it raises. My central thesis has two elements. The first is that the medium-term prospects for the Australian economy look to be more positive than they did some years back. This is partly the result of policy choices that have been made within Australia, but it also reflects the development of the economies in Asia. The second element is that as Australia’s mediumterm prospects have improved, the risks facing the economy have also changed and these risks need to be managed. In my time today, I would like to explore both these elements. The medium term and the development of Asia As is now well understood, Australia has come through the global downturn in good shape. Not only has the business cycle here been relatively muted compared with elsewhere, but our medium-term prospects look to be brighter than those of most other advanced economies. They also look brighter than they did a decade ago. For many years it seemed that Australia was inexorably slipping down the global league tables. The prices of our exports were gradually falling relative to the prices of our imports, and there was little optimism that this would change. And it was only a decade ago that Australia was viewed by some as an old-fashioned, low-tech economy, relying on its natural resources instead of developing new technologies. Today, things look quite different. While there are continuing uncertainties about the nearterm outlook, there is more optimism about medium-term prospects than there has been for some time. The prices of commodities have risen substantially. Investment in Australia is high and Australian assets are again viewed as attractive by international investors. I have talked on previous occasions about the factors that helped Australia through the global downturn and I don’t plan to revisit those today. Rather, I want to focus on why this change in perceptions about medium-term prospects has occurred and, in particular, the role that the development of Asia has played. At a general level, the importance of Asia to Australia is now well understood. Despite this, it remains the case that the financial news from the United States and Europe dominates our newspapers and our airwaves. With this constant flow of information about the North Atlantic, it is sometimes easy to forget just how profound – and important to Australia – are the structural changes taking place in Asia. Two of these changes are particularly important. These are the twin processes of urbanisation and industrialisation. As the countries of Asia have urbanised and industrialised, the demand for infrastructure has grown very strongly. When people move to the cities, new dwellings need to be built, and as living standards rise, so too does the quality of dwellings constructed. The growth of urban centres also requires the building of communication and transport networks, with the demand for roads, bridges, railways etc rising. All this development requires raw materials. In particular, it requires steel to build the apartments in which the new city dwellers live and to build the infrastructure that supports those cities. For example, a typical 90m2 apartment in China requires about six tonnes of steel, and 10km of metropolitan subway requires around 75,000 tonnes. On average, every tonne of steel that is produced requires around 1.7 tonnes of iron ore and over half a tonne of coking coal, and Australia is in the fortunate position of having ample low-cost, high-quality supplies of both. And with higher energy consumption also a feature of industrialisation, we are in the fortunate position of having large reserves of natural gas. Not surprisingly, the strong growth in demand for raw materials in Asia has led to a large increase in the price of raw materials over the past decade. As a result, Australia’s terms of trade have increased very significantly and are now at their highest level since the spike in the early 1950s when wool prices soared due to the Korean War (Graph 1). Graph 1 These higher prices have raised the return to capital in the Australian resources sector, and the result has been a very large increase in investment. Indeed, Australia has become one of the high-investment countries of the developed world, with the stock of physical capital estimated to have increased at an average rate of around 5 per cent over recent years. By way of contrast, in many other advanced economies, including the United States, the level of investment has been only a little above that needed to offset the depreciation of the existing capital stock (Graph 2). Graph 2 When discussing the impact of Asia on Australia over recent years, the focus has rightly been on China. The transformation that has been occurring there is truly remarkable and it is reshaping the global economy. Over the past three decades, the proportion of the Chinese population living in urban centres has more than doubled to almost 45 per cent (Graph 3). While there have been a couple of historical examples of other countries urbanising as quickly, the sheer number of people migrating to urban centres is unprecedented in human history – over the past 30 years, nearly 400 million Chinese citizens (almost 20 times the population of Australia) have moved to cities. As a result, there are now around 170 Chinese cities with more than a million residents, compared with only around 35 in Europe. And the urbanisation process still has quite a long way to run, with another 300 to 400 million people expected to move from the country to the city over the next 20 years. Graph 3 These developments in China are being closely observed in Australia, including at the Reserve Bank. A decade or so ago, we spent a lot of time puzzling over why quarterly movements in Australian GDP were so highly correlated with quarterly movements in US GDP. We don’t puzzle over this anymore – not because we solved the puzzle, but because the correlation has fallen (Graph 4). At the same time, the correlation between quarterly movements in Australian and Chinese GDP has steadily increased. Clearly what happens in the Australian economy is now more dependent upon what happens in China than has been the case at any time in our past. Graph 4 But as we think about the future, the story is broader than China. Over the years ahead, the Indian economy, which also contains more than 20 per cent of the world’s population within its borders, is likely to become increasingly important to Australia. After India grew at a disappointing pace in the 1960s and 1970s, growth has picked up over recent decades, averaging 7 per cent per year over the 2000s (Graph 5). The economy has gradually opened up to foreign trade and capital, and government influence over investment decisions has been scaled back. While India will inevitably follow a different development path to that of China, the prospects for sustained solid growth look to be better than they have for many years. Graph 5 Like China, India too is urbanising. The process though is more gradual, with the number of people moving to urban areas over the past 30 years less than half that in China (Graph 3). Despite India’s population currently being only marginally lower than China’s, it has about 40 cities with a population of over 1 million, compared with China’s 170 or so. This lower rate of urbanisation partly reflects the fact that India has not industrialised as quickly as China. As I mentioned a few moments ago, as people move to cities the demand for steel tends to rise. Not surprisingly, in China consumption of steel has more than quadrupled since 1997, with just over half of current steel consumption accounted for by the construction sector (Graph 6). 1 Indian steel consumption has also grown, but not nearly as quickly. However, the experience of China and that of other countries that have urbanised hints at the potential growth in India. While at the moment, the bulk of the Indian population live in rural areas and investment in infrastructure has been relatively low, there is the potential for this to change over the years ahead, just as it has in China over the past 30 years. If this does indeed occur then the demand for raw materials – and steel, in particular – is likely to be very strong over coming decades. Graph 6 The impact of Chinese and Indian development is not just confined to the resources sector though. As countries develop and living standards rise not only does the demand for steel increase, but so does the demand for higher-quality food, and consumption of protein increases. Again, the comparison of China and India is instructive (Graph 7). As income per head in China has grown over the past 30 years, protein consumption per head has also risen strongly, almost doubling over this period. Protein consumption has also risen in India, although the increases have been much smaller due to slower growth in income per head and differences in dietary preferences. China’s share of world steel consumption has increased from 15 per cent in 1997 to 44 per cent in 2009. Graph 7 Again, over the years ahead it is quite likely that global demand for protein will grow strongly, particularly if India and China continue on their current paths. With Australia’s strong history of agricultural production, this is another area where we have an advantage. The overall impact of this growth and urbanisation of Asia can be clearly seen in Australia’s international trade statistics. The four largest markets for our exports in 2009 were China, Japan, India and South Korea (Graph 8). Over the first half of 2010, around 22 per cent of Australia’s exports receipts have come from China and a further 8 per cent from India. These shares have been trending higher for some time and this is likely to continue over the medium term. There has also been a large increase in the share of resources in Australia’s total exports. A decade ago, iron ore and coal together accounted for around 10 per cent of Australia’s total exports (Graph 9). In contrast, over the past six months, this share has been around one third, with total resource exports accounting for 55 per cent of aggregate export revenue, up from around 35 per cent in the 1990s. Graph 8 Graph 9 These changes in the country and product composition of our exports are very large. They are also likely to be persistent given that Asian development still has some years to run. This development means that, in aggregate, the Australian economy has the potential to do very well over the years ahead. Conditions are, however likely to differ substantially across sectors of the economy. If past experience is any guide, the growth of the resources sector will have positive spin-off effects for some industries, and rising real incomes will increase demand for a wide range of goods and services. Other industries though will find conditions more difficult due to the level of the exchange rate and the competition for labour and capital. While these differences across sectors will create some challenges, the overall medium-term outlook for the economy is a positive one. The changing risks and risk management I would now like to turn to the second element of my thesis – that just as the medium-term outlook has changed, so too have the risks, and these risks need to be managed. One obvious way that the risks have changed is that the economy is more dependent than it has been in the past upon the performance of the Chinese economy and the resources sector, and I suspect that we will be saying the same thing about the Indian economy some years down the track. While, this is generally a good news story, both China and India face significant challenges over the years ahead. In China, the authorities face the difficult task of rebalancing growth away from exports and investment to domestic consumption. And in India, the burden of red-tape remains a major issue and ways need to be found to improve the country’s infrastructure if the economy’s potential is to be unlocked. It would be unrealistic to assume that the growth paths in these countries will be without bumps, perhaps large ones. And these bumps will have an impact upon Australia. Nor can we assume that commodity prices will remain at their current elevated levels. New sources of supply are being discovered and developed, and there is always the possibility of new technologies reducing the demand for Australia’s main resource exports. There is very little we can do about these external risks. But what we can do is to have the right policy framework in place so that we can respond when things inevitably turn out differently to what we expect. There are four aspects of risk management that I would like to talk about. The first is ensuring that productivity growth is strong. The second is ensuring that the economy retains its flexibility. The third is the way investment is financed. And the fourth is the rate at which national consumption increases in response to the improved medium-term outlook. First, the importance of productivity growth. Regardless of how things develop in the countries to our north, increasing productivity in Australia remains the key to sustained increases in our living standards. Ensuring that we continue to make progress here provides insurance against the possibility that developments in Asia do not turn out as positively as we expect. If we look back over recent years, we see that productivity growth has slowed. Since 2001, output per hour worked has increased at just over 1 per cent per year compared with over 2 per cent per year in the 1990s (Graph 10). This slowdown has occurred despite a significant rise in the economy’s overall capital-labour ratio, which would typically be expected to boost average output per hour worked. Normally, slower rates of productivity growth would lead to slower increases in average living standards. But this has not occurred. Indeed, over the past decade, growth in gross national income per hour worked has been unusually strong, averaging almost 2¾ per cent per year. The reason for this is that the prices of Australia’s exports have risen relative to the prices of our imports, lifting the purchasing power of Australia’s national income. With the proceeds of a tonne of iron ore we now can buy more LCD TVs and domestic services than we could a decade ago. This has allowed our living standards to increase at a faster pace than if we had to rely on productivity growth alone. Graph 10 Looking forward, this situation cannot continue indefinitely. Over the next few years, commodity prices are likely to decline somewhat from their current very high levels and this will put the focus back onto productivity growth and economic reform as the drivers of increasing living standards. The second issue is the importance of ensuring that the economy remains flexible, and can respond to unexpected developments. My colleagues at the Reserve Bank and I have spoken at length on previous occasions about the key elements here. Having a flexible exchange rate has been one of the great stabilising forces in the Australian economy over the past 30 years. Labour market flexibility is also important. So too is retaining the flexibility of both monetary and fiscal policy to respond quickly to unexpected developments. To this list, I would add the importance of having a highly trained and educated workforce. Not only does education help lift productivity, but it also makes the economy more flexible and this helps lower risk. The third element that affects the nature of the risks is the way that investment is financed. Historically, much of the external funding for business investment has come from banks. While bank financing is likely to remain important for many firms, a greater share of investment is likely to be financed from other sources than has been the case in the recent past. This may not be welcome news for the banks, but having investment financed from a variety of different sources helps reduce aggregate risk. Over the years ahead, foreign direct investment and capital market raisings by firms in the resources sector are both likely to play a more important role than they have over the past decade. This means that some of the risks – and, of course, some of the expected returns – from the rapid increase in Australia’s capital stock will be shared with foreign investors. The fourth element of risk management is the response of domestic consumption to the improved outlook. The textbook says that if future income prospects improve, the level of national consumption – either private or public – should increase now. But the textbook also says that the lower our appetite for risk, or the greater the uncertainty about the future, the smaller should be any immediate adjustment in consumption. It also says that the more uncomfortable we are about the possibility of a future decline in consumption if things do not work out well, the smaller should be adjustment now. If we look back at our own economic history, the early 1980s provides a good example of what can happen if the adjustment is too quick. In the first couple of years of that decade, there was much optimism about the future of the resources sector, largely reflecting the rise in oil prices as a result of OPEC II. This optimism was translated quickly into higher wages and increased spending, and the economy grew strongly for a while. But, the optimism turned out to be short lived and the result was a significant hangover, which required a substantial adjustment in spending and real wages over the following years. By way of contrast, the current experience looks quite different. Despite the considerable optimism about the future, household spending has been relatively restrained over the past couple of years and the appetite for debt has declined. Partly as a result, the pace of household borrowing has slowed significantly (Graph 11). One interpretation of this is that the household sector, after having increased its debt levels for many years and witnessed the problems elsewhere in the world, has a better appreciation of the risks. Graph 11 If this interpretation is correct it is likely to be a good thing from a risk-management perspective. I say this for two reasons. First, restraint now provides some insurance against the possibility that things do not work out as well as expected. In doing so, it can help lower the probability that costly adjustments will be required at some point in the future. Second, given that there is currently a relatively limited amount of spare capacity in the economy, the risk of upwards pressure on inflation would be increased if investment and consumption were both to increase very strongly over the next few years. In summary then, while we can do little to control the external environment that Australia faces, the choices that we make on productivity, flexibility, financing and national consumption will influence the overall risk-profile of the Australian economy. So while we look forward with considerable optimism about our medium-term prospects, we also need to be alert to the risks and how we might best manage them. Conclusion I would like to close with just a couple of observations on what all this means for the collection of statistics. First, we need high-quality and comprehensive statistics if we are to understand the structural changes that are taking place in the economy. One obvious area where the demand for statistics is increasing is the resources sector. We need to understand where the investment is going, and how both production volumes and prices are changing. But we also need to understand how these developments are affecting other parts of the economy – what are the linkages and how are they changing. Second, the ABS’s work is also important in helping us understand some of the riskmanagement issues I spoke about. We need to continue making progress on the measurement of productivity and improving our understanding of what drives increases in output per head. And on the financial side, we need to understand how the increase in Australia’s capital stock is being financed and how changes in the pattern of financing are altering the economy’s overall risk profile. I know these are the areas that the ABS is working on and I look forward to seeing the outcome of that work. Thank you. | reserve bank of australia | 2,010 | 9 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Foodbowl Unlimited Forum Business luncheon, Shepparton, 20 September 2010. | Glenn Stevens: Monetary policy and the regions Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Foodbowl Unlimited Forum Business luncheon, Shepparton, 20 September 2010. * * * Thank you for the invitation to come to Shepparton. No one knew, when the invitation was issued almost a year ago, that you would be battling floodwaters just a couple of weeks prior to today. It is good to see the recovery already well advanced. In the global economy, recovery from the effects of a different kind of deluge – a man-made one – has been under way for a while. Progress has been quite varied, however, and the outlook is uncertain just now. I will give an update on those matters today. It also seems a fitting occasion to talk about “monetary policy and the regions”, since a question we are often asked is how we take account of differing economic conditions across the country in the setting of monetary policy. I will offer some perspectives on the issues that arise when we have one policy instrument for a fairly diverse economy. The essential message here is that such diversity matters, but is often not as pronounced as people assume, because all the parts of the economy are ultimately connected. Things that affect one sector tend to have spillover effects elsewhere. Furthermore, economies have a certain capacity to adjust to differing conditions. In Australia this works reasonably well. Current economic conditions The global economy continues to present a mixed picture. In the Asian region, most countries have well and truly recovered from a downturn that occurred in late 2008 and the first few months of 2009. The main exception is Japan. In the bulk of cases, economies are much closer to their potential output paths now than they were a year ago and policies are moving to less expansionary settings. As a result, over the year ahead the growth in the Asian region is unlikely to be as rapid as over the year to mid 2010, when the “v-shaped” recovery was in full swing. Similar comments could probably be made about Latin America. In Europe, the German economy has been powering ahead this year, reaping the benefits of many years of attention to containing costs and building productivity. But other continental economies are not as strong, and some are in the grip of a very painful adjustment to a world of constricted private credit and limits to budgetary flexibility. In the United States an expansion has been under way for some time, but seems lately to have been losing a bit of steam and growth has recently not been robust enough to reduce high unemployment. In Australia, growth has been quite solid over the past year, unemployment is relatively low, and inflation has, for the moment, declined. In fact, growth trends have been favourable over several years now in comparison with many other economies. The charts below, comparing trends in Australia’s real GDP per capita with that of several countries, are illustrative. Of course we cannot match the extent of growth in China – a country where living standards are rapidly increasing in a process of “catch up” to the higher levels of high-income countries (Graph 1). But it is clear that compared with the US or Europe, or Japan, Australia’s per capita output and income has done pretty well over the past several years (Graph 2). Graph 1 Graph 2 The task ahead, then, is to seek as far as possible to continue a solid trend like this, through various challenges which lie ahead. The future is of course unknowable, and economic forecasts unfortunately are not very reliable. But we have no option but to try to form a view of how things will probably unfold. We think the global economy will record reasonable growth over the coming year, though not as strong as the past year (a strength that, incidentally, surprised most observers). We think Australia’s terms of trade, after reaching a 60-year high in the current quarter, will probably decline a bit, but remain high. We expect that this high level of relative export prices will add to incomes and spending, even as the stimulative effects of earlier low interest rates and budgetary measures continue to unwind. We expect, and indications from businesses are that they do as well, that resource sector investment will rise further – as we experience the largest minerals and energy boom since the late 19th century. Even with continued caution by households, that probably means that overall growth, which has been at about trend over the past year, will increase in 2011 to something above trend. We think that means that the fall in inflation over the past two years won’t go much further. Of course that central forecast could turn out to be wrong. Something could turn up – internationally or at home – that produces some other outcome. We spend a fair bit of time thinking about what such things could be. Possible candidates might be a return to economic contraction in the United States, or a bigger than expected slowdown in China, or the resumption of financial turmoil that abruptly curtails access to capital markets for banks around the world and damages confidence generally. But if downside possibilities do not materialise, the task ahead is likely to be one of managing a fairly robust upswing. Part of that task will, clearly, fall to monetary policy. The objectives of monetary policy What then are the objectives of monetary policy? Put simply, our job is to preserve the value of money over time and to try, so far as possible, to keep the economy near its full employment potential. Over the long run, these are mutually reinforcing goals, not conflicting ones. For the past 17 years the way we have pursued these goals has been to operate a medium-term target for CPI inflation of 2–3 per cent, on average. The “on average” specification allows us to accept short-term fluctuations in inflation – as long as they are only short-term – and so avoid the risk of attempting to over-control inflation and in the process de-stabilising the economy. But the specification still requires us to limit inflation in the medium term. Over the 17-year period, CPI inflation has averaged 2.5 per cent (excluding the one-time impact of the GST in 2000), and the economy generally has exhibited more stability, with real GDP mostly a little closer to trend than it had been in the preceding couple of decades. How does monetary policy work? The Reserve Bank has very effective control over one interest rate – namely the rate that applies when one financial institution lends cash overnight to another (hence the label the “cash rate”). This rate has a major impact – though not to the exclusion of other forces – on a range of short-term market rates. Since the bulk of financing activity in Australia is contracted on variable interest rates, that are axiomatically affected by changes in short-term rates, the rates paid by borrowers are usually closely affected by cash rate decisions – though other factors can impinge as well from time to time. Through this device the Bank can affect the relative incentives for saving versus borrowing, and so have an impact on spending on goods and services and on financial and “real” assets. Because the relative rates of return on Australian assets compared with foreign assets are altered when we change interest rates here, the exchange rate also moves in response to monetary policy changes (although most of the time it is moving in response to a host of other factors as well). Often, the expectation of what will happen to the cash rate in the future is just as important as, or even more important than, the level of the cash rate today. For this reason what the Bank says – or what people think we have said – can be very influential on markets and behaviour. It is for this reason that central bankers are usually so guarded in public comments. The effects of monetary policy in a diverse economy It is obvious even from the above highly condensed description that monetary policy will affect different groups in different ways. For a start, changing interest rates shifts the distribution of income between savers and borrowers. The larger the size of one’s balance sheet – either assets or debt – the more likely one is to be affected by a change in rates of interest. Someone with no debt and no savings will probably feel little impact – if they feel anything at all – of a change in interest rates, at least directly. In addition, we only have one set of interest rates for the whole Australian economy; we do not have different interest rates for certain regions or industries. We set policy for the average Australian conditions. A given region or industry may not fully feel the strength or weakness in the overall economy to which the Bank is responding with monetary policy. In fact no region or industry may be having exactly the “average” experience. It is this phenomenon that people presumably have in mind when they refer to monetary policy being a “blunt instrument”. The issue is that it is not possible to have different monetary policies by region or by industry within the country, at least not while we are all using one currency and funds are free to flow around. Either each area that wanted its own interest rate would also have to have its own currency, or there would need to be a draconian set of regulations to prevent savings in one region flowing to another to be loaned out – a sort of local and regional equivalent to the pervasive capital controls which once existed on international capital movements. Quite possibly both of the above might be needed for a comprehensive tailoring of interest rates to each set of local conditions. Obviously that is unlikely to be practical. Moreover there would be costs for a region having its own currency. It would have to establish its own Reserve Bank for a start, and would have to accept additional transactions costs for cross-border transactions with other regions, which would probably inhibit trade and investment flows with other regions in its own country. Very small currency areas have also often got into trouble over the years. These are reasons why many very small countries often peg their currency to that of a larger neighbour or simply adopt that currency outright. Perceived gains from being part of a larger monetary union have continued to attract small European countries to the euro, even though the membership conditions are fairly demanding, as we have recently seen. There is a field of economics that thinks about this set of issues. Apart from the obvious criteria like language, culture and political unity, a suitable case for a single currency is thought to be stronger when: the forces (“shocks”) that affect a group of regions or countries are fairly similar and the way in which the regional economies respond is similar; there is a lot of trade between the regions (as there usually is within a single country); factors of production (labour and capital) flow fairly easily between the regions in response to differences in conditions; and/or when other means for responding to differences in experience (particularly fiscal transfers) are available. That framework suggests several questions we might ask for Australia and its regions: How different are the shocks by region? How flexibly does the economy respond to such differences? What other policy mechanisms are at work to respond? And finally, how different, ultimately, are the experiences after these responses have occurred? Differences across the country It is worth observing that not all “shocks” that hit the economy have markedly different effects by region or industry. Some of them are fairly widespread in their effect. Take the sudden intensification of financial turmoil in September 2008. Confidence slumped and people began to “batten down the hatches” – in just about every industry and every region around the world – more or less simultaneously. Banks became more cautious in lending – most particularly to the property sector, but generally to almost all borrowers – in every country. Other shocks are more particular. The one most people would think likely to have a differential impact across regions would be the big rise in mining prices and associated buildup in investment that we saw a few years ago, and which has returned over the past year and a half. Since the mineral resources are not found in abundance in every region, some areas would be expected to receive more of a boost than others. For example in Western Australia, mining accounts for a quarter of production; it is only 2 per cent of production in Victoria. So it would seem obvious that the impact of an event that increases the demand for minerals is likely to see, in time, the output of WA given more of a boost than that of Victoria. But as usual, the picture gets more complicated when we think further. The headquarters of some major mining companies are in Melbourne. Those companies will be putting additional demand on various service providers around the nation – from air travel to consultants, from geologists to manufacturers, and so on. The effects of the engineering and construction build up for some of the minerals investment will be felt in other regions around the country (and indeed also by overseas suppliers). The higher incomes generated from the mineral boom will be felt by employees, shareholders (some of whom are overseas) and by governments (via various taxes). Depending on how these entities respond to these gains in income, there will be subsequent effects on economic activity around the country. It may well still be the case that the effects are most obvious and most pronounced in WA, but there will be substantial spillovers as the economy responds. Incidentally, most data suggest that until quite recently economic activity was growing faster in Victoria than in WA. So to the second question, how about the mobility of factors of production? A remarkable feature of some of the remote area mining operations is the way the labour operates on a “fly-in, fly-out” basis. Any user of Perth airport can easily attest to this but the “commutes” also occur from the eastern states. More generally, population shifts have long been occurring between the south-eastern states and the resource-rich states. While moving is costly, in most analyses I have seen the mobility of the Australian workforce is pretty good – people shift in response to opportunity. Capital is of course highly mobile, at least at the margin. As for other policy mechanisms at work, there are substantial fiscal transfers. The “automatic stabilisers” will take more taxes from regions that are doing well, since incomes will be rising relatively quickly, and transfer it to areas doing less well in the form of welfare payments. Governments can also use discretionary spending or other policies as part of this. Moreover there are structures in place that are deliberately designed to lessen systematically the differences in outcomes which might otherwise occur. Opinions will differ about how effective these have been, and about how effective they should be – as recent political events have probably demonstrated. But the general point is that in a political federation such as Australia, there are various fiscal transfer mechanisms that act to diminish the divergences that might result from differences in initial conditions and exposure to economic events. This is likely to be less so in an area which is a monetary union but not a political federation. Indeed some economists have long pointed to this as a potential difficulty for the euro area in some sets of circumstances, like the ones that exist in Europe at present. That said, we are seeing, albeit on a somewhat ad hoc basis, more intra-European transfer mechanisms being developed. So for Australia, the effects of a “shock”, even if concentrated initially, will tend to be felt more generally across the economy over time. The way the economy works will naturally tend to help this occur, as will various other policy devices. That is what is supposed to happen in a well-functioning, integrated national economy. The next question, then, is how different outcomes turn out to be after all these mechanisms have responded to the various impacts. Of course differences will remain at the industry level – ultimately, it looks likely that the mining sector and the areas that supply it will grow, and some other industries will, relatively, get smaller. And at this point, much of the impact of the recent resource price changes is yet to be seen. Nonetheless it is still worth examining just how different key trends have been to date across regions. There are various indicators at a state level and even a regional level. These are of varying reliability – sample sizes get pretty small in some cases. Two of the more reliable data sets are likely to be the consumer price index and the unemployment rate. It is these, of course, that people are probably most interested in as well. The CPI is available only for capital cities. Consumer prices in the capital cities have tracked remarkably closely (Graph 3) – at least as much as in other single currency areas like the United States or the euro area (Graphs 4 and 5). Graph 3 Graph 4 Graph 5 In the case of unemployment rates, a fair bit of disaggregated data is available. Graph 6 below shows the national unemployment rate and the range across the statistical regions measured by the ABS for which there are reasonably reliable continuous time series. 1 If we In general, the most disaggregated data available have been used. However, the “Northern, Far West-North Western and Central West” statistical region in NSW has not been disaggregated, as there have been instances in the past when the ABS did not publish data for one of its sub-regions. The number of regions varies with data availability, with two breaks in the series when the number of regions changed. From November 2007, there are 68 statistical regions. weight these unemployment rates by population, the shaded area is where 80 per cent of the weighted observations lie. Recent rates of unemployment have been between almost zero in the Hunter region (outside of Newcastle) of New South Wales and about 9 per cent in the far north of Queensland. Eighty per cent of the population face unemployment rates between 3 and 7 per cent. Graph 6 Graph 7 Also shown is the dispersion at a state level (Graph 7), which enables a comparison with the 50 states of the United States, and the 16 countries of the euro area (Graphs 8 and 9). Graph 8 Graph 9 These comparisons are affected just now by the fact that the US and Europe have had deep recessions and are only in an early stage of recovery, whereas Australia had only a mild downturn and unemployment has been falling for about a year now. As the charts show, dispersion of unemployment rates does tend to have a cyclical dimension. Nonetheless I think it is reasonable, based on the history shown here, to conclude that, while some events can lead to a divergence in economic conditions across Australia, overall these differences have not been especially large in recent times compared with those seen in other entities with whom we might compare ourselves. That is not to say the differences are unimportant or immaterial to people’s lives, nor that they could not get larger. Nonetheless some perspective as to how large they actually have been is useful. How does the reserve bank keep track of different economic performances? That having been said, it is important to add that the Reserve Bank makes considerable efforts to look below the level of national data in its pursuit of a full understanding of what is happening on the ground. Over the past decade or so we have put substantial resources into a comprehensive liaison program with firms, industry groups and state and regional government entities. Officers based in every mainland state capital spend much of their time talking to people about what is going on. Every month they talk to up to 100 organisations around the country. I know that some of our staff visited Shepparton last month and some of you may have met them. The purpose of this is to help us understand what is happening “at the coal face” – the conditions that businesses are actually experiencing and the things that concern them. This helps give a richer and often more timely understanding of what is going on than the higherlevel aggregate data alone might provide. Talking to businesses about their plans for the future helps inform our forecasts, and has been especially useful recently for building a profile of conditions in different sectors, such as expected investment in the mining sector over the coming years. This is important for our analysis of capacity in, for instance, the mining sector, which affects how we see commodity prices, the terms of trade, the exchange rate and exports. Conclusion As a physically large country, with quite a diverse set of industries, and our largest population centres separated by long distances and even living in different climates, Australia is always likely to see some differences in economic experience by region. What is remarkable, in fact, is that the differences are not, in the end, larger. That they are not is testimony to the degree of flexibility within our national economy that has been built up over time, and to the design of national policies that aim to lessen the more stark differences that might otherwise occur. Those structures have grown up in the context of a system of a national money. Monetary policy is, by design, appropriately a national policy. In conducting it, the Reserve Bank devotes considerable attention to finding out and understanding what is happening at the regional and industry level. That helps us to maintain an overall set of financial conditions that are appropriate for the national economy. But we know that there will always be some differences in how changes to monetary policy are felt (though it is not always to be assumed that these impacts are necessarily greatest in country areas). Monetary policy can’t make those differences disappear. In the end, however, if monetary policy can help to deliver reasonable macroeconomic stability, that will offer the best chance for any industry, any region, any business or any individual to succeed on their merits. The Reserve Bank, taking account of all the conditions across the various sectors, remains committed to that goal. | reserve bank of australia | 2,010 | 9 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Property Council of Australia, Queensland Division, Brisbane, 8 October 2010. | Ric Battellino: Financial developments Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Property Council of Australia, Queensland Division, Brisbane, 8 October 2010. * * * I would like to thank Patrick D’Arcy of the Bank’s Domestic Markets Department for his assistance in preparing this talk. Introduction The Reserve Bank has put out a considerable amount of material on the economy in recent weeks, so today I will keep my comments on economic developments relatively short. Rather, I will spend most of my time today talking about finance. As you know, there are concerns at present about the availability of finance, particularly for the property sector, so I think it is worth spending some time examining what is going on. Recent economic developments Before I talk about financing, however, let me set the scene with a few brief words on the economy. The global economy started to recover about a year ago from what was a very severe recession. That recovery is continuing, but the pace of growth differs significantly across the various regions of the world (Graph 1). Asian growth had been exceptionally strong late in 2009 and earlier this year and central banks in the region have begun to tighten monetary policy settings. Many commentators worry that the tightening might result in excessive slowing in these economies, but our reading of recent data suggests that growth is returning to around a trend rate. Graph 1 Latin America is also generally performing well. Growth in the US economy, however, has been lacklustre. It is continuing to grow, but momentum has clearly slowed. While recent data have been a bit better than over the previous couple of months, risks still look tilted to the downside. Consumer confidence remains low, the housing and labour markets remain weak, and the repair of household balance sheets still has quite a way to run. One bright spot in the United States is that business balance sheets are in good shape and equipment investment is recovering. In Europe, there is a large disparity in growth across countries. Germany remains the clear front-runner, benefiting from earlier economic reforms and Chinese demand for German capital goods. German unemployment has fallen to its lowest rate since the early 1990s. Other large countries such as France and Italy are growing but probably still below trend, while some small countries, such as Greece and Ireland, are still experiencing very deep recessions. Overall, recent data have been consistent with around trend growth in the global economy. Our central scenario is for growth to continue at around this pace over the next year or so. This view is broadly similar to that of the IMF and other forecasters (Graph 2). Graph 2 From Australia’s perspective, this would represent a favourable outcome, resulting in commodity prices remaining at relatively high levels compared with earlier decades, even if, as we forecast, they decline somewhat from their current elevated levels. In the Australian economy, growth is around trend and underlying inflation is in the target range. This is a comfortable position to be in, but the challenge is to keep the economy there over the next few years. The challenge will not be easy. First, the economy has been growing continuously for almost 20 years, having experienced only relatively mild downturns during that period, and is therefore approaching full capacity; and second, the resources boom that began about 2005, and which abated for a time during the global financial crisis, is re-emerging, adding to the pressure on capacity. Over the next couple of years, we expect economic growth in Australia to pick up from its current rate of 3¼ per cent, to closer to 4 per cent. Domestic spending is expected to drive this pick-up. Over the past year, final demand grew by about 5 per cent, partly due to government spending (Graph 3). This is in the process of being scaled back, but indications are that private spending will pick up noticeably in the period ahead. This is especially the case for business investment. Income growth will add to spending capacity; over the past year, reflecting the rise in the terms of trade, nominal GDP in Australia rose by 10 per cent. Graph 3 If, as expected, growth in Australia increases to an above-trend pace, it is likely that in due course underlying inflation will pick up from its current level of 2¾ per cent. We are currently forecasting it to rise to around 3 per cent by the first half of 2012 (Graph 4). Graph 4 As you know, earlier this year the Reserve Bank Board returned official interest rates to a level that is consistent with lending interest rates being close to their average levels. Having done so, we have been comfortable to leave official interest rates unchanged in recent months. However, as noted in the statement issued after the Board meeting earlier this week, if economic conditions evolve as currently expected, it will be likely that higher interest rates will be required at some point to ensure that inflation remains consistent with the medium-term target. Overall financing activity I will turn now to financing activity. Since the global financial crisis, the availability of credit has tightened significantly around the globe. The rate of growth of credit in most advanced economies is currently close to zero, or even negative (Graph 5). Graph 5 Australia has not been immune from these developments, though credit growth has held up better here than in other countries. We should not be surprised that credit growth has slowed, as this is typically what happens after a financial crisis. In the boom years that precede a crisis, credit expands very strongly as businesses or households (or both) gear up, either to fund spending or asset acquisition. Some of the decisions that people make during those periods are based on unrealistic expectations about future economic conditions or asset prices. As such, they turn out not to be financially viable. A process of de-leveraging therefore follows. Businesses and households become more cautious, increasing saving, selling assets and reducing debt. Lenders also become more cautious, both because they see the weaker economic circumstances as increasing the risk on loans, particularly as collateral values decline, and because they typically begin to experience a noticeable increase in bad loans. The result is that both the demand for, and the supply of, credit tend to decline. The authorities typically take steps to counter these forces, through tightening in the upswing and then easier economic policies in the downswing, and sometimes through direct fiscal assistance to lenders to help them sustain the supply of credit. However, it would be unrealistic to expect that these measures can entirely smooth out the credit cycle, just as it would be unrealistic to expect that the authorities can eliminate the cycle in equity markets. These cycles are inherent in human behaviour. History shows that it takes time for households, businesses and lenders to regain confidence after a financial crisis, and there are limits on the extent to which economic policy measures can accelerate the process. This is a very significant issue in many developed countries at present. Here in Australia, the credit cycle was mild compared with overseas experience, but nonetheless there was a cycle. Credit, particularly to businesses, increased relatively quickly for a number of years, and now the downside of that cycle is currently being played out. In the period since the mid 1980s, there have been three broad expansion phases in credit in Australia: two related to business credit and one to household credit. The first of the cycles in business credit began in the mid 1980s when financial deregulation led to a strong expansion in credit to businesses. The annual growth in business credit exceeded 30 per cent for a time. The subsequent economic downturn saw many business failures, large losses by the banks and a prolonged period of deleveraging by business (Graph 6). Graph 6 Following that episode, it took almost four years for credit growth to return to a relatively normal rate. The next phase of credit growth was driven by the household sector. This began in the mid 1990s. Up until then, Australian households had relatively little debt by international standards, with debt outstanding equal to about 50 per cent of household disposable income. The fall in interest rates in the early 1990s, the switch in financial innovation from products directed to businesses to those directed to households and the general prosperity of the economy saw households substantially increase their debt over the subsequent 10–15 years, to about 1½ times income (Graph 7). This ratio is broadly in line with debt levels of households in other developed economies. Graph 7 Most of this increase in debt was for the purchase of housing, and was mirrored in a corresponding rise in house prices. Since about 2005, the pace of growth of household credit has slowed, and on average has been broadly equal to the rate of growth of household income. As the Bank has noted before, this is a reassuring development since continued increases in the gearing of the household sector would eventually have exposed the sector to substantial risk. Growth in household credit continues to be moderate. Over the past year or so, household credit has increased by around 7 per cent. Most of this has been due to housing loans, while other forms of household debt, such as credit card debt, margin loans and personal loans have been relatively flat. All this is consistent with households taking a more cautious approach to their finances, as evidenced also by the increase in the household saving rate relative to that seen in the early and middle parts of the past decade. For households, therefore, the current picture is one where borrowing for housing is broadly growing in line with income, house prices are stable and there is little appetite for other forms of debt. From the Reserve Bank’s perspective, this seems to be a satisfactory state of affairs. The third episode I want to talk about is the pick-up in business credit that began in 2005. This cycle was not as pronounced as that in the 1980s but, nonetheless, for a time business credit grew by about 20 per cent per year. Part of this debt was to fund investment which, as you know, has been very strong, but a significant part was also for financial activity. There was a general increase in gearing in the corporate sector, as boards worried that they could be seen as having lazy balance sheets, making them takeover targets for private equity. Over the four years to 2008, the gearing ratio of the corporate sector rose from around 60 per cent to over 80 per cent (Graph 8). Graph 8 The global financial crisis brought a change in thinking by both businesses and their lenders, and there has been a sharp slowing in business credit. Over the past year, business credit has fallen by about 4 per cent. This has not translated to a sharp weakening in economic activity, as was the case in the early 1990s, because a shift is taking place in the way businesses are funding themselves. Helped by the pool of funds that has been built up through the superannuation system, businesses were able to raise substantial amounts of equity when debt markets dried up during the financial crisis. Most importantly, however, internally generated funding from profits has also been very strong. As such, the total availability of funds to businesses has continued to increase at around its long-run average rate (Graph 9). Graph 9 These shifts in funding patterns mean that movements in credit, by themselves, may not give an accurate picture of the overall availability of funds to businesses. The trends that we have observed recently are not evenly spread through the business sector. The mining sector has made heavy use of internal funds while the property and infrastructure sectors have relied much more on debt. I will say more about these sectoral issues later. While the small business sector is often the focus when people worry about the availability of credit, the recent cycle in credit to small business has not been as severe as that in credit to large business (Graph 10). Growth in credit to the small business sector through the boom years was more restrained than the run-up in credit to the large business sector, and credit outstanding has held up better since. Over the past six months or so, credit to small business has grown at an annual rate of about 8 per cent. Graph 10 Property financing Given the obvious interests of this group, let me end by looking in more detail at property financing. Property-related lending accounts for a very significant share of the business lending undertaken by banks and other lenders. It also tends to be among the most cyclical components of lending, rising strongly during boom periods and then contracting sharply. It is also a component of lending on which defaults can rise quickly. The Reserve Bank monitors lending to the property sector very closely, because it has important implications for both the performance of the economy and the stability of the financial system. Lending to the commercial property sector began to pick up noticeably from around 2004 onwards, and at its peak just before the global financial crisis was growing by 27 per cent per year (Graph 11). Foreign-owned banks were the lenders with the fastest growth through this period (Graph 12). Graph 11 Graph 12 With lending for commercial property growing significantly faster than other business lending, its share of total business lending increased from about one-quarter to around one-third. For the regional banks and foreign-owned banks, the ratio was considerably higher, in some cases close to half. Given this rise in the proportion of lending going to the property sector, it is perhaps not surprising that many banks now feel they are overweight to that sector and are reluctant to make new loans, while some are seeking to cut back. Since the peak in early 2009, commercial property lending has decreased by about 10 per cent. Foreign banks have led the contraction, reducing their exposures by a cumulative 35 per cent since the peak. Loan limits have fallen more than outstandings, so that usage of lending facilities has increased to about 90 per cent. At the same time, funding through non-bank sources has also tightened. Commercial mortgage-backed securities, which at the peak in 2007 accounted for around 5 per cent of total commercial property funding, have contracted by about two-thirds since then. The contraction in mortgage trusts and some other funds, entities that were substantial investors in these securities, helped to drive the decline. Adding to the cyclicality in commercial property lending is the fact that these loans have tended to be among the most risky of bank loans. That was the case in the early 1990s and it has again been the case recently. The proportion of commercial property loans that are impaired has risen sharply since 2007, from less than 0.5 per cent to around 6 per cent. This is much higher than the impairment rate for business loans in general, which has only risen to around 3 per cent (Graph 13). The impairment rate has risen particularly sharply for loans to the retail and residential segments of the commercial property sector. Graph 13 The banks that expanded their lending the fastest through the boom have since experienced the sharpest increase in impaired loans. For foreign-owned banks, about 15 per cent of commercial property loans are impaired, compared with around 4 per cent for the major Australian banks (Graph 14). Graph 14 The property sector is vulnerable to changes in the availability of credit because it operates with a relatively high level of gearing and low holdings of cash. Gearing of listed real estate companies has risen substantially over the past decade. It used to be the case that the sector had substantially lower gearing than the corporate sector in general, but the run-up in debt, followed by the fall in asset values, resulted in gearing of the sector reaching a peak of over 100 per cent by late 2008, well above the corporate sector average (Graph 15). Graph 15 Similarly, cash holdings of corporations in the real estate sector are low compared with other corporates (Graph 16). Through the boom years, cash holdings of listed real estate companies fell to less than 2 per cent of assets, compared with 6–8 per cent elsewhere in the corporate sector. Graph 16 In short, it is difficult not to conclude that the financing of the property sector became overextended during the boom years, and that a period of adjustment was largely unavoidable. In saying this, I don’t want to downplay the difficulties that some firms are now experiencing as that adjustment takes place, or the impact it is having on property development. The Reserve Bank is very much aware of both these issues. But cycles like the one we are going through seem to be endemic to the property sector and raise the question of whether, over the longer term, the financing model of the sector should shift towards more equity and less debt. Conclusion Let me end, however, on a more positive note by making the observation that the adjustment process has been underway for some time now and substantial progress has been made. The equity raisings that have taken place have made an important contribution to reducing gearing levels, and the run-up in arrears on property loans may be coming to an end. More generally, the expected improvement in the economy over the next couple of years will be reflected in the commercial property market also. I think there are already some signs of this. That in turn should boost lenders’ willingness to make loans to the sector, though I don’t think it would be in anybody’s interest to return to the free-flowing credit of a few years ago. | reserve bank of australia | 2,010 | 10 |
Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Australian Industry Group's Annual National Forum, Canberra, 25 October 2010. | Glenn Stevens: Cross-currents in the global economy Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Australian Industry Group’s Annual National Forum, Canberra, 25 October 2010. * * * Introduction The topic the AIG had proposed for this session was “The Australian Economy to 2020”. That would of course involve forecasting up to 10 years ahead. That’s a rather risky proposition because forecasts are very hard to make. It might be safer, especially for a central banker, not to look forward at all! The way I want to start is by looking back 10 years. This may serve as something of an admonition to be circumspect in making forecasts. But identifying some big trends in the Australian economy over the intervening period – one or two of which were quite unexpected a decade ago – may contain some indications of issues for us to be aware of in the next decade. A couple of the trends that are readily observable also point to some current challenges in global economics and finance, and it is these to which I shall turn in the second part of these remarks. 2000 – the year that was … A decade ago, Sydney had just hosted the 2000 Olympic Games. The city of Melbourne had hosted a meeting of the World Economic Forum. There were some wonderful sporting moments for Australians in the Games, though the Games are perhaps remembered for their logistical success as much as for the medal tally. The WEF meeting is perhaps most remembered for the protests, which turned ugly. 1 But these events should also be remembered as occurring at the height of the dot-com mania and its obsession with the “new economy”. Australians were told by more than one prominent visitor that year that we lived in an “old economy”, with the implication that we needed to shift towards the production of IT goods. Blue-sky valuations were being applied to companies that had not, at that point, earned a single dollar of profit (and many never would). The Australian dollar was slumping. The Economist magazine remarked that: “… As Sydney was presenting the new face of modern Australia to the world, the currency markets were giving a different verdict. At the end of the games’ first week, the Australian dollar fell to a record low of 53.63 cents against its American namesake. … The Australian dollar’s fall is partly explained by the greenback’s remarkable strength … But it also reflects a continuing belief among financiers and potential investors that Australia has yet to complete the transition from being an old economy, based on natural resources, to a new economy fired by information and other technology.” 2 Other examples could be given. A Google search seems to turn up numerous references to the various protests and protest groups, but not all that much in the way of what was actually said at the Forum. Whether that reflects an ephemeral discussion or the nature of news reporting is difficult to gauge. “Australia’s game still to win”, 28 September 2000. As we now know, the dot-com bubble had actually started to deflate by the time those words were printed. The NASDAQ share index had already fallen by about 25 per cent from its early 2000 peak. By early in 2001 the US Federal Reserve would be cutting interest rates as the US economy went into recession. The new economy – the latest (but not the last) in a long line of new paradigms – still had a business cycle after all. The Australian dollar would fall further in 2001, reaching a low point of about US48 cents in early April. Some felt that it might fall as far as US30 cents. More than any other single economic indicator, this particular price was often taken as a summary statistic for economic health. In 2000, some people were making the point that, in the old versus new economy stakes, it was probably in the use of information technology, rather than in the production of IT goods, that the gains would be greatest. On that score Australia ranked highly. 3 Or they made the point that Australia would probably do best, in its production structure, to stick to its comparative advantages in minerals or agriculture or various services. 4 But it was hard going trying to make sensible points against the barrage of market and media commentary. Ten years on, though, it does not seem to have been to Australia’s disadvantage not to have built a massive IT production sector. On the contrary, the terms of trade are at a 60-year high, the currency just about equals its American counterpart in value and we face an investment build-up in the resources sector that is already larger than that seen in the late 1960s and that will very likely get larger yet. In the area of information technology, meanwhile, the pace of change continues to be rapid: prices continue to fall, profits have proved very hard to come by and a number of prominent names from 2000 have disappeared. It is still better, it seems, to be a user than a producer of IT. The point of saying all this is not to poke fun at those whose prognostications a decade ago turned out to be wide of the mark. Anyone who has to forecast for a living has, from me, a degree of sympathy. The point is simply that forecasting is very hard and that the latest conventional wisdom often turns out to be just a passing fashion. We might add that market pricing, at some points in time, may not be much better than that, even though markets tend to get it roughly right on average. Long-term trends Having given that caution, it is worth recounting just a few of the trends we can observe over the past decade or longer. The increased borrowing of the household sector was one such notable trend. It had already been under way for nearly a decade by 2000, but kept going for the best part of another decade after then. I have said before that this probably won’t be a feature of the next decade. We are seeing more caution in borrowing, and the rate of household saving from current income, while still low, has risen over recent years. It follows that some personal and business strategies that did well in the earlier period of households gearing up probably won’t do as well in the future. Other trends have been a continuation of developments that had already been under way for a long time. For example, as a share of the economy, services have continued to rise, while manufacturing and agriculture have declined. Those sorts of trends, in broad terms, are pretty common to advanced economies. Mining’s share of output had changed little since the mid 1980s, but has picked up noticeably over recent years. This seems likely to continue in the near term at least, so we are seeing a See Macfarlane I, “Talk to World Economic Forum Asia Pacific Summit Melbourne”, 11 September 2000 and The Australian Financial Review, “Whither the new economy?”, 6 March 2000. See Harcourt T, “Should we worry about the IT deficit?” <http://www.austrade.gov.au/Should-we-worry-aboutthe-IT-deficit-/default.aspx>, 16 October 2000. faster pace of change in the relative sizes of industries than we had seen for a number of years. Formal metrics of the extent of structural change in the industry composition of GDP have increased but do not, at this point, show it to be outside the range of previous experience. 5 That could well change, though, given the size of the resources sector build-up that appears to be under way. Looking at the trade accounts, we can see that the share of resources in exports has risen very significantly over the past decade while those of the manufacturing, agricultural and services components have declined. This is not to say that the absolute values of exports for the latter sectors have fallen since 2000 – indeed services exports have grown quite strongly – but the rise in resource exports has well and truly outpaced everything else, as a result of both volume and price rises. It is in the destinations of exports, however, that we see perhaps the most striking changes over the space of a decade. As it happens, the weights in the Reserve Bank’s trade-weighted measure of the value of the Australian dollar were updated just a few weeks ago. In the most recent year, the overall weight on the Chinese currency rose by 4 percentage points. That was quite a large movement in a single year but it is just the latest manifestation of a profound trend. Stepping back, it is apparent that there has been a striking further orientation in trade towards the Asian region since 2000. 6 The table below tells the story. Australia’s merchandise exports by destination Per cent share of total, financial years Connolly E and C Lewis (2010), “Structural Change in the Australian Economy”, RBA Bulletin, September, pp 1–9. The data show shares based on exports of goods. The text also refers to trade in goods unless otherwise stated. A decade ago, Japan was far and away the largest export destination for Australian goods. The United States was second, South Korea and Europe tied for third and China came sixth after New Zealand. Today, Australia’s top goods export destinations are, in order, China, Japan, Korea and India – accounting for some 58 per cent – followed at some distance by the United States, New Zealand and the euro area, all closely bunched, accounting for a further 13 per cent or so between them. Given the ongoing shift in the world economy’s centre of gravity towards Asia, the direction of this change is not at all surprising. Many countries would be seeing the weight of their trade shifting in the same direction as ours. One of the reasons for the strong performance of the German economy this year, for example, has been the strength of demand for high-end manufactured products in Asia. For Australia, though, it is a powerful phenomenon. Now this is just the exports side. When we consider both imports and exports – and indeed when we include trade in services – the United States and Europe remain important for Australia (though less so than China these days). The United States and Europe – along with New Zealand – also continue to account for a large proportion of Australian investment abroad and are the source of the vast bulk of foreign investment into Australia. In fact, the share of outward Australian investment going to Asia has actually fallen slightly since 2000. Moreover, financial developments in the major economies, and especially the United States, are still very important drivers of capital flows, and of shifts in financial and business sentiment. So there are still important links to the major economies. I am not arguing for “de-coupling”, if by that idea is meant that somehow the north Atlantic countries have ceased to have a significant impact on the global economy, or no longer matter to us. Everything is connected, and economic events in the north Atlantic countries still matter greatly. But trends in those countries are leavened to no small degree by developments in the AsiaPacific region, which is progressively becoming both larger and more capable of exerting a degree of independent influence over its own economic performance. It used to be said that when the United States sneezed, Asia caught a cold. Recently it seems that the United States has contracted pneumonia, while Asia sneezed and caught a bad cold, but then recovered pretty quickly. Even in the financial field, the size of offshore investments by Asian official holders has become quite important, including for the Australian dollar. And while the stock of cross border investment between Asia and Australia remains small compared with that between Australia and the United States or Europe, that is surely in the process of changing. The point of all this is not to say that somehow Australia has been, or will be, “saved” by China or Asia. The emergence of Asia is to our advantage, if we respond to it correctly. But there is no free ride from the global or regional economy and there never will be. Nor is it to deny that a country’s own policies, for better or worse, and followed over a long period, also make a significant difference to its economic outcomes. There is no escaping responsibility to keep our own house in order. The point, rather, is that we ought to take more than a passing interest in events in our region, and in the conduct of economic policies in our region, and not just those in the countries that once completely dominated the global economy, but no longer do. This brings me to the issue foreshadowed in my title. Cross-currents in the global economy At the risk of over-using a clichéd term, the global recovery has been very much a two-speed one. The United States, the United Kingdom, Japan and some continental European economies saw deep downturns in output, and have to date experienced only weak recoveries that have left the level of output well below its previous trend and unemployment much higher than normal (Graph 1). In the United States in particular there is a very troubling increase in the duration of unemployment, which, with its likely atrophy of skills, does not bode well for future growth. In Asia outside of Japan and in Latin America, economies have traced out the more classic “v-shaped” path. In east Asia excluding Japan, the level of real GDP is well above its previous peak. It follows that most of these economies are likely to experience some moderation in the pace of growth, from something well above trend, to something more like trend. This is normal after a rapid recovery. Graph 1 This difference in performance between large parts of the emerging world and the core of what we could call the “established” world of industrialised economies leaves the global economy poised at a critical juncture. In Asia, capacity utilisation has more or less recovered and growth will moderate. Many of the old industrial countries, in contrast, still have large volumes of idle capacity and are searching, with increasing urgency, for ways to increase their growth. But they are having trouble increasing their own demand. So we face a slowdown of some degree in global growth at a time when substantial spare capacity remains in the global economy. The “global imbalances”, so called, have persisted, and have a new dimension: there is an imbalance in the location of spare capacity in the world. What could be done to foster a better outcome for everyone? There has been an increasing focus on exchange rates of late, with talk of “currency wars” and so on. My view is that more flexibility of exchange rates in key emerging countries in Asia – including China, but not only China – would be part of a more balanced outcome. But exchange rate flexibility alone isn’t enough. Changes in exchange rates don’t themselves create global growth, they only re-distribute it. Unless the exchange rate changes were accompanied by more expansion in demand globally, we would not have solved the problem of excess capacity, we would only have relocated it. The additional step needed is stronger domestic demand, compared with what would otherwise have occurred, in the countries whose currencies would appreciate in such circumstances. Of course there should be room for this given that the higher exchange rate would, other things equal, help to dampen inflation. In principle, at least, this looks like a potential “winwin” outcome. The appreciating countries could enjoy faster growth in living standards than otherwise, while the weaker countries whose currencies were moving lower would get some stimulus to aid their recovery. There are, however, some complications. A number of Asian countries have been experiencing worrying increases in property prices. Low interest rates and easy financial conditions have contributed to this. Arguably domestic financial conditions in these cases need to be tighter, not looser. So it is not clear that monetary policy would be the best option to boost domestic demand. That said, allowing exchange rates to appreciate more quickly would probably help to dampen increases in asset prices. What about more expansionary fiscal policies as the way of increasing domestic demand? Many, though not all, Asian countries would have some scope for that, given the long record of fiscal prudence and low public debt levels. But these countries are very unlikely to do things that would seriously impair their fiscal position in the long run. Hence my suspicion is that fiscal action, if it came, would be only modest. Some argue that structural changes are needed to lower national saving rates in countries like China. Such changes could involve a shift in the distribution of national income away from state enterprises to households, who are thought more likely to spend it, a better developed social safety net, and so on. In all likelihood these sorts of changes will occur over time. But structural change is rarely a rapid process. So I think we should be realistic about how much difference exchange rate flexibility would make to the unbalanced nature of growth in the global economy, at least over a time horizon of just a few years. It is definitely part of the answer (and it is surely in the interests of the countries with closely managed rates to accept more flexibility), but it is no panacea. A full resolution of the imbalances will take time. It will involve more far-reaching changes to very deep-seated attitudes to saving, which remain very different across the regions of the world. As incomes in Asia continue to rise, saving rates will probably decline over time, but only gradually. Meanwhile, aggregate saving rates in America and Europe will have to rise over time, given the extent to which financial obligations have grown relative to likely future income, particularly on the public side. The key question is whether these two trends, in opposite directions, will occur at the same pace, or not. Good policies can certainly help the world get to a better solution than might otherwise occur. But even with good policies, it is likely to be a slow grind out of the current difficulties for some countries. We probably have to accept that global growth was unsustainably fast in the few years prior to the crisis, that too much capacity of certain types was built up in the wrong places, that spending in some countries ran too far ahead of permanent income and that a period of adjustment and structural change cannot be avoided, even under ideal policy settings. If that is so, then, in all countries, an emphasis on accepting the need for adjustment generally – not just in exchange rates but in economic policies and structures across the board – is key. Conclusion Economies are not static machines. They are a complex and dynamic combination of actors, all continually seeking to adapt to changing conditions. That is one reason that economic outcomes are very hard to predict, and why I am circumspect about predicting “Australia to 2020”. Looking to the long run, we probably can make a few very general observations, but not much more. Real income per head has generally been on an upward trend in industrial economies for the past 250 years, with occasional setbacks. Most likely that will continue (albeit that some major countries will take some time to recover their income levels of three years ago). As a broad observation, and definitely not as a precise forecast, we might expect that a decade from now Australia’s per capita GDP will probably be roughly 15 per cent higher in real terms than it is now, give or take a few percentage points. The economic policy arguments, by the way, will all be about what policies might gain or lose those few percentage points. In 2020, there will probably be, at a rough guess, an extra couple of million people working, compared with today’s 11.3 million. But exactly how all those people working will earn their living and go about their work is considerably less predictable. A good proportion of those 13 million-plus jobs will be in firms that don’t yet exist. Some will be in industries or occupations that barely exist as yet. And no one can give you a blueprint for which areas will succeed and which will not, any more than the pundits a decade ago, at the height of the “new economy” fad, could foresee the shape of Australia’s economy today. Succeeding in the future won’t ultimately be a result of forecasting. It will be a result of adapting to the way the world is changing and giving constant attention to the fundamentals of improving productivity. That adaptability is as important as ever, in the uncertain times that we face. | reserve bank of australia | 2,010 | 10 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia Western Australia, Perth, 18 November 2010. | Ric Battellino: Economic developments Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (Western Australia), Perth, 18 November 2010. * * * Introduction After having held official interest rates steady for five months, the Reserve Bank earlier this month tightened monetary policy a little further. The background to that decision and the reasons for it are set out in the quarterly Statement on Monetary Policy and the monetary policy minutes of the Board meeting that have subsequently been released. My talk today will focus on that material and outline some of the issues that are likely to shape economic developments over the next few years. Global economy I will start with the global economy because, as always, this forms an important backdrop to understanding developments here in Australia. The world economy is quite divided at present. The United States, Europe and Japan are struggling to recover from the effects of the financial crisis, while emerging Asian economies, and to a lesser extent Latin America, are growing strongly (Graph 1). Graph 1 The US economy clearly lost momentum around the middle of the year, with GDP growth slowing to an annual rate of about 2 per cent over the June and September quarters. This is below potential. Our reading of more recent data is that they have been a bit stronger, but nonetheless consumer confidence remains low, the housing and labour markets remain weak, and the repair of household balance sheets still has quite a way to run. Basically, the US household sector is in very poor shape. One of the features of the US economy that has changed over the past 50 years or so is that households are now bearing more of the brunt of recessions than used to be the case, and businesses are bearing less. After each downturn, it has taken progressively longer for employment to regain its peak (Graph 2). Graph 2 Even after the 2001 downturn, which was relatively mild in terms of GDP, it took about four years for employment to recover to its earlier peak. The current downturn has been much more severe, with employment falling by 6 per cent from peak to trough and the recovery in jobs so far being quite tepid. It is therefore clearly going to be some time yet before employment regains its pre-crisis levels. Weak labour market outcomes, of course, mean subdued growth in household income, and the combination of job losses and low income growth has led to a big rise in mortgage foreclosures. Almost one in twenty houses that are mortgaged in the United States is in foreclosure. This is a very high figure (Graph 3). Graph 3 Household wealth has fallen sharply. Measured relative to household income, it is back to the levels of the late 1980s, so a large amount of wealth has been wiped out (Graph 4). Graph 4 At the same time, household gearing has risen sharply, with housing debt now equal to about 55 per cent of the value of the US housing stock. Understandably, the reaction of households to all this has been to stop borrowing, cut back on spending and increase savings, all of which means that US households are not going to be the driving force of the global economy that they were for much of the period since the mid 1990s. The US corporate sector, on the other hand, is in pretty good shape. Profits have recovered strongly and the arrears rate on loans to US corporates has peaked at a level that is quite moderate by historical standards; it is no higher than in the 2001 recession, which, as I have noted, was quite mild (Graphs 5 and 6). Graph 5 Graph 6 Also, holdings of cash by US corporations are at record levels – almost US$1½ trillion or equivalent to over 20 per cent of corporate debt (Graph 7). This means that US corporations are in a strong position to increase investment when confidence returns. Graph 7 The US Federal Reserve has been maintaining official interest rates close to zero since late 2008 but, despite this, the economy has remained sluggish. The Fed has therefore tried to use other instruments to stimulate economic activity. These measures generally fall under the heading of “quantitative easing”. They involve expanding the Fed’s balance sheet through the purchase of securities, with payment for those securities being made by giving banks extra deposits at the Fed. The Fed has roughly tripled the size of its balance sheet since the financial crisis began, to over US$2,000 billion. Earlier this month, it foreshadowed it would be prepared to purchase another US$600 billion of Treasury securities by next June, if circumstances warranted it (Graph 8). Graph 8 The objectives of these operations are to put downward pressure on market interest rates, so as to encourage households and businesses to borrow, and to provide banks with extra liquidity, so as to encourage them to lend. As noted, however, US households have little appetite for debt at present, US corporations are flush with cash and have little need to borrow, and banks appear to be quite happy to leave their extra liquidity on deposit at the Fed, rather than lend it. US banks are currently holding about 8 per cent of their assets on deposit with the Fed, while their loans to households and businesses are falling (Graph 9). Graph 9 These outcomes are typical of what happens in the wake of a financial crisis, as it takes a long time for households, businesses and banks to repair the damage done to their balance sheets and regain confidence to borrow or lend again. This often means a prolonged period of sub-par growth. In Europe, growth on average has been around trend over the past year, but there is a wide divergence in the performance of countries. Germany is doing well, benefiting from earlier economic reforms and Chinese demand for German capital goods, but, at the other extreme, Greece and Ireland are experiencing very deep recessions. Economic tensions have been building within the euro area, driven by earlier widening differentials in competitiveness. Unit labour costs in Greece, for example, have risen by about 25 per cent relative to those in Germany since the euro came into existence. Government debt problems are also probably at their most acute in Europe. The facility set up by European governments in May this year to provide financing to smaller European countries seemed for a time to lessen market concerns about sovereign debt levels. However, the situation has deteriorated noticeably again in recent weeks, as markets again question the capacity of some countries to sustain their current debt levels. On the other hand, as I mentioned, Asia is a bright spot in the global economy. The region bounced back very strongly from the global financial crisis and economic activity in all emerging Asian economies has substantially surpassed pre-crisis levels. Several central banks in the region have recently been tightening policy settings, but generally policy settings in Asia are still quite expansionary. Some commentators are concerned that the recent tightening might lead to excessive slowing in economic growth, particularly in China, but this seems unlikely while ever policy settings are still on the expansionary side. In fact, economic activity in China recently appears to have picked up again. Inflation could become a significant policy issue in Asia if growth remains strong. There are already early signs of rising inflationary pressures, particularly in food prices. Some Asian economies are also experiencing very strong rises in house prices, reflecting the favourable economic and financial climate (Graph 10). Graph 10 Overall, the outcome for global economic growth over the past year has been strong. When the figures for 2010 come in, they are likely to show that the world economy grew by around 4¾ per cent, a rate that is noticeably above trend (Graph 11). Most forecasters are expecting that the growth of the global economy over the next couple of years will be slower than in 2010, though probably at a pace that is close to trend. Graph 11 There are, of course, risks to these outcomes arising from some of the issues I have mentioned. In the developed economies, the concerns are mainly about downside risks. What is worrying people is that the capacity of the authorities in most developed economies to deal with any renewed economic slowdown would be limited, due to the fact that policy settings are already at extremes. In Asia, on the other hand, it is easier to see risks of overheating. Commodity prices The growth of the world economy that has occurred over the past year has resulted in a significant lift in the prices of commodities. The prices of the two commodities of most importance to Australia – iron ore and coal – have been especially strong, and have again risen in recent weeks (Graph 12). Graph 12 As a consequence, Australia’s terms of trade – the ratio of export prices to import prices – have surpassed the 2008 peak, and are pretty much at unparalleled levels. The increase in the terms of trade over the past year has added around $25 billion to the Australian economy. The question is: how long will this last? At the Reserve Bank, we have for some time been forecasting a gradual decline in the terms of trade over the next couple of years, on the assumption that the supply of commodities will increase and that demand will slow a little, in line with the assumed slowing in the global economy. This continues to be our projection, though recent commodity price outcomes have caused us to revise up our forecasts. Beyond the next couple of years, it is hard to predict what will happen. Both China and India, however, are going through a phase of their development that is very intensive in the use of steel. In the past, other countries have taken up to 20 years to move through this phase (Graph 13). It is likely that China, and more particularly India, will have strong demand for steel for quite some time yet. This, of course, would be a very favourable global environment for the Australian economy. Graph 13 The Australian economy Let me now turn to the Australian economy. As you know, our economy recovered relatively quickly from what was a shallow downturn following the global financial crisis, and over the past year has grown around its trend rate of 3¼ per cent (Graph 14). Graph 14 Domestic demand has grown substantially faster than this – about 5¼ per cent – due importantly to growth in public spending, though this is moderating now. Consumer spending has grown by a little below trend over the past year. It seems that even though consumer confidence is high, consumers remain cautious in their spending. The household saving ratio has picked up noticeably from the low levels it fell to earlier this decade. As we have said before, a period of consolidation by Australian households, after 10–15 years of fairly robust increases in spending and gearing, is probably no bad thing. Investment in new dwellings has increased over the past year, though growth in the number of dwellings is still falling short of growth of the population. As a result, rental markets are tightening, with vacancy rates falling and rents rising at a solid pace. At the same time, however, households now seem to be less inclined to increase their gearing in order to trade up to better housing. Auction clearance rates have fallen back to around long-run average levels and house prices have been relatively flat over recent months (Graph 15). This is in keeping with the more financially conservative approach that Australian households have taken recently. These trends are probably most pronounced here in Perth, which is going through a period of adjustment after the euphoria of 2006 and 2007. Graph 15 Business conditions are generally around average levels, although there are clear differences across sectors. Business investment is at a high level, particularly in the mining sector, and information published by the Australian Bureau of Statistics, as well as our own liaison with companies, suggest that it will pick up sharply further over the next couple of years (Graph 16). In this regard, I would like to acknowledge the vital role played by our office here in Perth, led by Virginia Christie, in helping us understand what is going on in the mining industry. And, of course, I would like to thank those many businesses that regularly make time available to talk to Virginia and her team. Graph 16 One segment of business investment that remains weak, however, is non-residential building. Following large increases in gearing and commercial property prices in 2006 and 2007, the commercial property market has since deleveraged and prices have fallen. The bulk of that adjustment is probably now over, though the availability of finance for commercial property development remains very tight. Employment has grown strongly over the past year and the unemployment rate has fallen back to a range of 5–5½ per cent, which historically has indicated a degree of tightness in the labour market. Other indicators, however, suggest that the overall labour market may not be as tight as suggested by the unemployment rate. The financial side of the economy remains subdued. Household credit is growing at a moderate pace while business credit remains soft. That softness is largely in relation to large borrowers; lending to small businesses has increased at an annual rate of about 5 per cent over the first nine months of 2010 (Graph 17). Graph 17 We have spent a fair amount of time at the Bank looking at the question of why business credit is so soft. It is clear that banks had tightened lending standards sharply following the onset of the global financial crisis, which no doubt contributed to the slowdown in business lending. This has been most acute in the area of commercial property, where there has been a sharp cutting back, particularly by foreign-owned banks. More recently, there are signs that banks are becoming more willing to lend, at least in areas other than commercial property, but demand for loans, in aggregate, is not very strong. It seems that the investment that is taking place in Australia, particularly in the case of the mining sector, is largely being financed outside the banking sector, either from retained earnings, direct investment from overseas or capital market raisings. The exchange rate is also clearly having an impact on business conditions. It has risen to post-float highs recently, although the real effective exchange rate remains below the levels recorded in the resources boom of the early 1970s (Graph 18). Graph 18 A rise in the exchange rate is a natural consequence of a resources boom and, at the aggregate level, is helpful in allowing the economy to adjust. Nonetheless, some sectors of the economy are adversely affected. A notable example at present is the tourism industry, where there has been a sharp increase in the number of Australians travelling abroad rather than taking holidays domestically. This is having a severe effect on traditional holiday destinations in Queensland, areas which are also suffering from overbuilding in the pre-crisis years. Given this double impact, it is not surprising that these areas are currently experiencing among the highest rates of unemployment in the country. The Bank is monitoring developments in these areas closely. The outlook While there are differences between sectors and between regions, the Australian economy overall is doing well. We expect that the economy will continue to grow at a solid pace over the next couple of years, with growth picking up to an above-trend rate towards the end of this period. This will be accompanied by further increases in jobs and falls in unemployment. With the economy now having grown more or less without interruption for about 20 years, it is understandable that spare capacity is limited. This means that the economy cannot grow much above its potential rate without causing a rise in inflation. With a large amount of money continuing to flow into the country over the next couple of years as a result of the resources boom, the challenge will be to manage the economy in a way that keeps economic growth on a sustainable path, with inflation contained. This is what the Bank is trying to do. At present, inflation is broadly in the middle of the target range (Graph 19). Over the medium term, though, as growth of the economy picks up, the pressures on inflation are more likely to be upward than downward. This is reflected in the forecasts the Bank recently published, which see inflation tending to rise after a period of near-term stability. Graph 19 For this reason, the Board of the Reserve Bank decided at its meeting earlier this month that it would be prudent to make an early, modest tightening to guard against such an outcome. This is consistent with the forward-looking approach to monetary policy that the Bank has been following for close to 20 years now, and which on balance has helped to keep the economy on a sustainable path. | reserve bank of australia | 2,010 | 11 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 26 November 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, 26 November 2010. * * * When we last met with the Committee in February this year, it was becoming clear that the recovery in the global economy was proceeding faster than many had expected. It was also clear that the strongest performance was in the emerging world, while recoveries in countries that had been at the centre of the financial events of 2007 and 2008 were relatively subdued. Global financial markets had continued to improve, but were paying close attention to the rise in sovereign debt in a number of countries. At that time, people were talking about an expansion in global GDP of something like 4 per cent in 2010. As it turns out, it looks like the outcome will be stronger than that: current estimates for the year are about 4¾ per cent, which is above trend. The pattern of growth is still rather uneven. The additional strength has been concentrated in the emerging countries, with growth in China and India running at a pace of around 10 per cent in 2010. In contrast, growth of about 2½ per cent for the G7 group, after a contraction of around 3½ per cent in 2009, will leave a considerable margin of spare capacity and particularly of unemployed labour. Financial markets and policymakers have maintained, and indeed increased, their focus on issues of sovereign debt sustainability. First Greece, and now Ireland have sought financial assistance from European partners and the IMF, after a change in economic circumstances and a large rise in market borrowing costs left authorities with little other option, even with deep cuts to spending. Across continental Europe and the United Kingdom, governments are embarking on a path of fiscal consolidation, in order to put public finances on a sounder footing in the face of increased obligations and reduced revenues. These programs will unavoidably have some short-term dampening effects on economic activity, which will likely become clearer during 2011. But the scope of alternative possibilities open to the governments concerned is really rather limited. In this environment it is no surprise that the major central banks are mostly maintaining very low interest rates and in some cases increasing the sizes of their already expanded balance sheets via asset purchases. These actions are designed to impart some further stimulus through reducing long-term interest rates even further or via effects on private-sector balance sheets. Yet at the same time many other countries have moved to tighten their monetary policies this year, in recognition of the robust recovery in output. In most cases in Asia – Japan being an exception – the rise in activity along the upward part of the “V” has now been seen and the pace of growth has to moderate if overheating is to be avoided. The combination of very low interest rates in the world’s developed financial centres, on the one hand, and strong growth and tightening monetary policies in Asia and Latin America, on the other, could be expected to place pressure on exchange rate regimes, and so it has proved. There have been substantial capital flows seeking the expected higher returns in emerging economies and a rise in asset values in many of the recipient countries. A number have responded with the imposition of capital controls and other measures to contain leverage, especially in housing markets. In this environment, where the policy imperatives differ so much across countries, the intensity of international discussion about exchange rates was bound to escalate, and it has done so, quite markedly. A year from now we will probably have observed some moderation in global growth, from this year’s above-trend pace to something closer to trend. That is the assumption we are making. The emerging world clearly needed some moderation, while the major countries working through the aftermath of banking crises are still likely, if history is any guide, to find it hard going for a while yet. How much progress we will have made in resolving the “imbalances” issue remains very unclear. But the strength of global growth thus far, and the particular pattern of growth in key emerging economies, with its very strong impact on demand for steel, has had a major effect on Australia’s terms of trade. These have returned to, and in fact exceeded, the six-decade highs seen two years ago. It is our assumption that prices for key resource exports will not remain this high, but will instead decline over the next few years. Even so, developments in the period since February have led us to lift our estimates for the terms of trade in the 2010/11 year. In February I suggested that real GDP growth in the Australian economy would be a little over 3 per cent in 2010, and a little higher than that – about 3½ per cent – in 2011 and 2012. It would take only pretty moderate growth in the second half of the year to achieve that forecast for 2010. Next year, growth could be stronger than we had expected nine months ago, though obviously there are still numerous areas of uncertainty. Measured in nominal terms, the rise in GDP is running at about 10 per cent per annum just now, because of the rise in the terms of trade. Consumer price inflation has returned to rates consistent with the medium-term target, running at about 2½ per cent in underlying terms, and 2¾ per cent in CPI terms, over the past year. This is clearly a marked improvement from two years ago, when the CPI inflation rate reached 5 per cent. A significant decline in inflation was expected at the time the Board started to reduce interest rates in September 2008. Sometimes, the process of disinflation can be quite costly in terms of economic activity. That is often the case when higher inflation lasts long enough to become embedded in expectations. That did not occur this time and the result was that inflation came down with relatively little short-run cost to output, very much as was the case in 2001 and 1995. It is, of course, one of the intended effects of having an announced objective for inflation that inflation expectations be well anchored, which aids economic stability and efficiency. It is unlikely, though, that we will see inflation fall much further from here. We will probably see some ongoing dampening effect on inflation of the rise in the exchange rate, as this usually takes some time to flow through fully. Growth in labour costs, however, is no longer declining, but rising. The overall pace could not be described as alarming at this stage, but the turning point is behind us. Nor is the growth of the economy falling short of potential growth; if anything, over the past year aggregate demand has risen considerably faster than potential output (something that is possible only with either considerable spare capacity or a rise in absorption from the rest of the world). At this point, the gap between actual and potential output is probably not that large. Moreover, while the annual pace of growth of utilities prices – a prominent feature of the past couple of years – has probably peaked, it is likely to remain high. Over the coming year, we think that inflation will be pretty close to where it is now, consistent with the target. But looking further ahead, in an economy with reasonably modest amounts of spare capacity, the terms of trade near an all-time high and the likely need to accommodate the largest resource-sector investment expansion in a century, it is pretty clear that the medium-term risks on inflation lie in the direction of it being too high, rather than too low. Last time we met, I explained it was important that monetary policy not overstay a very expansionary setting once it was clear that the danger of a really serious downturn in economic activity had passed. At that stage the Board had lifted the cash rate three times in late 2009. Most lenders raised borrowing rates by more than the cash rate, given that their costs of funds had moved up relative to the cash rate. I noted the Board was taking account of these shifts in deciding the appropriate setting of the cash rate. Most rates remained below normal at that stage. I also said that, if economic conditions evolved as we expected, further adjustments to monetary policy would probably be needed over time to ensure inflation remained consistent with the target. In the first half of 2010 the Board did indeed make further adjustments, lifting the cash rate to 4.5 per cent. This was roughly 100 basis points lower than what we would once have described as “normal”. In fact it was close to the lowest point reached by the cash rate in the two preceding interest rate cycles. But it resulted in borrowing rates pretty close to the average of the past decade or more, and so was what could be considered as “normal”, allowing for the changes in margins. The Board judged this to be an appropriate point at which to rest for quite some months. This allowed some time to assess the effects of earlier decisions and also to gauge what was happening in the rest of the world. Most recently, as you know, the Board decided to lift the cash rate by 25 basis points. Many lenders raised their loan rates by more than this. These moves have left the overall setting of monetary policy a little tighter than average, as judged by interest rate criteria. Of course, we are aware as well that, particularly for business borrowers, non-price conditions remain tighter than they were for some years prior to 2008. Overall, and also taking account of the exchange rate, which has risen substantially this year, we judge this to be the appropriate setting for the period ahead. As the minutes from the Board meetings show, recent decisions were finely balanced. Quite reasonable arguments could have been made to wait a little longer before taking this step. Good arguments could also be offered as to why, when we looked ahead, it was prudent to take an early modest step in the tightening direction. On balance, the Board judged that to be the better course. This sequence of decisions was taken in the same framework that has guided our monetary policy for nearly two decades now: seeking to keep the growth of demand sustainable so as to achieve an average inflation rate of between 2 and 3 per cent. It is worth noting, incidentally, that the recently re-elected Government has once again committed, as have I, to this framework, which will continue to guide our decisions. My colleagues and I are here to respond to your questions. | reserve bank of australia | 2,010 | 11 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Committee for Economic Development of Australia CEDA annual dinner, Melbourne, 29 November 2010. | Glenn Stevens: The challenge of prosperity Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Committee for Economic Development of Australia (CEDA) annual dinner, Melbourne, 29 November 2010. * * * Thank you for the invitation to play a part in marking the 50th anniversary of CEDA. It is particularly significant for me to be here because 2010 also marks 50 years since the commencement of central banking operations by the Reserve Bank of Australia. There were in fact a number of significant beginnings in 1960. It was a time of rising prosperity after a long period of difficulty. Between the depression of the 1890s and the end of World War II, real GDP per capita in Australia had risen by about 35 per cent – or around half a percentage point per year. But in the 15-year period from the end of the war to 1960, it expanded by about 25 per cent – or about 1½ per cent a year. The long post war boom would eventually see growing excesses from the late 1960s, which ended in the disastrous instability of the 1970s. But in 1960, the boom still had a long way to run. 1 So 1960 was a time of optimism. There have been many ups and downs for the Australian economy since then. CEDA has played its role in informing discussion and debate along the way. Two years ago, when I last addressed this group, optimism was anything but the order of the day. 2 The global financial system was in serious disarray and the global economy was heading into recession. It was obvious Australia would be affected but I suggested that there were good reasons for quiet confidence then about the long run future of Australia. There still are, two years later. But we have to turn that confidence into lasting prosperity. So I would like to offer a few observations about some of the things we need to be thinking about. I do not have definitive solutions, but offer these observations as a modest contribution to the discussion. In so doing, I am not trying to convey anything about recent or prospective monetary policy decisions. Tonight, at an event marking the 50th anniversary of a body devoted to Australia’s economic development, it is more useful to lift our gaze beyond the next interest rate decision to look at a broader canvas. I have one picture to show. In 1960, some saw that care was needed. In the Economic Record in August of that year, there appeared the following statement: “In July 1960 the Australian economy is producing more, and expanding its production faster … than at any earlier date. … One outstanding economic problem seems to remain, and it has been frequently discussed academically and in public debate: can the boom be sustained without a dangerous degree of inflation?” (Bowen 1960). “The Economic Situation”, address to CEDA Annual Dinner, Melbourne, 19 November 2008. Available at: http://www.rba.gov.au/publications/bulletin/2008/dec/pdf/bu-1208-3.pdf. This is a very long-run chart of Australia’s terms of trade. You may have noticed the Reserve Bank saying a lot about the terms of trade in the past few years. Before I describe the chart, why is it important? Our terms of trade have a big bearing on national income. In economic commentary, there is typically a very strong focus on GDP – the value of production – as a summary of national material progress. There is also quite rightly an emphasis on lifting productivity – real GDP per hour worked – as the source of our growth of material living standards. For open economies, though, our standard of living is affected not just by the physical output we can obtain from our resources of labour and capital, but also by the purchasing power of that output over things we want to have from the rest of the world. This is what the terms of trade is measuring. It is the relative price of our export basket in terms of imports. At the extreme, if the economy were open to the extent that we exported all our production and imported all our consumption, then the price of exports relative to imports would determine our living standards entirely, for any given level of productivity per hour worked. As it is, Australia is not that open, and not as open as many smaller economies, but it is considerably more open than the really large economies like the United States, the euro area or Japan. So the terms of trade matter. When the terms of trade are high, the international purchasing power of our exports is high. To put it in very (over-) simplified terms, five years ago, a ship load of iron ore was worth about the same as about 2,200 flat screen television sets. Today it is worth about 22,000 flatscreen TV sets – partly due to TV prices falling but more due to the price of iron ore rising by a factor of six. This is of course a trivialised example – we do not want to use the proceeds of exports entirely to purchase TV sets. But the general point is that high terms of trade, all other things equal, will raise living standards, while low terms of trade will reduce them. Returning to the chart, to my eye there are three key features. The first is the degree of variability in the terms of trade through the middle parts of the 20th century, from about World War I to the aftermath of the Korean War. This was, of course, a period of considerable instability in the global economy, with the attempt to return to the Gold Standard after the “Great War”, followed by the 1930s depression, the Second World War, the post war expansion and then the Korean War. I might add that, in those days, with the attempt to maintain a fixed exchange rate, these swings were very disruptive to the economy. Typically, a rise in export incomes would result in a rise in money and credit, a boom in economic activity and a rise in inflation. Then the terms of trade would fall back and the whole process would go into a rather painful reverse. The advent of the flexible exchange rate in the early 1980s made a great difference in managing these episodes. The second feature is the downward trend in the terms of trade, particularly noticeable from the early 1950s to about the mid 1980s. 3 This was the period of resource price pessimism, the “Prebisch Singer hypothesis” and so on, which held that primary products would tend to decline in price relative to manufactured products. 4 The latter part of this period was the one in which the realisation became widespread that the (apparently) easy gains in living standards of the post-war boom were gone, and in which pessimism about Australia’s economic future was probably at its most intense. It was also the period when, under strong political leadership backed by a highly capable bureaucracy and an economically literate media, our determination to press on with various productivity-increasing reforms was greatest. That these two phenomena occurred together was probably not entirely a coincidence. The third feature is the current level of the terms of trade relative to everything but the alltime peaks over the past century. Measured on a five-year moving average basis, and assuming (as we do) some decline in the terms of trade over the next few years from this year’s forecast peak, the terms of trade are as high as anything we have seen since Federation. To give some perspective on how important this is, let me offer one back-of-the-envelope calculation. The export sector is about one-fifth of the economy. The terms of trade are at present about 60 per cent higher than their average level for the 20th century, and about 80 per cent higher than the outcome would have been had they been on the 100-year trend line. This means that about 12–15 per cent of GDP in additional income is available to this country’s producers and/or consumers, each year, compared with what would have occurred under the average or trend set of relative prices over the preceding 100 years (all other things equal). That will continue each year, while the terms of trade remain at this level. Of course, part of this income accrues to those foreign investors who own substantial stakes in the mineral sector. In this sense, the current boom is a little different from the early-1950s one where most of the income went first to Australian farmers. Nonetheless, a good proportion accrues to local shareholders and employees, and to governments via various taxes. A non-trivial part of it is available to consumers as higher purchasing power over imports, as a result of the high exchange rate. It does not take much imagination to see that an event of this magnitude is expansionary. Incomes are higher – in some cases a lot higher – and, absent some offsetting force, some of that will be spent. So it has always proved in the past. Moreover, if, as seems very likely, these prices prompt a build-up in investment to supply more of the commodities concerned, there are further expansionary effects. Even applying significant discounts to stated investment intentions, as the Reserve Bank staff have done in their forecasts, there is likely to be a further significant rise in business investment over the next few years, from a level that is already reasonably high as a share of GDP. On all the indications available, we are living through an event that occurs maybe once or twice in a century. So a very important question for us is: how do we handle all this? We obviously have to be wary of overheating. The Bank has given its views on this point before and I will say no more about that tonight. In fact, fitting a trend to the data for the 20th century shows a statistically significant downward trend of about 0.2 per cent per annum on average. Prebisch (1950) and Singer (1950). But in fact the issues are broader than that. They extend to how we use the additional income, and how soon, and to questions of structural adjustment. One difficulty is that it matters a great deal whether the rise in the terms of trade is likely to be permanent or only temporary. Unfortunately, we cannot really answer that question. It is obvious from my chart that past episodes tended not to be permanent, but they sometimes lasted several years and certainly long enough to be very disruptive. If the rise in income is only temporary, it would be desirable not to raise national consumption by very much. Instead, it would make sense to allow the income gain to flow into a higher stock of saving, which would then be available to fund future consumption (including through periods of temporarily weak terms of trade, which undoubtedly will occur in the future). Moreover, it would probably not make sense for there to be a big increase in investment in resource extraction if that investment could be profitable only at temporarily very high prices (and which could come at the cost of reduced investment in other areas). If the change is likely to be persistent, then income is likely to be seen as permanently higher. Households and most likely governments will probably see their way clear to lift their consumption permanently, both of traded and non-traded goods and services. Structural economic adjustment will also occur as the sectors whose output prices have risen, now being more profitable, will seek to expand, in the process attracting productive resources – labour and capital – away from other sectors whose output will decline as a share of GDP. Australia’s floating exchange rate, which tends to rise in line with the increase in the terms of trade, helps the reallocation of labour and capital by giving price signals to the production sector. The higher exchange rate also speeds the spread of the income gains from the terms of trade rise to sectors other than the resources sector, by directly increasing their purchasing power over imports. The resulting rise in imports spills demand for tradable goods and services abroad, which helps to reduce domestic inflation. So the shift in the terms of trade will, unless clearly quite temporary, drive shifts in the structure of the economy. It is easy, of course, to speak in the abstract of “reallocation of productive resources”, but this means that some businesses and incomes become relatively smaller; jobs growth in some areas slows even as in others it picks up. Some regions struggle more than others. Some sources of government revenue are adversely affected even as other sources see an improvement. This process will be seen, not unreasonably, as costly by those adversely affected, even though the overall outcome is that the country as a whole is considerably better off. (It is also obvious that, if the terms of trade change really is only temporary, it may not be worth paying these adjustment costs from the perspective of the overall economy.) The policy challenge for governments will be whether to help these sectors resist change, or to help them adapt to it. We can carry out the thought experiment of imagining that, as a society, we wanted to resist these changes completely and seek to preserve the existing structure of the economy. Let me be clear I do not advocate this. But consider what would be involved. We would need, inter alia, to prevent the resources sector from responding to changed prices (preventing any increase in its size). That would probably involve taxing away completely any additional national income resulting from higher prices, and maybe also preventing any additional exploration or capacity expansion to take advantage of strong demand that could be met profitably even at after-tax prices. We would probably need to re-cycle any funds raised overseas, in the process holding down the exchange rate. It is important to note, by the way, that such funds could not be spent at home without adding to aggregate demand and hence risking the inflation we would still be seeking to avoid in this scenario. In the scenario where we want as much as possible to be unchanged, the additional income handed to us by the change in global relative prices all has to be used offshore, one way or another. If all the above could be achieved – a very big if, when one considers the logistics of what would be required – then the economy’s structure could, perhaps, remain as it was. This course would mean forgoing the potential for higher export income by investing more in resource extraction; either those gains would go instead to other resource-supplying countries or, in commodities where Australia is a major producer, our lack of supply response would result in further upward pressure on prices. So we would avoid the disruption of structural change, but overall would be poorer than otherwise would have been the case, as would, perhaps, our trading partners. It is hard to believe such an outcome could be achieved and no less difficult to imagine it being thought desirable. Realistically, we won’t be able to hold the economic structure static in that fashion if there is a major, persistent change in relative prices. Nor, I would argue, should we try. Had we had that approach through our history, we would still be trying to employ 25 per cent of our labour in agriculture and still be trying to ride “on the sheep’s back” in chase of a world economy that had moved on to place a much higher value on many things other than wool. We would not have the highly developed services sector that we have today, nor the standard of living we currently enjoy. So if the terms of trade do remain fairly high for a lengthy period, the task is going to be to facilitate structural adjustment so as to make it occur in as low cost a way as possible. But that ought to be feasible given that overall income is considerably higher. Of course we cannot know whether the terms of trade will be high for a long period. History certainly would counsel caution in this respect. We do know that supply of various resources is set to increase significantly over the years ahead and not just from Australian sources. It is for this reason that we assume some fall in commodity prices over the next several years. The assumption underlying the Bank’s forecasts published a few weeks ago is that iron ore prices fall by up to about 30 per cent over the next several years. Even if they do, the terms of trade will remain quite high by the standards of the past 100 years in the near term, as the chart showed. Is that assumed fall realistic? There is no way of knowing. Larger falls have happened before. In fact they have been the norm. On the other hand, experienced people seem to be saying that something very important – unprecedented even – is occurring in the emergence of very large countries like China and India. If the steel intensity of China’s GDP stays where it is already, and China’s growth rate remains at 7 or 8 per cent for some years to come, which appears to be the intention of Chinese policy-makers, then the demand for iron ore and metallurgical coal will rise a long way over the next couple of decades. If India’s steel intensity goes the same way as most other countries have, that will add further. Even with allowance for supply responses by other producers and considerably lower prices than we see today, that seems to point to a prominent role for the resources sector, broadly defined, over a longish horizon. So the most prudent assumption to make might be that the terms of trade will be persistently higher than they used to be, by enough that we will need to accommodate structural change in the economy, but not by so much that we shouldn’t seek to save the bulk of the surge in national income occurring in the next year or two, at least until it becomes clearer what the long run prospects for national income might be. As it happens, there does seem to be a good deal of saving going on, thus far, in the private sector. A little-noticed recent statistical release was the annual national income accounts for the year 2009/10. In that release, the Australian Statistician has made some major revisions to the estimates for household saving (which of course is a residual arising from other major aggregates). The revision lifted estimated household saving by $45 billion, or about 5 percentage points of income, from the previous estimates. The net saving rate is now seen at some 9–10 per cent of income over the past year or two, up from about −1 per cent five years ago. In all the circumstances, considering what has happened around the world in recent years, more cautious behaviour by households is not surprising. Nor, I would argue, is it unwelcome. With the stimulus from the terms of trade and the likely investment build-up, the economy can cope with more saving by households for a time. On the other hand, to expect it to absorb a major surge in consumption at the same time as an historic increase in investment is also occurring would be rather ambitious. In fact, we probably need private saving to remain on a higher trajectory, and we will also need public saving to rise, as scheduled. In the longer term, the economy’s increased exposure to large emerging economies like China and India (these two now accounting for over a quarter of exports) – assuming that continues – may also pose important questions. If these and other emerging economies continue to grow strongly on average, but also, as with every other country, still have business cycles, the result may be the Australian export sector, and therefore the Australian economy, having a potential path of expansion characterised by faster average growth in income, but with more variability. That possibility has been noted by some observers. It is worth recording that such concentration would hardly be unprecedented – think about the dominance of Japan in Australia’s trade in the 1970s and 1980s, or the dominance of the United Kingdom in an earlier era. Nonetheless, the degree of concentration could be higher than we have seen in the past decade or more, which was a time of considerable stability for the Australian economy overall. We can’t know whether this scenario of higher but more variable income growth will come to pass. But if it did, how should we respond? We could simply accept higher variability, if that comes, as the price of higher average income growth. That would see higher variability in demand in the economy, which would have its own implications, not least that it could make it harder for macroeconomic policies to foster stability. Another approach would be to reflect the higher income variability in our saving and portfolio behaviour rather than our spending behaviour. We could seek to smooth our consumption – responding less to rises or falls in income with changes in spending and allowing the effects to be reflected in fluctuations in saving. In the most ambitious version of this approach, we could seek to hold those savings in assets that provided some sort of natural hedge against the variability of trading partners, or whose returns were at least were uncorrelated with them. Of course, such assets might be hard to find – the international choice of quality assets with reasonable returns these days is a good deal more limited than it used to be. It is possible that this behaviour might be managed through the decisions of private savers. There might also be a case for some of it occurring through the public finances. That would mean accepting considerably larger cyclical variation in the budget position, and especially considerably larger surpluses in the upswings of future cycles, than those to which we have been accustomed in the past. There would also be issues of governance and management of any net asset positions accumulated by the government as part of such an approach, including whether it should be, as some have suggested, in a stabilisation fund of some sort. These are pretty big questions and addressing them would not be straightforward, so I am not going to attempt that tonight. The point simply is that, in the face of what appears to be a very big event in our terms of trade, these issues are deserving of consideration – perhaps by CEDA, among others, as you enter your sixth decade. Conclusion As I said at the outset, we have grounds for confidence in the future of our country, just as at CEDA’s beginning 50 years ago. Recent performance, not to mention the economic opportunities in our time zone, has helped to strengthen our confidence. But it would be a mistake to rest on recent achievements, as significant as they have been, and to fail to press on in our efforts to do better. Past periods of apparently easy affluence, conferred by favourable international conditions, probably lessened the sharpness of our focus on the other element of raising living standards, namely productivity. It was subsequently a long and difficult grind when we realised that international conditions had become less favourable. So while I have not talked about productivity this evening, I do not wish my focus on the terms of trade to be interpreted as implying that lifting productivity is unimportant. On the contrary, while our terms of trade are handed to us, for better or worse, by international relative prices, the efficiency with which we work is a variable we can actually do something about. A prudent approach might be to use the current period of exceptionally favourable international prices to raise our saving, while maintaining a disciplined approach to ensuring there are no impediments to lifting productivity. Consumption deferred – private or public – can easily be enjoyed in future; consumption we get used to today is harder to wind back in the future if circumstances change. These issues, and the associated structural adjustment issues, no doubt will pose a challenge. But that’s the challenge of prosperity – and not a bad challenge to have. It is sometimes said that Australia manages adversity well but prosperity badly. There will never be a better opportunity than now to show otherwise. References Bowen I (1960), “The Australian Economy, July 1960”, The Economic Record, 36 (75), pp 307–355. Prebisch R (1950), The Economic Development of Latin America and Its Principal Problems, United Nations, New York. Singer H (1950), “The Distribution of Gains between Investing and Borrowing Countries”, American Economic Review, 40, pp 473–485. | reserve bank of australia | 2,010 | 12 |
Address by Mr Guy Debelle, Assistant Governor Financial Markets of the Reserve Bank of Australia, at the Australian Securitisation Conference 2010, Sydney, 30 November 2010. | Guy Debelle: The state of play in the securitisation market Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian Securitisation Conference 2010, Sydney, 30 November 2010. * * * Thanks to Patrick D'Arcy and Daniel Ji for their help. At this forum last year I outlined the effects of the financial crisis on the Australian securitisation market and the prospects for securitisation in the post-crisis environment. At that time my assessment was, as it still is now, that securitisation assists in the efficient distribution of risk across the financial system and should have a role in the financial architecture going forward. The fundamental logic of securitisation is well understood by those in the room today. Of course, as is also widely appreciated in the industry, the financial crisis highlighted significant inadequacies in securitisation practices, particularly in the United States. Some of those inadequacies are still coming to light. This has forced participants on both sides of the securitisation market to re-assess the assumptions underpinning their business models. These inadequacies were absent in the Australian securitisation industry, but unfortunately the local industry has had to deal with brand damage not of its own making. This is despite the asset class in Australia continuing to perform exceptionally well in terms of rate of return. Today, I intend to briefly recap the main changes that have affected the securitisation industry as a result of the crisis and to review developments in the market over the past year. The main message that I want to leave you with is very similar to the one I gave last year. While it was clear that the industry will take some time to adjust to this new environment, there are sound prospects for securitisation remaining an important part of the financial landscape, albeit not at the levels seen in the heady pre-crisis period. Background Over the decade leading up to the financial crisis, securitisation was a rapidly growing segment of the financial sector globally and in Australia. This is demonstrated in the share of housing lending in Australia financed through securitisation, which rose from less than 5 per cent in the mid 1990s to over 20 per cent in 2008 (Graph 1). While residential mortgage-backed securities (RMBS) accounted for the bulk of securitisation activity, growth in other parts of the industry, including the securitisation of commercial property, auto and equipment loans also grew faster than aggregate lending in these market segments. A range of factors on both the demand and supply side underpinned the rapid growth in securitisation. On the supply side, changes in technology and the fall in nominal interest rates were important in improving the competitive position of non-bank originators in the mortgage market, who tapped securitisation markets for funding because they did not have access to cheap deposit funding. Graph 1 On the demand side, the dearth of supply of high quality credit instruments in the Australian market made asset-backed securities (ABS), and RMBS in particular, an attractive investment for many domestic investors. This domestic demand was the foundation of the market in the early days. Over time, the ability to tap international markets became an increasingly important source of demand for Australian RMBS, such that prior to the crisis, offshore issuance accounted for more than half of outstanding Australian RMBS (Graph 2). Graph 2 Offshore structured investment vehicles (SIVs) comprised a sizeable share of the international investor base. As is now widely known, these SIVs funded themselves short and invested in long-dated assets like RMBS, a business model that was particularly vulnerable. The impact of the financial crisis The re-appraisal of risk brought on by the financial crisis led to demand from international investors retreating faster than domestic demand (Graph 3). The SIVs were particularly hard hit by the crisis. Their funding was severely curtailed and many of their assets turned out to be poor performing, illiquid or both. Many were forced to shut down and liquidate their portfolios, in the process selling their Australian RMBS into the secondary market, notwithstanding its good performance. Indeed, Australian RMBS was often sold first because of its good performance. Graph 3 On top of this, investor demand for new issuance declined both internationally and domestically because of the brand damage to RMBS from the US in particular, where poor lending and servicing practices saw a material deterioration in collateral performance. The liquidation by the SIVs of their RMBS holdings, combined with the increased aversion to the product from investors because of the brand damage emanating from the US, saw the price in the secondary market decline significantly. Our estimate is that, in Australia, yields on RMBS in the secondary market widened from around 20 basis points over the bank bill rate pre-crisis to as much as 450 basis points. While the secondary market spread remained this wide, there was likely to be little new primary issuance. Investors could satisfy their demand much more cheaply in the secondary market. It is well understood that as a consequence of the demise of SIVs, the investor base for asset-backed securities is substantially narrower than prior to the crisis. This is particularly the case in offshore markets. As some of these investors relied on various forms of excessive leverage to be profitable, they are not likely to return. But there are still natural investors, both domestic and offshore, that ought to be attracted to the high quality of the Australian RMBS. Recent developments RMBS issuance this year has been around $18 billion, higher than the $14 billion issued last year but well below the $50 billion plus annual issuance prior to the crisis (Graph 4). However, this comparison exaggerates the situation. The underlying pace of housing credit growth has also slowed from around 15 per cent per annum to around 7 per cent. So given this slowing in system credit growth, comparisons of gross issuance with the pre-crisis period are not very informative. An alternative benchmark is the amount of issuance required for securitisation to hold its own as a share of total housing lending. A rough calculation suggests that annual gross issuance of around $25 to $30 billion would be required to see securitisation maintain its current share of housing credit. Graph 4 All of the issuance this year, with the exception of one tranche in early 2010, has been in the domestic market. The issuance has been mostly by the smaller lenders, regional banks, credit unions and originators, who have limited access to alternative funding sources. These issues have involved some degree of support from the AOFM. In total, only $3.2 billion of the RMBS issued have not had AOFM support. In thinking about the AOFM support for the RMBS market, I believe the AOFM program has a number of advantages relative to alternative means of support: it can be easily tailored to help specific types of institutions; it can be phased out easily; the likelihood that the Government loses money on its investment is very small; and there is no ongoing contingent liability to the Government from providing the support. If instead a government guarantee of RMBS were provided, it would be difficult to phase out, creating a commitment that could generate a large contingent liability for the Government. At this time last year, and into the early part of 2010, there were signs indicating that the market was developing some momentum. Issuance was on an upward trend and the share taken up by the AOFM had declined from the very high levels seen at the start of the Government’s support programme (Graph 5). There were also two issues in the first part of the year that did not have AOFM support. However, conditions deteriorated in the second quarter with credit markets generally unsettled by the sovereign debt concerns in Europe. Graph 5 In response to these difficulties, the AOFM adjusted the pricing of its cornerstone RMBS investments in May with the express purpose of making securitisation a more competitive source of funding for small players in the mortgage market. Prior to May, private investor bids were only just within the range which made deals competitive for issuers. The AOFM started buying long-dated tranches at a spread of around 110 basis points over swap. Private investors in these deals bought the shorter-dated tranches often at a spread that was around 100 basis points. As a result, average issuance costs for senior notes declined from around 140 basis points to close to 100 basis points over swap (Graph 6). Graph 6 This tightening in primary market spreads has seen the volume of issuance pick up in the second half of the year. Although the AOFM has increased its share of issuance, private investors have nevertheless taken around two-thirds of the issuance since May. There has also been a gradual lengthening in the average maturities of tranches taken up by private sector investors, and some sales of first-loss tranches. The cost of the recent Bank West deal that priced without AOFM support, and included a soft bullet structure to attract investors, also suggests some improving appetite on the part of investors. While it is difficult to get a precise estimate of secondary market pricing, it appears to have remained broadly stable over recent quarters still much wider than prior to the crisis. The widening of RMBS spreads was generally larger than that of other funding instruments, such as unsecured bank credit, and it has not narrowed as much from the peak (Graph 7). Graph 7 It is difficult, given the very strong historical performance of Australian mortgages that provide the underlying collateral, not to view this relative pricing as somewhat anomalous. On the other hand, it is the legacy of the brand damage the crisis inflicted on mortgagebacked securities and a measure of the work still to be done by the industry and regulators to restore investor confidence and improve liquidity. There is, of course a good story to tell: the arrears rates on Australian mortgages have remained at a low level and are well below the arrears rates in many other countries (Graph 8). Graph 8 The state of the securitisation market in Australia is by no means unique, with issuance in other markets also sluggish. Credit markets globally still remain cautious, with the sovereign debt concerns in the second quarter tempering investor appetite. For example, issuance in the UK RMBS market was particularly weak in the early part of the year, but has seen a modest pick-up in activity more recently (Graph 9). One promising development has been the pick-up in offshore issuance by UK originators, exemplified by the recent Lloyds issue in the US. Graph 9 A constraint on offshore issuance more specific to the Australian market has been the influence of the cross-currency basis swap on the cost of issuing in the international market. As I noted earlier, the international market was an important source of demand for the Australian market prior to the crisis. A significant share of the issuance to offshore investors was in foreign currency, but post-crisis there has only been one issue with a foreign-currency tranche. Part of the reason for this is that the wide basis swap has added to the hedging costs of offshore issues making them less economic, compared with domestic issues. Conclusion In conclusion, I have aimed to provide a recap of the state of play in the Australian RMBS market. The market is slowly returning to life and I believe it will again play a useful role in the provision of credit in Australia. But I do not see it returning to its pre-crisis share of the market any time soon. I look forward to discussing the policy issues surrounding the market with my fellow panel members. | reserve bank of australia | 2,010 | 12 |
Address by Mr Philip Lowe, Assistant Governor Economic of the Reserve Bank of Australia, at the Australian Business Economists Annual Forecasting Conference dinner, Sydney, 8 December 2010. | Philip Lowe: Forecasting in an uncertain world Address by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Business Economists Annual Forecasting Conference dinner, Sydney, 8 December 2010. * * * Thank you for the invitation to join the Australian Business Economists (ABE) this evening. It is both an honour and pleasure to be able to speak at the ABE’s annual dinner. This evening, I would like to talk about an issue that I know is close to the hearts of many of you. It is also one that you have been discussing all afternoon. And that is economic forecasting. As economists, forecasting is something we are required to do on a regular basis. As a policy adviser, as a business person or as an investor, one has no choice but to be forward looking. So for many of us, some form of forecasting – with all its difficulties and pitfalls – is the bread and butter of our professional lives. Tonight, I would like to talk about three aspects of forecasting from the perspective of a central banker. The first is the general role that forecasts play in the setting of monetary policy. The second is the approach to forecasting that we use at the Reserve Bank. 1 And the third is some of the issues that we have been grappling with as we have put our current forecasts together. Monetary policy and forecasting Australia’s monetary policy framework is best described as a medium-term inflation target. Over time, we want to ensure that inflation averages somewhere between 2 and 3 per cent. And this is exactly what has happened since this framework was put in place. Since 1993, CPI inflation, excluding the effects of the introduction of the GST, has averaged exactly 2.5 per cent. 2 This is in contrast to average inflation of 8.7 per cent over the previous two decades (Graph 1). An important feature of inflation-targeting frameworks is that they are forward looking. We know that it takes time for changes in monetary policy to have their full effect on the economy, just as it takes time for changes in other variables – like the terms of trade or government spending – to have their full effects. This means that if we are to achieve our medium-term objective, and to avoid unnecessary swings in the economy, we need to be thinking about what might happen in the future. When inflation-targeting regimes were first established around the world, many observers characterised the appropriate policy rule as setting the policy rate so that the inflation forecast was at the midpoint of the target band at some specific horizon, say two years. It was also often argued that for reasons of enhancing credibility, there should be some form of “penalty” on the central bank if inflation moved outside the target band; in effect, the edges of the band should be viewed as an “electric fence”, to be avoided if at all possible. Previous discussions of the role of forecasts at the RBA can be found in Stevens G (1999), “Economic Forecasting and its Role in Making Monetary Policy”, RBA Bulletin, September, pp 1–9, and Stevens G (2004), “Better than a Coin Toss? The Thankless Task of Economic Forecasting”, RBA Bulletin, September, pp 6–13. Excluding the effect of the GST and mortgage interest payments, the average inflation rate has been 2.6 per cent. Graph 1 This form of inflation targeting, however, never seemed particularly attractive to the RBA. While we are committed to ensuring that inflation outcomes are consistent with the mediumterm target, we have not felt the need to set the cash rate so that our inflation forecast at a specific horizon was exactly 2½ per cent. Nor have we felt that the edges of the target are like an electric fence. We have, from the outset, had a more flexible approach than this. Since the current framework was adopted, our two-year-ahead inflation forecast has on occasions been below 2 per cent, and on other occasions it has been above 3 per cent. 3 And in terms of actual outcomes, year-ended CPI inflation has been outside the 2 to 3 per cent range a bit more often than it has been within the range. This more flexible approach has two advantages. The first is that, in the event that inflation turns out to be unexpectedly too high or too low, the central bank has some flexibility about the pace at which inflation is returned to the target range. Provided the central bank’s commitment to medium-term price stability is credible, this flexibility can deliver better outcomes for the real economy. The second advantage is that this flexibility provides greater scope to take into account not just the central forecast, but also the medium-term risks around that forecast. Let me try and make this a little more concrete by asking you to think about an economy that experiences a positive supply shock, say an improvement in productivity or lower world prices for the goods that it imports. Normally, this type of shock would be expected to boost economic growth, increase asset returns and lower inflation, at least for a time. What then is the right monetary policy in this economy? In a world in which the setting of policy is determined solely by the two-year-ahead inflation forecast, the answer may well be to lower interest rates. If inflation is forecast to be below the target midpoint in two years time, lower interest rates, at least for a while, would help get inflation closer to target. But would lower interest rates be the best response? To answer this I would need to tell you some more parts of the story. If asset prices were rising very quickly, investors were exuberant, and the financial sector was making credit liberally available, then lowering interest rates simply to hit the inflation target at one specific point in the future may not be the In part, this reflects the fact that for much of the inflation-targeting period, the forecasts were prepared on the assumption that the cash rate was held constant over the forecast horizon. best response. Experience has taught us that low interest rates at a time of rapid increases in leverage and asset prices can pose significant medium-term risks to the outlook for the economy and for inflation. Ignoring these risks, and making leverage cheaper by lowering interest rates, simply to ensure that the short-term inflation forecast was at the target, is unlikely to be the best policy. The general point here is that while the central forecast for inflation itself will often provide a good guide for policy, this will not always be the case. On some occasions, the medium-term risks are just as important. It is sometimes argued that the way to deal with these risks is to simply extend the forecast horizon to say three years. So, instead of setting the interest rate so that the two-year forecast is at the midpoint of target, set it so the three-year forecast is at the midpoint of the target. The idea of thinking about what might happen beyond just the next two years makes a lot of sense, but the mechanical response of just extending the forecast horizon is probably not the best approach. The further out one goes, the less certain one can be about the future. It is hard enough to make judgements about the risks that the economy faces, let alone forecasting exactly when those risks might actually materialise. This makes it very difficult to incorporate the future realisation of risks into central forecasts. While we might have a reasonable degree of confidence that some particular risk will materialise at some point, predicting that point is extremely hard. In my own view then, this means that just simply extending the forecast horizon for the point forecast of inflation is an unsatisfactory way of dealing with risk. The better approach is to have a flexible inflation target that effectively anchors medium-term inflation expectations, but provides the scope to take into account the various risks that arise in the complicated world in which we live. This means that we need to be thinking about the whole distribution of possible outcome, both in the short-term and medium-term, and not just the point forecasts over the next one or two years. Under this approach, at times, the twoyear inflation forecast will be away from the midpoint of the target band. The flexibility embedded in this approach obviously needs to be exercised with care, and relatively rarely, but good policy means that, in some circumstances, it does need to be utilised. In setting policy from month to month, the RBA Board spends a lot of time discussing the likely evolution of inflation and output and the risks facing the economy. In late 2008, when the outlook took a turn for the worse and the downside risks increased, the Board lowered the cash rate quickly and in large steps, despite inflation at the time being above the target band. Then, in late 2009 and early 2010 when the outlook had brightened, the cash rate was increased, with lending rates returning to around normal levels. And just last month, the Board again increased the cash rate, with the result that monetary policy is now judged to be slightly on the restrictive side. This latest decision was taken not because the economy is currently growing too quickly or that inflation is currently too high. Clearly, neither is the case. Rather, it was made on the basis of the outlook for output and inflation. With the economy currently operating with relatively limited spare capacity at a time when a substantial lift in investment is expected, it was judged that inflation was more likely to rise than fall over the next few years. Given this, the Board judged that it prudent to make an early and modest adjustment to the cash rate. In doing so, the Board has sought to reduce the probability of inflation rising to uncomfortably high levels and thus requiring a more substantial increase in interest rates later on. Before I turn to the forecasting process itself, it is important to emphasise that the Board’s decisions are not driven in a mechanical fashion by the forecasts. Both the Bank staff and the Board are very conscious of the limitations of numerical forecasts. Predicting exactly which quarter inflation is likely to increase, and at what pace, is inherently difficult. What is often more useful is the analysis and storyline that support the numerical forecasts. It is this analysis, rather than exact numbers, that is rightly the main focus of our internal discussions and our communication with the public. Forecasting at the Reserve Bank I would now like to turn to the actual forecasting process at the RBA. As many of you know, we publish a table that sets out our forecasts of inflation and growth each quarter in the Statement on Monetary Policy. We also discuss the broad analysis underlying these forecasts and the main risks. Consistent with our general approach, we do this in words, rather than using fan charts showing statistical bands of uncertainty as has become popular in some other countries. The forecasts that are published in the Statement on Monetary Policy are discussed at the Board meeting three days earlier and are developed through a series of internal meetings over the preceding month. Outside of this quarterly cycle, the forecasts are kept under review by the staff. The actual forecasting process has three key elements. The first is the day-to-day assessment of trends in the economy. The second is the use of formal econometric models. And the third is the information that we obtain from our business liaison program. I would like to touch on each of these. The obvious starting point is to understand what is currently happening in the economy and the financial system and what that means for the future. In our Economic Analysis Department there are around 50 economists continually monitoring the pulse of the domestic and global economies. Elsewhere in the Bank, staff are analysing developments in the financial system and financial markets. Inevitably the data that we look at are subject to measurement error and they are often conflicting. This means that much of our time is spent discussing the data and what they tell us about recent trends, as well as the future. Judgement is obviously critical here, with the strong collective memory of the Bank staff playing an important role. The judgments that are reached are also anchored by some underlying economic relationships and concepts. As we prepare our forecasts, we are constantly asking ourselves questions such as: how much spare capacity does the economy have; what constitutes full employment; what is the neutral real interest rate; what is the potential growth rate of the economy; what is the state of private-sector balance sheets; and how well anchored are inflation expectations. I know many of you ask the same questions. In most cases it is not possible to come up with definitive answers to these questions, and the Bank certainly does not have doctrinaire views. What we do is continually confront our conditional assessments with the ongoing flow of economic data. When things turn out differently to what we expect, we study the outcomes very closely to see what we can learn. This process of continual testing, learning and re-testing is at the core of our forecasting process. The second element of our forecasting is the use of a suite of forecasting models. This suite includes simple, single-equation models, multi-dimensional vector autoregressive models, and an estimated structural Dynamic Stochastic General Equilibrium (DSGE) model. We use this suite, rather than just a single model, because of the considerable uncertainties in the modelling process. Most of the time, we look for the central tendency of the various models and use them to inform the more judgemental process that I just discussed. The models are also used in the development of various scenarios. The third part of the forecasting process is our liaison with business. Each month the RBA staff across the country conduct around a hundred meetings with businesses and agencies in an effort to better understand what is happening right now and what is likely to happen in the future. Over recent years, a couple of examples stand out where this liaison has been particularly important. One was in helping us understand the implications of the much tighter credit conditions in 2008 and 2009. And the other has been helping us understand the scale and the timing of the pick-up in investment in the resources sector. In both cases, our liaison provided us with valuable information that was not available elsewhere and had a significant role in shaping our forecasts. So that in a nutshell is how we go about forecasting. It is a combination of judgement, formal models and liaison. And, as I said a few minutes ago, it is as much about the underlying analysis and storyline as it is about a particular set of numbers. A higher capital stock I would now like to discuss a couple of practical considerations that we have been thinking about as we have put our forecasts together over recent times. The first of these is the implications of a significant increase in Australia’s stock of physical capital. As the Governor spoke about at length last week, Australia is experiencing a perhaps oncein-a-century boom in the terms of trade, largely reflecting the urbanisation and industrialisation of Asia. This boom has increased the average return on physical capital in Australia, although clearly there is significant variation across sectors, with the return on capital in some sectors having declined. The increase in the average return on capital means that it is plausible to argue that the optimal capital stock in Australia has increased, perhaps significantly so. Not surprisingly then, the ratio of business investment to GDP has been high over the past five years, and it is expected to remain high over the next few years. Since 2005, Australia’s capital stock (excluding dwellings) is estimated to have increased at an average annual rate of around 5½ per cent. This is up by 2 percentage points from the average rate of increase over the previous quarter of a century (Graph 2). Graph 2 One implication of this pick-up in investment is a pick-up in growth in the economy’s overall capital-labour ratio. Again, over the 25 years to 2005, this ratio increased at an average annual rate of around 1¾ per cent. In contrast, over the past five years, it has increased at twice this pace, and this faster rate of increase is also likely to continue for a while yet (Graph 3). In effect, we are becoming a more capital-intensive economy, with movements in world prices leading to a significant expansion of the resources sector, which is one of the most capital-intensive sectors of the economy. Graph 3 From a forecasting perspective, this raises a host of interesting questions. I want to touch on just three of them. The first question is the implication for the growth rate of potential output. If everything else were constant, faster growth in the capital stock should lead to faster growth in potential output. If we use a simple production function, for example, and hold everything else constant, the 2 percentage point increase in the growth rate of the capital stock (excluding dwellings) that we have seen would lift potential growth by ½ percentage point or possibly a bit more. But of course, everything else is not constant. In particular, total factor productivity growth has slowed significantly over the past decade. Indeed, according to the national accounts, almost all the growth in output since the early 2000s has been accounted for by growth in labour and capital inputs, rather than by improving the way we use that labour and capital (Graph 4). Graph 4 One important forecasting issue is whether this is likely to continue, or whether a return to closer-to-average productivity growth will see potential output grow a little more quickly than we have become accustomed to over the past decade. The latter is clearly the preferable outcome, although as yet there are few signs of a lift in productivity growth. A second question is the implications for inflation. If indeed potential output growth were to pick up, this would mean that the economy could grow more quickly over the medium term without causing inflation to rise. But in the short term, producing and installing the increased capital can add to demand pressures in the economy. Of course, one way in which these pressures can be mitigated is by importing the required machinery and equipment. To some extent this is what has been happening. Much of the physical capital for a number of the large resource projects is, by necessity, imported. And the appreciation of the exchange rate has lowered the relative price of capital goods from abroad. Over time, imports of capital goods have grown considerably more quickly than investment (Graph 5). Yet, even as we rely more on imported machinery and equipment to increase the capital stock, it still takes significant domestic resources to install this imported machinery and equipment. So an important forecasting issue here is to what extent the period of accelerated growth in the capital stock will affect inflation pressures in the economy, and to what extent can these pressures be reduced by importing goods from abroad. Graph 5 A third question is the implications for the risk profile of the overall economy of the higher capital stock. While the central scenario is a positive one, there are risks. In the late 1980s, for example, we saw a large increase in the capital stock, particularly of commercial buildings, but when the recession came, much of this investment had to be written off. The result was large losses to banks and investors. Similarly, there is no guarantee that the current wave of investment will earn high returns. So a relevant forecasting question here is how these risks are likely to play out and how they are influenced by the way in which the increase in the capital stock is financed. In thinking about each of these three questions – the impact on potential growth, the implications for inflation and the changing risk profile of the economy – it is the combination of judgement, models and liaison that I discussed a few moments ago that we rely on. As in other areas, we do not have fixed views, but instead we are continually testing, learning and re-testing. Confident but cautious A second consideration shaping our recent forecasts is the attitude of households to spending and borrowing. Over the past year or so, we have had the rather unusual situation in which households, when surveyed, report that they are quite optimistic about the future, yet at the same time, they are quite restrained in both their spending and borrowing. While measuring saving rates is notoriously difficult, the latest national accounts show a marked increase in the household sector’s saving rate over recent years, with the increase fully reversing the decline that took place from the end of the 1980s to mid 2003 (Graph 6). Somewhat remarkably, the increase in the household saving rate in Australia, at least as measured, has been larger than that in many other countries, including the United States where household balance sheet repair is a major factor weighing on the economy. And unlike in the United States, where household confidence is very low, this rise in saving has occurred in Australia at a time when confidence is quite high (Graph 7). Graph 6 Graph 7 There are a number of explanations for this increase in household savings in Australia, but it is likely that the most important is a rethinking of attitudes to debt and spending following the events in the global economy over the past few years. It would appear that many households now view high levels of debt and low rates of saving as more risky than they did previously. This has led some to save a little more and others to borrow a little less. And the strong growth in household incomes over the past year has made this easier to do. The forecasting issue here is how persistent is this change likely to be. Is it just a temporary phenomena that will wane as memories of GFC fade? Or has there been a long-lasting change in attitudes after two decades of rapid increases in household borrowing? It is difficult to know what the right answer is, but the restraint being exhibited by the household sector is turning out to be quite long-lasting. In preparing our own forecasts, we have, for some time, been assuming that the household saving rate stays high for quite a while yet. If this were to occur, not only would it lead to a lowering of risk in household balance sheets, but it would reduce inflationary pressures during the period of high investment. This is obviously an area that we are watching closely and it is one where our approach of testing, learning and re-testing is important as we continue to review our forecasts. Conclusion So, in summary there is no shortage of interesting issues to ponder over as we think about the future. The world economy is undergoing fundamental change as the weight of economic activity moves from the North Atlantic economies to Asia, and as the household sectors of many countries re-think their attitudes to spending and borrowing. These are important structural changes that are likely to shape the Australian and the global economies over coming years. I wish you luck in incorporating these changes into your central forecasts and into the risks around those forecasts! Thank you for your attention this evening and I wish you all the best for 2011. | reserve bank of australia | 2,010 | 12 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Senate Economics References Committee inquiry into competition in the Australian banking sector, Sydney, 13 December 2010. | Glenn Stevens: Inquiry into competition in the Australian banking sector Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Senate Economics References Committee inquiry into competition in the Australian banking sector, Sydney, 13 December 2010. * * * The Reserve Bank has provided a submission to the Committee that details trends in lending, costs, margins, fees and other factual material the Committee may find of use. We of course will seek to answer any questions on that submission. Perhaps I should note a few general points. First, risk has been re-priced since early 2007. All of us are still adjusting to this change and its implications. It is widely held that risk was under-priced for some years before then. That is to say, investors demanded very little risk compensation in their expected returns – perhaps in some cases because they didn’t understand the risks. So financial institutions of all types could get ample funding cheaply, and this could be passed on to their borrowers. Business models that took particular advantage of low-cost wholesale funding and/or securitisation were able to provide a very competitive edge to certain markets, particularly (though not only) to markets for mortgage lending. But investors around the world changed their attitude to risk in 2007 and 2008. The compensation they require for taking on risk has increased. Wholesale funding and securitisation are now more expensive. In the case of securitisation, costs have also risen in part because some investors have left the market altogether. The increase in costs has affected all financial institutions, but to varying degrees. As such, it has also affected the competitive landscape. Some business models that did well in the earlier state of the world find it harder going now. Part of the competitive advantage they had has been eroded by market developments. The current relationship between variable mortgage rates and market funding costs is making it more difficult than it used to be for the lenders relying on securitisation to compete with the major banks. This changed attitude to risk has affected the locus of competitive forces. Whereas four years ago the environment was one in which the competition among financial institutions to lend money was intense, more recently it has been the competition to raise money that has been intense. Various other things have happened that also have a bearing on the competitive landscape, but this is a very fundamental change in the state of the world. That said, the market remains a good deal more competitive than it was in the mid 1990s and borrowers have access to a much larger range of products. Moreover, the overall availability of finance to purchase housing in particular seems to be adequate. The second theme is that, the market price of risk having risen, various players want the public purse to take on some of this higher price through various forms of support or regulatory change. The various ideas should, of course, be assessed on their merits. But an important high-level point is that, in some instances at least, it would appear the taxpayer is being asked to shoulder more risk, one way or another, in order to facilitate the provision of private finance. Whether, and in which areas, that might be a good idea – and if so how much might be charged for such support – is of course for governments and legislatures to determine. Hopefully your inquiries will be able to assist this process. | reserve bank of australia | 2,010 | 12 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the 23rd Australasian Finance and Banking Conference, Sydney, 15 December 2010. | Guy Debelle: Bank funding and capital flows Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the 23rd Australasian Finance and Banking Conference, Sydney, 15 December 2010. * * * Thanks to Alex Heath, Chris Stewart and Crystal Ossolinski for their help in preparing this speech. The financial crisis has led to a significant re-assessment of risk. Having been underpriced for a number of years prior to 2007, risk was rapidly and substantially re-priced as the financial crisis unfolded. Counterparty risk came to the fore and there has also been a more fundamental re-assessment of the importance of liquidity risk. There is a new-found, or refound, appreciation for the complex ways in which risk can affect the broader financial system. Given the pivotal role of banks in the financial system, the evolution of the financial crisis has placed particular focus on them and the way they fund themselves. Because one of the main features of banking business is maturity transformation, banks were exposed to the realisation of a liquidity shock. Problems associated with liquidity (or more precisely the lack of it) proved to be an important channel for shocks in one part of the financial system to be propagated to others. The re-assessment and the re-pricing of these risks have caused changes in the structure of funding of Australian banks. Today, I will discuss these developments on the liability side of banks’ balance sheets. But at the same time, there have also been changes on the asset side of their balance sheets, with credit growth slowing significantly, particularly lending to large businesses. The combination of these changes, together with the investment-focused growth of the Australian economy, has had a marked effect on the composition of capital flows to Australia which I will discuss later in my talk. These developments may well persist for quite some time to come. Bank funding 1 The re-pricing of risk significantly increased the cost of wholesale funding for the global banking system. At the shorter end of the yield curve, the rise in costs primarily reflected counterparty concerns. This is best exemplified by the spread between a short-term rate in the interbank market and the expected policy rate (Graph 1). As has been noted in the past, this spread serves as one of the better summary illustrations of the evolution of the financial crisis. In Australia, this spread never rose as much as it did in other countries, reflecting the general absence of counterparty concerns and the associated smoother functioning of the interbank market throughout most of the crisis. As Graph 1 shows, this spread has fallen back in Australia to be not far above its pre-crisis levels: pre-crisis the 90-day spread averaged around 10 basis points, now it is around 20 basis points. It is not surprising this spread has narrowed so far. By and large, one would expect that in more stable times, counterparty concerns would be reasonably absent over shorter horizons and so not much of a risk premium should be present in the pricing. But when counterparty concerns are rising, they tend to be rapidly incorporated into this spread. For more detail on bank funding, see the Reserve Bank of Australia submission to the Senate Economics References Committee Inquiry into Competition within the Australian Banking Sector, 30 November 2010. Graph 1 At longer terms, the effect of this repricing of risk is much more stark and, while pricing has eased back from its peaks, it still remains well above its pre-crisis levels (Graph 2). The overall cost to a major Australian bank of issuing a three-year bond has risen to around 120 basis points over the government bond yield compared with around 50 basis points precrisis. Graph 2 shows that similar, but larger, developments have occurred in other banking sectors. Graph 2 In addition to this effect on the pricing of wholesale funding, the re-assessment of risk has had a marked impact on the structure of banks’ funding (Graph 3). Banks, their regulators and markets have re-assessed the riskiness of different sources of funding, particularly liquidity risk and the related concept of rollover risk. This change in perspective is embodied in the new Basel standards for the banking system. Graph 3 One notable change is the rise in the share of deposits from less than 40 per cent in 2007 to over 45 per cent currently. The Deputy Governor Ric Battellino talked about this at this conference last year. 2 The desire to increase the share of deposits reflects the assumption that deposits represent a more stable source of funding. In order to boost their share of deposit funding, banks in Australia have competed aggressively in terms of price. An indication of the degree of competition for deposits is the extent to which there has been an increase in the cost of deposit funding relative to the cash rate since mid 2008: the average cost of the major banks’ new deposits is now only slightly below the cash rate, whereas prior to the onset of the financial crisis, deposit rates were about 150 basis points below the cash rate (Graph 4). See Battellino R (2009), “Some Comments on Bank Funding”, Remarks to the 22nd Australasian Finance and Banking Conference, Sydney, 16 December 2009. Graph 4 Competition has been strongest for term deposits. The average rate on banks’ term deposit specials is currently more than 70 basis points above market rates for debt of equivalent terms (Graph 5). In the few years prior to the global financial crisis the average rate was generally about 60 basis points below. This is notwithstanding the fact that wholesale debt is a liquid tradable instrument whereas a deposit is not; one might expect that this liquidity of wholesale debt would result in it being cheaper. Graph 5 Rates on at-call savings deposits – including bonus saver, cash management and online savings accounts – have also risen relative to the cash rate. The average rate on the major banks’ at-call deposits, which account for a little under half of their total deposits, is currently estimated to be around 40 basis points below the cash rate compared to around 100 basis points below in mid 2007. So the bottom line of all of this is that the deposit market has been extremely competitive. The most marked increase in competition occurred late last year and the early part of this year. Since then, our liaison suggests that competitive pressures have not intensified further but nevertheless they remain at a high level. As Ric Battellino noted last year, at some point, it is likely that the elasticity of deposits to price declines. This means further increases in prices result in the banks mostly shuffling the deposits between themselves, rather than generating further increases in the share of funds investors allocate to deposits. At the same time as banks have increased the share of deposit funding by around 7 percentage points, the share of longer-term wholesale funding has also increased by a similar amount. This increase in the share of funding sourced from deposits and long-term debt has mirrored a decline in the share of funding sourced from short-term wholesale debt, both from domestic and foreign markets. The share of short-term funding has fallen by 10 percentage points over the past three years, a very large change indeed. As a result of these changes, the vulnerability of the Australian banking system to any further seizures in global financial markets has decreased. But these changes have increased the cost of funding for the banking system as a whole. The costs of all forms of funding have risen, and, at the same time, banks have shifted to more expensive sources of funding. As I said earlier, this shift has reflected market and regulatory pressures following a reassessment of risk. The re-pricing of risk has increased the cost of intermediation from its pre-crisis level, when it was arguably underpriced. This rise in the cost of intermediation is reflected in the increase in lending rates relative to the cash rate. 3 The financial crisis also raised awareness of the other sources of risk for the global banking sector. For a number of European banks, the currency and maturity mismatch between their assets and liabilities raised significant issues throughout the crisis and continues to be a vulnerability. The fact that this issue is ongoing has been reflected in the recent rise in the EUR/USD cross currency basis swap. In contrast, the Australian banks hedged the currency risk of their offshore borrowing using instruments that were maturity matched. As a result they did not face the issues that some European banks faced of funding US dollar assets from a euro funding base. The US dollar swap lines that a number of central banks, including the RBA, established with the Federal Reserve were established in large part to alleviate these stresses stemming from the European banking system. As their funding was being severely curtailed from other sources, the European banks turned to the swap market to fund their long-dated and illiquid US dollar asset positions. This demand from European banks for US dollars each day, at the same time as supply was being reduced, caused the price of US dollars to rise dramatically in all markets and time zones. 4 Again, more details on this are in the Reserve Bank of Australia submission to the Senate Economics References Committee Inquiry into Competition within the Australian Banking Sector, 30 November 2010. For more information, see “The Functioning and Resilience of Cross-border Funding Markets”, CGFS Papers No 37, March 2010. The RBA participated in the swap line to help distribute US dollars into this time zone (the Bank of Japan’s participation served a similar purpose). 5 It did not reflect any issue with the Australian banking system’s own need for US dollars. The funds provided under the swap line were cheaper than the extremely wide market price at the time. As a result, Australian based banks availed themselves of this and in a number of cases on-lent the funds to banks in other jurisdictions. The provision of these funds globally alleviated the strains in the swap market and the spread declined. Once it declined below the price of the swap line, demand in Australia dried up and the facility was no longer offered here, although it continued to attract demand for a longer period of time in other markets. Bank’s assets While these developments have been taking place on the liability (funding) side of banks’ balance sheets, there have been some interesting developments on the asset side too. Since mid 2008, there has been a significant easing in the pace of credit growth, particularly for the business sector (Graph 6). Further disaggregation indicates that the easing in credit growth has been most striking for large businesses (Graph 7). Graph 6 The Fed has recently published details of these transactions, along with that of all its other programs. See http://www.federalreserve.gov/newsevents/reform_swaplines.htm. The RBA's participation in this program was made available to the market in real time. For more details see the Operations in Financial Markets section of the RBA 2009 Annual Report. Graph 7 The decline in credit outstanding to large businesses reflects a number of factors: Some businesses have found it more cost effective to access funds directly from the market rather than through the banking system. In 2009, there was a record level of equity raisings by large businesses that enabled them to repay debt (Graph 8). There has been a tightening in lending standards for some sectors, most notably commercial property. A number of large businesses, particularly in the mining sector, have been able to fund their activities and repay debt from their retained earnings resulting from their strong cash flow (Graph 9). Looking forward, given the expected prominence of resource investment for GDP growth, it is quite possible this pattern of subdued business credit growth relative to robust growth in the economy might persist. The RBA’s forecasts have investment increasing as a share of the economy in the period ahead to historic highs. Much (although not all) of this pick-up in investment is in the resources sector. The companies undertaking this investment tend to be much less reliant on credit intermediated through the domestic banking system. Instead they are likely to fund a sizeable share of this investment from global capital markets either through direct raisings or syndicated loans. Graph 8 Graph 9 This slowdown in growth on the asset side of the balance sheet has alleviated pressures on banks to increase their funding. Over the past couple of years, credit growth has been slower than the growth in deposits for the first time the early 1990s (Graph 10). Graph 10 As mentioned earlier, part of the explanation for the strong growth in deposits is the increased competition for deposits in the banking system. But another part of the explanation reflects the changed nature of the financial flows in the economy. While parts of the corporate sector may be less reliant on the domestic banking system for their funding, ultimately a large part of the funding they raise from other sources still finds its way into the domestic banking system in the form of corporate deposits. Hence, if the economy evolves as forecast, it’s quite possible this pattern of deposit growth outstripping credit growth continues and deposits may continue to rise as a share of bank funding. Bank funding and capital flows These changes in bank funding, as well as in the funding of the increase in capital expenditure, are apparent in the financial accounts side of the balance of payments. These are the capital inflows that are the counterpart of the current account deficit. The net capital inflow into Australia masks very large gross capital flows both into and out of the country. For example, over the past five years, the average annual net capital inflow amounted to $55 billion. This net capital inflow comprised: foreign investment in Australian equity of $54 billion; Australian investment in foreign equity of $51 billion; foreign investment in Australian debt of $95 billion; and Australian investment in foreign debt instruments of $43 billion. Given the size of these gross flows, it can be somewhat misleading to analyse shifts in capital flows or how the current account deficit is funded by focusing on net flows only. For a number of years prior to 2007, Australian banks were a steady source of capital inflow, representing around 4 per cent of GDP, or around 80 per cent of net private sector inflow (Graph 11). These capital inflows reflected the fact that Australian banks found it cost effective to raise wholesale funds offshore to fund domestic asset growth. That these net flows into the banking sector were similar in size to the current account was as much coincidence as causation in my opinion. Graph 11 Given the changes to bank funding and the slowdown in the credit growth discussed above, financial inflows in the form of offshore debt raisings by Australian financial institutions have declined. In the first three quarters of 2010, the net inflow of foreign funding to banks was only 1 per cent of GDP. All of this occurred in the first quarter of the year, with the net amount of offshore funding by the banking sector amounting to zero in the two most recent quarters. At the same time, the current account deficit has fallen to around 2½ per cent of GDP. Going forward, the forecast rise in the investment share of the economy is likely to see an increase in capital inflows. As discussed above, given that mining companies are likely to rely less on locally intermediated debt to fund their activities, there are likely to be further changes in the composition of net private capital inflows away from banks towards nonfinancial corporates. Some of this might be in the form of increased direct debt raisings, some might be in the form of an increase in retained earnings. So the current account deficit may increase from its current level, but on the capital account side, there may not be a concomitant increase in banks’ net offshore raisings. Conclusion The financial crisis has had a marked impact on financial flows globally. In this speech I have described some of the effects it has had on financial flows in the Australian economy. The funding of the Australian banking system has changed quite markedly as has the cost of that funding. In addition, the forecast composition of growth in the Australian economy and the funding of that growth may have implications for the asset side of the banking system’s balance sheet. It is quite possible that intermediated credit growth will be slower, and deposit growth relatively higher, than has been the case in recent years. These changes have been, and may continue to be, reflected in the changed composition of capital flows to the Australian economy. | reserve bank of australia | 2,010 | 12 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 11 February 2011. | Glenn Stevens: Overview of the Australian economy and challenges ahead Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 11 February 2011. * * * In the relatively short period since we last met, the global economy has continued to expand and, if anything, looks a little stronger than it did. China and India have sustained a strong pace of expansion and the United States seems to be gaining a bit more momentum lately though it still faces considerable problems. Conditions in Europe remain quite mixed and the interplay of sovereign and bank creditworthiness continues to be a source of great uncertainty. Observers have been revising up both their estimates of global growth outcomes for 2010 and their forecasts of growth in 2011. The IMF is now saying world GDP growth was about 5 per cent in 2010, which is well above the 30-year average. For 2011 the IMF has lifted its forecast to 4.4 per cent, which is still noticeably above average. Global commodity prices have risen further in recent months. This has been quite widespread – from metals, to minerals, to energy and foodstuffs. In a number of countries, measures of consumer price inflation have reflected this rise in commodity prices, particularly in the case of food. China, India, indeed most of Asia, and Latin America are all facing these issues. Managing these pressures is shaping up as one of the major international economic policy challenges of 2011. The commodity prices most important for Australia are at very high levels. In the case of coal, this reflects in part the supply tightness resulting from the Queensland floods, which have reduced national production by something like 15 per cent and had a material effect on the global supply of traded coal. But supply of iron ore has not been much affected by the weather and its price has risen above the highs of 2008, driven by strong demand. As a result, Australia’s terms of trade are higher than assumed three months ago and look like they will peak higher and later than we had previously assumed. A large build-up of capacity in iron ore, natural gas and coal is planned. Over the summer, there have been further announcements of projects that had been proposed being given the “go-ahead”, principally in the gas sector. In broad terms, therefore, the main medium-term story the Bank has been pointing to for some time still seems to be in place: we are experiencing a terms of trade event of very large size, of the type that happens only once or twice in a century. Our job is to try to manage this so as to avoid, as far as possible, the instability that has accompanied most previous such episodes. To date, something that is probably a bit unusual in the face of such developments is the relatively cautious attitude of households towards their finances. This has been much remarked on over the recent period, but in fact looking back it seems that the rate of saving from current income has been rising for several years now. With the caveat that saving is not very accurately measured, it looks like the propensity to save out of new income has been quite high, and that people are working to reduce debt more quickly, and are more demanding of value in their purchases than they had been for some time. This is quite a difficult environment for retailers. But from a macroeconomic point of view, perhaps it is, on balance, not entirely unwelcome in the current circumstances. If consumption were to boom at the same time as we try to expand the resources sector, upgrade urban infrastructure and increase our pace of housing construction to house a BIS central bankers’ speeches growing population, it would be harder to avoid the economy overheating. The more cautious behaviour is also building resilience into household balance sheets, which will be a good thing to have in the future should developments turn in an unfavourable direction. The ratio of household debt to income seems to have stabilised, having risen continually for two decades. I might add that this is happening in many countries, not just in Australia. But we have the good fortune to be seeing this financial consolidation happening at a time when our incomes are being increased by other factors. Locally, attention has been focused on the devastation caused by extreme weather across several states, most particularly Queensland. The human cost cannot be quantified in dollars. The people affected are still absorbing that cost, and some will do so long after the economic effects have passed. Those of us not directly affected have admired their courage and resilience. The Reserve Bank, for its part, has an obligation to consider the potential impact on the national economy. We have to ask at least three questions: how large are the effects on output and prices that we should expect to see? are they due to demand or supply disturbances? and how long they will last – do they change the medium-term outlook? We have set out some estimates in our Statement on Monetary Policy. This was finalised after the Queensland and Victorian flooding had been observed, but before the impact of Cyclone Yasi could be assessed. I should emphasise that these estimates are preliminary and that a good deal of uncertainty inevitably surrounds them. With those caveats, we expect real GDP will be noticeably lower than it would otherwise have been in the December and March quarters. By the March quarter, it could be about a percentage point lower than the pre-flood forecast. As to the reason for this effect, it is not primarily because demand for goods and services has suddenly slumped, but because the economy’s capacity to supply goods and services, and especially some key commodities, has been disrupted. It will most likely recover the bulk of those supply losses in the June quarter as production, particularly coal mining, resumes. Nonetheless, for many businesses there has been a period of lost income, as indicated by the reduction in the level of GDP for the 2010/11 financial year of about half a percentage point compared with earlier forecasts. After the initial recovery in production over the next few months, the process of rebuilding damaged structures, accommodated in part by deferral of some other spending, will see a modest increment to demand over the coming year or two compared with what we expected three months ago. Since these estimates were put together, Cyclone Yasi has done major damage to some crops. Some very early intelligence we have received suggests that the damage to crops may not be quite as great as occurred with Cyclone Larry five years ago and that recovery of some crops might be a bit faster than in that episode. Nonetheless, there has clearly been a very substantial impact and a big rise in the prices of some fruits is already occurring, on top of the increases in prices for some foodstuffs as a result of the earlier flooding. The result of this is likely to be a temporary rise in the CPI inflation rate, to around 3 per cent in the June quarter. This is higher than the figure in the Statement because the impact of Cyclone Yasi could not be included in that forecast. The combined contributions to this outcome of all the summer flooding and the cyclone add up to about half a percentage point or a little more. These effects should begin to reverse in the second half of the year and should have largely dissipated by the end of 2011. We do not think the effects on activity of these events will derail the expansion. Nor should the price effects pose a serious threat to the achievement of the medium-term goal for BIS central bankers’ speeches inflation, provided the community can understand their temporary nature and expectations of ongoing inflation remain well-anchored. Accordingly, the view of the Board at the recent meeting was that while the impact of the floods on the short-term path of output and prices would be quite substantial, monetary policy should not respond to those effects. Likewise, while the recovery efforts may add a little to aggregate demand over the latter part of 2011 and 2012, those effects should be manageable. While we could not assess the impact of Cyclone Yasi at the Board meeting, our assessment of the medium-term outlook is not very different now. The outcomes for inflation in the latter part of 2010 were quite moderate and a little lower than we had thought they would be at the time of the last hearing. To what extent this represents a genuinely lower trend, as opposed to noise, is, as always, difficult to say. There would appear to be some association between consumer caution, reports of widespread discounting in the retail sector and the very high exchange rate. If that connection is in operation then the question arises as to how long such cautious behaviour might continue – and this is one of the uncertainties to which we point in the section on “risks” in the Outlook chapter of the Statement. There are of course other uncertainties as well. But stepping back, underlying inflation has fallen by a substantial amount from the peak in 2008. It is worth recording that a combination, on the latest figures, of a 5 per cent unemployment rate and an inflation rate clearly “in the 2’s” is a pretty favourable one by the standards of recent decades. Turning finally to monetary policy itself, as a result of the adjustment to the cash rate made in November, and the changes made by financial institutions to lending rates, interest rates being paid by borrowers are a bit above average compared with the past 15 years. Household credit growth is quite modest and business credit is still declining, as firms continue to consolidate balance sheets and, in the case of larger companies, to access capital markets directly. Reports suggest that there is some easing of lending conditions in some areas but my sense is that, generally, lenders remain quite cautious. The exchange rate is at peak levels for the floating rate era. This is not especially surprising given the level of the terms of trade, but nonetheless it is exerting dampening pressure on the traded sector outside of the resources sector. So, overall, financial conditions are on the firm side. In view of the general outlook that I sketched at the beginning, that seems to us to be appropriate. Having reached that position in a fairly timely fashion, the Board has judged it to be sensible of late to leave the cash rate steady. My colleagues and I look forward to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 2 |
Address by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) - New South Wales (NSW) Economic and Political Overview 2011, Sydney, 17 February 2011. | Philip Lowe: Some current issues in the Australian economy Address by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) - New South Wales (NSW) Economic and Political Overview 2011, Sydney, 17 February 2011. * * * I am very pleased to be able to participate again in CEDA’s annual Economic and Political Overview. In line with the theme of this morning’s conference, I would like to discuss a couple of issues that will have an important bearing on economic developments in Australia over the next year or so. The first of these is the performance of the world economy and, in particular, the ongoing strength in global commodity prices. And the second is the continuing evidence of restraint in consumption and borrowing by Australian households. I would also like to talk briefly about the RBA’s forecasts that were published in the latest Statement on Monetary Policy (SMP). The world economy and commodity prices When I spoke at this conference a year ago, the central forecast for the world economy was that it would grow by around 4 per cent in 2010, with many commentators focussing on the downside risks. Now that most of the GDP figures are in for the year, it looks like global growth was quite a bit stronger than this, with global GDP estimated to be up by around 5 per cent in 2010. There have also been upward revisions to forecasts for 2011, with the IMF now expecting that growth will continue to be above trend in both this year and next (Graph 1). Graph 1 BIS central bankers’ speeches While the recent outcomes for the world economy have been better than expected, significant downside risks remain, not least because of the poor state of public finances in many of the advanced economies. These risks clearly cannot be ignored, although the recent more positive data have led to renewed focus on another risk – that is, a rise in global inflationary pressures, particularly as commodity prices have increased significantly over recent months. As an illustration of this increase, the RBA’s own Index of Commodity Prices is at an all time high and has risen by almost 50 per cent over the past year (Graph 2). Graph 2 This upward pressure on commodity prices is occurring at a time when conventional measures of the global output gap remain quite large. Many of the advanced economies continue to operate well below full capacity and unemployment rates are still very high. These large output gaps mean that there is little upward pressure on domestic costs and prices in most advanced economies, with core measures of inflation generally still very low. In earlier episodes in which these economies were operating well below potential, there was typically also general softness in commodity markets, with weak demand weighing on prices. Yet, this is not occurring on this occasion. Instead, we are experiencing the co-existence of strong commodity prices and large output gaps in the advanced economies. The most plausible explanation for this is the continuing shift of global economic weight to the emerging market economies, particularly those in Asia. While industrial production in the advanced economies remains below its 2008 peak, industrial production in Asia has grown very strongly (Graph 3). As a result, there has been strong growth in demand for resources. And similarly, with incomes growing rapidly in the region over a number of years, the demand for agricultural commodities has also been very strong. BIS central bankers’ speeches Graph 3 In trying to understand what is going on, it is useful to put these recent developments in a longer-term context. 1 Graph 4 shows an index of global food prices using World Bank data – adjusted for changes in the general price level – back to the beginning of the 20th century. As is evident from this graph, the 1980s and 1990s was a period of unusually low food prices. According to this particular index, between 1982 to 2000, the average price of food was around 30 per cent lower than the average for the previous 80 years. The same general picture applies to the prices of base metals, and to a lesser extent, for iron ore and coal prices (Graphs 5 and 6). More recently, of course, this has all changed, with the relative prices of food, base metals, iron ore and coal all increasing significantly. In the case of iron ore and coal, the prices are now at very high levels compared with their historical averages. See also O’Connor and Orsmond (2007), “The Recent Rise in Commodity Prices: A Long-Run Perspective”, RBA Bulletin, April, pp 1–7. BIS central bankers’ speeches Graph 4 Graph 5 BIS central bankers’ speeches Graph 6 These movements in prices reflect the evolving balance of supply and demand. During the late 1980s and 1990s, the low prices for many commodities led to reduced global investment in exploration and mine development. And in parts of agriculture, the rate of technological progress slowed down with growth in both yields and the land area devoted to crops declining significantly (Graph 7). In effect, low prices meant that the incentive to expand productive capacity was diminished. We saw a clear example of this in Australia, with the level of mining investment (as a share of GDP) in the late 1980s and 1990s lower than it was in the early 1970s and early 1980s, and much lower than it has been over the past decade. Graph 7 BIS central bankers’ speeches As things have turned out, this period in which the supply side was being pushed out only slowly was immediately followed by a period of very strong growth in demand, largely because of developments in Asia. As I have spoken about previously, the urbanisation and industrialisation of China is very resource intensive, especially in the commodities used to make steel. 2 In addition, the demand for protein has risen rapidly in Asia as average incomes have increased. For many commodities, global inventories are now quite low and it would appear that we are currently operating on a relatively steep part of the global commodity supply curve, with weather-related disruptions adding to the recent price pressures for some commodities. Looking forward, we cannot be sure about what the future will hold; few people predicted the transformational effects on the world economy of China’s growth. At the moment though, there has been some response on the supply side to the high commodity prices, with increased rates of investment in the resources sector. In Australia, we see this more clearly than in most other countries. What is difficult to predict is the time frame over which this increase in global capacity will allow the world economy to again operate on a flatter part of the supply curve. If recent experience is anything to go by, this time may be some way off. What does seem clearer is that the world economy is going through a change in relative prices, and that this change is likely to be quite persistent. In theory, a change of this sort need not be inflationary for the world, with monetary policy ensuring that the target rate of overall inflation is achieved. And even where a change in relative prices is accommodated by a step up in the overall level of prices, the result need not be ongoing inflation, particularly if inflation expectations do not increase. In practice though, earlier international experience suggests that things are not always so easy. A complicating factor is that the current change in relative prices is playing out over a run of years and there is uncertainty as to how much of it will be reversed. It can also be difficult for some prices to fall to offset those that are rising. This change in relative prices is also occurring against the backdrop of ongoing stimulatory monetary policy around the world, including in Asia. While in most countries, domestically sourced inflationary pressures remain subdued, there is an important global factor coming from the capacity constraints in commodity markets. At least for the time being, it would appear that the ability of the world to produce commodities is becoming a key constraint on non-inflationary growth for the global economy. As the Governor said last week at the Parliamentary Hearing, managing these price pressures in commodity markets is shaping up as one of the major international issues of 2011. In Asia, the high food prices, in particular, have meant that headline inflation rates have risen and there has been a lift in inflation expectations in some countries. If these inflationary pressures were to intensify, a stronger policy response than seen to date would be likely, increasing the risk of a subsequent sharp slowdown in the region. Consumer restraint The second issue that I would like to talk about is the restraint in consumer spending and borrowing. As many retailers will attest, consumer spending has been subdued in recent times. You can clearly see this in the household saving ratio (Graph 8). While there are a whole host of measurement qualifications, the current data show that the saving ratio has increased from a See Lowe (2010), “The Development of Asia: Risk and Returns for Australia”, Speech to NatStats 2010 Conference, Sydney, 16 September and, Lowe (2009) “The Growth of Asia and Some Implications for Australia”, Speech to Citi Australia Inaugural Australian Investment Conference, Sydney, 19 October. BIS central bankers’ speeches little below zero in the first half of the 2000s to around 10 per cent in 2010. This increase has reversed the steady decline that took place over the previous two decades. Graph 8 With the benefit of hindsight, a change in the trend looks to have started in the middle of 2000s, although, at the time, this was difficult to detect. Over the decade to 2005, there was a large run-up in household debt and asset prices, and a decline in saving, as households adjusted to lower nominal interest rates and innovation in the financial system. It is plausible that this adjustment was largely completed by the mid 2000s and that since then, household spending patterns have returned to more traditional norms. Over the past few years, this change has been reinforced by the global financial crisis which has led some households to rethink their spending and borrowing decisions, partly in response to greater uncertainty about future asset returns. A slightly different way of seeing this change is to look at how much of the increase in household incomes each year is actually spent. In quite a few of the years during the decade and a half to 2005, household consumption increased by more than one dollar for every extra dollar of household disposable income received (Graph 9). In contrast, since 2005, only around 65 cents in every extra dollar of income has been spent. It now seems reasonably clear that after a long period of structural adjustment many households are putting a little more aside each month than they were for most of the 1990s and the early 2000s. BIS central bankers’ speeches Graph 9 This change can also be seen in a range of other indicators. One example is the disaggregated data available through the annual HILDA survey of household finances. In the surveys that were undertaken between 2000 and 2005, there was a clear trend, with fewer and fewer households with mortgages reporting that they were ahead of schedule in their repayments (Graph 10). However, this downtrend slowed around 2005, and then in 2009 – the most recent year for which data are available – there was a marked increase in the share of people reporting that they are ahead of schedule. Graph 10 BIS central bankers’ speeches Similarly, over the past couple of years, there has been an increase in the proportion of households who report that they pay their credit card balance in full each month. This change in behaviour is also evident in the responses to the monthly survey of consumers conducted by the Melbourne Institute and Westpac. In particular, over recent years, there has been a marked increase in the number of households that say paying down debt, or building up bank deposits, is the wisest thing to do with their savings (Graph 11). Correspondingly, there has been a decline in the perceived attractiveness of more risky investments. Graph 11 A similar story is also evident in the estimates of how much equity the household sector is adding to the housing stock. Until the late 1990s, it was normal for the value of new investment in housing to significantly exceed the total amount of new housing-related borrowing – in effect the household sector was building up equity in the housing stock. But during the early part of the 2000s this changed and we went to a position in which the household sector was withdrawing equity (Graph 12). Over recent years, things have changed again and we have returned to the more traditional pattern. BIS central bankers’ speeches Graph 12 Taking all these indicators together, it seems pretty clear that something has changed in the behaviour of households. It is likely that part of this change reflects the completion of the structural adjustment to lower interest rates and innovation in the financial system. But recently, there also appears to have been a change in attitudes. As was discussed in the SMP, an important factor shaping the outlook is how persistent this change in attitudes turns out to be. On the one hand, it is plausible that consumption growth will strengthen considerably over the period ahead, supported by strong income growth and an unemployment rate that is trending down. On the other hand, this more cautious approach to spending could be quite long lasting, with households using the strong income growth to further improve their balance sheets. In putting together our forecasts, we have assumed a middle path, with the saving rate staying high, but consumption growth broadly matching income growth over the next couple of years. We will, of course, be looking very closely to see if this is how things evolve. Before talking about the forecasts in more detail, I would like to draw your attention to one of the side effects of the recent subdued growth in retail spending. And that is the downward pressure on the prices of many retail goods. Over the past year, the ABS’s price index for clothing has fallen by 6 per cent (Graph 13). The price index for major household appliances has fallen by 4 per cent. The price index for furniture and furnishings has fallen by 1½ per cent and the price index for audio, visual and computing equipment has fallen by 18 per cent. In fact, there are very few (non-food manufactured) goods in the CPI whose prices have increased over the past year. BIS central bankers’ speeches Graph 13 These pervasive price declines follow a substantial appreciation of the exchange rate and tariff cuts on a range of goods in early 2010. While it is difficult to be definitive, it is possible that the weak consumer spending has led to faster pass-through of these changes than suggested by previous experience. There has also been some moderation in inflation for goods and services whose prices are not directly influenced by the exchange rate, although the effects have been smaller. Overall, over 2010 the CPI increased by 2.7 per cent, with underlying measures of inflation running at about 2¼ per cent. Updated forecasts I would now like to turn briefly to the Bank’s updated forecasts. Our central scenario remains for the economy to grow strongly over the next few years. The quarterly GDP outcomes in the near term are, however, going to be materially affected by the recent extreme weather events. These events significantly disrupted production in both the December and March quarters, especially in the coal industry. The Bank’s current estimate – which remains subject to significant qualifications – is that total output in the March quarter will be around 1 per cent lower than it otherwise would have been. Given this mainly arises from a disruption to production, the decline in spending is likely to be somewhat smaller than 1 per cent. Following the March quarter, we expect a strong rebound in output, as coal production recovers its fall and the rebuilding effort gets underway. Over 2011, our current forecast is for the economy to grow by around 4¼ per cent. This is higher than we were expecting three months ago, although this upward revision just reflects a lower starting point because of the decline in coal production in December 2010. Beyond the current year, our central scenario remains for the economy to grow in the 3¾ – 4 per cent range. The recent extreme weather events will also have a noticeable effect on the near-term outcomes for inflation. Since the SMP was released we have been able to make a preliminary assessment of the likely effects of Cyclone Yasi, primarily on banana and other fruit and vegetable prices. The Bank now expects CPI inflation to be around 3 per cent over the year to June 2011, with the combined effect of floods and the cyclone likely to contribute BIS central bankers’ speeches around ½ percentage point to this outcome. This forecast represents an upward revision to the one published in the SMP, largely because of the expected increase in banana prices. Of course, with the price of bananas expected to fall back to more normal levels later in the year as production recovers, there is a period during 2012 when the year-ended inflation outcomes can be expected to be lower than at the time of the SMP. Looking through these weather-related effects, inflation is expected to gradually increase over the next couple of years to around 3 per cent in late 2012. Finally, as always, these forecasts are subject to a number of uncertainties. As is the Bank’s usual practice, we will continue to examine the ongoing flow of data on the global economy, domestic activity and prices and assess whether the outcomes remain consistent with our broad outlook. As I said at the outset, developments in global commodity markets and the attitudes of Australian consumers to spending are likely to have an important bearing on how our economy evolves over the next year or so. Thank you for your time. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 2 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Victoria University public conference on The Resources Boom: Understanding National and Regional Implications, Melbourne, 23 February 2011. | Glenn Stevens: The resources boom Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Victoria University public conference on The Resources Boom: Understanding National and Regional Implications, Melbourne, 23 February 2011. * * * The rise in prices for natural resources and the associated planned increase in Australian based capacity to supply key commodities is one of the largest such economic events in our history. The Reserve Bank has had a good deal to say about it. I will touch again today on the main points we have made. I will not say much that is new. Nor will I be seeking to convey any messages about monetary policy. Those matters were covered in some depth with the House Economics Committee less than two weeks ago. I will structure my remarks around four questions. What do we know from previous booms? What do we know about this one? What don’t we know? Finally, how should that knowledge, and the limits to it, guide our response to the boom? What do we know about previous booms? I am going to re-use a chart that originated in a research paper by Jonathan Kearns and Christian Gillitzer 1 , with some updating. This was the basis of a previous address last November 2 . I have noticed it being shown rather more widely of late, no doubt because of the striking messages it conveys. One thing we know, by observing this time series, is that large swings in prices for agricultural and resource commodities, resulting in big variations in Australia’s terms of trade, have been a recurring feature of our economic experience ever since Australia became a significant producer of such commodities. There have been a number of big booms. They all ended. The really high peaks were quite temporary – just one or two observations in this annual time series, such as in the mid 1920s or the early 1950s. Periods of pretty high terms of trade lasted for some years in several instances – as shown by the five-year average – but so far they have all been followed by a return to trend, or even a fall well below trend. Gillitzer C and J Kearns (2005), “Long-term Patterns in Australia’s Terms of Trade”, RBA Research Discussion Paper No 2005–01. “The Challenge of Prosperity”, address to CEDA Annual Dinner, Melbourne, 29 November 2010. Available at: <http://www.rba.gov.au/publications/bulletin/2010/dec/pdf/bu-1210-9.pdf>. BIS central bankers’ speeches Graph 1 We also know that these swings were very important for the macroeconomy. My colleague Ric Battellino gave a very thoroughly researched speech on this question a year ago today. 3 He looked at five major episodes, including the current one, over two centuries. Let me offer a reprise of his four main observations. First, global developments have always played a part in causing the booms. Changes to the availability of capital or the emergence of large, low-income countries with rapid growth prospects (Japan or China) have often affected the price of minerals and energy. Second, these booms were always expansionary for the Australian economy overall. Third and related, previous booms were usually associated with a rise in inflation. The exception was the one in the 1890s, which occurred when the economy was experiencing large-scale over capacity. Fourth, the role of the exchange rate is crucial. The current episode stands apart from the previous ones because all those booms were experienced with a fixed or heavily managed exchange rate. This severely compromised the conduct of monetary policy, and also muddied many of the price signals that the economy needed to receive. In short, these episodes were major externally generated shocks that proved very disruptive, not least because the country’s macroeconomic policy framework was not well equipped to handle them. The high levels the terms of trade reached on some occasions were not permanent, but they did persist long enough to have a big impact on economic outcomes. “Mining Booms and the Australian Economy”, address to the Sydney Institute, Sydney, 23 February 2010. Available at: <http://www.rba.gov.au/publications/bulletin/2010/mar/pdf/bu-0310-10.pdf>. The fact that we were talking about this issue a year ago, and indeed two years earlier than that, that we are still taking about it now, and doubtless will be for another year at least, says something in itself. BIS central bankers’ speeches What do we know about this boom? The main thing we know about the current episode is that it looks very large. It is being driven by a big increase in demand for key Australian export commodities. Global consumption of coal has increased by about 50 per cent over the past decade; consumption of iron ore has increased by 80 per cent since 2003. Back then, Australia shipped around half a million tonnes of iron ore each day; now it is over a million tonnes a day. Coal shipments have been running at a rate of around 300 million tonnes a year, at least until the recent floods. Australian capacity to export LNG is now around 20 million tonnes a year, up from around half that in 2004. This looks like it will increase to over 50 million tonnes within five years. The rise in demand has been driven in large part by the rapid growth of key emerging market economies such as China and India. Over the past decade: the average annual growth of GDP per capita has been around 5½ per cent in India and almost 10 per cent in China; the number of people living in cities in those two countries, especially China, has risen by over 250 million, which implies having to expand or create cities (with the attendant buildings and infrastructure) to house the entire population of Australia more than 10 times over or, alternatively, to house the populations of France, Germany and Japan combined; and steel production has doubled in India and it has more than quintupled in China. Thus far, the demand for resources has stretched the global capacity of suppliers. Prices of key raw materials have consequently been driven upwards. As a result Australia’s terms of trade have risen sharply, to be about 65 per cent above the 20th century average level, and about 85 per cent above the level that would be expected had the downward trend observed over the 20th century continued. Even assuming the terms of trade soon peak and decline somewhat, they are nonetheless, over a five-year period, at their highest since at least Federation – by a good margin. With the terms of trade at their current level, Australia’s nominal GDP is about 13 per cent higher, all other things equal, than it would have been had the terms of trade been at their 100-year average level. Of course Australia has substantial foreign ownership in the resources sector so a good proportion of this income accrues to foreign investors. Nonetheless, probably about half of that additional 13 per cent of GDP accrues to Australians one way or another. We also know that a large expansion in the resource sector’s capacity to supply commodities is being planned. Already, mining sector capital investment has risen from an average of around 2 per cent of GDP over the past 25 years to about 4 per cent, which exceeds the peak reached in the booms of the late 1960s and early 1980s. Given the scale of possible additional investment projects that have been mooted, resources sector investment could rise by a further 1–2 per cent of GDP over the next couple of years. If it occurs, this will be by far the largest such expenditure of a capital nature in the resources sector in Australia’s modern history. Again, a significant proportion of the physical investment will be imported, but a large domestic spend is nonetheless likely. A further thing we know about the boom is that it is associated with a much higher level of the exchange rate than we have been accustomed to seeing for most of the time the currency has been market determined, a period of more than 25 years (though, over the long sweep of history, the nominal exchange rate was often considerably higher than it is now). On a trade-weighted basis, it is 25 per cent above its post-float average. The striking relationship between the effective exchange rate adjusted for price level differentials (the “real” exchange rate) and the terms of trade that is observable over quite a long period in the data still seems broadly to be in place. BIS central bankers’ speeches Interest rates also have a bearing on the exchange rate. Even though most market interest rates are very close to medium-term averages, or even below them in some cases (e.g. the cash rate and the 90-day bill rate), interest differentials have recently strongly favoured the Australian dollar because of the persistence of extremely low rates in all of the world’s major financial centres. Moreover, the expectation that relatively high returns will be earned on real capital in Australia – in mining for example – is a powerful factor influencing capital flows. We know that changes in the real exchange rate are part of the textbook adjustment mechanism to shocks like changes in the terms of trade. In past episodes, where movements in the nominal exchange rate were more limited (or did not occur at all), a range of other prices in the economy had to respond – arguably a more disruptive way of adjusting to the shock. On this occasion, the nominal exchange rate has responded strongly. This helps to offset the expansionary effect of the increase in investment, and also gives price signals to the production sector for labour and capital to shift to the areas of higher return. In other words, firms in the traded sector outside of resources are facing a period of adjustment. But in the face of such a shock they were always going to face that adjustment, one way or another. What don’t we know? The main thing we don’t know is how long the boom will last. This matters a great deal. If the rise in income is only temporary, then we should not respond to it with a big rise in national consumption. It would be better, in such a case, to allow the income gain to flow to savings that would then be available to fund future consumption (including through periods of temporarily weak terms of trade, which undoubtedly will occur in the future). Likewise it would not make sense for there to be a big increase in investment in the sorts of resource extraction activities that could be profitable only at temporarily very high prices. Moreover, the economic restructuring that would reduce the size of other sectors that would be quite viable at “normal” relative prices and a “normal” exchange rate – assuming there is such a thing – would be wasteful if significant costs are associated with that change only to find that further large costs are incurred to change back after the resources boom ends. If, on the other hand, the change is going to be quite long-lived, then national real income is going to be permanently higher, and we can look forward to enjoying significantly higher overall living standards into the distant future. In that world, a great deal of structural economic adjustment is bound to occur. In fact it almost certainly could not really be stopped. It would not be sensible to try to stop it. We know that the peaks of previous terms of trade booms were relatively short-lived. In the current episode, the very high level of the terms of trade already seems to be persisting for longer than in previous episodes. Is this telling us that we should expect the boom to disappear at any moment? Or is it telling us that this episode is different from the others? 4 In favour of the latter view, if China and India maintain, on average, their recent rates of “catch-up” to the productivity and living standards of the high-income countries, and if they follow roughly the same pattern of steel intensity of production as seen in the past in other economies, a strong pace of increase in demand for resources will likely persist for some time yet. On the other hand, resources companies in Australia and beyond are rushing to take advantage of the current increase in prices by bringing new capacity on line. Will this increase in supply be just sufficient to match demand? Will it be too little? Or too much? An additional complicating factor is that serious attempts at reducing CO2 emissions would I asked our econometricians to test the hypothesis that the observations over the past few years were drawn from the same process as generated the observations over the 20th century. Their answer, based on a battery of suitable tests for a univariate time series, was that it was too early to tell. BIS central bankers’ speeches probably change the story at some point. The lessons of history, moreover – that booms don’t go on indefinitely – are also too great to ignore. At this stage, the Reserve Bank staff are assuming that the terms of trade will fall in the latter part of the forecast horizon. The associated assumptions about key resource prices are toward the conservative end of current market forecasts, which typically assume a smaller fall in prices. Even under the Bank’s current assumptions, however, the terms of trade are still very high, by historical standards, at the end of the forecast period. But any forecast or assumption made in this area is subject to wide margins of uncertainty. We know that something very big is happening and has been for a while. We simply do not know whether it will continue like this, or not. How to respond? How, then, should we respond to our knowledge, and to the limits of our knowledge? To recap, we know that: Previous commodity price and/or mining investment booms were big events that had major expansionary and inflationary effects. Those booms all ended, generally with more or less a total reversal of the earlier rise in the terms of trade, though this often took some time. On some occasions, this brought on a significant economic downturn. The current boom looks bigger than any other since Federation at least, in terms of the rise in the terms of trade over a period of several years. The previous episodes occurred without the benefit of a flexible exchange rate to help manage the pressures. On this occasion that particular price is adjusting, which should help to contain the pressures and help the economy to adjust more efficiently. We do not know what the terms of trade will do in future. It would be rather extreme to assume that the rise of China and India is a short-run flash-in-the-pan phenomenon. Likewise it would be imprudent not to allow for a fairly significant fall in prices, even if only to still pretty attractive levels, over several years. 5 But the truth is that we will learn only gradually what the detailed shape of the new environment is. How should we handle this uncertainty? A few simple messages seem to me to be important. First, we should not assume that the recent pace of national income growth is a good estimate of the likely sustainable pace. We should allow a good deal of the income growth to flow into saving in the near term. We can always consume some of that income later if income stays high, but it is harder to cut back absorption that rises in anticipation of income gains that do not materialise. To date, that precautionary approach seems to be in place. Households are saving more than for some years and the much-discussed “consumer caution” has been in evidence. Firms are consolidating balance sheets. Governments have reiterated commitments to stated medium-term fiscal goals. Second, there is going to be a non-trivial degree of structural change in the economy as a result of the large change in relative prices. This is already occurring, but if relative prices I note that prices observed over the past year have exceeded, more or less continually, what had been assumed. BIS central bankers’ speeches stay anywhere near their current configuration surely there will be a good deal more such change in the future. Because we can’t confidently forecast where relative prices will settle, we cannot know how much such change is “optimal”. Therefore we can’t be sure that some of it will not need to be reversed at some point. But the optimal amount of change is unlikely to be none at all. So we should not look to prevent change; we should look to make it cost as little as possible. In general, that means preserving flexibility and supporting adaptation. Third, productivity is going to come back into focus, especially in sectors that are exposed to the rise in the exchange rate. Their prices will be squeezed, and their costs potentially pushed up by the demand of the resources sector and related industries for labour. Surely maintaining viability will involve achieving significantly bigger improvements to productivity than we have observed in recent years. Fourth, if we have to face structural adjustment, it is infinitely preferable to be doing it during a period in which overall income is rising strongly. If nothing else, in such an environment the gainers can compensate the losers more easily. Many other countries face major issues of economic adjustment in an environment of overall weakness. Conclusion At the risk of sounding like a broken record, the rise in Australia’s terms of trade over the past five years is the biggest such event in a very long time. It reflects powerful forces at work in the global economy to which our country is more favourably exposed than most. It presents opportunities and challenges. With a large boost to income, we need to think about the balance between saving and spending, because we do not know the permanent level of the terms of trade. I argue for erring on the side of saving for the time being, and I think this is by and large what is happening so far. With a large change in relative prices, we should also expect to see a good deal of structural change in the economy. A careful response to that prospect is also needed, and no doubt your conference will examine such issues over the day ahead. I wish you well in your deliberations. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 2 |
Address by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, to the Australian Industry Group 11th Annual Economic Forum, Sydney, 9 March 2011. | Philip Lowe: Changing relative prices and the structure of the Australian economy Address by Mr Philip Lowe, Assistant Governor of the Reserve Bank of Australia, to the Australian Industry Group 11th Annual Economic Forum, Sydney, 9 March 2011. * * * Thank you for the invitation to speak again at the Australian Industry Group’s Annual Economic Forum. Over many years, Ai Group and its members have provided the Reserve Bank of Australia with valuable insight into the issues affecting firms and so it is a pleasure to be here this morning. The topic I would like to talk about is structural change in the Australian economy. For the Reserve Bank, understanding the various shifts that are going on in the industrial structure of the country is important. It is also obviously important for the firms that are living through these changes and having to respond to them on a daily basis. I would like to focus on two aspects of the changes that are taking place. The first is the movement in relative prices that is occurring within the economy. The most obvious relative price that has shifted – and the one we have spoken most about – is the price of Australia’s exports relative to the price of our imports – what economists call the “terms of trade”. With commodity prices having increased very substantially since the early 2000s, Australia’s terms of trade are currently around their highest level on record and around 90 per cent above their average level for the 1990s (Graph 1). But there are many other relative prices that are changing as well and I would like to touch on some of these this morning. Graph 1 The second, and obviously related, issue is how these changes in relative prices are affecting the current structure of the economy, and in particular how labour and capital are being allocated across different industries. BIS central bankers’ speeches Changing relative prices There are three broad sets of relative prices that I would like to draw your attention to: the price of manufactured goods relative to the price of other goods and services; the price of investment goods relative to output prices; and the price of labour relative to both the price of output and the price of consumption. Each of these sets of relative prices has been undergoing quite large changes over recent times, with these changes reflecting the combined effects of high global commodity prices and the associated high level of the exchange rate. In terms of manufactured goods, it has been common worldwide for their prices to fall over time relative to the price of services. This is the result of faster growth in productivity in manufacturing than in services, as well as globalisation. This long-term trend is clearly evident in the Australian data, but over recent years, as the Australian dollar has appreciated, the decline in the relative retail price of manufactured goods1 – many of which are imported – has been particularly pronounced (Graph 2). Indeed, over 2010, the difference in the CPI inflation rate for manufactured goods and the CPI inflation rate for other goods and services was larger than it has been at any time over the past two decades. Graph 2 Not unexpectedly, this decline in the relative price of manufactured goods has caught the attention of the household sector. In consumer surveys, the number of people that say now is a good time to buy major household items is around its highest level in more than two decades (Graph 3). But interestingly, households do not appear to have responded particularly strongly to this fall in both the absolute and the relative price of manufactured goods, with retail spending having been quite subdued recently. Many households have “Manufactured goods” here refers to clothing, footwear, furniture & floor coverings, motor vehicles, audio, visual and computing and similar items. BIS central bankers’ speeches preferred to use the growth in their incomes to increase their savings rather than to buy more manufactured goods at lower prices. As the Bank has discussed on a number of occasions recently, whether or not this continues will have a significant bearing on how the economy evolves over the next year or so. Graph 3 The current large change in relative prices is also making it more difficult for households to assess the rate of overall inflation. This is because when relative consumer prices are moving a lot, the perceived inflation rate depends more than usual on the particular bundle of goods and services that one buys. Over the past year, people whose purchases are more tilted towards goods will have experienced a lower rate of inflation than those whose purchases are tilted towards services and utilities. But, importantly, for the community as a whole, consumer prices have increased by 2.7 per cent over the past year, consistent with the medium-term inflation target. The second relative price that I mentioned is the price of investment goods relative to the price of output. When the price of machinery and equipment is cyclically low relative to the price of goods and services produced using those investment goods, investment tends to be high. And indeed this is what we have seen over the past 10 years in Australia. As with the price of manufactured consumer goods, there is a clear downward trend over time in the relative price of machinery and equipment (Graph 4). This is largely, but not solely, driven by technology improvements lowering the price of computing power. But again, just as is the case for consumer goods, the decline in the relative price of machinery and equipment has been unusually large over the past decade. The exchange rate has obviously played an important role here as well. And the lower prices for investment goods have helped make investment more attractive in a number of areas of the Australian economy. BIS central bankers’ speeches Graph 4 The third set of relative prices that I would like to talk about are those that relate to the price of labour. For workers, what matters is the wage that is received relative to the price of the goods and services that they purchase – the so-called real consumption wage. For firms, what matters is the wage they pay, relative to the price of the goods and services that they sell – the so-called real product wage. Normally, at least at the aggregate level, these two are pretty similar, since there is a close correspondence between the goods and services that people buy and the goods and services that firms produce. Over recent years, however, this correspondence has broken down as the improvement in the terms of trade has increased the price at which aggregate output is sold relative to the price of consumption (Graph 5). Since 2000, the economy-wide real consumption wage has increased by around 25 per cent, which represents a substantial increase in the purchasing power of the average wage. In contrast, over the same period, the aggregate real producer wage has increased by only around 10 per cent. This relatively modest increase in the cost of hiring labour relative to the price at which aggregate output is sold has helped underpin strong employment growth. It has also contributed to an increase in the aggregate profit share of national output, which is currently around its highest level in the past 50 years (Graph 6). The relatively modest growth in the aggregate producer wage is also consistent with the slowing in aggregate labour productivity growth, as firms have been willing to hire more labour than would otherwise have been the case. BIS central bankers’ speeches Graph 5 Graph 6 While this aggregate picture is pretty clear, it hides very significant differences across industries (Graph 7). These differences largely arise because of differences in productivity growth across industries as well as movements in world prices. In industries with relatively BIS central bankers’ speeches fast productivity growth, real product wages tend to rise over time, as the productivity growth puts downward pressures on prices relative to wages. This is evident in the increase in real product wages in the manufacturing sector. In contrast, in many service industries, real product wages have moved broadly sideways. In these industries, labour is the main input and measured productivity growth has been slower, so output prices and labour costs have tended to move broadly in line with one another over the past decade. It is in the mining sector where real product wages have fallen very significantly. While wage growth in mining has been above average for a number of years, the increase in commodity prices has been much larger due to development in world markets. The result has been a substantial reduction in wages relative to prices for the mining sector. Graph 7 The overall picture emerging from the various relative prices that I have talked about is one of significant change. And when relative prices change, the allocation of resources within the economy also changes. And it is to this issue that I would now like to turn. Structural change Before looking at recent developments, it is useful to take a slightly longer-term perspective. In an article published in the Reserve Bank’s Bulletin in September last year, two of my colleagues looked at the current pace of structural change in the Australian economy compared with that in the past.2 Their conclusion was that, with one notable exception, the rate of structural change is not especially high at present, although it is above average. See Connolly and Lewis (2010), “Structural Change in the Australian Economy”, RBA Bulletin, September, pp 1–5. BIS central bankers’ speeches One reason that they draw this conclusion can be seen in a long-run graph of employment shares by industry (Graph 8). In the middle decades of the twentieth century there was a lot of structural change as the share of the workforce that was employed in the agricultural sector declined as more capital-intensive farming techniques became widespread. And then in the decades following the 1960s, as average incomes rose and tariff barriers came down, there was a very marked shift to employment in the services sector and away from manufacturing. Looking at this long-run record, it is obvious that structural change is something that is occurring all the time and, at least in terms of the labour market, the current rate of change is not unusual. A similar conclusion is reached when we look at changes in the composition of real output. Graph 8 The notable exception to this general picture however is the very large change in the composition of investment in the economy. Over the past year, investment in the mining sector has accounted for almost 20 per cent of total investment in Australia (including both the private and public sectors), which is much higher than the average of earlier decades (Graph 9). Looking forward, the latest data from the Australian Bureau of Statistics on firms’ investment plans suggest that further very large increases in mining investment are in prospect (Graph 10). Taken literally, these data imply an increase in investment spending in the mining sector of over 50 per cent in 2011/12, from an already elevated level. The projected increases are particularly large in the gas and the iron ore sectors. If they were to occur, it would mean that the mining sector would account for over one quarter of all investment spending in Australia next financial year. This would be a remarkable change over a short period of time. BIS central bankers’ speeches Graph 9 Graph 10 BIS central bankers’ speeches The high price of resources is also leading to very strong employment growth in the mining sector, with total employment in the sector up by around 20 per cent in 2010. But while this is very fast growth, it is important to remember that the sector still only directly accounts for less than 2 per cent of the overall workforce in Australia. The main effects on employment of the resources boom are being felt elsewhere, particularly in the services sector where the vast bulk of Australians work. These indirect effects on employment from the resources boom arise through two main channels: one operating through a demand effect as investment ramps up, and the other through an income effect. In terms of demand, the improved outlook for resource-sector investment has increased demand for a whole range of ancillary professional services. These include engineers, project managers, equipment lessors, lawyers, accountants, recruiters and IT specialists. As a result, employment in a number of these business services has grown strongly over recent years (Graph 11). In terms of the income effect, the higher prices we are receiving for our exports has delivered a tangible increase in national income. Over time, a substantial part of this will get spent. Right at the moment, spending on goods is relatively subdued, but with the population and aggregate incomes growing strongly, the demand for a range of services by households has also been growing strongly. As a result, employment growth in these areas has been robust. Graph 11 In contrast to this relatively positive picture in a number of industries, the changes in relative prices that are occurring are contributing to subdued conditions in some other industries. One very clear example is domestic tourism. Since the mid 2000s, the total number of nights that Australians spend away from home in Australia has fallen by around 12 per cent, despite the population increasing by 10 per cent. The high value of the Australian dollar has lowered the relative price of overseas travel and Australians have responded by travelling abroad in ever increasing numbers. Conversely, as Australia has become a more expensive destination, growth in overseas arrivals has slowed noticeably (Graph 12). Given these trends, it is not surprising that the tourist industry’s share of total employment has fallen over the past decade. BIS central bankers’ speeches Graph 12 Another area where the effects of the changes in relative prices are apparent is in the composition of Australia’s exports (Graph 13). During the 1990s, exports of manufactured goods and services grew strongly, at an annual rate of around 10 per cent. Growth then slowed in the early 2000s and it has been particularly weak over recent years. This weakness has been quite broad based, with exports of machinery and equipment, beverages and transport services all falling over the past three years. While there are a range of factors that account for this, an important one is the higher exchange rate which has increased the price of domestically produced goods relative to world prices. As a result, in a number of the affected sectors, employment growth has been relatively slow. Conditions have also been subdued recently in the retail and wholesale sectors, largely reflecting consumers’ more cautious approach to spending. Graph 13 BIS central bankers’ speeches These various shifts in the economy are occurring at a time where there is little overall spare capacity. This is quite different to the situation prevailing over most of the past 40 years. At times when there is a lot of spare capacity, all sectors can grow quite quickly without the overall economy butting up against capacity constraints. But this is not the situation we currently find ourselves in. Our favourable starting point means that faster-than-trend growth in some parts of the economy will inevitably be associated with slower-than-trend growth in other parts of the economy. And the movement in relative prices will be one of the factors that help determine which sectors grow more quickly than average, and which sectors grow more slowly than average. The challenge we face is how best to accommodate these changes, and to capture the considerable benefits that they can bring, while minimizing the costs that can arise when the structure of the economy is changing. This is no easy task. But it is surely a better challenge to face than those confronting most other advanced economies. The most important contribution the Reserve Bank can make to this task is to keep inflation low and stable, so that firms can respond to the shift in relative prices without their decisions being distorted by concerns about inflation in the general level of prices. The inflation targeting regime that we have had for nearly two decades provides the right framework to do this. Finally, in thinking about the implications of the recent changes in relative prices an important consideration is how persistent they are likely to be. There would seem to be little benefit in changing the structure of the economy to reflect the new relative prices, only for the old set of relative prices to reassert themselves quite quickly. As the Governor noted in a speech a couple of weeks ago, we cannot be sure how long the current boom in the terms of trade will last. However, given that it is being driven by structural changes in the global economy, it is likely that commodity prices will be above their average over recent decades for some time yet. If this is the case, Australia will do very well. History, however, does suggest caution and we cannot be sure what the future will hold. The best way of dealing with this uncertainty is to make sure that the economy retains its flexibility to deal with whatever set of relative prices the global economy delivers us. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 3 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business in Europe, United Kingdom Robert Walters Boardroom Series, Australialive Business Lunch, London, 9 March 2011. | Glenn Stevens: The state of things Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business in Europe, United Kingdom Robert Walters Boardroom Series, Australialive Business Lunch, London, 9 March 2011. * * * Quite a lot has happened since I last had the opportunity to address a London audience in January 2008. Later that year, a sequence of financial events saw the global financial system teeter on the brink, followed very quickly by a very sharp global economic slowdown in the closing months of 2008 and the early part of 2009. For the global economy, a recovery in activity commenced shortly thereafter. It has turned out, contrary to widely held expectations two years ago, to be quite a robust one overall. Real GDP for the world is estimated by the IMF to have grown by 5 per cent in 2010, well above the medium-term trend of a touch under 4 per cent. As of the most recent published forecasts, the IMF expects the world economy to grow by almost 4½ per cent this year – still above trend. But the pattern of the growth has been rather uneven. Here in this part of the world, recovery is proving to be difficult and protracted. Yet in the Asian region, the recovery has been quite rapid and concerns have been expressed about excesses. There is more than just cyclical dynamics at work in these trends. Important structural forces are in operation, and they have significant implications. These are worthy of careful consideration, even though we cannot do them full justice today. The North Atlantic region The group of countries that could be labelled as being in the North Atlantic region (North America, the United Kingdom and continental Europe) are in the early phase of recovery from a deep downturn. For several of them, the downturn was the worst for decades. In other cases the downturns were serious, though not more so than those of the mid 1970s or the early 1980s. But what has been unusual is less the depth of the downturn than the slowness of the recovery. For most major countries, in most cycles in the second half of the 20th century, the pace of a recovery tended to be related to the depth of the preceding recession: generally, the deeper the recession, the sharper the upturn that followed. This episode has been different, in that a serious recession has been followed by a fairly shallow upswing so far. In the case of the United States, the level of real GDP has reached its pre-crisis peak, but it took three years to do so. In the United Kingdom and the major continental economies, levels of real GDP remain well below their peaks of three or so years ago. In some other cases in Europe the declines are larger and, in fact, are continuing. In all these cases the level of output remains well below what policy-makers would regard as their respective economies’ “potential” level. A corollary of that is the rate of unemployment in most cases remains unusually high after a year or more of recovery. This slowness of initial recovery is of course related to the nature of the downturn, which differed from most of the post-war business cycles in that it was characterised by serious and widespread financial distress. History shows that recoveries from downturns associated with banking crises and collapsed asset booms are, more often than not, drawn-out affairs. Really we need look no further than Japan’s experience over the past two decades to see this, but in fact it is well established by a great deal of research. Moreover, while banking systems are in the process of regaining health, that process is not yet complete. Nor is it clear that households are yet finished the process of reducing their leverage. BIS central bankers’ speeches Output and Unemployment Real GDP Percentage change from pre-crisis peak Unemployment rate Percentage point change from pre-crisis trough North Atlantic Canada 1.2 1.9 United States 0.0 4.5 Euro area −2.9 2.7 Germany −1.4 −0.6 France −1.6 2.0 Spain −4.3 12.5 Ireland −12.8 9.3 United Kingdom −4.6 2.7 China* 23.2 – India* 20.9 – East Asia** 8.0 0.5 South Korea 6.2 0.6 Australia 4.4 1.1 New Zealand −1.8 3.4 Japan −4.1 1.3 Asia Pacific * Quarterly GDP did not contract during the global downturn; percentage change in GDP is from the quarter preceding a marked slowing in output growth ** Excluding China and Japan; GDP aggregated at market exchange rates; unemployment rate also excludes Indonesia, Malaysia, the Philippines and Thailand Sources: ABS; CEIC; RBA; Thomson Reuters There are now some other factors that may impede the recovery. One of them is the delicate state of government budgets, which leaves many of these countries feeling they have little choice but to pursue policies of fiscal contraction. In a proximate sense, this problem is due to the financial crisis. The direct costs of assisting banking systems were the smaller part of the effect – the main impact on budgets has simply been the cumulative loss of revenue and the general impost on spending that comes with a protracted period of economic weakness. Ideally, government budgets should move temporarily into a position of deficit when the private economy suffers an adverse shock. The budget should play the role of a “shock absorber”. But that ideal assumes that the government’s own accounts are in a strong enough position to play such a role without raising questions of the state’s own solvency. The problem is that BIS central bankers’ speeches in a number of countries, large burdens of spending, significant debt burdens, underfunded pension systems and unfavourable demographics have been on a collision course for a long time. What the crisis has done is to bring on the adjustment sooner. In the euro area the intersection of banking and fiscal issues – including through the exposures of banks to sovereign debt – heightens the difficulty. Although the single monetary policy framework is highly developed, single frameworks for other areas of financial policy have been less highly developed. This is gradually being addressed, though of course it is a complex issue. At its heart, the debate is essentially over the incidence across the taxpayers of Europe of the various costs of fixing banking problems. The Asia-Pacific region The contrast between the story for the North Atlantic countries and that for Asia could, in all frankness, hardly be more pronounced. Most of the countries in the Asian region have had a “v-shaped” recovery. Of course this has been led by China and India, where levels of GDP actually did not fall at all and where very robust growth rates have been maintained since the second quarter of 2009. Real GDP in both cases is now 20 per cent or more above pre-crisis levels. A range of other countries have also had a pretty strong rebound. Japan is an exception. The long aftermath of the “bubble economy” period, together with a declining population and generally low rates of return on capital, have made Japan a much less significant source of dynamism for the region and the world than it was for the couple of decades up to 1990. In truth, though, the global economy has become used to this. How is it that the Asian story has been so different to that of the North Atlantic? The first important factor was that Asia did not have a banking crisis. In fact, most countries in the world didn’t have one. The extraordinary events of September and October 2008 put immense pressure on markets, and banks everywhere inevitably felt the effect of that. But most banks in Asia and Latin America over the past few years have generally not seen unusually bad losses on loans, nor had they been very much involved in the holdings of securities that did such damage to some of the world’s largest banks. Similarly, the majority of governments have not ended up needing to re-capitalise banks in these regions. The second factor was that various countries in the Asian region had ample scope for fiscal stimulus, and were prepared to use it. The Chinese stimulus measures were just about the largest anywhere. The manner in which these were implemented may have led, in the view of some people, to other problems. But there is little doubt such measures were effective in boosting demand at the critical moment. The fact that there was scope to use fiscal policy this way reflects a long period of impressive fiscal discipline among most countries in the region. This is reinforced by Asian habits of thrift among the population and the generally better growth dynamics for these countries, which of course makes fiscal management inherently easier. There is another factor at work too, whose implications have been powerful but increasingly are being seen as not quite so benign. That is that monetary policy in Asia has been quite accommodative. Compared with the North Atlantic countries, this monetary accommodation has been much more effective as a stimulus, again because of the better state of banks through which much of its effect is transmitted. The issue more recently has been that accommodative conditions have started to look out of place given the robust growth in output, rising asset values and increasing goods and services price inflation. A number of countries, including key ones such as India and China, have been responding to this with tightening. Some of the Latin American countries have done likewise. The matter is complicated for those countries by the very low interest rates in the major countries – implemented, understandably, for their own domestic reasons – and concerns BIS central bankers’ speeches over the extent of capital inflow and potential exchange rate appreciation. This is one of the key issues for the year ahead. Shifts in the global economy These are all important manifestations of the fact that different regions are at different points in their recoveries from the crisis. It isn’t, however, only a cyclical matter. This contrast between the economic performances of the key emerging countries and those of the older industrial economies in the past few years is seeing a marked acceleration in the shift in the world economy’s centre of gravity towards the east (or west, if viewing from North America). Since the beginning of 2008, Asia (excluding Japan) has accounted for about 70 per cent of the growth in global GDP (measured on a purchasing power parity basis). It has also accounted for about 70 per cent of the growth in global demand over that period. This compares with a figure of about 30 per cent over the period 2000–2007. It has often been said that more domestic demand is needed in Asia to help “rebalance” the global economy. There may have been a structural sense in which Asian saving rates were “too high” and saving in some other countries too low. But it is not at all clear that more demand growth in Asia is desirable at present. After all, global GDP growth has been strong, and prices for most commodities have been rising. Just at the moment, from a global perspective, what we need is not so much faster domestic demand growth in Asia, but a way of supplying more of Asia’s demand for goods and services from the parts of the world where excess supply remains – mainly the North Atlantic countries. Of course exchange rates are relevant here. Moreover, there is a secular increase in living standards occurring in Asia and changes in consumption patterns are accompanying that. Energy intensity is rising quickly with income. The steel intensity of production is already high in China but, with China seeking strong overall growth for many years yet, steel consumption could well continue to increase at a rapid pace. In India, steel intensity has a long way to rise yet. In many developing countries, higher living standards are also prompting changes to diets. The already clear trend towards higher protein consumption in emerging countries such as China potentially has major implications for demand (and prices) for livestock and grain feed globally. So it is not really surprising that rapid economic growth in Asia is placing upward pressure on prices for foodstuffs, energy and minerals. There may be speculative demand adding to these pressures at the margin. But speculators can’t hold up prices over the long run. These big changes, which appear to be rather long-running, surely are mainly a result of powerful, and rather durable, fundamental forces. What is new is that this pressure on prices is not coming from the advanced world (except perhaps in the case of demand for grain to be converted into ethanol). It is not the story that would have been told, until only a few years ago, of the industrial cycle of the OECD countries picking up and adding to demand for resources and energy. The action is, for the most part, occurring outside that group. Prices are under upward pressure because of rising demand,1 but it is the demand coming from a couple of billion people in Asia seeking, and in many cases rapidly converging on, the way of life that the advanced countries have enjoyed for decades. These price rises, not to mention those occurring most recently as a result of pressure on oil supplies, are quite unhelpful for the advanced countries, particularly those whose recoveries have been hesitant to date. They will also be unwelcome for very poor countries whose populations spend much of their meagre incomes on food. For practical purposes they Food prices, as well as oil, are also being affected by supply disturbances at present. BIS central bankers’ speeches amount to a supply shock for the advanced countries – someone else’s demand has pushed up the price at which markets are prepared to supply energy, agricultural and resource commodities. That will make it harder to engender a strong recovery in the advanced countries. Moreover, were demand in the advanced countries to grow faster, as is presumably the intent of current economic policies in those countries, the price pressures will grow more intense, unless substantial new capacity comes on stream and/or growth in the emerging world moderates somewhat. As it happens, new capacity is being planned in many resource commodities. In Australia, where iron ore shipments are running a little over a million tonnes a day, projected capacity expansion will likely take that to about 2 million tonnes within four or five years. Significant capacity expansion is also planned in other areas. These and similar expansions in other countries will presumably help to contain pressure on prices for many resources over time. In the case of foodstuffs, much of the growth in supply over the medium term will need to come from productivity gains or greater farming intensity. The experts seem to think that such productivity gains are possible but not given. In fact the rates of productivity growth will need to be higher than those actually observed in recent years to generate sufficient output.2 One thing is for certain: the rise of Asia is changing the shape of the world economy and the set of relative prices that goes with it. It seems to be doing so more quickly than was generally assumed. Australia Australia sits in an interesting position here. Like our Asian neighbours we were affected by the events of late 2008. But the downturn was fairly brief. We were in a position to apply a liberal dose of stimulus to the economy, which was done in a timely fashion. The banks remained in good shape. Hence recovery began in the first half of 2009. A strong Asian recovery has also helped Australia. As in other developed countries, our consumers feel the effects of higher commodity prices as a reduction in real income. But since Australia is also a producer, the big rise in demand for energy, resources and food is expansionary for the economy. In fact, with our terms of trade at by far their highest level, on a five-year average basis, in more than a century, these events are very expansionary indeed. A very large increase in investment in the resources sector is under way and has a good deal further to run yet. Just recently, we have been experiencing growth close to trend, relatively low unemployment – about 5 per cent – and moderate inflation, about 2¼ per cent in underlying terms. In comparison with the experience of the past generation, that is a pretty good combination. Looking ahead, our job is to try to manage the terms of trade and investment booms. Historically, Australia has often not managed periods of prosperity conferred on us by global trends terribly well. On this occasion, we have to do better. We have to take the opportunity to capitalise effectively on some very powerful trends in the global economy to which we are, almost uniquely, positively exposed. A few things are working in our favour. One is that the exchange rate is playing a role of helping the economy to adjust to the change in the terms of trade in a way that it was prevented from doing on numerous previous occasions. Another is that, at least so far, households are behaving with a degree of caution, insofar as spending and borrowing are See, for example, the UN Food and Agriculture Organization (FAO) discussion paper “How to Feed the World in 2050”, which was prepared for a high-level expert forum of the same name held in Rome on 12–13 October 2009. The document, and other background information, is available at: <http://www.fao.org/wsfs/forum2050/wsfs-background-documents/issues-briefs/en/>. BIS central bankers’ speeches concerned, that we have not seen for a long time. Having taken on quite a degree of debt over the preceding 15 years or so, households have thought better of taking on too much more. They are saving more than at any time for 20 years or more. So are households in many other countries, of course, but our good fortune is to be making that adjustment against a backdrop of rising income. We are now engaged in a national discussion about how to stretch the benefits of the resources boom over a long period, and how to manage the risks that it will bring. These are complex matters that involve a wide range of policy areas – macroeconomic, microeconomic, taxation, industrial and so on. But if that discussion can be conducted in a mature fashion, and followed up with sensible policies, then we have a good chance of leaving to the next generation a wealthier, more secure and more stable Australian economy. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 3 |
Speech by Mr Guy Debelle, Assistant Governor of the Reserve Bank of Australia, at the KangaNews Australian DCM Summit, Sydney, 15 March 2011. | Guy Debelle: The Australian bond market in 2011 and beyond Speech by Mr Guy Debelle, Assistant Governor of the Reserve Bank of Australia, at the KangaNews Australian DCM Summit, Sydney, 15 March 2011. * * * Today I will discuss the current structure of the Australian bond market and talk about some trends that might influence its evolution in the coming years. I will focus on the bank debt and Kangaroo markets, given the theme of this conference. I will also address some of the issues surrounding the implementation of the forthcoming Basel liquidity standard. Overview To set the scene, relative to the size of the Australian economy, the Australian bond market is around the average for developed economies (Table 1). However, unlike in many countries around the world today, the private debt market is significantly larger than the public market. This reflects the prudent fiscal policy pursued by both sides of politics, at the federal and state level, over an extended period of time (Graph 1). BIS central bankers’ speeches Graph 1 Structure of the Australian non-government debt market The non-government debt market in Australia consists of four categories of issuers: financial institutions, other corporate issuers, asset-backed issuers and non-resident Kangaroo issuers. As can be seen in Graph 2, while all four segments of the market have grown over time, the development of the market has not been uniform: Financial institutions have for some time had the largest share of issuance; asset-backed issuance grew rapidly during the early 2000s, but its growth was severely affected by the financial crisis; corporate issuance has grown steadily over the past two decades; more recently, strong demand for Australian-dollar assets has seen rapid issuance of Australian-dollar debt by non-residents. I’d like to touch briefly on the main drivers of developments in each of these markets and talk about some of the potential factors affecting future issuance. BIS central bankers’ speeches Graph 2 Financials Over much of the past two decades, demand for credit outpaced the growth in deposits, so that banks accessed wholesale funding markets to support growth in lending. This outcome reflected a number of factors. Australia’s relatively high level of investment, and the sustained growth momentum of the economy over the past two decades, underpinned the demand for credit. While the source of the demand for credit shifted between household and business sectors, from the early 1990s recovery until the financial crisis, aggregate credit growth was sustained at a rate of over 10 per cent per annum. At the same time, on the supply side, the importance of superannuation in Australia has, for much of the past few decades, constrained the growth in household deposits. Superannuation funds have historically tended to invest in wholesale bank paper rather than hold bank deposits. So, compared with other countries, more of the savings of the Australian household sector has tended to end up in wholesale bank paper rather than in deposits, with the superannuation sector as the intermediary.1 More recently, however, the demand for credit from households and businesses has slowed in tandem. For businesses, the reduced appetite for debt was initially due to a desire to strengthen balance sheets. More recently, strong profitability, most obviously in the mining sector, is ensuring many segments of the business sector have sufficient internal funding to meet their investment needs. As has been discussed in much recent RBA commentary,2 for households the slowing in demand for credit appears to be driven by a more cautious approach to debt. There are a number of factors contributing to this. One is that the increase in household leverage that occurred through the 1990s and first half of the 2000s in response to the downward shift in the nominal structure of interest rates has run its natural course. The slower growth in R Battellino (2010), “Financial Developments”, Address to the Property Council of Australia, Brisbane, 8 October. For more details see P Lowe (2011), “Some Current Issues in the Australian Economy”, Address to the Committee for Economic Development in Australia (CEDA), Sydney, 17 February and, G Stevens (2011), “Opening Statement to House of Representatives Standing Committee on Economics”, Canberra, 11 February. BIS central bankers’ speeches household wealth, and particularly the large negative shock to equity wealth at the height of the crisis, has also contributed to the cautiousness, even though equity wealth has recovered and household income growth has remained robust. This growing caution of households in the past few years has seen the household saving rate pick up substantially, and much of this saving has been in the form of deposits, given the attractive yields on offer. The strong cash position of many businesses is also contributing to stronger deposit growth. As a result of these factors, deposit growth has outpaced credit growth for the past two years (Graph 3). Graph 3 So banks have experienced a slowdown in asset growth and have funded the assets with a greater share of deposits. A consequence of this is that wholesale debt issuance by financial institutions has declined to its slowest pace since the mid 1990s. The most pronounced slowing has been in the issuance of short-term debt as banks have sought to lengthen the average maturity of their funding by increasing the share of long-term debt in total funding (Graph 4). BIS central bankers’ speeches Graph 4 There are reasonable grounds to expect these trends may be sustained for some period to come. In particular, if one thinks about the composition of growth in Australia in the period ahead, it is likely to be investment-intensive. But much of that investment is likely to be funded by companies which are cash-rich or tap global capital markets directly. This means that the growth in the economy in the period ahead may be associated with less growth in business credit than has been the case in the past. It is also likely to boost deposit growth. So banks may be seeing a prolonged period of faster deposit growth but slower asset growth. Asset-backed securities During the period of expansion in household balance sheets, an increasingly significant source of funding for financial institutions was the asset-backed securities market. The best example of this was residential mortgage-backed securities (RMBS) which grew rapidly as a share of the mortgage market. But as you all know, structured credit products were a major casualty of the financial crisis, even in Australia where they continued to perform very well. As a result, their share of the market has declined sharply over the past three years (Graph 5). BIS central bankers’ speeches Graph 5 I have spoken at length recently about the specific dynamics and challenges facing the Australian securitisation market,3 so will simply reiterate some of the key points here: Australian mortgage-backed securities have performed well throughout the crisis with no investor losing any money in a rated tranche; the fundamental quality of local collateral suggests that securitisation ought to be a viable funding mechanism in Australia; but securitisation will not return to the levels seen in the heady pre-crisis period, given some of the purchasers of the paper pre-crisis are no longer around. The recent issue by one of the major banks demonstrated demand is improving for the product, at a price which was inside the recent AOFM supported deals. The Government recently announced that it will permit the issuance of covered bonds. It will be interesting to see where this product will fit with the existing RMBS. There may be different preferences between the local buyers, who are more familiar with RMBS, and offshore buyers, most obviously in Europe, who are more familiar with covered issuance. Corporate issuers In many respects, the corporate segment has been the quiet achiever of the Australian debt market over the past few decades. The stock of bonds on issue from Australian entities grew solidly from the mid 1990s until the financial crisis. Although the significance of market-based funding as a share of total debt funding for Australian corporates has fluctuated somewhat, over the long run, debt market funding has grown in line with the funding needs of the corporate sector (Graph 6). As I just noted, the investment-intensive composition of growth over the next few years is likely to see continued strong corporate issuance by Australian names, particularly resources companies. For more details see Debelle (2010), “The State of Play in the Securitisation Market”, Address to the Australian Securitisation Conference 2010, Sydney, 30 November. BIS central bankers’ speeches Graph 6 Non-resident issuers – Kangaroos and Australian dollar eurobonds The fastest growing segment of the Australian capital market over much of the past decade, and certainly in recent months, has been Australian-dollar issuance by non-residents – the market of most interest to the audience here today. Initially, much of this issuance was offshore in the Eurobond market, but increasingly issuance has moved to the onshore “Kangaroo” market (Graph 7). Graph 7 In addition to the shift in the location of market activity, an important compositional shift is occurring with new issuance increasingly dominated by AAA-rated names (Graph 8). This probably reflects the increased risk aversion of investors in the post-crisis environment. BIS central bankers’ speeches Graph 8 Growth in the AAA-segment of the market has been underpinned by rapid growth in issuance among the supranational and sovereign agencies (SSA) group. SSA issuance in all currencies has grown rapidly in recent years, as these borrowers have responded to the large fiscal demands stemming from the impact of the global recession on public budgets in a range of jurisdictions. In addition, SSA issuers have displayed a growing tendency to issue in Australian dollars over recent years. Last year, Australian dollar issuance accounted for more than 8 per cent of SSA issuance in all currencies (Graph 9). Graph 9 This greater tendency to issue in Australian dollars has been driven by both demand and cost considerations for issuers. On the demand side, it is clear (although hard data are not available) that global demand for high-yielding Australian-dollar assets has been growing in recent years. An emergent group of international investors, along with the domestic investor base, are interested in purchasing high-quality Australian-dollar assets, and, given the relative scarcity of Australian government paper this has created a natural opportunity for the SSA issuers. BIS central bankers’ speeches Moreover, there has tended to be a cost advantage to issuing in Australian dollars, owing in part to the elevated cross-currency basis swap that has encouraged issuance by supras and agencies in Australian dollars. Equally as important as the cost of hedging is the large amount of foreign issuance by Australian entities that ensures access to a deep swap market for SSAs funding in Australian dollars. APRA liquidity announcement I would like to finish with a few remarks on the recent APRA announcement on eligible assets for the forthcoming Basel liquidity standards.4 The APRA announcement stated that CGS and semis are the only assets that currently qualify as Level 1 assets and that there are currently no Level 2 assets on issue. This outcome reflected an assessment of the liquidity characteristics of the various asset classes. As outlined in the Basel documents, key considerations in determining which assets qualify are assessments of the depth of local trading activity and the performance of assets in stressed market conditions. Specifically, the observed performance of assets during the crisis – a period indicative of a situation in which banks would need to rely on the liquidity in these instruments – was taken as evidence of proven liquidity. The statement did not rule out other assets qualifying as liquid assets at a later date, but there will need to be some history to support an assessment that a particular market has genuine liquidity. As is widely understood, in Australia, the amount of CGS and semis on issue falls well short of the amount of liquid assets banks will need to hold to meet the liquidity standard. Moreover, it would be counterproductive to require banks to hold such a large share of these assets that it would impair the liquidity in these markets. Hence, as announced in December,5 the RBA will offer the banks a committed liquidity facility to meet the shortfall. The eligible assets that banks will need to hold to access this facility are those which are currently eligible for repo with the RBA in its normal operations. While a fee will be charged for this facility, I don’t see that affecting the relative demand for securities, other than CGS and semis, for the following reason. One can think of the current situation as an arrangement where a flat rate of zero is charged. Banks currently hold a range of assets to satisfy their liquidity requirements, with each asset having different credit, maturity and market liquidity characteristics. Our view of how much we are willing to lend against each asset under repo are based on these characteristics, and will continue to be so. In the future, we are moving to a world where there will be a formalised liquidity facility where a flat, positive fee is charged. So that should affect all asset classes equally and should not affect their relative attractiveness. So I would not expect this to change bank balance sheet’s demand for the non-government assets they hold in their liquidity portfolios. For example, to the extent they hold SSAs today, they should still hold them in the future. For more details on the APRA media release, see APRA clarifies implementation of global liquidity standards in Australia, 28 February 2011. For more details on the joint RBA and APRA media release, see Joint Media Release: Australian Implementation of Global Liquidity Standards, 17 December 2010. BIS central bankers’ speeches Conclusions In my talk I have described the configuration of the bond market as it stands in early 2011. The structure of the market has changed noticeably after the events of recent years. Some of the dynamics that have emerged from the crisis may continue to shape the bond market in the future. I have highlighted three here today: First, the relative growth of deposits and credit may be quite different from that observed over the previous fifteen years. This, together with regulatory and other pressures, will have a material effect on the composition of bank liabilities. Second, while asset-backed issuance was most disrupted by the crisis, there are signs of a re-emergence. Third, investors have a much stronger preference for high-quality assets than they did in the pre-crisis period. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 3 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Basel III Conference 2011, Sydney, 24 March 2011. | Malcolm Edey: Basel III and beyond Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Basel III Conference 2011, Sydney, 24 March 2011. * * * Thanks very much for the opportunity to speak to you today. At the end of last year, as you know, the Basel Committee on Banking Supervision released its new set of prudential standards known collectively as Basel III. It was a major re-think of the existing minimum standards for international banking. Unlike its two forerunners, this was an agreement in which Australia participated.1 One of the early responses of the international regulatory bodies to the financial crisis was to make their membership structures more representative. In the case of the Basel Committee, the membership was widened in mid 2009 to encompass 27 jurisdictions, a major expansion from the original G10 membership. Australia is represented on the Committee by the Reserve Bank and APRA. I’ve been asked to speak today about what might lie beyond Basel III. It’s a good question because it recognises that there’s more to financial regulation than just the Basel accord. I’ll try to address some of that in a moment, but before I do it’s worth recapping why we have a Basel process, why we specifically have a Basel III accord, and what it is intended to achieve. The origins of the Basel Committee go back to 1974, when regulators from the G10 countries began meeting at the offices of the BIS to share information about their approaches to bank supervision. The original Basel capital accord (what we now call Basel I) was reached in 1988, and it was a relatively simple affair. The main document was a mere 13 pages long2, compared to the many hundreds of pages that later comprised the second and third Basel packages. The centrepiece of Basel I was the minimum capital standard, set at 8 per cent of risk-weighted assets and calculated on a common basis. One preliminary question we could ask is: why was there a need for that kind of agreement, rather than just having a series of national approaches? Obviously the Australian regulators weren’t parties to formulating Basel I, but I think we can see it as having two interrelated rationales. First, financial stability can be thought of as an international public good. All countries benefit from the stability of the world financial system as a whole, they all experience some cost when the system is unstable, and so they all have an interest in promoting sound minimum standards. That’s one important rationale for a coordinated approach. Secondly, there is the rationale of avoiding a competitive lowering of standards. If we think of this in a domestic context, the principle is well understood. In the long run, we might expect market discipline to ensure that banks maintain high standards of balance-sheet quality and risk control. But in the short run, we know that if a bank tries to expand quickly by lowering its standards, it can be highly destabilising for the system. A bank that tries to do that will either gain market share at the expense of more prudently run banks, or else force the other banks to follow suit, thereby lowering standards for all. To some extent, what is true of individual banks can also be true of jurisdictions. And so the Committee took the view that there was a collective interest in agreeing to a set of minimum standards to be applied by all its members. That is, Australia participated officially as a member of the committee. There were an additional 12 pages of annexes. BIS central bankers’ speeches As I said, Basel I was a relatively simple affair. Basel II, which was announced in 2004 and became effective in 2008, was a much more complex and nuanced agreement. In essence, it was intended to broaden the scope of risk coverage, and to bring in some flexibility to accommodate differences in banks’ business models and in the sophistication of their risk management. Among other things, Basel II: introduced the three-pillar structure into the prudential framework, those pillars being the minimum capital standard, supervisory oversight, and disclosure. So the framework was expanded beyond a simple reliance on the minimum capital ratio; it introduced a framework of capital requirements to cover operational and other risks. In that way it recognised that credit quality wasn’t the only source of risk that needed to be backed by capital; and it allowed flexibility for sophisticated banks to determine some of their capital requirements using model-based inputs rather than fixed weights. That said, the central principle of having a minimum capital standard for all internationally active banks remained at the core. When we talk about the Basel standards, it’s important to keep in mind that these standards were always conceived of as being only a minimum. Individual jurisdictions have always been free to exceed them, and it’s to be expected that a good national regulator would tailor the standards to local conditions and supplement them with effective supervision. In Australia’s case, I think we have been well served by our prudential regulator APRA taking a more conservative and hard-headed approach than required by the international minimum. Clearly, the Basel I and Basel II standards didn’t prevent the GFC, and neither did the existing web of nationally-based regulations in the major economies. So what went wrong? This isn’t the occasion to give a detailed account of what caused the financial crisis. But regulators around the world drew a number of important lessons from it: banking systems needed more capital, and better quality capital, to withstand losses; they needed to be made more robust to liquidity risk; loan underwriting standards needed to be improved; governance arrangements for banks and financial regulators needed to be improved;3 various forms of conflict of interest needed to be eliminated or better managed. Examples of that included the originate-and-distribute lending model that went seriously off-track in some countries, and the role of rating agencies in advising on structured securities. It also included badly structured remuneration practices in the industry; and there needed to be more scope for regulatory regimes to act against the build-up of financial excess. Not all of these are matters for the Basel Committee. There are a number of different international bodies working on these things in their different spheres of influence, including the G-20, the Financial Stability Board and the international insurance and securities I am referring specifically here to the regulatory systems in the United States and Europe, where there was perceived to be a need for greater coordination among regulatory agencies. BIS central bankers’ speeches regulators. But since this is a conference about Basel III, I’ll focus mainly on the work of the Basel Committee. Basel III is about applying the lessons learned from the crisis to the way we regulate banks. Its core is a revised set of standards for capital and liquidity. On capital, the key elements are: more and better-quality capital required to meet the basic minimum; a capital conservation buffer that sets rules for managing capital above the minimum; a time-varying countercyclical buffer, aimed at mitigating the effects of the credit cycle; and an unweighted capital ratio (or “leverage ratio”) to act as a backstop to all of that. For the liquidity standard, there are two main elements: a liquidity coverage ratio, which requires banks to hold enough liquid assets to meet a 30-day stress scenario; and a net stable funding ratio, which requires banks’ long-term assets to be matched by stable sources of funding. These were the main elements of the package announced in December last year. Earlier speakers today will have talked about these things in some detail, and I don’t want to repeat that. Instead I’m going to use the remainder of my time to focus on some areas where work still needs to be done. The first point to make here is that there is a lot of work coming from the international regulatory bodies that’s still to be completed. By that, I mean work that groups like the Basel Committee have started but not yet finished, and also areas where the Australian regulators have work to do in determining our response to the new international standards. Let me go through a few of them. The liquidity standard It’s well understood now that the liquidity coverage ratio, in the form originally proposed in the Basel process, couldn’t have been applied in Australia. Australian governments simply don’t have enough debt outstanding for banks to hold to meet the standard in that form. Incidentally, this is a problem that other countries would love to have. The Australian government’s gross debt to GDP ratio is not much more than 10 per cent, compared with numbers of the order of 80 to 100 per cent projected in the next few years in the United States and the major European economies. There are some other countries in a similar position to ours, but not many. To accommodate cases like these, the Basel standard allows, among other options, an alternative treatment whereby banks can count a committed facility with their central bank towards meeting the requirement. I think this is now widely understood and accepted as a sensible solution for the Australian case. But there are still a number of details yet to be worked out. APRA has indicated that it will require banks to make all reasonable use of their own ability to maximise liquidity before relying on the RBA facility. And they’ve indicated that they will be consulting with banks as to how compliance with that principle will be monitored. The terms of the RBA liquidity commitments haven’t yet been determined. That includes the fee. What we have made clear is that, to meet the objectives of the international standard, the fee will need to be market based, and it will be designed to leave banks with broadly the same incentives as exist in other jurisdictions where the alternative treatment is not needed. BIS central bankers’ speeches Since the international LCR requirement doesn’t come into effect until 2015, there’s plenty of time to work through these details and to undertake appropriate consultation. There is even more time for that in the case of the stable funding ratio, where implementation isn’t scheduled until 2018 and the details of the proposed Basel standard are less well developed. So these are both areas where further work will be ongoing. The counter-cyclical capital buffer The Basel III package provides for an additional layer of capital to be set by national regulators based on the state of the credit cycle. The intention is that regulators would adjust the buffer so as to have a countercyclical influence, raising it in good times, and then releasing it to support lending when credit is tight. To avoid regulatory arbitrage, the standard includes a system of mutual recognition, which would have the effect of ensuring that the capital charge is based on the location where the lending occurs, rather than the home jurisdiction of the lender. The buffer proposal also specifies a standard quantitative indicator to assist in deciding when to activate it. Glossing over the technical detail, this would be based on the ratio of aggregate credit to GDP. When that ratio is sufficiently above trend, it would be a signal to raise the buffer, and when it’s below trend, to lower it. In that way, it would allow surplus capital to be released to the system when most needed. I know there has been some scepticism about this kind of rule-based approach, and it’s important to recognise that the Committee’s proposal leaves a lot of scope for flexibility and discretion at the national level. In my view, that’s going to be very much needed. Having worked in the monetary policy area for many years, the indicator approach proposed here reminds me of an analytical device known as the Taylor rule. The economist John Taylor, some years ago, made the observation that a well-designed monetary policy would respond systematically to deviations of inflation and output from their normal values. It’s a relationship that can easily be verified in the data. Taylor’s work sparked an army of researchers to try to estimate “optimal” Taylor rules for setting the policy interest rate. It’s all useful analytical work, but it’s not a field that is open to definitive conclusions because the world is simply too complex to be summarised in that way. No-one would think of reducing the actual decision-making process to a mathematical formula, least of all one devised by an international committee. If that’s true for monetary policy, then it’s much more true for financial stability policy, where the complexities are even greater. There’s nothing in financial stability policy, for example, that corresponds to the core monetary policy objective of a numerical inflation target, or the single instrument of a policy interest rate: financial stability policy has a wide range of instruments at its disposal, and there’s no single summary indicator of aggregate financial risk. So I think we’ll need to avoid too much focus in this area on the simple formula. Having said that, I’m not against the idea of the prudential regulator varying the capital requirement in response to changing circumstances4, presumably with some co-ordination with the central bank. But I suggest this is an area where it will take some time for national policy approaches to develop, and it’s one where too much effort at international standardisation isn’t going to be helpful. In fact, the Basel II principles under Pillar II already allow scope for this to occur. BIS central bankers’ speeches Systemically important banks Another area of ongoing international work is on systemically important financial institutions, known by the acronym SIFIs. This gets at the question of how to regulate institutions that are too big to fail – or, as some would prefer to call it, too important to fail, or too interconnected to fail. The focus on this question really arose from the experience of the United States, the UK and some other European countries during the crisis, when significant public funds were committed to rescuing failing institutions. Understandably, those countries would like to reduce the risk of that happening again. One obvious line of approach is that, if an institution is considered too important to fail, then it should be made safer and, therefore, less likely to fail. On that front, it is proposed that institutions judged to be systemically important should be subject to an additional layer of required capital. Work on this is currently being done in both the Basel Committee and the FSB. Another line of attack (and this isn’t mutually exclusive with the first one) is to reduce the prospective impact of failure if it does occur. This leads into proposals for banks to come up with business resolution plans, or so-called “living wills”, which are supposed to ensure the orderly continuity of core functions if a bank fails. It’s very important, of course, that there should be good preparation for stress events, and I know a number of regulators are now pursuing this with their banks. How far it’s possible to push this idea of living wills remains to be seen, but I wouldn’t see it as a panacea. And given the differences in national circumstances, I think this is another area where too much effort at international standardisation isn’t going to be helpful. When we talk about having an international approach to regulating systemically important institutions, there’s an interesting question as to how that group of institutions should be defined. I am firmly of the view that they should be defined by their global importance, not their relative importance within their own national systems. The purpose of a global SIFI policy (to use a cumbersome expression) is to limit international spillovers, where the failure of a major bank can affect the system as a whole because of its global scale. Individual countries can and do have their own SIFI policies for institutions that are large in domestic terms. APRA for example has a well-articulated framework for calibrating its standards and its intensity of supervision according to the circumstances of each institution.5 But in my view the international efforts on SIFI regulation need to focus firmly on systemic importance at the world level, and that means focusing on the small number of very large players that can have a global impact if they fail. Is there too much internationalisation? So far, I’ve spoken about things that are already reasonably well advanced on the international regulatory agenda. One big question that I think hasn’t got the attention it deserves is: Is there too much internationalisation in the banking industry? When we talk about banks being too interconnected to fail, an important dimension of that is international interconnectedness. It’s reasonable to ask the question: if banks are too interconnected in that sense, should they be made less interconnected? One way that that might be done is through greater use of subsidiary structures by banks that operate across borders. I don’t want to overstate the case for this because I recognise it’s a complex issue. But I can think of a number of advantages for that kind of model from the point of view of financial See Probability and Impact Rating System (APRA November 2010) and Supervisory Oversight and Response System (APRA November 2010). BIS central bankers’ speeches stability. In particular, all of the key policy tools for managing financial distress are located at the domestic level.6 Liquidity provision to banks is a currency-specific tool, and is the preserve of the national central bank that issues the currency. Bankruptcy laws, resolution powers, bank regulatory regimes, and the fiscal powers that might be needed in a crisis all operate at the domestic level. The effect of subsidiarisation, at least in principle, would be to ring-fence the national operations of cross-border banks within separate legal entities in the countries where they operate. There’s a good argument that that kind of structure would simplify the management of financial stress events. It might also reduce concerns about cross-border arbitrage of differences in capital regulation. I am aware that there are also arguments on the other side. In some instances, ring-fencing might not be a realistic option, or host countries might prefer foreign banks to enter as branches in order to benefit from the full support of the parent. Some would argue that concerns about cross-border resolution could be better addressed in other ways. Another point is that the subsidiary structure is likely to be more expensive to operate. But I’m not sure we should view that on its own as a decisive argument against it. A lot of the post-crisis regulatory changes will add to the cost of financial intermediation, but they are being done anyway to reduce systemic risk. The point is that the costs and benefits need to be carefully weighed. So there are arguments on both sides. I’m not today seeking to present a firm view, but I think it’s an area that hasn’t been sufficiently debated, and so I simply raise it as one that deserves further attention.7 Supervision and lending standards I started out by saying that there’s more to financial regulation than just the Basel Committee. There’s also more to financial stability than just having good regulations. The best possible set of regulations won’t, on its own, stop the next crisis, for the simple reason that every crisis is different, people innovate around regulations, and you can’t regulate against foolish behaviour. I don’t want that to be interpreted as a counsel of despair. Good regulation obviously makes a difference, and the effort to improve our regulatory regimes, and keep them up to date, has to be made. But we also need other things that are hard to convert into rules (and I’m talking about the international scene here): we need bankers and investors who don’t take silly risks, supervisors who are prepared to ask tough questions and step in when they see excess, and good-quality implementation of the rules that we already have. I think, by the way, that Australia has been well served by its prudential regulator on this front. But it would be a shame if, in the international debate, those basics got lost in all the focus on re-writing the rules.8 This leaves aside the special case of Europe, where the supranational entity operates in some respects as a single jurisdiction. For a more detailed discussion, see Fiechter et al: Subsidiaries or Branches: Does One Size Fit All? IMF Staff Discussion Note 11/04, 7 March 2011. International regulatory bodies are clearly aware of the issue. See for example Intensity and Effectiveness of SIFI Supervision (FSB 2 November 2010). BIS central bankers’ speeches End-piece I want to conclude, if I may, by saying a few words about the current situation. As you know, the Reserve Bank released its half-yearly Financial Stability Review earlier today. As usual, we’ve given an account of the various uncertainties that exist around the global financial system. The tragic events in Japan are a new element in that picture, as is the instability in North Africa and the Middle East. It’s going to take some time before the implications of all that can be assessed. But, acknowledging the uncertainties, the world financial system over the past half year has generally been improving. Australian banks are in good shape, and they came through the crisis profitable and well capitalised. They have strengthened their liquidity positions and their use of deposit funding. Australian businesses have reduced their gearing. Households have raised their saving rates. When we think about what the post-crisis environment might look like, it seems unlikely that we’ll be going back to the days of consistent double-digit growth in credit that we saw in the pre-crisis years. That growth was driven in part by factors that can’t be repeated – the deregulation of the financial system in the 1980s, and the transition to low inflation in the 1990s. In the post-crisis environment, borrowers and investors are more cautious than they were, both at home and abroad. That’s likely to mean less demand for leverage and less growth in private balance sheets, even when the economy itself is growing strongly. If those trends continue, I think it will be good for financial stability, but it will also mean that our lending institutions have to get used to lower rates of expansion than were typical in the pre-crisis years. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 3 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Cards and Payments Australasia 2011, Sydney, 29 March 2011. | Malcolm Edey: The Reserve Bank’s strategic review of payments innovation Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Cards and Payments Australasia 2011, Sydney, 29 March 2011. * * * I thank Darren Flood for his assistance in preparing this speech. Thanks very much for the opportunity to speak here today. This is a conference that is all about innovation in the payments system. I know that the businesses represented here would all have their own approaches to innovation, and some of those will have been on display in the various presentations. But we also have a common interest in ensuring that the system as a whole can develop as efficiently and cost effectively as possible. I’ve been asked to talk today about the Reserve Bank’s role in that. As you know, the RBA launched a strategic review of payments innovation in July last year. In talking about the review, the first thing I want to stress is that we see this as very much a co-operative project. When we announced the review, the first thing we did was to call for an initial round of consultations, both with industry and with any other interested parties that wanted to contribute. We’ve had a good response to that. We have had discussions (sometimes multiple discussions) with most of the main market players; we have talked to people working in particular fields of payments innovation; and we have had some discussions with end-users of the payments system. Based on what we learn from that, we’ll be putting together a more detailed document for release around mid year, which will then be the basis for a more formal round of consultation in the second half of the year. We hope to have a final report ready by around year-end. I start with that description of the process because I want to emphasise that this is very much something that we’re doing with the involvement of the interested parties. It’s not just a topdown exercise. The process still has some way to go, and I’m not going to pre-empt any conclusions today. But I want to use my time to report on what we’ve found so far, how we’re approaching the task, and the issues we’re likely to be focusing on from here.1 Economic case for co-ordination in the industry The first question that might be asked is: why do we need a strategic review in this area, and why now? I have to say that there’s no particular trigger for having it now, but we do believe it’s a good general principle that these matters should be kept under periodic review. The RBA, through its Payments System Board, has a mandate to promote payments system efficiency. A good deal of our work in that area has focused on the efficiency of price signals. The Bank has taken the view that, where price signals are distorted for some reason, there is a case for using its regulatory powers to correct them. To clarify the scope of the exercise, this review is about low-value payments (in other words, retail and relatively small business-to-business payments). It's not about the high-value wholesale payments system, which is subject to its own regular assessment process. BIS central bankers’ speeches But efficiency also covers operational aspects of the system, including things like the cost, speed and reliability of payment services and, the subject of today’s talk, its capacity to innovate. When we think about innovation in a network setting like this one, it’s useful to distinguish between two types: proprietary innovations, where the benefits are localised to the business that’s doing the innovating (and to the customers of that business); and system-wide innovations, where the benefit accrues to users of the system as a whole. It’s reasonable to expect that service providers will do a good job with the first kind of innovation. In fact we see examples of that kind of development all the time. For example, we are currently seeing financial institutions exploring new ways to use mobile devices for payment purposes, including for making person-to-person payments using the existing infrastructure. Similarly a major bank is promoting the ability of its systems to update customer account information in real time. But it’s in the second type of innovation that there is the more serious potential for inefficiency, or for under-investment. That might happen through a lack of co-ordination among industry participants, or through a lack of incentive for individual providers to participate in system-wide improvements. We’re not starting with the presumption that that’s the case – only that it could be. As a regulator, we recognise that our approach to these questions has to be quite different from the way we approach other cases for regulatory involvement. The RBA has significant powers, as you know, to designate payments systems and to set standards. But we’re well aware that you can’t regulate innovation into being. That’s not the intention. As far as possible we’ll be aiming to work with industry, looking at whether there are areas where more co-ordination is needed, and assisting with that where we usefully can. Objectives of an efficient payments system In taking on a project like this, it’s useful to start off with some idea of the characteristics we’re looking to promote in an efficient payments system. Here are some of the main ones: Timeliness Not all payments are time-critical, but users of the system should at least have options available that give recipients timely access to their funds and allow timely confirmation to both parties. Accessibility It’s desirable that everyone who needs to make and receive payments should have ready access to the payments system. Ease of use It goes without saying that systems that are easier to use are preferable to those that are more cumbersome. But this is not only an issue of convenience. Systems that require manual entry of account and transaction details are prone to errors that can be costly to correct and can discourage use. That is one reason why payment cards are so popular – because most of the need for manual entry is removed. The need to know a recipient’s account details is another challenge for many payment systems. One of our oldest payment methods – the cheque – deals with that by only requiring the recipient’s name, with the recipient doing the rest. The challenge for electronic payment systems is to replicate or improve upon that sort of convenience. BIS central bankers’ speeches Ease of integration with other processes Payments are rarely made in complete isolation. Typically they are made as part of a process that requires reconciliation and recording of information by the parties involved. It’s desirable that payment systems should be able to integrate efficiently with these processes. A key example here is the capacity of payment systems to carry additional reconciliation information with the payment. Safety and reliability End users of a payment system need to have confidence that the system will be available when needed and that payments will reach the intended recipient at the time promised. They also need to be confident that the system is secure, so that using it will not expose them to future losses as a result of information being fraudulently obtained. Some of these problems can be addressed by system participants guaranteeing payments, but good system design is a more fundamental solution. Low and transparent costs Some would say that this has been a preoccupation of the RBA over the past decade. If two systems perform exactly the same function, we should of course prefer the cheaper one. But the reality is more complicated than that. Each system typically has different attributes from every other system, and so end users need to make choices as to which one most costeffectively meets their needs. That means that costs need to be transparent, so that those choices can be well-informed. These, then, are some of the qualities that we might regard as desirable in an efficient payments system. You can probably think of a few more. But having given a list like that, we also need to recognise that there are trade-offs. Investment in innovation comes at a cost, borne initially by industry but ultimately by the customer. So in conducting the review, we’ll need to be talking with providers and users of payment services about both the costs and benefits they see in different approaches. Payments use study One important source of information about that from the end-user perspective will be the Reserve Bank’s latest Payments Use Study. This was a study of around 1,200 households conducted in October/November last year, updating an earlier study from 2007. Participants were asked to keep a diary of their payments over a one-week period and were also asked about their attitudes to newer payment methods not covered in the diary, like contactless or mobile payments.2 We expect to publish a detailed analysis of the findings later in the year, but I can give you a few preliminary results today that throw some useful light on the innovation review. Results from the diary data suggest two main conclusions on payment patterns. 1. First, the broad patterns of payments behaviour observed in the 2007 study still hold. a. Cash remains the most widely used payment instrument in Australia and the dominant instrument for low-value payments. The study was conducted by Roy Morgan Research on behalf of the RBA, and is largely a repeat of the payments diary study undertaken as part of the 2007/08 review of the card payments reforms. It asked around 1,200 study participants in late October and early November 2010 to carry a payments diary with them for a week and record details of all their payments and cash withdrawals. Details recorded included: the payment method used; the size of the transaction; the merchant category and the payment channel (for example, in person, internet, phone, or mail). BIS central bankers’ speeches 2. b. Cards are the dominant payment method for mid-value payments (between $50 and $500), with the use of credit cards growing relative to debit cards as the transaction value increases. c. BPAY and internet banking are used frequently for bill payments and highvalue transactions. Second, payment patterns have nonetheless evolved to some degree in the three years since the initial study. In particular: a. Use of cash has declined somewhat. This is especially noticeable in cash’s share of the value of what we would call traditional payment methods – down from around 40 per cent to 30 per cent of the value of those payments; b. Debit cards appear to have been substituted for cash, with scheme debit and EFTPOS transactions both gaining share. Those are the broad results on the pattern of actual payments made. A questionnaire conducted at the end of the diary study also gives some additional information as to how people think about different payment methods. Here are just a few samples. First, on the use of cheques: fewer than 40 per cent of consumers reported making a payment by cheque in the past year. Of those 40 per cent, this graph shows the main reason that they chose to use a cheque (Graph 1). Graph 1 The most common reason was that people felt that they had no alternative for the type of payment they were making. That is significant, given that one of the issues being considered both by the industry and the current review is the scope for phasing out cheque use. Next, in order to understand the attributes that people value for point of sale payments, we asked people what factors influence their choice of payment method at the checkout. Perhaps not surprisingly, the most important factor was what they happen to be carrying with them at the time. Beyond that, the main factor cited in determining how people pay is the speed of processing the transaction, followed by the ability to use their own funds and the ease of managing finances (Graph 2). The importance of speed is significant because it helps explain why people continue to use cash for small value transactions, and it also indicates that the current push towards contactless cards might be quite important for many consumers. BIS central bankers’ speeches Graph 2 Given the increasing importance of internet payments over recent years, we also spent some time exploring consumers’ use of, and attitudes towards, different types of online payments. First of all, we found what seems to be quite high adoption of online payments. Around 90 per cent of respondents had access to the internet, either at home or at work. Of those, about 80 per cent reported having made an online purchase and almost 60 per cent reported an online transfer of funds to a family member or friend. A surprisingly high 60 per cent of people with internet access said they pay most of their bills online. We also tried to find out what things prevent people from making even greater use of online payments (Graph 3). The graph we have here shows the answers for online bill payments, but we also collected responses for online purchases and transfers. Graph 3 BIS central bankers’ speeches First of all, to explain the large bar at the bottom: we were asking people what would make them happier to use online bill payments, but what we found was that more than a quarter of respondents were already satisfied and didn’t think they could be improved. Beyond that, by far the biggest factor preventing people from making more use of online bill payments is the risk of fraud. This was even more marked for online purchases, where around half of respondents identified risk of fraud as a factor discouraging greater use. In fact, the level of satisfaction is lower for online purchases overall than for online bill payments and transfers. Probably this reflects a lower degree of comfort with online purchases using methods like credit cards and PayPal, compared to making bill payments using BPAY and internet banking transfers. Adoption of the other two new waves of payments technology – contactless payments and mobile payments – is much lower than online payments. Only around 3 per cent of survey respondents had made a contactless payment in the last month. Less than 10 per cent of respondents had ever made mobile payments. Where they had, the main purpose was for phone-related purchases such as ringtones or games (Graph 4). Most of the other mobile payments made were effectively internet payments made using a smartphone. Graph 4 In short, the survey doesn’t seem to point to any major dissatisfaction with payments services in Australia, but it sheds some light on why payment-use patterns are as they are, and some possible areas of improvement that can be looked at further. We’ll be publishing a fuller analysis of these results later in the year. Results of the initial consultations As I said earlier, we’ve had significant interest shown by a wide range of industry and other players in response to our initial request for comments. A number of interested parties have provided us with written submissions, and many more have made themselves available for informal discussions with RBA staff. I expect we’ll receive a more substantial body of submissions during the second round of consultation in the second half of the year. The consultations to date have highlighted a number of quite specific issues that are going to be worth considering as part of the Strategic Review. I’ll briefly go through a cross section of those, but this is by no means exhaustive. I also note that many of these issues are not new, and are already being thought about by the industry. BIS central bankers’ speeches Transmission of data with payments Successful integration of payments systems into other processes requires that sufficient information travel with the payment to allow proper reconciliation. A business owner making payment to a supplier might wish to convey information, not just on the invoice number, but (for example) on which items on that invoice are being paid and why. An employer making a payment to a super fund needs to be able to provide information on the relevant employee accounts, the amounts of each payment and even the type of payment. Even an individual sending money to a friend or relative might simply want to attach a personal message to that payment. At the moment, the choices are largely either: to limit the additional information to the 18 characters permitted by the direct entry system; to separate the payment from the information and put in place a process to bring them back together at a later stage; or to pay by cheque attached to the information source. The question for the review will be whether this is likely to represent a significant shortcoming in our payments system in the years ahead? And if it is, what is the best means of addressing it and how should that be achieved? Timeliness and ease of addressing payments There are times when we really need payments to be made quickly. The classic example is government emergency payments. Most government payments to individuals can be made perfectly adequately by the direct entry system. But in an emergency, the availability of funds the next day might not be sufficient. In recent times many such payments have been made using the RTGS system, even though this is a long way away from that system’s intended use. Even then, the speed can vary significantly depending on the systems of the recipient bank. A related issue is the ease of addressing payments to individuals. As I said before, writing someone’s name on a cheque is relatively straightforward, but directing an electronic payment can be much more difficult. For most people this currently involves entering BSB and account number details into an internet banking package. This of course means having to obtain those details from the recipient (who mightn’t even remember them) and then keying in all the details correctly. This probably does not meet the “ease of use” test. Overseas experience might give us some guide on this issue. For example we know that the United States is putting a lot of emphasis on pre-paid cards for government payments, although this no doubt in part reflects the country’s high number of unbanked welfare recipients. On the other side of the Atlantic, the UK’s Faster Payments system provides a closely watched example of improving the timeliness of payments. Of course the Strategic Review is intended to be forward looking. So we should be asking, not just about the demand for these sorts of improvements, but also the extent to which likely developments could meet that demand over the next few years. These questions might also lead to a focus on the constraints that the major banks’ own internal systems place on their capacity to provide faster payments. The decline of cheques The number of cheques written in Australia has been declining by an average of 9 per cent per year over the past decade. Over time, this is adding to unit costs. The result is that cheques, which were already an expensive form of payment, are becoming increasingly so. Nonetheless, our consultations have reinforced the fact that cheque use remains entrenched in certain areas because it meets a number of specific needs. I have already mentioned BIS central bankers’ speeches several of these areas, including the ease with which cheques can be addressed to others and accompanied by additional information. They are also very suitable in face-to-face exchanges and for providing an element of financial control. Any decision to move away from cheques (and I’m not pre-judging the issue) will be dependent on the industry’s capacity to develop suitable and equally convenient electronic alternatives. I’m aware that the industry is separately looking at this, but it seems appropriate that the Payments System Board should also be considering how the decline in cheques is addressed from a public interest perspective. In addition to these issues, there are a number of other things that we expect will come into consideration, whether as stand-alone topics or interwoven with other discussions. These include: Mobile payments. There is already a lot of interest and activity in this area. The Board’s main interest will be in determining whether there are impediments to the development of mobile payments, for example in relation to standards. Standards themselves cut across many areas of payments, including messaging, device and security standards. Their design and application can have significant implications for efficiency and for innovation. The increasingly global nature of commerce suggests that adoption of internationally compatible standards will be very important for maintaining a world class payments system. Electronic purse systems – that is, general purpose, prepaid, and typically contactless cards like Oyster in London and Octopus in Hong Kong. Where these have been successful, there tends to be significant interdependency with electronic transport ticketing systems, which have been slow to develop here. The question once again is whether there is a significant impediment to development of these systems in Australia, given the already high use of payment cards. Security. Our survey results suggest that concerns about fraud are impeding the take-up of online payments. This may also become an issue for mobile payments. A question for the Strategic Review is whether there is a need for increased coordination and co-operation on fraud issues. Finally it’s worth saying that, more important than any of these individual issues is the overarching environment for innovation. I made the distinction at the start between proprietary and system-wide innovations. Our focus in this review is very much on the second one of those. This is the area that needs the most careful attention from a publicinterest perspective, because it requires a degree of co-operation amongst industry competitors that might not otherwise happen efficiently. It also requires that the interests of end-users and non-incumbents be taken into account. The next stage of the review will be seeking views on those issues, whether there are better ways to address them and whether there are new areas where a co-operative approach is needed. An inevitable component of that is what role the Reserve Bank should play, given that it has often stepped in, in one way or another, when a solely industry-based approach has not proved feasible. Conclusion What I’ve outlined today is a big agenda, and I expect it will keep us very busy in the time ahead. As I said at the start, this review is very much a co-operative effort. I and my staff appreciate the assistance we’ve had already, both from industry and from payment users. And we look forward to continuing to work with you to promote best-practice innovation in the Australian payments system. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 3 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Australian Association 2011 Annual Spring Lecture Lunch, New York, 14 April 2011. | Glenn Stevens: America, Australia, Asia and the world economy Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Australian Association 2011 Annual Spring Lecture Lunch, New York, 14 April 2011. * * * Thank you for the invitation to speak in New York. New York City remains one of the world’s dominant financial centres, on any metric. Its stock exchange is by far the largest in the world in terms of market capitalisation. The US corporate debt market similarly eclipses that of other countries and the city is home to some of the world’s largest financial institutions. Likewise, the United States remains the world’s largest national economy by a substantial margin. But the world is changing, and quite quickly. The rise of China (and, very likely, India) is a transformative event for the global economy. Unless something pretty major goes wrong, we are likely to see much more of this trend for quite a long time yet. As recently as 1990, the United States accounted for a quarter of the world economy. The European Union was just a little over a quarter. Japan, east Asia and India combined made up roughly another quarter; Japan on its own was about a tenth of global GDP. (Australia was then, and still is, just over 1 per cent of global GDP.) In 2010, the US share was about 20 per cent of world GDP, about the same as the European Union. By then, Asia was making up just under a third of the total. China alone had raised its share of global GDP from less than 4 per cent in 1990 to over 13 per cent – quite a change in the space of 20 years. India’s share, which had been the same as China’s in 1990, had been little changed until about 2004. It has started to increase more noticeably since then, though it remains well below China’s at the moment. But given that the demographics for India are more favourable than those for China, we could expect that in another 20 years India’s prominence will have grown a great deal – assuming that country continues the process of reform that has helped it to generate impressive growth over recent years. These figures are all based on the IMF’s Purchasing Power Parity estimates for countries’ respective GDPs. Some might find them a bit abstract – if you doubt that, try explaining purchasing power parity to your mother. But we can appeal to various other “real” indicators to chart the rise of China in particular. The number of people in paid employment in China was 780 million as of 2009. The increase since 1990 was about 130 million, which is nearly the total number of employed workers in the United States (and 11 times the total number currently employed in Australia). In that year of 1990, China produced just over 50 million tonnes of steel products. By 2010, China was producing more than that volume of steel products each month, and accounted for nearly half of global crude steel production. Virtually all of this steel is consumed within China, to build new cities and transport infrastructure. Currently, steel consumption in China is nine times higher than that of the United States. Electricity generation has tripled in China over the past decade, overtaking the European Union in 2008 to become the world’s second biggest generator of electricity after the United States. Of course, per capita usage rates of electricity are still much lower in China but they will rise with incomes. In 1999, just over 23,000 Chinese postgraduate students were studying abroad. A decade later, there were 230,000. All of these metrics tell a similar story: the rise in the importance of the Chinese economy is extraordinary. Other countries in the Asian region have also shown solid rates of growth over this period, but the size and pace of change in the Chinese economy stands out. There are few countries that have noticed this more in their trading patterns than Australia. Our trade patterns have been strongly oriented towards Asia since the emergence of the BIS central bankers’ speeches Japanese trade relationship in the 1960s. But this has taken a further step up in recent years, with the share of merchandise exports going to the Asian region rising from a little over 50 per cent as recently as 2003 to over 70 per cent in 2010.1 A similar trend has occurred in imports. China alone has risen from 6 per cent of exports a decade ago to 25 per cent today. The rise in Australia’s terms of trade – about which I will not give yet another sermon today – is part of this same picture. But it is of course not only Australia that has seen this shift in trade patterns. In fact, many countries are seeing a significant expansion in two-way trade with China and there are a number for which China is now the most important partner. Among that group is not only Australia, but also Japan and Korea. Clearly trade integration has been happening quickly in the Asia-Pacific region. These forces are also being felt further afield. The US economy has seen a much increased trade engagement with China. The share of US imports coming from China has increased from about 3 per cent in 1990 to 19 per cent today. That is a very large increase, though it appears to offset a decline in the shares coming from Japan and other east Asian countries: imports from Asia as a whole make up about the same share of US imports today – about a third – as they did 20 years ago. Probably what is happening here is that China has displaced other Asian countries to some extent as a source of finished products, including by becoming the final point of assembly for many manufactured items constructed from components sourced all over Asia. Even more interesting is the fact that the United States sells a higher share of its exports to China than to any other single nation apart from Canada and Mexico, its two North American Free Trade Agreement partners. All these trends will surely continue, for the process of integrating China and India into the global economy has a good way to run yet. The Chinese Government is seeking growth of 7 per cent per annum over the coming five years. That would be a lower outcome than we have seen in the past five years, but is still very strong by the standards of the advanced countries. Growth at that sort of pace, on average, would see China’s weight in global GDP exceed that of the euro area within five years and approach that of the United States within a decade. Of course, the future will not be that deterministic. The Chinese economy will have cycles; it will not trace out a path of steady, uninterrupted expansion. China could not expect to be immune from various other afflictions experienced by all countries that can occasionally impede economic growth. But by any reckoning, the emergence of China is a huge historical event. And then there is India. So the world of production and consumption is changing. But it must also follow that the world of finance is changing as well. As incomes rise so there is an accumulation of physical capital (which accommodates further increases in labour productivity and incomes) funded by saving out of current income. Moreover, the scale, scope and sophistication of financial activity increases, which typically sees the size of gross financial claims rise faster than income. The fact that Asian countries have traditionally seen quite high rates of private saving accentuates this trend. China’s saving rate, at about 55 per cent of GDP, is one of the highest recorded and because China has become a large economy, the extent of that annual flow of saving is now globally very significant. In absolute terms, according to the available national income statistics, China is in fact now the world’s largest saver. Its gross national saving, at an estimated US$3.2 trillion, exceeded that of both the United States and the euro These and subsequent trade figures refer to merchandise exports. BIS central bankers’ speeches area in 2010.2 Its gross investment is also the world’s largest – at an estimated US$2.9 trillion in 2010. The gap between these two figures – around US$300 billion – is of course China’s current account position. That is the extent to which China, in net terms, exports capital to the rest of the world. As you might expect, to deal with this large volume of saving China has some large banks. As measured by total assets, 12 of the world’s 100 largest banks are Chinese. This is a higher number than for any other single country, including the United States. Between 2005 and the start of this year, the Shanghai and Shenzhen stock exchanges grew by over 800 per cent. As measured by the market capitalisation of listed domestic companies, the Shanghai stock exchange is still far smaller than the New York stock exchange, but it is now more than two-thirds the size of the London and Tokyo stock exchanges. In terms of turnover, the annual value of share trading on the Shanghai stock exchange in 2009 surpassed that of each of the London and Tokyo exchanges.3 Asian bond markets, and particularly those in China, have also grown in size. Five years ago, total domestic debt securities outstanding in China were less than half of those outstanding in countries such as France, Germany and Italy; today these markets are roughly all comparable in size.4 So it is not just the centre of gravity of economic activity that is shifting to Asia – the weight of financial assets is also shifting. Now this is a slower process since the stock of wealth is a result of a long accretion over time and economies that rapidly become large in production terms may have a smaller stock of wealth than countries that have been similarly large for a long time – such as Europe and the United States. So at this point the advanced industrial countries still account for the lion’s share of global wealth. Nonetheless, things are moving quickly. Within the remainder of the careers of many of us here today, we will very likely see a pretty substantial change in relative positions. It is interesting to contemplate how that world might differ from the one to which we have been accustomed. Every morning, Australian financial market participants wake up to the closing moments of the New York trading day. The rest of the Asian region wakes up shortly thereafter. Despite the rapid increases in size of the Asian markets, most of the time it is changes in US or European markets that set the tone for the Asian trading day. Every so often, though, an event in Asia prompts global market responses. Surely this will happen more often in the future. As the Asian region becomes more integrated economically, with an ever larger Chinese and Indian economic mass at the core, and as the accretion of Asian financial wealth assumes increasing global significance, Asia is likely more often to be a source of “shocks” for the global economy and financial system. I am not suggesting that Wall Street will dance exclusively to Shanghai’s tune. The US economy and financial system will remain very large and internationally important for the foreseeable future. The point is that there will be several potential sources of music emanating from various centres around the world, to which markets everywhere will respond to some extent. The United States will certainly be one, and so will Europe (not always an enjoyable tune of late). We will all need to attune our ear to Asia’s rhythms as well. Sometimes those differing tunes will clash – as they do at present. At the moment we see a US recovery that is gaining some traction after a lengthy period of weakness, a subdued experience in Europe overall with intraregional differences probably at their most extreme These data are compiled from IMF Article IV and World Economic Outlook reports. Annual value of electronic order book trades. Total outstanding debt securities issued onshore in local currency, measured in US dollars. BIS central bankers’ speeches since the euro commenced, while China and India are seeking to slow their expansions in the face of clear evidence of rising inflation. US banks are well ahead of their European counterparts in cleaning up their problems, to the extent that the government capital injections of two years ago are being repaid, while markets are still waiting for more complete information about the state of balance sheets in Europe and worrying about the feedback to public sector finances. Asia’s banks, meanwhile, did not have a solvency crisis and have been able to perform their task of supporting growth. If anything, their problems are more likely to be those of exuberance. More attention is being paid to the US fiscal position – and that will probably increase further. In Asia, public finances are generally strong except in Japan. These differences were bound to increase the focus on policy differences between regions, and exchange rate systems in particular. It is not surprising that we are returning to discussion of the “global imbalances”, since many of the underlying factors behind them have not gone away. Renewed efforts to find a framework for talking about these issues are now under way. As others have said, a prerequisite for a solution is a shared understanding of the problems within an agreed intellectual framework. But finding that combination is not proving easy. The dialogue needs to occur on multiple issues, to which countries bring different perspectives. Many of the countries of Asia come, for example, with a mindset in which the international monetary system is a device for stability, one of the foundations for strategies to grow economies and increase wealth. They see flows of capital, and fluctuations in exchange rates, as potentially disruptive to the real sectors of their economies. This is in many respects a traditional post-war perspective, when there was a US dollar standard, when the United States as an economic and financial power was unrivalled and all other economies and financial systems were truly small. But of course Asia is no longer small. Countries like the United States or Australia, on the other hand, have a different frame of reference. They tend to see the international monetary system as a device for accommodating shocks and reflecting differences in economic circumstances. They see price movements and capital flows, generally, as helping resource allocation. European countries share that perspective as far as flows and exchange rates between the major regions of the world are concerned, but share Asian perspectives on the need for stability within their own region. There are good reasons, in logic and history, for all these perspectives. We need to understand them, and find an accommodation. It does not help, in my judgment, that so much of the discussion takes place through a bi-lateral prism – particularly the US-China current account prism. Twenty years ago the prism was the US-Japan balance. The issues are multi-lateral, not bi-lateral. The US trade deficit was pretty widely spread for many years. It wasn’t just with China. Over the past decade, the United States had a trade deficit with 13 of the 18 other countries in the G-20 (of the five surplus positions, the largest was with Australia). This bi-lateral focus can be quite troubling, and not only because it risks over-simplifying problems and therefore lessening the likelihood of solutions. It can be troubling for a host of small countries, which worry about the potential for more widespread effects of solutions that may be attempted. This is why it is so important that the problems be considered, and resolved, in a multi-lateral setting. Hence the importance of the international financial institutions, and of fora like the G-20, in providing the table around which these discussions should take place. That of course means that the legitimacy of those institutions, in the eyes of all their stakeholders, is key. Good progress has been made in improving the governance of bodies such as the IMF and no doubt more will be done in this area over the years ahead. The G-20, a body with a broader constituency than the G7, has taken a more prominent role. This is all good, but will need to be accompanied by ongoing efforts to reach a shared vision of the role of the institutions and the system they are supposed to watch over and protect. If we BIS central bankers’ speeches are all still not talking the same language about the role of the system or the institutions, then we will not collectively get very far. So much work needs to be done yet. America – still the world’s dominant single economy and financial power, albeit not as dominant as it was – is critical to reaching the necessary framework. But so too is Asia – a fast-growing, high-saving region with increasing financial resources, a much increased part of the global economy and financial system, and with, therefore, commensurately increased responsibilities. Australia – a small but outward-looking country with very substantial ties to both the United States and Asia – has more than a passing interest in the progress of this very difficult, but very important, discussion. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 4 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, at the Annual Stockbrokers Conference, Sydney, 26 May 2011. | Ric Battellino: Recent financial developments Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, at the Annual Stockbrokers Conference, Sydney, 26 May 2011. * * * Introduction My talk today is about some of the changes taking place in the financing of the Australian economy. As you know, after 15 years of rapid growth, credit has been growing at a much more subdued pace over the past couple of years. In fact, for the first time since the early 1990s, banks are finding that credit is growing more slowly than deposits, with the result that they are able to repay funds previously borrowed in wholesale markets, including from offshore. These developments have been associated with a noticeable increase in national saving and a marked reduction in the current account deficit. I would like to spend some time today going through these developments. Credit cycles Over the very long run, money and credit in most economies tend to grow somewhat faster than GDP. This is part of the financial deepening that occurs as economies develop and incomes grow. Since 1960, for example, credit in Australia has increased on average by about 12½ per cent per year, while GDP (in nominal terms) has increased on average by about 9 per cent per year (Graph 1). Graph 1 Credit and GDP Growth Over shorter periods, however, credit shows pronounced cycles. During periods when optimism is high, households and businesses tend to increase their use of credit, often for BIS central bankers’ speeches the acquisition of assets. At other times, typically in the wake of economic downturns, borrowers can become very conservative and cut back their demand for credit; lenders, too, can become more cautious. The most recent cycle in credit began in the mid 1990s and extended through the years leading up to the global financial crisis. For most of that period the expansion in credit was driven by households (Graph 2). Financial deregulation and innovation greatly increased the supply of credit, and the fall in interest rates as inflation declined in the early 1990s gave households greater capacity to borrow. The rapid expansion in household debt that followed was not unique to Australia, with most developed economies experiencing sharp rises in household indebtedness. Most of this expansion in household credit, both in Australia and offshore, was used to buy dwellings and was therefore accompanied by strong rises in housing prices. Graph 2 Household Credit Ratio to GDP As you know, in many countries the marked expansion in housing credit went on to cause severe financial difficulties. Here in Australia, however, this has not happened; in particular, household loan arrears remain relatively low (Graph 3). Contributing to this better outcome in Australia was the fact that the deterioration in lending standards was not as severe or as widespread as in some other countries. Also, household incomes have continued to grow solidly, in the context of a strong economy and low unemployment. BIS central bankers’ speeches Graph 3 Banks’ Non-performing Housing Loans* Per cent of outstandings However, within this overall picture of resilience, there are, as always, pockets of housing stress. In the early part of last decade, those pockets were heavily concentrated around the south-west parts of Sydney. These problems followed the very strong rises in Sydney house prices over 2002 and 2003. They were linked to a sharp rise in loan approvals, some lowering of lending standards, particularly by second-tier lenders, and increased speculative activity. Conditions in that region subsequently improved, helped by a period of stable house prices and rising incomes, though the process took a long time and the arrears rate in that part of Sydney remains higher than the national average. Recently, it has been parts of Queensland and Western Australia that have shown a deterioration in loan arrears, albeit from low levels. As had been the case in Sydney earlier in the decade, the recent increase in loan arrears in these states followed a sharp increase in housing loans and unusually strong rises in house prices between 2006 and 2008. Some part of this was justified by the emerging resources boom but, as had occurred earlier in Sydney, this was accompanied by some lowering of credit standards and increased speculative activity, with the result that some households over-extended themselves. Adding to the stress on household finances was the fact that both these states experienced largerthan-average increases in unemployment during the 2009 downturn, though again from relatively low levels. Another potential source of vulnerability in the housing market that is often mentioned is the many first-home owners who were attracted into the housing market in 2009 by the increase in the first-home owner grant. The concern is that some of these may have over-committed themselves financially in order to enter the market, and are now vulnerable to rising interest rates. This group bears close watching but, so far at least, first-home owners do not seem to be disproportionately represented in loan arrears. While the household sector as a whole continues to show a good deal of resilience in meeting loan repayments, the increase in indebtedness over the past 15 years does mean that households are now significantly more sensitive to changes in interest rates. The BIS central bankers’ speeches proportion of household income devoted to debt servicing is relatively high, even though housing interest rates are only a little above average (Graph 4). It is therefore not surprising that households have become more cautious. Household saving increased markedly in the wake of the global financial crisis, and it has remained high in the face of the continuing problems in European financial markets and rising global inflationary pressures (Graph 5). Graph 4 Household Interest Payments* Per cent of household disposable income Graph 5 Household Saving Ratio* Per cent of household disposable income BIS central bankers’ speeches In the current environment, it is unlikely that households will have much enthusiasm for increasing indebtedness. The most likely scenario is that household borrowing will continue to grow at a relatively subdued rate for some time yet. From the Reserve Bank’s perspective, this would be a welcome development. It would allow the period of consolidation in household balance sheets to continue and would avoid households adding to pressures in the economy at a time when its productive capacity is already being stretched by the resources boom. While most of the growth in credit in the lead-up to the global financial crisis was driven by households, a substantial increase in business credit also occurred in the years immediately before the crisis. This expansion in lending was mainly to large businesses and, while some of it was used to fund real investment, a substantial amount was for financial activity. As often happens during a credit boom, a disproportionate amount of the lending that took place over that period came from second-tier lenders. Business credit provided by foreign banks, for example, rose by about 80 per cent between 2006 and 2008, while business credit provided by regional banks rose by 60 per cent (Graph 6). A lot of this was directed to commercial property. Graph 6 Business Credit by Source January 2006 = 100 Since the global financial crisis, the inevitable correction has occurred. Business credit has fallen and those lenders that expanded the most have since contracted the most. Similarly, sectors such as commercial property that increased gearing the most have since experienced the sharpest increase in problem loans and the sharpest contraction in credit. Through all this, credit to the small business sector has been much more stable; it increased by less through the boom and has continued to expand, albeit slowly, since the crisis (Graph 7). BIS central bankers’ speeches Graph 7 Business Credit by Borrower January 2006 = 100 It is not unusual for business credit to be subdued for a time following a period of strong expansion. Both supply and demand usually contribute to this. For instance, businesses often look to repay debt, to repair balance sheets that had become stretched during a boom. Also lenders that expand strongly during a boom often end up making significant amounts of bad loans, and when this becomes apparent they respond by cutting back on new lending. Normally, periods of soft business credit are accompanied by soft business investment. What is somewhat unusual about the current softness in business credit is that it is occurring at a time when business investment is at a very high level. This unusual conjuncture arises largely from the fact that the strength of investment at present is concentrated in the resources sector, and is being funded mainly by the large amounts of cash that resource companies are generating from existing operations. As a result, despite the very high levels of investment, there has not been the need to resort to substantial borrowing (Graph 8). Graph 8 Business Funding Quarterly flow BIS central bankers’ speeches There are signs, however, that the low point in business credit growth is now behind us. Substantial repair has taken place in business balance sheets since the crisis, business investment is picking up and the banking system is showing greater willingness to lend. On average, recent monthly figures for business credit have been somewhat stronger than earlier in the year. It would be normal for this pick-up to continue over the next couple of years as the economic recovery strengthens and broadens. Implications for bank funding What do recent developments mean for bank funding? During the period of rapid credit growth that began in the mid 1990s, bank balance sheets expanded rapidly. At the same time, deposit growth slowed noticeably, both because of the decline in national saving and a shift in household saving towards securities rather than deposits. With aggregate credit growing by 12½ per cent per year on average and deposits growing by 10½ per cent per year, banks were left with a noticeable funding gap, which they filled by borrowing in wholesale markets, including from offshore (Graph 9). Graph 9 Funding Composition of Banks in Australia* Per cent of funding This funding model was well suited to the market conditions of the time. Banks had little difficulty in raising funds in wholesale markets, due to the weight of money seeking investments in Australia. In fact, it could be argued that the whole dynamic was driven by this flow of offshore money wanting to come to Australia – i.e. banks were offered ample amounts of funds by foreigners, which they in turn lent domestically, causing an increase in spending, a reduction in saving, a slowing in deposits and a widening in the current account deficit. This is a situation not dissimilar to that faced by the United States over the past decade, which Federal Reserve Chairman Bernanke has described in detail in his explanation of the global savings glut. Two things can go wrong in this environment. The first is that the weight of money can lead to an erosion of lending standards as banks try to find more and more borrowers. If this is severe enough, it will eventually lead to a financial crisis because loans are made that cannot be repaid. This is essentially what happened in the United States. As noted earlier, however, here in Australia the reduction in lending standards was relatively slight in comparison. The second risk, which is the one most people focus on, is that the flow of offshore money suddenly stops. The common presumption is that there would then be a crisis because BIS central bankers’ speeches banks could no longer fund themselves. People who worry about this usually do so as part of a broader concern about countries running current account deficits. This view of the world is not new. Its origins lie in the pre-1970s world of fixed exchange rates, since in that regime a cessation of capital inflow quickly caused a crisis. This framework remains relevant for emerging market economies which have relatively fixed exchange rates and unhedged foreign borrowings, but it is not well-suited for analysing risks in mature economies with welldeveloped financial markets and a floating exchange rate. Some people claim that the global financial crisis was a vindication of the view that offshore borrowing causes problems. But this misses the point that all banks were affected by the crisis, irrespective of whether they were borrowers or lenders in international markets. In fact, the Australian banks, which many see as being among the largest users of offshore wholesale markets, emerged from the crisis in better shape than most. While they benefited from a temporary government guarantee, so too did banks in most other countries. Another point that is often missed in this debate is that, if there is a loss of offshore funding, other things also change due to the ensuing changes in market pricing and consumer and business behaviour. This allows the financial system to adjust. For example, when the financial crisis hit: The demand for credit slowed sharply; after growing on average by over 14 per cent per year in the three years to mid 2008, it has grown by only about 4 per cent per year in the three years since. Private saving increased, particularly at the household level. This has narrowed the gap between national saving and investment which, as you know, is the counterpart to the current account deficit. The current account deficit in the December quarter fell to 2 per cent of GDP, and is likely to move lower in the immediate future. Households became more cautious, shifting their saving from investments in securities towards bank deposits. Deposit growth is currently out-pacing credit growth, allowing banks to reduce wholesale borrowings. Capital inflows into Australia did not cease but switched to more conservative investments such as government bonds. The inflow of foreign capital into government bonds during the past year has been more than sufficient to fund the current account deficit, and has been accompanied by the private sector (particularly the banking sector) repaying offshore capital (Graph 10). Graph 10 Australian Capital Flows Net inflows, per cent of GDP BIS central bankers’ speeches The question that arises is what will happen to bank funding if, as expected, credit growth picks up over the next few years? Will it return to the pre-crisis pattern? This seems unlikely at this stage. For one thing, credit growth is unlikely to return to pre-crisis rates in the foreseeable future so pressures on funding will not be as severe. Second, changes to supervisory rules and market conditions have made pre-crisis funding patterns less attractive. In addition, if household saving continues at its recent higher level, it will sustain deposit growth. The household saving rate could even increase further. It is still below its historical highs and strong employment and income growth could provide the wherewithal for higher saving to co-exist with steady consumption growth. Also relevant will be trends in nonbank capital inflows. If the current diversified pattern of capital inflow continues, this too will add to deposit growth as these inflows find their way into bank deposits. All in all, it is likely that banks will be able to maintain the more conservative funding pattern they have put in place recently. Conclusion Let me sum up. The credit boom that began in the mid 1990s ended with the global financial crisis. The Australian financial system weathered that crisis much better than most and, while the adjustment was not painless, the banking system remained resilient. It is currently transitioning through a period of slower growth. History tells us that periods of weak credit growth such as the present one are relatively short-lived in a growing economy, so some pick-up in credit growth is to be expected. It would be wrong, however, to think that this means a return to the growth experienced in bank balance sheets in the period since the mid 1990s. That was an extraordinary period, driven by what was largely a one-off adjustment to household gearing following financial deregulation and the sustained fall in inflation. In the economic climate likely to be faced by banks over the next few years – solid economic growth but with cautious behaviour by households and relatively low inflation – it would be reasonable to assume that the rate of growth in credit will remain somewhere in the single-digit range. That rate of credit growth should be able to be matched by deposit growth, reducing the need to raise funds in wholesale markets. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 5 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Economic Society of Australia (Queensland) 2011 Business Luncheon, Brisbane, 15 June 2011. | Glenn Stevens: Economic conditions and prospects Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Economic Society of Australia (Queensland) 2011 Business Luncheon, Brisbane, 15 June 2011. * * * Thank you for the invitation to visit Brisbane today and to join with the Economic Society here in Queensland to talk about our economic situation. It is barely five months since the flooding that inundated parts of Brisbane and had such a tragic impact only a couple of hours west of here in Toowoomba and the Lockyer Valley. It is only four months since Cyclone Yasi wrought havoc on some northern coastal communities and flattened key crops. The people of Brisbane, and of Queensland, have shown their resilience and adaptability in the face of these disasters. The economic effects of those events, and of the Western Australian cyclones over the summer, have been seen at the national level. Falls in coal and iron ore production more than fully explained the decline in measured economic output in the March quarter, which occurred not because demand slumped but because the economy’s capacity to supply output was temporarily curtailed. There was also a sharp rise in some prices, which tends to happen when supply is suddenly disrupted. Bananas are the most celebrated manifestation of this. With 75 per cent of the crop more or less destroyed, and few sources of alternative supply available, prices to the consumer have quadrupled. The effects of these natural disasters are now gradually abating. Information on coal mining suggests that it is gradually recovering, though more slowly than had been expected initially owing to the difficulties of getting water out of the pits. Iron ore production has fully recovered. The banana plants are re-generating. Most other crops are also getting back to normal supply levels. As this occurs, we should see the impact of these events on prices start to reverse. For Queensland, the scars from last summer’s events remain – and always will. The destruction of capital stock is a loss of wealth, but capital can ultimately be rebuilt; lives lost cannot. But despite the tragedy, Queenslanders are getting on with things. The broader context in which these events have occurred is well known. The proverbial pet-shop galah can by now recite the facts on Australia’s trade with China and our terms of trade, which are at a level not seen in over a century. It was already clear by about 2006 that something quite profound was happening in the continuing rapid growth of China, India and other emerging countries.1 This upward trajectory continued, and even accelerated in some cases, in the subsequent period. Then the crisis occurred, and the Chinese economy slowed abruptly. But the authorities responded forcefully and China’s economy returned to very strong growth quite quickly. And so the trends in place up to the middle of 2008 had resumed within a year. The rapid growth in Chinese, Indian and other emerging world demand has been stimulating demand in the global economy, despite the weakness in demand from the “north Atlantic” group of countries. This gives a boost to a country like Australia: our economy’s increased exposure to Asia – the part of the world where much of the growth is occurring – plus the high terms of trade make for an expansionary macroeconomic event. At present Australia’s At that time, my predecessor noted that structural factors such as the industrialisation of China had led to “the largest cumulative increase in our terms of trade since the early 1970s”. See Macfarlane IJ, “Opening Statement to the House of Representatives Standing Committee on Economics, Finance and Public Administration”, Canberra, 17 February 2006. BIS central bankers’ speeches terms of trade are about 85 per cent above their 20th century average. The amount of additional income accruing to production in Australia from that is 15 per cent or more of annual GDP. Even allowing for the fact that a substantial fraction of this income accrues to foreign investors that own large stakes in many of Australia’s resources companies, this represents a very large boost to national income. These expansionary forces are at work on an Australian economy that was widely regarded as very fully employed by early 2008, and that experienced only a fairly mild and short downturn thereafter. As of today, measures of capacity utilisation are not as high as at the end of 2007, and unemployment is not as low as it was then. Nonetheless, the degree of slack in the economy overall does not seem large in comparison with the apparent size of the expansion in resources sector income and investment now under way. With that general outlook, it follows that macroeconomic policies must be configured in the expectation that there will need to be some degree of restraint. Monetary policy has already been exerting some restraint for a while. Looking ahead, our most recent analysis (as published in early May) concluded that the underlying rate of inflation is more likely to rise than fall over the next couple of years. This central expectation – subject to all the usual uncertainties inherent in forecasting – suggests, as we said at the time, that “further tightening of monetary policy is likely to be required at some point for inflation to remain consistent with the 2–3 per cent medium-term target”. It remains, though, a matter for judgement by the Board as to whether that point has been reached. At its most recent meeting, the Board’s view was that it had not been. New information will, as always, be important in our monthly assessments of what monetary policy needs to do. As far as prices are concerned, we will get another comprehensive round of data in late July. Fiscal policy is also playing a significant role. The “fiscal impact”, calculated as the shift in the Federal budget position from one year to the next, is forecast to be minus 2 per cent of GDP in the 2011/12 fiscal year. A further, though slightly smaller, effect is forecast by the Treasury in the following year. There remain, of course, differences in economic performance around the country. Given movements in commodity prices over the past year and the stated investment intentions of major resources companies, these differences are more likely to increase than decrease over the coming period. More generally, while everyone understands that there is a “mining boom”, many people would say that they themselves cannot directly feel the effects. We have seen widespread re-emergence of talk of “two speed” or “multi speed” economies. Within the state of Queensland itself there were differences in performance, even before the floods, let alone after them. How then do we make sense of these phenomena? It is a complex story, and I do not wish to make light of any of the legitimate concerns that people have about the differing economic conditions – actual and potential – across regions or industries. But there are three observations worth making. The first is that the impact of the resources sector expansion does get spread around, in more ways than might immediately be apparent. Obviously mining employs only a small share of the workforce directly – less than 2 per cent. But to produce a dollar of revenue, companies spend about 40 cents on acquiring non labour intermediate inputs, primarily from the domestic sector. Apart from the direct physical inputs, there are effects on utilities, transport, business services such as engineering, accounting, legal, exploration and other industries. It is noteworthy that a number of these areas are growing quickly at present. Once the costs of producing the output and other factors – such as taxes – are taken into account, the remaining revenue is distributed to shareholders or retained. While a significant proportion of the earnings distributed goes offshore, local shareholders also benefit. In fact, most of us are shareholders in the mining industry through our superannuation BIS central bankers’ speeches schemes.2 We don’t get this income directly to spend now – it is in our superannuation. Nonetheless, it is genuine income and a genuine increase in wealth. A good proportion of the earnings retained by companies is used to fund a further build up of physical investment, which imparts demand to construction and manufacturing. Based on the industry liaison the Bank has done, around half – give or take – of the demand generated by these projects is typically filled locally, though, of course, this amount varies with the nature and details of any specific project. So there are effects that spill over, even though it is not always easy to spot them. In the end the combination of the resources sector strength and all the other factors at work in the economy has, to date, produced a national rate of unemployment of around 5 per cent, and in Queensland only a bit over 5 per cent. There are regional variations in unemployment rates, but at this point these look comparable to what has been seen at most times in the past 10 years – a period that has seen both lower average unemployment rates and lower variation in unemployment rates than the preceding decade. Secondly, some of the undoubted differences in performance observable at present look like the inverse of earlier differences. Take housing prices and population growth, which are of course quite closely related. It surely is no coincidence that the two state capitals that have had the clearest evidence of declining house prices over the past couple of years – Brisbane and Perth – are the two that previously had the highest rate of population growth and that have since had the biggest decline in population growth. Moreover, it is hard to avoid the conclusion that changes in relative housing costs between states, while certainly not the only factor at work, have played an important role. Relative costs are affected by interstate population flows, but those costs then in turn have a feed-back effect on population flows. This is particularly so for Queensland. Historically, Queensland has had faster population growth than the southern states, as it has seen a slightly higher natural increase, a rate of net international migration on par with other states and a very substantial net positive flow of interstate migrants. Net interstate migration to Queensland peaked around 2003 – not long after Sydney dwelling prices had reached a new high relative to other cities. Interstate migration at that time was contributing a full percentage point a year to Queensland’s population growth. By 2008 this flow had slowed a bit, but international migration had picked up and Queensland’s population growth increased, peaking at nearly 3 per cent. Western Australia’s population growth was even higher, peaking at almost 3½ per cent. Meanwhile, at least up to 2007, people were confident and finance was readily available. Brisbane housing prices, which had been a bit over half of the average level of Sydney and Melbourne prices in 2002, had risen to be almost the same by 2008, which was unusually high. The rate of interstate migration to Queensland then slowed further, to be at its lowest in at least a decade. The effects of that on state population growth were compounded by a decline in international migration, something seen in all states. At the same time, finance became more difficult to obtain and lenders and borrowers alike became more risk averse. This happened everywhere, but its effects in Queensland seem to have been more pronounced. Since then, Brisbane housing prices have been declining relative to those in the southern capitals and the construction sector here has found it tough going. If the allocation of super funds’ equity assets to resources companies is broadly similar to that of the Australian share market, then around 10 per cent – or $130 billion – of Australians’ superannuation assets are invested in resources companies. And this 10 per cent has been providing a healthy return; over the past year alone, the average return on resources company stocks has been around 20 per cent. BIS central bankers’ speeches So a complex interaction of forces – the commodity price cycle, the financial cycle, population flows, endogenous responses of housing prices that then feed back to population flows and so on – has been occurring. The ebb and flow of these forces has made for differences in performance, first in one direction, then the other. Thirdly, the industry make-up of our economy is continually changing. While this is often a slow process – almost imperceptible in most years – these shifts have been significant over time. There is little doubt that trade-exposed manufacturing firms not linked to the resources sector are facing tough conditions at present. But many people might be surprised to learn that the peak in manufacturing’s share of Australia’s GDP was in the late 1950s – more than five decades ago. Its fastest rate of relative decline, so far, was probably in the second half of the 1970s. On the other hand “business services” – including things such as accountancy, legal and numerous other services – have grown fairly steadily and now are credited with more than twice the share of GDP of manufacturing.3 Several of these sectors are being boosted by the flow-on effects of the resources boom at present. As for the mining sector itself, its share of GDP has tended to rise since the late 1960s, having been quite low in the mid 20th century. But in 2010, the mining sector’s share of GDP was still only about the same as it was in 1910. It will surely increase noticeably over the next five years, though will remain much smaller than it was in the gold rush era. Again, none of this is to deny that there are differences in performance by industry and region. It is simply to give some perspective on what we see. The point about long term shifts reminds us to look beyond the immediate conjuncture, and to think about the magnitude of the event through which we are living. For a good part of the change in our terms of trade is a manifestation of a large and persistent change in global relative prices. Let me be clear here: there is a cyclical dimension to the China story, and it is important that we remember that. But there is also a structural dimension. And the associated change in relative prices constitutes a force for significant structural change in the economy. I think we have all only begun to grasp its implications relatively recently. For a long time, the world price of foodstuffs and raw materials tended to decline relative to the prices of manufactures, services and assets. But for some years now the prices of things that are grown, dug up or otherwise extracted have been rising relative to those other prices. This is mainly due to trends in global demand. At any point in time for a particular product we can appeal to supply-side issues – a drought, a flood or a mine or well closure, or some geo political event that is seen as pushing up prices. But stepping back, the main supply problem is really that there has simply been more demand than suppliers were prepared or able to meet at the old prices. We do not have to look far for the cause: hundreds of millions of people in the emerging world have seen growth in their incomes and associated changes in their living standards, and they want to live much more like we have been living for decades. This means they are moving towards a more energy- and steel-intensive way of life and a more protein-rich diet. That fact is fundamentally changing the shape of the world economy. Even if China’s growth rate moderates this year, as it seems to be doing, these structural forces almost certainly will continue. It is worth noting in this connection that many commentators have for years been calling on policymakers in the emerging world to adopt growth strategies that rely more on domestic demand and less on exports to major countries. This is happening. It carries the implication We define “business services” as those where the end user is more often a business than a household. The category encompasses the following sectors: Information, Media and Telecommunications; Financial and Insurance Services; Rental, Hiring and Real Estate Services; Professional, Scientific and Technical Services; and Administrative and Support Services. BIS central bankers’ speeches though that, first, more of the marginal global spending dollar is going to products that are steel-, energy- and protein-intensive for the emerging world’s consumers and less on other things like, say, luxury property in western countries. Secondly, more of the marginal production of the world economy has to be in those raw material intensive products – and in the raw materials themselves – and less in the production of the other things. Ultimately there will be enough steel, energy, food and so on to meet demand – supply is responding. But considerable adjustment is needed to get there (and Australia is a very prominent part of that adjustment). The average consumer in an advanced economy is effectively experiencing a decline in purchasing power over food, energy, and raw material-intensive manufactures. Australian consumers face this to some extent as well. Were Australia not a producer of raw materials, we would be experiencing a good deal more of it. In such a world, there would be no resources sector build up. Our currency would be much lower. We would be paying much more for petrol at the pump, for our daily coffee and for a wide range of other consumer products. We would not be holidaying overseas in our current numbers. We would have more of some other forms of economic activity that we currently have less of – we would, perhaps, be less of a “multi speed” economy. But it’s unlikely our economy overall would be stronger. As it is, the rate of unemployment has seldom, in the past few decades, been much lower than it has been recently. Moreover, in that alternative world the real income of Australians in aggregate would be a good deal smaller. But Australia is a resource producer, so we have the advantage of being able to take part in the additional supply of things that are in strong demand. This helps our incomes. Mining companies are doing their best to capitalise on the increase in demand, and the effects of this will flow through the economy, but other producers are also enjoying a boost to their income. Rises in the global prices of rural commodities over the past couple of years have been sufficient to deliver higher prices to most farmers despite the appreciation of the Australian dollar. As consumers, the rise in our currency means that we take some of that higher income in the form of greater command over tradeable goods and services. The foreign exchange market being what it is – namely an asset market – it has looked a long way forward into the resources boom and pushed up the currency quite quickly. This is having significant effects. While consumers do seem to be continuing their more cautious mindset overall, many seem over the past year to have had the confidence to leave the country to experience foreign travel at prices more attractive than any seen for a long time. Australia’s tourism sector is feeling the resultant loss of business, particularly in Queensland where the floods also had a separate impact on confidence. That latter effect will pass – Queensland’s set of natural endowments that attract tourists remains in place. But the need to adapt to the high exchange rate may continue. For as well as conveying a rise in purchasing power to consumers, the high exchange rate is exerting a powerful force for structural change. I think we are seeing this in the retail sector. The rapid growth of internet commerce – from a very small base – has been the topic of considerable discussion. This was bound to happen anyway with technology. But with the higher Australian dollar, the component of the retail “product” that is added in Australia – the local distribution and retailing overheads that are required to provide the retail “experience” – has become both much more visible, and much higher relative to the production cost of the good itself. So the incentive for the consumer to avoid those overhead costs has increased quite noticeably. The retail sector is therefore under pressure to reduce those costs. These are just some of the structural adjustment forces at work. Of course it is easy to talk about structural change in the abstract. It is another thing to cope with it in practice. There are no magic-pill solutions, nor are there any real alternatives to adjustment. What solutions BIS central bankers’ speeches there are, though, are likely to involve a re-focusing on productivity performance after a period in which, at least at a national level, our productivity growth has been disappointing. Yet, as I have said before, this is a much better problem to have than those we see in many advanced countries. The event to which we have to adjust is inherently income-increasing for Australia. Moreover, we do not carry the legacies of the past several years in our banks’ or public sector balance sheets that are such an impediment in other places. Conclusion Queenslanders have shown their resilience and adaptability this year in the face of extraordinary events. People from elsewhere in Australia have nothing but admiration for you. Resilience and adaptability are among the characteristics we will all need in order to cope with a global environment that is growing more complex rather than less, and that presents both economic challenges and opportunities greater than those we have seen for many years. The task for the economics profession – all of us here today and in like gatherings and institutions around the country – is to do our part in trying to understand these challenges and opportunities, to explain them to our communities, and to articulate the responses that are most likely to see our country prosper. 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Keynote address by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, to BankSA "Trends" Business Luncheon, Adelaide, 24 June 2011. | Philip Lowe: Inflation – the recent past and the future Keynote address by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, to BankSA “Trends” Business Luncheon, Adelaide, 24 June 2011. * * * I would like to thank Patrick D’Arcy, Hugo Gerard, Christie Lewis and Shalini Shan for assistance in preparing this talk. Good afternoon. I would like to thank BankSA for the invitation to speak in Adelaide today. It is a pleasure to be here. The topic that I would like to talk about this afternoon is inflation, which ties in very nicely with the main theme of BankSA’s quarterly bulletin which is being released today. First, I will talk in some detail about the distinct cycle in underlying inflation that we have seen in Australia over the past six years or so. After that, I will discuss the lessons that we might take from this cycle, as well as the broader lessons we have learnt from the past two decades of inflation targeting in Australia. The Recent Cycle in Inflation I would like to start with the cycle in underlying inflation that began in the mid 2000s (Graph 1). Graph 1 Across a range of measures, this cycle has been the most pronounced since the introduction of inflation targeting in the early 1990s. Between 2005 and September 2008, underlying inflation rose by more than 2 percentage points from around 2½ per cent to just above 4½ per cent. Then, since late 2008, underlying inflation has steadily declined to be around 2¼ per cent over the year to March 2011. As the RBA discussed in the latest Statement on Monetary Policy, this decline in underlying inflation looks to have now run its course and a gradual rise is expected over the next couple BIS central bankers’ speeches of years. Given this, it is timely to look back and to review what caused the recent cycle and what lessons it holds for our understanding of the inflation process. Before doing this it is worth noting that a cycle in headline CPI inflation is less obvious (Graph 2). This largely reflects the quarter-to-quarter volatility in the prices of fuel and fruit & vegetables. This volatility has been especially pronounced over recent years, partly because of the effects of Cyclones Larry and Yasi on banana prices.1 This volatility is also one reason that we often use the various underlying measures when assessing the ongoing inflation pressures in the economy. Graph 2 At a general level, the fact that underlying inflation picked up between 2005 and 2008, and then subsequently declined, is hardly surprising. In the period immediately prior to the North Atlantic financial crisis, global commodity prices were rising strongly, the unemployment rate in Australia had fallen to its lowest level in more than three decades and there was considerable pressure on capacity in the economy. The result was a pick-up in inflation. Then when the slowdown occurred, pressures on capacity eased and global commodity prices fell. Again, not surprisingly, the result was a moderation in inflation. What did, however, surprise us somewhat was the amplitude and the timing of this cycle in inflation. Within the RBA, the staff run a number of standard “workhorse” models based on historical relationships to help explain and forecast inflation.2 While these models are all consistent with a pick-up, and then moderation, in inflation, they have difficulty explaining the amplitude of the recent cycle. This is obvious from Graph 3 which shows the average fitted values of four of these models, along with the trimmed mean measure of underlying inflation. In mid 2008, for example, underlying inflation was around ¾ of a percentage point higher than can be explained by the average of these models, and none of the models can explain There has also been considerable volatility in the price of financial services due to the effect of the financial crisis. For a discussion of these models see Norman D and A Richards (2010), “Modelling Inflation in Australia”, Reserve Bank of Australia Research Discussion Paper No 2010-03. BIS central bankers’ speeches why underlying inflation reached over 4½ per cent. In contrast, during the period 2005 to 2007, inflation was mostly lower than can be explained by these models. Graph 3 The general picture that one gets from this analysis is that underlying inflation in Australia was slower to pick up than suggested by the historical relationships, but when it did eventually pick up, it did so more quickly, and by a larger amount, than suggested by these relationships. When we look closely at the details of the CPI, it is clear that this pattern is largely accounted for by the prices of services. This can be seen in Graph 4 which shows the inflation rate for manufactured goods in the CPI separately from that for non-manufactured items. Over the past decade, movements in the prices of manufactured goods are reasonably well explained by import prices, the exchange rate and labour costs. In comparison, over this period, the historical relationships do less well in explaining the inflation rate for non-manufactured items; the models over-predicted inflation in the middle years of the decade and then later under-predicted inflation. BIS central bankers’ speeches Graph 4 This overall pattern of surprisingly stable inflation for a few years and then a sharp pick-up is evident in the RBA’s own inflation forecasts over this period. In late 2006 and early 2007, the outcomes for underlying inflation were surprisingly well contained. At the time, we and others wondered whether something had changed significantly in the inflation process. But not long after that, the inflation outcomes were turning out to be considerably higher than we had expected. In fact, the difference between the RBA’s 18-month-ahead forecast for underlying inflation and the actual outcome over the year to September 2008 was the largest over the inflation-targeting period. In trying to understand this experience, there are three specific issues that I would like to touch on: the evolution of unit labour costs; the impact of housing-related costs on the CPI; and the role of international factors. Unit labour costs In the long run, movements in unit labour costs – i.e. average labour costs per unit of output – have an important bearing on the rate of inflation. Over the inflation-targeting period, unit labour costs have increased at an average annual rate of 2.6 per cent and the CPI inflation rate has averaged 2.7 per cent.3 The fact that these two numbers are so close to one another is no accident. If the profit share is to remain relatively steady over time, average growth in unit labour costs needs to be consistent with inflation target. Of course, in the short run, the link between unit labour costs and inflation is not nearly as tight. In the recent cycle, growth in unit labour costs picked up in 2004 and remained high until late 2008 (Graph 5). This was the result of both faster growth in average labour costs and slower growth in productivity. This calculation excludes the estimated effects of the introduction of the GST on the price level, as well as interest charges which were included in the CPI prior to September 1998. BIS central bankers’ speeches Graph 5 The pick-up in labour costs in the middle years of the 2000s is evident in a wide range of measures. Not only was there a lift in annual wage increases as the labour market tightened, but there were reports of many firms upgrading positions in an effort to retain and attract staff, with the upgraded positions attracting higher rates of pay. Some firms also increased the bonuses and other benefits paid to their staff. This increase in labour costs coincided with a period of slower growth in labour productivity. Since 2005, estimated labour productivity growth has averaged less than ½ per cent per year, compared with average growth of 2 per cent over the 1990s. The reasons for this slowdown are not fully understood, although it may partly be a result of the high commodity prices that have allowed lower quality and/or more costly mines to be developed. In any case, productivity growth will need to pick up again if our living standards are to improve at the rate we have become accustomed to over the past two decades. This is a major challenge facing both the private and public sectors. Looking back to the recent cycle in inflation, it is clear that developments in unit labour costs had a significant role, both in contributing to the increase in inflation and then to its decline. But they provide only a partial explanation, and alone cannot explain why inflation picked up so sharply in 2007 after having been stable over the preceding few years. One possible explanation for this pattern is that there is some threshold in capacity utilisation which when crossed causes inflation to increase very quickly. An alternative explanation is that the short-run dynamics of underlying inflation were influenced by other factors during this period. It is difficult to formally test these two explanations, but other factors do appear to have played a significant role. Of these, developments in housing costs were perhaps the most important. Housing cost inflation Currently, housing-related costs – including rents, utilities and the cost of building new dwellings – account for around 20 per cent of the CPI, the largest share of any single group. Broadly speaking, the housing component of the CPI shows the same general pattern as that in underlying inflation, although the recent moderation is less pronounced (Graph 6). BIS central bankers’ speeches Graph 6 A couple of factors are important in explaining this general pattern. The first is that the large run-up in Australian house prices that was driven by the adjustment to low inflation ended in late 2003. When the housing boom came to an end, building cost inflation came down and growth in rents was subdued for a few years. These outcomes helped hold down overall inflation rates during this period. But by 2007, the cycle had again turned, with building costs rising more quickly and growth in rents accelerating. This faster growth in rents reflected the changing balance of demand and supply in the rental market, with strong population growth coinciding with relatively slow expansion of supply. The second factor has been utilities prices. During the middle years of the 2000s utilities prices were increasing at an average rate of 4 per cent, which was slightly lower than that in the previous few years. Then from 2007, utilities price inflation accelerated sharply. The proximate cause was the regulatory decisions allowing double-digit price increases, partly to help fund infrastructure investment, particularly for the distribution of electricity. But a deeper cause was the low levels of investment in previous years, which meant that the capacity of the system to distribute electricity had not kept pace with the growth in demand, particularly during hot weather.4 While these developments in rents and utilities do help explain the particular dynamics of inflation over the recent cycle, they also demonstrate that when the economy is operating up against supply constraints, all sorts of prices – and not just the price of labour – start rising more quickly. International factors The third issue that I would like to touch on is the role of international factors. Looking at headline inflation rates across countries over recent years, there is a deal of similarity in the movements (Graph 7). Many countries in both Asia and the North Atlantic experienced increases in headline inflation rates in 2007 and 2008 and many experienced For further details, see Plumb M and K Davis (2010), “Developments in Utilities Prices”, RBA Bulletin, December, pp 9–18. BIS central bankers’ speeches declines in late 2008 and in 2009. This co-movement partly reflects the large changes in global commodity prices over recent years. When global oil prices went up, they boosted the CPI in almost all countries, and when they went down during the financial crisis, they led to CPI inflation falling almost everywhere. Movements in food prices had a similar global effect. Graph 7 In terms of underlying inflation, we also see some co-movement across countries over recent years, although somewhat less than in headline inflation (Graph 8). When underlying inflation in Australia was rising, so too were equivalent measures of underlying inflation in the United States, as were exclusion-based measures of core inflation in most Asian countries.5 Similarly, measures of underlying inflation fell almost everywhere in the aftermath of the financial crisis, although there has been more dispersion recently. These common movements reflect the correlation in the business cycle across countries, as well as the flow-on effects of the large changes in global commodity prices to the prices of a wide range of final goods and services. Trimmed mean measures of underlying inflation are not available for most countries in Asia. BIS central bankers’ speeches Graph 8 Movements in the exchange rate have also influenced inflation outcomes over recent years. In particular, the trend appreciation of the Australian dollar from 2002 has helped hold down the prices of many imported manufactured goods. For example, the price index for household electrical appliances is 8 per cent lower than it was nine years ago. Over this same period, clothing prices have fallen 10 per cent, the price of shoes by 13 per cent and the price of manchester by 24 per cent. These are all large price declines. Around the trend appreciation of the exchange rate there have, however, been significant swings. In particular, the large depreciation of the currency as a result of the financial crisis saw the prices of many manufactured goods increase in 2009. These increases slowed the moderation in underlying inflation during this period. More recently, the subsequent appreciation of the currency has led to quite large falls in the prices of many manufactured goods. Overall though, these swings in the exchange rate have played only a relatively minor role in explaining the recent cycle in underlying inflation which has been primarily driven by domestic factors. Some Lessons So to summarise, an important lesson from this recent experience is that inflation responds to the changing pressures on capacity in the economy. When demand is high relative to the economy’s capacity to produce goods and services, the cost of labour and raw materials tend to rise and firms’ mark-ups tend to increase. Conversely, when demand is low relative to the economy’s capacity to produce goods and services, these pressures ease and inflation tends to fall. It is also clear that the dynamics of the recent cycle in inflation were influenced by capacity pressures in the housing market and by developments in utilities prices. They were also influenced by capacity pressures in the global markets for commodities. But these factors alone fall well short of fully explaining the cycle, with the upward pressure on prices in 2008 being very widespread. At that time, around three-quarters of the 90 individual items in the CPI were increasing at faster than their average rate of the previous two decades (Graph 9). BIS central bankers’ speeches Similarly, the deceleration of inflation since September 2008 has been widespread, with the prices of relatively few items currently increasing at faster than their average rate. Graph 9 Looking at the experience over the past six years as a whole, it is clear that the protracted period of above-average growth in unit labour costs did eventually lead to higher inflation and this was compounded by a variety of other capacity pressures in the economy. Subsequently, the slowing in unit labour costs during the downturn and the easing of these other capacity pressures saw inflation moderate significantly. But looking beyond this recent cycle, the past 20 years carry a broader and more important lesson. And that is the economy works better with low and stable inflation, and that the monetary policy framework matters. In the 1970s and 1980s we saw the consequences of high inflation rates. Inflation eroded the value of people’s hard-earned savings. It made long-term planning difficult. It added to uncertainty. It distorted investment decisions. And as the late 1980s showed it made leveraged asset purchases an easier path to wealth than hard work. The end result was slower growth and greater economic volatility. High inflation also meant high interest rates. In the 1980s, the inflation rate averaged 8 per cent, and the mortgage rate averaged 13 per cent and peaked at 17 per cent. In contrast, since 1993 inflation has averaged just a little above 2½ per cent and the mortgage rate has averaged 7½ per cent. And the volatility of both inflation and interest rates has also been lower under the inflation targeting regime. The clear lesson here is that changes in the average inflation rate ultimately lead to changes in average interest rates, including those on mortgages. Today, most people take low inflation as a given, as a permanent part of our economic landscape. Inflation expectations are well anchored and the possibility of a rapid increase in the general price level is not something that most people worry about. This is how it should be. There are enough uncertainties in today’s world, without adding uncertainty about the average rate of inflation to the list. For all these reasons, there is broad community acceptance that the main contribution that the Reserve Bank can make to strong sustainable growth in the Australian economy is to BIS central bankers’ speeches maintain low and stable inflation. In concrete terms, our objective is to keep the average rate of inflation over time somewhere between 2 and 3 per cent. We have achieved this over the past two decades, and this has been one of the key building blocks for Australia’s strong economic performance. Importantly, we have had from the start a flexible inflation targeting regime focusing on medium-term outcomes, which is what ultimately matters to both households and businesses. Under this framework, inflation has been both below, and above, the 2–3 per cent range. The framework allows us to respond to one-off events and to large changes in world relative prices in a way that promotes economic stability and the framework has been important in anchoring inflation expectations. Looking ahead, as the Bank has discussed recently, the current environment is a particularly challenging one. In the central scenario, we are looking at a significant boom in investment in the resources sector at a time when the overall economy has relatively little spare capacity. While conditions are very strong in parts of the economy, other parts are finding things very difficult because of either the high exchange rate or the ongoing restraint in household spending and borrowing. And to add to the complications, global commodity prices are undergoing a structural shift as hundreds of millions of people in Asia enter the global economy. It is not easy to navigate our way through this difficult environment. The new realities of the global economy have improved Australia’s medium-term prospects. At the same time though, they are causing considerable structural change in the economy which is leading to difficulties in a number of areas. As Australia takes advantage of its new opportunities and manages the process of structural change the task for the RBA is to keep inflation low and stable. By doing this, we can help promote sustainable growth in jobs and as well as economic and financial stability. Over the past 20 years, low inflation has been a key ingredient to Australia’s economic success and maintaining that record will help us meet the challenges that lie ahead. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 6 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Conference on Systemic Risk, Basel III, Financial Stability and Regulation, Sydney, 28 June 2011. | Guy Debelle: Collateral, funding and liquidity Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Conference on Systemic Risk, Basel III, Financial Stability and Regulation, Sydney, 28 June 2011. * * * I thank Chris Stewart and Matt Boge for their help in preparing this talk. Today I am going to talk about a few interrelated issues concerning the banking system: collateral, funding and liquidity. The financial crisis brought into sharp relief the liabilities side of a financial institution's balance sheet, that is, the funding structure. This had previously been somewhat neglected, but the fates of Northern Rock, Bear and Lehmans were clearly affected by the nature of their funding. While their funding structure played a significant part in the downfall of those institutions, I would argue the ultimate concern was about the quality of their assets. The funding problems were symptomatic of concerns about asset quality. In my view, the pendulum has swung too far in focusing on liabilities. Such a swing is evident in the proposed change to Standard & Poor's ratings methodology for the global banking system. The proposed new methodology shifts the assessment of financial strength of an institution markedly towards funding and away from asset quality. Asset quality should still be paramount and should be given a far larger weight than liabilities in assessing financial strength, along with the extent of leverage (capital). The solvency of any bank first and foremost is a function of the quality and value of its assets. This is, of course, true of any entity, but it is particularly true for banks because of the implications asset quality has for liquidity and because of the leveraged nature of financial institutions. The crux of my argument today is this: if I am a creditor of a bank, my due diligence should be spent mostly on assessing the asset side of the bank's balance sheet in determining whether or not I will get repaid in full. If asset quality remains high, I should be confident of being repaid. Financial institutions prior to the crisis had been in what might be described as an asset-driven world. Banks grew their asset portfolio on the assumption (which was generally realised) that the funding required would be easily forthcoming to support the asset growth. To paraphrase Field of Dreams, the financial environment was ‘if you lend it, they will fund’. That environment has been turned on its head by the financial crisis. Financial institutions are now in a funding-driven world. They can no longer assume that the funding will be readily forthcoming at a given price. We are now much more in a liability-driven world. So the structure and maturity profile of liabilities does bear close analysis. Because banks are in the business of maturity transformation, liabilities mature at a faster pace than assets. Assets can be difficult to liquefy in the market, particularly in stressed circumstances. As a result, a bank generally meets the need to repay its liabilities as they fall due by issuing more debt. But the bank's ability to refinance its maturing liabilities still fundamentally depends on the asset portfolio. An investor's decision as to whether it will be willing to lend to the institution will be based on its credit assessment of the institution's assets. If there are doubts about the quality of that asset portfolio, a bank will find it considerably more difficult to obtain more funding. BIS central bankers’ speeches Liquidity1 I will now focus more directly on the important relationship between asset quality and liquidity. If a bank is experiencing a problem of illiquidity, the state of its asset portfolio is even more paramount. This relates to one of the fundamental tenets of central banking, most famously associated with Walter Bagehot. Writing in Lombard Street in 1873, Bagehot states that central banks should lend freely (ie, liberally) at a high rate to solvent but illiquid banks that have good collateral. There are a number of important elements to Bagehot's statement which I am going to discuss in some detail. Starting at the end of the statement, and germane to the argument thus far, is that the bank must have good collateral. Therefore, critically, it is the asset side of the balance sheet which enables the bank to overcome a problem on the liabilities side: the central bank must be sure that it is lending against good collateral. The second aspect of the statement which bears further discussion is that the central bank should lend to solvent but illiquid banks. I don't see this as being materially separable from the collateral issue. As I have argued above, a bank's solvency is most strongly influenced by the quality of its collateral. Capital and leverage play an important role too. It is sometimes said that it might be difficult to determine whether the issue really is one of solvency rather than one of liquidity. Clearly, the fact that a liquidity issue has risen may well be a signal that the market has concerns about solvency. Hence the central bank certainly should pay heed to that signal from the market. But the experience of the past few years demonstrates liquidity crises can arise because of uncertainties that can be exacerbated by funding structures which are heavily skewed to the short term. In keeping with my argument thus far, in my opinion, it behoves the central bank to look through those uncertainties to the underlying asset quality of the institution under question, and be prepared to lend secured against quality assets if the situation warrants. This is particularly true when there is systemic uncertainty. That is, counterparty risk aversion increases. Such instances have arisen on a number of occasions in recent years. As I have said before, in those circumstances, the central bank acts not so much as lender of last resort, but as intermediary of last resort.2 Participants in the market are uneasy about lending to each other at any price, secured or unsecured, because of concerns about the solvency of the counterparty. The central bank can refrain from participating in the risk aversion and intermediate this process across its own balance sheet, thereby ameliorating the tensions created by the shortage of liquidity in the market. Together with the provision of liquidity, there may also be a need for the central bank, or prudential regulator, to provide information about the quality of banks' balance sheets to reduce the uncertainties that pervade. One could characterise the stress tests conducted in the US in the middle of 2009 as an example of this. Moreover, by providing the liquidity (against collateral), the central bank is indicating its confidence in the solvency of the institutions that can be reinforced by this provision of information. These issues are also covered in Stevens G (2008), “Liquidity and the Lender of Last Resort”, Seventh Annual Sir Leslie Melville Lecture, RBA Bulletin, May, pp 83–91. Debelle G (2009), “Some Effects of the Global Financial Crisis on Australian Financial Markets”, Finance Professionals Forum, Sydney, 31 March. BIS central bankers’ speeches The final aspect of Bagehot's statement is that the lending should be at a high rate.3 But a higher rate than what? A relevant benchmark is the rate at which the central bank provides liquidity in its normal operations. In the Reserve Bank's case, that is a rate which is a small spread (normally less than 10 basis points) to the cash rate. Emergency liquidity provision would clearly need to be a higher rate than this, otherwise institutions would avail themselves of this source of liquidity even in normal times. That is, the central bank should be a last resort, not a first resort. Within the Reserve Bank's operating framework, a reasonable benchmark would be the rate charged on the standing overnight facility, which is 25 basis points above the cash rate.4 This facility is called upon at various times throughout the year, generally as a result of small unexpected technical hitches in the money market.5 For example, over the past financial year, it was utilised on two occasions, with a total of $363 million drawn, and for a term of no more than one day. But in a stressed situation, that rate is still likely to be less than the market rate, as otherwise there would be no need for recourse to the central bank. Thus the rate is penal relative to the normal cost of liquidity provision but not necessarily relative to the stressed market price of funding, a distinction which is often overlooked in such discussions. It is also worth noting that the central bank can apply a haircut to the value of the collateral it is lending against. That is, it will not lend dollar for dollar against the collateral but rather against some (generally large) fraction of its value. This provides protection to the central bank. Of course, the issue of value can be difficult to determine in stressed situations. The current market price may well not be an adequate guide to the value of the collateral. But the central bank can ensure adequate protection for its liquidity provision by setting an appropriately sized haircut. That said, if the central bank assesses that there is indeed little concern about the quality of the collateral, this should not be too much of an issue. The final issue that often arises about the provision of liquidity support by the central bank is that of stigma. During the crisis, in some jurisdictions, banks were clearly loath to approach the central bank because of concerns about stigma. That is, the call on the central bank's liquidity facility, in and of itself, would exacerbate the stresses the institution was facing. In Australia, this has been much less of an issue. In part, I believe this reflects the design of the Reserve Bank's market operations system. The key aspect is that a wide range of counterparties deal with the Reserve Bank on a regular basis as part of our daily liquidity operations. Hence banks are accustomed to dealing with us and have a well-established relationship with us. To recap, there is an important role for a central bank to play in a fractional reserve banking system as the lender of last resort. This is particularly the case in dealing with liquidity events where the central bank's provision of liquidity can be regarded as a public good.6 As noted, the central bank does not provide the liquidity insurance for free; it is at a penal rate. Moreover, the institution must hold an adequate amount of collateral that is of acceptable quality to the central bank to lend against. Such collateral may well deliver a lower rate of See again the Governor’s Melville Lecture as well as Charles Goodhart in “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. To be clear, I am not talking about the proposed liquidity facility that will form part of the Australian approach to the Basel liquidity rules discussed below. RBA (Reserve Bank of Australia) (2010), Annual Report 2010. See Kearns J and P Lowe (2008), “Promoting Liquidity: Why and How?”, in P Bloxham and C Kent (eds), Lessons from the Financial Turmoil of 2007 and 2008, Proceedings of a Conference, Reserve Bank of Australia, Sydney. BIS central bankers’ speeches return than other assets the bank might otherwise hold (although not necessarily so on an appropriately risk-adjusted measure). In that regard, I will now turn briefly to the Basel liquidity standards. The aim of those standards is to reduce the frequency with which banks might need to seek assistance from the central bank in a liquidity event to a very small number. It does so by making the size of the liquidity buffer banks are required to hold dependent on the structure and maturity of funding. Thus, while the central bank can ultimately liquefy part of the balance sheet of a solvent institution in times of liquidity stress, in expectation, this would be a rare event. An institution should not be careless about its funding structure on the presumption of that support. Relevant to the arguments I have presented thus far, the Basel standards also make determinations around the quality of assets that can be held. The Basel guidelines focus primarily on government debt as the liquid asset. That is clearly not possible in Australia, given the prudence of governments over a long run of years. The amount of government debt that the Australian banking system would need to hold to meet the liquidity standard is in excess of the stock on issue. Moreover, if the banks were to hold the stock on issue, the government bond market would no longer retain any liquidity, which would be completely self-defeating. Hence it was announced late last year that the RBA would provide a committed liquidity facility to meet the shortfall between banks' holdings of government paper and their total liquidity needs. The banks will be charged an ongoing fee to be able to access the facility, the size of which is still under consideration. The eligible assets for the facility are those currently eligible for the Reserve Bank's market operations. Funding and assets of the Australian banking system Having talked thus far about the fundamental importance of collateral quality in determining solvency and in determining liquidity provision, I will now spend the remainder of my address talking briefly about recent developments in the asset and liability structure of the Australian banking system. On the asset side, the most marked development has been the slowing in aggregate credit growth. Lending for housing has slowed from the double digit pace of the two decades until 2007 to its current pace of around 5–6 per cent. This is noticeably slower than growth in household income, which was over 8 per cent in the year to March. For those who like to agonise about debt to income ratios, which I personally don't, this implies a marked change in that dynamic. On the corporate side of banks' assets, growth has been very subdued reflecting a number of different dynamics. The large investment boom currently underway is being financed in quite a different way from growth episodes in the past. Companies in that sector are funding themselves from cash or directly from global financial markets. Hence the domestic banking system is seeing much less of that business than in the past. To put it another way, intermediated business credit is likely to grow a lot slower in the period ahead than historical relationships with GDP and investment would lead one to believe. Finally, lending conditions to the commercial property sector remain tight as banks are still reluctant to increase their exposure to that sector. The changes in funding structure of the banking system are also quite stark (Graph 1). Most notably, there has been a marked increase in the share of deposit funding. Over the past three years, banks' deposit funding has grown by about 15 per cent per annum. As a result, deposits have also increased by about 9 percentage points as a share of overall funding liabilities. There has been strong growth in deposit growth from households as well as businesses. The former reflects the increased saving rate of the household sector, much of which has flowed to the banking sector. The latter partly reflects the strong growth in BIS central bankers’ speeches corporate profits, particularly in the resources sector.7 While growth in business deposits has been considerably faster over the past 12 months, household deposit growth has still been a very robust 9 per cent. Through late 2009 and early 2010, the strength of growth in deposits reflected, in part, the intense competition amongst the banks for deposits.8 This saw the yield on deposits rise markedly as the Reserve Bank has documented in its regular output over the past few years. But that competition appears to have levelled off in recent months, yet deposit growth has still continued at a robust pace. I would characterise the recent growth as being more an endogenous counterpart to the change in the growth and funding composition of the economy as a whole. One might expect that robust endogenous deposit growth to continue for some time yet. Graph 1 There has also been a significant drop in the share of short-term wholesale funding, reflecting regulatory and market pressures. The share of long-term wholesale funding has correspondingly risen, as banks have sought to term out the maturity of their liabilities. One noteworthy development that has generally escaped attention is that banks have raised less of this wholesale funding from offshore than has matured over the three of the past four quarters. That is, in net terms, the banks have been repaying their foreign liabilities. The Australian banks' use of offshore funding sources was particularly visible through 2009. They were a relatively large share of global bank debt-funding in that year, but that as much reflected the decrease in the number of highly rated institutions, as well as a lack of borrowing by other banks around the world through that period, as it did a pick-up in borrowing by the Australian banks. (That is, it was as much a function of the denominator shrinking as the numerator growing.) The Australian banks are a much smaller share of the Debelle G (2011), “The Australian Bond Market in 2011 and Beyond”, KangaNews Australian DCM Summit, Sydney, 15 March. Fabbro D and M Hack (2011), “The Effects of Funding Costs and Risk on Banks’ Lending Rates”, RBA Bulletin, March, pp 35–41. BIS central bankers’ speeches global market again now given they are raising relatively less and banks in the rest of the world are raising relatively more. This is likely to remain the case for the foreseeable future. Finally, to link back to the arguments I made earlier, I will talk briefly about concerns surrounding the extent to which Australian banks rely on foreign funding. If a liquidity issue were to arise around this funding, it is of critical importance that the foreign-currency denominated funding is fully hedged into Australian dollars, which indeed it is.9 This means that the liquidity issue is in Australian dollars rather than in foreign currency.10 As I discussed earlier, an Australian dollar liquidity issue can be addressed by the Reserve Bank. The Reserve Bank can meet a temporary liquidity shortfall by lending Australian dollars against the stressed bank's assets denominated in Australian dollars. The vast bulk of the Australian banking system's assets are denominated in Australian dollars. This stands in comparison to the situation of a number of European banks that funded US dollar assets with US dollar liabilities which had been swapped out of their local currency. When liquidity issues arose for those European banks, the ECB was constrained in its ability to provide the foreign currency liquidity to address those stresses.11 Conclusion The main argument I have presented here today is that it is the asset quality of a bank which is the primary determinant of a bank's financial strength. The asset quality affects both the ability of the bank to raise funding in the market and also, importantly, has a first-order effect on the ability of the institution to obtain liquidity support from the central bank during a stressed situation. While the funding structure of a financial institution warrants close scrutiny, an investor in that institution should pay the greatest scrutiny to the asset side of the balance sheet. D’Arcy P, M Shah Idil and T Davis (2009), “Foreign Currency Exposure and Hedging in Australia”, RBA Bulletin, December, pp 1–10. That said, as well as matching the currency, the hedging is generally also maturity matched. For more discussion of this issue, see CGFS (Committee on the Global Financial System) (2010), “The Functioning and Resilience of Cross-border Funding Markets”, CGFS Paper No 37. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 7 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the ADBI/UniSA Workshop on Growth and Integration in Asia, Adelaide, 8 July 2011. | Guy Debelle: In defence of current account deficits Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the ADBI/UniSA Workshop on Growth and Integration in Asia, Adelaide, 8 July 2011. * * * I thank George Gardner and Michael Shoory for their help. Thank you to Tony Cavoli and the other organisers for putting together this interesting conference examining issues around trade and capital flows. I’m very pleased to be in my home town to give this talk which will address the theme of the conference. Current account deficits have a pretty poor reputation, unfairly so in my opinion. While in some instances this reputation is earned, today I want to provide some arguments in their defence, highlighting that there are a number of circumstances in which one should not be concerned about their presence. In particular, I want to make the point that deficit does not have to equate to imbalance. Deficits are not always and everywhere a bad thing, notwithstanding the pejorative connation of the word deficit. 1 Cross-border capital flows, which are the mirror of current account positions, can convey large benefits. As the BIS states in its recent Annual Report: “international financial flows … free firms’ investment decisions from domestic financing constraints while allowing investors to reduce risks and optimise returns by globally diversifying their assets. International financial flows thus enhance the efficiency with which capital and know-how are allocated.” 2 This is very much the argument I wish to prosecute, but the BIS then follows this positive statement with a chapter highlighting the risks of international flows. Much of my argument is presented considerably more eloquently in a recent paper by Max Corden, and I commend that paper to you. 3 I hope I can do some justice to the position Max puts. I will start by presenting a short summary of the global imbalance argument. Then I will present a framework with which one can think about the issue and present a case for the defence. In the final part of the speech, I will describe some recent developments in the Australian current account position and particularly the associated capital flows. Current account imbalances Olivier Blanchard and Gian Maria Milesi-Ferretti provide a concise summary of the global imbalance argument in a recent IMF paper. 4 They describe the difference between “good” and “bad” current account deficits. Bad current account deficits are those which result from domestic distortions or excessive fiscal positions. Good ones are those which do not have such causes. It is interesting to note that the language associated with current account deficits also tends to be pejorative. Current account deficits worsen rather than widen and improve rather than narrow. BIS (Bank for International Settlements), BIS Annual Report 2010/11, p 33. Corden WM (2011), “Global Imbalances and the Paradox of Thrift”, CEPR Policy Insight, No 54; see also Corden WM (2008), “The Global Imbalances: What is the Problem”, Revised version, Wincott Lecture, September 2007 and Corden WM (2007), “Those Current Account Imbalances: A Sceptical View”, The World Economy, 30(3), pp 363–382. Blanchard O and GM Milesi-Ferretti (2011), “(Why) Should Current Account Balances be Reduced?”, IMF Staff Discussion Note 11/03. BIS central bankers’ speeches This is effectively Pitchford/Lawson redux. 5 As you may recall, John Pitchford and Nigel Lawson (then Chancellor of the Exchequer) presented the “consenting adults” view of current account positions. As long as current account positions are the result of savings and investment decisions by the private sector which are not affected by distortions, then there is no cause for concern. Pitchford and Lawson used this framework to argue that the current account positions in their respective countries (Australia and the UK) did not represent an imbalance, given the absence of any apparent distortions. In contrast, Blanchard and Milesi-Ferretti conclude that even good current accounts are mostly bad too and hence most current account deficits are imbalances. Blanchard and Milesi-Ferretti also make the point that it is important to look beyond current accounts to the whole structure of the capital (financial) accounts. While disagreeing with their conclusion just mentioned, this is a point I would wholeheartedly endorse for two reasons: Firstly, current accounts are fundamentally endogenous. They reflect the net outcome of a raft of savings and investment decisions taken by households, businesses and government across the whole economy. The current account position is a symptom not the cause. If one is concerned about the imbalance, the focus should be on the policy that is causing it. Secondly, the capital (or financial) account, which is the mirror of the current account, is the net of a large array of gross capital flows. These flows reflect the financial decisions taken by both domestic and foreign investors. For example, in the global imbalances debate, it is often noted that Europe has a current account position that is close to zero. This is true, but it masks large divergences between current account positions within the euro area, which are symptomatic of the problems manifesting themselves now. Secondly, there is nothing intrinsically optimal about zero. It may well be the case that the appropriate balance for Europe is not zero but distortions of one form or another have delivered such an outcome. If that were the case (and I am not arguing that it necessarily is), then Europe would be contributing to global “imbalances” as much as those with large current account positions. Thirdly, behind the European zero balance, there are very large capital flows in both directions. Some of these, most obviously investment in US sub-prime mortgage securities, were clearly problematic, while others were clearly beneficial. Similarly, the US current account deficit through the 2000s was the net balance of very large capital inflows and outflows. Much of the inflows were into either US treasuries or to US mortgage securities and related products, while a sizeable share of the outflow was foreign direct investment by US corporations. The US was able to earn relatively more on its stock of foreign assets than it paid on its foreign liabilities such that its net income position was often in surplus. 6 Some of the flows were “bad”, at least ex post, such as those which found their way into poor-performing securities. However, very few were able to identify ex ante the distortion that was generating these “harmful” flows. Other flows were clearly “good”. But the point to make is that focusing on the net balance of these flows, which is the current account position, is not particularly helpful relative to more scrutiny of the various components of the gross capital flows. Pitchford J (1989), “A Sceptical View of Australia’s Current Account and Debt Problem”, The Australian Economic Review, 86, pp 5–14. This “exorbitant privilege” is examined in detail by Gourinchas P-O and H Rey (2005), “From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege”, NBER Working Paper 11563 and Curcuru S, T Dvorak and F Warnock (2010), “Decomposing the U.S. External Returns Differential”, Journal of International Economics, 80, pp 22–32. BIS central bankers’ speeches Some context To mount a defence of current account deficits, I would like to provide a bit of context with which to think about this issue. One place to start is with an overlapping generations model of a closed economy, 7 which we can think of as a country. Within this country there are households that are at various stages of their lifecycle. The younger working households save, the middle-aged households borrow, while the older households run down their stock of accumulated saving. So we have “imbalances” across the household sector. 8 The young households have current account surpluses, the middle-aged households like me are in current account deficit. But these “imbalances” are not generally cause for concern. It would not be socially desirable if there were no cash flows between households. Alternatively, we could consider the Australian states. At any point, there can be large current account positions between the Australian states. There are large financial flows across state borders too. Are we even aware that this is the case and should we be concerned? By and large, we should not. Again it is useful to think about why any such imbalances across the Australian states are not a cause for concern. Here we are straying into the optimal currency literature, most famously associated with Robert Mundell, which is currently getting a fair working over in the context of the problems of the European periphery. Some of the reasons we are not concerned about the current account “imbalances” of the Australian states are that the Australian states have a common currency, a federal fiscal system, sizeable interstate labour mobility (of which I and much of my Adelaide cohort are a good example of) and generally experience similar economic shocks. These are the main prerequisites identified for an optimal currency area. 9 The point of the two scenarios I’ve described here is that current account positions, even large ones, can exist that are benign and could not be classified as imbalances. The capital flows that are the counterpart to these current account positions are “good”, because they are associated with appropriate intergenerational transfers in the first case, and appropriate cross-border flows in an integrated economy in the second. Max Corden distils the concern that many have about global imbalances down to a concern about the “return journey”. Lenders of capital expect to receive the money they have lent back with interest (dividends if it is an equity investment). One reason that might increase concern as we move from transfers between households to crossing state borders to crossing national borders is that the information asymmetry about the return journey increases. Amongst other things, the geographic separation reduces the ability of the lender to monitor the use of funds by the end-borrower. One could question why this still remains true today, with increased transparency and lower cost of information. For example, in the recent episode, the funds that made their way to the US housing market over the 2000s had a long and non-transparent chain between the provider of the funds and the ultimate borrower. There were major problems of information asymmetry and failures of due diligence right along the chain. Another reason that borders matter is that the capacity to borrow in one’s own currency is important. The claims across state borders are denominated in Australian dollars, which are This is the model which Olivier Blanchard himself taught me! In this stylised world, one could also add the corporate sector to the mix. As they are generally a net borrower, they would be another generator of current account deficits. In the current economic climate in Australia, one could think about the possibility of the Western Australian economy experiencing an exchange rate appreciation relative to the rest of the country to mitigate the adjustment. However, the assessment is that the benefits of a common currency union for the Australian states vastly outweigh any costs. BIS central bankers’ speeches easily settled without doubt in the integrated Australian financial system. Indeed, the system is so integrated that there is no easily obtainable measure of cross-border claims for the states. A further aspect that appears to be a common cause for concern about current account deficits is the economic adjustment that might ensue were they to narrow precipitously. Much of this concern appears to stem from a fixed exchange rate world. In a fixed exchange rate world, sudden stops can (and did) occur that are very disruptive. Capital inflows dry up rapidly and capital outflow increases, necessitating a sharp contraction of domestic demand so that the trade balance moves into surplus. Inevitably, this is associated with a domestic recession. Such a scenario does not directly translate into a world of floating exchange rates. In that environment, the main mechanism of adjustment is the exchange rate. If global investors reduced their appetite for investment in a particular country, the exchange rate would depreciate until the point where investors would be happy once again with their allocation to the country in their overall portfolio. While the exchange rate might overshoot in this scenario, the depreciation is stimulatory to the economy, whereas in the fixed exchange rate world, the adjustment is contractionary. The conclusion I wish to draw then is that there can be perfectly good reasons why current account balances are not zero, and indeed can even be quite sizeable, without them constituting imbalances or being a cause for concern. The accompanying capital flows are often beneficial. This is not to say that they should not be scrutinised but rather that the scrutiny should really be on the nature of those capital flows to examine whether they are being driven by inappropriate policies or distortions. Recent changes in the composition of Australia’s capital flows With the previous discussion in mind, I will now turn to a short analysis of the Australian situation. Over the past three years, there have been some quite sizeable changes in the size and composition of Australia’s current account and capital account. Graph 1 BIS central bankers’ speeches From the early 1990s until 2007, Australia recorded a current account deficit which averaged around 4¼ per cent of GDP (Graph 1). 10 There were cycles around that level, with the current account narrowing to 2 per cent of GDP in 2001 in the aftermath of the Asian crisis and widening to around 6 per cent of GDP in 2007. At the same time, there was reasonable stability in the major components of the capital account. The inflow arising from the offshore funding of the banking sector was around 3½ per cent of GDP. This led to the common assessment that the Australian banking sector was “funding the current account”. In my opinion, this analysis is incomplete. As mentioned earlier, a current account deficit and its equivalent capital account surplus is the net outcome of considerably larger gross flows. This is evident in Graph 1. Through this period there was substantial Australian investment abroad, particularly in the form of equity. Much of this was the result of the Australian superannuation sector investing a sizeable share of their funds in offshore equity markets. At times, there were also sizeable equity inflows to Australia. Over the past few years, the composition of these capital flows has changed quite significantly, providing some contrary evidence to the hypothesis that the banks fund the current account. I don’t think there was any particular problem with the structure of these capital flows previously, nor do I think there is one now. Graph 2 In 2010, the net inflow to the Australian banking sector was close to zero (Graph 2). Indeed, over the last three quarters of 2010, the Australian banking sector was a net repayer of its offshore liabilities. That is, maturities exceeded issuance. This did not reflect a lack of appetite for Australian bank paper, as the cost of issuance was broadly flat or even slightly Indeed, Australia has recorded a current account deficit for much of its history. BIS central bankers’ speeches lower over the period. Instead, as I discussed in a recent speech, 11 it reflected the fact that the banks had less need for wholesale borrowing given the conjuncture of fast deposit growth and subdued asset growth. The terming out of the banking sector’s funding is also evident in the decline in the stock of short-term foreign liabilities but an increase in their longer-term liabilities. Graph 3 This picture is reinforced if we include flows into Australian non-bank securitised assets (Graph 3). After net inflows amounting to around 1–2 per cent of GDP through the first half of the 2000s, there have been net outflows over the past three years. This change in net flows reflects the sharp drop-off in global appetite for securitised products as the problems in the US housing market came to the fore. The decline in demand for Australian securitised assets in part reflects the fact that a lot of the buyers of the paper pre-June 2007, structured investment vehicles, are no longer around. 12 Recent developments suggest appetite for these assets is growing again, both on- and offshore. In 2010, while the banking sector’s net offshore borrowing was zero, the current account deficit, while narrower than earlier years, was still 2½ per cent of GDP. An increase in foreign purchases of Australian government debt and decreased Australian investment abroad offset the decline in net capital inflow to the banking sector. Turning to the current account side of the balance of payments, the notable development has been the shift in the trade balance from deficit to surplus as the much-commented-on rise in Debelle G (2011), “Collateral, Funding and Liquidity”, Address to Conference on Systemic Risk, Basel III, Financial Stability and Regulation, Sydney, 28 June. See Debelle G (2010), “The State of Play in the Securitisation Market”, Address to the Australian Securitisation Conference 2010, Sydney, 30 November. BIS central bankers’ speeches Australia’s terms of trade has significantly boosted resource export earnings. In that respect, it is sometimes remarked that absent the terms of trade rise, Australia’s current account would be markedly wider. But that ignores the fact that the exchange rate has also appreciated significantly alongside the rise in terms of trade, thereby reducing the boost to export earnings as well as causing changes in domestic absorption and production. Another effect of the rise in the terms of trade has been on the net income deficit. Because a sizeable share of Australia’s resource sector is foreign-owned, the increased income of that sector partly “leaks” into a higher payment to the foreign owners, either in the form of dividend payments or retained earnings, thereby increasing the net income deficit. This also would not be occurring if the terms of trade were not at their current level. Conclusion So in conclusion, I am reminded of some sage advice from Hamlet: “there is nothing either good or bad, but thinking makes it so”. Current account deficits have a bad reputation, which is not always warranted. While some current account positions are the result of distortionary policies that should be redressed, others are not. The examples I have discussed show that there are configurations of current account positions and capital flows that should not be a cause for concern. Indeed, in many cases, they are beneficial and facilitate a productive reallocation of global capital. At a minimum, a more nuanced examination of current account positions, and the associated capital flows, is appropriate, rather than a simple focus on headline numbers. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 7 |
Panel session speaking notes by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Property Council of Australia, Darwin, 25 July 2011. | Malcolm Edey: General economic and financial environment in Australia Panel session speaking notes by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Property Council of Australia, Darwin, 25 July 2011. * * * I’ve been asked to speak today about the general economic and financial environment in Australia. I’ll leave it to the other panellists to talk more specifically about the property sector. As you know, the Australian economy came through the recent financial crisis in better shape than most – certainly in the developed world. In fact, what is often referred to as a global crisis was mainly a crisis of the United States and Europe. Those were the economies that experienced the most serious distress in their financial sectors, and they were also the ones that required significant public-sector capital support for their banks. They also experienced severe recessions, from which they are still recovering. The Australian economy avoided recession, and the banking sector remained in relatively good condition throughout the recent period, though of course it was not immune from the international distress. The overall dimensions can be summed up in a few facts and figures: At the height of the downturn, the US economy contracted by about 4 per cent over a year; the euro area by 5 per cent, and the UK by 6 per cent. For all these economies, it was their most severe recession in the post-war period. In contrast, growth of the Australian economy remained positive. It dipped to an annual figure of around 1 per cent during much of 2009, before picking up to a pace that was around trend in 2010. (I note in passing that the most recent growth outcomes are affected by the temporary effects of flooding and cyclone at the beginning of this year.) Unemployment in Australia rose only moderately during the global downturn, and has since fallen. And Australian banks, in aggregate, remained profitable, although they did experience a decline in loan quality. Loan losses have generally now peaked, and banks have strengthened their capital and liquidity positions since the crisis. When I’m asked to explain Australia’s good performance in this period, I usually attribute it to a mixture of good luck and good management. Australia was fortunate to have been at a relatively strong point in the business cycle when the crisis hit; and, in the recovery phase, as is often remarked upon, we have benefited from being well connected to the fast-growing economies in the Asian region. But I think there were also some important areas of good management in macroeconomic and regulatory policies: Australia’s strong fiscal position allowed plenty of scope for countercyclical action to support growth during the world downturn. Monetary policy was well-positioned to cut rates aggressively at the height of the crisis. And our financial system has been well served by APRA’s relatively conservative prudential approach. Australian banks were held to higher standards than many of their international counterparts, and we’ve been well served by a prudential regulator prepared to ask banks tough questions about the risks they were taking. The upshot is that, although there was some deterioration in banks’ asset quality BIS central bankers’ speeches around mid-decade, this was nowhere near as pronounced as it was in the US and Europe. In saying all that, I also like to make the point that the resilience of the financial sector and the real economy are inter-related. The banks performed well partly because the economy itself kept growing; and the economy in turn was resilient partly because there was no major deterioration in the balance-sheet quality of our banks. One of my responsibilities at the RBA is to oversee production of the half-yearly Financial Stability Review, which reports on developments and risks in the financial system (both globally and domestically). I’d like to pick up some of the themes from our recent reports. The most intense phase of the financial crisis is now some way behind us. It corresponded roughly to the six-month period from September 2008 to March 2009, which was just following the collapse of Lehman Brothers (along with a number of other high-profile failures in the US and Europe). That six-month period was the period of sharpest falls in world equity prices, and the most serious dislocation in credit markets. Global banks posted major losses, and there was a sharp contraction in trade and output across the US, Europe and Asia. Since then, financial conditions have generally been improving, along with the recovery in the global economy itself. Global economic growth has picked up to a strong pace overall, led by China, India and a number of other economies of the developing world. In the most heavily crisis-affected countries, indicators of financial sector performance have improved across a range of fronts: Banks have generally returned to profitability Asset quality in the banking system has begun to recover Equity markets have recovered from their early-2009 troughs And conditions in credit markets have improved. These are encouraging signs, but they certainly don’t amount to a return to pre-crisis conditions. Loan impairment rates are still high and property markets in the US and Europe are still weak, and these things have contributed to some ongoing nervousness in global credit markets. In addition to all that there is a particular focus at present on sovereign debt. A number of countries are running with very high levels of government debt in relation to their GDP and large fiscal deficits; and there is obviously considerable focus on the sustainability of those positions and the risk of default. I’m not going to make any predictions as to how that might evolve, partly because the situation is subject to ongoing change and policymakers in the various countries are still developing their responses. But I would make two points regarding potential implications for Australia: First, the Australian banks have only limited direct exposures to sovereign debt in the countries regarded as being most at risk. So potential effects on Australian banks’ overall asset quality are not an issue. A second channel of possible effect would be if there were some generalised disruption in global wholesale funding markets. Here it is important to note that, in the post-crisis environment, the Australian banks have significantly strengthened their positions. They have increased their reliance on domestic deposit funding, lengthened the average term of their wholesale funding, and correspondingly reduced their reliance on short-term wholesale debt. These changes will help to BIS central bankers’ speeches make them more resilient to any disruptive event in international credit markets, should it occur. Let me make a few more general remarks about the Australian financial system in the current environment. I’ve already made the point that Australian banks came through the crisis in good shape. Bank profits did decline during the downturn but they have since recovered, largely as a result of declining loan loss charges. Arrears rates in some areas have continued to creep up, but asset quality generally remains good (especially by international standards). Despite the uncertainties about Europe that I’ve already referred to, conditions in funding markets for the Australian banks have improved since the crisis, and so has system-wide growth in deposit funding. Domestic securitisation markets have been recovering. These developments have helped smaller lenders to regain some of the market share lost during the crisis period. Aggregate lending by banks has been relatively subdued in the past few years. Lending to the housing sector has continued to expand, but at a slow pace, while business lending has tended to fall, with businesses relying more on internal funding and equity raisings. These trends have reflected several factors, not least of which has been a shift towards greater financial conservatism by households and businesses. Household saving rates have increased, and there has been widespread de-leveraging by businesses. I expect this audience will be interested in the likely environment for lending by banks in the future. The trends I’ve just described can be seen (at least in part) as responses to the lessons drawn from the crisis – by households and businesses – regarding the dangers of excessive debt. Another factor is that the funding environment for banks has been more difficult than it was before the crisis, and this has raised the net cost of financial intermediation. To some extent, these effects might be expected to fade as economic expansion proceeds and confidence in global credit markets improves. Nonetheless, when we think about what the post-crisis environment might look like further ahead, it seems unlikely that we’ll be going back to the days of consistent double-digit growth in lending that we saw in the pre-crisis years. That growth was driven in part by factors that can’t be repeated – the deregulation of the financial system in the 1980s, and the transition to low inflation in the 1990s. There was also a world-wide trend towards greater appetite for risk and leverage. In the post-crisis environment, borrowers and investors are more cautious than they were, both at home and abroad. That’s likely to mean less demand for leverage and more reliance on equity funding, even when the economy itself is growing strongly. If those trends continue, I think it will be good for financial stability, but it will also mean that our lending institutions have to get used to lower rates of expansion than were typical in the pre-crisis years. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 7 |
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, 26 July 2011. | Glenn Stevens: The cautious consumer 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, 26 July 2011. * * * Thank you for coming out once again in support of the Anika Foundation. 1 I want also to thank in particular Macquarie Bank and the Australian Business Economists for their continuing support of this annual series. In last year’s Anika Foundation address, I talked about the fiscal difficulties being faced by governments of some of the world’s largest countries in the wake of the financial crisis. A theme of that talk was that a number of major advanced economies had been facing for a while the need to address long-term structural issues in their fiscal accounts. In large part these stemmed from the inevitable collision of long-run trends in demographics and entitlements. A deep recession and the prospect of a slow recovery have brought forward the pressure to face these issues. Over the past year, we have seen the focus on fiscal sustainability continue to increase. The problems have been most acute in Greece, though unfortunately not confined to it. Greece is a small country that has nonetheless assumed considerable significance. The citizens of Greece are now experiencing an austerity regime of historic proportions, which is a precondition for access to the foreign official funding that will allow them to meet their near-term obligations. But the longer-term solution surely will involve the taxpayers of Europe accepting part of the costs of restoring Greece to sustainability. The recent agreement appears to be a further step in that direction, with risk being shifted from the private sector onto the European public sector. I would view this as a step on the road to an eventual solution, though European policymakers continue to face a very delicate task in preserving the combination of fiscal sustainability and the single currency. Concerns about the US fiscal position have also increased, though this has not been reflected, at this point, in market prices for US debt. The immediate need is for the US authorities to lift the debt ceiling, then for them to work towards longer-term sustainability. In both the US and European cases, the process of allowing things to go right to the brink of a very disruptive event before an agreement is reached on the way forward has been a source of great uncertainty and anxiety around the world. That anxiety has extended to Australia, even though, as I am sure people are sick of hearing me say, Australia is in the midst of a once-in-a-century event in our terms of trade. I won’t recite the facts yet again. Suffice to say that this is, at least potentially, the biggest gift the global economy has handed Australia since the gold rush of the 1850s. Yet it seems we are, at the moment, mostly unhappy. Measures of confidence are down and there is an evident sense of caution among households and firms. It seems to have intensified over the past few months. There are a number of potential factors to which we can appeal for an explanation of these recent trends. The natural disasters in the summer clearly had an effect on confidence, for example. Interest rates, or intense speculation about how they might change, are said to have had an impact on confidence – even after a period of more than a year in which the cash rate has changed only once, the most stable outcome for five years. Increasingly bitter The Anika Foundation supports <http://www.anikafoundation.com/>. BIS central bankers’ speeches research into adolescent depression and suicide. See: political debates over various issues are said by some to have played a role as well. The global outlook does seem more clouded due to the events in Europe and the United States. We could note, on the other hand, that the Chinese slowdown we have all been anticipating seems to be relatively mild so far – that country has continued to expand at a pretty solid pace as measured by the most recent data. But these days, mention of the Chinese expansion reminds people that the emergence of China is changing the shape of the global economy and of the Australian economy. And structural change is something people rarely find comfortable in the short term, even though a capacity to adapt is a characteristic displayed by the most successful economies. So the description of consumers as “cautious” has become commonplace. It is not one I disagree with. Indeed the RBA has made such references on numerous occasions over the past couple of years. Nor do I wish to dismiss any of the concerns that people have. People want to make sense of the disparate information that is coming at them. I want to suggest that to do that – to make sense of it all – it is worth trying to develop a longer-run perspective, particularly in the area of household income, spending, and saving. That is my task today. I have two charts that I think help us to understand the story. Graph 1 These figures are from the quarterly national accounts (Graph 1). The top panel shows the level of household disposable income, and household consumption spending. Income as shown here takes account of taxes, transfers and household interest payments. Both series BIS central bankers’ speeches are measured in real per capita terms, and shown on a log scale. In the lower panel is the gross household saving ratio, which is of course the difference between the other two lines expressed as a share of income. 2 Also shown is a trend line for each of the income and consumption series, estimated using ordinary least squares, over the period 1995–2005. The trend is then extrapolated for the 21 quarters since the end of 2005. Notice that the trend growth for real per capita household income over the period 1995 to 2005 was 2.0 per cent per annum. That’s a pretty respectable rate of growth for an advanced country. It was more than double the growth rate seen in the preceding two decades from 1975 to 1995. Growth at that pace means that the average real income doubles about every 35 years. Notice also that the trend line for consumption was steeper than that for income over the same period. These two lines were on their way to meeting. Real per capita consumption growth averaged 2.8 per cent per annum. This was a full percentage point higher than in the preceding ten-year period, and similar to the sorts of per capita growth rates for consumption seen in the late 1960s and early 1970s. For ten years up to 2005, then, consumption growth outpaced income growth, which was itself pretty solid, by three-quarters of a percentage point, on average, every year. In fact this convergence of income and consumption was the continuation of a trend that had already been in place for about a decade. As the bottom panel shows, the flow of saving fell as a share of income. As you can see, things began to change after that. From about 2006, real per capita income began to grow faster. Over the five years to the end of 2010, it rose by 2.9 per cent per annum. It may not be entirely coincidental that that period is when the terms of trade really began to rise in earnest. Yet from about the end of 2007, even as income was speeding up, household consumption spending slowed down. In per capita terms, real consumption today is no higher than three years ago. It’s no wonder that people are talking about consumer caution, and no wonder that retailers are finding things very tough indeed. Coming after a period in which real consumption had risen by 2.8 per cent a year for a decade, and had outpaced income growth for two decades, no net growth in consumption for three years is quite a big change. But these figures suggest that lack of income growth is not the reason for lack of consumption growth. It’s not that the income is not there, it’s that people are choosing, for whatever reason, not to spend it in the same way as they might have a few years ago. Why is that? To find an answer we need to look to the financial accounts of the household sector. It is now time to introduce the second chart (Graph 2). It shows gross household assets, also measured per capita, in real terms (i.e. deflated by the consumption deflator). The two components are financial assets (including superannuation assets) and nonfinancial assets, the bulk of which is dwellings. These data say that gross assets across Australian households presently average about $800,000 per household, or about $300,000 per capita. The measure here differs from the commonly cited net saving rate, which deducts an estimate of depreciation of the stock of fixed assets (such as dwellings) owned by households. BIS central bankers’ speeches Graph 2 Between 1995 and 2005, assets rose at an average annual pace of 6.7 per cent in real, per capita terms. Completely comparable figures for earlier periods are hard to come by. But it’s pretty clear that this increase stood out. Using the Treasury’s series for private wealth, from 1960 to 1995 the annual average per capita rate of increase in total wealth, in real terms, was 2.6 per cent. That is, it was broadly similar to the per capita growth rate of real GDP, which is what one would expect. So the growth from 1995 to 2005 was at a pace well over double the average of the preceding three or four decades. A large part of the additional growth was in the value of dwellings. The extent of leverage against the dwelling stock also tended to increase, with the ratio of debt to total assets rising from 11 per cent at the start of 1995 to around 17½ per cent by the end of 2005. It has tended to rise a little further since then. Had we really found a powerful, hitherto unknown route to genuine wealth? Or was this period unusual? Looking back, it appears the latter was the case. In 2008, the trend changed. Real assets per person declined for a period during the financial crisis. Given the nature of that event and the potential risks it presented, that is not surprising. Real asset prices have since risen again but, so far, have not resumed the earlier trend rate of increase, and at this stage they show no signs of doing so. They look very much like they are on a much flatter trend. This adjustment has been considerably less abrupt than those seen in some other places. Nonetheless, it is a very substantial change in trend. If people had been banking on a continuation of the earlier trend, they would be feeling rather disappointed now. Of course if that earlier trend in gross wealth owed something to a tendency to borrow to hold assets, then a continuation would have exposed households to increased risk over time. Casual observation suggests that this change of trend in the growth of assets, or “wealth”, roughly coincided with the slowing in consumption spending relative to its earlier very strong BIS central bankers’ speeches trend. It seems fairly clear that these financial trends and the real consumption and saving behaviour of households were closely connected. I would argue that the broad story was as follows. The period from the early 1990s to the mid 2000s was characterised by a drawn-out, but one-time, adjustment to a set of powerful forces. Households started the period with relatively little leverage, in large part a legacy of the effect of very high nominal interest rates in the long period of high inflation. But then, inflation and interest rates came down to generational lows. Financial liberalisation and innovation increased the availability of credit. And reasonably stable economic conditions – part of the so-called “great moderation” internationally – made a certain higher degree of leverage seem safe. The result was a lengthy period of rising household leverage, rising housing prices, high levels of confidence, a strong sense of generally rising prosperity, declining saving from current income and strong growth in consumption. I was not one of those who felt that this was bound to end in tears. But it was bound to end. Even if one holds a benign view of higher levels of household debt, at a certain point, people will have increased their leverage to its new equilibrium level (or, if you are a pessimist, beyond that point). At that stage, debt growth will slow to be more in line with income, the rate of saving from current income will rise to be more like historical norms, and the financial source of upward pressure on housing values will abate. (There may be other non-financial forces at work of course.) It is never possible to predict with confidence just when this change will begin to occur, or what events might potentially trigger it. But an international financial crisis that envelops several major countries, which has excessive borrowing by households at its heart, and which is coupled with a major change in the global availability of credit, is an event that would be likely to prompt, if nothing else did, a reassessment by Australian households of the earlier trends. It would also prompt a re-evaluation by financial institutions of lending criteria. This is precisely what has occurred over recent years. 3 What are the implications of these changes? An important one is that, as I said at a previous Anika Foundation lunch two years ago, the role of the household sector in driving demand forward in the future won’t be the same as in the preceding period. 4 The current economic expansion is, as we all know, characterised by a very large build-up in investment in the resources sector and expansionary flow-on effects of that to some, but not all, other sectors of the economy. It is certainly not characterised by very strong growth in areas like household consumption that had featured prominently in the preceding period. That is partly because the change in the terms of trade, being a relative price shift, will itself occasion structural change in the economy: some sectors will grow and others will, relatively speaking, get smaller. That is particularly the case if the economy’s starting point is one that is not characterised by large-scale spare capacity. I am conscious that this explanation has not made explicit reference to demographics – in particular the decisions of “baby boomers” in the years leading up to their planned retirements. No doubt these factors also played a role. But there is enough complexity to grapple with here already for today’s purposes. I have spoken before about population ageing and finance. See: <http://www.rba.gov.au/speeches/2005/sp-dg161105.html>. “… 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.” See: <http://www.rba.gov.au/speeches/2009/sp-gov-280709.html>.[ BIS central bankers’ speeches But those pressures for structural change are also coinciding with changes in household behaviour that are associated with the longer-run financial cycles I have just talked about. Just as some sectors are having to cope with the effects of changes in relative prices – manifest to most of us in the form of a large rise in the exchange rate – some sectors are also seeing the impacts of a shift in household behaviour towards more conservatism after a long period of very confident behaviour. It would be perfectly reasonable to argue that it is very difficult for everyone to cope with both these sets of changes together – not to mention other challenges that are in focus at the same time. However, if we were to think about how things might have otherwise unfolded – if households had been undergoing these shifts in saving and spending decisions without the big rise in income that is occurring, to which the terms of trade have contributed – it is very likely that we would have had a considerably more difficult period of adjustment. What then about the future? Can we look forward to a time when these adjustments to household saving and balance sheets have been completed? We can. To return to the first of my two charts, the current divergent trends between income and consumption spending are no more sustainable than the previous trends ultimately were. At some point, the two lines are likely to stop moving apart. That is, the saving rate, debt burdens and wealth will at some stage reach levels at which people are more comfortable, and consumption (and probably debt) will grow in line with income, with a relatively steady saving rate. We could then reasonably expect to see consumption record more growth than it has in the past few years. After all, it is very unusual for real consumption per person not to grow. We cannot really know, of course, when that might happen. Doubtless it will depend on what else is occurring. We can note that the rise in the saving rate over the past five years has been much faster than its fall was in the preceding decade. In fact it is, at least as measured, the biggest adjustment of its kind we have had in the history of quarterly national accounts data. So the adjustment in behaviour to what should be a more sustainable relationship between spending and income has in fact proceeded pretty quickly (which is presumably why it has become such a prominent topic of discussion). That in turn means that the time when more “normal” patterns of consumption growth recur is closer than it would have been with a more drawn-out adjustment. Viewed in long-run perspective, it is not unreasonable for a nation to save a good deal of a sudden rise in national income conferred via a jump in the terms of trade, until it becomes clearer how persistent that new level of income is. As a better sense of the degree of persistence is gained, people will probably be more confident to spend than perhaps they are just now. It is entirely possible that, were some of the current raft of uncertainties to lessen, the mood could lift noticeably, so I don’t think we need to be totally gloomy. But what is “normal”? Will the “good old days” for consumption growth of the 1995 2005 period be seen again? I don’t think they can be, at least not if the growth depends on spending growth outpacing growth in income and leverage increasing over a lengthy period. A rapidly rising saving rate isn’t normal, but nor is a continually falling one. While the rise in the saving rate has been unusually rapid, the level of the saving rate we have seen recently looks a lot more “normal”, in historical perspective, than the much lower one we saw in the middle of last decade. A return to those earlier sorts of growth rates for consumption would instead require, and could only really be sustainably based on, a continuation of the faster pace of income growth we have seen since about 2006. To the extent that that income growth has been a result of the increase in the terms of trade, however, it probably won’t be sustained at the same pace. The level of income will probably stay quite high – above the level implied by the earlier trend – unless the terms of trade collapse. But the rise in the terms of trade has probably now come to an end. So the rate of growth of per capita income could be expected, all other things equal, to moderate from its recent unusually strong performance. BIS central bankers’ speeches If we want to sustain the rate of growth of incomes, and hence lay the basis for a return in due course to the sorts of growth of spending seen in the golden period of 1995–2005, we will have to look elsewhere. As everyone in this room would know, there is only one source of ongoing higher rates of growth of real per capita incomes, and that is higher rates of growth of productivity. Everyone here also knows that it is now just about impossible to avoid the conclusion that productivity growth performance has been quite poor since at least the mid 2000s. So everything comes back to productivity. It always does. It has been observed before that past periods of apparently easy affluence, conferred by favourable international conditions, probably lessened the sharpness of our focus on productivity. Conversely, the will to reform was probably most powerful when the terms of trade reached a long-term low in the mid 1980s. Those reforms ushered in a period of strong productivity growth. The thing that Australia has perhaps rarely done, but that would, if we could manage it, really capitalise on our recent good fortune, would be to lift productivity performance while the terms of trade are high. The income results of that would, over time, provide the most secure base for strong increases in living standards. That sort of an environment would be one in which the cautious consumer might feel inclined towards well-based optimism, and re-open the purse strings. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 7 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to The Economist's Bellwether Series: Australia, Sydney, 23 August 2011. | Ric Battellino: The Reserve Bank of Australia’s thinking on the economy over the past year Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to The Economist’s Bellwether Series: Australia, Sydney, 23 August 2011. * * * Over the past year, the Australian economy has been subject to a number of strong, often countervailing, economic forces: strong demand for commodities, rising global inflation, global financial market instability, consumer caution, slower population growth and slow productivity growth. The economy has also been affected by severe weather events. Today I would like to look back over the year and review how these forces have shaped the economy and the Reserve Bank’s thinking on monetary policy. If we start by casting our minds back a year ago, you will recall that the Bank at that time was starting to contemplate whether it should move from a relatively neutral setting of monetary policy to one that was slightly restrictive. The global economy was growing at a solid pace, though with clear downside risks. Domestically, a rebalancing in demand, from public to private spending, was starting to take place; the outlook for business investment was particularly strong. Employment was growing very quickly, unemployment had fallen back to just above 5 per cent, and inflation was forecast to reach the top end of the target range over the subsequent couple of years. The Board’s assessment of these circumstances was that, if they continued and the economic outlook evolved as expected, there would be a case to raise interest rates a little at some point. However, the uncertainty in global markets, due to the spread of sovereign debt concerns beyond Greece, was seen as posing downside risks to the global economy, and consequently to Australia. Also, the strong exchange rate and weak demand for credit pointed to financial conditions perhaps being somewhat tighter than might be indicated simply by reference to interest rates. These considerations were seen as reasons for caution and, in the event, the Board held interest rates steady through to November 2010. By the November meeting, financial market volatility had declined and the Chinese economy was continuing to grow strongly. Earlier downside risks to global growth had diminished somewhat and it was becoming clear that global GDP would record a very strong increase for 2010 as a whole. Domestically, employment had continued to grow very quickly. While there were significant differences in the performance of various sectors of the economy, overall it appeared that resource utilisation in the economy was tightening. The CPI outcome for the September quarter had been a little lower than expected, but the assessment remained that the downward trend in inflation had largely run its course. The forecasts envisaged a strengthening economy, with the effects of the rising terms of trade more than offsetting those from fiscal tightening. Also, inflation was testing the top of the target range by the end of the forecast period. The Board therefore concluded that the balance of risks had shifted to the point where a move to a slightly restrictive stance of monetary policy was prudent, and it decided to lift the cash rate by 25 basis points to 4.75 per cent. Banks responded to the November increase in the cash rate with substantially larger increases – around 40 basis points – in interest rates on housing loans. The size of this increase, and the controversy it created, seemed to have a noticeable impact on household behaviour. Consumer confidence fell, though to levels that were still above average. Coincidentally, there was a renewed step up in financial market volatility, stemming from the widening government debt problems in Europe; this probably also contributed to households becoming less confident. BIS central bankers’ speeches At the same time, however, the prices of commodities important to Australia – i.e. coal and iron ore – continued to strengthen and prospects for the terms of trade were revised up further. The outlook for investment in the resources sector remained very strong. The Board concluded at its December 2010 meeting that, having moved in a forward-looking way in November, there was scope to hold rates steady for a while to see how conditions in Australia developed and how the various risks to the economy evolved. As we moved into the early months of 2011, domestic economic activity was severely disrupted by floods and cyclones. The two main economic impacts were the sharp fall in coal production, and the destruction of the Queensland banana crop. The former meant that GDP was likely to fall in the March quarter, before recovering in the June and September quarters, while the latter meant that CPI inflation would spike higher over the year ahead due to a sharp, yet temporary, increase in banana prices. Neither of these factors, by itself, was seen by the Board as having direct implications for monetary policy, although it was recognised that they would make reading the underlying economic trends more difficult over the months ahead. Global economic data generally continued to be strong in the early months of 2011, particularly in Asia but also in the United States and Germany. Commodity prices continued to rise, and there were increasing signs that this was feeding, via rising cost pressures, into inflation outcomes in a wide range of countries. As a result, there was a general trend towards tightening monetary policy through Asia and Latin America. Domestically, the effects of the floods were becoming clearer in the data, and liaison with mining companies was starting to point to a more protracted recovery in production. Economic indicators were mixed: business conditions were around average, the outlook for investment was strong, unemployment was holding steady at a low level but retail sales had been growing only modestly. Financial market uncertainty had lessened following further measures taken by European governments, though social unrest in the Middle East and North Africa was keeping markets on edge. Against this background, the Board saw little need to change the level of interest rates at its February, March and April meetings. In May, the Board again held the cash rate steady. However, the CPI outcome for the March quarter was higher than expected and inflation forecasts were scaled up somewhat. Global economic growth was expected to continue at an above-trend pace, notwithstanding the disruption to global supply chains caused by the Japanese earthquake in March; commodity prices were higher than earlier expected; and global inflationary pressures had risen. Therefore, while the Board saw the existing mildly restrictive stance of monetary policy as appropriate for the time being, its assessment was that if conditions evolved in line with the outlook, another rise in interest rates would likely be required, at some point, if inflation was to remain consistent with the medium-term target. By the June meeting, signs were emerging that economic growth in many developed economies had lost some momentum. Increased financial volatility, as the debt problems within Europe spread, added to the downside risks. Growth in China and most other parts of Asia, however, remained a bright spot. The March quarter national accounts suggested that the impact of the floods on Queensland coal production had been significantly larger than expected and the timing of the recovery in production was pushed out further. While the outlook for mining investment was very strong, non-mining investment was looking softer and households were showing more signs of caution, with confidence declining; households’ perceptions of their own personal finances over the coming year were particularly weak. It was also more apparent that employment growth had slowed, though this appeared to be taking place against a background of slowing population growth, and unemployment was holding steady at a relatively low rate of around 5 per cent. BIS central bankers’ speeches While the Board remained of the view that, if conditions evolved in line with the forecasts, further tightening of monetary policy would be necessary at some point, the recent flow of data had not added any urgency to the need to adjust policy. Accordingly, the cash rate continued to be held steady. At the time of the July meeting, global economic growth had eased, and the downside risks stemming from the European debt problems looked more significant. In Australia, households remained cautious and the housing market was soft. Also, it now appeared that the slow recovery in coal production would mean that earlier GDP forecasts for 2011 would not be met. Nonetheless, the medium-term outlook for the Australian economy remained strong. In these circumstances, the Board continued to hold rates steady, noting that the CPI outcome to be published in the next month would provide an update on inflation. The state of the global and domestic economies had not changed much by the time of the August meeting, but the CPI outcome for the June quarter again surprised on the upside. Price increases for a range of manufactured goods were larger than expected in light of the appreciation of the exchange rate and the ongoing caution among consumers. There was the possibility that the slower growth in productivity that had been evident for some years was pushing up unit labour costs at a pace faster than was consistent with the inflation target. At the August meeting the Board therefore discussed whether there was a case to tighten monetary policy further. The general case to do so was that the economy was continuing to operate with relatively little spare capacity, and the staff forecasts showed inflation rising above target during the forecast period. On the other hand, activity in parts of the non-mining economy was subdued and downside risks to the global economy had increased significantly due to the volatility in financial markets. Also, the softness in credit demand and the high exchange rate pointed to financial conditions exerting a reasonable degree of restraint. These considerations led the Board to conclude that it would be prudent to continue to hold rates steady. Summarising all this, the general pattern that has emerged over the past year has been as follows: First, the effects of the mining boom have turned out to be stronger than expected a year ago. The terms of trade are noticeably higher and forecasts for national income and mining investment have been revised up over the year. Second, despite this strength in the mining sector, overall economic growth is turning out to be weaker. The forecasts published earlier this month reduced growth in GDP for 2011 to 3¼ per cent, versus 3¾ per cent expected last November. Part of this downward revision reflected the higher exchange rate as well as a softening in some components of demand, stemming partly from consumer caution. However, some of the revision also reflected a slowing in the economy’s capacity to supply goods and services, due to weather events and slower growth in the labour force. In recent quarters, growth of the working age population has been running at an annualised rate of only a little more than 1 per cent, down from a peak of around 2¼ per cent a few years ago. In these circumstances, while employment growth has slowed noticeably, there has been little change in the unemployment rate. Third, inflation outcomes for 2011 are likely to turn out to be higher than thought last November, both in headline and underlying terms. Inflation forecasts for the longer term have risen to be a little above the top end of the target range. This was the situation as it stood at the time of the last Board meeting. As you know, since then market volatility has become more extreme. An important issue ahead of us will be to assess what impact this is likely to have on global and domestic economic activity, commodity prices and inflation. As yet, there is little information on which to base such judgements. BIS central bankers’ speeches Conclusion Let me conclude. The main reason for running through this material has been to make the point that the environment for monetary policy over the past year has been challenging. As the year has progressed, the resources boom has strengthened, but the divergence between the mining and non-mining sectors of the economy has increased and the mix of growth and inflation has turned out to be less favourable than expected a year ago – i.e. there has been less growth but more inflation. Decisions about monetary policy through the year have sought to balance these various forces. This challenge remains. In fact, with the recent volatility in financial markets adding to the uncertainty about the economic outlook, it does not look like the challenge will become any easier over the months ahead. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 8 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Melbourne, 26 August 2011. | Glenn Stevens: Overview of 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, Melbourne, 26 August 2011. * * * Quite a bit has happened in both the global and local economies since we last met with the Committee. In February, we had seen the Queensland floods, and Cyclone Yasi had just occurred. Tropical storms had disrupted iron ore shipments out of Western Australia. There was understandably a focus on what the economic effects of those events would be. It was thought likely that economic activity as measured would be materially weaker in the March quarter than had been earlier expected, but that there would be a recovery in the middle of the year. It was thought that the rebuilding efforts in Queensland would exert a mild expansionary effect on demand beginning in the second half of the year. GDP was indeed weak in the March quarter, with the fall in coal and iron ore production more than offsetting a modest increase in output in the rest of the economy. Since then, the rebound in production of iron ore has been more or less as expected and the disruption to general economic activity in Queensland associated with floods has abated. But in the case of coal, largely for environmental reasons, the process of dewatering pits is taking longer than initially expected. The recovery of coal production in Queensland is probably about two-thirds complete at the present time. It may be early next year before production has fully recovered. This has had a material effect on the forecasts for GDP. It was also understood in February that there would be large effects on the consumer price index because of the loss of key crops. These were expected to be temporary and, indeed, prices for the relevant items are now falling back as crops begin to recover. The Bank has been clear that such fluctuations have had no implications for monetary policy. We didn’t know in February that a serious Japanese earthquake would have a significant effect on global manufacturing production and sales, including in Australia’s motor vehicle sector. This explains part of the apparent slowing in global growth in the June quarter. Part of the slowing in growth in major countries is also likely to have been caused by the increase in energy prices in the early part of the year, which now appears gradually to be reversing. Another factor at work, though, has been the concerns about public debt in major countries. These were apparent six months ago, but have escalated markedly in the intervening period. Not only did yields on the obligations issued by so-called “peripheral” euro area countries reach new highs, but interest rates faced by large countries like Spain and Italy also rose to levels that would have made their financial positions much more difficult. The euro area’s response to these issues has had some positive effects, but it remains a work in progress. Meanwhile, the United States is having a very difficult time finding a path that avoids an immediate major fiscal contraction but still puts the US fiscal accounts onto a sustainable medium-term trajectory. As financial markets confronted all this, and also sought to digest a re-appraisal of near-term global growth prospects, we have seen during August a period of intense turmoil, particularly in equity markets. The net result of this period is that equity prices in most markets around the world are anything from 15 to 25 per cent below their recent highs. Yields on long-term securities for the United States and core European countries have fallen to historical lows as investors have sought safety, despite the US sovereign rating downgrade by S&P. Measures of volatility have increased sharply. There has been a degree of renewed pressure on US dollar funding for European banks. The currencies of certain countries regarded as safe havens, like Switzerland, have soared and the price of gold has reached new highs. So markets remain on edge. All that said, the dislocation has not, on most common metrics, approached the extent of that seen three years ago. The main effect on Australia’s financial BIS central bankers’ speeches markets has been lower equity prices, which have fallen along with those in major markets. Other Australian markets have, to date, travelled fairly well in the circumstances. Funding costs have, if anything, declined, which is being reflected in lower costs of fixed rate mortgages. Major Australian banks report being offered substantial US dollar funding offshore on account of their relatively high credit standing. In any event, their reliance on such wholesale funding is much reduced from three years ago, with the large increase in deposit funding at home and slower balance sheet growth. There has been no abnormal demand for liquidity by financial institutions from the Reserve Bank in this period and the quantity of settlement funds in the system has been completely normal over the past month. The exchange rate has come off its peaks of a couple of months ago, but it remains quite high compared with most of the post-float experience. Some commodity prices have declined, but they have not slumped the way they did in late 2008 and early 2009, and spot prices for major Australian commodities remain quite high. People will understandably want to draw comparisons with the financial crisis of 2008. We cannot know, of course, what will transpire in the months ahead, but I think that what we have witnessed is best seen not so much as a new crisis, as part of the long aftermath of the 2008 crisis. Among the countries at the heart of that crisis it was to be expected that, after serious problems in private-sector balance sheets, economic recovery would be a drawn out affair. That is usually the way. This is having a predictable effect on fiscal positions: revenues are weak and budget deficits have remained large. It is not surprising that coping with this is politically difficult and it remains a point of considerable uncertainty what the ultimate resolutions in the various major countries will look like. This may be leading to precautionary behaviour and, as a result, the global growth outlook does not look as strong as it did six months ago, even though it is not necessarily as weak as some of the pessimists fear. In our own region, indicators suggest some moderation in growth in the Chinese economy, but it appears to be still pretty solid. Around Asia, inflation rates have generally tended to rise over the past six months. A key question for the countries in the region is whether enough has been done to contain the inflation pressure, which does look to have spread beyond initial rises in food and energy prices. Asia’s management of these challenges will ultimately matter a good deal for Australia, and for the world. In the meantime, Australia’s terms of trade are very high and the investment expansion in the resources sector is proceeding. On the indications available it has quite some distance to run yet. This is having positive spillovers to some parts of the Australian economy. Our liaison suggests that, beyond the benefits being experienced by equipment hire, engineering, surveying and consulting firms, businesses as diverse as those supplying modular housing, laboratory services and the training of semi-skilled, trade and other workers are seeing effects of the expansion. Meanwhile, other sectors are being squeezed by the high exchange rate or by the much-touted household caution. Now it is important not to overstate the degree of caution. Some areas of household spending – like overseas travel – are growing very strongly. But overall it is, in my judgement, increasingly clear that we have seen a significant change in household behaviour. There was a lengthy period in which households saved progressively less from current income, increased their leverage and enjoyed a sense of rising prosperity from the increase in asset values. That was most likely a one-time, if rather drawn out, adjustment to a number of important factors. It is quite understandable that it occurred – and it should be equally understandable that it wasn’t going to continue like that indefinitely. The “new normal” – which is actually the old normal – is where households save a non-trivial fraction of income and keep their debt levels more in line with income. One positive is that the adjustment to this “new/old” normal has been pretty fast, which means that a lot of it may already have been accomplished. Nonetheless, in view of the financial turmoil of recent weeks, it would not be surprising if a degree of caution remained for a while yet. BIS central bankers’ speeches Three months ago, the Bank voiced concerns over the outlook for inflation in Australia, on the basis that measures of underlying inflation looked like they had ended a decline that had lasted for more than two years, were starting to turn up and were forecast to rise over the three-year forecast horizon. That outlook suggested that policy would need to be tightened “at some point”. The Bank did not have a pre-committed notion of when that point might be. Such indications are, in any event, always conditional on the ongoing assessment of the outlook. The policy decision must consider not only the central forecast but also the possibility that things turn out differently from that forecast. In the intervening period, the international situation has become more clouded and evidence of caution at home has, if anything, intensified. Asset prices have declined, credit growth has moderated further and the exchange rate remains very high. While each of these is affected by factors other than monetary policy, together they suggest a fair degree of restraint is being exerted by financial conditions. Under the circumstances, the Board judged the most prudent course was to sit still through this period, in spite of inflation data that, on their face, continue to be concerning. Looking ahead, the year-ended CPI inflation rate will probably remain well above 3 per cent in the September quarter. It is then likely to come down as the impact of last summer’s floods on food prices continues to unwind; we will see those effects around the end of the year and the early part of next year. After that, the assumed impact of the carbon pricing scheme, which we have now put into the forecasts, starts to affect the headline inflation figures. We have been very clear that the Bank will abstract from those carbon price effects in setting monetary policy, just as we did with the implementation of the GST a decade ago. It is the more persistent path of inflation on which the Bank must focus. In that regard, the question is whether recent events will have a bearing on the medium-term inflation outlook. It would be reasonable to anticipate that a decline in confidence arising from the recent events internationally may well dampen demand somewhat compared with the outlook set out in the Statement on Monetary Policy published in early August. That, together with the increased visibility of structural change in the economy, may also condition wage bargaining and price setting. If these forces persist, they may act to lessen the upward trend in inflation pressures that appeared to be in prospect. At the same time, significant rises in a range of administered prices are still set to occur over this period and unit costs have been rising quite quickly given the fairly poor performance of multi-factor productivity growth over recent years. So as usual, there are varying factors about which the Board will need to make careful judgements over the months ahead. In summary, there is a heightened degree of uncertainty at present. There are major challenges in the global economy and significant forces at work in the Australian economy. But at this point in time, our terms of trade are at a record high, while our unemployment rate remains low. Inflation bears careful watching, but we can keep it under control. Our banks are strong, our currency is sound and our sovereign credit position is in the international top tier. Consumer “caution”, while making life hard for the retail sector, is also building resilience in household balance sheets. If we are entering another period of weaker international conditions, this is a pretty good starting point from which to do so. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 8 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Chamber of Commerce and Industry (Western Australia) and the Chamber of Minerals and Energy (Western Australia) Corporate Breakfast, Perth, 7 September 2011. | Glenn Stevens: Still interesting times Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Chamber of Commerce and Industry (Western Australia) and the Chamber of Minerals and Energy (Western Australia) Corporate Breakfast, Perth, 7 September 2011. * * * It is very good to be with you this morning. In the process of deciding a title for this address, I recalled that three years ago I was talking in public addresses about the times being interesting, perhaps a little too interesting. That still seems to be the case, hence the title. As you know, yesterday the Reserve Bank Board met here in Perth. The Board reviewed the international and local information to hand since its last meeting, and decided once again to leave the cash rate unchanged. The reasons for that decision were given in the statement released following the meeting. More information on the nature of the discussion and considerations the Board took into account will be published in the minutes of the meeting, two weeks from yesterday. I do not want to dampen any of your undoubted eager anticipation for what may be contained in those minutes. What I will do is say a little more about the sequence of decisions the Board has taken over recent months. To do that in appropriate context, it is worthwhile first recounting the framework for monetary policy that has been in operation since the early 1990s and that continues to guide the decisions of the Board. So I will say something about that. Then I will describe how the flow of recent events, viewed through that framework, has had a bearing on decisions. The framework for monetary policy The framework for monetary policy is a medium-term, flexible inflation target. It seeks to achieve a rate of increase in the Consumer Price Index of between 2 and 3 per cent, on average, over time. This arrangement has a fair bit of history now. The Reserve Bank began to articulate it in the early 1990s and it has been formally agreed between successive Treasurers and Governors, in published statements, beginning in 1996.1 The “on average” specification allows the Bank to take account of the fact that it cannot finetune inflation over short periods, and of the obligation to promote, insofar as monetary policy can, full employment, which is another of the Bank’s charter obligations. Having a numerical goal takes account of the importance of inflation expectations, and seeks to provide an anchoring point for them – which is a critical function of any monetary policy regime. It also provides a focal point and a measuring stick for monetary policy decisions, which recognises that, in the end, monetary policy is really about the value of money. We arrived at this framework after a long search – the “search for stability” set out in detail by Ian Macfarlane in his ABC Boyer Lectures in 2006.2 The current framework is not necessarily the end of history. But it has worked well for a period not far short of two decades now, with no obviously superior framework on offer. The first such statement was between Treasurer Costello and Ian Macfarlane in August 1996. We are now up to the fifth incarnation of this agreement. See: <http://www.rba.gov.au/monetary-policy/framework/stmtconduct-mp-5-30092010.html>. Macfarlane I (2006), The Search for Stability, Boyer Lectures 2006, ABC Books, Sydney. BIS central bankers’ speeches Sometimes people ask whether a higher target for inflation might not be better, particularly when inflation is looking like it will rise and the Bank is running a setting of monetary policy designed to resist that. The answer ultimately hinges on how prepared we would be to accept the things that would go with higher inflation. Higher average interest rates would be among them – there is no reason that savers, any more than wage earners, would be prepared simply to accept an erosion of their financial position. That is why countries with higher inflation generally have higher nominal interest rates. Moreover, whatever structural challenges the economy faces would still have to be faced at higher inflation rates. Higher inflation wouldn’t make those issues go away, nor make them any easier to cope with (as we know from our own history when inflation was high and structural change still had to occur). We would simply waste more real resources as everyone sought to protect themselves from the higher inflation. In supporting the decision process that puts this framework into practice, the Bank carries out a great deal of detailed statistical work, tracking several thousand individual data series. It conducts extensive liaison with businesses and other organisations, usually speaking in detail to as many as 100 contacts each month. It produces voluminous published analysis of these data. The objective of these efforts is, at its heart, fairly simple. We are trying to form an assessment about the course of overall demand in the economy and how it is travelling in relation to the economy’s supply potential. That assessment in turn informs a judgement as to whether inflation pressure in the economy is likely to increase, decrease or stay about the same, and how the likely outcomes compare with the announced objective. That judgement then informs a decision as to whether monetary policy needs to restrain demand, to support it or to be “neutral”. Of course other factors that affect prices – like exchange rate changes, changes in the price of oil, and so on – have to be taken into account as well. Note that the economy’s supply potential is a key element in the above framework. This is not a directly observable thing: there is no time series labelled “potential supply”. Assumptions have to be made about the availability of productive factors – labour and capital – and about the productivity with which these factors can be used. This is why the current productivity discussion is so important. Incidentally, the desire for more productivity is not a call for working harder. Australians already work pretty long hours by international standards. Productivity per hour, which is what counts, is not improved by adding more hours, but by finding ways of making the hours that are already being contributed more effective. The Board’s decision each month, and the reasoning behind it, are communicated to the public. These statements are among the most closely scrutinised documents in the country. I am often awed by the layers of hidden meaning that people are able to detect in them. But the main purpose of these statements, and of all the other communication we do, is simply to try to make the Bank’s assessment of the outlook and its actions as understandable as possible to the many people who need to make long-term decisions, including households and businesses. Of course, events and new information often change the outlook, as we have seen recently. Recent developments How has the Board evaluated recent developments within the above framework?3 Throughout the past year or so, the forecasts that the Bank’s staff have provided to the Board have suggested that underlying inflation would probably stop falling and then gradually rise through the three-year forecast period. The backdrop to this view was that the rise in the The Deputy Governor recently gave a very good account of this in more detail than I can attempt here today. See: <http://www.rba.gov.au/speeches/2011/sp-dg-230811.html>. BIS central bankers’ speeches terms of trade was expansionary for incomes and investment, which would likely see demand growth remain pretty strong even as fiscal stimulus spending unwound. The exchange rate was working to offset a good deal of this expansionary impact, by restraining some parts of the economy exposed to international trade but not exposed to mining. Nonetheless, given the size of the terms of trade rise, and the fact that the economy started from a position of reasonably low unemployment, it was thought that underlying inflation was more likely to start to go up than to keep falling. On the evidence we have so far, that’s what seems to have been happening. Faced with that outlook, the Board judged that it was appropriate for monetary policy to exert a degree of restraint. As of the end of last year, the Board’s view was that it had reached that position. We believed that we were therefore in a position of being able to maintain a steady setting for a while. The post-Board statements I issued each month at successive meetings said that the Board viewed the stance of monetary policy as remaining appropriate for the outlook. Of course, there are always uncertainties surrounding forecasts, and the Bank’s publications have been careful to articulate possible risks that we could identify – including things such as the possibility of a serious worsening of the situation in international financial markets, driven by sovereign debt concerns. Most of these risks do not come to pass, and if they do eventuate they don’t necessarily unfold as we had imagined they might. Still, the Bank makes considerable efforts to think about how things could turn out differently to the central forecast. By the time of the May Board meeting, there was evidence that the pace of underlying inflation had started to pick up. I myself felt that the Board was still well placed to sit still at that time. We had already put in place a response in advance of the expected pick-up in inflation and it is not necessarily always wise to respond to one high (or low) figure. Nonetheless, the updated forecasts carried a fairly clear message: policy would probably need to be tightened further, at some point, if things continued to evolve as expected. The Bank said that – indeed there was no other credible thing we could have said. In the ensuing months, little has changed about the outlook for resources sector investment. More large projects have been approved and the pipeline of future investment looks very large. On all the available information, resources sector investment will probably rise by another 2 percentage points or more of annual GDP over the next couple of years. Prices for important commodities remain high and the nation’s terms of trade are at an all-time high in the current quarter. At the same time, it has become clearer that precautionary behaviour by households and some firms is exerting restraint on the pace of growth in demand, and that the higher exchange rate is diverting more demand abroad. This is putting pressure on trade-exposed sectors. Moreover, the sense that a higher exchange rate might not just be a temporary phenomenon may be leading to a pick-up in the pace of structural change in the economy. In net terms, the outlook for the non-resources economy in the near term is weaker than it looked a few months ago, and the recovery of flood-affected mining in Queensland is taking longer than earlier thought. At the same time, looking at financial variables, credit growth has slowed a bit further and asset prices have tended to decline. These factors, along with ongoing evidence that underlying inflation had turned up, were incorporated in the Bank’s outlook as published early last month. Meanwhile, the sense of unease about how Europe will manage its problems has increased over recent months. We also had the anxiety over the US debt ceiling issue, which became acute early in August. Measures of confidence in both economies declined significantly as all this occurred. Equity markets fell as investors shifted to the relative safety of bonds issued by the major countries – even though S&P had announced a downgrade of the US sovereign credit rating. BIS central bankers’ speeches It is too soon to see much evidence of a concrete impact of these events on the global economy. Any assessment we make at present is highly preliminary. Moreover, we have no way of knowing what events will transpire in financial markets over the months ahead. There are any number of hurdles in Europe or the United States that could serve as a catalyst for increased anxiety. This state of affairs is likely to persist for the foreseeable future. With those caveats, a few preliminary observations can be offered on this episode in comparison with what we saw in 2008. First, the focus is more on sovereign creditworthiness as opposed to the state of private bank balance sheets per se (though in Europe of course the two are intertwined). In a proximate sense, that is the direct result of the previous crisis and especially the ensuing period of weak growth that has had a severe impact on government revenues in the affected countries. But, taking a longer-term perspective, some countries, especially in Europe, have had fiscal positions that were quite vulnerable to a shock to confidence for some time now. High debt levels were sustainable while markets thought they were and hence were prepared to offer financing at low interest rates; if people suddenly doubt sustainability and charge high interest rates, that same position becomes much less sustainable. So to no small extent, it is actually a matter of confidence – confidence that there is a sustainable long-run fiscal path, that policymakers know how to get onto it, and that they have the will to do so. In crafting any policy response to near-term economic weakness, this is a key point. Second, there have been pressures in funding markets for some European banks recently, but at this point not to the same extent as in October 2008. Bank capital levels are improved from three years ago and leverage is reduced. We have not seen significant funding problems for US or UK banks recently; their problems at present seem to relate more to the possible size of legal costs arising from pre-crisis lending standards. Overall, we have not, to this point, seen the widespread withdrawal of willingness to deal with counterparties that we saw in late 2008. Third, a key feature of this episode is that confidence in the euro is a more prominent issue than was the case three years ago. Those countries at the so-called periphery’ are paying a high price as they play their part in keeping the euro together. But the ultimate outcome is going to hinge on the willingness of “core” euro countries to accept socialisation across the euro zone of some of the losses associated with countries in trouble. That is really the issue that is being debated in Europe now. If there were a major international downturn, an important question would be how policymakers in major countries would respond. The scope for fiscal policy easing in many major countries is hotly debated. Some commentators call for further stimulus, citing faltering recoveries, while others point to medium-term debt paths that look very troubling as a reason for fiscal consolidation. Both have a point. The question in major countries is whether a package combining short-term stimulus with a highly credible medium-term path back to sustainability could be crafted. It certainly does not look easy. As for possible monetary policy responses, most major countries would be quickly into the realm of “quantitative methods”, if they are not there already. It is hard to gauge the effects of those measures. In Asia and other parts of the emerging world, however, ample policy ammunition is available, both fiscal and monetary, should the authorities have a need to use it. To do so credibly would presumably require confidence that the upward trend in inflation seen over the past couple of years would be likely to turn down. Of course, a significant weakening of the global economy would result in lower commodity prices and generally lower underlying inflation pressures. So far, the decline in major commodity prices has been fairly modest, though enough to help rates of CPI inflation to moderate a little. In summary, the environment presents no shortage of challenges, though we should not assume that this is necessarily 2008 all over again. It is reasonable to conclude, at this point, that the outlook for global growth is not as strong as it looked three months ago. Forecasters are generally revising down global growth estimates for 2011 and 2012, mainly as a result of weaker outcomes for the major countries. BIS central bankers’ speeches Turning back to the implications for Australia, periods of sudden increases in anxiety within international financial markets are moments when, if at all possible, it is good to be in a position to be able to maintain steady settings. In the recent few meetings, the Board has judged it prudent to sit still, even though we saw data on prices that were, on their face, concerning. To be in that position of course requires timely decisions to have been made in earlier periods. Looking ahead, the task for the Board is to assess what bearing recent information, and recent international and local events, will have on the medium-term outlook for demand and inflation. They probably won’t have much effect on the large-scale investment plans in the resources sector, but households and firms watching what is happening may continue their precautionary behaviour for longer than otherwise. This would presumably dampen demand somewhat compared with the outlook set out in the Statement on Monetary Policy published in early August; it may also condition wage bargaining and price setting. If so, that may act to curtail the upward trend in inflationary pressures that has, up to this point, appeared to be in prospect. At the same time, significant rises in a range of administered prices are still set to occur over the period ahead. Moreover, unit costs have been rising quite quickly given the fairly poor performance of multi-factor productivity growth over recent years. In fact the experience of the past year, as the Deputy Governor noted recently, is that while growth seems to be turning out weaker than expected at the end of last year, underlying inflation seems to be turning out higher. A key question is whether that is just the vagaries of statistical noise and lags, or whether it is telling us that the combinations of growth and inflation available to us in the short term are less attractive than they seemed a few years ago. If the latter, the spotlight will come back on to supply-side issues. Conclusion More than at most times in my professional life, Australia’s economy faces a very unusual, and powerful, set of complex forces. Major countries are still coming to terms with the excesses of earlier years and experiencing what many have learned before, which is that after a period of financial distress it is usually a long and difficult recovery. Economic growth has been uneven and patchy, and financial concerns keep recurring, with waves of positive and negative sentiment sweeping global markets. Australians feel the effects of those swings in sentiment. Meanwhile, the emerging world continues to expand, and it is not all due simply to exports to the rich world, even though the world could still do with some more re-balancing. There is an epochal change occurring, and Australians are also feeling that. It is overwhelmingly positive for us in net terms, even if our tendency to dwell on the downside is more prominently on display at present. The future is uncertain, but it always is. What we know is that, as we move into that future, whatever it holds, we do so: with our terms of trade at a record high; with more jobs in the economy than ever before, and with 95 out of every 100 people seeking work in a job; with our banks sound, our financial system stable and our sovereign credit respected globally; and with the capacity for macroeconomic policy to respond sensibly to events, appropriately guided by well-established frameworks. We have our problems, but with some good sense and careful judgement we ought to be able to navigate what lies ahead. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 9 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Euromoney Forum, New York, 21 September 2011. | Ric Battellino: Will Australia catch a US cold? Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the Euromoney Forum, New York, 21 September 2011. * * * It is a great pleasure to be taking part in this conference, and in particular to be here in New York again. I have been visiting New York regularly for a large part of my career at the Reserve Bank. I have always very much enjoyed these visits, but that, of course, was not their purpose. The point of my visits was to find out what was going on in the US economy because, for a long time, this had a major bearing on the Australian economy. Through the 1980s and into the 1990s, developments in the Australian economy showed a close correlation with those in the US economy. It was particularly striking that the recessions of the early 1970s, early 1980s and early 1990s were highly synchronised between the two countries and had many similarities in their nature and origins. As a result, it was common in the 1980s and 1990s to hear the phrase “when the US sneezes, Australia catches a cold”. Australian economists, including those in the Reserve Bank, spent a lot of time researching the question of why growth in the Australian economy was so highly correlated with that in the US. We were intrigued by the closeness of the relationship because the trade flows between the two economies were not particularly large. The United States has always been only a moderately important export destination for Australia. The research unearthed various channels that contributed to the close relationship, but two factors seemed particularly important: First, the economic shocks faced by the two countries in the lead up to the recessions of the 1980s and 1990s were similar, as were the policy responses. It was understandable, therefore, that the economies would follow similar paths. Second, the financial and cultural links between the two countries have always been very strong. The United States is a large investor in Australia and many Australian companies have operations in the US. US economic news receives very wide coverage in the Australian media. This, in turn, has often promoted very similar movements in financial prices, business sentiment, and even household behaviour. Scrutiny of this close relation between the two economies reached its peak around the mid 1990s. Ironically, this was around the time when the relationship began to change. Certainly, by the first decade of this century, the paths of the economies had clearly diverged. Whereas the United States experienced recessions in 2001 and 2008/9, the economic downturns in Australia around those times were relatively mild. It has been 20 years since the Australian economy experienced a year of negative growth. This represents the longest period of uninterrupted growth in Australia’s economic history, and one for which there are few precedents among the developed economies. Why have the paths of the two economies diverged? I don’t think I can provide an exhaustive or conclusive answer to this question, but there are a couple of factors that have clearly played significant roles. First, both the 2001 and 2008/9 recessions in the United States were to a large degree the consequence of financial misadventure. The former was heavily influenced by the collapse of the “tech” bubble, and the latter by the collapse of the sub-prime housing bubble. Australia was not affected nearly as seriously by either of these events. The tech bubble largely missed Australia. In fact, in the late 1990s Australia was constantly being berated for BIS central bankers’ speeches being an old-world economy in that it did not have a home-grown information technology industry. As it turns out, being a heavy user of technology, but not a manufacturer of it, was an advantage. The Australian economy was not distorted by the tech bubble that built in the late 1990s, and it did not weaken as much as the US economy when the price of tech stocks collapsed in 2001. The mildness of the 2001 economic slowdown in Australia meant that the Reserve Bank was able to normalise interest rates relatively quickly thereafter. In the event, this helped Australia avoid the worst of the excesses in housing markets that subsequently built up in many other countries. The housing market was most “frothy” for Australia as a whole around 2002–2003, and it cooled noticeably in 2004 as interest rates rose. While there were subsequent price increases in particular cities, the speculative element in the market had subsided considerably in most states by the time the global financial crisis hit in 2008. Aside from increasing interest rates, the Reserve Bank also warned repeatedly around that time about the danger of excessive increases in house prices and borrowing, which may have, at the margin, curtailed some speculative activity. It was also helpful that the Australian Prudential Regulation Authority (APRA), the prudential supervisor, pressed the banks to maintain relatively high lending standards. While there was some sub-prime lending activity in Australia, it was on a small scale, and mainly by non-bank lenders. As such, arrears rates on housing loans have remained at low levels, and Australian banks have remained profitable. Australia, therefore, did not have a home-grown financial crisis in 2008/09, and its financial institutions also had little direct exposure to the US housing market. As a consequence, just as had been the case in 2001, Australia experienced only a mild economic slowdown in 2008/09. The fact that Australia avoided the direct impact of both the tech crash and the sub-prime crisis obviously helps to explain why the Australian economy has done better than the US in the past decade. But another factor that has contributed to its outperformance has been the growing role of China in the global economy. The expansion of China has had an overwhelmingly positive impact on the Australian economy over the past 10 to 15 years, whereas the implications of the Chinese expansion for the United States have been more mixed. The integration of China into the global economy has been an important factor shaping the performance of many economies over the past 10 to 15 years. Generally, economies that complement the Chinese economy have done relatively well. Obvious examples are commodity exporters such as Australia and some Latin American countries, exporters of capital equipment and luxury cars, such as Germany, and countries that are part of the China supply chain, such as many in Asia. Arguably, Australia is one of the economies that most complements the Chinese economy. It is a large producer of food, energy, basic materials and education and tourism services – products and services for which China has a very strong demand – while the limited size and specialised nature of Australia’s manufacturing sector mean that the economy as a whole is not facing wide-scale competitive pressures from China. As evidence of this, over the past decade Australia has experienced a much larger rise in its terms of trade than all other major commodity exporters, apart from Chile. While it is clear that China now has a large influence on the Australian economy, that is not to say that US developments no longer matter. Clearly, they do. They continue to play an important role in shaping financial market behaviour, and household and business sentiment. The point, however, is that over the past 10 to 15 years these channels have not been powerful enough to dominate overall economic outcomes, being outweighed by the other influences I have mentioned. At this juncture, the US and Australian economies find themselves in very different cyclical positions. The United States is still struggling to recover from the deep recession caused by the sub-prime crisis, while Australia, having grown for 20 years, is operating with relatively BIS central bankers’ speeches little spare capacity and is investing heavily to meet rapidly growing demand for resources from China, and elsewhere in Asia. A topical question at present is whether the recent turmoil in global markets will eventually overwhelm the positive effects on the Australian economy from China. That could occur either because the financial uncertainty undermines household and business confidence, and therefore consumer and investment spending, or because the turmoil also weakens the Chinese economy, leading to reduced demand for resources. It is simply too early to be able to answer this question. For one thing, nobody yet knows when, or how, the issues that are causing the financial turmoil will be resolved. In some cases they go to the heart of institutional arrangements in Europe, and cannot be resolved quickly. It is impossible to know, therefore, how long the turmoil will last, or even if it will escalate further. As yet there is little in the way of hard economic data available for the period since financial market volatility escalated, but let me briefly run through what we do know. I will begin with some observations about China. A few years ago, a common question was whether the Chinese economy could continue to grow if the US economy slowed. The experience of the past three or four years has, I think, answered that question, and the answer is in the affirmative. China has maintained strong growth in the face of the US recession and the sluggish recovery. The latest batch of Chinese data, which relates to August, suggests that any slowing in the economy has, to date, been modest. This is confirmed by recent data on Australia’s shipments of coal and iron ore to China, which have also held firm. So too have the prices of iron ore and coal. In relation to Australia, the most comprehensive data on the economy – the national accounts – are only available up to the June quarter, and so pre-date the recent financial volatility. They confirmed, at that point, a picture of very strong business investment; declining government investment, as earlier fiscal stimulus is unwound; relatively flat dwelling investment; and weak commercial construction. All this was broadly in line with expectations. The one area of the national accounts that surprised was the strength of household consumption. Retail sales had been subdued through much of this year, and this had generally been taken as a sign of weak consumption overall. But the national accounts showed that household spending on services has been strong. Households are spending more on entertainment, eating out and travel, particularly overseas travel. At one level, this was surprising given the clear signs of caution among households, but it is less surprising when account is taken of the on-going fast pace of increase in household income. For a time, this increased income was used to rebuild saving, but with the household saving ratio having stabilised in recent quarters, income growth is now providing the wherewithal to fund consumption. The national accounts also showed that Australia’s GDP continues to be affected by the severe effects on mining activity of the floods over the Australian summer. Taken literally, the weakest sector of the Australian economy over the past year has been the mining sector, where output has fallen by 9 per cent over the past year. We know this is in the process of being reversed, so we need to look through it to judge the underlying strength of the economy. Our estimate of the underlying trend in mining-related activity over the next couple of years is for increases in the order of 10 to 15 per cent. The rest of the economy on the other hand, is growing at an annual rate of only about 2 per cent. This is below what would have been regarded as normal in the past. This slow pace of growth in the non-mining sector is not simply a matter of a shortfall in demand. There are signs that the capacity of this part of the economy to supply goods and services has also slowed. For one thing, growth in the working-age population has slowed markedly over the past couple of years, due largely to a slowdown in immigration. Also, BIS central bankers’ speeches productivity growth continues to be low. For growth in the non-mining economy to pick up, it is likely that these trends will need to reverse. Labour market data are available up to August. They continue to point to soft outcomes for employment, after the surprisingly fast increase last year. The unemployment rate has also risen by 0.4 percentage points over the past few months, after having been steady at around 5 per cent for much of the year. These trends could be an indication of the economy having slowed recently to a pace that is below its potential. On the other hand, there are some aspects of labour market numbers that have a stronger feel. Contrary to the slowing in the number of people employed, there has been solid growth in total hours worked recently. Also, the very recent rise in unemployment has been most pronounced in the resource-rich states, while an independent indicator – the number of people on unemployment benefits – does not point to any rise in unemployment. All this suggests more information is needed before we can draw any firm conclusions about whether or not the labour market is weakening. Measures of consumer and business confidence declined sharply in August, following the increase in financial market volatility. This is not surprising. Consumer confidence has subsequently recovered somewhat in September. We will need to wait to see how these swings in confidence affect spending. So far, recent liaison information from retailers does not point to any further significant weakening. Let me end with a few words on how the Reserve Bank has been seeing monetary policy. The context for monetary policy over the past year or so has been that the overall economy is operating with relatively little spare capacity, and is facing a very large boom in investment and a large rise in national income. The Bank’s view has been that, if this is to be accommodated without generating undue inflationary pressures, other components of spending would need to grow less than might otherwise be the case. The implication of this is that monetary policy would need to provide an element of restraint. Accordingly, the Bank late last year lifted the cash rate to the point that resulted in most lending rates in the economy being a little above average. From time to time over the past year, the Bank has considered whether further restraint was required, but on balance concluded that existing policy settings remained appropriate, particularly given the restraint also being applied by the high exchange rate. At its most recent monetary policy meeting, the Board judged that the recent financial volatility could weaken the outlook for demand, and hence may, in due course, act to dampen pressure on inflation. On this basis, the Board judged that it was prudent to maintain the current stance of monetary policy. In the meantime, financial markets seem to have concluded that the risks are weighted towards the Australian economy weakening sharply and, taken literally, seem to be pricing in a reduction in official interest rates towards the unusually low levels reached after the global financial crisis. There are technical reasons why current market pricing may not be giving an accurate picture of interest rate expectations. Nonetheless, markets do seem to have reached a pessimistic assessment and this appears to be based mainly on the assumption that weakness in the US and Europe will flow through to Australia. The present situation has some similarities to that in 2003. From late 2002 to the third quarter of 2003, financial markets were pricing in cuts in interest rates in Australia, largely on the back of concerns about the sluggishness of the US recovery at that time. In the event, however, that sluggishness in the United States did not flow through to the Australian economy and Australian interest rates did not fall. BIS central bankers’ speeches Conclusion Let me conclude. It is too early at this stage to judge with any degree of certainty whether Australia will catch cold from the US. However, given that over the past 10 to 15 years the Australian economy has been less vulnerable to severe US symptoms, there are reasonable grounds for optimism. Until a clearer picture emerges, the Bank’s approach will be to keep an open mind, and base its assessments about appropriate policy on a careful analysis of the data that become available. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 9 |
Speech by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Australian Economic Forum 2011, Sydney, 22 September 2011. | Philip Lowe: Changing patterns in household saving and spending Speech by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Australian Economic Forum 2011, Sydney, 22 September 2011. * * * I would like to thank Jarkko Jaaskela, Luis Uzeda and Callan Windsor for extensive assistance in the preparation of this talk. Good morning. I am very pleased to be able to be part of this year’s Australian Economic Forum. Two weeks ago, the Governor of the Reserve Bank of Australia (RBA), Glenn Stevens, gave a speech in Perth titled “Still Interesting Times”. One consequence of living in these interesting times is that there is no shortage of interesting things to talk about. There is the inexorable shift of global economic weight to Asia, the public-debt problems in the North Atlantic economies, the multi-speed nature of the Australian economy, the more conservative approach to spending and borrowing by Australian households, and the list goes on. You will be relieved to hear that I don’t plan to talk about all these today. Rather, I would like to spend my time this morning exploring just one of these issues, and that is the changing patterns in household saving and spending in Australia. This issue is not only interesting in its own right, but understanding these changes also helps us understand some of the broader changes that are occurring within the Australian economy. Household savings At the aggregate level, the story on household saving is, by now, well known. Graph 1 From the mid 1980s to the mid 2000s, the aggregate household saving ratio declined significantly (Graph 1). Then, over the past half dozen years, this decline has been reversed, and the aggregate household saving ratio is now back to where it was in the mid 1980s. BIS central bankers’ speeches Glenn Stevens has recently spoken at length about why these changes took place.1 In particular, he drew attention to the fact that as nominal interest rates declined and the availability of credit increased, household spending grew more quickly than income for around a decade or so. Although this adjustment was drawn out, it was, by nature, a one-off event. So even before the North Atlantic financial crisis, households were returning to more traditional norms of saving and borrowing, and, no doubt, the crisis accelerated this return. This aggregate story is interesting, but it can only take us so far in understanding what has been going on. At the RBA, we spend considerable effort delving underneath these aggregate figures, so as to better understand the factors affecting individuals’ decisions about saving and spending. One way that we do this is to use the HILDA (Household, Income and Labour Dynamics in Australia) survey which, each year, tracks the finances of individual households. Although the survey does not ask households how much they saved each year, saving ratios can be estimated from 2006 onwards using the income and spending numbers reported in the survey.2 Having done this, we can compare how the distribution of saving ratios across the population changed between 2006 and 2009, the latest year for which data are available. This period is especially interesting because of the large increase in the aggregate saving ratio that occurred, with 2009 marking a peak in the aggregate ratio. Graph 2 Perhaps the easiest way to summarise the results is to show how the median of the distribution has changed over time (Graph 2). Between 2006 and 2007, the median saving ratio increased by 1 percentage point. It increased by a further 2 percentage points in 2008 and then jumped by 4 percentage points in 2009, for a cumulative increase of 7 percentage See Stevens G (2011), “The Cautious Consumer”, Address to the Anika Foundation Luncheon, Sydney 26 July. Similar changes are evident across the entire distribution of saving ratios. BIS central bankers’ speeches points over these three years.3 This figure turns out to be quite close to the 8 percentage points increase in the aggregate saving ratio over this period calculated from the national accounts. The micro level data suggest that the increase in saving ratios was quite widespread across the population. It also confirms that an increase in saving ratios was occurring prior to the financial crisis, but that the crisis saw a marked acceleration of this trend. When we drill down into the data in more detail, an increase in saving ratios is apparent across the entire income distribution, although not surprisingly, the increase is smallest for households with the lowest incomes (Graph 3).4 Many of these low-income households spend a significant share of their income on the basic necessities and they have limited scope to increase the share of their income that they save. Graph 3 Another way of looking at the data is by housing tenure. Graph 4 shows that the saving ratio has increased for those that rent, for those with a mortgage and for those that own their dwelling outright. This again confirms that the increase in saving has been quite widespread, although, the increase in saving has been smallest for those households that own their dwelling outright. The actual levels of the saving ratios calculated from the HILDA data are substantially higher than those from the national accounts, as the HILDA survey does not capture all components of household expenditure. This difference should, however, have relatively little effect on estimates of the change in the saving ratio over time. For the purposes of classifying households into income bands, income is measured as average household disposable over the period from 2005/06 to 2008/09 in an effort to capture income in “normal” times. It is also “age matched” to avoid the effect of life-cycle factors and an adjustment is made for the number of people in the household. BIS central bankers’ speeches Graph 4 It is also possible to look at how saving rates have changed for different age groups (Graph 5). Doing this, it is clear that the increase has been largest for younger households and smallest for older households. This result holds for both households that are renting and those that are owner occupiers. The survey suggests that younger households have experienced income growth broadly in line with that of other groups. However, their spending has not grown as quickly as these other groups, hence the relatively large increase in their saving. Graph 5 Taken together, this evidence is consistent with the idea that higher housing prices and debt levels have contributed to a reassessment of saving decisions, although, obviously, the BIS central bankers’ speeches reasons for the increase in saving go well beyond what has happened in the housing market. Higher housing prices have required higher deposits and this requires more savings. This trend has probably been reinforced by developments on the lending side, with most lenders lowering their maximum loan-to-valuation ratio over recent years. Saving decisions today are also likely being influenced by the earlier rise in debt levels relative to incomes and by debt servicing burdens that are staying higher for longer. The adjustments seem to have been particularly pronounced among younger households who are hoping to enter the housing market or who have recently entered the market. There are two other aspects of the individual level data that I would like to draw your attention to. The first of these is the relationship between the change in saving and a household’s holdings of financial assets (excluding deposits).5 To explore this relationship, we have divided households in each income quintile into two groups – those with above-average holdings of financial assets and those with below-average holdings – and then calculated the median change in the saving ratio for each group between 2008 and 2009, the year of the financial crisis. The results of this exercise are shown in Graph 6, with the top line showing the median increase in the saving ratio for households with high financial assets and the bottom line showing the change for those with low financial assets. It is clear that for all five income quintiles, households that had relatively high levels of financial assets before the financial turmoil increased their saving by more than households with relatively low levels of financial assets. Graph 6 This evidence is consistent with the idea that the fall in financial asset prices over recent years led households to increase their saving out of current income in order to rebuild their asset positions. When share prices fell, household wealth declined and, as a consequence, Financial assets include superannuation, cash investments (i.e. bonds), equity investments, trust funds and life insurance. BIS central bankers’ speeches increased saving was required to attain any desired level of wealth. This was particularly the case for those households that held a lot of financial assets. This experience is the flipside of what happened during the decade to the mid 2000s. During that period, household wealth increased substantially by way of increasing asset prices, despite households saving relatively little out of their current income. The second aspect of the individual-level data that I would like to draw your attention to is the relationship between the change in the saving ratio and how much uncertainty a household feels about the future. This is a difficult issue to investigate, but it is an important one as the financial crisis of 2008/09 all too clearly illustrated. During that period, uncertainty around the world increased greatly, with the result that both households and businesses delayed discretionary spending and increased their savings, amplifying the downturn in the global economy. In the HILDA survey, households that are in employment are asked each year how worried they are about the future of their job.6 Using the responses to this question, we classify households into four groups: those that have become less worried over time; those that have become a little more worried over time; those that have become a lot more worried; and those where there has been no change. As before, we calculate the change in the median saving ratio for each of these groups and the results are shown in Graph 7. It is clear from this graph that the largest increase in saving ratios is for those households that have become a lot more concerned over time about losing their job. And conversely, the smallest increases in saving have been for those who have become less concerned about losing their job. Graph 7 Here, the evidence is consistent with the idea that when people become more uncertain they save more to build up larger buffers against the possibility that something goes wrong later Respondents are asked to rank their feeling about the statement “I worry about the future of my job” on a scale of one to seven (strongly disagree to strongly agree). Households were classified as: “less worried” if their perceived job insecurity response decreased between 2006 and 2009; “slightly more worried” if their response increased by one step; and “a lot more worried” if their response increased two or more steps. BIS central bankers’ speeches on. It is also consistent with earlier work at the Reserve Bank showing that households that are particularly uncertain about the future tend to spend less of any increase in income than do households that are more confident.7 In summary, this work on savings using household level data confirms many of the popular explanations for the recent increase in savings. Higher housing prices and debt levels have had an effect, as have falls in the prices of investment portfolios and a general increase in uncertainty. This work also confirms that the increase in saving has been widespread across the population. Household spending I would now like to turn from saving to spending and look at the changes that have been taking place in household expenditure patterns. The two most comprehensive sources of data in this area are the quarterly national accounts and the Household Expenditure Survey, which is currently conducted every six years by the ABS. The latest survey took place in 2009/10 and was released just a couple of weeks ago. It covered almost 10,000 households and classifies expenditure into over 600 individual categories, ranging from “towels and face washers” to “road tolls” to “ten pin bowling charges”. Looking at the longer-term trends from both these sources, two changes stand out. Graph 8 The first is the significant rise over time in the share of total expenditure on housing. When the Household Expenditure Survey was conducted in the early 1980s, housing accounted for a little less than 13 per cent of total expenditure (Graph 8). By way of contrast, in the recent survey this share had increased to 18 per cent. This is the largest change in any single expenditure category. The bulk of this change took place over the past decade and largely reflects the rise in interest payments on mortgage debt due to higher levels of debt relative to income. See Berger-Thomson L, Chung E and R McKibbin (2009), “Estimating Marginal Propensities to Consume in Australia Using Micro Data”, RBA Research Discussion Paper No. 2009–07 BIS central bankers’ speeches The second longer-term change is a decline in the share of spending on goods and an increase in the share of spending on (non-housing) services. For example, in the early 1980s, spending on clothing, footwear, household equipment and furniture totalled around 14 per cent of total household expenditure. Today, the figure is just over 8 per cent. In contrast, there have been substantial rises in the shares of total expenditure accounted for by health, education and a range of household and personal services. While these increases are partly explained by a rise in the relative prices of many of these services, the volume of consumption of these services has also increased. These broad trends can be seen across the entire income distribution, although there are some subtle differences across incomes. The decline in the share of spending on clothing and footwear, for example, is evident across all income groups. Conversely, households in all income quintiles are spending a higher share on services, with the largest increases evident in expenditure on recreation services, such as pay TV and the internet (Graph 9). In addition, for many middle and lower income households there has been a noticeable increase in the share of spending on holidays. It would appear that rising incomes, the appreciation of the exchange rate and the emergence of low-cost airlines have made travel more affordable for many people. There has also been a general increase in the share of expenditure devoted to education and, for higher-income households, a noticeable increase in spending on household and personal services. Looking forward, it is likely that these broad trends will continue. Graph 9 Returning to the aggregate data, the different trends in spending on goods and services are also evident in the national accounts which measure changes in expenditure adjusted for movements in relative prices. The differences have been unusually pronounced over the past year, with consumption of goods increasing by around 1¾ per cent, compared with growth of around 4 per cent in the consumption of services (Graph 10). BIS central bankers’ speeches Graph 10 The recent relatively weak growth in the consumption of goods has led to very subdued trading conditions in many parts of the retail sector. In contrast, conditions have been better in a number of the service parts of the economy. Again, according to the national accounts, consumption of education services is up by 5 per cent over the year, recreation and culture is up by 7 per cent, hotels cafés and restaurants is up by over 6 per cent, and consumption of transportation services is up by well over ten per cent. These outcomes suggest that although households are saving a higher share of their income than in the past couple of decades, they have also been prepared to increase their spending on services quite significantly. Exactly why this is so is difficult to pin down. One can’t completely rule out the possibility that spending on some goods is being understated due to increased internet purchases from foreign retailers, although this is unlikely to be a particularly large part of the story. Another explanation is that there has been a gradual shift in household preferences away from goods and towards “experiences”. This would be consistent with the strong growth in spending on recreational activities that has occurred over recent times. A more important factor though is likely to have been the strong growth in household income. Over the past year, aggregate household disposable income is up by around 7½ per cent, and this has boosted spending on those services that are quite sensitive to income growth. This increasing importance of consumption of services in Australia poses a challenge in tracking overall growth in consumption in real time. The main high-frequency data that we have is on the consumption of goods. Australia has long had a comprehensive retail trade survey that is published on a monthly basis by the ABS, with this survey reporting separate results for various types of retail establishments. But the spending measured in this survey currently accounts for only about one third of total consumption, and this is down from around 40 per cent in the early 1980s. Unfortunately, for most services there are few timely and comprehensive measures of spending. There are, however, a number of high-frequency indicators that the Bank tracks that provide some insight into this part of the economy. To take just one example, there are a variety of monthly indicators of spending on transportation including: the number of litres of petrol sold; the number of domestic flights; the number of international flights; and the BIS central bankers’ speeches number of passengers on certain public transport networks (Graph 11). Over recent times, the data on international flights, in particular, have provided some timely insight into the relative strength of services consumption, with Australians travelling overseas in ever increasing numbers. Graph 11 However, while these various partial indicators are useful, they fall well short of being a full substitute for comprehensive and timely measures of services consumption. The ABS forward work program includes efforts to improve the measurement of services consumption and the Bank strongly supports these efforts. Conclusion So in conclusion, there are significant changes in saving and spending patterns taking place in Australia. The effects of these changes are probably most pronounced in the retail sector, with both increased saving and the switch towards services lessening growth in spending on goods. As a result, conditions are quite difficult for many retailers. The increased household saving is, however, a positive development from a national riskmanagement perspective. Households are using some of their income growth to build up bigger financial buffers, and this should hold them in good stead in the uncertain world in which we live. These higher saving rates are likely to be quite persistent and they represent a return to more traditional patterns. While they partly reflect the ongoing adjustment to the earlier big run up in housing debt and housing prices, the evidence that I have talked about today suggests that there are also other factors at play. In particular, many households appear to have increased their saving in response to the decline in equity prices and an increase in uncertainty about the future. It is reasonable to expect that, at some point, the impact of these factors will begin to wane, although exactly when remains an open question. The Reserve Bank continues to monitor these trends very carefully, both at the national level and the micro level. Over the period ahead, the way in which households respond to the global uncertainties and the continuing growth in their incomes will, no doubt, have an important bearing on developments in the Australian economy. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 9 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the ACI High Frequency Trading Conference, Sydney, 12 October 2011. | Guy Debelle: High frequency trading in foreign exchange markets Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the ACI High Frequency Trading Conference, Sydney, 12 October 2011. * * * Thanks to the participants of the BIS Working Group who all made significant contributions to the report, and James O’Connor and James Whitelaw for helpful comments. High Frequency Trading (HFT) is somewhat of the bête noire of financial markets at the moment. It has been blamed for many adverse market developments in recent times, most famously the “flash crash” in equity markets on 6 May 2010. But the assessment of HFT is often hampered by difficulties in identifying it, because it is hard to distinguish from other types of automated (but not high frequency) trading, generally known as algorithmic or algo trading. HFT is a part of algo trading but algo trading has a many times greater presence in the market than HFT. It is therefore crucial to have a clearer understanding conceptually of what HFT is (and is not) and what it does (and does not do). My talk today is based on a report recently published by the Markets Committee of the BIS.1 The report presents the results of a fact-finding exercise conducted by a study group that I chaired consisting of FX market experts from 14 central banks. One of the primary motivations for the report was that much of the attention thus far has been on HFT in equity markets. There had been relatively little analysis of HFT in foreign exchange, despite its large and growing presence in the market. As a result we felt it was useful to document some of the facts and issues around HFT in foreign exchange. The exercise in itself was invaluable. Beyond the information that we gathered, it helped to strengthen, and in some cases establish, contacts with a number of the main HFT players in the market. Furthermore, given the different nature, structure and size of the FX market compared to equity markets, it is important to ensure that any conclusions about HFT in equities – as well as any regulatory responses – are not inappropriately generalised to HFT in FX. So how might we think about HFT? Is the very fact that it is too fast for human perception a major cause for concern? Let me answer that question with an analogy to another form of high frequency technology. A BMW is a High Frequency system. There are large numbers of electronic messages flying round a BMW at all times, much faster than you, the driver, can possibly comprehend. You are generally unaware of their presence. But that doesn’t cause you any great concern. Why? Because you are confident about the engineering and you are confident about the monitoring systems. You are confident that this High Frequency system has been appropriately stress-tested and that the systems are resilient to the stress. If, on the other hand, you stick a BMW engine in a Leyland P76 and let it loose on the autobahn, there would be a high probability it would crash, potentially taking out some of the surrounding cars with it. So speed per se is not the problem. The issue is the resilience of the HFT system and the adequacy of the monitoring. So it is useful to think about HFT in foreign exchange in terms of Bank for International Settlements (2011), “High-Frequency Trading in the Foreign Exchange Market”, BIS Report submitted by a Study Group established by the Markets Committee, September. BIS central bankers’ speeches these metrics. On resilience, the HFT firm itself has a large incentive to make sure the system being used is resilient. It is typically the firm’s own capital at stake. Moreover, there is generally not a lot of leverage involved with HFT. On the adequacy of the monitoring, that is a function of the trading platforms, and particularly the prime brokers. I will return to these issues shortly. So in my talk today, I will summarise some of the main findings of the Market Committee’s report. First, I will describe the topography of the HFT market in foreign exchange and the relationships between the main participants. I will then discuss the effect of HFT on price discovery and liquidity. I will briefly examine the behaviour of HFT in two recent episodes of volatile market conditions, namely the flash crash and the spike in the yen just prior to the intervention in March earlier this year. I will also highlight the key similarities and differences between HFT in FX and HFT in equities. Finally, I will conclude with some of the lessons learned so far and highlight some of the issues for further consideration. Market structure One can usefully think of a topography of the foreign exchange market which starts off at the top with electronic trading and voice trading. The former completely dominates the marketplace these days. Electronic trading can then be divided into manual, where instructions are executed by humans on an electronic trading platform, and automated, where instructions are executed by computer algorithms and there is little or no human intervention. The split here is about fifty-fifty. Mind you, the landscape is changing at a high frequency! In the FX market, segmenting types of traders is difficult; there is inevitably a lot of crossover in styles and blurring of boundaries. So for the purposes of our study, we split algorithmic (algo) trading into two categories: algo execution and algo decision-making. The former is when a trader uses an algo to execute an order, often used for large orders. The latter is where a model is used to initiate a trade based on parameters such as order book imbalance, momentum, correlations and systematic responses to economic news. It is in the latter camp that HFT is located. HFT firms generate their revenues from doing a large number of small-size, small-profit trades. They operate with low latency and their risk-holding period is very short, frequently less than one second. As speed is of the essence, indeed the defining characteristic of HFT, co-location is important, that is locating the server that sends the order message as close as possible to the servers of the trading venue. However, our discussion with a number of participants in the market suggested that diminishing returns to speed have well and truly set in, such that the value of future gains may not be worth the investment cost. Indeed, there was a general sense that HFT was reaching a mature phase, where greater returns were more likely to be had from moving into new market segments rather than spending more on enhancing speed.2 HFT participants in FX tend to be located in three cities: Chicago, New York and London, although the physical location of the server is more important than the physical location of the office. The bulk of trading volume appears to be accounted for by several large firms. Most of the activity occurs on the inter-dealer electronic broking platforms (Reuters and EBS) and the multi-bank electronic communication networks (ECNs, such as Currenex, Hotspot and FXall). The various platforms have differing technologies, trading rules and trading parameters. For example, there are varying restrictions on quote life and fill ratios. This assumes, of course, that technology is not developed to let one trade faster than the speed of light! Here’s where we might get to in the future: “Trading firm hits speed of light”, Financial News, 1 April 2011. BIS central bankers’ speeches To operate in the market, a relationship with a prime broker (PB) is required. There is a handful of large PBs in the foreign exchange market, generally the large investment banks. Our conversations with the market indicated that the terms of access varied a reasonable amount across PBs. As the PB provides the credit to the HFT firm, it needs the capacity to measure and monitor this credit. HFT firms tend to trade in small size and hold risk only for a very short period, so the outstanding credit at any point in time is likely to be small, particularly compared to other PB clients. But the high-speed nature of HFT can mean that positions can accumulate rapidly, meaning that the PBs need to have rapid monitoring technology to manage their risk effectively. One reflection of this is the recent development of “kill switch” technology to cut off clients’ access to multiple markets simultaneously if unacceptable positions are being accumulated. Andy Haldane highlights the risk of this, given that trading is occurring faster than human comprehension.3 One concern that the report highlights in this regard is whether PBs are adequately pricing the risk in the provision of their services. This risk not only relates to the credit risk but also the potentially detrimental effect the PB customer may have on other parts of the bank’s business, either through spread compression or through reputational risk as the customer typically is trading in the PB’s name. Note that this issue applies to prime broking generally, not just to HFT in foreign exchange. How large a presence is HFT in the foreign exchange market? It turns out this is a difficult question to answer. Most surveys of FX turnover data do not separately identify HFT activity. As many HFT firms access the market through their prime brokers, the dealers who report the turnover data will only record the trade as being with the broker, rather than the HFT firm. While Reuters and EBS cannot easily directly identify HFT, an estimate can be obtained by summing volumes of counterparties known to participate in HFT. Nevertheless, the BIS Triennal Survey of foreign exchange activity provides some indirect evidence on the increased presence of HFT.4 Between April 2007 and April 2010, daily average FX turnover grew by almost 20 per cent. Three-quarters of this growth was in spot turnover, primarily in the UK and to a lesser extent, the US. The growth in the UK was principally on electronic broking platforms, while that in the US was mostly on ECNs. Given the electronic broking platforms Reuters and EBS are UK-based and the ECNs, mostly USbased, this is consistent with HFT being a significant contributor to the increase in turnover, given their preference to trade in these marketplaces. In the report, we calculate an upper-bound estimate for HFT. This estimate is based on the fact that around 45 per cent of trading on EBS and Reuters (depending on the currency pair) is automated. Given that electronic trading itself is around 50 per cent of spot foreign exchange trading, this would imply that HFT could be around 25–30 per cent of all foreign exchange turnover.5 Haldane A (2011), “The Race to Zero”, Speech at the International Economic Association Sixteenth World Congress, “Approaches to the Evolving World Economy”, Beijing, 8 July. See the 2010 BIS Triennial Survey on Foreign Exchange Market Activity and particularly M King and D Rime (2010), “The $4 Trillion Question: What Explains FX Growth Since the 2007 Survey?”, BIS Quarterly Review, December, pp 27–42. The increased market presence of HFT and the impact it is having on the market structure does, however, highlight the need to reassess the way that we are measuring foreign exchange turnover in the BIS survey. BIS central bankers’ speeches Effect on price discovery and liquidity What has been the effect of HFT on the market? The most obvious impact is that spreads are tighter in normal times, particularly at the top of the book. There are questions about the quality of liquidity, however, with claims that liquidity has been impaired for larger orders. Moreover, as we note in the report, the quality of a bid or ask is determined by more than just its price. The size of the quote and its longevity matters too. The effect of spread compression and depth of book, however, is mostly an issue of redistribution of profit around the marketplace. A number of complaints levelled at HFT firms often reflect the fact that they are taking margin from the party complaining. One example of this is the accusation of predatory pricing. This is sometimes mislabelled front-running. But front-running implies advance “insider” knowledge of a trade. HFT firms don’t have advanced knowledge of the trade as a whole. Rather they detect patterns in trading which are indicative of a large trade coming to market and take advantage of that piece of information (which is available to the whole marketplace). In doing so, they are taking profit at the expense of another participant, but this should be best viewed primarily as redistribution. There are concerns, however, that while liquidity is improved in normal times, HFT is causing changes in the ecology of the market which result in a worsening of liquidity in stressed circumstances. One of these changes is that some banks are internalising more transactions, which means that less trades are ultimately seeing the public marketplace. A related issue is that traditional market makers may pull back in the normal times as the business becomes less profitable meaning that there may be less liquidity available than in the past in stressed times. In that regard, we tried to gain some perspective on this issue by looking at the behaviour of the foreign exchange market around the time of the flash crash in equities in May 2010 and the sharp movements in the yen just prior to the coordinated intervention in March this year. The general sense of the evidence from May 2010 is that HFT participants were very active in the foreign exchange market before, during and after the time of the flash crash. However, while they were present, it is an open question about the quality of the liquidity being provided. This episode also supports the proposition that while not necessarily being the initiator of the shock, HFT can propagate a shock brought on by a rogue or poorly specified (non-HFT) algorithm. In the case of the yen episode, there are indications that HFT players withdrew from the market around that time, but so did others, including traditional market makers. Some of those market makers who remained in the market widened their bid ask spreads dramatically thereby again calling into question the quality of the liquidity being provided. This is standard behaviour, highlighting the point that no participant has an obligation to always provide a quote. Turning to the issue of the comparison between HFT in equities and HFT in foreign exchange, there are some significant differences between the two. An important difference is the nature of the underlying demand in foreign exchange versus equity. There is wider diversity of participants in foreign exchange and arguably more underlying demand. But there are also signs of convergence, with the foreign exchange market becoming more order driven, rather than quote driven. Lessons learned and unresolved issues Having covered some of the facts about HFT in foreign exchange, I will conclude by summarising the lessons and issues that the report highlights: On market functioning: HFT has had a marked impact on the functioning of the FX market in ways that could be seen as beneficial in normal times. HFT helps to BIS central bankers’ speeches distribute liquidity across the decentralised FX market, improving efficiency, and has narrowed spreads, at least for smaller trade sizes. But liquidity for larger trade sizes may have become inferior. The introduction of HFT to the market has affected the ecology of the FX market in ways that are not yet fully understood. Questions remain about HFT participants’ willingness to provide liquidity on a sustained basis under different market conditions. While HFT generates increased activity and narrower spreads in normal times, it may have reduced the resilience of the system as a whole in stressed times by reducing the activity of traditional market participants who may have otherwise been an important stabilising presence in volatile environments. That said, recent experience suggests that HFT participants are not necessarily flightier than traditional participants in times of market stress and may be quicker to re-enter the market as it stabilises. Furthermore, the market infrastructure itself, such as the various electronic trading platforms, is also changing in reaction to the growth of HFT and is likely to have a significant impact on how different market participants execute trades over time. For example, HFT has led to traditional liquidity providers developing proprietary liquidity pools through which to hedge their own risk. Banks are internalising more transactions in-house using the same technology that makes HFT viable. However, this takes liquidity out of the main markets such as Reuters and EBS. As a result, less information is flowing to the market on trading activity; a development that might detract from the price discovery process, at least for some market participants. On HFT and Systemic risks: The 6 May 2010 flash crash in equities shows that rather than HFT per se, algorithmic execution more generally can be a trigger of systemic risk. Rather than being an initiator of such shocks, HFT may accelerate and propagate shocks initiated elsewhere. It is important to bear in mind that, while HFT is dependent on technology to function and that trade positions are often being open and closed faster than human comprehension, there still remains an important human element. The HFT models are continually monitored by human traders to ensure that they are performing as expected. In turbulent times, it is a human trader who makes the discretionary call as to whether to turn off the trading model if it has not already ceased trading. On market integrity and competition: Many of the “predatory” or “unfair” practices attributed to HFT, in light of their technology-driven ability to detect orders and take advantage of latencies, are in fact not new. HFT is but the latest high-tech, highspeed manifestation of them. Turning to regulation, HFT in FX is subject to three levels of self-regulation. In addition to HFT firms’ own risk controls, there is also monitoring by prime brokers. One significant concern we document in the report is whether the prime brokers are technologically capable of keeping up with their HFT clients or have the financial incentives to do so appropriately. Furthermore, trading platforms also have rules to help foster an orderly and fair trading environment, but the nature and severity of such rules varies across platforms. Thirdly, the Foreign Exchange Committees in a number of jurisdictions are currently considering implementing enhanced codes of conduct which aim to address the market integrity issues raised by the increased presence of HFT. Finally, an interesting question to ask, but not addressed in the report, is whether HFT is a socially efficient use of resources. One can ask this question of a number of fields which adopt cutting-edge technology, such as Formula 1 racing or America’s Cup sailing, where the social benefits are not always immediately apparent, but have led to technological BIS central bankers’ speeches improvements that have benefited society. It is not clear that the quest for trading speed, in and of itself, is socially beneficial. But perhaps the more pertinent way to pose the question is to ask instead, whether HFT is harmful. One of the purposes of the Markets Committee’s report has been to provide a set of facts with which one can try to answer that question. In sum, HFT in FX is a rapidly evolving phenomenon. It is having a notable effect on the structure and functioning of the FX market. It is causing behavioural changes in other market participants that may have an impact on the resilience of the system as a whole. While it may be the case that the impact of HFT on market functioning is generally benign, HFT does require ongoing monitoring to ensure this remains the case. The monitoring currently is done predominantly by the prime brokers and the trading platforms. There is a concern that PB monitoring may be inadequate if the risk inherent in the services they are providing is not appropriately priced. Policymakers are endeavouring to keep abreast of the impact of HFT on the FX market by maintaining contact with the different and evolving market participants. In some cases, this is happening through the involvement of policymakers in the Foreign Exchange Committees in various jurisdictions. Industry bodies, such as the ACI, also have a role to play through their work on market codes of conduct. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 10 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the 24th Annual Finance & Treasury Association Congress, Sydney, 19 October 2011. | Guy Debelle: Bank funding Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the 24th Annual Finance & Treasury Association Congress, Sydney, 19 October 2011. * * * Thanks to Justin Fabo, Claudia Seibold and Dan Fabbro for their help. One aspect of the current heightened risk aversion in financial markets has been an increase in funding pressures for some banks, particularly in Europe. In my talk today, I will discuss some aspects of these developments, comparing and contrasting the situation in Europe with that in Australia.1 A summary indication of investors’ assessment of the financial sector can be gleaned from the share prices of banks globally. Graph 1 shows the movements in bank share prices over the past four years and compares them to developments in the rest of the market. It shows that, in most cases, bank share prices have significantly underperformed the rest of the market. Many banks are now trading at a sizeable discount to their book value. Graph 1 also shows that European bank share prices have fared worse than those in other parts of the world. Volatility has also been very high at times, with some banks in Europe recording intraday share price movements of 20 per cent! The share prices of the Australian banks have not fallen as far as those in the major countries, although it is interesting to note that the share prices of Canadian banks have been even stronger. Over the period since June 2007, banks have actually outperformed the rest of the Australian market. Graph 1 With the share prices as a backdrop, today I will focus on one particular aspect of the banking sector that is causing concern, primarily in Europe, namely the resilience of the funding structure. This issue has implications for all of you as corporate treasurers as it flows on to you in terms of price and volume, although not necessarily always in a negative way: A number of these developments are discussed in detail in the Reserve Bank’s September Financial Stability Review. BIS central bankers’ speeches we have seen some corporates able to access markets directly on better terms and conditions than financials. As the concerns about the fiscal sustainability of the euro area have intensified in recent months, and have spread to the financial system, there has been increased pressure on bank funding.2 The cost of funding for European banks generally has risen, while many banks in the European “periphery” countries have all but been locked out of funding markets. As an illustration of this, the cost for banks to borrow euros from each other has risen sharply since significant concerns re-emerged about Greece in May this year. Graph 2 shows that the cost of European banks borrowing from each other in the short-term unsecured market has risen to its highest level in the post-Lehman period, reflecting heightened counterparty concerns. By way of contrast, the equivalent spread in the Australian market (the spread between the bank bill rate and the expected cash rate), while higher than earlier in the year, has remained markedly lower than that in Europe. There have been spikes in this spread on occasion in the past few months, but they have reflected sharp downward movements in the expected cash rate, rather than upward movements in the bank bill rate.3 Graph 2 To mitigate the impact of the sharp increase in the cost of unsecured interbank lending for European banks, the ECB has recently announced an expansion of its open market operations. Since May 2010, the ECB has stood willing to provide three month funding to banks in unlimited amount (against acceptable collateral) at its policy rate. At its most recent meeting in early October, it lengthened the maturities for which it was willing to provide this funding to terms as long as 13 months. That is, banks can source unlimited euros from the ECB at fixed interest rates for periods of at least one year. Thus European banks should not have difficulty in sourcing euro funding for some time to come, provided they hold the appropriate collateral. The ECB is intermediating the interbank market, thereby See the discussion in the ECB’s latest Financial Stability Review. On occasion, the sharp movements have also reflected factors including around the middle and end of the month as the reference bank bills move from one half of the month to the next. See Boge M and I Wilson (2011), “The Domestic Market for Short-term Debt Securities”, RBA Bulletin, September, pp 39–48. BIS central bankers’ speeches circumventing the counterparty concerns, as has long been the proper practice of central banks in periods of stress at least since Bagehot. Graph 3 Graph 4 The take-up of this short-term liquidity by banks in Europe is reflected in the expansion in the balance sheet of the ECB.4 Since April this year, the ECB’s lending to banks has grown by about €180 billion (or 40 per cent) as a result of these operations, with the bulk of the increase occurring since July. Graph 3 shows a breakdown of the lending for selected The ECB’s balance sheet has also expanded as a result of its Securities Markets Program, whereby the ECB has purchased securities issued by Greece, Portugal and Ireland, and more recently Italy and Spain too. BIS central bankers’ speeches countries. It shows that banks in the euro area periphery, particularly those in Greece and Ireland, have been relying heavily on ECB loans for the past year or two (Graph 3).5 This is even more stark if shown as a share of total banking sector assets (Graph 4). These data are mostly up until the end of September (except France and Greece which are August). They show the pick-up in borrowing from the ECB by Italian and Spanish banks since the middle of the year and a rise in borrowing by French banks in August. By way of contrast, the RBA’s provision of liquidity has not changed in recent times. Australian banks’ deposits with the RBA (ES balances)6 have remained around $1¼ billion for over 18 months now.7 More generally, we see little sign of strain or counterparty concern in the local interbank market. Bond issuance by banks globally has fallen sharply in recent months. A partial, but not complete, explanation for the low level of issuance is that bank balance sheet growth globally has been very low and even negative in some cases. Graph 5 shows that unsecured bond issuance by euro area banks has been at very low levels, but until recently, secured issuance in the form of covered bonds had been relatively robust. This is indicative of a general trend for investors to take greater comfort in secured rather than unsecured exposures. Graph 5 Graph 6 shows the issuance by Australian banks. The secured issuance by the Australian banks has been in the form of mortgage-backed securities (RMBS). However, the Australian Parliament last week passed legislation permitting the issuance of covered bonds by Australian banks. As a result, one might expect to see some covered bond issuance by local banks in the near future, given the apparent preference of global investors for this product in the current environment. As market volatility has increased in recent months, issuance by the The decline in ECB lending to Irish and Greek banks in recent months has been partially offset by an increase in lending to those banks from their home central banks through Emergency Liquidity Assistance (ELA), which permits a broader range of collateral than the ECB. It also reflects the fact that their balance sheets are shrinking. One can assess the provision of liquidity from either side of the balance sheet. Here I am using lending for the ECB and deposits for the RBA. Except for the temporary increases in ES balances at month-, and particularly, quarter-end. BIS central bankers’ speeches Australian banks has also declined. As the Reserve Bank has noted on a number of occasions,8 the Australian banks are much better placed to ride out these periods of volatility than in the past. This is for a number of reasons, including that deposit growth has outstripped credit growth for more than two years now, thereby reducing the banks’ need to access wholesale debt markets, and that banks have increased their use of longer-term funding. Graph 6 Let me make a brief detour into the world of credit default swaps (CDS). A number of commentators have pointed to the large rise in CDS premia for Australian banks in recent months. Graph 7 shows this rise, and also shows that, to a large extent, it is reflective of a rise in bank CDS globally. The rise in CDS appears to be much larger than the rise in primary unsecured issuance costs, although it is difficult to gauge exactly where the latter are, given the low level of issuance recently. But earlier in the month, the Commonwealth Bank issued an unsecured 3-year bond at a spread of 115 basis points over swap, 20 basis points wider than a similar issue earlier in the year, while the three-year CDS premium for the CBA has risen by 80 basis points over the same period. This divergence between CDS premia and issuance costs reflects the fact that, while subject to the same forces, they are not the same thing. While one is an insurance premium and the other contains a premium to compensate for a risk of default, there are other important elements too which differ. This is true for sovereigns, financials and corporates. To further illustrate this, it is interesting, particularly for you as corporate treasurers, to look at the CDS premium on BHP Billiton. As you may know, BHP has an extremely low gearing ratio. Its cash holdings have generally been about the same size as its outstanding debt. Notwithstanding this, at one point during the past month, BHP’s CDS premium had increased by as much as 110 basis points since the beginning of the year. It appears that there are typically 2 or 3 trades in BHP CDS a day. From DTCC data, we know that there are certainly less than 50 trades a week in BHP CDS (this is also true of the Australian banks and the Australian sovereign CDS contracts), as that is the minimum number of trades that the DTCC reports. So the CDS premium does not have a lot of trading volume behind it, which potentially allows traders a cheap way (relative to a debt security) to take a position either on See recent RBA Board Minutes and the RBA’s September Financial Stability Review, as well as my speech delivered at the 23rd Australasian Finance and Banking Conference, “Bank Funding and Capital Flows”, Sydney, 15 December 2010. BIS central bankers’ speeches the entity in question or as a proxy for a broader position, such as the Chinese economy in the case of BHP and the Australian sovereign CDS contracts. Graph 7 After that little detour, back to the bank funding story. So far I have talked about banks borrowing in their own currencies. But European banks have also experienced a substantial increase in the cost of borrowing US dollars to fund their US dollar assets.9 While BIS data indicate that these US dollar asset positions of European banks have declined since 2008, they remain sizeable in some cases.10 An important point to note is that these are US dollar assets which require US dollar funding. Many of these assets are of long maturity, but the associated funding of these positions tends to be at much shorter maturities. Therefore, these banks face “rollover risk”, both in terms of price and availability, on this US dollar funding. European banks have a number of ways of obtaining US dollars including: short-term debt issuance, including to money market funds; deposits; secured borrowing; swapping euros for US dollars through the swap market; from the Fed or ECB, including via the US dollar swap line. Exacerbating European banks’ US dollar funding pressure has been a pull-back by US money market funds (MMFs) from holding debt issued by these banks.11 These funds invest in highly rated short-term debt and that issued by European banks has traditionally accounted for a large share of their assets. Since concerns about a Greek default escalated in May, US MMFs have experienced significant investor outflows (Graph 8). The majority of This has been a topic I have had a keen interest in for some time, including through chairing a working group for the BIS Committee on Global Financial Stability (CGFS) on the effect of central bank swap lines. See CGFS, “The Functioning and Resilience of Cross-border Funding Markets”, CGFS Publication No 37. See BIS Quarterly Review, September 2011. Useful analyses of the US money market funds are provided on a regular basis by JP Morgan and Fitch. BIS central bankers’ speeches this has been reflected in reduced holdings of European bank debt. Notably, these funds now hold no or negligible amounts of debt issued by banks in Greece, Ireland, Italy, Portugal and Spain. US MMFs have also shortened the average maturity of their asset holdings. Graph 8 As this and other sources of funding have diminished, European banks have increasingly sought to obtain US dollars via foreign exchange swaps. As a result, the cost of doing this relative to the cost of unsecured interbank funding – the “basis” – has increased substantially since May this year, although it remains below the peaks post-Lehman (Graph 9). Graph 9 To counter the impact of this, in addition to sourcing more US dollars via foreign-exchange markets, some European banks are tapping US dollar repo markets for funding, reportedly, in some cases, with increased haircuts applied, and are also actively reducing their US dollar asset positions. European banks also appear to have built up cash buffers in US dollars earlier in the year. Cash holdings of foreign banks in the United States, presumably a BIS central bankers’ speeches reasonable share of which are European, had risen to over US$1 trillion from less than US$400 billion earlier this year before declining (Graph 10). Graph 10 One important reminder from the financial crisis was that central banks can substantially help market functioning when liquidity strains emerge. As I mentioned earlier, European banks can access liquidity in their own currency (euros) effectively in unlimited amounts (as long as they have collateral). But to fund US dollar asset positions requires US dollars, not euros. Euros are useful if the swap market is functioning, but in the current circumstances, that market may not be open to all market participants. This certainly was the case in late 2008 and early 2009, when the provision of US dollar liquidity by the Federal Reserve to foreign banks through swap lines with other central banks clearly helped to alleviate European and other foreign banks’ US dollar funding pressures (Graph 11). These swap lines effectively provided unlimited US dollar funding to these banks (again against appropriate collateral). Graph 11 BIS central bankers’ speeches The swap lines ran off in early 2010 and while the major central banks maintained them at 7-day terms, they were barely utilised. In September 2011, three-month terms were re-introduced by the major central banks. But despite the recent tensions in US dollar funding markets, recourse to these central bank US dollar swap lines with the Fed has been negligible. At the ECB’s threemonth auction conducted in mid October, the take-up was only US$1.4 billion in aggregate by six banks. Nevertheless, the major central banks will conduct further US dollar liquidity operations with maturities of around three months in November and December. Turning now to look at the Australian banks’ offshore funding, there are some important differences to the situation in Europe. Graph 8 also shows that the cost of swapping Australian dollars for US dollars has not increased in the most recent episode and indeed has gone negative at times. There are some fundamental differences in the nature of the Australian banks’ offshore funding. The funding that the Australian banks raise offshore, in US dollars predominantly, is swapped back into Australian dollars to fund Australian dollar assets. That is, the Australian banks are funding Australian dollar assets, not US dollar assets. Thus, if they experience increased difficulty in accessing US funding markets, this is resolved by sourcing Australian dollar liquidity, including in stressed circumstances from the Reserve Bank,12 rather than trying to source liquidity in a foreign currency. The swaps are generally of the same maturity as the funding, so there is no maturity mismatch. Moreover, given the use of CSAs and the net underlying position of the Australian banks, in the event of a depreciation of the Australian dollar, such as has occurred in the past two months, the Australian banks receive large inflows of US dollars into their collateral accounts, effectively increasing their supply of US dollar funding. In contrast to the recent experience of some European banks, the Australian banks have found that US MMFs have been more than willing to maintain their exposures, including at longer maturities. Indeed, recently the Australian banks have been beneficiaries of a reallocation by the MMFs away from the European banks. Conclusion The banking system globally has been under scrutiny for much of the past four years to varying degrees. At the moment, we are in another period where that scrutiny is intense. My aim today has been to provide you with some context to that scrutiny, particularly around bank funding. The actions by the ECB, together with the Fed through the provision of the US dollar swap facility, should alleviate some of the funding tensions for European banks. In effect, provided they have appropriate collateral, European banks should be able to meet their liquidity needs in the period ahead both in euros, and in US dollars. I have also provided some comparison with the situation facing the Australian banks. We are not seeing the same sort of stresses for the Australian banks, as are present for some of the European banks. The Australian banks’ funding structures are considerably more resilient to periods of stressed markets than they were previously, given the changes that have occurred over recent years. See my speech delivered earlier in the year: “Collateral, Funding and Liquidity”, Address to Conference on Systemic Risk, Basel III, Financial Stability and Regulation, Sydney, 28 June. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 10 |
Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the ISDA Annual Australia Conference, Sydney, 20 October 2011. | Malcolm Edey: The challenge of central clearing in OTC derivatives markets1 Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the ISDA Annual Australia Conference, Sydney, 20 October 2011. * * * Good morning, and thank you to ISDA for the opportunity to speak here today. This conference is taking place at an interesting and challenging time for the global financial system. Obviously a good deal of attention right now is focused on Europe, particularly on the problem of sovereign debt sustainability and its interaction with the condition of the European banking system. This is a source of significant uncertainty for the rest of the world. Policymakers are working hard to find solutions that will rebuild confidence, but the situation is still fluid and it remains an area that will need to be closely watched. In Australia meanwhile the financial system is continuing to perform relatively well. The broad outlines of that story are, I think, well known. During the GFC Australia avoided a recession and a banking crisis. Our banks are profitable and well capitalised, and their overall asset quality remains good. We can’t of course expect the Australian system to be entirely immune from the unfolding events in Europe, but a couple of points are worth emphasising. The first is that the Australian banks have only limited direct exposures to sovereign debt in the countries that are most at risk. So potential effects on Australian banks’ overall asset quality are not an issue. The second point is that, since the height of the GFC, the Australian banks have done a lot to strengthen their funding positions. They have increased their use of domestic deposits as a funding source, lengthened the average term of their wholesale funding, and correspondingly reduced their reliance on short-term wholesale debt. These things will help to make them more resilient to the uncertainties that are now affecting international credit markets. As important as these current challenges are, financial regulators around the world have been focusing not just on those, but also on longer-term regulatory reforms. The reform effort is proceeding on a number of fronts, aimed at building more robust financial systems for the longer term and thereby reducing the risk of future crises. Many of these efforts are being coordinated internationally through the G20 process, through the Financial Stability Board, and through standard-setting bodies like the Basel Committee. In all of these bodies Australia is actively represented. In broad terms, the various reforms draw on the lessons that emerged from the GFC, and they seek to remedy the weaknesses that became apparent during that period. Hence, among other things, there is a significant effort through the Basel process to increase the amount and quality of capital in the global banking system, and to strengthen liquidity management by banks. Although, as I said, we didn’t have a banking crisis here during the GFC period, the Australian regulators recognise the importance of improving standards, and we are working on implementation of the various international initiatives in all these areas, and others. One particular piece of the picture that has absorbed a lot of our attention at the Reserve Bank has been the work on financial market infrastructure, particularly in relation to OTC For a more detailed treatment of the issues discussed in this speech, readers are referred to the Council of Financial Regulators Discussion Paper, Central Clearing of OTC Derivatives in Australia, June 2011 http://www.rba.gov.au/publications/consultations/201106-otc-derivatives/pdf/201106-otc-derivatives.pdf. BIS central bankers’ speeches derivatives clearing. I know this is very relevant to ISDA members here today, and it’s on this topic that I want to focus my main remarks. At the Pittsburgh Summit in September 2009, G20 leaders agreed, among other things, to a common commitment to central clearing in key derivatives markets. The commitment states that “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end2012 at the latest”. Australia was part of that agreement, and the Australian regulatory agencies, like those in other G20 jurisdictions, are working through the issues associated with its implementation. In focusing on that today, I want to look at three questions: why is there a general case for promoting central clearing? what are the complexities involved?; and where does the process stand in Australia? First, why central clearing? The general case for promoting central clearing in derivatives markets is based on the aim of reducing systemic risk by managing interconnectedness. In markets without central clearing, counterparty exposures build up bilaterally and, in certain kinds of products, they can accumulate to very large notional amounts over time. In many cases this might not be a problem, but where the interconnections are extensive enough they can be a source of systemic risk. The risks from those exposures might be managed well by individual institutions, but an institution can’t be sure that its dealings with others don’t expose it to a lower standard of risk control practiced by a counterparty, or anyone else in the market that is linked through bilateral trades. The clearing process, by novating positions to a central counterparty (CCP), allows risks to be centrally managed to a standard acceptable to the market and its regulators. Moreover, with legally enforceable multilateral netting, gross exposures can be drastically reduced. As long as the CCP is itself robust, the effect should be to reduce the scope for contagion and thereby limit the impact on the market if one or more of the participants fail. The experience with resolving the Lehman failure in 2008 testifies to the effectiveness of this mechanism in a crisis. We might also expect that confidence in this mechanism will help to underpin market liquidity during periods of financial stress. All of this presupposes that the CCP is itself robust. Of course, CCPs themselves have a strong incentive to control their risks, since they are after all in the risk-reduction business. But it also points to the need for appropriate regulatory standards to ensure that the risk controls in a CCP are commensurate with its significance for the wider system. Subject to that proviso, central clearing reduces aggregate counterparty risk by replacing a web of bilateral exposures with a set of potentially much smaller net exposures of each participant to a CCP with robust risk management. Individual participants benefit from the reduction in risk but, importantly, so does the stability of the system as a whole. In a nutshell, that is the basic case for promoting central clearing as a policy objective in systemically important derivatives markets. Which brings me to my second question: what about the complexities? When talking about these things in the abstract, it’s easy to talk as though a central counterparty is truly “central”. But in fact, as we all know, it’s not that simple. There is a huge array of markets in financial instruments around the world and there are multiple CCPs for different instruments. Some instruments are centrally cleared already, many are not. Not all instruments are good candidates for central clearing, because they are not sufficiently standardised and can’t easily be made so. BIS central bankers’ speeches It’s also important to recognise that not all market participants are alike, and not all can be expected to have direct access to the major CCPs even when the new structures are fully in place. So the abstract model in which all participants are connected to the central clearer won’t be realised in practice. For all these reasons, the optimal configuration of clearing arrangements in the real world is far from obvious, and the way global markets will evolve in response to a mandatory clearing environment across multiple jurisdictions is hard to predict. Another complication is the question of interconnectivity between clearers. A central clearer should, in some sense, be central. In theory, netting benefits might be maximised by a single global CCP clearing all the major instruments, with all active traders as members and all positions included in the scope of multilateral netting. It’s not clear that such an outcome would be desirable even if it were possible. It would amount to a massive concentration of risk at a single point and would give rise to complex operational issues and questions of jurisdictional oversight. But in any case, even if such an outcome were desirable, it won’t be achieved. The closest alternative might be to provide links that allow trades to be cleared between participants in different CCPs. The question of how this might eventually occur, or even of whether it is achievable at all, then becomes very important. The weight of expert opinion is that the capacity to develop these links is still a good way off. Links between CCPs also raise complex questions about the transmission of risks from one CCP to another, and these will need to be carefully studied. For the foreseeable future, then, we will be in a world in which there is a collection of CCPs, each of which has some source of competitive advantage in its own location or its own area of specialisation. That advantage might derive from historical legacy, or it might arise because the market that a CCP is servicing has some sort of natural home in its own location. But these markets will remain contestable and so the configuration of CCPs around the world is likely to stay fluid, not least because the market will be rapidly evolving in response to changing regulatory requirements. It is in this very unpredictable environment that the domestic regulators are considering the policy framework for central clearing in Australia. Before I come to that, it’s worth reviewing a few general facts about the Australian OTC derivatives market. Its largest component, in terms of the amounts outstanding, is the market for single-currency interest rate swaps – the bulk of which are Australian dollar denominated. Australian banks (both locally incorporated and foreign bank branches) have aggregate notional principal amounts outstanding in this market of around $8 trillion.2 But banks operating in Australia are not the only entities to transact in this market. From a jurisdictional point of view, we can (in principle) divide transactions in the global market for Australian dollar derivatives into three types, namely local-to-local, local-to-offshore, and entirely offshore. In fact the distinction between a local and an offshore market participant is not entirely straightforward, since many local participants are affiliated with offshore entities. That said, the available data suggest that all three of those transaction types form a significant share of the market. Most of the activity that involves the large foreign banks as the two counterparties is already cleared through LCH SwapClear, while the remainder of the market is currently uncleared. It is of course misleading in another way to talk of these three market segments as if they were separable. They are in fact closely interdependent, and liquidity in each of the three parts benefits from the liquidity of the others. As a related point, the Australian dollar market APRA data on banks’ off-balance sheet business as at end June 2011. Note that this figure double counts amounts outstanding between reporting banks. BIS central bankers’ speeches is itself interdependent with other global markets, and specifically with derivatives markets in other currencies. The regulatory agencies in Australia have indicated that they view the Australian dollar IR swap market as being systemically important to the domestic financial system. This reflects a number of considerations, including: the size of the market its fundamental role in hedging domestic interest rate risk, and the long duration of counterparty risk in these instruments. It is important to note, however, that although this market is large in relation to the Australian financial system, it is not large in global terms. The next largest OTC derivatives market in Australia3 is for FX-related derivatives4, in which the Australian banking system has a notional principal outstanding of around $4 trillion. Other OTC markets, such as those for commodity derivatives, are much smaller, though that is not to say that they don’t have the potential to grow over time. For various reasons, international regulators are at this stage giving priority in their regulatory strategies to single-currency interest rate swaps. Among the reasons for that is that these instruments are often of relatively long duration and have very large volumes outstanding, as well as the fact that cross-currency instruments (the next biggest market) give rise to more complex jurisdictional issues. In Australia, for similar reasons, any mandatory clearing policy is likely to focus initially on the Australian-dollar interest rate swaps market. At the heart of the policy challenge are two inter-related questions: should there be a mandatory clearing requirement in this market and, if so, should it include a locational requirement, to the effect that trades be cleared by a locally incorporated and locally regulated CCP? Since there is no domestic CCP offering such a service currently, that would involve requiring industry to come up with a solution that meets the regulatory objectives. There are many factors that will have a bearing on this decision, but I think they boil down to finding a balance between the two objectives of stability and efficiency. The stability consideration comes from the point that I made at the outset. The purpose of promoting central clearing is to reduce systemic risk. CCPs reduce risk in one important respect, but they also concentrate it in a specific location. Where a market is systemically important to the Australian economy and financial system, this points to a case for the CCP that clears it to be subject to appropriate safeguards that control the propagation of risks to domestic participants. This might be best achieved where the CCP is locally incorporated and subject to domestic regulation. At the least, it argues that the CCP should be subject to safeguards that take into account its systemic significance for the Australian market. The second set of considerations are those related to efficiency. We have to recognise that, even for instruments that are denominated solely in Australian dollars, the market is a global one. The cost-effectiveness of a local CCP will thus depend to a significant degree on global forces. I’ve tried to highlight the uncertainties involved in predicting how the global market will evolve. On that front, a number of submissions to our consultation process have emphasised the risk of splitting the Australian dollar market if any local clearing mandate turns out to be not sufficiently effective. The cost-effectiveness and viability of a local CCP for this market will also depend on aspects of the international regulatory environment that are not yet determined, including the As measured by the amount outstanding. That is, FX swaps, forwards and options. BIS central bankers’ speeches extent of eventual mutual recognition of CCPs across borders by their respective regulators. We need to avoid an outcome where internationally active banks find themselves subject to inconsistent mandating requirements among the jurisdictions in which they operate. On that issue, I note that the Financial Stability Board has recently begun discussions on the challenges of mutual recognition, though these are still at an early stage. Adding further to the complexity is that the environment is already being shaped by regulatory developments in the major jurisdictions, especially the US and Europe. Australian entities that are active in those markets will need to meet the clearing requirements that soon come into force there, and they will also be affected indirectly to the extent that they deal with counterparties that are subject to those jurisdictions. In the United States, the Dodd-Frank regulations on OTC clearing are likely to start taking effect around the second quarter of next year, and in Europe the corresponding regulations under EMIR5 are likely to take effect by around 2013. Even before then, market behaviour, and hence the environment for the Australian banks, will be influenced by the anticipation of those requirements. In broad outline, then, these are some of the key considerations that will need to be taken into account in determining the way forward in Australia. This brings me to my third question: where does the policy process in Australia now stand? In June, as you know, the Council of Financial Regulators6 released a discussion paper setting out these issues in detail and calling for submissions from interested parties. To help focus discussion, the Council paper put forward four propositions. In summary, these were: that in the absence of Australian regulatory action, domestic CCP solutions may not emerge; that where a market is of systemic importance to Australia, a move to offshore central clearing might introduce risks to the Australian financial system that do not currently exist; that the Council agencies considered the market for Australian dollar interest rate swaps to be systemically important within Australia; and that in light of this, the Council agencies were considering the case for a requirement that those instruments be centrally cleared, and as part of that were considering whether such clearing should take place domestically. I stress that these were not conclusions. They were preliminary propositions that the Council agencies were seeking to test. In response to the paper, we have received around 30 submissions, including one from ISDA and a good number from ISDA members who are no doubt represented here today, along with others from a range of other market participants and interested parties. Most of the submissions are available on the Bank’s website. Council agencies have also engaged in a series of follow-up meetings with those who made submissions. I’ve participated in a number of those myself, and I’ve appreciated the spirit in which the industry has provided its input. If I’ve conveyed anything today, it’s that these are difficult and complex issues. Most of the submissions have stressed that point, and there was a strong view from industry that it’s European Markets Infrastructure Regulation. Comprising the Reserve Bank of Australia, ASIC, APRA and the Australian Treasury. BIS central bankers’ speeches important to take the time to get it right.7 We take the complexities seriously, and we need to continue engaging with industry in the process of determining the best way forward. That said, the Council’s advice on these matters, when it’s made, will be determined by the public policy considerations of stability and efficiency that I’ve just outlined. Not all industry participants will have the same commercial interests and not all will be of the same view as to their preferred outcome. But where the industry contributions will be valuable is in helping to make clearer what are the costs and benefits, and the risks, of the alternative approaches. We hope to be in a position to put forward some conclusions from the consultation process soon, but I can’t foreshadow those today. In the meantime, I take the opportunity to thank all those in the industry who have made constructive contributions, and we look forward to continued engagement. But not too long. Others have pointed to the need to respond in a timely way to the rapidly changing international environment. Again, it’s a question of balance. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 10 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Citi's 3rd Annual Australian & New Zealand Investment Conference, Sydney, 25 October 2011. | Ric Battellino: Economic and financial developments Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to Citi’s 3rd Annual Australian & New Zealand Investment Conference, Sydney, 25 October 2011. * * * Introduction 2011 has been a frustrating year for the world economy. The recovery in most of the large advanced economies lost momentum in the first half of the year and financial market volatility and concerns about sovereign debt posed renewed threats in the second half. This led the IMF in September to note that the world economy had “entered a dangerous new phase”. In many ways, these difficulties can be seen as the continuing after-effects of the financial crisis that gripped the North Atlantic economies in 2008. Australia, as with most of Asia, has to date been relatively shielded from the events in the North Atlantic countries. Nonetheless, the local economy has not been as buoyant as had been expected at the start of the year and downside risks stemming from further weakness in the major overseas economies or financial market volatility cannot be ruled out. The situation in Europe is particularly disturbing since the authorities need to agree on policies that deal simultaneously with excessive government debt, weak banking systems, soft economic activity and sharp differences in competitiveness among European countries. The situation is not all gloom, however. Economic data in the United States over the past month or two have, more often than not, surprised on the upside, Asia is also generally continuing to do well, and some of the local economic news has also been more positive of late. Let me run through some of these issues in more detail. I will start with the world economy. The world economy As you know, 2010 had been a very strong year for the world economy. Growth was a little over 5 per cent, which is about as fast as the world economy ever grows. The strong growth was not surprising, as most countries were applying unprecedented amounts of monetary and fiscal stimulus as they sought to recover from the 2008/09 recession. It was always expected that economic growth in 2011 would not be as strong. Early in 2011, most forecasters were expecting growth for the year of about 4½ per cent; while this was less than 2010, it was still a very good figure. By the second quarter, however, economic outcomes were beginning to disappoint. In the United States, consumer confidence and spending weakened, possibly due to the strong increases in oil prices that had taken place; US industrial production was affected by the disruptions to global supply chains caused by the Japanese earthquake in March; employment growth slowed; and jobless claims, which had been gradually declining, started to rise again. Growth in Europe also faltered in the second quarter, with confidence being eroded by the escalating concerns about sovereign debt in several European countries. And, of course, Japanese economic activity was severely disrupted by the after-effects of the earthquake. Elsewhere in the world, however, economic activity remained robust. In fact, through most of Asia and Latin America the concern was that the strength of economic activity was putting upward pressure on inflation, and the authorities in many countries in these regions were tightening monetary policy. BIS central bankers’ speeches Overall, forecasts for global growth in 2011 were scaled back around mid year to around 4¼ per cent, due mainly to the softer outlook for the major developed economies. Subsequent to this, the marked increase in financial market volatility that occurred in the third quarter caused analysts to expect further weakening in the global economy, due to the sharp falls in consumer and business sentiment that occurred in most countries and the significant reduction in wealth caused by the falls in share prices. The reductions in growth forecasts were again most pronounced for the developed economies. IMF forecasts for growth in the United States and the euro area in 2011 were reduced to around 1½ per cent. Although growth forecasts for Asia and Latin America were also revised down somewhat, the forecast outcomes for these countries remained quite robust. While the forecast for overall growth for the world economy in 2011 was reduced to 4 per cent, that figure is still a healthy outcome. It is broadly in line with trend. The disparate outcomes between the advanced economies and the emerging economies, however, mean that the growth is very unbalanced and there is a sense that the forecast is fragile because of possible severe downside risks. While forecasts have been revised down since the recent period of financial volatility, the run of actual economic data that has become available over that period, at least for countries outside Europe, has generally been better than might have been expected. This is particularly the case in the United States. It seems that, before the onset of the financial volatility, the US economy was starting to recover from the first half slowdown and that, so far at least, despite the fall in confidence, real economic activity has held up. Recently, analysts have been revising up their estimates of annualised US GDP growth for the third quarter, and the consensus is now for a figure of around 2½–3 per cent. Japan also seems to be continuing to recover gradually from the economic effects of the earthquake. Elsewhere in Asia, recent data have been mixed, though broadly consistent with the modest slowdown that authorities in the region have been trying to achieve in order to contain inflationary pressures. India perhaps has been the country pursuing this approach most vigorously, and seems to be the country where growth has slowed most noticeably. Overall, however, growth in the region remains solid. Growth in Chinese GDP over the year to the September quarter was 9.1 per cent, and recent monthly data for retail sales and industrial production have been robust. The latest data available to the Bank on shipments of Australian coal and iron ore to China (these are up to September) suggest that shipments have held up, though the weakening in iron ore prices over the past couple of weeks may be pointing to some softening ahead. The Australian economy Here in Australia, 2011 got off to a shaky start, despite the bright prospects offered by the second phase of the resources boom. A lot of this was due to the weather, as cyclones and floods disrupted economic activity, and coal production in particular. As you know, GDP fell noticeably in the first quarter of the year. GDP recovered in the second quarter but, overall, measured economic output in the first half of the year was pretty flat. As well as the weather-related disruptions, there remained a generally cautious mood among households and businesses. BIS central bankers’ speeches As the Bank has pointed out before, in recent years there has been a structural change in household spending and financing in Australia.1 After a 10–15 year period during which households increased their gearing and reduced their rate of saving, they have returned to a more conservative, and traditional, pattern of financial behaviour. Household credit growth has slowed to a rate in keeping with, or slightly below, the growth in household incomes; the saving rate has increased to a level that is more normal based on history; and household spending growth has slowed from a rate that substantially exceeded household income growth, to one that, over the past year, has been broadly in line with income growth. Within total consumer spending, there appears to have been a shift away from spending on goods in stores to spending on services, particularly services such as overseas travel, eating out and entertainment. As a result, retail sales have been particularly weak. This adjustment in consumer behaviour has created a difficult trading environment for some businesses, coming as it has after a prolonged boom. But the adjustment in Australia has been benign compared with the adjustments in household finances and housing markets elsewhere in the world, and it has put household spending and financing on a more sustainable path. This will ultimately benefit the health of the economy. In the case of business investment, there is a clear dichotomy between the resource and non-resource sectors of the economy. Investment by the former is very high at present, and much more lies ahead. Outside the resources sector, however, business investment is relatively flat. In some cases this is due to the dampening influence of the high exchange rate, with the manufacturing and tourism industries particularly affected. In the case of tourism, the problem is not so much that foreign tourists have stopped coming to Australia but that many more Australians are going overseas. Overseas trips by Australians are running about 60 per cent higher than five years ago. Given the increase in overseas travel, it is not surprising that the traditional holiday destinations in Australia, such as the Gold Coast and North Queensland, are currently among the weaker parts of the Australian economy. In other sectors, such as commercial property, the weakness is mainly the result of investors and lenders having to deal with the consequences of over-gearing in the pre-2008 period. When too much borrowing and lending occurs, as it did in this sector, it can take many years for the excesses to be unwound. Some large adjustments have already taken place in the commercial property sector but the process probably still has further to run. While the sectoral composition of business investment is uneven, the overall growth of investment has been very solid, with a rise of 6 per cent in the first half of 2011. Overall, private demand is rising solidly, and taking the place of public spending, which is now growing more slowly as earlier fiscal stimulus is unwound. Total final demand grew by 3.4 per cent over the year to June, which is about in line with past trends. That, however, has not translated to trend growth in GDP, as the high exchange rate and the high import content of some mining investment have seen an increased proportion of demand being met from imports, rather than domestic production. The weatherrelated disruptions to coal exports added to the shortfall in production. In this environment, employment growth slowed noticeably in the first half of the year, and around the middle of the year there was some rise in unemployment. At the same time, inflationary pressures, which had declined through 2010, appeared to pick up noticeably in the first half of 2011 and the prospects were that inflation would rise to above the target range of 2–3 per cent over the next couple of years. That created a difficult environment for monetary policy. As the Bank noted after the October Board meeting, however, the downward revisions to recent estimates of underlying inflation and the softer global economic outlook have made the outlook for inflation less concerning, providing scope See Stevens G (2011), “The Cautious Consumer”, Address to The Anika Foundation Luncheon, Sydney, 26 July. BIS central bankers’ speeches for monetary policy to be supportive of economic activity, if needed. Tomorrow’s CPI data will provide further information in this regard. It remains to be seen how the Australian economy will respond to the recent financial volatility and the consequent fall in confidence and the loss of wealth. To date, however, as in the United States, the flow of monthly data in Australia has been a little better than might have been expected given the volatile financial environment. Retail sales have picked up a little, housing loan approvals also seem to be picking up somewhat, most measures of business conditions remain around average levels and the most recent employment data have been more positive after a number of weak months. Nonetheless, job vacancies and advertisements are lower than their peak around the start of the year, overall credit growth remains subdued and the housing market remains soft. Recently, there has been some easing in financial conditions following the fall in market interest rates that has accompanied the financial volatility. Banks have passed through to borrowers notable declines in interest rates on term housing loans and some business loans, as their cost of funds has declined. Increased competition among banks in response to the increased availability of deposits and relatively subdued demand for loans, has also resulted in some shaving of interest rates on standard variable mortgage loans for new borrowers. As a result, the interest rates on new loans are now around 10–15 basis points lower than they were early in the year. The modest net fall in the exchange rate in recent months has also, to some extent, reduced pressures on some sectors of the economy. Looking ahead As I have noted, as yet there have not been signs outside Europe that the rate of growth of economic activity has taken another step down since the recent bout of financial volatility. It is, however, still too soon to conclude that this will not happen. As we have seen from last weekend’s events in Europe, much still needs to be done to deal with the challenges these countries are facing, and further market volatility is therefore to be expected. The United States also has challenges to deal with in the areas of fiscal policy and housing, so it would be optimistic to assume that the US economy will resume robust growth any time soon. Economic activity in large parts of the developed world is therefore likely to remain subdued in the period ahead. The question is whether this will flow through in due course to the large emerging economies that have been the main force driving global GDP growth in recent years. Some flow-on is, of course, to be expected, even if the situation in the advanced economies does not deteriorate further. However, so far at least, there has not been the debilitating freezing up of trade finance that damaged Asian economies in 2008. More generally, domestic demand in these economies has considerable momentum and, should it slow more than the authorities desire, they have considerable scope to provide support via monetary and fiscal policy, unlike in many advanced economies. The fact that inflationary pressures in many of these economies seem to be peaking may provide room to do so. Overall, while it is possible that the global economic situation might take a sharp turn for the worse, at this stage the Bank’s central scenario is that global GDP growth will be broadly in line with its long-run average over the period ahead. That would create a reasonably benign environment for the Australian economy. The global situation remains fragile, however, and will require careful monitoring. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 10 |
Speech by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Farm Institute Agriculture Roundtable Conference 2011, Melbourne, 10 November 2011. | Philip Lowe: World prices and the Australian farm sector Speech by Mr Philip Lowe, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Farm Institute Agriculture Roundtable Conference 2011, Melbourne, 10 November 2011. * * * I would like to thank Troy Gill, Ewan Rankin and Trent Wiltshire for assistance in the preparation of this talk. Good morning. Thank you for the opportunity to speak today about some of the challenges and opportunities facing the farming sector in Australia. Perhaps more than any other parts of the Australian economy, farmers understand uncertainty. They live with uncertainty about rainfall and growing conditions. They live with uncertainty about the costs of their key inputs. And, of course, they live with uncertainty about the world prices for their outputs. It is this ability to deal with uncertainty that is one of the strong and enduring characteristics of the Australian farming sector. This morning, I would like to begin by talking a little about some of the uncertainties facing the global economy. I would then like to discuss why it is that, despite these uncertainties, the medium-term global environment facing the Australian farming sector is quite favourable. And then finally, I would like to briefly touch on current conditions in the farming sector in Australia. Global uncertainties It is clearly a difficult time for the world economy. Financial markets remain captivated by the unfolding events in Europe. The authorities there are dealing with a very difficult combination of excess government debt and weak banking systems. The problems are compounded by the weak growth prospects in the region and increasing fear of widespread contagion. This situation is, in part, a legacy of many years in which a number of governments spent much more than they raised in taxes, with bondholders being more than willing to finance the difference at low interest rates. It is being compounded by the fact that the policy options facing the members of a currency union are more restricted than those that would face a country with its own currency. In preparing the Reserve Bank’s latest forecasts of the world economy, we have assumed that the European authorities do enough to avert a real disaster but are not able to avoid periodic bouts of considerable market volatility and uncertainty. There are, of course, a range of other scenarios, many of which, unfortunately, are on the downside. This inevitably means that there is likely to be considerable uncertainty about the global economy for some time. But amongst the gloom emanating from Europe, it is important not to lose sight of what is going on elsewhere in the world. In the United States, recent economic data have generally been better than they were earlier in the year. It now seems clearer than it was a few months ago that temporary factors – including the rise in oil prices and the supply-chain disruptions from the Japanese earthquake – contributed to the weak US economic outcomes earlier in the year. As is normal though for a country having experienced a financial crisis, the recovery in economic activity has been slower than normal. Nonetheless, corporate balance sheets in the United States remain in good shape and a pick-up in business investment is under way. And importantly, there are few signs that the recent financial turbulence has led to the significant deferrals of spending on capital goods that caused so much damage in 2008 and 2009. BIS central bankers’ speeches In Asia, growth remains firm, although below the pace in 2010. This moderation in growth partly reflects a general tightening of macroeconomic policy over the past year in response to a pick-up in inflation. Recently, there have also been some indications that the weakness in the North Atlantic economies is having an effect in the region, with growth in exports having slowed. But taking a slightly longer-term perspective, one encouraging development is that domestic demand in the region appears still to be growing reasonably strongly. This is important because over the years ahead, Asia will need to rely more on domestic consumption, rather than exports and investment, to drive its growth. To do this, further policy reforms in the region will be required, but progress on this front is being made. So the global environment is a very complex one at the moment. Over the course of this year, forecasts for world growth in 2012 have been revised down from slightly above-trend growth to slightly below-trend growth. It is noteworthy that around three-quarters of the expected increase in global output is expected to come from the emerging and developing countries, a marked change from the past when the advanced economies accounted for the bulk of growth in global output. From Australia’s perspective, global growth somewhere around average, or just a little below, would make for a relatively benign international backdrop. The difficulty for many other advanced economies is that average growth will not allow them to make inroads into their very high levels of unemployment and excess capacity, and this is likely to create both economic and social strains in these countries for some time. The global environment facing farming I would now like to look beyond these global macroeconomic risks to the medium-term global outlook facing the farming sector. And here the news is more positive. In short, farming is benefiting from some of the same underlying forces that have led to an improvement in the outlook for the mining sector: namely, the development of Asia and the steady rise in incomes of the many hundreds of millions of people who live on the Asian continent. As incomes rise, especially from low levels, food consumption tends to increase, and the increase is concentrated in food with relatively high value added. There is also growing demand for agricultural products for energy production. And this increase in demand is occurring at a time when global growth in agricultural productivity has been slow by the standards of previous decades. This changing balance in global demand and supply can be seen in the global prices for agricultural goods, which have increased significantly. As one example, the IMF’s global food price index has almost doubled over the past decade, after trending lower in the 1980s and 1990s (Graph 1). While after adjusting for overall inflation, food prices are still just below their average over the twentieth century, the downward trend evident over most of the past 100 years appears to have stopped. And looking forward, there are reasonable prospects that higher prices are not just a temporary development. For example, in its latest review of world agriculture, the OECD is predicting that prices of a wide range of products over the next decade will be 20 to 30 per cent higher than their average over the past decade (after adjusting for inflation).1 The higher prices of agricultural commodities – together with their greater volatility – have attracted the attention of policymakers around the world. Just last week, the G20 issued a comprehensive report looking at the reasons for these developments. Its central conclusion is that “marked shifts in the physical supply-demand balance … have been the main driver of See OECD-FAO (Organisation for Economic Co-operation and Development and the Food and Agriculture Organization of the United Nations) (2011), OECD-FAO Agricultural Outlook 2011–2020, OECD Publishing, Paris. BIS central bankers’ speeches the price fluctuations over the past ten years” and that “for many commodities, the expansion of supply has fallen short of buoyant demand”.2 Graph 1 This buoyant demand for agricultural commodities is underpinned by rising food consumption per capita as incomes rise, particularly in Asia (Graph 2). Since the early 1960s, the number of kilojoules consumed on average per person across the planet has increased by almost 30 per cent. In China, the rise in average food consumption has been particularly pronounced, with food consumption per capita more than doubling over the past 50 years. And in recent times, there has also been a significant increase in average food consumption in the world’s least developed economies, after there had been little growth for many years. Graph 2 See G20 (2011), “Report of the G20 Study Group on Commodities under the Chairmanship of Mr Hiroshi Nakaso”, November, p 5. See also FAO, IFAD, IMF, OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN HLTF (2011), Price Volatility in Food and Agricultural Markets: Policy Responses, OECD Publishing, Paris. BIS central bankers’ speeches Looking at cross-country data, it is clear that higher-income countries consume much larger quantities of meat and sugar per person than do lower-income countries (Graph 3). In contrast, there appears to be little relationship between the average human consumption of grains and a country’s per capita income. However, overall demand for grains does increase with income, given the use of grains as food for animals. One implication of these findings is that as average incomes increase over time, there is a tendency to consume more protein, especially meat. Over the years ahead, this switch in diets is likely to generate strong underlying growth in demand for a wide range of agricultural commodities. Graph 3 Another factor adding to global demand has been an increase in the use of agricultural commodities for non-food purposes, particularly for biofuels. In the United States, for example, bioethanol production now uses more than one-third of the total corn crop and, in Brazil, sugarcane is used extensively to produce ethanol. Globally, the OECD estimates that almost one-quarter of total sugar cane production is now used for non-food purposes, and this share is expected to increase significantly over the years ahead. Similarly, a substantial rise is expected in the use of vegetable oil for purposes other than food (Graph 4). Graph 4 BIS central bankers’ speeches These developments on the global demand side have coincided with relatively modest expansion on the global supply side. In the years prior to the surge in demand, global research into improving yields was relatively low, as was investment in expanding the supply of arable land. This is one of the consequences of the low level of prices in the 1980s and 1990s. The result has been that the rate of growth in yields has slowed and there has been little growth in the area devoted to agricultural production over recent decades, partly due to the urbanisation process in Asia (Graph 5). Another factor affecting global supply has been an increase in the frequency of reported extreme weather events including droughts, floods and high temperatures.3 Export bans imposed by some countries have also reduced the supply coming onto world markets. Graph 5 All up, these fundamental global drivers are reasonably favourable for the Australian farming sector. No doubt, global prices will continue to fluctuate in a wide range and there will be problems in individual markets. But the overall external environment is likely to be a relatively positive one over the medium term. And this external environment is being driven by some of the same underlying factors that have improved the outlook for the mining sector. I would now like to turn more specifically to recent developments in Australia. Developments in Australia To begin with, it is worth noting that the high prices for agricultural commodities in global markets have flowed through to higher prices for many commodities in our domestic markets. However, the higher exchange rate has meant that the increase in Australian dollar prices has been less than the increase in foreign currency prices. In Australian dollar terms, the IMF’s food price index that I showed earlier has increased by 40 per cent since 2004; this is substantially less than the increase in foreign currency terms, but significant nevertheless See, for example, G20 (2011), p 17. BIS central bankers’ speeches (Graph 6). The other notable feature of this graph is that the long-run swings in Australian dollar prices tend to be smaller than those in foreign currency prices. This is another illustration of the stabilising effects of our floating exchange rate; when commodity prices are high, the exchange rate tends to be high, and when commodity prices are low the exchange rate tends to be low, smoothing out the fluctuations in domestic prices. This provides an important source of stability for the economy as a whole. Graph 6 At the individual commodity level, there have been substantial increases in the prices of a number of commodities over recent years (Graph 7). While prices are generally lower than earlier in the year, partly due to problems in the global economy, most are substantially higher than they were a decade ago. This is true for the commodities in this graph as it is for lamb prices and the prices of many dairy products. Graph 7 BIS central bankers’ speeches This rise in prices is the good news for domestic producers. The bad news is that the same forces that have driven up global prices have also put upward pressure on the prices of many inputs used by the farming sector. Obvious examples here are the higher prices of fuel, fertiliser and seed. For some parts of the industry, these increases in costs have been a significant constraint on profitability. It is also important to recognise that there are substantial differences in the current situation across commodities. In particular, the producers of commodities whose global prices have not risen have found that the exchange rate appreciation and higher input costs have had a significant effect on their competitive position in global markets. One clear example is the wine industry, where the price of grapes internationally has not shown the same pattern as that for many other commodities, with the Australian dollar price of grapes falling significantly. As a result, the average Australian dollar export price for wine has declined by around 40 per cent over the past decade, and production has fallen over recent years. And according to its latest assessment, ABARES does not expect a reversal of this trend in prices any time soon (Graph 8).4 A similar, although less dramatic picture, is evident for some horticultural products. Graph 8 Turning now to the volume of output, as opposed to the price of output, the recent aggregate outcomes for the farm sector have also been generally favourable. According to the Australian Bureau of Statistics (ABS), farm GDP increased by almost 10 per cent in the past financial year, boosted by higher levels of rainfall. As one example, the winter wheat crop is expected to be a near-record high of around 40 million tonnes this year and this follows a good harvest last year. Taking a somewhat longer perspective, farm output has increased by around 70 per cent since the mid 1990s, although there have been a number of bad years over this period, particularly due to severe drought. This combination of generally high prices and high output has provided a substantial boost to aggregate income of the farming sector over the past financial year, and another favourable ABARES (Australian Bureau of Agricultural and Resource Economics and Sciences) (2011), Agricultural Commodities: September quarter 2011. BIS central bankers’ speeches outcome is expected this year (Graph 9). After adjusting for inflation, farm incomes over these two years are expected to be almost double the average of the previous two decades. As I mentioned earlier though, the picture is not uniform across the industry and some parts of the farming sector have experienced very difficult conditions over the past year. But overall, the current picture is better than it has been for some years. Graph 9 Of course, agriculture remains an industry whose fortunes can change quickly from year to year. And it is one in which very significant structural change has occurred over many decades. Given its importance to the overall Australian economy, it is also an industry that the Reserve Bank has paid close attention to over the years, and it continues to do so. Looking forward, no doubt the fortunes of the industry will continue to wax and wane. And like many other parts of the Australian economy, the farming sector will need to continue the process of structural change. As I have talked about, this process is being driven, in part, by a fundamental realignment of global relative prices due to the re-emergence onto the global stage of the populous countries of Asia. This realignment of relative prices is creating new opportunities for Australian agriculture. I wish you success in finding those opportunities and in taking advantage of them over the years ahead. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 11 |
Opening remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Institute of Internal Auditors Financial Services Forum, Sydney, 17 November 2011. | Glenn Stevens: The role of internal audit in financial services firms Opening remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Institute of Internal Auditors Financial Services Forum, Sydney, 17 November 2011. * * * I am pleased to be with you this morning to open this Financial Services Forum focusing on the role of internal audit in financial services firms. The Reserve Bank’s Audit Department has a long association with the IIA and we are strong supporters of the work of the Institute. The fact that you are holding this Forum is significant. As all of you know only too well, there have been many practices exposed in global financial institutions over the past few years that show poor risk management and failure of controls over lending and trading activities. The fact that these issues continue to surface is a clear indication that the subject matter of today’s Forum remains relevant. From my own experience at the Reserve Bank over many years, I have gained an appreciation of the important role that internal audit can play in our financial institutions. The Reserve Bank is, of course, very much a bank. We have a substantial balance sheet that requires management, we provide a range of banking services to government clients, we operate key pieces of financial infrastructure, and we rely heavily on our IT systems to deliver these services. Over the years, we have worked to develop a detailed risk management framework to identify where the key risks lie, and set out how they are to be managed. Yet even though much work has gone into developing that framework, like any risk-management approach, it can only ever be a work in progress – and it remains under continual review. Complementing the risk framework, our internal audit program focuses its attention on the most important risks identified by management. Like many auditors today, our Audit Department takes a broad view of their responsibilities, reviewing not only the effectiveness of controls but also whether they are the most efficient way to achieve an end. I know that they are conscious that procedures they may have recommended some years ago may no longer be appropriate, given the changes in technology. And of course technology continues to challenge both our systems operators and our auditors, as the threats to the security of our data and communications increase. Audit Department’s work is overseen by the Board’s Audit Committee, which has among its members two of the Bank’s independent directors, one of whom (Jillian Broadbent) is chair, and which also brings external expertise to bear on assessing the overall audit work of the Bank. This is a key part of the governance structure. Of course, these arrangements are not unique in any way. They are designed both to meet requirements for Commonwealth authorities and also to be in line with good practice at commercial entities. They do, however, give us at the Reserve Bank an insight into some of the practical challenges facing other financial organisations. Of particular importance to this audience, we also recognise the challenges involved with appointing, training and keeping an audit staff capable of assessing whether the controls are working as they should. Our audit team has continually to improve its understanding of the breadth and depth of our business and changes to it. To help us maintain best practice, our auditors need to ensure that their technical skills remain up to speed. The IIA’s training and certification processes play an important role in assisting this process. Fostering improvements to the practice of identifying and managing risks, and to the audit processes that are an integral part of that, are central to development of policies aimed at BIS central bankers’ speeches fostering greater financial stability, both in Australia and internationally. The financial stresses of the past few years have placed much greater emphasis on this aspect of our policy work in the Reserve Bank. There are few signs that the additional focus is going to lessen any time soon. If anything, it will increase. Domestically, we have worked closely with the other members of the Council of Financial Regulators on a number of initiatives including the Financial Claims Scheme, the structure of financial market regulation and the role of central counterparties in the settlement of securities and derivatives transactions. Internationally, through our membership of the Financial Stability Board, the Basel Committee on Banking Supervision and the G-20, along with colleagues in APRA and the Treasury, we have been involved in efforts to strengthen the international financial architecture, the rules governing the risks to which financial institutions are exposed and the buffers they are obliged to maintain in case things go wrong. The implications of these initiatives on the way in which financial institutions are managed are potentially far reaching. They are also important for internal auditors, in two respects. First, they are designed to make the institutions you are working for more resilient in the face of a wide range of pressures. If the changes are made effectively, they should help you sleep a little better at night. But second, many of the changes are complex and challenging, requiring important shifts in the way institutions operate, with even more emphasis on controls focused on risk than in the past. There is clearly a need for internal auditors to keep well abreast of these developments in financial institutions so that you can play the role expected of you in contributing to good corporate governance and, thus, to improved prospects for financial stability. Australia’s corporations and governments, not to mention savers and investors, rely heavily on your work and it is crucial that it is done well. Today’s agenda suggests that you should finish the day even better equipped to meet this challenge. I wish you a successful day. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 11 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Securitisation Forum, Sydney, 21 November 2011. | Guy Debelle: The present and possible future of secured issuance Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Securitisation Forum, Sydney, 21 November 2011. * * * Thanks to Craig Evans, Justin Fabo, Tom Rosewall and Claudia Seibold for their assistance and helpful discussions. The funding of the banking system has very much been front and centre at various times throughout the financial crisis, and it is under heavy scrutiny again. The particular aspect of bank funding that I want to focus on today is the role of secured funding, a topic at the heart of a conference on securitisation. The development I wish to highlight is the quite divergent trends in the composition of bank funding over the past four years, particularly in terms of the share of secured versus unsecured funding. The most striking example is in Europe, where banks have raised around half of their wholesale funding in 2011 in the form of secured funding, whereas in the US there has been almost a complete absence of secured funding (outside that raised by the mortgage agencies). Instead the banking system’s funding has almost entirely been driven by deposits. In Australia, the composition of bank funding has also changed over the past four years, in a manner more along the lines of the US than the European experience. These developments reflect changes on both the supply and demand side including: Banking systems generally have experienced slow (or even negative) growth on the asset side of the balance sheet but deposit growth has been considerably faster. Hence, customer deposits, both retail and corporate, have accounted for a considerably larger share of bank funding than they did pre-crisis. As a result, the need for banks to raise funds in wholesale markets has declined. Investors, particularly over the past year and particularly in Europe, have exhibited a strong preference to purchase secured forms of funding from banks. As I will discuss later, it is not clear to me that the delineation between secured and unsecured funding for the banking system is quite so stark as current market conditions would imply. At this point, it is worth thinking about the various forms of funding available to banks. For the purposes of this talk I will simplify these into five categories: 1. Equity raising. 2. Deposits, some portion of which may be insured or guaranteed. 3. Unsecured wholesale funding, in the form of bond issuance or short-term paper. 4. Asset-backed issuance, such as residential mortgage backed securities (RMBS), where the bank sells a security backed by a pool of assets to the market. The assets are no longer present on the bank’s books after the sale. 5. Covered bonds, where the issuance is again backed by a pool of assets. However, in this case, the assets remain on the balance sheet of the issuing bank, and the investor is given an additional claim on the balance sheet of the bank. Note that the first three forms of funding are claims on the bank’s balance sheet as a whole. In the case of deposits, in many countries, insurance or guarantees provide protection up to some level but any deposit larger than that is a form of unsecured funding. Asset-backed issuance is obviously secured issuance, while covered bonds are primarily secured issuance but with an element of unsecured funding in terms of the recourse to the balance sheet as a whole. Today I will focus primarily on the last three modes of funding, generally characterised as wholesale funding. First I will summarise developments in bank funding in Australia, the US, BIS central bankers’ speeches Europe and UK since the financial crisis began over four years ago. Central bank actions in each of these areas have had implications for bank funding, so I will then spend a little time discussing this issue. Finally I will pose some questions about how wholesale funding might evolve in the future, focussing particularly on the sustainability and desirability of the current investor preference for secured issuance. Present Graphs 1 to 4 show the patterns of bank wholesale funding over the past five years in the US, UK, Europe and Australia, using the taxonomy described above.1 The one additional source of wholesale funding (not described above) is government-guaranteed bond issuance for the period from September 2008 until the cessation of the guarantee on new issuance. In every case bar Australia, it is noteworthy that the level of wholesale issuance in 2011 is substantially below that in 2007. To a large extent, this reflects the fact that outside Australia, credit growth has been very low or even negative for much of this period (Graph 5 below). The other important factor, mentioned earlier, is the relatively strong growth in deposits in all four regions. This trend is well documented for the US, Europe and the UK in a graph from a recent paper published by some of my colleagues on the Committee on the Global Financial System.2 In Australia, since mid 2007, deposits have grown at an annualised pace of 11 per cent, compared with credit growth of 5 per cent. As a result, while the level of wholesale issuance by Australian banks in 2011 is about the same as that in 2007, it is a significantly smaller share of total bank funding. In the US, there are three developments that stand out. First, is the marked decline in the issuance of non-agency mortgage-backed securities. In 2010 and 2011, almost all of the mortgage-backed securities (MBS) issuance in the US has been by the agencies. As you recall, the agencies purchase eligible loans from mortgage originators (including banks) and either keep them on their own balance sheets or pool them into MBS to be sold to investors. (They can also provide guarantees to MBS issued by approved lenders and purchase MBS to hold on their own balance sheets.) Second is the significant decline in unsecured bond issuance from 20 per cent of wholesale funding in 2007 to 11 per cent in 2011. Graph 1 Note that private placements are not well captured in the data used here, except in the case of Australia. See Graph A4.1 in “The Impact of Sovereign Credit Risk on Bank Funding Conditions”, Committee on the Global Financial System, Paper No 43, July 2011. BIS central bankers’ speeches The change in issuance patterns in the US is also affected by the fact that a sizeable share of housing lending in the US was funded off balance sheet. As that source of housing finance has dried up significantly, and housing lending growth has been negative for more than two years now, a much greater share of lending has been in the “conforming” market supported by the agencies. So the changes in funding are much larger for the shadow banking system in the US, than they are for the balance sheet funding of the banking system. More generally, when comparing the changes in funding across the four regions, it is important to bear in mind that a significantly smaller share of finance to both the household and business sectors was, and is, provided by the banking system in the US than in the other regions. In Europe, unsecured issuance accounted for a little over half of total issuance in 2011, a similar share to 2007. However, the issuance pattern varies quite markedly across institutions. The stronger institutions have generally had ready access to unsecured funding, but a number of institutions have been shut out of unsecured markets, particularly since the middle of this year. The composition of secured funding has changed dramatically, with covered issuance accounting for the vast bulk of secured issuance in 2011, compared with a roughly equal split in 2007. The covered market has been the primary funding source for those institutions unable to tap unsecured markets. But the secured issuance data are also significantly affected by “self-securitised” issues, both MBS and covered, which are retained on the balance sheet of European financial institutions to access liquidity at the ECB (see below).3 Finally, the aggregate figures for Europe mask some quite significant differences across countries and institutions with, for example, secured issuance by German institutions almost entirely in the form of covered bonds (pfandbriefe) while banks in the Netherlands issue RMBS. Graph 2 In the UK, the share of unsecured issuance in total issuance is about the same in 2011 as it was in 2007, at just over 50 per cent. However, total unsecured issuance is significantly smaller in 2011 than in 2007. The share of funding from MBS has declined but has been fully compensated for by an increase in the share of covered bond issuance. Note that part of this For more detail, see “Recent Developments in Securitisation”, European Central Bank, February 2011. BIS central bankers’ speeches shift reflects a compositional shift in the industry. Entities such as Northern Rock, which sourced a large share of their funding from MBS, were a large part of the market in 2007 but are obviously not so today. A final point on the UK data: the large amount of MBS in 2008 predominantly reflects “self-securitised” issuance in order to access the Special Liquidity Scheme (SLS) at the Bank of England; more on which shortly. Graph 3 In Australia, the share of unsecured funding has actually increased between 2007 and 2011, in contrast to the other regions. In large part this reflects a compositional effect. A number of institutions, some banks but particularly non-banks, were significantly more reliant on MBS for their funding than the larger banks. Following the dislocation in the MBS market, the larger banks now account for a much larger share of the financial sector in 2011 than they did in 2007. Graph 4 Obviously in Australia, the covered bond market is in its infancy, with the first issue only last week, following the passage of enabling legislation in October. So nearly all the secured issuance this year has been in the form of MBS. BIS central bankers’ speeches Credit growth in Australia, while slow relative to recent Australian history, has outstripped that in the other three regions (Graph 5). But it is apparent from the Australian data that total wholesale issuance is broadly the same in 2011 as it was in 2007, and hence a smaller share of overall funding, with deposits accounting for the difference. Graph 5 Differences in central bank support The nature of central bank support has also had an influence on the developments in bank funding. The balance sheets of the Fed, ECB and Bank of England have increased significantly since 2007. The ECB’s balance sheet has approximately doubled, while those of the Fed and the Bank of England have roughly tripled over the past four years (Graph 6). The Reserve Bank of Australia’s balance sheet, while increasing in 2008,4 is smaller than it was in 2007 (reflecting the withdrawal of deposits at the RBA by the Future Fund to invest in a broader range of assets). Graph 6 See the “Operations in Financial Markets” chapters in the Reserve Bank of Australia Annual Reports of 2009 and 2010 for more discussion. BIS central bankers’ speeches In the US, the Fed’s program of quantitative easing has injected a large amount of liquidity into the banking system. Moreover, the Fed’s program of asset purchases has included over US$1 trillion of mortgage-backed securities. Similarly in the UK, the Bank of England has conducted a large asset purchase program. It has also provided support to the banking system through the Special Liquidity Scheme, whereby banks were able to exchange MBS or covered bonds for Treasury Bills to more easily obtain liquidity in the market. At its peak, £287 billion of securities were exchanged for £185 billion of bills. Drawdowns under this scheme closed in January 2009, and a large part has been repaid this year with the remainder to be repaid by January 2012. In Europe, the ECB has assisted bank funding through its fixed rate full allotment liquidity provision operations. This has enabled banks that are having difficulties obtaining funding in the market to borrow from the ECB against acceptable collateral at the ECB’s policy rate for terms of up to one year or so. As mentioned above, some of this collateral has taken the form of secured issuance retained on the books of the issuing bank. The ECB has also supported bank issuance through its covered bond purchase program. In its initial phase, which commenced in July 2009, the ECB purchased €60 billion in covered bonds. It has recently restarted the program with the intention to purchase a further €40 billion. In Australia, the RBA provided liquidity support to the banking system through its repurchase operations, including against self-securitised mortgages, at the height of the dislocation in funding markets in 2008 and 2009. But the RBA’s liquidity provision has been at normal levels for over two years now. Future The first part of my talk today has summarised the current state of affairs in wholesale funding markets. In the final part of my speech, I will briefly discuss how things might evolve in the future. There is a clear preference on the part of investors in the current risk-averse climate for secured investments. A number of financial institutions, particularly in Europe, have been only able to access funding through covered bonds. I don’t see this trend towards predominantly secured issuance as being sustainable. A difficult message for this forum to digest I know, but securitisation is not the be all and end all of funding! Banks can’t encumber their balance sheets through secured issuance to such an extent that unsecured issuance, and even deposit gathering, is no longer possible. Too much issuance of covered bonds and you’re effectively back in the unsecured world. Hence most jurisdictions put a cap on the amount of covered bonds that can be issued. In Australia, the cap on the total amount of encumbrance is 8 per cent which, given the degree of overcollateralisation in covered bonds, translates into an issuance level below that, and well below a level which is likely to compromise the safety of deposits. Nevertheless, the introduction of covered bonds does subordinate unsecured debt holders to a degree. Any pricing gain obtained from issuing covered bonds is likely to be offset to some extent by a demand from unsecured debt holders for more compensation in the future. So I see the role of covered bonds as primarily broadening the potential investor base rather than a means of reducing overall funding costs for banks. There is clearly a segmented investor base. Some investors will only buy covered bonds and have no interest in RMBS or unsecured paper. Other investors are completely happy with RMBS and have no interest in covered bonds which pay a lower yield for a similar credit exposure. I would expect that covered bonds are likely to be primarily an offshore funding source for the Australian banks with the domestic investor base more comfortable with RMBS. BIS central bankers’ speeches In that regard, it is worth posing the question as to how different the various forms of bank funding actually are. All of the forms of funding are claims on a bank’s balance sheet in one form or another. Unsecured bank funding (including deposits) is a claim on the balance sheet of the bank as a whole. The assets underpinning that claim are the same form as those which back the secured issuance. An RMBS is not an on-balance sheet claim, but is a claim on a set of assets very much representative of a sizeable part of the balance sheet. In Australia, at least, the mortgages which are securitised by banks in their RMBS issues have similar characteristics to those mortgages which remain on the banks’ balance sheets. The same is also true of the forthcoming covered bond issues by the Australian banks. So the underlying assets aren’t that much different, rather the difference is in the degree of credit enhancement provided by subordination in the case of RMBS or over-collateralisation (and additional recourse to the balance sheet) in the case of covered bonds. The strong motivation for the current preference of investors for secured issuance is about repositioning themselves towards the front of the creditor queue. That is the fundamental point of differentiation between the various forms of funding. But ultimately, everyone can’t be at the front of the queue. In theory, or in a less risk-averse environment than the current one, pricing should equalise the incentives to issue and purchase the various forms of funding. Investors should be compensated for their risk of being further down the creditor queue with a higher risk premium. But in today’s environment, there are plenty of examples where market pricing is not always sending the most accurate signal. In due course, investors in bank paper might again come to the realisation that there is not as stark a difference between secured and unsecured issuance, as current pricing would suggest. Investors need to heed the seminal words of The Saints: “Know Your Product” and do the necessary due diligence. So in the end, I think we should return to a world where banks access all five of the sources of funding I outlined at the beginning of my talk. It is useful to have a diverse range of funding instruments at hand, as at various points in time, some markets are more functional than others. A world where the only source of funding available is secured is just not sustainable. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 11 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, APRA (Australian Prudential Regulation Authority) Basel III Implementation Workshop 2011, Sydney, 23 November 2011. | Guy Debelle: The committed liquidity facility Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, APRA (Australian Prudential Regulation Authority) Basel III Implementation Workshop 2011, Sydney, 23 November 2011. * * * As you know, last week the Reserve Bank released details of the Committed Liquidity Facility (CLF) that forms part of Australia’s implementation of the Basel III liquidity reforms. At the same time, the Reserve Bank also released details of a revised set of margins for the collateral that is eligible in both its regular open market operations and for the CLF. Today, I will talk to those two press releases and provide more detail and some of the thinking behind them. Why do we need a CLF? Charles Littrell has already explained the motivation behind the need for the CLF, but it is worth reiterating some of those arguments. The Basel liquidity standard requires that banks have access to enough high-quality liquid assets to withstand a 30-day stress scenario, and specifies the characteristics required to be considered an eligible liquid asset. The issue in Australia is that there is a marked shortage of high quality liquid assets that are outside the banking sector (that is, not liabilities of the banks). As a result of prudent fiscal policy over a large run of years at both the Commonwealth and state level, the stock of Commonwealth and state government debt is low. At the moment, the gross stock of Commonwealth debt on issue amounts to around 15 per cent of GDP, state government debt (semis) is around 12 per cent of GDP.1 These amounts fall well short of the liquidity needs of the banking system. To give you some sense of the magnitudes, the banking system in Australia is around 185 per cent of nominal GDP. If we assume that banks’ liquidity needs under the liquidity coverage ratio (LCR) may be in the order of 20 per cent of their balance sheet, then they need to hold liquid assets of nearly 40 per cent of GDP. In addition to government debt, the Basel standard also includes balances at the central bank in its definition of high-quality liquid assets (level 1 assets in the Basel terminology). That is, the banks’ exchange settlement (ES) balances at the RBA are also a liquid asset. Hence, one possible solution to the shortage of level 1 assets would be for banks to significantly increase the size of their ES balances to meet their liquidity needs. While this is possible, it would mean that the RBA’s balance sheet would increase considerably. The RBA would have to determine what assets it would be willing to hold against the increase in its liabilities, and would be confronted by the same problem of the shortage of assets in Australia outside the banking system. Similarly, the government could increase its debt issuance substantially with the sole purpose of providing a liquid asset for the banking system to hold. Again, it would be confronted with the problem of which assets to buy with the proceeds of its increased debt issuance. Moreover, it would be a perverse outcome for the liquidity standard to be dictating a government’s debt strategy. However, the Basel Committee acknowledges that there are jurisdictions such as Australia where there is a clear shortage of high quality liquid assets. In such circumstances, the liquidity standard allows for a committed liquidity facility to be provided by the central bank against eligible collateral to enable banks to meet the LCR. The net stock of Commonwealth government debt on issue is considerably lower at 6 per cent of GDP, reflecting the assets held by the Commonwealth government, including through the Future Fund. BIS central bankers’ speeches Access to the CLF As Charles has explained, APRA will work with the banks to determine their overall liquidity needs. They will discuss how much of these liquidity needs can be met through holdings of government paper. An important consideration in that discussion is ensuring that the banking system’s holdings of government paper are not so large that they compromise the liquidity of the market. Otherwise this would be completely self-defeating, as the whole aim of the liquidity regime is to ensure the banks hold liquid assets. One influence in this determination is the large amount of government debt that is held offshore by investors that are not overly price sensitive (and also do not necessarily lend their securities). This further limits the size of the government debt stock that the banking system can realistically hold. As a result of that discussion, APRA will allow banks to reach an agreement with the RBA for a CLF for a specified amount, subject to RBA approval, to enable them to meet the balance of their liquidity requirement under the LCR. APRA may ask banks to specify the size of their access to the CLF as much as 12 months in advance. The facility will only be available for banks to meet that part of the liquidity requirement agreed with APRA. Access fee The Reserve Bank has set a fee of 15 basis points in return for its commitment to provide liquidity to a bank under the CLF. The fee will be paid on both the drawn and undrawn amount. The general motivation in determining the price of the Reserve Bank’s commitment was to replicate the effect in other jurisdictions where a bank could meet its liquidity needs of holding eligible assets in a liquid market, solely through holding government paper. Hence the yield differentials between government bonds and the assets that will be eligible for the facility is a logical starting point.2 However, the spreads on the eligible securities incorporate compensation for a variety of risks, including credit and liquidity. It is only the latter risk that the facility is addressing and hence the banks should be charged only for the liquidity access. Importantly, the Reserve Bank will not be offering any credit protection on these assets and so the banks should be able to retain the compensation for holding these riskier assets. The Reserve Bank is protected as it provides the liquidity to an institution under a repo with appropriate margining (see below). While at times like the present, liquidity can have considerable value, the Reserve Bank will not be varying the size of the fee through the cycle. Consequently, the facility is to be priced at a level that takes into account the value of liquidity in more normal conditions, as well as in stressed circumstances. From the history of the Reserve Bank’s own market operations, we can look at repo rates on some of the eligible securities to try and gauge how much a one month liquidity premium might be worth. The answer is not very much in normal circumstances, generally less than 10 basis points. Moreover, when you take into account the fact that to access the facility, an institution has to pay a penalty rate and, in most cases, with greater haircuts than previously applied, a “market-based” valuation from historical rates would imply a low fee. However, part of the point of the new liquidity regulations is to recognise that the market has underpriced liquidity in the past. Consequently, it is appropriate to levy a fee which is greater than implied by a long run of historical data. The net outcome is thus a weighted average of a One complication in doing this calculation in Australia is that because government paper has been in short supply for many years, it has tended to trade with a scarcity premium. This widens the observable spread between the yield on government paper and the yield on other assets in a way that is not present in most other jurisdictions. BIS central bankers’ speeches relatively low liquidity premium in normal times and a much higher liquidity premium in stressed times. In determining the fee, it must be remembered that ADIs will not only have the option of meeting their LCR requirements through the Reserve Bank’s liquidity facility, they will always have the option of meeting their LCR requirements through holding RBA obligations. This is because, as mentioned earlier, ES balances are also recognised as liquid assets. Within the Reserve Bank’s monetary policy framework, the supply of ES balances is effectively market-determined. That is, the Reserve Bank stands ready to supply whatever quantity of ES balances is necessary (against eligible collateral) to keep the cash rate trading at the Board’s target. In normal times, and even at times like the present, the demand for ES balances is very low. This is because the remuneration on ES balances is purposefully set at a “below-market” rate – 25 basis points below the cash rate target – in order to encourage banks to recycle their surplus balances. However, in an environment where banks need to obtain more liquid assets, there is the possibility that a liquid asset (one that is in every way risk-free) priced 25 basis points below the OIS curve may become more attractive. This would particularly be the case were the fee on meeting a bank’s LCR requirement through non-liquid assets to be set at a sufficiently high level so as to make ES balances appear reasonable value. While ES balances pay 25 basis points less than the cash rate, the cash market is not riskfree; it is an unsecured interbank market. Consequently, a fee a little less than the 25 basis points has been deemed necessary to ensure banks did not have the incentive to meet the LCR by holding unduly large amounts of ES balances. Beyond the problem (discussed above) that such an outcome would present to the RBA in terms of what assets it would need to hold, this outcome would also significantly affect the ability to meet the cash rate target set by the Reserve Bank Board. That is, we do not want to impair the operational framework for monetary policy which has served us well for many years. If the banks were to hold large ES balances with the RBA, this would also be likely to significantly impair the short-term interbank market in Australia, which is an important pricing reference for many other markets. As a result of these considerations, the RBA concluded that the fee needed to be set high enough to ensure banks had the appropriate incentives under the liquidity standard, but low enough to not generate unwarranted distortions in the domestic market. Interest rate on the facility Should a bank need to obtain liquidity under the facility, it will undertake a repo with the Bank using its eligible collateral and pay an interest rate on the repo of 25 basis points above the Reserve Bank Board’s target for the cash rate. This is the same as the current arrangements for the RBA’s overnight repo facility. This 25 basis points charge will be in addition to the ongoing access fee of 15 basis points. Eligible securities The securities that a bank can hold to access the CLF are the same as those which are eligible for the RBA’s normal market operations. In addition to government paper, these securities include domestic issues by supranationals and other foreign governments, ADIissued debt securities and asset-backed securities, including residential mortgage-backed securities (RMBS). However for the purposes of the CLF, the RBA will also allow banks to present certain related-party assets such as self-securitised RMBS. There are a number of reasons for this BIS central bankers’ speeches decision, but the primary motivation is to reduce the systemic risk of excessive crossholdings of bank-issued instruments. As mentioned earlier, a large share of the securities on issue in Australia are “inside” the banking system. That is, they are securities issued by the banks themselves. The available pool of outside assets in Australia which includes securities issued by supranationals and corporates is small. Hence, the primary type of asset available in the market to the banking system to meet its liquidity needs is a security issued by another bank. In our judgement, and that of APRA’s, it would be undesirable for a bank to meet its liquidity needs by significantly increasing its exposure to the rest of the banking system. If a stressed situation was to arise at one bank, the increased cross-holdings could rapidly translate this to other banks. Moreover, if the stressed bank was to meet its liquidity needs by selling its holdings of securities issued by other banks into the market, this would also serve as a possible source of contagion to the rest of the banking system. Thus to reduce the likelihood of systemic risk, a bank will be able to hold some share of its liquid assets in the form of self-securitised mortgages. There is a trade-off here between systemic risk and reduced “market” liquidity of the bank’s asset holdings, but the bank will have access to liquidity from the RBA with these assets. In terms of the range of assets eligible for the CLF, the RBA reserves the right to broaden that range at any time, but will give 12 months’ notice of any decision to narrow the range. The latter condition will give banks adequate time to adjust their liquids holdings in response to any change. Margins At the same time as the RBA released the details of its CLF, we also issued a revised schedule of margins for the securities that are eligible in our domestic market operations. This revised schedule of margins will take effect on 1 February next year. The Reserve Bank applies margins to the collateral held under repo in its domestic market operations in order to protect the Bank against all but the most extreme movements in market prices, should its counterparty in the repo be unable to repay the repo. The margins are set to ensure that the Reserve Bank’s contingent risk is the same across all eligible securities. This implies that margins need to be higher on those securities with longer duration, greater illiquidity and greater credit risk. It was appropriate to revisit the Reserve Bank’s schedule of margins in light of the experience of recent years which has provided some indication of how the various asset classes perform in stressed situations. Moreover, the margins are important in determining the amount of liquid assets a bank will need to obtain a given level of access to the CLF. In conducting the review, we examined the average daily yield movements across the range of eligible securities, as well as the largest daily yield movements. We also compared the margins set by the RBA with those in other jurisdictions. As a result of this review, we have made a number of changes. The principal change is that the margins on unsecured bank paper have been increased, with the margin increasing with time to maturity and the lower the credit rating. The RBA has also adjusted the eligibility criteria for unsecured bank paper. All senior debt securities with less than 12 months to maturity issued by ADIs with a public credit rating will be eligible. There will no longer be a requirement that an ADI hold an ES account with the Bank. For securities with longer than 12 months to maturity, the minimum credit rating required is BBB+. Margins on asset-backed securities were maintained at 10 per cent. For self-securitised mortgages, and other private securities for which it is difficult to identify a timely market price, the securities will be valued at a price equal to 90 per cent of par, prior to the application of a BIS central bankers’ speeches margin. Hence, for example, to obtain liquidity of $100 under the CLF, a bank will need to present a self-securitised RMBS with a value of $122. Conclusion I have provided some background to the decisions taken by the Reserve Bank around the application of the new Basel liquidity regime in Australia. The new Basel standards are designed to ensure that the banking system in Australia is even more resilient and stable than it has been to date. While these reforms are not costless to comply with, the benefits of a stable banking system are considerably larger. Both ourselves and APRA will continue to work together to promote a strong and resilient financial system. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 11 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 24 November 2011. | Glenn Stevens: On the use of forecasts Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 24 November 2011. * * * Thank you for the invitation to return to this platform. This being a forecasting conference, you will have spent much of your time contemplating the outlook for 2012. The Reserve Bank set out its views on the outlook only a few weeks ago, and I will not canvass any changes to them on this occasion. Instead, I propose to return to a theme I have covered on some previous occasions, namely, the nature and use of forecasts for policy purposes. A couple of important points that have been illustrated over the past two or three years are worth drawing out. To begin, I would like to draw some observations from another kind of forecast. I do a bit of aviation in my spare time. Hence I am a serious user of weather forecasts and there are very detailed forecasts prepared on a frequent basis for the aviation community, in order to make flying more predictable and safer. I want to give an example. A couple of months ago, a pilot I know had planned to fly in a light aircraft from Bankstown airport in Sydney’s west to Armidale, about 90 minutes flight time to the north, pick up some people and return to Bankstown. On the relevant day (25 September), pertinent excerpts from the forecasts for the two aerodromes were as follows: YSBK (Bankstown) 15015G25KT 9999 LIGHT SHOWERS OF RAIN FEW 012 SCT020 BKN030 TEMPO 2500/2506 3000 SHOWERS OF RAIN BKN008 YARM (Armidale) 16012 9999 LIGHT SHOWERS OF RAIN SCT030 INTER 2501/2508 4000 SHOWERS OF RAIN BKN010 PROB30 INTER VRB20G30KT 3000 THUNDERSTORMS WITH RAIN SCT 045CB It was windy and wet in Sydney that day, one of those days when strong south easterly winds bring in moisture from the Tasman Sea and dump it on the Sydney basin. The Bankstown forecast indicated that for much of the day, there were expected to be periods of reduced visibility and heavy, low cloud. Conditions could thus be quite marginal for a landing on the return flight, and it was possible they would be below the legal minimum for a landing off an instrument approach during those periods of time. This meant a requirement to have extra fuel on board in case of the need to hold prior to landing, waiting for the weather to improve. The Armidale forecast showed some similar periods of weather, also requiring extra fuel. More significantly, the Armidale forecast indicated that there was a probability (assessed as 30 per cent) of thunderstorms in the area, which could persist for up to half an hour at a time. Thunderstorms at the airport amount to very dangerous conditions in which to attempt a landing because of the potential for very strong winds and windshear near the ground, not to mention heavy rain or hail. Even large aircraft avoid landing in such circumstances. Again, this meant a requirement to have additional fuel in case of the need to hold prior to landing, waiting for the storm to pass. Apart from that, the general conditions between the two airports were forecast to include isolated thunderstorms, rain and areas of low cloud, all produced by the south easterly airstream operating across much of NSW. The route goes more or less along the Great Divide, which means that terrain effects on weather conditions are an issue to keep in mind. BIS central bankers’ speeches These conditions did not necessarily preclude the flight, which could have been legally commenced, provided the requisite additional fuel was carried. It is very likely that it could have been safely completed. For professional pilots, who fly every day in a multi person crew environment in high performance aircraft, dealing with these conditions would be seen as reasonably routine, if a bit tedious. The main question was whether it was prudent for an amateur single pilot flying a light aircraft to conduct the flight on this occasion. It was observable that at the intended time of departure from Bankstown, conditions there were at least as bad as forecast, while a phone call from Armidale indicated that there were in fact storms present at that time. It did not look like a day on which the forecasters had been too pessimistic. The pilot in question decided to stay on the ground. The point of this little diversion into aviation is to make a few observations about the nature and use of forecasts, which I think have some relevance in the economic sphere. The first is that the weather forecasters had understood what I would call the “big forces”. In this case, there was a high pressure system over Tasmania, and a low pressure system off the north-east coast of NSW. This combination fed very moist air over the south-east of the continent, resulting in cloud and rain. In fact, meteorologists know a lot about how weather works. They have pretty long time series of observations and increasingly frequent real time observations of conditions. They have highly developed models. The combination of real time data, understanding of how the dynamics of weather occur and their experience, enabled the forecasters to get the big picture right, and give a very useful forecast for those planning on venturing into the skies that day. The second point of note is that some elements of the forecast were probabilistic in nature. This was explicit in the use of the term “PROB30”. Weather forecasters know they are dealing with a very complex, non linear system, and are careful to present their forecasts accordingly. They are able to observe the unstable atmospheric conditions that are conducive to storms – mainly heat and moisture, with a role played by terrain as well. They cannot say for sure that there will be storms over a particular location, but they know enough about likely conditions in an area to assess a probability. On the day in question, there would almost certainly have been some storms to avoid somewhere along the route. The third observation is that forecasts are used in particular ways. In aviation, lives can depend on the way a forecast is used. Professional pilots in large, well equipped aircraft that fly above most of the weather still carefully study forecasts and make the requisite amendments to their plans. They carry additional fuel, have a plan B for an alternate airport and so on as needed, in response to the forecast conditions. Many of us have had the experience of fog induced delays in Canberra in winter, for example, where the runway is not fully visible at the legal minimum on approach and so the aircraft cannot land and must go somewhere else. International flights into Sydney very occasionally end up in Brisbane or Melbourne because of fog, having been required by the forecast to carry the necessary additional fuel. They may have carried it all the way across the Pacific, at non-trivial cost. Despite the criticism aimed at weather forecasters, the forecasts I have seen in use for aviation are generally pretty good. And the saying that economic forecasters are there to make weather forecasters look good has something going for it. Of course one big difference in economics is that some decisions based on forecasts may alter the outcomes – as in the case of economic policy decisions, or spending decisions by businesses and households – whereas our response to a weather forecast will not actually alter the weather. That factor makes economic forecasting more difficult than weather forecasting. Still, some aspects of the process of weather forecasting are valuable in the economic sphere. One is that the most useful economic forecasts, like weather forecasts, are those that are based on a good sense of the “big forces”, as well as on an understanding of the dynamics of how economies typically behave. In addition, we should admit that economic forecasts have a margin of error – they are a point in a distribution of possible outcomes. BIS central bankers’ speeches On the latter point, often much is made about small changes to forecasts, or small differences in two forecasters’ numbers. But when consideration is given to the real margin for error around central forecasts, such differences are often, for practical purposes, insignificant. For example, in the case of a year ended forecast for growth of real GDP four quarters ahead, experience over the past couple of decades is that the probability of a point forecast being accurate to within half a percentage point is about one in five. For year average forecasts the accuracy is better, but still the margins for error are non trivial. So any point forecast will very likely not be right. The likelihood of some outcome other than the central forecast is actually quite high. When comparing forecasts, if we are not talking about differences of at least half a percentage point, the argument is not worth having. In any event, the question is not really whether the forecasts will turn out to be exactly right. The question is whether they form a reasonable basis for sensible analysis or decisions at the time. When the forecast turns out to be not exactly correct, as is very likely, that is actually not much of a basis on which to criticise the decision makers who used the forecast (or, for that matter, the forecaster). For monetary policy operating a medium term inflation target, we are naturally interested in our ability to forecast inflation. Experience over the inflation targeting era (since 1993) suggests that the probability of the CPI outcome being within half a percentage point of the central forecast is roughly two in five at either a one year or a two year horizon. For underlying inflation, the probability of the forecast being within half a percentage point is about two in three at one year and just over one in two at two years. The smaller forecasting errors for underlying inflation reflect the inherently more stable properties of the underlying measure, which of course is by design. Hence, if the central forecast for CPI inflation at a two year horizon was 2½ per cent, the chances of the outcome being between 2 and 3 per cent, based on this historical experience, would be about two in five. The chances of being between 1½ and 3½ per cent would be three in five. I note in passing that, if this is a reasonable description of forecast accuracy, it suggests that the configuration of the inflation target is a pretty good one (though I hasten to add that, when it was first set out, we did not really have a great deal of confidence in the accuracy of inflation forecasts). It would, in my judgement, be vastly preferable for discussions of forecasts to be couched in more probabilistic language than tends to be the case in practice, and for there to be more explicit recognition that the particular numbers quoted are conditional on various assumptions. Careful observers will have noted that the latest forecasts published by the Bank actually have a range for growth and inflation at the horizon. Moreover, there is more extensive discussion these days of the ways in which things could turn out differently from the central forecast. This goes at least some way to recognising the inherent uncertainties in the forecasting process, and is also important in relating the forecast to the policy decision. Taking account of the accuracy statistics I have quoted above, we can characterise the RBA’s latest published outlook as suggesting that, absent large shocks to oil prices or the Australian dollar, or further extreme weather events, or the world economy taking a serious turn for the worse (say because of events in Europe), Australia’s inflation rate in 2012 has a pretty good chance of being between 2 and 3 per cent. The chances of a similar outcome in 2013 are also reasonable, though with slightly greater probability that inflation would end up above 3 per cent in that year than seems the case for 2012. That is, the point forecast is a little higher in the second year. Even so, a margin of uncertainty is inevitable. A big change in any of the variables subject to assumptions would quite easily push outcomes away, and maybe a long way away, from the forecast. This degree of uncertainty can of course be quite disconcerting. It is only natural to desire certainty. Everyone wants to know what will happen. We all want to believe that someone, somewhere, does know and can tell us what to expect. But the truth is that the best we can BIS central bankers’ speeches do when talking about the future is to speak about likelihoods and possible alternative outcomes. This is not a counsel of despair. It is not as though we can say absolutely nothing about likely performance. We know something about average rates of growth through time, and we know something about the long run forces that work to produce them (productivity and population growth). We know that there have been, and will be again, periods of recession and recovery, though our ability to forecast the timing of those episodes is limited. We know from experience some things about the nature of inflation, including its characteristic persistence, and the things that can push it up or down. We know some of the “big forces” at work on the global and local outlooks – a once in a century terms of trade event, for example, and a once in a century deleveraging event in major countries. We know that our country is exposed to both forces – the expansionary effects of the rise in the terms of trade, and the dampening effects of a mild degree of deleveraging in our household sector (and indirect effects of the more intense deleveraging in some other countries). We also know that the terms of trade change is a large shift in relative prices, which will bring about changes to economic structure. So there is a good deal we can say about the things that are relevant to our future, and economists’ understanding about these forces will be helpful in making sense of what occurs over time. We simply have to recognise the limits on our capacity to predict their net impact with any precision. This in turn has implications for the way policymakers use numerical forecasts. In the case of monetary policy, forming a forecast is unavoidably part of the process, simply because the evidence suggests that monetary policy changes take time to have their full effect. So we have to use forecasts – but not unquestioningly. We have to form a view about the big forces at work, but also operate with due recognition of the limitations of numerical forecasts. The extent to which policy should respond to forecasts will therefore always have some element of judgement. The conduct of policy over the past few years has exhibited these features. The Bank’s assessment of the very broad major forces at work has been central. Policy was tight in a period in which the economy was very fully employed, confidence was high, the terms of trade were rising and inflation was picking up. The very large and rapid easing of monetary policy late in 2008 and early 2009 was a response to a major change in the outlook, which occurred because the “big forces” changed direction very quickly, due to the financial events at that time. Among other things, this saw strong growth in Asia go into sharp retreat, appetite for risk and willingness to lend sharply curtailed and confidence slump. The changes to monetary policy beginning in the latter months of 2009, designed to restore “normal settings”, occurred when it had become clear that the risk of a major economic contraction in Australia had passed. In fact the “big forces” in the expansionary direction had reasserted themselves, after an unexpectedly short absence: resurgent Asian growth helped to push the terms of trade to new highs. In that world, leaving interest rates at 50-year lows would have been imprudent. Over the past 18 months or so, policy changes have been much less frequent, but the process of decision making has nonetheless not been dull. A year ago, the then current data on inflation showed nothing particularly alarming. The analysis of the Bank’s staff suggested, however, that the fall in inflation we had been seeing since 2008 would probably not continue, but instead inflation would probably begin to rise, albeit quite gradually. The Board took the view that, on the basis of that outlook and in the circumstances prevailing, it would be prudent for policy to exert some mild restraint, and so it decided late last year to raise the cash rate by 25 basis points. The inflation data for the first half of 2011 do indeed show some increase in underlying inflation (though after a sequence of revisions, this is not quite as large as it looked a few months ago). As of May this year, the central forecast was for inflation to pick up further over BIS central bankers’ speeches the ensuing couple of years, eventually rising to be clearly in excess of 3 per cent. This carried a simple message. As the Bank said in the May Statement on Monetary Policy: “The central outlook sketched above suggests that further tightening of monetary policy is likely to be required at some point for inflation to remain consistent with the 2–3 per cent medium-term target.” But there was still a matter of judging how to respond to that message. The Board did not tighten policy at that time, nor did it do so three months later when the forecasts for inflation still looked similar to those in May. It certainly considered whether that course of action would be appropriate, but elected to sit still, watching unfolding events. Eventually, last month, far from tightening, the Board actually eased policy slightly – though by then, of course, the forecasts had changed materially from those of six months earlier. This was not a repudiation of the forecasts, nor a sign that forecasts are not useful. The process of forming forecasts remains key to the forward-looking conduct of policy. In electing to take time in considering their response to signs of an increase in inflation, and central forecasts of further increases, the policymakers were simply recognising the inherent uncertainties of the situation and the difficulties the forecasters face, and giving those factors due consideration. It is, in my view, entirely appropriate that there be this degree of limited discretion for the policymakers in their response to changes in numerical central estimates. It is not that forecasts should be ignored. But neither should the decision be rigidly and mechanically linked to forecasts. Were that to be so, the policymakers would in effect have delegated the policy decision to the forecasters, which is not what policymakers are supposed to do. So the relationship between the formal forecasts and the policy decision can sometimes be a subtle one. Ultimately, the policymakers have to make a judgement call, based partly on what the central forecast says but conditioned also by the degree of confidence they have in it. At the same time it must be emphasised that policymakers can be in a position to make the sorts of judgements I have just been describing only if they have generally acted in a timely, forward-looking way in earlier decisions. In my view, these judgements over the past year were the right calls. But in truth we will not know for a while – such are the lags in monetary policy. As always, more data will help the process of evaluation, though they might also provide evidence of new shocks (that is, things the forecasters could not predict). Such is the nature of the forecasting game. In conclusion, to those of you here who do not have to make forecasts, I hope you realise how fortunate you are! To those who do, I offer my sympathy – and best wishes for clear vision over the year ahead. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 11 |
Text of The Inaugural Warren Hogan Memorial Lecture by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the School of Economics, University of Sydney, Sydney, 8 December 2011. | Glenn Stevens: The Inaugural Warren Hogan Memorial Lecture Text of The Inaugural Warren Hogan Memorial Lecture by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the School of Economics, University of Sydney, Sydney, 8 December 2011. * * * It is a very great pleasure, as a former student of Professor Warren Hogan, to give this lecture in his memory. Thank you to the Hogan family, many of whom are here this evening, and to the School of Economics at the University of Sydney for giving me this honour. Before recounting one or two personal reminiscences, it is appropriate to say something about his life. Many fascinating details of it are revealed in the interview with John Lodewijks, and the eulogy by Tony Aspromourgos, both fittingly published in the Economic Record.1 Warren Pat Hogan was born in Papakura, just south of Auckland, New Zealand, in 1929. He completed his undergraduate and Master’s education at Auckland University College, where he was taught by Colin Simkin, who later was also at the University of Sydney. He married Ialene, a fellow student in the same faculty, in 1952. Hence it is not altogether surprising that Hogan’s children seemed drawn to economics. Four of the five children, and several of the grandchildren, have degrees in economics. After gaining early work experience at the Reserve Bank of New Zealand, Hogan, with a young family in tow, came to Australia in the mid 1950s, where he gained a PhD from the Australian National University in 1959, his research being on growth theory. His supervisor for that work was Trevor Swan, one of Australia’s most renowned theoretical economists (and subsequently a member of the Reserve Bank Board). Ivor Pearce, with whom he would later collaborate in writing about international finance, was a close confidant and mentor. Among the early fruit of this work, as recounted in the Lodewijks interview, is that Hogan uncovered an error in a celebrated paper by Robert Solow. This led to an exchange between Hogan and the future Nobel Prize winner in the Review of Economics and Statistics.2 Heady stuff indeed for a young graduate student from the antipodes. Hogan rose quickly through the ranks at Newcastle University College in the 1960s. But it was as Professor of Economics at the University of Sydney, for 30 years from 1968, that Hogan came to more prominence. Joined by Simkin, he sought to lift the technical standard of economics at the faculty, including by putting more emphasis on quantitative techniques. This met a good deal of resistance as part of the broader debates about how economics should be taught. By the time I was a student here from 1976 on, both sides seemed to have dug into the trenches and the dispute had been bitter.3 None of that stopped Warren Hogan from grappling with significant issues in economics or economic policy. In fact, Hogan’s professional life shows an active mind always pursuing some important question. In a career that produced over 150 articles, books and chapters of books and many shorter publications, he ranged broadly. As early as 1958 he was producing articles examining the rise of new financial intermediaries outside the regulated banking system – a theme about which we were still hearing in the 1980s, and one which should resonate today in light of the attention being given to “shadow banks” and the expansion of Lodewijks (2007) and Aspromourgos (2010). Hogan (1958a) and Solow (1958). My own perspective, for what it is worth, is that the shift in emphasis towards quantitative techniques at the University of Sydney probably did not go far enough, at least as far as my own undergraduate education was concerned. This was something which had to be rectified at graduate school. BIS central bankers’ speeches the weight and width of the global regulatory footprint currently under way.4 Hogan retained an interest in both financial regulation and deregulation throughout his career, and married this with a nuanced understanding of the behaviour of financial players in their appetite for risk. Hogan also worked on issues of development in the emerging world, wages, immigration and transport. He served as economic adviser to one Federal Treasurer (Lynch) and as a director of various companies, most notably serving on Westpac’s board for 15 years, including through the period of deregulation and subsequent tumult. In his later years he conducted a major review of pricing in aged care. He also served in numerous capacities over the years in various university administrative positions and on other committees in the broader community. His was a full life indeed. It was in my third year at Sydney University that I think I first encountered Professor Hogan. This would have been in 1978. More than three decades after I sat in afternoon seminars conducted by him, the memories of his general style are clearer than the things he actually said. He was usually dressed in a suit – which would have been much more unusual for an academic in the late 1970s than it is now. The reason was perhaps that he had been in the city earlier in the day as he was active in dealing with practical policy issues and had links with the business world. On days when there might have been a nice business lunch, there was a certain relaxed expansiveness to his demeanour. He spoke often without notes on whatever economic topic we were covering, and as he spoke he would take the various coins from his pocket and arrange them into small piles on the table. We wondered what subconscious portfolio balance idea might have been behind that behaviour. Warren often had a somewhat elliptical way of saying things – you had to listen carefully to get what he may have really been saying, and sometimes you weren’t sure you had understood correctly. As I reflect now on this characteristic, I wonder whether he missed a calling as a central banker! He certainly had built up contacts in the central banking world, as an occasional visitor to the BIS, where he was on very good terms with the late Palle Schelde Andersen, a renowned BIS economist and student of the international economy and financial system. I assume that their acquaintance was made in the late 1970s, when Andersen visited the University of Sydney for a period, funded by a grant from the Reserve Bank.5 One Hogan paper of that era that really struck a chord with me then – I have always recalled its title – was about the issue of revisions to economic statistics. It was entitled “How Do We Know Where We Are Going, When We Don’t Know Where We Have Been, Let Alone Where We Are?”.6 These days the study of revisions to data is an art in itself (though the quality of national accounts data is better than it was in the 1970s). Central banks put huge effort into what has come to be called “nowcasting” – that is, working out what the national accounts probably will, or should, say about the current quarter in three or four months’ time when they are released. Some central banks actually “backcast” the recent past, deciding their own version of GDP, not necessarily the same as the one published by the statisticians, in effect foreshadowing revisions to come.7 The RBA has not gone to that extent, though of course we have seen certain difficulties in assessing the current pace of underlying inflation in our own country over recent months, with reasonably significant revisions to some – as far back as 1978. See Hogan (1958b). Hogan was at the conference in Basel to honour Palle Schelde Andersen’s professional life in December 2007. Hogan (1978). For example, the Bank of England’s (BoE) Monetary Policy Committee, for some time, has been presented with output growth numbers that contain various adjustments by the BoE’s staff. For more information, see Cunningham and Jeffery (2007). BIS central bankers’ speeches But the work on which I wish to focus for a brief period tonight is the book Hogan co-authored with Ivor Pearce entitled The Incredible Eurodollar.8 Published first in 1982, with subsequent editions published in 1983 and 1984, this fascinating little book sought to explain the workings of the Eurodollar market and the institutions which operated in it. In the 1970s – the dataset on which Hogan and Pearce based their work – the Eurodollar markets were an exotic new development, spawned by a period of international financial turmoil and innovation, some of which was in response to regulation. The post-World War II compact known as the Bretton Woods system had held for about 20 to 25 years. This involved a US dollar standard, under which countries fixed, and occasionally adjusted, their exchange rates to the US dollar; the dollar was fixed to gold at US$35 per ounce; private capital flows were limited in scope; and official flows made major contributions, via the IMF, to international adjustment. But by the late 1960s and early 1970s, this arrangement had come under severe strain as private capital flows began to increase in size and US policymakers found they could not live with the constraints of the system. In a sequence of events, including the break of the link with gold and the decision by key countries to allow their currencies to float against the dollar, the system broke down. The result was a system in which exchange rates between the then major currencies have floated, with occasional efforts at management, ever since. The Eurodollar Market was in essence a pool of obligations issued by banks outside the US jurisdiction but denominated in dollars. It grew rapidly, apparently unconstrained by regulation conducted on a national basis (as all regulation was, and largely still is). It was part of a large increase in cross-border financing activity by internationally active banks. When Hogan and Pearce published their third edition in 1984, the stock of cross-border assets held by BIS reporting banks was about US$2 trillion. Today, it is around US$32 trillion. In the early 1980s, much of the talk about the Eurodollar Market was couched in terms of whether Eurodollar deposits should be added to measures of the money stock, which were the height of economic fashion at the time. As you will recall, this was the period in which the US Federal Reserve targeted monetary aggregates explicitly and in which weekly monetary aggregates data were scrutinised closely for signs about the likely direction of US interest rates. One can see this background quite clearly in Hogan and Pearce’s little book, which has lots of discussion about whether Eurodollar deposits are “money” (they thought not) or just “debt” (they thought so). It was only a few years later that most countries gave up the effort to define “money” and to conduct their policy discussion in terms of money aggregates, instead going back to the former model of setting a short-term interest rate. It is interesting, though, that in recent years the “zero lower bound” for nominal interest rates, which as students we would have been taught about as “the liquidity trap”, is no longer a curiosum in the textbook from a bygone era, but has actually been binding in several major countries. One implication, among others, has been that calibrating monetary policy in terms of monetary quantities has come back into vogue in some places – this time with the relevant central banks consciously seeking to increase the size of their balance sheets. Whether the relationship between “money” and nominal GDP or prices has become any more reliable than it was 25 years ago, when it was found too fluid to be useful for policy purposes, is not clear. In choosing this work for more detailed consideration, I am conscious of the question: was it more Hogan’s work or Pearce’s? Certainly Pearce had already released a piece by that name (Pearce, 1980). But equally Hogan was clearly a student of financial intermediaries and markets from early in his career, and released two working papers on Eurofinance markets in 1979 (Hogan, 1979a and Hogan, 1979b). No doubt he and Pearce had exchanged views on such issues over time, particularly during Hogan’s visit to the University of Southampton in 1979. My assumption is that the book published as Hogan and Pearce (1982) was a genuinely collaborative effort. BIS central bankers’ speeches But if the language in Hogan and Pearce’s early 1980s work is, perhaps, a product of its times, some of the observations are astute, and there are some quite prescient insights. To begin with, Hogan and Pearce note that the activities of Eurocurrency markets – and we could generalise this to cross-border private financing generally – lessened the pressure on countries to adjust to current account imbalances, especially on the deficit side. This could be seen as good – allowing capital to flow more efficiently to the locations offering the highest risk-adjusted return. Or it could be worrying: the markets giving a nation more rope, so to speak, by allowing current account balances to become larger and more persistent than they would otherwise. Remember that at the time they wrote, current account positions had rarely been more than a few percentage points of GDP for any length of time, at least since 1945. The analysis of the mythical planet Htrae, with three countries Surplusia, Deficitia and Balancia, with respective currencies Surps, Defs and Bals, focuses on the operation of markets and, importantly, the role of financial institutions as intermediaries between savers in one country and borrowers in another. In the language of more recent times, financial institutions are key to the dynamics of so-called “global imbalances”. Indeed, Hogan and Pearce state, rather bluntly: “Financial intermediaries live upon imbalances”.9 At one level that is obvious – financial intermediaries or markets exist to transfer resources from savers to borrowers (and back again), which is to say that an imbalance between saving and investment at the level of an individual household or firm in the economy is matched against an equivalent imbalance of opposite sign in some other firm or household. The deeper sense in which this “thriving” takes place in an international setting is that savers in one country lend their money to borrowers in another jurisdiction, about whom they know next to nothing, but feel safe in doing so because what they hold directly is an obligation of a large, wellknown, globally active bank, assumed to be safe. But as Hogan and Pearce point out, a European entity raising dollars to fund a balance sheet does not have automatic access to a lender of dollars of last resort in the event that market conditions change. It is therefore exposed to serious funding risk in a way that does not occur in purely local currency operations. The average “Eurobank” in the early 1980s had access to marks or francs – today euros – or pounds from its national central bank, but it could not be assumed that in times of stress these currencies could necessarily easily be swapped for dollars. In fact, this very phenomenon was at the heart of the crisis that began to unfold in 2007. It was in Europe, where banks had, and still have, a structural need for dollar borrowing to fund US dollar denominated assets, that the market strains first appeared in August 2007. As the crisis intensified, the need for access to central bank funding in dollars required a number of central banks to enter into swap arrangements with the US Federal Reserve so their domestic banks could borrow US dollars secured by local currency collateral. European banks were by far the largest users of these facilities – about US$400 billion was accessed via the ECB and other central banks in Europe at the peak in December 2008. Of course, it is also in Europe that we have seen the epicentre of the most recent stage of the crisis. In some other respects, today’s problems are a little different, and perhaps more complex, from those of three years ago. They arise from cross-border lending within a currency area that has a single money but very divergent experiences in terms of fiscal discipline and productivity, and that lacks a well-developed capacity for intra-area transfers – which is being built as we speak. Nonetheless, dollar funding for European banks has again tightened up and the swap lines among major central banks have again been activated to assist. This is presumably designed to slow the speed of European bank deleveraging of dollar assets that would otherwise be forced to occur. Hogan and Pearce (1984), p 60. BIS central bankers’ speeches Lots of people claim to have predicted the crisis, though I doubt that Warren Hogan, were he here, would claim that he and Ivor Pearce foresaw it in all its dimensions almost 30 years ago. I think they would perhaps claim that their saga of Htrae, where international crossborder financing ultimately produced a crisis, contained many relevant insights. I doubt that they fully appreciated the role that the financial institutions of the leading deficit country – the United States – would play in creating risk and transferring it elsewhere. In their story, the key institutions were those of the country of Balancia, where the international accounts initially were balanced. I think they would have expected the response of major central banks to the crisis to have resulted in more inflation than it has, so far. That may be a reflection of the inflationary times in which they were writing – when it seemed almost inconceivable that deflationary problems akin to the 1930s could re-emerge. The example of Japan, where there has been deflation for well over a decade, had not yet occurred in 1982. Of course, they might just have expected the inflation still to be coming. They would not be alone in that view. It is certain though that Hogan would have been watching all these developments with close interest. He would have been recognising certain things that he could have broadly predicted, and I suspect he would have said so with that very dry turn of phrase he had. He would also, surely, have been observing things that would have surprised him, and he would have been thinking about how his view of the world needed revision. He would have been pondering the future of the international financial system. In that vein, I shall use the remainder of the time this evening to make a few observations in that area. The first is that there is an extensive program of regulatory reform under way. In an international setting potentially the most far-reaching is the set of proposals recently endorsed at the G-20 summit to mitigate the problems posed by institutions that are too big to fail at an international level, otherwise known as Globally Systemically Important Financial Institutions, or G-SIFIs. Some 29 individual banks have been identified as fitting the criteria to be labelled G-SIFIs at present, though the list is not a fixed one: banks can enter and leave it over time. There will, in due course, be a framework for globally systemic insurance companies with parallel criteria. The intention of the policy is to make the failure of such entities less likely by requiring additional capital, and to make the consequences of failure less dramatic by developing better tools to resolve entities that have failed or are on the point of failure. The latter, in particular, is a very ambitious undertaking and contains some potentially far-reaching components – such as the ability to “bail in” certain creditors to an institution on the point of failure, effectively turning them into shareholders, so as to lessen the likelihood that taxpayers will be called upon in such a situation. To make it work would require considerable co-operation across jurisdictions at moments where everyone’s instinct is to protect creditors and counterparties in their own jurisdiction. I don’t know what Hogan would have made of this. I suspect he would be wondering whether, if regulatory actions bind on one group of institutions, the behaviour in question would end up migrating to other, less-regulated places. This possibility is understood by the international regulatory community, which also has a regulatory agenda for “shadow banking”. This is actually a critical point. I would offer the observation that, if we can get through the next year or so without a major crisis and successfully implement the various reforms – which might both be big “ifs” – the next financial crisis may not occur in the same sorts of institutions as last time (or this time), but in different ones. It could well occur in institutions or markets that do not as yet exist. The key thing in avoiding disastrous crises in the future is less the specifics of regulation or resolution – as important as these are – than having a clear understanding of the nature and extent of risk-taking behaviour, in all its potential dimensions and locations. On my reading of Hogan’s work, I believe he would have shared this view. Put in the simplest of terms, we might ask: where are financiers apparently making easy money? In what area of risk-taking BIS central bankers’ speeches are the profits large or expected to be large? There is a good chance that it is there that, given enough time, the likelihood of excesses is greatest. In Hogan and Pearce’s book, financial institutions and their behaviour were seen as central to the build-up of imbalances. But they are in one sense merely facilitating flows of capital that are reflective of other phenomena, resulting from the collective behaviour of the actors in surplus and deficit countries. So in contemplating the future of the international financial system, reforming the regulation of financial institutions, and understanding their behaviour, will be key, but it will be of equal importance to understand the underlying behaviour of the entities in the real economies. The role of official capital flows, in particular, is one element of the post-crisis world that seems to be becoming quite prominent. Indeed, perhaps one of the most striking features of the international financial system is the size of official reserve assets that have been accumulated by what Hogan and Pearce would have labelled “Surplusia” – the countries that have run persistent current account surpluses. In the early 1970s, the accumulation of US dollars by surplus countries made for problems of monetary control in some large reserve holders like West Germany. When the Bretton Woods system finally broke down in 1973, total foreign reserves of all countries amounted to about 2½ per cent of annual global GDP. West Germany’s reserves were about 7 per cent of West German GDP. Today, total reserves in the world amount to the equivalent of about 15 per cent of global GDP, up from 10 per cent only five years ago. China’s reserves are close to 50 per cent of Chinese GDP. Many other Asian countries have equivalent ratios around 30 per cent or more; while, in Latin America, foreign exchange reserve holdings are typically in the 10–15 per cent range.10 There are numerous reasons behind this build up. The very high levels of energy prices in recent years have pushed up the reserves of oil producers, and this accumulation may have some logic as they seek to spread over a long period the income gains accruing from a finite resource. The reserves of many Asian countries have risen to much higher levels after the 1997 crisis, as a form of insurance against capital flow reversal. Indeed the IMF advised this after the crisis, advice that has been taken to heart perhaps a little more than the Fund intended. One can understand the desire for self-insurance, and particularly as those Asian countries that had IMF programs in the late 1990s felt the conditions for mutual insurance – through the IMF – were very onerous. But the self-insurance provided by large holdings of reserves is costly, especially in the low interest rate environment we see in the major countries. Trillions of dollars and euros held on behalf of the citizens of countries across Asia (and elsewhere) are earning meagre returns and subject to increasing sovereign risk. This cost of selfinsurance is therefore becoming increasingly apparent, a trend that will surely continue as, inevitably, Asian productivity levels continue to increase relative to the Western countries and their real exchange rates rise. Large centres of high saving with portfolios that are overweight in foreign assets whose return is low and whose value is highly likely to go down, measured in the currencies of the holders, amounts to something of a problem. Attempts by those holders to exit this position quickly would be, to say the least, highly disruptive. They know that and that is why they do not attempt it, though there is a degree of diversification under way. To paraphrase the old line, if I owe you a few billion, I may have a problem. If I owe you a trillion or two, you may have a problem every bit as big as mine. So there is a very long-term issue of portfolio re-balancing to be addressed here as well as one of structural realignment of national price levels (i.e. real exchange rates). At the same time though, there are increasing calls for the emerging economies with large surpluses and Australia’s official reserve assets, for comparison, are equivalent to about 3 per cent of our annual GDP. BIS central bankers’ speeches high reserve holdings to play a part in assisting Western economies facing budgetary and banking sector problems. With the balance sheets of many Western sovereigns already under pressure, there is hope for contributions from large reserve holders – they, after all, are the ones with the cash. It has to be observed, surely, that pressing reserve-heavy emerging economies to lend into structures designed to smooth adjustment processes in the advanced world amounts to a call to perpetuate, to a fair extent and for at least a bit longer, some of the very “imbalances” that so many have lamented for so long. What people are really saying is that they want to move only quite slowly away from the current constellation of resource flows and prices that, in other discussions, have been seen as constituting the problem. That may well be the best approach. But it is observable that large reserve holding countries are already getting uncomfortable with their degree of exposures to major Western governments. Hence, any offers of assistance are likely to be made with a careful eye to risk minimisation. This is likely to mean they will prefer to operate through international institutions, such as the IMF. Alternatively, they may prefer to take hard assets in return for their cash, rather than financial obligations, which, in turn, could easily raise the social and political tension level. At the very least, managing all this over the next decade will require level-headed analysis, far-sighted decisions on the part of national policymakers and a degree of international co-operation much greater than we usually see. Moreover, there will be some very important questions to be confronted. Not least among them will be that, with the relative economic weight of the emerging world rising quickly, and a rise in their financial weight flowing from their high rates of capital accumulation and increasing creditor status, they will expect an increased role in global financial governance as a condition of accepting more obligations to contribute to the global common good. The willingness of the established, post-war leadership countries to cede a degree of status and control to the emerging world will need to increase at the same speed as the emerging countries’ willingness to grasp and accept their rising responsibilities. Will this occur? It is hard to judge. Much will depend on whether the various parties have the same general ideas about the purpose of the international monetary system. That is, at this point anyway, not clear. Another thing we might see is a certain tendency towards the financial repression that was a feature of the post-war world in which Warren Hogan first studied economics. A legacy of the 1930s was a much tighter regulatory regime for banks, elements of which lasted for decades. A legacy of the 1940s was a very large stock of government debt. Debt to GDP ratios were well into triple digits for countries like the United Kingdom and the United States (and for Australia). Yet from the 1950s through to the 1970s, debt-servicing dynamics were kept within manageable bounds. The rapid growth in economic output in the long post-war boom, which was aided by demographics and productivity performance, was a major help. But also contributing was a combination of central banks holding down long-term interest rates at government direction, and banks and other entities being forced to hold government debt. And of course, at the end of that boom, a period of unanticipated high inflation played a role in lowering debt to GDP ratios. In the current era, however, the rapid output growth will likely occur in the countries that don’t have much government debt but do have productivity catch-up working for them, while in many of the countries that have a lot of debt the demographics will be going the wrong way. It is therefore conceivable that with slow-growing countries feeling pressed for solutions, regulatory actions might have certain attractions. Given this, and with many emerging countries having mixed feelings about many aspects of free financial markets anyway, it is conceivable that the current trend towards more assertive and intrusive financial regulation – which is occurring for very understandable reasons – will end up going much further than contemplated at present. The potential for an outcome that eventually involves significant inflation is also obvious. BIS central bankers’ speeches I have only touched the surface of many of these issues. As I said earlier, I cannot know what Warren Hogan would have thought of them, or whether he would agree with my views. I am sure, though, that he would have thought these matters worthy of further discussion and that he would have contributed to that discussion. Hopefully, I will have succeeded in stimulating some further discussion tonight. Once again, thank you to the University, and to the Hogan family, for permitting me this honour. I hope this marks the start of a successful series of lectures. References Aspromourgos, T (2010), “Warren Pat Hogan, 1929–2009”, Economic Record, Volume 86, Number 273, pp 289–93. Cunningham, A and C Jeffery (2007), “Extracting a Better Signal from Uncertain Data”, Bank of England Quarterly Bulletin, Volume 47, Number 3, pp 364–75. Hogan, WP (1958a), “Technical Progress and Production Functions”, Review of Economics and Statistics, Volume 40, Number 4, pp 407–11. Hogan, WP (1958b), “The Banking System and the New Financial Intermediaries”, The Australian Quarterly, December, pp 17–29. Hogan, WP (1978), “How Do We Know Where We Are Going, When We Don’t Know Where We Have Been, Let Alone Where We Are?”, Economic Society of Australia and New Zealand, NSW Branch General Meeting, October. Hogan, WP (1979a), “Eurofinancing: Currency, Loans and Bonds”, Working Papers in Economics, University of Sydney, Number 33. Hogan, WP (1979b), “Controlling Eurofinance Markets”, Working Papers in Economics, University of Sydney, Number 36. Hogan, WP and I Pearce (1982), “The Incredible Eurodollar”, George Allen & Unwin, London. Hogan, WP and I Pearce (1984), “The Incredible Eurodollar, or Why the World’s Monetary System is Collapsing”, 3rd edition, Unwin Paperbacks, London. Lodewijks, J (2007), “A Conversation with Warren Hogan”, Economic Record, Volume 83, Number 263, pp 446–60. Pearce, I (1980), “The Incredible Eurodollar”, Discussion Papers in Economics and Econometrics, University of Southampton, Number 8006. Solow, R (1958), “Technical Progress and Production Functions: Reply”, Review of Economics and Statistics, Volume 40, Number 4, pp 411–13. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 12 |
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 24th Australasian Finance & Banking Conference, Sydney, 14 December 2011. | Ric Battellino: European financial developments Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the 24th Australasian Finance & Banking Conference, Sydney, 14 December 2011. * * * I would like to thank Laura Berger-Thomson, Justin Fabo, Chris Stewart and Grant Turner for their extensive assistance with this talk. Introduction Over recent months we have all watched with concern the growing financial problems in Europe. The problems are multi-dimensional, involving excessive government debt, weak banking sectors, slowing economic growth and marked differences in competitiveness across countries within the euro area. They have become the main threat facing the global economy and the international financial system. It is hard to tell how and when the problems will be resolved. In the meantime, turbulence continues in global financial markets and most forecasters are now predicting a very significant weakening in the European economy over the coming year as government spending is cut back, credit tightens and confidence declines. Given the size of the European economy and financial system, it will be hard to avoid adverse consequences for other parts of the world, though the extent of these spillovers remains an open question. At this stage, most forecasters think that growth in the world economy will be only a little below trend in the coming year, though with the risk of a significantly worse outcome. Australia, like other countries, will be affected by the events in Europe, but its strong government finances, healthy banking sector and relatively limited direct trade and financial exposures to Europe make it one of the countries best placed to weather the situation. Australia is also fortunate to be subject, simultaneously, to a resources boom that is resulting in unprecedented investment and therefore helping to sustain economic activity. I will begin my talk today with a round-up of the European government debt situation. I will be brief as I think we all know the broad facts. I will then focus on the effect that the deterioration in government debt has had on European banks and the role that European banks are playing in spreading the problem to other countries. I will conclude by looking at the channels through which Australia could be affected, including through financial links, trade links and effects on confidence and wealth. The European debt situation As you know, the trigger for the problems currently being experienced in Europe was the rapid build up in government debt following the global financial crisis. Government budgets deteriorated sharply after 2008, due to the weakening in economic activity, the large fiscal stimulus applied by governments and, in some cases, the cost of bailing out banks. Government debt in the euro area had been rising as a ratio to GDP, however, for much of the period since the 1970s (Graph 1). This occurred because governments loosened fiscal policy during recessions but did not fully reverse those policies during the subsequent cyclical recoveries. In aggregate, budgets in the countries that now form the euro area have been continuously in deficit for the past 40 years (Graph 2). Clearly, there was no fiscal rule that aimed to balance the budget over the economic cycle, as there is in Australia. BIS central bankers’ speeches Graph 1 Graph 2 At the onset of the global financial crisis, the ratio of net government debt to GDP in the euro area was about 45 per cent and it has since risen to around 60 per cent. Within the euro area, Greece has the highest net debt ratio, at about 130 per cent, with Italy next, at about 100 per cent. Concerns in financial markets about the sustainability of government debt levels in Europe first emerged in late 2009, when the Greek Government revealed that its fiscal position was significantly worse than it had previously led the markets to believe. Greek sovereign debt was downgraded and spreads on the debt widened, despite some fiscal tightening. By April 2010, the situation in Greece had deteriorated to the point where it was forced to seek external financial assistance from the IMF and other European countries. BIS central bankers’ speeches As typically happens, market participants quickly began to ask which country might be next, and spreads in some other euro-area countries also began to widen sharply. By November 2010, Ireland had been forced to ask for external assistance, and Portugal followed in April 2011. Recently, Italy and Spain have also come under severe financial pressure, though as yet have not needed external assistance. As the crisis has spread, a succession of measures has been announced to try to contain the problem, the latest being announced last weekend. These have typically provided some short-term respite, but in the past none has managed to provide lasting reassurance to financial markets. It remains to be seen whether the latest measures will be more successful. Most commentators see the long-term solution as involving greater fiscal co-ordination and discipline. In the short term, it is highly likely that part of the solution will involve substantial financial assistance from outside the region or the purchase of sovereign debt by the ECB, or some combination of both. A sticking point here is that the ECB’s charter precludes it from providing direct financing to governments. The ECB was initially also reluctant to buy government debt in the secondary market, though it has done so in substantial quantities recently. The restriction on the ECB’s funding of governments was put in place both to guard against the risk of inflation and to avoid the moral hazard that would arise if national governments had direct access to central bank financing in a situation where there is no central co-ordination of fiscal policy. While an arrangement where the central bank is precluded from direct financing of the government guards against the risk of inflation – i.e. monetary instability – it increases the risk of financial instability. This is because if the central bank is not prepared to step in as a financial back-stop, a government that is unable to fund itself in the market is left with no option but to default or seek external assistance. It is highly unusual for a government in a developed economy to be forced to seek funding from an external party such as the IMF. The concerns about the sustainability of debt levels in various countries have resulted in interest rates on government debt rising sharply in some countries, returning to the relativities that prevailed before the formation of the euro (Graph 3). Pre-euro, there was a wide variation in the interest rates paid by European governments, reflecting each country’s history of inflation and fiscal discipline. The formation of the euro area brought convergence of interest rates towards the low levels previously enjoyed only by Germany, but pre-euro relativities are now re-asserting themselves. This suggests that markets are pricing in the possibility of a break-up of the euro area or a significant risk of default by some governments, or both. Graph 3 BIS central bankers’ speeches The effect on European banks The problems in European sovereign debt markets have affected European banks through two main channels: first, these banks have experienced valuation losses on their sovereign debt holdings; and second, these losses have raised concerns about the financial soundness of banks, particularly in an environment where some governments are seen as having less capacity to support banks financially. This has caused investors and other banks to become reluctant to lend to them, and has pushed up banks’ funding costs. Let me say something about each of these points in turn. Euro-area banks, in total, hold about €2.5 trillion of euro-area sovereign debt. This is about one-third of all the euro-area sovereign debt on issue. The exposure is quite substantial, being equal to about 8 per cent of these banks’ assets and 130 per cent of their Tier 1 capital. The majority of the debt held by banks in each country is home-country debt but, not surprisingly for a common-currency area, there are also large cross-border holdings. This is particularly the case for Italian debt, which is widely held by non-Italian banks. Given the rise in yields that has occurred in some countries, the market value of the bonds has declined significantly. Greek debt, for example, has fallen in value by around 70 per cent. This means that even though the face value of Greek debt is about €260 billion, the market value of the debt is now only about €75 billion (Graph 4). Italian debt has fallen in value by 10 per cent. Banks have brought some of these losses to account already, but they remain heavily exposed to further losses if the situation continues to deteriorate. Graph 4 As I mentioned, concerns about these exposures have made investors and depositors more cautious. The cost of long-term funds has risen sharply (though it remains below that reached during the global financial crisis) and, for some euro-area banks, bond markets have largely closed. As such, very few bonds have been issued by euro-area banks recently (Graphs 5 and 6). BIS central bankers’ speeches Graph 5 Graph 6 Banks in some euro-area countries have also suffered large reductions in deposits. Greek bank deposits have fallen by about 25 per cent over the past couple of years and deposits in Irish banks by 10 per cent. Italian and Spanish banks have experienced a small fall in deposits. Banks in Germany and France, in contrast, have experienced increases (Graph 7). BIS central bankers’ speeches Graph 7 With banks under funding pressure, the ECB has had to increase its lending to banks. Essentially, it currently allows euro-area banks to borrow as much as they need (subject to the availability of eligible collateral) at its policy interest rate, for periods up to three years. Some banks have increased their use of ECB funding significantly: Greek banks and Irish banks are financing almost one-quarter of their balance sheets from either the ECB or their national central bank (Graph 8). For the banking system as a whole, however, central bank funding is equivalent to less than 3 per cent of liabilities. Graph 8 BIS central bankers’ speeches European banks have also found it increasingly difficult to access US dollar funds, which they use to fund US dollar assets, including trade finance. Lending to euro-area banks by US money market funds has fallen by 55 per cent this past year. In response, banks have turned to foreign exchange swap markets to source US dollars, pushing up the cost significantly (Graph 9). Graph 9 To alleviate the shortage of US dollar funds among European banks, the US Federal Reserve has re-activated its US dollar swap lines with a number of other central banks. This is to allow these central banks to lend US dollars to banks in their jurisdiction. Until recently, however, banks had not made much use of this facility, instead seeking to reduce their need for US dollars by selling US dollar assets and cutting back on cross-border financing. Following the recent reduction in the interest charged on the facility, however, usage has picked up somewhat. To try to enhance investor confidence, European banking authorities recently announced a requirement for a large number of euro-area banks to lift their core Tier 1 capital ratios to 9 per cent by mid 2012.1 It has been estimated that, other things equal, this would require about €115 billion of new capital. This is not a particularly large amount, being equivalent to about 12 per cent of these banks’ current capital. Nonetheless, there is evidence that at least some banks are unwilling or unable to raise equity and are seeking to achieve the higher capital ratio by reducing assets, particularly in offshore markets. This will add to the general tightening of global credit conditions. Euro-area banks are large participants in cross-border lending, though this is mainly oriented towards other European countries and North America (Graph 10). Their role in the Asian region is smaller, though they are thought to play a significant role in trade financing. While no data are available for the recent months during which the European banking problems have escalated, anecdotal evidence suggests that a lack of trade financing is not as significant a problem in Asia as it was in 2008. After including a buffer for valuation losses on their sovereign debt exposures. BIS central bankers’ speeches Graph 10 Australia’s exposure to European developments There are various channels through which developments in Europe could affect Australia. These include financial linkages, trade linkages and confidence and wealth effects. (a) Financial linkages The direct exposures of Australian banks to the euro area are small. Their claims on euroarea countries amount to $87 billion, or 2.7 per cent of total assets. Moreover, 80 per cent of this exposure is to Germany, France and the Netherlands (Table 1). Table 1 Australian-located Bank Claims on Euro Area Countries(a) Ultimate risk basis, as at 30 June 2011 BIS central bankers’ speeches The main effect of the European crisis on Australian banks is through the increased cost of funds in global markets as debt has become more expensive in Australian banks sharply have reduced their issues of long-term debt (Graph 11). Short-term debt remains more readily available, particularly in the United States, where money market funds have shifted their investments from European banks to Australian, Canadian and Japanese banks. Graph 11 Australian banks, overall, remain relatively liquid as they continue to receive strong inflows of deposits. Over the past year, total bank deposits in Australia have risen by 9 per cent, which has been more than sufficient to fund the increase in banks’ lending (Graph 12). Graph 12 BIS central bankers’ speeches (b) Trade links The euro area accounts for only about 4 per cent of Australia’s merchandise exports, a low share compared with many other countries. Table 2 Share of Merchandise Exports going to Euro Area While the direct exposure of Australia to a slowing in European demand is low, the indirect exposure, through the effect on some of our important trading partners, could be significant. China and India, for example, both ship a substantial share of their exports to the euro area and these could be expected to decline. Further, history shows that, when exports slow, domestic demand in Asia also slows, albeit to a lesser degree (Graph 13). Graph 13 BIS central bankers’ speeches Overall, it would be prudent to assume that, if the European economy were to slow markedly over the next year or so, Australia would be affected, particularly through indirect trade exposures. It is also likely, however, that if that were to eventuate, the exchange rate of the Australian dollar would weaken, as it has when the global economy has weakened in the past, providing some cushion for the Australian economy. (c) Confidence and wealth effects Confidence and wealth effects are difficult to quantify, but ultimately can be very important in transmitting economic shocks. Household confidence in Australia was below average through much of 2011, with households being particularly pessimistic about their financial situation over the coming year. No doubt, these perceptions were being affected by the unsettling financial news coming out of Europe and the associated large declines in share prices. In recent months, however, measures of confidence have improved despite the escalating problems in Europe and the continuing volatility in share prices, suggesting that other factors are providing an offset. The changed picture for interest rates is one of these. However, the continuing solid expansion in household disposable income, which has risen by about 7 per cent over the past year, has no doubt also been important. Measures of business confidence are a little below average at present, even though business conditions are around average levels. Conditions are weakest in the retail, manufacturing and construction sectors and are noticeably weaker among smaller businesses than among larger businesses. Overall, however, business confidence, like household confidence, has improved in recent months. The gradual spread of the benefits of the resource boom is helping to sustain business confidence in the face of the worsening European situation. The key drivers of wealth are changes in share prices, house prices and deposits. Share prices are down by 10 per cent over 2011, though a significant part of this has been offset by higher dividend payments. House prices on average are down by 4 per cent in 2011. On the other hand, deposits have risen strongly and overall household wealth has fallen by a relatively modest 2 per cent in 2011 (Graph 14). This is a much smaller decline than occurred following the global financial crisis in 2008, and has not caused households to respond by sharply raising their rate of saving, as happened on that earlier occasion. This has allowed household spending to grow broadly in line with income. Graph 14 BIS central bankers’ speeches Conclusion The sovereign debt problems in Europe have escalated over recent months and an unfavourable feedback loop has developed between government debt, the banking sector and the economy. The large size of the euro-area economy and the significant role played by European banks in global cross-border banking mean that it is inevitable that there will be spillovers to other parts of the global economy, including Australia. Nonetheless, it is encouraging that, to date, any impact on the US economy has been more than offset by other factors, with recent US economic indicators being better than they were around mid year, despite the recent escalation of the European crisis. The same is also true in Australia. Asian economies have slowed, but it is not clear how much of this is due to earlier policy tightening within Asia (which in some cases is now being reversed as inflation pressures subside) or the effect of the developments in Europe. The situation is still unfolding, however. The impact on the global economy will ultimately depend on how the European problems are resolved. It is possible that a combination of credible fiscal commitments by governments and short-term support from the ECB and IMF will provide a solution that is relatively benign for the European and world economies. However, other outcomes, including deflation caused by prolonged fiscal austerity, inflation caused by large-scale debt monetisation, or some disruptive event such as a change in the composition of the euro area, cannot be ruled out at this stage. We therefore need to monitor the situation carefully and remain alert to the risks. Having said that, I remain confident that Australia, with its strong government finances, resilient banking system, relatively low exposures to the troubled countries and strong links to the dynamic Asian region, is well placed to deal with events that may unfold. BIS central bankers’ speeches | reserve bank of australia | 2,011 | 12 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to Bloomberg Seminar, Sydney, 14 February 2012. | Guy Debelle: On Europe’s effects on Australian financial markets Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to Bloomberg Seminar, Sydney, 14 February 2012. * * * Thanks to Justin Fabo, Craig Evans and Tom Rosewall for their help with this talk. Europe has been at front of mind a lot of late. The almost daily machinations of the European political behemoth have been a major driver of financial market volatility. On that, I was pleasantly surprised that the Australian summer holiday was relatively uninterrupted by European headlines. But the downside was that we didn’t really get summer in Sydney. European developments influence Australian financial markets through a number of channels. I will focus on a few of those today. I think the European development that has had the most material impact on financial markets over the past few months has been the European Central Bank’s (ECB) 3-year liquidity operation. In December, the ECB provided as much 3-year funding as the European banking sector desired at the ECB’s policy rate (against acceptable collateral). Nearly €500 billion euros was borrowed. This large liquidity injection has had a number of effects. One of the more important is that it effectively takes funding out of the equation for the European banking system in the period ahead. There are large maturities of bank debt falling due around now, a sizeable share of which is government-guaranteed (Graph 1). There were serious concerns about the ability of some banks to refinance themselves, but these concerns have been alleviated by the ECB’s actions. The ECB has provided banks with the funds to repay these obligations and indeed ECB commentary suggests that a number of those who borrowed were those with large debt maturities coming up. Graph 1 Euro Area Bank Bond Issuance Quarterly €b Unguaranteed Guaranteed Covered Maturities €b * -200 -400 -200 -400 * Quarter to date Sources: Bloomberg; Dealogic; RBA; Thomson Reuters In assessing the impact of the ECB’s actions, some commentators focus on the size of banks’ deposits with the ECB as a measure of their effectiveness. If these deposits are rising, the assessment is that the ECB’s actions aren’t working, because the banks are just parking their money at the ECB and not lending it to the real economy. Such an assessment is inaccurate. The size of the banking system’s deposits with the ECB is completely determined by the ECB’s liquidity operations. On the ECB’s balance sheet, the assets it generates by lending to the banking system must also appear on the liabilities side as bank deposits with the ECB. That is, once the ECB has done its liquidity operations, the BIS central bankers’ speeches size of ECB balance sheet is what it is. The amount of deposits provides no real information above and beyond the net amount the ECB has injected into the system, which is already known. It does not tell you anything about what the banks are doing with the funds they have borrowed from the ECB. Or about how many times those funds circulate before ending up back at the ECB. This is true of all central banks, not just the ECB. A similarly misleading statement is often made about the Fed, with bank deposits “piling up” at the Fed supposedly indicating that the Fed’s policy actions are ineffective. Again, the size of banks’ deposits at the Fed is the mirror image of the Fed’s liquidity operations. One possible way to gain a handle on the impact of these operations, and the extent to which the liquidity has circulated, is to look at money multipliers. Graph 2 shows money multipliers for the euro area, the US and the UK. The money multiplier is the ratio of a broad measure of the money supply to the money base, which is the part that is more or less under the control of the central bank. The graph shows that there have been large declines in the money multiplier in all three regions. Graph 2 Money Multipliers Broad money as a ratio to the money base Ratio Ratio UK Euro area US Sources: RBA; Thomson Reuters These declines provide some indication that the banks aren’t circulating the liquidity as much as was the case in the recent past. The declines are consistent with the deleveraging that is occurring in the banking sector and on private sector balance sheets. It also suggests that the economies in each of these regions are likely to have been significantly weaker if not for the large expansion of central bank balance sheets. While the ECB’s liquidity provision significantly reduces the funding risk for European banks, there are still pressures in terms of bank capital. A number of European banks are responding to these pressures by deleveraging rather than by raising equity in the market. Some of that is evident in Australia and the Asian region more generally, particularly around the provision of commodity finance. However, at least in Australia’s case, European banks do not have a large presence, and thus far we have seen other banks step in to offset some of the withdrawal. There are also clearly still significant issues in terms of sovereign debt to be resolved. The ECB will conduct another 3-year operation at the end of the month. There is some possibility that banks will use that operation to fund increased purchases of sovereign debt and earn the large carry on offer, which might help alleviate the sovereign pressures for a time. Graph 2 showed the collapse in money multipliers that has occurred. But it is also interesting to think about the equivalent concept on the other side of the balance sheet, what might be called collateral multipliers. That is, how many times do assets get recycled in the system, particularly in terms of generating funding. Collateral multipliers don’t appear in standard BIS central bankers’ speeches textbooks, but they are an important construct in the world of shadow banking, where repo, collateral hypothecation etc are crucial. Some very interesting work has been done on this in recent times, including by Manmohan Singh and Zoltan Pozsar at the IMF, along with James Aitken.1 Hyun Shin and others have developed a useful framework in which to think about the issue.2 The evidence seems to be that there is a sizeable reduction in the velocity of collateral taking place. Some of this is because of a change in the willingness to lend securities on the part of some asset managers, some is a function of regulatory changes. This has implications for the provision of credit, particularly from the shadow banking sector. It is an area which is certainly worth examining in more detail. Returning to the topic of debt issuance, the new year has seen a thawing in bank debt markets. Some of this I think can be attributed to the calendar itself. Investors were reluctant to take any position towards the end of 2011, either to lock in gains already accrued or to avoid exacerbating losses in an environment of considerable uncertainty. With the beginning of the new year, the investment slate is clean and risk tolerance thus far is on the increase. This development has been bolstered by the avoidance of worst case outcomes and, as I’ve already mentioned, by the ECB’s action. However, there is a reasonably large amount of bank debt maturing in the first quarter and concerns continue to be expressed about that. In that regard, it is always important to remember that when the debt matures, the investor in the maturing paper has to decide what to do with the cash. Do they reinvest in bank debt or do they invest it somewhere else? In the current quarter, an additional wrinkle in thinking about this is that a fair chunk of debt maturing is government-guaranteed bank paper. So the decisions of some of these investors may not be the same as those of more traditional bank credit investors. But while the market has reopened in the new year, there has been a sizeable step up in the cost of the issuance. Investors are demanding much higher compensation for bank credit risk now than they were in mid 2011. The repricing probably happened in the last quarter of 2011, but the general lack of issuance made it more difficult to observe. This global repricing of bank debt has clearly affected the Australian banks’ wholesale funding costs. The Reserve Bank will provide a detailed analysis of this in the March Bulletin. Table 1 provides some illustration of recent developments. Singh M (2011), “Velocity of Pledged Collateral: Analysis and Implications”, IMF Working Paper WP/11/256; Singh M and J Aitken (2010), “The (Sizable) Role of Rehypothecation in the Shadow Banking System”, IMF Working Paper WP/10/172; Pozsar Z and M Singh (2011), “The Nonbank-Bank Nexus and the Shadow Banking System”, IMF Working Paper WP/11/289. See, for example, Adrian T and HS Shin (2010), “Liquidity and Leverage”, Journal of Financial Intermediation, 19(3), 418–437. BIS central bankers’ speeches Table 1: Bond Market Issuance Costs 5-year Issue date Spread to BBSW (bps) Major banks Senior unsecured Jun 2011 Jan 2012 Feb 2012 Domestic Jan 2012 Offshore RMBS Jan 2012 Apr 2011 Nov 2011 Coca-Cola Amatil (A-) Jan 2012 Australia Post (AA+) Jan 2012 SPI Electricity and Gas (A-) Jan 2012 Covered bonds Corporates Source: RBA It shows that the covered bonds issued by the Australian banks were at markedly wider spreads than their unsecured issuance mid year. This is notwithstanding the fact that covered bonds are senior in the creditor queue. While the cost of the first wave of covered bond issuance by the Australian banks has been high, it is broadly comparable to that of recent covered issuance by banks in other jurisdictions where there has been a similar step up in cost (Graph 3). In the past few days, there has been a sizeable narrowing of spreads in the secondary market on the domestically issued covered bonds, to around 140 points over swap. This narrowing in bank credit spreads was confirmed by the unsecured issuance last week. Graph 3 Covered Bond Pricing Spread to US$ swap, 4–6 year AAA-rated Bps Bps – France – Netherlands – Norway – Canada Australia -100 M l J l S l D l M l J l S l D l M -100 * Non-US$ issuance converted into US$ spreads Sources: Bloomberg; RBA The other point of interest in Table 1 is that some corporates are able to issue at lower rates than the banks, even for the AAA-rated covered bonds. For example, Coke, which is rated A-, was able to issue more than 100 basis points below the AAA rated domestic covered bond issues. BIS central bankers’ speeches The rise in wholesale funding costs has been accentuated for funds raised offshore by a widening in the cost of swapping foreign exchange into Australian dollars (Graph 4). This is another example of European issues affecting the local market, as the widening is partly a function of the lower volume of Kangaroo issuance in recent months. The Kangaroo issuers seek to swap the $A funding they raise back into foreign currency, while the Australian banks do the reverse with their foreign currency raisings. Graph 4 A$ Cross-currency Basis Swap Spreads* 5-year funding Bps Bps Swapping euro into A$ Swapping US$ into A$ -25 -25 -50 -75 -50 l l l l -75 * Premium paid for hedging cash flows on foreign currency bond issues Source: Bloomberg Over the past few years, issuance in the first quarter, particularly by Kangaroo issuers, has been strong. That has not been the case so far this year. Ratings uncertainty around European sovereigns has contributed to this. With the downgrade of a number of European sovereigns by some rating agencies in December, including France, some pan European entities, including the European Financial Stability Facility (EFSF), were downgraded. The European Investment Bank (EIB), historically a large issuer in the Australian market, was not downgraded, although it remains on negative watch. At times, there has been poor liquidity in the market, which has seen spreads on supranational debt marked a lot wider, particularly EIB, with little turnover behind the wider marks. Again, reflecting improved sentiment, those spreads have started to narrow. The final channel I want to talk about today is the sizeable flows occurring into Australian government debt. This has been evident for quite a few quarters now in the balance of payments statistics (Graph 5). Over the first three quarters of 2011, the net purchases of government securities by foreigners amounted to over 3 per cent of GDP, markedly larger than the current account deficit. This pattern of capital flows likely continued in the December quarter. As a result of these purchases, based on the ABS financial accounts data, our estimate is that around 75 per cent of the stock of Commonwealth Government securities (CGS) is held offshore, as at end September. Our discussions with market participants suggest that a sizeable share of recent purchases has been by sovereign asset managers. These investors tend to buy CGS predominantly (though not exclusively), rather than debt issued by the state government borrowing authorities (semis). This has contributed to the widening in spreads between CGS and semis. However, as the yields on CGS have fallen to 50-year lows, state borrowing costs are not all that high by historical standards notwithstanding the wider spreads. BIS central bankers’ speeches Graph 5 Australian Capital Flows Net inflows, per cent of GDP % % Current account deficit Public Private* -4 -8 -4 -8 * Adjusted for US dollar swap facility in 2008 and 2009 Sources: ABS; RBA This portfolio shift by foreign asset managers appears to be having an effect on the currency. The Australian dollar is close to its recent highs despite the terms of trade declining from their peak in the September quarter. Conclusion So these are some of the channels of influence of the situation in Europe on Australian financial markets. So far this year, that has been a more positive story than it was at the end of the last year. The major instigator of this change, in my opinion, was the ECB’s 3-year liquidity operation. Whether this happier state of affairs persists is difficult to tell. There have been outbreaks of optimism over the past couple of years which were dashed. I think the only thing which is certain, is that uncertainty is likely to persist for some time to come. In that regard I’d like to finish with a variation on the famous Rumfeldian take on uncertainty, recently articulated by David Murphy on his Deus Ex Macchiato blog: There are known unknowns and unknown unknowns, which complicate the pricing of risk, but over the past decade, there has also been a fair few examples of “too-lazy-to-be-knowns”. European sovereign debt before 2007 might conceivably fall into that category. While mispricing due to Knightian uncertainty is excusable, mispricing due to laziness is not. As I said last November, you’ve got to Know Your Product, otherwise, it can quickly turn into a case of No, Your Product.3 Aficionados of the Saints will be aware that these two songs bookend side one of Eternally Yours. This can be translated into financial terms as: If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 2 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia, Sydney, 16 February 2012. | Philip Lowe: The forces shaping the economy over 2012 Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia, Sydney, 16 February 2012. * * * This is the third year that I have had the pleasure of participating in CEDA’s annual Economic and Political Overview. Each of these years has brought us yet more economic surprises and challenges. In 2010, the world economy grew surprisingly quickly and commodity prices increased sharply. Then in 2011, global growth fell short of what was widely expected and the sovereign debt problems in Europe came to dominate much of the global economic and financial news. This morning, I would like to discuss some of the issues that are likely to shape the economic environment over 2012. These issues were also set out in the Reserve Bank’s quarterly Statement on Monetary Policy that was released last Friday. The global environment It is appropriate to start off with developments in the global economy, with the troubles in Europe seemingly in our newspapers every day. As was widely reported in mid January, the IMF recently lowered its forecasts for world growth. It is now expecting global GDP to increase by around 3¼ per cent in 2012, which is nearly ¾ of a percentage point lower than the forecast made in September last year (Graph 1). This rate of growth is below average, although it is well within the normal range of outcomes, and it is nothing like the very weak outcome recorded in 2009. The downward revision is largely due to developments in Europe, with the European economy now seemingly in recession. What we are seeing there is a fundamental shift in fiscal policies. For more than 30 years, many European governments spent much more than they raised in revenues. And financial markets were prepared to finance the difference at low interest rates, apparently ignoring the steady build-up of debt. This, of course, has now all changed and this change is a wrenching experience for the countries concerned. The sharp economic contraction has led to large increases in budget deficits at a time when the tolerance of public debt has diminished and financial markets, after having ignored risks for many years, can now see risks everywhere. These changes are also proving very difficult to manage. The task is made more complicated by having a single central bank, but many fiscal authorities. This set of arrangements has BIS central bankers’ speeches opened up issues that normally do not arise. Not least of these is the question of under what conditions is it appropriate for the single central bank to buy the government bonds of just one, or a few, of the members of the currency union. This is an issue that the Federal Reserve in the United States, the Bank of England and the Bank of Japan have not had to confront as they embarked on their own large-scale purchases of government debt in an effort to lower long-term yields. Working through the various challenges is taking the Europeans time. The process has been frustratingly slow and we have witnessed some missteps along the way. But for all of that, we should not lose sight of the fact that progress is being made. Late last year there was a palpable sense that something might go badly wrong over our summer. Clearly, that has not happened. Instead, government bond yields for some of the troubled countries in Europe have declined a little (Graph 2). Equity markets have picked up and confidence has improved a bit. And significantly, bank debt markets are functioning again, although the cost of issuing bank debt, relative to government yields, is higher than it was in the middle of last year. As my colleague, Guy Debelle, discussed earlier this week, an important development over recent months was the ECB’s decision to make unlimited funds available (subject to adequate collateral) to the European banking system for three years at an interest rate of just 1 per cent.1 All up, around ½ trillion euros have been lent and a further operation is scheduled to take place later this month. There has also been progress through the various euro-area summits in building political structures that, over time, have the prospect of delivering more disciplined fiscal policy than has been the case in the past. Clearly, more will need to be done, and there is still the possibility of a very disorderly outcome in Europe. But, at least for the time being, the probability of this seems to have declined a little. Obviously how things play out on this front will have a major bearing on how the world economy evolves over 2012. A related issue that I suspect will be discussed frequently in 2012 and beyond is the impact of fiscal consolidation on economic growth. Over 2012 and 2013, fiscal policy is set to be quite contractionary in both Europe and the United States as governments attempt to put their public finances on a sounder footing. Indeed, the aggregate fiscal contraction across the advanced economies is likely to be the largest seen for many decades. This is not because Debelle, G, “On Europe’s Effects on Australian Financial Markets”, Address to Bloomberg Seminar, Sydney, 14 February 2012. BIS central bankers’ speeches the size of the fiscal consolidations in individual countries is unprecedented, but rather because the consolidations are occurring simultaneously in a large number of countries. Unusually, they are also taking place in an environment where output in the affected countries is considerably below potential. The economic literature is mixed on the effects of fiscal consolidation on growth. There are certainly some examples where consolidation has been associated with fairly strong GDP growth. But in most of these examples, the countries undertaking the fiscal consolidation have benefited from some combination of robust growth in their trading partners, an easing of monetary policy and a depreciation of their exchange rate. Given the nature of the current situation, it is unlikely that the advanced economies, as a whole, can benefit from these factors. There is therefore a material risk that fiscal consolidation weakens growth in the short run, which leads to more fiscal consolidation in order to meet previously announced targets and, in turn, yet weaker growth. We are currently seeing this dynamic play out in a couple of the countries in southern Europe. If it is not to be repeated on a wider scale, the fiscal consolidation in the North Atlantic economies will need to be accompanied by reforms to the supply side that lift the underlying rate of growth of these economies. As interesting as the developments in Europe are, it is important that we do not lose sight of what is going on elsewhere in the world. In the United States, the recent data, particularly on the labour market, have been better than was widely expected (Graph 3). There are also some tentative signs of improvement in the housing market. Corporate balance sheets are generally in good shape and borrowing costs are low. While, undoubtedly, the US economy still faces many challenges, it does seem to have emerged from the soft patch in the middle of 2011 with some momentum. The Chinese economy is also continuing to grow solidly. The pace of growth has slowed, but it has done so in line with the authorities’ intentions. Inflation in China has also moderated. Across the rest of east Asia, the recent data have been mixed. Nevertheless, for the region as a whole, growth in 2012 is expected to be around trend, with domestic demand likely to play a more important role in generating growth than it has for most of the past two decades. Overall, as the IMF recently noted, the global risks still look to be tilted to the downside. But the better-than-expected US data and signs of some progress in Europe have lifted sentiment a little since the turn of the year. In January, business surveys for the manufacturing sector (the so-called PMIs) were up across the globe – in the United States, China, east Asia and even in the euro area (Graph 4). A similar picture is also evident in the available surveys for the services sector. While it is too early to be confident that this trend will continue, these timely surveys suggest that 2012 started a little better than many had expected. BIS central bankers’ speeches The Australian economy I would now like to turn to developments in Australia. At the moment, the economy is being influenced by a large number of factors. These include the sovereign debt problems in Europe, the changes in household spending patterns, and the softness in the housing market. But this morning I would like to focus on the two factors that are perhaps having the most profound effects. And they are, on the one hand, the investment and terms of trade boom and, on the other, the very high exchange rate. These factors are, of course, interlinked, and in many respects are different sides of the same coin. The investment boom in the resources sector, which the RBA has been discussing for some time, is clearly well underway. Over the past year, business investment has risen by around 20 per cent and there is more to come. Given the plans that have already been announced, the RBA is expecting double digit increases in business investment in each of the next couple of years. If this occurs, it would take the ratio of investment to GDP to a record level by a considerable margin (Graph 5). It is not an exaggeration to say that this is a once-in-a-century investment boom. It is, of course, occurring at a time when the terms of trade are also at a very high level, with the industrialisation and urbanisation of Asia supporting commodity prices and putting downward pressure on the prices of manufactured goods. This boom is having positive spill-over effects to a number of industries, with some of these effects being direct and others being indirect. BIS central bankers’ speeches The indirect effects come through a variety of channels. Day to day, they can be hard to see but they do percolate through the economy. In effect, there is a chain that links the investment boom in the Pilbara and in Queensland to the increase in spending at cafés and restaurants in Melbourne and Sydney. This chain starts with the high terms of trade that has pushed up the Australian dollar. In turn, the high dollar has meant that the prices that Australians pay for many manufactured goods are, on average, no higher than they were a decade ago, despite average household incomes having increased by more than 60 per cent over this period. The stable prices for many goods, combined with strong disposable income growth means there is more disposable income to be spent on services in the cities and towns far from where the resources boom is taking place. As I said, this chain can be hard to see, but it is real, and it is one of the factors that have had a material effect on the Australian economy over recent years. At the same time, the high exchange rate is having a contractionary effect on other parts of the economy, as it reduces the international competitiveness of some industries. Over recent months, the Australian dollar has appreciated despite the uncertainty about the global economic outlook and some decline in commodity prices since mid 2011. After adjusting for differences in inflation rates across countries, the exchange rate is currently at around its highest level since the early 1970s (Graph 6). The effects of the high exchange rate are evident in the manufacturing, tourism and education sectors, as well as some parts of the agriculture sector and, more recently, in some business services sectors. With the exchange rate having been high for some time now, more businesses are re-evaluating their strategies, as well as their medium-term prospects. In some cases, this is prompting renewed investment to improve firms’ international competitiveness. But in other cases, businesses are scaling back their operations in Australia and some are closing down. These changes are obviously very difficult for the firms and individuals involved. Both the investment boom and the very high level of the exchange rate are historically very unusual events. This makes it difficult to assess their net effect. It seems, however, that over the past year these forces have balanced out reasonably evenly. Abstracting from the weather-related disruptions in early 2011, GDP growth over the year was likely to have been around trend. Underlying inflation was at the midpoint of the medium-term target range. The unemployment rate remained low at 5–5¼ per cent. And most lending rates in the economy were around average by end year. It is fair to say that very few developed economies could make these same claims. BIS central bankers’ speeches Looking forward, there are reasonable prospects that these favourable aggregate outcomes can continue for a while yet. The RBA’s central forecasts, which were released last week, are for around trend growth in the economy over the next couple of years, and for underlying inflation to remain in the 2–3 per cent range. The unemployment rate is also expected to remain low, although some increase is possible over coming months. At the industry level, the picture is a lot more complicated. The economy is clearly going through a period of heightened structural change, and this is set to continue. Some industries are expanding in relative importance, while others are contracting. Given this, it is difficult to be sure how the countervailing expansionary and contractionary forces will balance out. So at the RBA we are carefully examining every piece of data that comes in for insight into the net effect of these forces. We are also frequently talking to businesses and industry groups to better understand what is happening in firms at the forefront of structural change. It is the balance between these various forces that is likely to be a major influence on how the Australian economy evolves over 2012 and beyond. Before I conclude, I would like to say just a few additional words about the outlook for inflation. Over recent quarters, headline inflation has come down as expected due to the unwinding of the large rise in fruit and vegetable prices that occurred in early 2011 (Graph 7). Over the next few quarters further declines in the year-ended headline inflation rate are expected as the earlier increases in food prices fall out of the figures. Indeed, it is likely that the headline rate will fall below 2 per cent in the middle of 2012, before increasing again to above 3 per cent. This increase is partly due to the introduction of a price on carbon, which is estimated to add 0.7 percentage points to headline inflation in the 2013 financial year. As was the case with the introduction of the GST more than a decade ago, the Bank will look through this direct effect when setting monetary policy. In underlying terms, inflation is expected to remain within the 2–3 per cent range over the next couple of years, with the carbon price adding around ¼ percentage point to underlying inflation in the 2013 financial year. One interesting aspect of the recent inflation data is the divergent trends in the prices of internationally traded items and the prices of goods and services that are not internationally traded (Graph 8). Over recent times, the prices of non-traded goods and services have been increasing at a fairly firm pace, although down markedly from the rates in 2007 and 2008. The overall CPI inflation rate has, however, been held down by a decline in the prices of tradable goods as a result of the exchange rate appreciation. But the prices of these goods are unlikely to continue to fall over the medium term, particularly as the effects of the exchange rate appreciation dissipate. As a result, some slowing in the rate of increase in the prices of non-tradables is likely to be required at some point for overall inflation to remain consistent with the mid-point of the target range. BIS central bankers’ speeches While we cannot be sure that non-tradables inflation will moderate, there are reasonable prospects that it will do so. The Bank is expecting a modest pick-up in productivity growth over the period ahead from the low rates of recent years, as well as a slight moderation in wage growth. Together, these developments would help lessen cost pressures in the economy and thus see some slowing in the rate of non-tradables inflation. In the event that they did not occur, it is likely that non-tradables inflation would be uncomfortably high. Conclusion So, to conclude, 2012 will no doubt again contain its fair share of surprises. Globally, we are seeing events that are historically very unusual, including widespread fiscal consolidation in the advanced economies and the rapid development of emerging market economies, with hundreds of millions of people entering the global economy. In Australia too, we are experiencing events that are historically unusual – a huge boom in investment and a very high exchange rate, both of which are related to the very high level of the terms of trade. In this environment, economic forecasting seems to have more than the usual number of pitfalls. However, we can take some comfort from the fact that despite these powerful forces, the Australian economy started 2012 in relatively good shape. Growth has been around trend and inflation is consistent with the target, and there are reasonable prospects for this to continue. We also have much more flexibility to deal with unfolding events than almost any other developed economy. I wish each of you success as you navigate your own way through 2012. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 2 |
InteOpening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 24 February 2012. | Glenn Stevens: Latest 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, 24 February 2012. * * * When we last met with the Committee in August, we had entered a period of heightened uncertainty about the global economy and financial system. The investment community was focusing increasingly on the high levels of public debt in major countries, and especially on the situation in the euro area, where budgetary pressures, banking pressures and competitiveness issues within the single currency area make for a very difficult set of problems. There was considerable instability in markets. But our view at that time – tentatively – was that we were not witnessing a repeat of the events of late 2008. Admittedly, the second half of 2011 saw some very anxious moments. There was a flight from risk that pushed up borrowing costs for major countries like Spain and Italy, but pushed them down for countries like Germany and the United States to the lowest levels for more than 50 years in spite of the fiscal challenges the US itself faces. Funding markets for European banks in particular effectively closed for a few months, and for other banks became much more difficult and certainly more expensive. The palpable fear before Christmas that Europe was on the brink of some sort of very bad financial event has lessened over our summer. The anxiety has not gone entirely away, and nor will it for some time. But the worst has not happened. Financial markets, while hardly brimming with confidence, have recovered somewhat over the past couple of months. Banks are able to access term funding markets again, albeit at higher cost. High-frequency gauges of business conditions and confidence have stabilised over the past couple of months in Asia and North America, and even in Europe. We have not seen the very steep fall that we saw in all these indicators in late 2008. The actions of the European Central Bank contributed greatly to the stabilisation of financing conditions, essentially by removing, for a time, questions over the funding of European banks. The efforts of European leaders to craft a stronger framework for euro-wide governance on the fiscal side have also continued. A great deal more needs to be done to place European banks and sovereigns onto a stable footing, and to boost potential growth in Europe. But progress is being made. Forecasts for the global economy in 2012 have been marked lower, mainly due to the effects of the problems in the euro area. Revisions to the IMF’s forecasts in particular have been given great prominence. Our own forecasts have come down too, though they had already been a bit weaker than the IMF’s. On these forecasts, global GDP will grow by about 3¼ per cent in 2012. That is down from about 3¾ per cent in 2011, which was about the average rate of growth over the past 15 years. On its face, this performance, should it occur, would be no disaster. After all, growth is going to be below average some of the time. If we look for things to worry about, we will certainly find them. The global outlook has a very uneven composition: some countries, particularly in Europe, will record very weak outcomes. Moreover it is unlikely that a moment will come any time soon when we will be able to say the problems in Europe are behind us. Progress will be slow and there will be periodic setbacks and bouts of heightened anxiety – that is the nature of these things. But equally, we should recognise that things have not been uniformly bad recently. The US economy has not experienced the “double dip” some had feared six months ago, but instead has continued growing. The US corporate sector is in very strong shape, is cashed up and will at some point be able to start moving ahead more quickly. It appears American corporations have stepped up the pace of hiring in the past few months. BIS central bankers’ speeches In China, the slowing in growth we have seen seems to have been roughly what the policymakers were looking for, and they appear to be getting on top of their inflation and housing boom problems. Around the rest of Asia, activity has also slowed, in part reflecting trade links with Europe. But it has not slumped and as inflation comes down, policymakers have increased room to respond. The pressure on European banks to shed assets has led to some tightening of trade credit in the Asian region, but at this stage the system seems to be adjusting to that without major drama. We have not, to date, seen the collapse of trade credit and trade flows we saw in late 2008. Commodity prices, which had declined noticeably from their peaks in the first half of 2011, have actually moved sideways, or in some cases picked up a bit, for a few months now. They remain high by historical standards. That seems roughly consistent with the group of countries that makes up Australia’s main trading partners expanding at a reasonable pace – expected by the IMF to be over 4 per cent this year, not very different from last year. Again, we do not, at this point, see the signs of the rapid collapse in global demand we saw three years ago. At home, most of the information coming in suggests the economy has grown at close to an average pace over the past year. This outcome was weaker than we had expected a year ago. It was partly due to the effects of flooding on resource production but also due to softer outcomes in the non-resource side of the economy. CPI inflation has come down, as expected, as the impact of last summer’s floods on food prices reverse. In underlying terms, inflation was about 2½ per cent over 2011, also a slightly lower outcome than we had, at one point, thought might occur. The labour market was generally softer in 2011 after a year of unusual strength in 2010 (though the unemployment rate at its latest reading was virtually unchanged from a year earlier). These changes to the macroeconomic picture, against a backdrop of a period of intensified international turmoil, saw the Board lower the cash rate by 50 basis points in the closing months of 2011. Perhaps surprisingly in the face of developments in wholesale funding costs, this was initially fully reflected in a reduction in most lending rates, though there has been a partial reversal of that recently. We have repeatedly made clear that the shifting relationship between the cash rate and other rates in the economy is a factor the Board takes into consideration in setting the cash rate. That will remain the case. Recent developments do not materially affect the capacity of monetary policy to achieve its goals. Looking ahead, the Bank’s central expectation is for growth to be close to trend, and inflation close to the target, over the coming one to two years. There are, naturally, risks surrounding this central view. Those are spelled out in the latest Statement on Monetary Policy. Perhaps what is most noteworthy about the Australian economy is the way in which the drivers of growth have changed in recent times. The Bank has spoken at length before about the terms of trade, and the resulting resource investment boom, which is still building and which will take the share of business investment in GDP to its highest level for 50 years. We have spoken also about how, on the other side, household behaviour has changed – people are saving more and borrowing less. Spending is growing in line with income, but people are spending their money differently. The retail sector is finding it has to adapt to this changed environment. Some other industries are struggling with the high exchange rate. Meanwhile certain service sectors are growing quite smartly. Hence, while the economy overall has recorded “average” growth, few sectors are in fact experiencing “average” performance themselves – some are clearly quite weak relative to average, while some others are much stronger. The Bank is quite aware of these differences and the pressures they bring to businesses and individuals. But we also know that monetary policy cannot remove the forces generating different paces of growth in our economy. We have to keep our eye on the overall performance of demand and prices. We are acutely conscious that history may offer limited BIS central bankers’ speeches guidance in assessing the net impact of the disparate and very powerful forces that are at work. Nonetheless, that is the assessment we must try to make. Our most recent assessment was that, with growth near trend, inflation consistent with the target, interest rates about average and an outlook suggesting more of the same, the setting of policy was about right for the moment. Of course, we continue to reassess things each month. My colleagues and I are here to respond to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 2 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Industry Group 12th Annual Economic Forum, Sydney, 7 March 2012. | Philip Lowe: The changing structure of the Australian economy and monetary policy Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Industry Group 12th Annual Economic Forum, Sydney, 7 March 2012. * * * I would like to begin by thanking the AiGroup for the invitation to once again speak at the annual Economic Forum. When I spoke at last year’s Forum, the title of my remarks was “Changing Relative Prices and the Structure of the Australian Economy”. Today, I would like to revisit this topic of structural change, first talking about some of the adjustments that are taking place within the Australian economy and then, second, discussing some of the implications of these adjustments for monetary policy. Structural Change in the Australian Economy Structural change is, of course, something that is not new. It is one of the ongoing features of all economies. Over the past half a century, one of the most obvious changes has been the growth of the services sector, which has accounted for a steadily increasing share of both output and employment. In 1960, for example, a little over 50 per cent of the workforce in Australia was employed in the services sector. Today, the figure is over 75 per cent (Graph 1). Conversely, the shares of manufacturing and agriculture have steadily declined. Graph 1 1 These trends have been driven by a range of factors, but three stand out. The first is that the demand for services has increased faster than the demand for goods as average incomes have risen. The second is that most services are produced domestically rather than imported. And the third is that the rate of labour productivity growth in the production of Withers G, T Endres, and L Perry (1985), “Australian Historical Statistics: Labour Statistics”, Australian National University Source Papers in Economic History No 7. BIS central bankers’ speeches services is lower than that in the production of goods. Not surprisingly, these same general influences have also been at work in all other advanced economies. Beyond these long-term influences, the structure of the Australian economy is currently also being affected by a number of other factors that are more unusual in nature. I would like to take a few minutes to talk about two of these. The Mining Boom and the Exchange Rate The first is the mining boom and the high exchange rate. As is well known, Australia is currently experiencing, on the one hand, a once-in-a-century terms of trade and investment boom and, on the other, a very high exchange rate. These events are, of course, related to one another and are really different sides of the same coin. It is worth noting that these developments have not led to unusually large shifts in the industry structure of employment, and they are unlikely to do so. While employment in the mining sector has increased by around 70,000 people, or 40 per cent, over the past couple of years, its share of total employment is still low and the mining boom will not change the fact that the vast bulk of Australians work in the services sector. Instead, due to the capital-intensive nature of mining, it is in the investment figures where the evidence of structural change is clearest. Over the next few years, mining-sector investment will reach new highs as a share of GDP, and is likely to account for around 40 per cent of total business investment (Graph 2). Structural change is also clearly evident in the export numbers, with resources now accounting for around 60 per cent of total exports, up from 35 per cent a decade ago. Graph 2 This boom in the mining sector and the terms of trade is having positive spillover effects to a number of areas of the economy, including parts of the services sector. It has delivered a very substantial increase in Australia’s real income and this increase has boosted spending. But the accompanying high exchange rate is also having a contractionary effect on a number of sectors of the economy. The manufacturing sector is clearly one of these. Over the past decade there has been little growth in manufacturing output and the level of employment has declined, particularly over BIS central bankers’ speeches the past couple of years (Graph 3). Exports of manufactured goods also remain below the level reached in 2008. This stands in contrast to the volume of global trade which has regained its earlier peak. Graph 3 Notwithstanding these trends, manufacturing still has an important role to play in the Australian economy. It employs around 950,000 people and accounts for 9 per cent of output. This role is, however, changing. Realistically, Australia cannot hope to be a large-scale producer of relatively standardised, plain-vanilla, manufactured goods for the world market. But what we can be is a supplier of manufactured goods that build on our comparative advantages: our educated workforce; our ability to design and manufacture specialised equipment; our reputation for high-quality food; our research and development skills; and our expertise in mining-related equipment. Inevitably, the high exchange rate means that the manufacturing industry has little choice but to move up the value-added chain in order to compete. This is, of course, a lot easier to say than to do. It means difficult changes for many firms and those who work for them. It also means ongoing investment in human capital and the latest machinery and equipment and constant attention to improving productivity. One piece of evidence that things are moving in this direction is in the ABS business characteristics survey, which asks firms a series of questions about innovation. In this survey the manufacturing sector clearly stands out as one where firms are actively reviewing their business practices and, over recent times, they have been doing this more frequently (Graph 4). No doubt, more of this will be required over the years ahead. BIS central bankers’ speeches Graph 4 The changes within manufacturing are also evident in the export figures. While, in aggregate, exports of manufactured goods are little changed from their level in 2007, there has been strong growth in some categories including specialised industrial machinery and professional and scientific instruments (Graph 5). These are both areas where human capital and specialised skills are important. In contrast, exports of motor vehicles and construction materials are well down on their earlier levels. Graph 5 Another area of the economy where the high exchange rate is having a noticeable effect is the tourism sector. As is the case in the manufacturing sector though, the story is not uniform across the industry. Indeed, the structural change that is occurring in the economy is taking place not just across industries, but within industries as well. BIS central bankers’ speeches The boost to real incomes from the mining boom has clearly increased Australians’ ability to travel. However, the high dollar has contributed to a decline in travel to the traditional domestic holiday destinations, with Australians travelling overseas in ever increasing numbers. This has created quite difficult conditions for parts of the industry with, for example, room occupancy rates along the Queensland coast having fallen over recent years (Graph 6). In contrast, conditions are noticeably stronger in the accommodation sectors in some of the large cities which are benefiting from an increase in business travel and an apparent shift in preferences by overseas tourists for city-based experiences. In Sydney, for example, room occupancy rates are at quite high levels. Graph 6 Household Spending and Borrowing A second general factor that has been driving changes in the structure of our economy is the adjustment in household borrowing and spending behaviour. The RBA has talked frequently about this issue over recent years, and the flow-on effects are evident in various parts of the economy. One of these is the property market. In the early 2000s, when the property boom was in full swing and investors were busy buying properties to rent out, around one in 12 dwellings in Australia was changing hands each year (Graph 7). Today, the rate of turnover is only about half of this, with around one in 25 dwellings changing hands last year. This lower rate of turnover has contributed to weak employment growth in the real estate sector over recent years, after many years of strong growth. BIS central bankers’ speeches Graph 7 The change in household behaviour is also affecting the financial sector. Financial institutions are having to learn to live with much lower growth in their balance sheets than was the case over recent decades. This is leading to changes in business practices, and there has been a slight decline in employment in the banking sector over recent years. Conversely, there has been strong growth in employment in the provision of financial advice, partly due to the steady inflows into superannuation funds. A third area where the change in household behaviour is having a structural effect is in the retail industry. While I talked earlier about the increase in the consumption of services, there are also significant changes taking place within the retail industry. Perhaps the most striking of these is the decline in sales at department stores and clothing and footwear retailers (Graph 8). Indeed, since early 2009, the volume of sales in these stores has declined by around 6 per cent. This stands in contrast to relatively steady growth in the volume of sales in the rest of the retail industry. BIS central bankers’ speeches Graph 8 There are a variety of explanations for these divergent trends, but there is no doubt that the greater price transparency brought about by the internet is part of the story. Many Australians have worked out that the prices charged by domestic retailers for certain goods are higher than those charged by overseas online retailers. Whether this price difference is because of higher domestic costs or because foreign manufacturers and wholesalers are selling into the Australian market at higher prices, Australian consumers have responded by increasingly going online. As in the other areas of the economy that I have talked about, this is causing a rethinking of business models and retailers are having to make changes to the way they run their businesses. So, putting all this together, the overall picture is a pretty complicated one. How you view the economy depends very much on your perspective. Even within specific industries, experience can vary widely from firm to firm. To date though, while there are obviously large effects on individual businesses and people, the various cross currents have balanced out reasonably well from a macroeconomic perspective: GDP growth is close to trend, inflation is consistent with the target, interest rates are around average and unemployment is low. These macroeconomic outcomes are much better than those being recorded in other advanced economies. However, the various cross currents are having an unsettling effect on parts of the community, with many people focusing on the costs of structural change. These costs are undoubtedly real and they are not borne evenly across the country. However, the benefits of structural change are also real and, over time, as we have seen in the past, these benefits do get spread widely across the population. If Australia is to take advantage of the opportunities that lie ahead, the structure of the economy must continue to evolve and we need to ensure that our labour and capital are used where the returns are highest. Implications for Monetary Policy I would now like to turn to some of the implications of the ongoing structural change for monetary policy. There are four closely related observations that I would like to make. The first is that structural change adds to the difficulty of assessing the balance between supply and demand in the economy. Given the historically unusual nature of the forces affecting the economy, history provides only limited guidance as to the magnitude of their ultimate effects. This is one reason why the Reserve Bank is devoting considerable BIS central bankers’ speeches resources to understanding these forces, including by frequently talking to businesses at the forefront of this structural adjustment. The second observation is that the main role for monetary policy is to keep inflation low and stable. The current list of economic uncertainties is long enough without adding uncertainty about the general level of prices to the list. The task for monetary policy is to ensure stability in the overall economy so that difficult decisions at the firm and industry level are not further complicated by macroeconomic instability. In undertaking this task, the Bank needs to understand the forces driving structural change, and we are working hard on this. But it is important to recognise that the RBA can do little to affect these forces. As I said at last year’s Forum, the emergence of Asia as a major force in the global economy has shifted world relative prices and this underlies many of the changes that are occurring in the Australian economy. This shift in relative prices is not something that monetary policy in Australia can influence. It is driven by global developments and is causing adjustments not just in Australia, but around the world. Monetary policy in Australia can, however, help in our own adjustment process by keeping the overall economy on an even keel. The third observation is that the flexibility of the economy is important when structural change is taking place. To the extent that there are significant impediments to resources moving between industries and/or parts of the country, these impediments are likely to worsen the short-run trade-off between inflation and unemployment. While the degree of flexibility in the economy is determined by factors other than monetary policy, it can have an important bearing on overall macroeconomic outcomes. And the final observation is more directly about the link between monetary policy and the exchange rate. It has been argued in some quarters that Australia’s high interest rates by current world standards have put upward pressure on the exchange rate, and thus have added to the pressures being experienced in some industries. Some who have argued this see part of the solution as being a material easing of monetary policy. The difficulty with this argument is that, at least on the evidence to date, something like the current combination of exchange rates and interest rates appears to be what is needed to maintain overall macroeconomic stability. The high exchange rate and the high interest rates relative to the rest of the world are both being driven by the fact that Australia is a major beneficiary of the change in world relative prices. They are both playing an important role in preserving overall macroeconomic stability, something which has proved very difficult to achieve in previous resources booms, which typically ended in a bout of serious inflation with significant costs to the community. Of course, it is possible for exchange rates to overshoot. Australia is seen by foreign investors, including central banks and sovereign wealth funds, as an attractive destination for investment, and we need to be alert to the possibility that portfolio flows could push up the exchange rate too far. While the evidence of the past 30 years is that movements in the exchange rate have been an important stabilising force for the Australian economy, the unusual nature of the current forces means that we need to watch things closely. An important indicator here is the labour market with the unemployment rate having been in the 5 to 5¼ per cent range over the past year. If the unemployment rate were to rise persistently, it might suggest that the contractionary effect of the high exchange rate was more than offsetting the expansionary effect of the investment boom and the terms of trade. If this were to turn out to be the case, monetary policy would have the flexibility to respond provided the inflation outlook remained benign. Conclusion To summarise, the challenge that we Australians face is to make the best of the fundamental changes that are taking place in the global economy. As a country rich in natural resources, BIS central bankers’ speeches we are well placed to benefit from this change. But if we are to take advantage of this opportunity, the structure of the economy must continue to evolve. Labour and capital will continue to shift to the resources sector. Industries affected by the high exchange rate will need to find ways of moving up the valued-added chain. And parts of the service sector will need to continue their adjustment to the changes in household spending and borrowing. These adjustments are difficult, but if they are not allowed to occur, as a nation we will have given up the potential benefits that the changes in the world economy are making possible. Public policy can help in the adjustment process by promoting flexibility in the economy and by reducing some of the costs of change for individuals and communities. It can also help manage some of the new risks arising from these global developments. Monetary policy can help the adjustment by keeping inflation under control and maintaining stability in the overall economy. Our judgement is that the current setting of monetary policy is consistent with this, with the Board keeping the cash rate unchanged at 4.25 per cent at its meeting yesterday. I would like to thank you very much for your time this morning, and I am happy to answer questions. 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Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Credit Suisse 15th Asian Investment Conference 2012, Hong Kong, 19 March 2012. | Glenn Stevens: Economic conditions and prospects Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Credit Suisse 15th Asian Investment Conference 2012, Hong Kong, 19 March 2012. * * * Thank you for the invitation to join this conference here in Hong Kong. Asia remains one of those parts of the world where prospects for growth are exciting, and where people expect – for good reason – the future to be better than the past. Yet for the past six months or more, global attention has been riveted on the “old world” – continental Europe – where many have feared the best was in the past. The Reserve Bank of Australia has taken a very close interest in the events in Europe. At the purely analytical level, the sheer magnitude and complexity of the problems that have arisen will be a fertile area of study for students of economics and other disciplines for decades to come. Of course the adoption of the euro was not solely, maybe not even primarily, an economic decision, but it nonetheless had economic consequences. In several very important respects the euro area’s first decade was a remarkable success. But there were important structural stresses underneath and some of these have suddenly become more visible in the past few years. Now the euro’s future depends on whether the commitment of the Europeans extends to building more of the economic sub-structure consistent with the single currency, which will entail both fiscal and supply side reforms. It is of course quite difficult to lay foundations when the house has already been erected on the site, but that is the job ahead in Europe. I think the evidence is that European policymakers understand the importance of their response and are going to great lengths to implement it. Progress has been made. But there is a long way to go yet. During that long journey, there will surely be numerous episodes of heightened anxiety, any one of which could erupt into a more extreme crisis if one or more of the key actors makes a serious mistake. In terms of the practical impact of these events, at present we can say that the euro area has been in recession for some months. Some individual countries have been in a deep downturn for much longer than that, but I am speaking here of the euro area in aggregate. The recession is expected by official forecasters in Europe, and bodies like the IMF, to be a relatively mild one, though all would acknowledge that it is impossible to be sure, as is usually the case with such episodes. We see three potential channels of effects from these events to Australia. The first is a direct trade link. Australia’s exports of goods and services to Europe are actually quite modest (Table 1). By far the biggest trade relationships these days are with Asia. Hence, a bigger impact of the euro crisis on Australia would come indirectly via trade with Asia. It is pretty clear that growth across much of East Asia moderated in 2011 and that there has been some effect of the slower euro area economy on Asian exports. There have been other forces at work too – the Japanese tsunami a year ago had significant effects on production chains around Asia. These effects had probably not completely disappeared when the floods in Thailand had another significant impact, which may still be affecting the data. So detecting the effects of weaker European growth against the backdrop of the supply disturbances to trade patterns following these natural disasters might be a little like trying to pick up one conversation in a crowded room: there’s a lot of background noise. BIS central bankers’ speeches But most of the high-frequency data on trade and production did not seem to show the slowing intensifying as we went into 2012. It is too early yet to say that a new strengthening is under way. But we do not seem to be seeing the signs of a rapid fall in trade that we saw in late 2008. A reference to 2008 brings me to the third channel through which we think about the effects of the European crisis. And it is perhaps the most unpredictable and potentially most damaging kind: the financial link. It would not be the direct exposures of Australian institutions to the most troubled countries of Europe that would be of concern, because those are quite small. It would be the more general impact on global markets of a European problem. What we saw in late 2008 was effectively a closure of funding markets for financial institutions for a period, after the failure of Lehman Brothers. These sorts of events affect virtually all countries, because the impacts on credit conditions, trade finance, share prices, and household and business confidence – all of which lead to precautionary behaviour – occur almost instantaneously everywhere. There was a period late in 2011 where there was a genuine fear that this could happen again. Funding markets tightened up and effectively closed for many European banks. Interbank activity more or less ceased in Europe. The cocktail of sovereign credit concerns, large bank exposures to those sovereigns, possible bank capital shortfalls and prospective large debt rollover needs of banks, not to mention the unpredictable dynamics of the Greek workout, had everyone very much on edge. The effects were felt globally. The actions of the ECB have alleviated the immediate funding issues for banks. Tensions eased a good deal, and this has been reflected in reopened term markets, falls in sovereign spreads for countries like Italy and Spain, and a rise in equity prices. We have also heard reports that BIS central bankers’ speeches some European participants in trade finance in Asia that had been pulling back in the last quarter of 2011 have begun to seek some business again recently. Yet much more needs to be done to put sovereigns and banks onto a sound footing longer term. Interbank activity remains constrained and unsecured funding remains expensive for banks. It is noteworthy that large corporates can borrow more cheaply than can banks with higher credit ratings, such is the odium investors attach to banks (though this is not confined to Europe). Much also has to be done on the supply side to generate growth in Europe, for without growth the fiscal arithmetic will always be challenging, if not impossible. The road to sustainability on these multiple fronts is a long one, which is why, as I say, there will be more periods of anxiety in the months (and years) ahead. While everyone has been fixated on Europe, the United States economy has avoided a “double dip” recession, and continues grinding out a modest expansion. In recent times, the pace of jobs growth in the United States has picked up and other labour market indicators are showing signs of improvement. The United States has its own challenges of course, not least that it must sooner or later have some fiscal consolidation and that may slow growth. America’s inherent dynamism and capacity to innovate, however, which is matched by few other societies, has to be seen as a positive over the longer term. Then there is China. The slowdown in Chinese growth – from 10 per cent to a mere 8 per cent! – is a major talking point, and some see it as portending a major crash. But some slowing was required to reduce inflation and, therefore, put growth on a more sustainable path. One can certainly think of ways in which China could have a “hard landing” at some point. It is very difficult for anyone to know (doubly difficult, I think, if trying to know while sitting in a trading room in New York or London). But if the Chinese economy does slow “too much”, one could expect that the Chinese authorities will have both the will and the capacity to respond, the more so now that inflation has moderated. China will have cycles like other economies, but it seems likely that the Chinese economy will grow pretty strongly on average for a while yet. It will be a very large economy. Even at the new growth target of 7½ per cent, a lower target than in the past five years (all of which were, of course, exceeded), Chinese GDP will equal that of the United States, in Purchasing Power Parity terms, in about a decade. It will exceed that of the euro area within the next few years. There are issues of rebalancing the sources of growth in Asia, to which I shall return shortly. But the main point for now is that the global economy is faced at present with a year of subtrend growth in 2012, according to international forecasters. This is a subdued but not disastrous outcome. And Asia in particular is well-placed to do fairly well, given sensible policies. Downside risks certainly do remain, and are easier at this point to imagine than upside ones. At this point though they remain risks, rather than outcomes. What then about Australia? At the moment, the viewpoints of those inside Australia differ somewhat from those of people outside Australia. Viewed from abroad, judging by what people say, observers see an economy that experienced only a relatively mild downturn in 2008–2009, that made up the decline in output within a few months, and that has continued to expand, albeit at only moderate pace, since then. They see an economy that has not experienced a significant recession for 20 years, that has strong banks and little government debt – and that debt remains AAA-rated. Some observers worry about high levels of housing prices and household debt. This is understandable given the problems that have occurred in some other countries. But then others point out that the arrears rate on mortgages, at 60 basis points, is quite low, and that the rate of new construction of dwellings in recent years has been low relative to population needs. BIS central bankers’ speeches Foreign investors see a country that remains quite open to them, and that, reflecting its economic circumstances, offers rates of return that are high by international standards, even though they are low by Australian historical standards. They understand the potential returns on the mineral and energy wealth stored in or around the Australian continent, and that our terms of trade have over the past year been higher than at any time for more than a century. There has been increased appetite for Australian dollar denominated assets, particularly sovereign debt, and the Australian dollar has risen strongly, to be at its highest level in three decades. Those at home see this as well. As consumers, they have responded to the higher exchange rate with record levels of international travel. As producers, however, they also see, with increasing clarity, that the rise in the relative price of natural resources amounts to a global and epochal shift, which carries important implications for economic structure in Australia, as it does everywhere else. Some sectors of the economy will grow in importance as they invest and employ to take advantage of higher prices. Other sectors will get relatively smaller, particularly in the traded sector, as they face relatively lower prices for their products and competition for inputs from the stronger sectors. The exchange rate response to this shift in fundamentals is sending very clearly the signal to shift the industry mix, though this would occur at any exchange rate. The shift in relative prices is a shift in global prices that is more or less invariant to the level of the Australian dollar. In other words, while the global shift in relative prices is income-enhancing for Australians overall, it is also structural change-inducing. A former leader once quipped that “microeconomic reform” was such a common topic in Australian discussion that even the parrots in pet shops were talking about it. I think the same is increasingly true of structural change: it is a term that will be on everyone’s lips over the next few years. Structural adaptation is hard work. Few volunteer for it. But we have little choice but to do it, not just to make the most of the new opportunities that have been presented, but to respond to the changed circumstances that some industries face as a result. In this sense, Australia, though blessed with many natural endowments, is in the same position as most other nations. We have to adapt to changing times. This perhaps helps to explain the sense of concern in some parts of the Australian community and the tendency to focus on the difficulties, rather than the opportunities, which come with our situation. This difference in perceptions between foreigners and locals is quite unusual. For most of my career, the difference has tended to be in the opposite direction. We always seemed to struggle to get foreign observers and investors to give us credit for performance we thought was pretty reasonable. And it is only little more than a decade ago that Australia was being described as an “old economy”. Now perceptions have changed, at least in a relative sense. The shift in global portfolio allocation that seems to be associated with this is potentially very important. In a more risk averse world, the supply of genuinely low-risk assets seems smaller. Countries that have offered a reasonably stable economic environment and relatively sound public finances – of which Australia is one – are attracting greater flows of official capital now than they did a decade ago. This has recently been adding to the upward pressure on the exchange rate, independently of the rise in the terms of trade. As is so often the case in economics, there are two sides to this. On the one hand, the additional rise in the exchange rate pushes our cost structure in the tradable sectors of the economy up relative to other countries. This is a contractionary force and adds further to the already considerable pressure for structural change. On the other hand, it amounts to a reduction in the cost of international capital for Australian borrowers, particularly government borrowers. At the margin, this has to make the task of ensuring fiscal soundness a little easier. Even for private borrowers the unusually low level of long-term rates for the official sector offsets a good deal of the widening in spreads due to perceptions of higher private credit risk (that being, of course, a global phenomenon). BIS central bankers’ speeches A greater flow of cheaper capital to a country is an advantage. It is important, of course, that it is used wisely. When risk appetite is strong, and risk assessment by lenders too loose, such conditions can result in problems. For example, it has been argued that the flow of capital to the United States looking for low-risk assets was channelled by the US financial system into structured products that had the illusion of high quality, but which ultimately resulted in the sub-prime mortgage crisis. At this point, however, we do not seem to have that problem in Australia. If anything, households, businesses and governments are looking, to varying degrees, to reduce their debt. The financial sector is quite risk averse in its lending practices, particularly towards some of the business sectors that might be willing to take on additional debt. In such circumstances, the competitiveness-dampening effect of the higher exchange rate on the traded sector that results from the portfolio shifts may, for some period of time, outweigh the expansionary effect of a lower cost of capital. The economic background to this shift is an economy where a range of indicators had been tending to suggest that growth was running close to average. Key business surveys, for example, have suggested average performance compared with the past 20 years; the rate of unemployment has been little changed at what remains, by the standards of the past three decades at least, a reasonably low level. On the other hand, recent national accounts data suggest growth in the non-farm economy somewhat below trend over 2011. Overall, recent economic performance in Australia is not too bad, particularly when compared, over a run of years, to a number of other advanced economies. But neither is it so good that it cannot be improved. The full range of policies – macroeconomic and structural – need to play their part in seeking that improvement. Monetary policy can play a role in supporting demand, to the extent that inflation performance provides scope to do so. But monetary policy cannot raise the economy’s trend rate of growth. That lies in the realm of productivity-increasing behaviour at the enterprise, governmental and inter-governmental levels. Improving productivity growth is just about the sole source of improving living standards, once the terms of trade gain has been absorbed. This is increasingly being recognised in public discussion, but it is important we do more than just debate it. Nor can monetary policy obviate the pressure for the production side of the economy to change in response to altered relative prices. These changes in relative prices are essentially given to us by the world economy; they are not driven by any policy in Australia. So in Australia, reorienting our economy, adapting to structural changes and improving productivity performance are challenges we face. But we are hardly alone in facing adjustment challenges. More generally, reorienting economies in the Asian region, and around the world, remains a major challenge. Changes in the right direction have been occurring. Countries in this region have been prepared increasingly to develop and follow domestic policy frameworks that guide their behaviour in sensible ways (for example, inflation targeting). They have been prepared to accept some more movement in exchange rates, and to seek more domestic-led growth in demand. China in particular has seen the ratio of domestic demand to GDP rise over the past few years, reversing much of an earlier decline. More of this will be required, however, over time, for at least three reasons. First, it is not a sustainable model to expect developed world households to consume ever higher volumes of the output of Asian factories with borrowed money. That model cannot return, which means that the imperative to find domestic sources of growth is not just a cyclical one. Second, the eventual sheer size of the Asian economy is such that it will have to absorb more of its own output as it continues to grow. Continental-size economies such as the BIS central bankers’ speeches United States and the euro area have long done so. Here it is important to note that for East Asia outside of China and Japan, the decline in domestic demand relative to GDP that understandably occurred during the crisis of 1997–98 largely remains in place, more than a decade later. Third, and most important, it will surely be the most enriching strategy for the people of this region to turn more of their own savings to developing their own physical and human capital. Yet at present trillions of dollars are lent by taxpayers in Asia to some highly indebted advanced world governments at yields that seem extraordinarily low. It seems very unlikely that there are not better risk-adjusted returns in Asia than that. So for all of us, the challenges are those of adaptation to changing circumstances and new opportunities. A fascinating journey lies ahead. We in Australia will be facing our own adjustment imperative. We will also be taking more than a casual interest in developments in the region in this “Asian century”. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 3 |
Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Cards & Payments Australasia 2012 Conference, Sydney, 20 March 2012. | Malcolm Edey: The current agenda in retail payments regulation Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Cards & Payments Australasia 2012 Conference, Sydney, 20 March 2012. * * * Once again I thank the organisers of Cards and Payments Australasia for the invitation to speak here today, my third time at this event. Looking at the conference agenda for these two days, what stands out to me is the intense focus on innovation. This is an industry where there is a great deal of work going on in areas like online payments, mobile payments, new card-payment products, and improvements in security. All of these are signs of a vibrant industry. My subject for today is the current agenda in retail payments regulation. The Reserve Bank has had a direct role in payments regulation since 1998. Following the report of the Wallis Committee, the Payment Systems (Regulation) Act in that year established the basic governing structure that we have today. It set up the Payments System Board within the Reserve Bank with a mandate to promote efficiency and stability. And the Act gave the Bank significant powers to that end. They include the power to designate a payment system and to set standards in areas like network pricing and various aspects of a payment system’s internal rules. One of the first areas of focus for the Board was on credit card schemes. But the remit of the Payments System Board extends much more broadly than just card payments, or even retail payments more generally. The Board also has oversight responsibilities in the high-value system as well as for clearing and settlement facilities in Australia, and it has been increasingly devoting attention to the second of those areas. I expect that trend will continue, given the rapid changes that are taking place internationally. Today, though, I want to focus on our work on retail payments. Public consultation is an important part of that work. In some matters we have a formal obligation to consult, but that is not the only reason for doing it. The issues involved in payments regulation are often complex and we see it as very important to engage with industry, and other stakeholders, to make sure we have all the relevant facts when we make our decisions. Currently there are four areas of retail payments regulation where we are in various stages of public consultation. I want to take the opportunity to review those briefly today. The first is the surcharging standard for card payments. The question here is a simple one: should card schemes be allowed to place limits on merchant surcharging for card payments, and if so, in what form? That question was first examined by the Payments System Board during its initial round of credit card reforms, which were announced in 2002. The Board’s decision, as you know, was to require the removal of rules against surcharging. That was part of a wider reform package that also included a standard for interchange fees. A newcomer to this debate might ask the question, why did we take action against no-surcharge rules when the effect would be to make some cardholders pay more for their transactions? It’s worth briefly re-capping the answer to that. One of the distinctive features of card payment systems, historically, has been a lack of alignment between pricing and decision-making power. In a typical credit card transaction, the person who makes the choice of payment instrument is usually the cardholder, but the BIS central bankers’ speeches transaction fee is incurred by the merchant. In simple terms, the cardholder makes the decision but the merchant pays the fee. The interchange arrangements that underpin this fee structure have tended to be configured in a way that rewards issuance and usage of cards while adding to merchant costs. We have observed in this structure that competition tends to push fees up rather than down because, the higher the fee, the greater the capacity to reward cardholders for using a given card. Scheme rules prohibiting surcharging have had the effect of reinforcing that pattern, because they prevent price signals from flowing to the person who chooses the payment instrument. This was the basic logic for the decision to prevent schemes from making rules against surcharging. A decade later, what can we say about the effects of that decision? I can best answer that by describing the results of the reform package as a whole, because the different elements of it were closely inter-related. The clearest impact has been a reduction in card payment costs. In the case of the four-party credit card schemes, the average merchant service fee has fallen by about 60 basis points. Although the three-party schemes are not regulated in this way, they have voluntarily accepted the surcharging standard and have been subject to some of the same competitive pressures. As a result, merchant service fees for the three-party schemes have fallen by a similar amount. Since the adoption of the reforms, the prevalence of surcharging has significantly increased. According to data from East & Partners, around one-third of Australian merchants now impose a surcharge on at least one of the credit cards they accept. The figure is higher for the largest merchants1, where the proportion surcharging is slightly over half. It also seems likely that surcharging will become more widespread in the future – only 12 per cent of merchants say they are not at least considering applying a surcharge. In the early stage of the reform process the Payments System Board considered, but did not proceed with, an alternative approach that would have allowed schemes to limit surcharging to an amount linked to the cost of acceptance2. The Board’s view, on balance, was that giving merchants the right to surcharge was important in realigning incentives and in giving merchants more bargaining power in the determination of fees. The Board also took the view that market forces could be expected to work as a discipline against excessive surcharging. The growth of surcharging has, however, brought to light practices that look inconsistent with the efficiency objective. While comprehensive data are not available, there is significant anecdotal evidence of some surcharging that is not reasonably related to the cost of acceptance. One example is the practice of blended surcharging, where a merchant might be recovering costs on an average basis without distinguishing between high- and low-cost card payments. Another would be where a surcharge simply exceeds any reasonable estimate of the cost of acceptance. Although these practices do not appear to be widespread, they are of concern from a payments efficiency point of view because they can distort consumer choices about the payment methods that they use. They go against the principle I stated earlier of allowing the efficient flow of price signals to the economic decision maker. It is for these reasons that the Bank reopened consideration of the surcharging standard last year A draft revision to the standard was released in December, and is now in the final stage of consultation. If adopted, the revised standard will allow schemes to limit surcharging to a reasonable cost of acceptance, but schemes will not be able to prohibit surcharging altogether or prevent merchants from recovering their costs. For this purpose, the cost of acceptance will be defined as including, but not being necessarily limited to, the merchant service fee. Currently, those with annual turnover greater than $530 million. The existing Standard does allow the merchant and the acquirer to agree to do so. BIS central bankers’ speeches I want to stress that we should not view this change as a panacea that will do away with every consumer complaint. It is also important to make clear that the Reserve Bank is not setting itself up as a regulator of merchant behaviour. What the proposed standard does is to empower the schemes to take action where surcharging is clearly excessive. It will be in their own interests to make use of this power. At the same time, the proposal preserves the original goal of giving merchants the right to recover their costs. In that way I think it strikes a reasonable balance and it should strengthen the incentive for schemes to compete in lowering their fees to merchants. The less a scheme costs to merchants, the lower will be the permissible surcharge. The second policy area I want to talk about is the Reserve Bank’s strategic review of payments innovation. This was the subject of my talk here a year ago and so I can be much briefer in my remarks today. When we talk about innovation, we need always to keep in mind the distinction between what is proprietary and what is systemic. The proprietary sphere covers any area where a service provider can act independently and use an innovation to gain a competitive edge. The payments industry is very good at innovating in that way, and we see the evidence of it in many of the things that are being talked about in today’s conference. Systemic innovation is much harder to achieve because it requires co-operation in the collective interest, even when there may be no strong proprietary benefits at the level of the individual service provider It’s this second area that is the focus of the current review. We are asking the question, are there any gaps in the system that can only be addressed collectively, and if so, how do we make that happen? Submissions to the review have been helpful in identifying a number of gaps of that nature. Here are the main ones: Transmission of data with payments. This has been a long-time concern of businesses, who often find the 18 character limit under the Direct Entry system too restrictive. Often this drives businesses to use cheques so that paper-based information, like an invoice, can accompany the payment. Alternatively they might separate the payment and the remittance information, and then rely on a separate process to reconcile them at a later stage. This is likely to be expensive and error prone. Use of international standards. I won’t dwell on this one, but in some ways it is related to the previous point, because the international framework for messaging standards provides for transmission of a significant amount of additional data. I think there is widespread acknowledgement within the payments industry that international standards should be adopted wherever possible. Timeliness of Payments. As communications technology advances, there is little doubt that people are expecting greater immediacy in many areas, and payments are no exception. It is currently not possible for me to make a payment to someone who banks with another bank and for them to be able to use those funds within a short space of time. In some circumstances this lack of capacity can be a significant problem – for instance when someone is waiting on an emergency government payment. This seems like an area we could improve on and it is increasingly becoming a focus overseas. Likewise, the fact that payments cannot occur between banks out of normal business hours seems out of line with the ‘always on’ world we now live in. Addressing Payments. Cheques are always a good reminder of the things that are missing in our electronic payments. I can pay someone with a cheque when all I know about them is their name. But if I want to make an electronic payment, I BIS central bankers’ speeches typically need to know a 6-digit BSB number and a 9-digit account number, things the receiver probably cannot readily provide. People are finding partial workarounds that make use of mobile phone numbers or email addresses, but we are yet to have a truly seamless system. All of these are areas where any progress will have to be made co-operatively, because they are characteristics of the network, not just of the individual players. But that also means that a decision to move ahead in any of these areas needs to take into account the costs and benefits across the system as a whole, both for service providers and end-users. That raises the broader question of whether there needs to be a change in governance arrangements in the industry, so as to make them more conducive to innovation in general. There are a number of reasons why co-operative innovation can be hard to achieve. Industry participants have differing commercial interests, and even factors like the timing of their investment cycles can make coordinated actions difficult. A change in messaging standards or timeliness of payments might benefit the public, yet remain hard to achieve because there is no proprietary benefit to the individual service providers. The challenge is to find a way of determining when innovations of that nature are in the public interest and, if so, to ensure they go ahead. Industry-level decision making may be only part of the answer. Along with these questions of governance, the critical decisions of the review are likely to relate to the architecture of the payments system. By that I mean in particular the question of whether there is a place for additional centralised architecture in the Australian payments system. A possible argument for that proposition is that centralised systems may be better able to innovate than bilateral systems. They may also be structurally more efficient when a network has a large number of participants, and better suited to providing open access to new players. The possible need for a centralised architecture is also relevant to the question of faster (or real-time) payments at the retail level. The consultation process has brought out a range of views on this subject. Some argued that the existing architecture provided a sufficient level of centralisation, or pointed to the potential cost of moving existing systems onto a hub. Others focused on the potential for some form of hub to provide real-time retail transfers and went as far as proposing a governance framework for such a system. We should be in a position to announce some conclusion on that in the near future, along with the other matters I’ve outlined today. Let me turn briefly to the third and fourth areas of current policy work. Issue number three is the regulatory framework for the eftpos system. One of the very significant developments in recent times has been the establishment of ePAL as a national scheme for eftpos payments. The Reserve Bank has welcomed that development because we see it as strengthening competition among card payment schemes in the domestic market. As a consequence of the establishment of ePAL, the eftpos system now works largely as a multilateral network. But much of the existing framework – the Access Regime and interchange fee standards – was designed in reference to the earlier bilaterally-based system. As a result, the relevance and applicability of the existing framework will need to be reviewed. One change that has already been made was the decision in November 2009 to bring multilateral eftpos fees under the same interchange fee standard as applies to scheme debit cards. But further changes to all elements of the regulatory framework for the eftpos system will need to be considered. Some of the reasons for that are purely technical, because the regulations as they stand do not reflect the system’s current structure. But there are also some more substantive questions as to whether we need to maintain the currently existing arrangements and, if so, in what form. We expect to complete the consultation on those questions and reach conclusions later in the year. BIS central bankers’ speeches The fourth issue on which we are currently consulting is retail payments system resilience. Much of the work of the Payments System Board over the years has been in regulation and oversight of what we might call self-contained systems: things like a credit card network, or a clearing and settlement facility. But the Board’s remit extends more broadly to the efficiency and stability of the payments system as a whole. On any common sense reading, the payments system encompasses the capacity of person A to make a payment to person B when they bank with different banks. The ability of the system as a whole to deliver that basic service, dependably and efficiently, clearly comes under the Payments System Board’s overall policy mandate. That is why it is appropriate for the Board to be conducting the innovation review that I’ve just outlined. It relates to the efficiency of the system as a whole. It is also why it is appropriate for the Board to take an interest in the operational resilience of individual payments service providers. In recent years there have been a number of high-profile outages affecting the availability of services to significant numbers of customers. Obviously individual banks have a strong incentive to minimise the risk of these sorts of incidents. It affects their own reputation when something goes wrong and it impairs their ability to meet the needs of their customers. But there is also a system-wide dimension to these problems. All participants in the system, and all users of payments services, have an interest in high standards being maintained across the system as a whole, not just their own component of it. When Bank A’s systems go down, customers of all the other banks are affected, because their capacity to exchange payments with customers of that bank is impaired. For some time the Reserve Bank has been monitoring significant retail payment outages, and following up with the relevant banks as to diagnosis and appropriate remedial actions. So in a sense, a role for the RBA in this area is not new. What we are now proposing is to formalise that role in two ways. First, we have announced that we will be putting in place a more systematic reporting regime for retail outages. And second, we have begun a consultation process with the banks as to whether further measures are needed to improve operational resilience across the system. Conclusion Those then are the four areas in retail payments regulation where the Reserve Bank is currently conducting consultations with industry, and with other interested parties. What ties all of these things together is the focus on efficiency and competition. In many ways competition is working well to deliver benefits to end users. But in an industry of complex network interactions like this one, there is an important role for regulation in promoting efficient outcomes. As I said earlier, in carrying out that role the Payments System Board takes very seriously the need to consult, both with industry and end-users. Many of you here today will have participated in that process, and I take the opportunity to thank you for your co-operation. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 3 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian DCM Summit 2012, Sydney, 22 March 2012. | Guy Debelle: Bank funding Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian DCM Summit 2012, Sydney, 22 March 2012. * * * I thank Chris Stewart and Cameron Deans for their help. As you may be aware, last week the Reserve Bank published a Bulletin article that documented recent developments in the structure and costs of the funding of the Australian banking system.1 The Bank has published an article on this topic annually for a few years now, and also reports regularly on developments in the various components of bank funding in its quarterly Statement on Monetary Policy. Today, I am going to talk to that article and highlight some of its main findings. The discussion around bank funding costs can get confused at times. It is often unclear whether a participant in the debate is referring to movements in levels or in spreads, and if the latter, what exactly the spread is relative to. The article and my speech today provide some facts that can serve as a common foundation for discussion. The main points I want to highlight are: The level of the cash rate set by the Reserve Bank is a primary determinant of the level of intermediaries’ funding costs (and hence the level of lending rates). However, there are other significant influences on intermediaries’ funding costs, such as risk premia and competitive pressures, which are not directly affected by the cash rate. Over the past year, funding costs have fallen in absolute terms but have risen relative to the cash rate. Deposit pricing, particularly for term deposits, has been the major driver of recent changes in funding costs, reflecting the strong competition for deposits. This has obviously been welcomed by the savers in the population. There has been a rise in the spreads on wholesale debt issued by banks reflecting investors’ concerns about the global banking industry. While spreads have narrowed recently, they are still higher than they have been over the past couple of years. Let me start with the first point. The cash rate set by the Reserve Bank Board is the short-term interest rate benchmark that anchors the broader interest rate structure for the domestic financial system. It is the front end of the risk-free yield curve off which other financial assets are generally priced. When the cash rate is adjusted up or down, the whole structure of interest rates in the economy moves up and down, with the effect most direct at shorter maturities. But the cash rate is clearly not the only determinant of the rate structure in the economy. To use three examples: As one moves out along the term structure of the risk-free curve, term premia play an increasing role. Risk premia are an important component of borrowing costs for private sector entities, including the banks. Deans C and Stewart C (2012), “Banks’ Funding Costs and Lending Rates”, RBA Bulletin, March pp 37−43. BIS central bankers’ speeches Competitive pressures play an important role in deposit pricing. These sorts of determinants of the rate structure are not directly affected by movements in the cash rate. As I will discuss shortly, over the past few years, competitive pressures in the deposit market and risk premia for the banking sector globally have risen substantially. These have had a material impact on the cost to banks of funding their lending books. While these developments are not the result of movements in the cash rate, the Reserve Bank Board takes these developments into account in its setting of the cash rate to ensure that the structure of interest rates in the economy is consistent with the desired stance of monetary policy. Moreover, the link between movements in the cash rate and lending rates in Australia is much tighter than in many other countries. In the US, for example, movements in the Fed funds rate have a much less direct influence on 30-year fixed-rate mortgages. Composition of banks’ funding The funding structure of the Australian banking system has changed markedly over the past few years (Graph 1). Deposits have become a much larger share of overall funding, rising from a little under 40 per cent in 2007 to 52 per cent currently. The rise in the share of deposit funding has come at the expense of a decline in the share of short-term wholesale funding from around 30 per cent to 20 per cent currently. Graph 1 The structure of funding shown in Graph 1 is for the banking system as a whole, not that of any particular financial institution. Similarly, the analysis presented is for the cost of funding this aggregate structure and will certainly differ institution by institution. For example, the regional banks generally fund a larger share of their books via deposits, and have significantly decreased their use of securitisation. Credit union and building societies continue to raise the vast majority of their funds via deposits. The major change in the funding structure of the larger banks has been the switch from short-term wholesale funding to deposits, although they have also recently increased their BIS central bankers’ speeches use of long-term secured issuance, particularly in the form of covered bonds. While the covered bond issuance has had little effect on the composition of banks’ funding at this stage, given the large stock of existing funding, it has allowed the major banks to achieve funding at longer tenors than has been the case previously. Covered bonds have generally been issued for terms of 5 to 10 years, whereas unsecured bank bonds are generally issued with maturities of up to 5 years. Within banks’ deposit funding, there has been a marked shift towards term deposits, which pay higher interest rates than other forms of deposits. Indeed, term deposits have accounted for most of the growth in bank deposits since the onset of the financial crisis. They now account for about 44 per cent of the major banks’ deposits, up from 30 per cent in the middle of 2007 (Graph 2). Graph 2 The increase in the share of deposits, particularly term deposits, reflects a number of interrelated factors: First, banks have offered relatively attractive rates to depositors. Second, strong business profits have resulted in larger corporate cash holdings, which have been increasingly invested in deposits rather than other financial instruments, particularly short-term bank paper. Third, households have significantly increased their term deposits placed directly with banks, instead of investing in other financial assets. There has also been a rise in deposits placed via superannuation and managed funds. Some part of the second and third of these factors reflects as much a change in name as a fundamental shift in funding structure. Instead of holding an exposure to the banking system that is called short-term wholesale debt, some corporates and superannuation funds hold the very same exposure in the form of a term deposit (of comparable maturity). This reflects BIS central bankers’ speeches pressures from regulators, ratings agencies and the market for financial institutions to be more deposit funded, because deposits are assessed to be more stable, even though, in this instance, the behavioural response of the investor is probably not materially different. For banks, term deposits have the advantage of generally being a relatively stable funding source. The average contractual maturity of term deposits is fairly short, at somewhere between four and seven months. But these term deposits are typically rolled over a number of times so that the effective maturity is more around a few years. From the banks’ point of view, the rates on new term deposits can also be adjusted quickly to influence the growth in this source of funding. However, because term deposits have a relatively short contractual maturity, changes in the pricing flows through the whole term deposit book quickly. Hence movements in these rates can be one of the biggest short-run influences on changes in overall funding structure. While most of the competition among banks has been for term deposits, banks have also offered more attractive transaction and savings accounts. They are paying higher interest rates on these accounts and are offering greater functionality. The increase in the value of funds invested in these deposits has largely been placed in online saver accounts and accounts with introductory bonuses and/or bonuses for regular deposits. Banks have reported little growth in the value of low-interest transaction-style deposit accounts. At-call online saver accounts are generally assessed to have more rapid run-off rates under the Basel III liquidity standards, so they will not be particularly attractive from the banks’ point of view once those liquidity standards take effect from the beginning of 2015. That does not seem to have affected the pricing of these products yet, but it will be interesting to see how that evolves both in terms of pricing and product design as we approach that date. Cost of funding Having discussed the structure of funding, I will now turn to the cost of that funding. The Reserve Bank uses a wide range of sources to derive our estimates of banks’ funding costs. We use data reported by financial institutions to APRA and banks’ regular profit statements to the market to track the composition of funding. We monitor the prices offered on various forms of deposit accounts, and maintain a comprehensive database of wholesale funding, which is updated issue by issue. We supplement all of this with extensive consultations with financial institutions, big and small. The analysis presented contains our best estimates. But there remains a degree of imprecision around them. Moreover, as I mentioned earlier, our estimates are for the system as a whole, not for any particular financial institution. That said, in summary, our estimate is that the absolute level of banks’ funding costs fell from mid 2011 to February 2012, but by less than the reduction in the cash rate. There were particularly pronounced increases in the cost of term deposits and long-term wholesale debt relative to the cash rate as financial market conditions deteriorated in late 2011. Deposits Competition for deposits, which had moderated somewhat in early 2011, intensified again in late 2011. Consequently, our estimate is that while the cash rate has fallen by 50 basis points since mid 2011, the major banks’ average cost of deposits has declined by about 25 basis points. In other words, while the average interest rate on deposits has indeed fallen, it has risen relative to the cash rate. The average spread above market rates on the major banks’ advertised term deposit “specials” has increased by about 35 basis points over the past year (Graph 3). Furthermore, BIS central bankers’ speeches an increase in the share of deposits written at rates higher than the rates advertised by banks has meant that the average rate on outstanding term deposits has not fallen as quickly as benchmark rates, as term deposits have been rolled over. That is, banks have been increasingly paying customers more than the rate advertised in the window if the customer asks for it, reflecting competitive pressures. Moreover, there has been some shortening in the average maturity of term deposits recently given the inverted yield curve, which has meant that changes in pricing have passed through more quickly. Graph 3 The average advertised rate on at-call savings deposits rose by around 20 basis points relative to the cash rate over 2011. Again, in absolute terms, the interest rate declined. Taking into account an increase in the proportion of savings deposits earning bonus rates, the average rate on these deposits is estimated to have increased by between 35 and 50 basis points relative to the cash rate. Interest rates on transaction accounts have not fallen in line with the cash rate as many only pay very low nominal interest rates. Hence, as the cash rate falls, there is no scope to lower the interest rates on these accounts. Wholesale debt The absolute cost of issuing new unsecured wholesale debt fell during 2011 (Graph 4). Relative to risk-free benchmarks, however, the cost of issuing wholesale debt has increased since mid 2011. The increase in spreads on banks’ wholesale funding reflects global investors demanding more compensation for taking on bank credit risk, although the rise for Australian banks has been less marked than it has been for other banks globally. This widening in spreads was at its peak at the beginning of the year but over recent weeks these spreads have narrowed noticeably. BIS central bankers’ speeches Graph 4 There has also been an increase in the costs associated with hedging the foreign exchange risk on new foreign-currency denominated bonds. This rise in the basis swap reflected the dearth of Kangaroo issuance earlier in the year at a time when the banks were raising foreign-currency debt. The pick-up in Kangaroo issuance in recent weeks has alleviated some of that pressure. Spreads on banks’ new wholesale debt have come down somewhat following the ECB’s 3-year longer-term refinancing operations. However, they still remain higher than in mid 2011 (Graph 5). Graph 5 BIS central bankers’ speeches While the relative cost of new long-term wholesale funds is currently higher than that of maturing funds, this has had only a moderate effect on the major banks’ average bond funding costs relative to the cash rate to date. This reflects the fact that it takes at least 3 to 4 years for the major banks’ existing stock of bond funding to be rolled over. Since spreads began to rise sharply in August 2011, the major banks’ issuance of new bonds amounts to about an eighth of their outstanding bonds. As a result, the cost of the major banks’ outstanding long-term wholesale debt is likely to have risen by about 25 basis points relative to the cash rate over the past year. The increase is smaller if fixed-rate wholesale debt is assumed to be swapped back into variable-rate obligations. The extent of the rise in relative costs for individual banks varies according to each bank’s use of interest rate derivatives. Short-term wholesale debt is mainly priced off 1- and 3-month bank bill rates. While these rates generally fell (in terms of level) over the latter half of 2011 due to the sharp fall in the expected cash rate over this period, there was an increase in the cost of short-term debt relative to the expected cash rate as measured by the bank bill to OIS spread over the same period (Graph 6). Graph 6 The increase in this spread also contributed to a higher average cost of long-term wholesale debt, relative to the cash rate, given that most of this debt is benchmarked to short-term bank bill swap rates. These pricing conventions ensure that changes in the cash rate, and expectations about its future level, have a direct effect on both short- and long-term wholesale funding costs. Since the start of the year, the spread between bank bills and OIS has narrowed noticeably. The reduction in the spread reflects, in part, the reduction in short-term issuance because of a higher level of term wholesale issuance. Short-term issuance is somewhat of a buffer for the major banks. When global markets are dislocated, they tend to issue more onshore short-term debt. This tends to drive up the cost, which may also be rising at the same time because of the tensions which are causing the dislocation globally. Conversely, when conditions improve and term wholesale issuance picks up, short-term issuance declines, reducing the spread with further downward pressure from the improved market sentiment. BIS central bankers’ speeches If the lower spread between bank bills and OIS is maintained, this should alleviate some of the upwards pressure, relative to the cash rate, on the cost of funding banks’ aggregate loan books. Overall cost of funding Taking the costs of individual funding sources noted above, and weighting them by their share of total bank funding, provides an estimate of the overall change in the cost of funding banks’ aggregate loan books. Compared to mid 2007, the average cost of the major banks’ funding is estimated to be about 120–130 basis points higher relative to the cash rate (Graph 7). Most of the increase occurred during 2008 and early 2009 when the financial crisis was at its most intense. Since the middle of 2011, however, there has been a further increase in banks’ funding costs relative to the cash rate of the order of 20–25 basis points. The graph shows that a fairly large part of this increase comes from the pricing of deposits. Graph 7 The increase in funding costs, relative to the cash rate, differs across institutions given differences in their funding compositions and the pricing of different liabilities. The available evidence suggests, for example, that the overall increase in the regional banks’ funding costs since the onset of the financial crisis has been larger than that experienced, on average, by the major banks. This mainly reflects the larger increase in the cost of the regional banks’ deposits and a more significant shift in their funding mix. Banks’ lending rates I have primarily focused on funding costs today, but in closing I will briefly touch on developments in lending rates. The Bulletin article goes into this in more detail. The cost of funding is the most important factor that influences the lending rates banks set. But there are a number of other factors that affect pricing including: the credit risk associated BIS central bankers’ speeches with the various types of loans, the liquidity risk involved in funding long-term assets with short-term liabilities, and choices about growth strategies in different markets. For close to a decade prior to the global financial crisis, banks’ overall cost of funds followed the cash rate closely, as risk premia in markets were low and stable. Accordingly, interest rates on business and housing variable-rate loans tended to adjust in line with the cash rate. Nevertheless, over this period there was a gradual decline in the spread between average interest rates paid on loans and the cash rate. For example, the spread between the average mortgage rate paid and the cash rate declined from 275 basis points in 1996 to around 125 basis points in 2007 (Graph 8). Graph 8 Since the onset of the financial crisis, banks have increased the spread between lending rates and the cash rate for all loan types. The increases have varied across the different types of loans, partly reflecting differences in the reassessment of the riskiness of those loans and expectations regarding loss rates. But the primary factor driving the increase in the spread between lending rates and the cash rate has been the increase in the relative cost of funding that I have described above. Financial institutions have increased their lending rates in the face of the increase in costs to maintain their net interest margins within the range observed in recent years.2 In turn, this has been with the aim of maintaining profitability. Without seeking to answer the question as to whether or not these movements in lending rates have been “appropriate”, the aim of my speech today, and the Bank’s recently published analysis, has been to provide some facts to help in that discussion. As noted in Deans and Stewart (2012), there are a number of other factors which affect the reported net interest margin in addition to movements in lending rates and funding costs. And similarly, there are additional factors which affect the translation of net interest margins to profitability. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 3 |
Remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at a panel session on "Public policy and innovation" at the Federal Reserve Bank of Kansas City Payments Conference, Kansas City, 30 March 2012 (to be delivered 31 March 2012). | Malcolm Edey: Inertia and coordination problems in payment networks Remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at a panel session on “Public policy and innovation” at the Federal Reserve Bank of Kansas City Payments Conference, Kansas City, 30 March 2012 (to be delivered 31 March 2012). * * * The question I have been asked to address is whether inertia (or coordination failure) is an obstacle to payments system innovation. And if so, what do we do about it? To begin with, it helps to distinguish between two types of innovation: proprietary and systemic. An example of the first type might be a new piece of card technology, or a new customer platform for an individual bank. An example of the second might be the adoption of a new interbank messaging standard or a system-wide shift to faster payment times. The difference lies in whether the benefit can in some sense be captured by the innovator, or whether the benefits are more dispersed and dependent on coordinated action. Payments service providers are good at proprietary innovation, as you would expect – they have an incentive to be good at it. It’s in the second area that problems of inertia and coordination failure can come into play. I can think of two general reasons why this is the case. The first is the problem of capturing benefits so as to give a return to the innovator. To give a concrete historical example, think of the question of faster cheque clearing. For a given cost, faster clearing is obviously an improvement, but it can only be achieved collectively. Yet doing so confers no competitive advantage to any individual participant in the chequeclearing system, so there is little incentive to agree on costly action to make it happen. To make the example more up-to-date, the same problem exists with incentives to deliver faster (or real-time) electronic transfers at the retail level. Faster payments can only happen if the system as a whole is set up for it, and then only if a critical mass of the individual participants are set up to provide timely access. But putting this in place will obviously involve some cost, with little or no proprietary benefit to the investor, particularly where it may cannibalise other potentially profitable product lines. This problem would exist even if all the payments industry participants faced identical incentives. Without an effective coordinating mechanism, industry will tend to under-invest in this kind of innovation. The second reason is that the costs and benefits of participating in coordinated actions of this kind are not in fact evenly distributed across participants. Some participants will benefit more than others from a given innovation, or may find it more costly than others, for reasons to do with their size or their business model. Another factor is the timing of investment cycles: collective action has to be collective, but the timing of any given investment in payments technology will always be more advantageous to some than to others. A bank that is just about to undertake a regular technology upgrade may be quite receptive to aligning that with a general change in standards; whereas a bank that has just completed a major round of investment may not be. These things can make it very hard for industry participants to agree on the timing of a systemic innovation, or on the pricing arrangements that will underpin it. The end result can be a degree of inertia, or a slower pace of innovation than would be socially efficient. I think this problem is inherent in any network that doesn’t operate as a kind of proprietary unit in the way that, for example, a credit card network does (competing of course with other networks). BIS central bankers’ speeches For the payments system as a whole, then, this points to the need for coordination mechanisms. What sorts of mechanisms might we be talking about? For a lot of issues, the appropriate coordination mechanism could be an industry body – especially where the issue is mainly technical in nature and where there are no strong proprietary interests at stake. An example would be routine updating of technical standards. But where there are significantly conflicting incentives that make coordinated decisionmaking more difficult, it may need a regulator to take a leadership role. In Australia the payments system regulator is the central bank, and regulatory decisions are made by the Reserve Bank Payments System Board. We have a mandate to promote stability and efficiency, which I think we can view as including the efficient resolution of the coordination problems that I’ve just described. And we have significant powers that can be directed to that end. For these reasons, the RBA has been increasing its focus on these coordination issues in recent times. As you may be aware, we announced a Strategic Review of Innovation in the Payments System in July 2010, and we are now in the finishing stages of that review. In the course of the review, we held two rounds of extensive consultation with service providers as well as with end-users of the payments system. Broadly speaking, the Review focused on three questions, which I could sum up as Gaps, Governance and Hubs. On Gaps, the question is, are there potential innovations that would be in the public interest that are not happening because of coordination failures? Responses to the consultation suggested that there might be. The main points highlighted as possible areas for improvement were: Faster or real-time payments at the retail level Greater availability of payments systems outside normal banking hours Improved capacity to send information with payments And, greater ease of addressing payments The last one of these can be illustrated by analogy with the cheque. A cheque payment can be addressed very easily when all you know is the name of the recipient. But we don’t yet have a comparably easy mechanism for addressing electronic payments. Obviously it is not costless to deliver these things, and so a coordinated decision process would need to have some way of taking into account both the costs and benefits, including benefits to end-users, in order to determine whether an investment is worth making. That raises the further question of who should provide that leadership and under what arrangements – the general question of Governance. To make it more concrete, we can pose the following questions. In the Australian case, should the Payments System Board take a more prescriptive approach to setting objectives for payments system innovation? Could it, for example, set an objective of real-time consumer payments, or the adoption of new messaging standards, by a specified target date? Could it then perhaps delegate the implementation of those targets to an industry body with the necessary technical expertise? All of that would amount to a governance model where the regulator makes high-level decisions as to the public interest, while industry participants determine the most efficient means of implementing them. I won’t foreshadow what we might conclude on these things, but these are the sorts of questions the Payments System Board is now considering. BIS central bankers’ speeches The Board is also considering a third area, namely Hubs, or specifically the question of whether there needs to be greater use of centralised architecture for clearing and settlement of retail payments. This is a particular issue in Australia, because many of our payments systems are built on bilateral links between institutions. Arguments can be made in favour of hubs on the basis that they may be more efficient than bilateral networks and more conducive to both competition and innovation. But these considerations need to be balanced against the costs of the investment. Again, this is a key question of system design for which there needs to be a coordinated answer, whether the eventual decision is for or against. To sum up: Coordination failures can be an obstacle to innovation. That problem is inherent in the nature of payment networks. It’s very hard to design governance structures that make appropriate provision for coordination while still allowing for normal competition to occur. That suggests a role for leadership by payments regulators or central banks In some ways, central banks have a natural leadership role because they act as a hub already in many payment systems. In Australia’s case, the central bank is also the regulator for payments-system efficiency and stability. Finally, in carrying out any leadership role in this area, it’s very important to consult. The advantage we have (as regulators or as central banks) is that we can take a public-interest perspective. But we also need to make use of the expertise of payments industry participants in determining what is feasible and what is the most efficient means of delivery. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 4 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the ADC Future Summit, Melbourne, 14 May 2012. | Philip Lowe: Developments in the mining and non-mining economies Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the ADC Future Summit, Melbourne, 14 May 2012. * * * Thank you very much for the opportunity to speak today. It is a pleasure to be in Melbourne again. As you are all no doubt aware, the Australian economy is currently going through some major structural adjustments. It is adjusting to a once-in-a-century boom in mining investment and the terms of trade, and to a very high exchange rate. It is also adjusting to a return to traditional patterns in household spending and borrowing after more than a decade in which both consumption and debt grew much faster than household income. These changes are occurring in an economy that has, over recent times, performed much better than other advanced economies. The unemployment rate in Australia remains low, output is continuing to expand, inflation is contained, the banking system is strong and public finances are in much better shape than in other advanced economies. Yet the structural changes that are taking place are creating a sense of unease for many in the community, particularly amongst those who are not benefiting directly from the mining boom. So this morning, I would like to touch on three interconnected issues, all of which are related to structural change. The first of these is the recent GDP growth and inflation outcomes and what they tell us about the evolving balance of demand and supply in the economy. The second issue, and one that the Bank staff have been grappling with for some time, is the different growth paths for the mining-related and non-mining-related parts of the economy. A particular question here is what rate of output growth in the non-mining-related part of the economy is likely to be consistent with low inflation during the once-in-a-century investment boom that we are now experiencing. And the third issue that I would like to touch on is the recent decisions on monetary policy and the Reserve Bank’s latest forecasts. GDP growth and inflation A year ago, the Reserve Bank’s central forecast was for aggregate output in Australia to increase by around 4¼ per cent over 2011. Our forecast for aggregate demand growth was a bit higher than this, with some of the very strong growth in demand being met by even stronger growth in imports. As things turned out, the outcome for aggregate demand was pretty close to the expected outcome – at an above-trend rate of 4½ per cent compared with the forecast 4¾ per cent. In contrast, growth in aggregate output – at a below-trend rate of 2¼ per cent – was slower than we had expected. When we look at why output growth over 2011 was not as strong as forecast, well over half of the difference is accounted for by unexpectedly weak growth in exports, particularly of coal. It has taken longer than was originally expected to remove water from the flooded coal mines and for firms to take advantage of increases in port and rail capacity. As a result, despite all the talk about Australia’s resources boom, the volume of resource exports increased by only 1 per cent over 2011. A much stronger outcome than this is likely both this year and next. BIS central bankers’ speeches But exports are, by no means, the full story. Other factors were also at work, with more of the strong growth in domestic demand being met through overseas production – rather than domestic production – than was originally expected. An important factor here has been the composition of the growth in demand. As I mentioned a moment ago, growth in aggregate demand was pretty close to what was expected. However, the composition of that growth contained a few surprises. In particular, while the Reserve Bank had long expected a very large lift in investment in the resources sector in 2011 – and this indeed occurred – the increase was even larger than had been forecast. As one indication of the very strong outcome, the ABS estimates that engineering investment increased by almost 50 per cent over 2011. On the other hand, growth in demand not directly related to mining investment was not as strong as was forecast. The biggest surprise was probably in terms of home building. We had expected dwelling approvals to pick up gradually over 2011, but this pick-up did not eventuate. One possible explanation for this is that it is one of the side effects of a return to more traditional savings and borrowing behaviour by households. This change in behaviour is having ripple effects through the economy, including through a lowering of expected capital gains on housing. This has made developers, financiers and households less willing to commit to new construction despite rising rental yields, lower prices relative to income and ongoing growth in population. While, at some point, the improving fundamentals should generate a pick-up in home building, the recent forward-looking indicators do not suggest that this is imminent. Another other area that was weaker than expected was private business investment outside the resources sector. This partly reflects the decline in business confidence over the year, with a number of factors, including renewed concerns about the fiscal problems in Europe, adding to uncertainty. Public demand was also weaker than was expected. In contrast, consumption growth – at around 3½ per cent – was in line with our forecasts, with total consumption increasing broadly at the same rate as household income. This composition of demand growth – with its heavy weight on mining-related investment which tends to be very import intensive – has contributed to very strong growth in aggregate imports. Or put a little differently, it has meant that the strong growth in aggregate demand that we have seen has, at least to date, not boosted domestic production in the same way as might have occurred in the past. As a result, there has been less pressure on domestic capacity than earlier expected. One consequence of this is that the inflation pressures that were evident in the beginning of 2011 have moderated. At the beginning of last year, underlying inflation looked to have reached a low point of about 2¼ per cent and was starting to rise and was expected to be close to 3 per cent by the end of 2011. As things turned out, inflation did pick up in the June quarter last year, but it then began to moderate, with the latest readings for underlying inflation over the year to the March quarter being in the lower part of the medium-term target range of 2–3 per cent. Not surprisingly, the prices data reflect the particular composition of aggregate demand that has been witnessed over recent times. In parts of the resources sector, costs remain under upward pressure, with very strong demand for some intermediate inputs and for a range of occupations, predominately in engineering and science, but also in accounting, legal and human resources. In contrast, in a number of other parts of the economy, the subdued demand growth is putting downward pressure on prices. In the latest CPI, there were, for example, declines in the prices of most goods, the price of domestic holidays, and for the price of new dwellings. These are all areas where demand growth has been soft and firms’ margins are under downward pressure. So, to summarise, the overall picture is one in which aggregate demand has grown strongly, and is expected to continue to do so. However, a higher-than-average share of that growth in demand is being met through imports, not only because of the high exchange rate but also because of the heavy weight of resource sector investment in overall demand. Partly as a BIS central bankers’ speeches result of this, as well as the direct effects of the exchange rate appreciation on the prices of imported goods, the recent inflation outcomes have been subdued. The mining and non-mining economy I would now like to turn more directly to the second issue – that is the size and growth rates of the mining-related and non-mining-related parts of the economy. While for many decades, the ABS has published separate data on farm and non-farm GDP, it does not publish separate data for mining and non-mining GDP. The ABS does, however, publish gross value added of the mining sector. This is currently equivalent to a little less than 10 per cent of the output of the economy as a whole. But this figure does not include the very significant inputs into the mining sector produced by other domestic industries, and given this we have found it helpful to consider broader measures of the mining-related economy. The main approach we have used is to start with the expenditure components of GDP, summing resource exports and investment in the resources sector and then subtracting the imported component of that investment. To this, is added resource production for domestic consumption, less the imported inputs that go into that production. This gives an estimate of total expenditure on resources production and investment that is satisfied by domestic activity. To complement this analysis, we have also used the input-output tables published by the ABS to understand the linkages from demand for mining output and investment to activity in other domestic industries. Not surprisingly, this analysis shows that mining investment draws significantly on construction activity, which in turn generates activity in industries such as business services, manufacturing, transport and wholesale trade. This work suggests that the resources sector accounts for around 16 to 17 per cent of current GDP. Of course, different approaches and assumptions could generate either a higher of lower number, although most alternatives deliver estimates in the 15 to 20 per cent range. The approach that we have adopted here includes the output of workers who indirectly provide inputs to the mining sector. Defined this way, mining-related employment accounts for around 8 per cent of total employment, although only around 2¾ per cent of the workforce is employed directly in mining and resource processing. The rest of the 8 per cent are involved in a wide range of activities related to the mining boom, including construction, utilities, project management, legal services, surveying, leasing etc.1 Based on these figures, mining-related activity is estimated to have expanded by around 12 per cent over the past year and similar growth is expected over the next couple of years. If this expected growth eventuates, the mining-related sector’s share of GDP will continue to increase and there will be strong jobs growth both directly in resource extraction and processing and in a wide range of ancillary activities. Indeed, it would not be surprising if, over the next few years, growth in mining-related employment, broadly defined, was as high as one-half of the total growth in the Australian workforce. If these broad forecasts for the mining-related sector come to be realised, then employment growth in the non-mining-related part of the economy averaging around ¾ to 1 per cent a year is likely to be needed to maintain the unemployment rate around its current level. The rate of growth in output in the non-mining-related economy would then depend upon the rate These figures exclude the boost to Australia’s real income, as opposed to output, from the rise in the terms of trade. If this rise had not occurred and instead the terms of trade over recent years were equal to their average during the 1990s, real income in Australia would be around 15 per cent lower than it currently is. This is a very big effect and it is in addition to the current boost to output that is occurring because of the investment phase of the boom. BIS central bankers’ speeches of productivity growth. If, for example, growth in labour productivity were to average 1 to 1¼ per cent per annum, then non-mining output might be expected to grow by around 2 per cent per year on average. This is above the recent rate of growth of the non-mining economy – which we estimate to be a bit less than 1 per cent – but below the long-term average of a bit over 3 per cent. There are, of course, a wide range of other scenarios and these calculations are best thought of as a guide to what broad configuration of output growth might be possible given the supply-side constraints. Inevitably, there are a number of uncertainties, foremost amongst which are the future rate of productivity growth in the non-mining economy and the ability of the labour market to effectively match workers with the new employment opportunities that are being created. These are both issues that we will need to watch carefully over the period ahead as we continue to assess the balance between supply and demand in various parts of the economy. The overall conclusion from this work is that given the huge pipeline of mining investment and the current relatively low unemployment rate, it is likely that conditions will continue to vary significantly across industries for some time to come. This work also serves as a reminder that improving productivity growth remains the key to strong output growth in the non-mining-related parts of the economy. It also suggests that there is some scope for non-mining-related demand to grow a little more quickly than has been the case in the recent past. Monetary policy I would like to draw all this together, with a few remarks about monetary policy and the Reserve Bank’s latest forecasts. In the first half of 2011, our judgement was that strong growth in demand, together with evidence that inflation had picked up, required mildly restrictive financial conditions. As the year progressed though, and it became evident that this strong demand growth was not putting the expected pressure on domestic capacity and thus prices, the Board eased monetary policy, lowering the cash rate in both November and December. And then following the recent CPI data which provided confirmation of the subdued inflation pressures, the Board lowered the cash rate by a further 50 basis points, bringing the cumulative decline since November to a full percentage point. Over this period, most lending rates in the economy have fallen by around three-quarters of a percentage point and are now at slightly below-average levels. The Bank’s latest inflation forecast is for underlying inflation, abstracting from the effects of the carbon price, to stay close to its recent rate over the next one to two years. Given that the disinflationary impact of the appreciation of the exchange rate on prices of imported goods is likely to lessen over time, this forecast incorporates some moderation in domestically generated inflation pressures. In particular, it is based on an expectation that productivity growth will pick up somewhat as firms respond to the difficult trading environment that many currently face. It is also based on an expectation that the current pressures on margins being experienced by many firms in the non-mining-related parts of the economy will work their way up the production chain, leading to some moderation in growth in input costs, including in the cost of labour. In terms of output, overall GDP growth is expected to return to around trend over the forecast horizon, with the recent reductions in the cash rate providing some boost to demand in the non-mining-related parts of the economy. However, it does seem likely that growth in some sectors will remain below the average experienced over the past couple of decades. How things develop will depend importantly on the ability of firms to improve their productivity and on the ability of the labour market to match workers with the new jobs being created. BIS central bankers’ speeches Finally, as we work our way through these myriad of issues, it is important that we do not lose sight of the considerable benefits to Australia from the lift in the prices of our key exports and the unprecedented level of investment that is taking place. This morning I have talked about how these developments are changing the structure of the economy. I have also talked about the challenge that they pose for assessing the balance between supply and demand. Yet for all this, the high commodity prices and high investment provide Australia with tremendous opportunities – opportunities that many other countries wish they had. As our society works out how best to take advantage of these opportunities, the job of the Reserve Bank is ensure that inflation remains low and stable and that the overall economy remains on an even keel. The medium-term inflation-targeting arrangements that have been in place for nearly two decades now provide a strong framework in which to do this. Thank you for listening and I look forward to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 5 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Payments Clearing Association (APCA) 20th Anniversary Symposium, Sydney, 28 May 2012. | Glenn Stevens: Innovation, stability and the role of the Payments System Board Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Payments Clearing Association (APCA) 20th Anniversary Symposium, Sydney, 28 May 2012. * * * I have not spoken publicly on payments system matters for some time, but it would be hard to find a better moment and a more appropriate event to take up the issue once more. This symposium of course marks 20 years of the Australian Payments Clearing Association, which was set up as a vehicle to coordinate decision-making in relation to clearing and settlement following the recommendations of the Brady and Martin Reports in the years prior. It effectively replaced the Australian Clearing House Association, which was largely focused on cheques – the dominant payment system of the time. Sharing the stage with APCA in the early days was the Australian Payments System Council, which had been established in the 1980s as an advisory body to the Government aimed at promoting and influencing the development of payment systems. The Council was wound up when the Payments System Board was established in 1998, following the recommendations of the Wallis Inquiry. APCA itself has evolved over the years. New clearing streams have been added and it has moved more into an industry representation role. Its make-up has also evolved; for instance I note that it was originally chaired by a representative of the Reserve Bank, an arrangement that ended in 1998. All this change over an extended period is a sure sign that there has long been recognition of how critical governance arrangements are to payments systems. The same debates that have occurred in Australia on these issues are repeated around the world. In fact, while the institutional arrangements for payments vary enormously from one country to another, it is remarkable how similar the debates are in each of those countries. I will be dealing with some of those issues today. The other reason that it is a good time to be speaking about payments is that, as I am sure many of you are aware, the conclusions of the Reserve Bank’s Strategic Review of Innovation are due to be released very soon. In fact they will be out within the next couple of weeks. I cannot pre-empt the detailed findings, but I will share with you some of the major themes. Naturally, most people will focus on the implications for the payments industry. But the conclusions will also have implications for the way that the Payments System Board goes about its business in relation to retail payments issues. That is as it should be. The Board is not a static entity either and its role evolves over time. My focus today, then, will be both innovation and the role of the Payments System Board. But with regard to the latter, I will talk not just about challenges in the retail payments sphere, but also about the other role of the Board that is probably less known to most of the people in this room – that is, the regulation of financial market infrastructure in order to preserve financial stability. This takes up a sizeable and increasing part of the Board’s time. Payments innovation: why is it important? Why all the focus on payments innovation? It might, on its face, seem strange for the Reserve Bank to have devoted a considerable amount of time and effort to reviewing innovation in the payments system. For one thing, Australia has received great dividends from allowing, in most cases, commercial imperatives to drive the process of delivering new products, including payment BIS central bankers’ speeches products. We of course take a more cautious approach when it comes to matters of risk in the financial sector and we have seen how important those considerations are over the past few years. But in general, the notion that a regulator should be involved in matters of innovation might be seen as inconsistent with the regulatory philosophy in Australia. Certainly the Payments System Board has been reluctant to “pick winners”. The other reason that it may seem slightly anomalous for the Reserve Bank to be preoccupied with payments innovation is that we see a great deal of it around us and every sign that there is significantly more around the corner. If we think about the rapid rise of PayPal, the spread of chip and now contactless card payments, and the enormous amount of energy that is being focused on mobile payments at the moment, there is clearly no shortage of innovation in payments. There is, however, a problem, and one about which the various players in the payments space themselves have become increasingly concerned. It is that the innovation in the customer-facing technology is moving at a pace much greater than the underlying infrastructure. This is a problem because innovation in a network industry is not like innovation in other industries. No matter how much time, effort and money a financial institution puts into its own systems and the ways in which customers interface with those systems, the payments service it can provide is only as good as the arrangements that allow payments to pass between institutions. These arrangements are in the cooperative space; not even the most innovative payments provider has the capacity to control these on its own. It is easy to see how this could act as a constraint on innovation. Cooperative decision-making between competitors is notoriously difficult. The implications of different business mixes, strategies and investment cycles can easily derail cooperation, not to mention the constraints of committee-based decision-making. These are classic coordination issues, where some external impetus may be required to initiate change. Even if coordination problems could be overcome for an innovation that is in the public interest, institutions collectively might find it difficult to make a business case to invest. Once again, this largely seems to be a quirk of the payments industry. Payment systems are “two-sided markets”. In other words, the market must satisfy two distinct sets of customers; for instance, a point of sale payment system can be successful only if it is adopted by both consumers and merchants. In two-sided markets the price faced by each set of end-users may be altered so that the party with the greatest decision-making power faces a low price. This is most evident in the credit card market, where consumers typically face a low or negative price while merchants face a relatively high price. The flow of interbank fees to support this has traditionally made issuing cards profitable for financial institutions. Because payment systems often do not simply operate on a user-pays model, establishing a business case can be more difficult than in other industries, even where there is a clear demand from end-users. This means there is a case for some kind of mechanism to overcome coordination problems and to ensure that any disconnect between the public interest and the business case is properly managed. But any intervention by a regulator like the Payments System Board of the Reserve Bank must of course be carefully considered. The Payments System Board will be addressing the issue from two different perspectives. First, it will be expressing some views about the governance arrangements within the industry, with the aim of giving those the best possible prospects of successful collective decision-making and appropriate consideration of the public interest. More details on that will be included in the conclusions of the Review. Second, the Board believes that in order to overcome coordination problems, it will need to take a stronger role in setting some general goals for the payments system, so as to help provide an appropriate focus for the innovation efforts of the various players. There will need, in the Board’s view, to be greater interaction between the Board and the industry to establish and work towards shared goals. Our assessment of experience both in Australia and BIS central bankers’ speeches overseas is that superior industry outcomes have been achieved when there has been a policy influence promoting public interest goals. Examples range from reform of the ATM system in Australia to the establishment of the Faster Payments Service – for real-time retail payments – in the United Kingdom. Therefore, you can expect the conclusions of the Review to have more to say about a more constructive engagement between the Board and the industry in relation to payments innovation. The Board will not be picking winners, nor generally will it dictate the technical details of systems. The Payments System Board is a policy-making body. It would not seek to impose the technical details of solutions, unless it was aware of a very clear public policy basis for preferring one approach over another. In most cases, it is for the Board to provide guidance as to what outcomes it believes are required in the public interest, but not specific solutions. The latter are clearly the domain of industry experts, with their knowledge of the technical and business constraints. But it is important that they be informed by the Board’s broader policy goals. The Board’s thinking about those goals has been informed by two considerations. First, early in the Strategic Review of Innovation, the Board identified a number of attributes that were valued by end-users, as well as some that are important in payments system design. These included such things as: the timeliness of payments; accessibility; ease of use; ease of integration into other processes (such as business systems); and safety and reliability. Examining the services the payments system offers in terms of these attributes strongly suggests the areas where greater innovation in the payments system is needed, and where the underlying infrastructure might be imposing constraints on innovation. Second, the Board has considered developments in retail payment systems around the world. An understanding of what is available elsewhere and whether those things are valued and adopted by the users of payment systems is a very important common-sense test when considering what our own system ought to look like. This effort has in part been aided by interactions with many parties over the course of the Strategic Review, along with the work of the Committee on Payment and Settlement Systems of the Bank for International Settlements, which has conducted an examination of innovation in retail payment systems. On the basis of this information, the Board sees the need to focus on the infrastructure capabilities of retail payment systems, rather than the specific products that are offered. Appropriate infrastructure can only be delivered cooperatively, but success in that delivery will allow payments providers to compete vigorously over the products and services they offer to customers. That should be true, not just for deposit-taking institutions, but for other innovative players that have something to offer in the provision of retail payments. I talked before about customer-facing innovation outpacing innovation in core infrastructure. What the Board is interested in is lifting the constraints imposed by that infrastructure. As to the specific areas on which the Board is focused, to those who have followed this process, and the documents that have been produced along the way, it will be no secret that one area on which the Board has focused is the timing of payments. It is very clear that both individuals and businesses are demanding greater immediacy and greater accessibility in all facets of their day-to-day activities. This includes payments. People expect to be able to book an airline ticket and choose their seat at any time of the day or night. They expect to be able to download music or a book while they are sitting on the bus. Our payments system supports these transactions by allowing the payment to be initiated, and goods or services exchanged, even though the funds will not be available to the merchant until some time later. This delivers the immediacy to the transaction itself, as people have come to expect. On the other hand, if a business or an individual wishes to receive funds into an account at a financial institution, that same immediacy is not available. For instance, if a business wishes to make timely use of the proceeds from a large shipment, or an individual is in need of emergency assistance from a government agency, options are very limited. This is because the infrastructure that underpins retail payments assumes that making funds available the BIS central bankers’ speeches next business day is sufficient. This has served acceptably well to date, but, with systems for real-time transfers available in countries ranging from the United Kingdom to Mexico, Australia’s approach is starting to look a bit dated. It is our belief that availability of real-time transfers would fill some important existing gaps, but would also open up enormous potential for innovation on top of that system. This would contrast with the current situation, where a significant amount of effort is being put into finding work-arounds for the current constraints of our systems. Another element of the timeliness of payments is the availability of the payments system out of standard banking hours. Some systems, such as card payment systems, give the impression of operating 24/7, but in reality no funds move between financial institutions out of hours, constraining the services that can be offered to end-users of the payments system. Some would argue that anything more is unnecessary and that consumers and businesses are not unduly inconvenienced by this. But we receive enough complaints about this to suggest that expectations are changing. It is not that long ago that it was accepted that if a person wanted to ensure that they had enough cash to see them through the weekend, they had to make sure that they visited their bank branch by closing time on Friday. But we would all see that as completely unacceptable these days and I think we have reason to hold the rest of our payments system to the same standards. One question that we have come back to during the Strategic Review is what sort of payments system architecture would best allow us to deliver the features that we think are going to be demanded by payments system users in the years to come, including improved timeliness. Australia has had a long-running practice of operating payment systems that are based on both bilateral business agreements between participants and the bilateral exchange of payments between those participants. This model presents a number of problems, not least the complexity and cost of adding a new entrant, which must establish similar arrangements with each existing participant. Some of the significant changes we have seen in the payments system over the past few years have represented partial moves away from those bilateral arrangements. This includes the move to the industry community of interest network for clearing payments and the creation of eftpos Payments Australia Limited to centralise governance of the eftpos system. These changes denote recognition of the constraints of bilateral payment systems. While the Reserve Bank does not advocate walking away from some of the well-established and low-cost bilateral systems we have, we can see a strong case for any new architecture that is established to meet emerging needs to be based on centralised architecture; that is, a hub and spokes, rather than bilateral, model. So these are some of the things that will gain attention in the conclusions of the Strategic Review of Innovation when they are released in the next couple of weeks. I do not mean to suggest that the issues identified by the Review will be solved quickly, but I think we – the industry and the regulator – owe it to the users we serve to embark now on the process that will get us on to the right path. As a first step, in the months following the release of the conclusions of the Review, I expect there to be a healthy dialogue with the industry on the sorts of goals that the Payments System Board has in mind for the payments system, along with more focused discussions on some specific solutions. Other work of the payments system board I have been talking about the innovation review and the way it will alter, in some respects, the role played by the Payments System Board in the future. But it is also worthwhile to talk briefly about other developments that also have an impact on the direction of the Board more generally. The reality is that the Board’s mandate of promoting stability, efficiency and competition requires it to play quite different roles in respect of two quite different sets of players in the BIS central bankers’ speeches financial system. Most people in this room would think of the Payments System Board as the body that capped credit card interchange fees and worked with the industry to achieve reforms in the ATM system. There is another set of players out there who think of the Payments System Board as the body that seeks to ensure the stability of key financial market infrastructure, or “FMIs”, such as securities settlement systems and, increasingly importantly, central counterparties – which stand between financial market participants in order to better manage risk. Much of this role came to the Board later than its initial payments mandate, when the Corporations Act 2001 adopted licensing arrangements for all clearing and settlement facilities in 2001. As important as the Board’s work on payments system efficiency is, the stable operation of FMIs has a direct bearing on financial market and financial system stability. Oversight of FMIs therefore demands a significant proportion of the Board’s time. It is also this work that is expanding most rapidly. In fulfilling its responsibility for the stability of financial market infrastructure, the Board has historically focused on the high-value payments system, RITS, with which people in this room are more than familiar, along with the debt and equities settlement systems operated by the ASX and the equities and derivatives central counterparties also operated by the ASX. In addition, the Reserve Bank has for some years been part of an international cooperative oversight arrangement for the global foreign exchange settlement system, Continuous Linked Settlement (CLS). Two developments mean that the Bank’s and the Board’s workload in this area is increasing. First, while most financial market infrastructures serving Australian markets are currently operated by one entity, cross-border competition is increasing, particularly for central counterparty clearing services. It is likely that the Bank’s oversight responsibilities will increase and become more complex as it has to deal with new entities offering services in the Australian market. The other development affecting the Board’s role is the global push to strengthen financial regulation in the wake of the global financial crisis. That includes the push for OTC derivatives to be cleared through central counterparties and reported to trade repositories, as embodied in the G-20 commitments from Pittsburgh in 2009. All this means financial market activity that is important to Australia will be increasingly reliant on centralised financial market infrastructure. The logic of this reform is that it will reduce and simplify bilateral exposures between counterparties. But it will also increase the systemic importance of the financial infrastructure, because we will in effect be creating a small number of “single points of failure”. Hence the resilience of that infrastructure will be critical, and the obligation of the official sector to provide proper oversight to ensure that resilience will correspondingly increase. These trends have been recognised in a number of areas that will affect the Payments System Board’s work in the period ahead. • The international standards used by central banks and securities regulators around the world as the cornerstone for oversight of FMIs have been comprehensively rewritten to reflect the lessons of the crisis and the increased importance of central counterparties and trade repositories. The revised standards were released just last month and it will be a substantial task for the Bank to reflect those changes in its own regulatory framework. • The Council of Financial Regulators has made a number of recommendations regarding the framework for regulation of FMIs in Australia, including that the Reserve Bank – along with ASIC – be given the power to, in extremis, “step in” and operate an FMI in the event that it suffers financial or persistent operational problems. The Bank has long had this capacity in regard to Austraclear, because of the systemically important nature of that system for the operation of the domestic money market. Domestic work in this area is occurring in parallel with international BIS central bankers’ speeches efforts to develop principles for the recovery and resolution of FMIs. Over the coming year, the Board will need to devote increasing attention to establishing how step-in and other recovery and resolution tools for FMIs would operate in Australia. • Following further work by the Council of Financial Regulators, the Treasury is consulting on a legislative framework to support mandating of central clearing, exchange trading or reporting of OTC derivatives transactions, should this be warranted. Initially, however, the Council intends to rely on existing market and regulatory incentives to promote central clearing. The Payments System Board is likely to have a central role in the new regime, such as overseeing new central counterparties entering the market to clear these products, as well as input into decisions about when mandates for central clearing might be appropriate. • It is inevitable that the Bank will become increasingly involved with cooperative oversight arrangements for financial market infrastructure that operates on a global basis. The upshot of all this is that the financial stability element of the Payments System Board’s role is only going to increase. This is a continuation of a trend that has been under way for some time, and to which we have already responded with a significant boost in the resources we devote to these issues within the Bank. The work of the Payments System Board on the regulatory framework complements the Bank’s broader focus on financial stability, which is of course overseen by the Reserve Bank Board. Conclusion There is a clear sense within the Payments System Board that our work over the next few years will in some respects take us into some different activities. The work for which the Board has mostly been known has focused on addressing problems or distortions in individual systems, albeit with knowledge that these distortions had significant effects on other parts of the system. The solutions have tended to be focused on the rules of those systems. Payments innovation requires something quite different because it is more clearly about solving coordination problems, which by their nature are likely to be ongoing and do not necessarily occur within the confines of an existing system. Addressing this issue will require a change in the nature of the conversation between the Board and the industry. That conversation began with the innovation roundtable earlier this year, and will continue in the period ahead, stimulated, hopefully, by the release of the conclusions from the innovation review. At the same time, the Board’s mandate in relation to financial stability remains a key focus, and the global response to the financial crisis dictates that we take on a greater, and probably more complex, role as the global focus shifts to centralised financial market infrastructure. This doesn’t mean that the Board will be paying less attention to the payments system efficiency matters for which it is perhaps best known. Much as we might want to live in a world where that type of regulation is not necessary, unfortunately the issues do not become any fewer or any less complex, and the Board is committed to continuing to meet its legislated responsibilities in this area. In fact, one challenge from innovation is that old tensions about competition might emerge in new ways. The Board will need to remain just as vigilant in these areas in the years to come. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 5 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce (SA) AMCHAM Internode Business Lunch, Adelaide, 8 June 2012. | Glenn Stevens: The glass half full Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce (SA) AMCHAM Internode Business Lunch, Adelaide, 8 June 2012. * * * It is very good to be back in Adelaide. Thank you for the invitation. As we meet here, economic discussion in Australia has reached a rather curious position. Consider the background. Australia avoided a deep downturn in 2009, when most countries did not. A large number of businesses and jobs were saved by that outcome – though we will never know how many. Almost as a matter of arithmetic, the ensuing upswing was always going to be of the moderate variety. Rapid cyclical growth usually comes after a serious slump (and when it doesn’t, it comes just before one). After small downturns, less spectacular growth is the usual experience. So it has proved on this occasion. Even so, three and a half years after the depths of the crisis in late 2008, this unspectacular growth has nonetheless seen real GDP per capita well and truly pass its previous peak. This is something yet to be achieved in any of the other nations shown here (Graph 1). Graph 1 According to data published this week by the Australian Statistician, real GDP rose by over 4 per cent over the past year. This outcome includes the recovery from the effects of flooding a year ago, so the underlying pace of growth is probably not quite that fast, but it is quite respectable – something close to trend. Unemployment is about 5 per cent. Core inflation is a bit above 2 per cent. The financial system is sound. Our government is one among only a small number rated AAA, with manageable debt. We have received a truly enormous boost in national income courtesy of the high terms of trade. This, in turn, has engendered one of the biggest resource investment upswings in our history, which will see business capital spending rise by another 2 percentage points of GDP over 2012/13, to reach a 50-year high. To be sure, we face considerable structural adjustment issues arising from the mining expansion, and from other changes in the world economy. These are not easy to deal with BIS central bankers’ speeches (though they are not insurmountable). And we live in a global environment of major uncertainty, largely because of the problems of the euro zone. Nonetheless, an objective observer coming from outside would, I think it must be said, feel that Australia’s glass is at least half full. Yet the nature of public discussion is unrelentingly gloomy, and this has intensified over the past six months. Even before the recent turn of events in Europe and their effects on global markets, we were grimly determined to see our glass as half empty. Numerous foreign visitors to the Reserve Bank have remarked on the surprising extent of this pessimism. Each time I travel abroad I am struck by the difference between the perceptions held by foreigners about Australia and what I read in the newspapers at home. I harbour no illusion that this can suddenly be lifted by anything I say today. But it is, hopefully, worthwhile to offer a few facts, and some perspective and analysis of the situation. The multi-speed economy Much of our public discussion proceeds under the rubric of the so-called “two-speed economy”. It’s become very much the description of the moment, and not only in Australia. One picks up the same theme in many other countries. Indeed it is a description of the global economy. Growth in the advanced industrial countries continues to be sluggish, and in some cases output is going backwards. Within Europe, Germany has been doing well, while other nations face huge economic challenges. Meanwhile growth in the “emerging world” has been pretty robust apart from the effects of natural disasters. So in popular terms, we might say that there are varying lanes on the global growth highway: fast, slow, very slow. There are a few economies in the breakdown lane. Turning to Australia, we have long had a multi-speed economy. For example, it has been a very long-running trend that population growth tends to be faster in Western Australia and Queensland than in Tasmania or South Australia. Typically, certain industries such as housing construction show the expected differences due to population growth. Moreover while we debate the rise of mining and the much heralded “decline of manufacturing”, we might note that it has been a very long running trend that output and employment in manufacturing has grown more slowly than in the economy as a whole, and that output of various kinds of service provision has grown faster. That has been happening for at least five decades, and in most countries in the developed world. In the case of Australia’s manufacturing sector, this decline reverses an earlier rise. In fact, the respective shares of mining and manufacturing in Australia’s GDP at present are about where they were in 1900. It is obvious at present that the mining expansion is quite concentrated both in its industrial and geographical dimensions, and economic indicators do reflect that. But the mining sector is not the only sector growing. If the recent data are taken at face value, the non-mining economy has grown at about 2 per cent over the past year. Mining employment is indeed growing quickly – interestingly enough according to the available data, the increase in mining employment exceeded the fall in manufacturing employment over the past year. But the largest increase of all was in the sector called “health care and social assistance”, in which employment rose by about the size of the combined fall in manufacturing and retailing employment over the same period. And while there are clearly differing drivers by industry and by region, there are mechanisms that even out at least some of these differences. Spillovers do occur both in the private sector and via the tax and expenditure system.1 Remarkably, in the face of the understandable concern about job losses in particular regions See Lowe, P, “The Forces Shaping the Economy over 2012”, Address to the Committee for Economic Development of Australia, Sydney, 16 February 2012. BIS central bankers’ speeches and industries, the dispersion of unemployment rates by statistical region is no larger today than has usually been the case over the past 20 years. Hence while there are clearly multiple speeds, the total speed seems to have been one of reasonable growth and low unemployment. The behaviour of households But there is another aspect of the “multi-speed” experience, which I suspect explains a good deal of the dissatisfaction we see, and it has to do with the behaviour of the household sector. Some parts of the economy that depend on household spending are still experiencing relatively weak conditions, compared with what they have been used to. But this isn’t because the mining boom spillovers have failed to arrive. It is, instead, the result of other changes that actually have nothing to do with the mining boom per se, but a lot to do with events that occurred largely before the mining boom really began. The story is summed up in the two charts shown below. The first shows household consumption spending and income, both measured in per capita terms, and adjusting for inflation (Graph 2).2 In brief, household spending grew faster than income for a lengthy period up to about 2005. The arithmetically equivalent statement is that the rate of saving from current income declined, by about 5 percentage points over that period. Graph 2 It was no coincidence that households felt they were getting wealthier. Gross assets held by households more than doubled between 1995 and 2007. The value of real assets – principally dwellings – rose by more than 6 per cent per annum in real, per capita terms over the period (Graph 3). These are updated versions of charts I first used one year ago. See Stevens, G, “The Cautious Consumer”, Address to The Anika Foundation Luncheon, Sydney, 26 July 2011. BIS central bankers’ speeches Graph 3 Only a small part of this was explained by an increase in per capita expenditure on dwellings. The bulk of it came from rising prices. Moreover, a good deal of borrowing was done to hold these assets and household leverage increased. The ratio of aggregate household debt to gross assets rose, peaking at about 20 per cent. There was definitely a large rise in measured net worth, but relative to aggregate annual income, gross debt rose from 70 per cent in 1995, to about 150 per cent in 2007. Correspondingly, by 2007 the share of current income devoted to servicing that debt had risen from 7 per cent to 12 per cent, despite interest rates in 2007 being below those in 1995. It is still not generally appreciated how striking these trends were. I cannot say that it is unprecedented for spending to grow consistently faster than income, because it had already been doing that for the 20 years prior to 1995. That is, the saving rate had been on a long-term downward trend since the mid-1970s. But it is very unusual in history for people to save as little from current income as they were doing by the mid-2000s. And it is very unusual, historically, for real assets per person to rise at 6 per cent or more per annum. It is also very unusual for households actually to withdraw equity from their houses, to use for other purposes, but for a few years in the mid-2000s that seemed to have been occurring. Of course, Australia was not alone in seeing trends like this. There were qualitatively similar trends in several other countries, particularly English-speaking countries that experienced financial innovation. The international backdrop to this period was the so-called “great moderation”, in which there was a decline in macroeconomic variability. There were still business cycles but downturns were much less severe than in the 1970s or 1980s, inflation was low and not very variable, which meant that nominal interest rates also were generally low and not very variable, and compensation for risk became very modest.3 There was, of course, a nagging problem of periodic financial panics. But several of these seemed to be managed without serious lasting damage. The Asian financial crisis was devastating for the Asian countries involved, but the global economy was not badly affected. The Russian crisis of 1998 – described, remarkably, by one experienced observer at the time as the worst since the 1940s – was similarly handled without serious fall-out. The bust of the dot-com bubble was associated with an economic downturn in the early 2000s but this too was, by historical standards, quite mild. Perhaps people began really to believe that major downturns were always avoidable and that higher leverage therefore was safe. If so, they had a major fright from 2007 onwards. BIS central bankers’ speeches This “moderation” came to an end with the crisis beginning in 2007. And with a few years of perspective, it is increasingly clear that Australian households began to change their behaviour at that time, or even a little before. The rate of saving from current income stopped falling probably around 2003 or 2004, and began to increase (we now know), slowly at first as the income gains from the first phase of the resources boom started in about 2005 or 2006, and then more quickly in 2008 and 2009. Real consumption spending per head initially remained pretty strong in this period, reaching a peak in 2008. It then declined for a year or so, before resuming growth in the second half of 2009. That growth has, however, been much slower than had been observed previously. In the nearly three years from mid-2009 through to the March quarter 2012, real consumption per head rose at an annual pace of about 1½ per cent. This is more than a full percentage point lower than the growth rate from 1995 to 2005. But this sort of growth is in fact quite comparable with the kind of growth seen in the couple of decades leading up to 1995. It is line with the quite respectable growth in income. But the gap between the current level of consumption and where it would have been had the previous trend continued is quite significant. If we then consider the growth of foreign online sales and so on, and the fact that consumers seem more inclined to consume services – experiences, as opposed to goods – we can see this is a significant change for the retail sector. No doubt reinforcing this trend towards more circumspect, but more typical, behaviour is that the earlier strong upward trend in real assets per head has abated over recent years. In fact, real household assets per head today are about the same as they were five years ago, with a dip during the crisis, a subsequent partial recovery and then a slow drift down over the past couple of years. Both dwelling prices and share prices – the two really big components of wealth – have followed that pattern. At some point, wealth will begin to increase again. After all, people are saving a reasonable amount from current income and placing the proceeds into various assets (especially, of late, deposits in financial institutions). That is, they are building wealth the old fashioned way. Ultimately these flows will be reflected in higher holdings of real and financial assets, at least once debt levels are regarded as comfortable. Asset valuation changes can of course dominate saving flows in shifting wealth over short periods and they are inherently unpredictable. So no one can predict the course of these measures of wealth over any particular short period. But wealth will surely resume an upward track, sooner or later.4 When it does, however, it is unlikely to be at 6 or 7 per cent per year in real, per capita terms. I would guess that over the long term, something more like 3 per cent would be nearer the mark. I think this is a profoundly important point and worth emphasising. The decade or more up to about 2007 was unusual. It would be quite surprising, really, if the same trends – persistent strong increases in asset values, very strong growth in per capita consumption, increasing leverage, little or no saving from current income – were to re-emerge any time soon. That is, the gap between consumption today and the old trend level on the chart is not going to close. In considering these trends in wealth and household spending behaviour, we could ask which way causation ran – did changing wealth drive changing spending patterns, or was it the other way around? The answer is almost certainly that causation ran both ways. If rising asset values creates a sense of greater wealth and people feel less need to save from current income to achieve any goal they might have for their assets, they can spend more from current income. But in spending more, and being prepared to borrow more, they also tend in the process to affect asset values for both real and financial assets, which then reinforces the trend in wealth, and so on. So it is not possible, in a very simple analysis such as the one presented here, to disentangle all that. But it seems the two trends have been related, and mutually reinforcing, in both directions. Both the strong rise in spending and the strong rise in gross assets (and leverage) ended some years back now. BIS central bankers’ speeches I noted to another audience about three years ago that the prominence of household demand in driving growth in the 1990s and 2000s was unlikely to be repeated.5 If there were business strategies that assumed a resumption of the earlier trend, they will surely be disappointed in time, if they have not been already. There were several parts of the economy that benefited from that earlier period, and that are finding the going much tougher now. Retailing was obviously one, but so was banking. Banks and other financial institutions enjoyed rapid balance sheet and profit expansion as they lent to households and some businesses. But they can see that period has now finished. Businesses that serviced rapid turnover in the dwelling stock (such as real estate agents, mortgage brokers) are seeing those revenue streams considerably reduced, and are having to adjust their strategies and capacity to suit changed conditions. For example, the rate of dwelling turnover is about one-third less than it was on average over the previous decade, and about half its peak levels. This is affecting state government stamp duty collections as well as the real estate sector. We can also see some echoes of these changing trends in household demand in business investment spending. Graph 4 This chart shows business investment, split into mining and non-mining, and measured in real, per capita terms, so as to be consistent with the earlier charts (Graph 4). Investment has been on a stronger upward trend since the mid-1990s than it had been for a number of years before that. In particular, business investment in real per capita terms has grown, on average, by over 6 per cent per annum since 1995, more than double the average pace over the preceding 35 years. Moreover a lot of this was in the non-mining sector, and it began before the present run up in mining investment really got going. Some of this growth reflected the same “consumer facing” growth sectors mentioned above. Of the four sectors that had the fastest growing investment spending over that period, three were finance, one called “rental hiring and real estate services”, and retail trade. Some of these sectors are slowing their investment rates now. Stevens, G, “Challenges for Economic Policy”, Address to The Anika Foundation Luncheon, Sydney, 28 July 2009. BIS central bankers’ speeches Meanwhile, mining investment has recently been rising at an extraordinary pace. In 2005, mining investment was near its long-run average of around 2 per cent of GDP. By mid-2014 we expect it to reach at least 9 per cent of GDP. If that occurs, mining investment will be about as large as business investment in the rest of the private economy combined. As a result of that, total business investment will reach new highs this year, and next. Hence there is a very large build-up in the nation’s capital stock occurring. If it is well managed and soundly based, that ought to allow the possibility of further growth in output and incomes. The investment phase of the mining boom will start to tail off in a couple of years’ time, after which the shipments of natural resources should step up significantly. We might expect by then as well that some other areas of investment spending that are weak at present will be picking up. More generally, I suspect we will discuss the nature of investment quite a bit in coming years as we grapple with structural change in the economy and powerful shifts in the population’s needs (think of investment in the aged-care sector, for example, or public infrastructure needs). We will also be looking for productivity pay-offs from the various investments. But the key message for today is that the multi-speed economy is not just about the mining sector squeezing other sectors by drawing away labour and capital and pushing up the exchange rate. It is doing that, but slower growth in sectors that had earlier done well from unusually strong gains in household spending would have been occurring anyway, even if the mining boom had never come along. It is these changes in behaviour by households, in asset markets and in credit demand, that I think lie behind much of the disquiet – dissatisfaction even – that so many seem to have been expressing. But this would, as I say, have occurred with or without the mining boom. In fact, without the mining boom and its spillovers, we would have been feeling the effects of those adjustments rather more acutely than we do now. The period of household gearing up could have ended in a much less benign way. Implications for policy What are the implications of these trends for economic policy, and particularly monetary policy? Does it have a role in helping the adjustment? One thing we should not do, in my judgement, is to try to engineer a return to the boom. Many people say that we need more “confidence” in the economy among both households and businesses. We do, but it has to be the right sort of confidence. The kind of confidence based on nothing more than expectations of ever-increasing housing prices, with the associated willingness to continue increasing leverage, on the assumption that this is a sure way to wealth, would not be the right kind. Unfortunately, we have been rather too prone to that misplaced optimism on occasion. You don’t have to be a believer in bubbles to think that a return to sizeable price increases and higher household gearing from still reasonably high current levels would be a risky approach. It would surely be a false basis for confidence. The intended effect of recent policy actions is certainly not to pump up speculative demand for assets.6 As it happens, our judgement is that the risk of re-igniting a boom in borrowing and prices is not very high, and this was a key consideration in decisions to lower interest rates over the past eight months. Hence, I do not think we should set monetary policy to foster a renewed gearing up by households. We can help, at the margin, the process of borrowers getting their balance sheets into better shape. To the extent that softer demand conditions have resulted from As in 2009, the challenge is “how to ensure that the ready availability and low cost of housing finance is translated into more dwellings, not just higher prices”. See Stevens, G, “Challenges for Economic Policy”, Address to The Anika Foundation Luncheon, Sydney, 28 July 2009. BIS central bankers’ speeches households or some businesses restraining spending in an effort to get debt down, and this leads to lower inflation, our inflation targeting framework tells us to ease monetary policy. That is what we have been doing. The reduction in interest rates over the past eight months or so – 125 basis points on the cash rate and something less than that, but still quite a significant fall, in the structure of intermediaries’ lending rates – will speed up, at the margin, the process of deleveraging for those who need or want to undertake it. In saying that, of course, we cannot neglect the interests of those who live off the return from their savings and who rightly expect us to preserve the real value of those savings. Popular discussion of interest rates routinely ignores this element, focusing almost exclusively on the minority of the population – just over one-third – who occupy a dwelling they have mortgaged. The central bank has to adopt a broader focus. And to repeat, it is not our intention either to engineer a return to a housing price boom, or to overturn the current prudent habits of households. All that said, returns available to savers in deposits (with a little shopping around) remain well ahead of inflation, and have very low risk. So monetary policy has been cognisant of the changed habits of households and the process of balance sheet strengthening, and has been set accordingly. As such, it has been responding, to the extent it prudently can, to one element of the multi-speed economy – the one where it is most relevant. What monetary policy cannot do is make the broader pressures for structural adjustment go away. Not only are the consumption boom and the household borrowing boom not coming back, but the industry and geographical shifts in the drivers of growth cannot be much affected by monetary policy. To a large extent, they reflect changes in the world economy, which monetary policy cannot influence. Even if, as a society, we wanted to resist the implications of those changes other tools would be needed. In fact Australia does better to accommodate these changes, and to think about what other policies might make adjustment less difficult and quicker for those adversely affected. It is in this area, in fact, that we need more confidence: confidence in our capacity to respond to changed circumstances, to respond to new opportunities, and to produce goods and services which meet market demands. It is also to be hoped that some of the recent positive data outcomes will give pause to reflect that, actually, things have so far turned out not too badly. Conclusion We face a remarkable period in history. The centre of gravity of the world economy seems to be shifting eastwards – towards us – perhaps even faster than some of the optimists had expected. Granted, that is partly because the relative importance of Europe seems to be shrinking, perceptibly, under the weight of its internal problems. But even if the Europeans manage the immediate problems well, there is no mistaking the long run trend. That this comes just as a very unusual period for household behaviour in Western advanced countries (including Australia) has ended, has been a remarkably fortuitous combination for Australia. Certainly it means we have the challenge of adjusting our behaviour and our expectations to new drivers for growth and new imperatives for responsiveness, but we do so with growing incomes, low unemployment and exposure to Asia. That is infinitely preferable to the sorts of adjustments that seem to be the lot of so many others at present. The Australian community has understood that we can’t base growth persistently on falling saving and rising debt and that is forcing changes to business models. But it has to be said that the return of a certain degree of thrift actually strengthens our medium-term position. If we can marry that to a focus on incrementally improving the way we do things – lifting productivity – there is actually a lot to look forward to. For Australians, the glass is well and truly half full. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 6 |
Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the 41st Australian Conference of Economists, Melbourne, 11 July 2012. | Philip Lowe: Bank regulation and the future of banking Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the 41st Australian Conference of Economists, Melbourne, 11 July 2012. * * * Thank you for inviting me to be part of this panel on Bank Regulation and the Future of Banking. As you know, the world of bank regulation has seen a lot of activity in recent years. This activity has coincided with a rethinking of the role of financial institutions in our societies. It has also coincided with market-based pressures to change the way that financial institutions manage their risks. Many of the regulatory changes are quite complex and my fellow panellists – John Laker and Steven Münchenberg – are better placed than me to discuss the details. Instead, what I would like to do is to talk first about some of the implications of these changes for the financial system, including the consequences of making financial intermediation more expensive. I would then like to highlight a few of the broad regulatory issues that we are likely to confront over the years ahead. The increased cost of financial intermediation First, the higher cost of financial intermediation. Prior to the financial crisis, credit spreads were low, leverage was easily available, financial institutions had become highly interconnected and large maturity mismatches were common. You might remember, it was the time of the “Great Moderation” – many financial assets were priced for perfection and many financial institutions had based their business models on the assumption that little would go wrong. For a while, everything looked to be working out quite well; financial institutions were highly profitable and global growth was strong. But in reality, risk was being underpriced and there was too much leverage, and little was done to address the building vulnerabilities. The result has been that the citizens of many advanced economies have paid a heavy price. There has also been a serious erosion of trust in the financial sector globally, with the banking industry suffering considerable “brand damage”. Quite rightly, many people question how global banks, with their sophisticated risk models and their highly paid staff, could have managed risks so poorly. Fortunately, in contrast to these global developments, the Australian banks have fared considerably better. But because finance is a global industry, some of the consequences of the events abroad are being felt here as well. In the wake of this experience, it is not surprising that regulators and, to some extent the financial institutions themselves, have sought to address the various problems. Capital ratios are being increased, and the quality of capital is being improved. Maturity transformation is being reduced. And banks are holding more liquid assets. These changes are occurring not just because of new regulations, but also because they are being demanded by the marketplace. Together, these various changes are increasing the cost of financial intermediation conducted across the balance sheets of banks. In effect, the choice that our societies are making – partly through our regulators – is to pay more for financial intermediation and, perhaps, to have less of it. The benefit that we hope to receive from paying this higher price is a safer and a more stable financial system. This choice has a number of related implications, and I would like to mention just a couple of these. BIS central bankers’ speeches The first concerns lending spreads and the return on bank equity. In particular, loan rates are likely to be higher relative to short-term money market rates than would otherwise have been the case; in effect, some of the incidence of the higher cost of financial intermediation falls on the borrowers. In addition, if banks are safer, then, all else constant, some of the incidence of high cost of financial intermediation should also fall on the owners of bank equity who should be willing to accept lower returns. But, of course, the story does not stop here. Lower returns on equity are likely to increase the incentive for bank management to take on new risks in an attempt to regain earlier rates of return. Lower rates of return may also lead to renewed efforts at cost cutting. This could have some positive effects, but if it were to involve cuts to the risk-management function, cost cutting could create new risks. And finally, to the extent that investors realise that credit and other risks are higher than they had previously thought, they might want more compensation for holding bank equity despite the efforts to make banks safer. These various effects are quite complicated and they will take time to play out. The one change that we have already seen very clearly is a rise in loan rates relative to the cash rate. For example, during the 10 years prior to 2007, outstanding variable mortgage rates averaged 150 basis points above the cash rate. Today, this difference is around 270 basis points. This increase is due partly to the global loss of trust in financial institutions, which has led to all banks paying more for funds in capital markets. It is also due to the strong competition for deposits domestically, with banks prepared to pay large premiums for liabilities that are called “deposits” rather than “wholesale funding”. It is worth pointing out that a similar dynamic is also occurring in a number of other countries where there is strong demand for deposits, including the United Kingdom, Sweden and New Zealand. In Australia, while public attention has clearly focused on the widening spread between the mortgage rate and the cash rate, there has been much less attention paid to the fact that reductions in the cash rate have not been passed through fully into deposit rates. Only a few years back, depositors did well to be paid an interest rate close to the cash rate on their at-call deposits, and not long before that they were paid well below the cash rate. In stark contrast, today there are a number of deposit products that pay about 2 percentage points above the cash rate. In effect, what we are seeing as a result of both market and regulatory developments is an increase in most interest rates in the economy relative to the cash rate. This is something that the Reserve Bank has spoken about at length and it has been an important factor in the setting of monetary policy over recent years. In particular, this increase in interest rates relative to the cash rate has been offset by the Bank setting a lower cash rate than would otherwise have been the case. While it is difficult to be too precise, the cash rate today is in the order of 1½ percentage points lower than it would have been in the absence of these developments. A second broad implication of the increase in the cost of financial intermediation is that there is likely to be less of it, particularly across the balance sheets of banks. This effect is being compounded by a reduced appetite for debt by the private non-financial sector. One area where banks are likely to find it more difficult than in the past is in lending to large businesses. Given the current pricing, many large businesses can raise funds more cheaply in capital markets than banks can, even where the credit rating of the business is lower than the bank. In part, this reflects the brand damage done to banking which is unlikely to be repaired any time soon. With banks paying more for funds, and being subject to a range of regulatory requirements, they are likely to find it hard to intermediate between savers and the large borrowers that can go directly to the savers. This will, no doubt, provide opportunities for some banks as they help businesses connect directly with these savers, but other banks will need to focus even more on lending to households and small and medium businesses. These structural changes will bear close watching over the years ahead. BIS central bankers’ speeches Some regulatory issues I would now like to turn to the related topic of the future direction of financial regulation. This is obviously a very broad topic, but there are three issues that I would like to touch on. These are: the importance of system-wide supervision; the regulation of innovation in the financial system; and the interconnections between financial institutions. First, the importance of supervision. One of the clearest lessons from financial history is that the financial sector has an uncanny ability of finding ways of connecting savers with borrowers. When obstacles are put in the way, detours are often found. New forms of financing pop up. New institutions develop. New products come into play. We saw numerous examples of this in Australia in earlier decades, and there are many overseas examples as well, some of which are quite recent. This intrinsic flexibility of finance is one reason why the international regulatory community is spending a lot of time thinking about so-called “shadow banking”. There is a legitimate concern that current efforts to tighten regulation will push activities off banks’ balance sheets, in time creating new risks to the global financial system. While tighter rules were clearly needed in some areas, we need to remain aware of the limitations of rules alone. Looking back over the global experience of recent years, it seems that in some jurisdictions rules have been viewed as a substitute for supervision. This has been a mistake. The preservation of financial stability cannot be achieved by rules alone. It requires active and competent supervision. Importantly, a good supervisor needs a whole-of-system focus. The supervisor needs to think about the consequences of institutions following similar strategies. It needs to examine closely the interconnections between financial institutions, including those outside the formally regulated sector. It needs to examine developments in aggregate credit growth, construction activity and asset prices, and how these aggregates are distributed across the country. And it needs an understanding of how the competitive dynamics in the system are changing. And then having thought about these issues, the supervisor must be willing, and able, to act and constrain activities that pose unacceptable risks to the financial system. Judgement, not rules, is the key here. On this score, Australia has been well served by APRA’s approach to supervision, which has had an industry-wide focus. APRA has been supported in doing this by the Reserve Bank and by the Council of Financial Regulators which has regular discussions about system-wide developments. It is important that as the new rules are agreed and implemented, this strong focus on system-wide supervision is retained. The second issue – and one that has probably not received the attention that it deserves – is how regulation should deal with financial innovation. Over many decades, our societies have benefited greatly from innovation in the financial system. Financial innovation has delivered lower cost and more flexible loans and better deposit products. It has provided new and more efficient ways of managing risk. And it has helped our economies to grow and our living standards to rise. But financial innovation can also have a dark side. This is particularly so where it is driven by distorted remuneration structures within financial institutions, or by regulatory, tax or accounting considerations. Problems can also arise where the new products are not well understood by those who develop and sell them, or by those who buy and trade them. Over recent times, much of the innovation that we have seen has been driven by advances in finance theory and computing power, which have allowed institutions to slice up risk into smaller and smaller pieces and allowed each of those pieces to be separately priced. One supposed benefit of this was that financial products could be engineered to closely match the risk appetite of each investor. But much of the financial engineering was very complicated and its net benefit to society is debateable. Many of the products were not well understood, BIS central bankers’ speeches and many of the underlying assumptions used in pricing turned out to be wrong. Even sophisticated financial institutions with all their resources did not understand the risks at a microeconomic and system-wide level. As a result, they took more risk than they realised and created vulnerabilities for the entire global financial system. Recently, a number of commentators have turned their attention to how society might improve the risk-return trade-off from financial innovation, in particular the question of how we obtain the benefits that innovation can deliver while reducing the risks. Doing this is not easy, but a common thread to a number of the proposals is for greater public sector oversight of areas where innovation is occurring. There are considerable challenges here, but it is useful to think about how this might be done in practice. I suspect that the answer is not more rules, for it is difficult to write rules for new products, especially if we do not know what those new products will be, and the rules themselves can breed distortions. But to return to my earlier theme, one concrete approach is for supervisors and central banks to pay very close attention to areas where innovation is occurring: to make sure that they understand what is going on and to test, and to probe, institutions about their management of risks in new areas and new products. And ultimately supervisors need to be prepared to take action to limit certain types of activities, or to slow their growth, if the risks are not well understood or not well managed. The third issue is the interconnections between financial institutions. These institutions, by their very nature, are often highly interconnected: they hold one another’s liabilities and they trade with one another extensively in financial markets. These interconnections are an important part of a well-functioning financial system and they have tended to increase over time as finance has become more important to economies and more globalised. However, these interconnections bring risks, and addressing these risks has been an important element of the global regulatory reform work over recent times. There are a number of dimensions to this work. These include moves requiring foreign banks to set up subsidiaries, rather than branches, and efforts to increase margining in financial markets. But the one dimension that I would like to talk a little about is the greater use of central counterparties. These counterparties replace bilateral connections with connections to a central entity whose job it is to manage risk. By doing so, they hold out the promise of a more stable financial system. There are, however, some complications, so in pursuing these benefits we need to proceed with care. While a central counterparty reduces bilateral exposures, it does create a single point of failure – if the central counterparty fails every participant is affected. This means that the riskmanagement practices of the central counterparty are very important, and designing and implementing the appropriate regulatory arrangements is an ongoing task. So too is understanding the implications of any increase of demand for collateral assets that might arise due to greater use of central counterparties. Another complication is that it is typically quite costly for every participant in financial markets to become a member of a central counterparty. This means that some participants need to use the services of another institution that is a member of a central counterparty. If many participants use the same intermediary institution, then an extensive set of new bilateral interconnections will have been created and this introduces new risks that need to be managed. Indeed, since there are economies of scale in the provision of these intermediary services, there is a clear potential for concentration. A third complication is that there is not a single central counterparty and not all dealings in financial instruments will go through a central counterparty. The issue of how various central counterparties relate to one another, and compete with one another, is important. So too is understanding how the bilateral exposures between institutions change when some types of transactions go through a central counterparty and others do not. BIS central bankers’ speeches These are difficult issues and it is important to get the details right. I encourage you all to think about them and to remain actively involved in the debates. Conclusion Finally, it is worth repeating that the Australian banks have fared better than many of their international peers over recent years. This is partly because of the strong economic outcomes in Australia as well as APRA’s approach to regulation and supervision. But it also reflects the Australian banks’ higher lending standards than in some other parts of the world and their relatively limited exposure to innovative, and ultimately quite risky, financial products. While Australia did not have a financial crisis, the North Atlantic crisis is having a significant impact on our financial system. This is occurring through the tightening of regulation and though developments in the marketplace. Many of these changes are positive and, over time, they should enhance the safety and resilience of our financial system. But as these changes take place, all those interested in finance need to do their best to understand the impact on the cost and availability of finance. And we should not lose sight of the importance of systemwide supervision, including understanding the innovations in both the Australian and the global financial systems. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 7 |
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, 24 July 2012. | Glenn Stevens: The lucky country 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, 24 July 2012. * * * The Anika Foundation raises funds to support research into adolescent depression and suicide. See: <http://www.anikafoundation.com/>. I thank Mark Hack for assistance in preparing these remarks, and Ryan Fox for help in understanding the difficulties in comparing dwelling prices across countries. Thank you for coming today to support the Anika Foundation. Before I proceed I want also to thank Macquarie Bank for their support, once again, in providing today’s venue and sustenance, and the Australian Business Economists for their continuing organisational support for these annual functions. It is slowly becoming better recognised that the Australian economy’s relative performance, against a very turbulent international background, has been remarkably good. Many foreign visitors to Australia comment on this relative success and I have noticed an increase in the number of foreign companies interested in investing in Australia as a result, notwithstanding our domestic tendency towards the “glass half empty” view. But some observers – admittedly not the majority – still harbour concerns about the foundations of recent economic performance and question the basis for confidence about the future. There are several themes to these doubts, but the common element is that recent relative success owes a certain amount to things that will not continue – to luck – and that our luck may be about to turn. Rapid growth in Chinese demand for resources, for example, has been of great benefit to date, but what if the Chinese economy suffers a serious downturn? Another potential concern is dwelling prices. Australia saw a large run up in dwelling prices and household borrowing until a few years ago. Some other countries that saw this subsequently suffered painful corrections and deep recessions, associated with very stressed banking systems. Can Australia escape the same outcome? A further theme is the focus on the funding position of Australian financial institutions, insofar as they raise significant amounts of money offshore. Could this be a weakness, in the event that market sentiment turns? Actually, this is another version of the old concern about the current account deficit: what will happen if markets suddenly do not want to fund our deficit? It has long been a visceral fear among Australian officials and economists that global investors will suddenly take a dim view of us. The same sorts of concerns of organisations such as the International Monetary Fund and the ratings agencies seem to lie behind a perpetual question mark about Australia and its financial institutions. It is unlikely we will ever be able to change definitively the views of all the sceptics. And – let us be clear – we should welcome the sceptics. Perhaps some of their concerns are valid. The Reserve Bank gives a lot of thought to these issues; we certainly do not dismiss them. We should always be wary of the conventional wisdom being too easily accepted. We should never, ever, assume that “it couldn’t happen here”. It is in that vein that I wish to pose a set of questions that are thrown up by these sceptical views. In particular: How much of the recent relatively good performance was due to luck? To what extent did we improve our luck by sensible policies, across a range of economic and financial fronts? Are there signs of any of the things going wrong that people typically worry about? BIS central bankers’ speeches And if there are, or were to be, such signs, could we do anything about it? To begin, I shall re-state some key metrics. Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 These charts really require no exposition (Graph 1, 2 and 3). The message is clear. It is fair to conclude that, given the circumstances internationally, the Australian economy has exhibited more than acceptable performance over recent years. This conclusion would stand whether comparisons were made either against most other countries, or against our own historical experience. Why was it that Australia did not have a deep downturn in 2009 when so many other countries did? And why was it that we have returned to reasonable growth, when others have struggled to do so? This question has been answered on numerous occasions. There are several elements. First, the Australian banking system went into the crisis in reasonable shape. To be sure, there were some poor lending decisions during the preceding period of easy credit and there was, in hindsight, too much reliance on wholesale funding. But among major institutions, credit quality issues have turned out to be manageable. Asset quality was not as good among some of the regional banks, and even less so among some foreign banks operating in Australia, but the problems have not been insurmountable. Some observers might counter that the banks received assistance with wholesale fund raising in the form of the government guarantee. But the banks paid for that, and it was an appropriate response at a time of massive market dislocation when all their peers were receiving like assistance – and much more. Moreover the banks have neither had, nor needed, access to this for some time now and the stock of guaranteed liabilities outstanding has fallen by about half from its peak level, as issues mature or are repurchased So our banking system, while not entirely free from blemishes, was nonetheless in pretty good shape overall. Banks were able to raise capital privately in the depths of the crisis. The lowest rate of return among any of the major banks over a year during the crisis period was about 10 per cent. The Australian Government has not needed to take an ownership stake in a financial institution. Second, Australia had scope for macroeconomic policy stimulus, which was used promptly and decisively. Interest rates were lowered aggressively, from a high starting point, lowering BIS central bankers’ speeches debt servicing burdens at a rapid rate. The fiscal stimulus was one of the larger ones, as a percentage of GDP, among the various countries with which we can make comparisons. The evidence suggests that these macroeconomic measures were effective in sustaining growth. Thirdly, the rapid return to growth of the Chinese economy saw demand for energy and resources strengthen again after a brief downturn in late 2008 and the first couple of months of 2009. This reversed the fall in Australia’s terms of trade, and in fact pushed them to new highs, which led to a resumption of the historic investment build-up that had already begun. It benefited the whole of Asia, which staged a very pronounced V-shaped recovery on the back both of the Chinese measures and things other countries did themselves. A fourth element that many people add is that the exchange rate fell sharply, which was an expansionary impetus for the economy. But of course the exchange rate was responding endogenously to the various shocks and policy responses, and has since reversed the fall. It was doing what it was supposed to do. Perhaps the real point is that the right exchange rate system was implemented nearly 30 years ago, and that it was allowed to work. So Australia had these things going for it. Was this all just luck? We could not deny that our geography – thought for much of our history to be a handicap because of the distance from European and American markets – combined with our natural resource endowment has provided a basis for the country to ride the boom in Asian resource demand. We did not create that, though we still have to muster the capability to take sustained advantage of it. But a well-managed and well-supervised banking system is not an accident.1 Years of careful work both by banks and APRA went into that outcome. Nor was the ability to respond forcefully, but credibly, with macroeconomic policy just luck. You don’t suddenly acquire the credibility needed to ease monetary policy aggressively while the exchange rate is heading down rapidly. Authorities in lots of countries would not feel they could do that. At an earlier point in time we probably would not have felt we could have done it either. The credibility needed to do it comes from having invested in a well-structured framework, and having built a track record of success in containing inflation, over a long period. The floating exchange rate is an integral part of that framework. Likewise, you can’t have a major fiscal easing and expect it to be effective if there are concerns about long-run public debt dynamics, as recent debate elsewhere in the world shows. You need to have run a disciplined budget over a long period beforehand, so that the amount of debt you have to issue in a crisis does not raise questions about sustainability. In both the monetary and fiscal areas, of course, having used the scope we had so aggressively, it was also necessary, as I argued in 2009, to re-invest in building further scope, by returning settings to normal once the emergency had passed. So, yes, Australia has had its share of luck. But to explain the outcomes, we need also to appeal to factors that didn’t just happen by accident. Of course, that doesn’t mean we still couldn’t have problems. Even if success to date hasn’t been due to luck alone, perhaps our luck could turn so bad that all our efforts at good policy making could be overwhelmed. Canada’s banking system was sound like Australia’s, which has helped it outperform their G7 peers. But the large neighbour to which Canada exports about 20 per cent of its GDP has held it back. Australia’s exposure to Asia, as opposed to Canada’s exposure to the United States, presumably helps to explain Australia’s stronger growth outcome relative to Canada’s. Australia’s terms of trade experience has also been stronger than Canada’s. BIS central bankers’ speeches Let us then take a look at some of the potential pressure points that people sometimes worry about. The first is the Chinese economy. One of the data series people pay a lot of attention to is the Chinese version of the so-called “Purchasing Managers’ Index”. The usual commentary surrounding such indexes invariably refers to the “50” level as the threshold between growth and contraction in the sector of the economy being examined. But what have these PMIs actually been saying about the Chinese economy? Properly calibrated, as in this chart, they suggest that growth in China’s industrial production has been running at about 5 percentage points below average, which means it is just under 10 per cent (Graph 4). But it is a long way from a contraction. We did actually see Chinese IP contract for several months in 2008; we are not seeing that at present. Graph 4 The conclusion I draw is that the Chinese economy has indeed slowed over the past year or so. It was intended that a slowing occur. But the recent data suggest that, so far, this is a normal cyclical slowing, not a sudden slump of the kind that occurred in late 2008. The data are quite consistent with Chinese growth in industrial output of something like 10 per cent, and GDP growth in the 7 to 8 per cent range. To be sure, that is a significant moderation from the growth in GDP of 10 per cent or more that we have often seen in China in the past five to seven years. But not even China can grow that fast indefinitely and there were clearly problems building from that earlier breakneck pace of growth. Inflation rose, there was overheating in property markets and no doubt a good deal of poor lending. It is far better, in fact, that the moderation occur, if that increases the sustainability of future expansion. Moreover, the Chinese authorities have been taking well-calibrated steps in the direction of easing macroeconomic policies, as their objectives for inflation look like being achieved and as the likelihood of slower global growth affecting China has increased. Prices for key commodities are lower than their peaks, but are actually still high. So far, then, the “China story” seems to be roughly on course. It is certainly true that we will feel the effects of the Chinese business cycle more in the future than we have been accustomed to in the past. That presents some challenges of economic analysis and BIS central bankers’ speeches management. But even so, it may be better to be exposed to a Chinese economy with a high average, even if variable, growth rate, than, say, to a Europe with a very low average growth rate that is apparently also still rather variable. Next I turn to dwelling prices. As everyone knows, dwelling prices rose a great deal over the decade or more from 1995, and not just in Australia. This occurred globally. The fact that it was a widespread phenomenon is a hint that we should be wary of explanations that are solely domestic in their focus. It suggests that the global dwelling price dynamic had a lot to do with financial factors – and there is little doubt that finance for housing became more readily available. In various countries prices have subsequently fallen. In the United States, for example, prices are down by about 30 per cent from their peak, though they look like they have now reached bottom. In the United Kingdom the fall was smaller – at about 15–20 per cent. In Australia, the decline since the peak has been about 5 to 10 per cent, depending on the region. There are of course prominent examples of particular localities or even individual dwellings where price falls have been much larger. Scaled to measures of income, Australian dwelling prices on a national basis have in fact declined and are now about where they were in 2002 (Graph 5). That is, housing has become more “affordable”. Four or five years ago we supposedly had a housing affordability “crisis”. Now it seems that the problem some people fear is that of housing becoming even more affordable. Are dwelling prices overvalued? It’s very hard to be definitive on that question. There are two aspects to the claim that they might be. The first is that prices relative to income are higher than they were 15 or 20 years ago. If this ratio is somehow mean-reverting, then either incomes must rise a lot or prices must fall. It could be that this analysis is correct, but the problem is that there is no particular basis to think that the price to income ratio 20 years ago was “correct”. There are reasons that might be advanced for why the ratio might be expected to be higher now than then – that the mean has shifted – though again there is little science to any quantification for such a shift. In any event, arguments that appeal to historical averages for such ratios lose potency the longer the ratio stays high. In Australia’s case the ratio of prices to income on a national basis has been apparently at a higher mean level – about 4 to 4½ – for about a decade now. The second support for the claim that dwelling prices are overvalued is the observation that they seem high in comparison with other countries. In seeking to make such comparisons, though, there are serious methodological challenges. The key difficulty is in sourcing comparable data on the level of prices across countries. Such data are, at best, pretty sketchy. With that caveat very clearly in mind, consider the following two charts. Simply comparing Australia and the United States, it is hard to avoid the impression that gravity will inevitably exert its influence on Australian dwelling prices. But if we put these two lines on a chart with a number of other countries with which we might want to make comparisons, the picture is much less clear (Graph 6).2 To the extent that we can make any meaningful statements about international relativities, the main conclusion would be that Australian dwelling prices, relative to income, are in the pack of comparable countries. In this comparison, the United States seems the outlier. These comparisons use average (rather than median) dwelling prices and average household income. Average dwelling prices are estimated using nationwide (urban and regional) prices for both houses and apartments (mostly for the privately owned housing stock); dwelling price data are taken either from transaction price information or from data on national capital stocks. Average household disposable income is sourced from national accounts data. Note that alternative income measures give slightly different results, and Australia’s relativity is somewhat higher when using broader income measures that incorporate the taxation and social welfare system. BIS central bankers’ speeches Graph 5 Graph 6 None of this can be taken to say definitively that Australian dwelling prices are “appropriate”, or that there is no possibility they will fall. It is a very dangerous idea to think that dwelling prices cannot fall. They can, and they have. The point is simply that historical or international comparisons, to the extent they can be made, do not constitute definitive evidence of an imminent slump. At the very least, the complexity of making these comparisons suggests we ought to look at some other metrics in thinking about the housing market. BIS central bankers’ speeches One would be the performance of the associated mortgages. Here, the main story is that not much has changed. Arrears remain low and if anything have been edging down over the past year. That in turn is not altogether surprising given that debt servicing burdens have declined (Graph 7). Graph 7 As a result of lower house prices and therefore lower loan sizes, somewhat lower interest rates and a good deal of income growth, the repayment on a new loan on a median-priced house as a share of average income is now at its lowest for a decade (except for the “emergency” interest rate period in 2009). It is true that a low unemployment rate is a key factor helping here, but it is also true that the proportion of households that are ahead on their mortgage payments is also high – with some evidence pointing to over half – which would provide a buffer of some months for those households in the event a period of lower income was experienced. If we look at applications for possessions of dwellings, they have been running at about 0.15 per cent of dwellings on an annualised basis. Such applications have actually declined since their peak in both NSW and Victoria, though they have risen over the past couple of years in WA and Queensland. In the United States the most comparable figure for repossessions – “foreclosures started” – peaked at over 2 per cent of dwellings. The conclusion? We should never say a crash couldn’t happen here, and the Reserve Bank continues to monitor property markets and the performance of mortgages quite closely, as we have for many years. But it has to be said that the housing market bubble, if that’s what it is, seems to be taking quite a long time to pop – if that’s what it is going to do. The ingredients we would look for as signalling an imminent crash seem, if anything, less in evidence now than five years ago. What then about funding vulnerabilities? BIS central bankers’ speeches The pre-crisis period saw too much “borrowing short to lend long”, and too much reliance on the assumed availability of market funding. Banks everywhere have been adjusting away from that model over recent years, Australian banks among them. The share of offshore funding has fallen, and its maturity has been lengthened (Graph 8). Graph 8 The flip side of this is of course the rise in domestic deposit funding, which has occasioned such competitive behaviour in the market for deposits. Interestingly enough, while we have been told over the years how Australian banks were doing the country a favour by arranging the funding of the current account, they have stopped doing this over the past year without, apparently, any dramatic effects. As measured in the capital account statistics, there has been a net outflow of private debt funding over the past two years, offset roughly by increased inflow of foreign capital into government obligations (Graph 9). This has occurred with a net decline in government debt yields and a net rise in the exchange rate. The current account deficit has, in other words, been easily “funded” without the assistance of banks borrowing abroad – in fact, while they have been net re-payers of funds borrowed earlier. BIS central bankers’ speeches Graph 9 A reasonable conclusion is that the degree of vulnerability to a global panic of any given magnitude appears to have diminished, rather than grown, over the past few years. It hasn’t completely disappeared, and it would not be sensible to expect it would, unless we were pursuing a policy of financial autarky. But there is little reason to assume that Australian institutions are somehow unusually exposed to these risks compared with most of their counterparts overseas. In the end, of course, any bank’s ability to maintain the confidence of its creditors is mainly about its asset quality. That brings us back to lending standards, the macroeconomic environment, and so on. One would think that, overall, things look relatively good in Australia, compared to the world’s trouble spots. Think for just a moment about the holdings of government debt on the books of banks in any number of other countries, and about the state of public finances of many of those countries. The arguments I have presented amount to saying that some necessary adjustments have been occurring gradually and reasonably smoothly. China’s growth had to moderate. It has slowed, but it hasn’t collapsed. Housing values and leverage in Australia couldn’t keep rising. They haven’t. Dwelling prices have already declined, relative to income, and it is in fact not obvious that they are particularly high compared with most countries. Housing “affordability” has improved significantly; over 99 per cent of bank-held mortgages are being serviced fully. Banks have reduced their need for the sort of funding that might be difficult to obtain in a crisis situation. The current account deficit is being funded by a combination of direct equity investment, and flows into high-quality Australian dollar-denominated assets, the latter at costs that have been falling. In fact, the Commonwealth of Australia, and its constituent States, are at present able to borrow at about the lowest rates since Federation. Markets do not, then, seem to be signalling serious concerns about Australia’s solvency or sustainability. But markets can be wrong sometimes. They can sometimes be too optimistic (and other times too pessimistic). So even though we don’t face immediate problems, we should ask: what if something went wrong? Below I consider a few possibilities. BIS central bankers’ speeches If the thing that goes wrong is a major financial event emanating from Europe, the most damaging potential transmission channel would be if there were a complete retreat from risk, capital market closure and funding shortfalls for financial institutions. Let me emphasise, importantly, that this is not occurring at present and if it did occur it would be a problem for a great many countries, not just Australia. But in that event, the Australian dollar might decline, perhaps significantly. We might find that, in an extreme case, the Reserve Bank – along with other central banks – would need to step in with domestic currency liquidity, in lieu of market funding. The vulnerability to this possibility is less than it was four years ago; our capacity to respond is undiminished and, if not actually unlimited, is not subject to any limit that seems likely to bind. An alternative version of this scenario, if it involved the sort of euro break-up about which some people speculate, could be a flow of funds into Australian assets. In that case our problem might be not being able to absorb that capital. But then the banks would be unlikely to have serious funding problems. If the thing that goes wrong is a serious slump in China’s economy, the Australian dollar would probably fall, which would provide expansionary impetus to the Australian economy. But more importantly, we could expect the Chinese authorities to respond with stimulatory policy measures. Even if one is concerned about the extent of problems that may lurk beneath the surface in China – say in the financial sector – it is not clear why we should assume that the capacity of the Chinese authorities to respond to them is seriously impaired. And in the final analysis, a serious deterioration in international economic conditions would still see Australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question. If dwelling prices in Australia did slump, then there would be obvious questions about how that dynamic could play out. In such circumstances people typically worry about two consequences. The first is a long period of very weak construction activity, usually because an excess of stock resulting from previous over-construction needs to be worked off. But we have already had a fairly protracted period of weak residential construction; it’s hard to believe it will get much weaker, actually, at a national level. The second potential concern is the balance sheets of lenders. This scenario is among those routinely envisaged by APRA’s stress tests over recent years. The results of such exercises always show that even with substantial falls in dwelling prices, much higher unemployment and associated higher levels of defaults, key financial institutions remain well and truly solvent. Of course, it can be argued that the full extent of real-life stresses cannot be anticipated in such exercises. That’s a reasonable point. But we actually had a real life stress event in 2008 and 2009. The financial system shows a few bruises from that period, but its fundamental stability was maintained Conclusion Most Australians I encounter who return from overseas remark how good it is to be living and working here. We are indeed “lucky” in so many ways, relative economic stability being only one of them. But what matters more is what we do with what we have. Not every good aspect about recent performance is down to luck. By the same token there are things we can do to improve our prospects – or, if you will, to make a bit of our own future luck. Some of the adjustments we have been seeing, as awkward as they might seem, are actually strengthening resilience to possible future shocks. Higher – more normal – rates of household saving, a more sober attitude towards debt, a re-orientation of banks’ funding, and a period of dwelling prices not moving much, come into this category. The years ahead will no doubt challenge us in various ways, including in ways we cannot predict. But what’s new about that? Even if the pessimists turn out to be right on one or more BIS central bankers’ speeches counts, it doesn’t follow that we would be unable to cope. Acting sensibly, with a long-term focus, has as good a chance as ever of seeing us through whatever comes our way. Most of all, and to return to the whole point of today’s event, we have much to live for. We want to do everything we can to ensure the next generation can share the positive outlook that most Australians have (almost) always had. That is why the Anika Foundation’s work is so important, and why your presence here today is so valuable. Thank you again for your support. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 7 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 24 August 2012. | Glenn Stevens: Australia’s economy against the background of recent global developments Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 24 August 2012. * * * Since the meeting we had in February, assessments of the global and local economies have waxed and waned. In February, sentiment about the international financial system was recovering somewhat, after a scare late in 2011. The actions of the European Central Bank in extending its liquidity provision to euro area banks had taken major re-funding hurdles out of the picture for a time. This was a critically important action that bought time. It was clear that the European economy had slowed, that the United States was still growing, but at only a modest pace, and that China’s growth was moderating to something more sustainable. But high-frequency indicators of the global business cycle were stabilising. So even though forecasts for global growth were at that stage being marked down a bit, we did not seem to be seeing a slump of the kind seen in late 2008. Subsequently, there were actually some small upward revisions to global growth forecasts. But, as we said at the last hearing, sorting out the problems in the euro area is likely to be a long, slow process, with occasional setbacks and periodic bouts of heightened anxiety. We saw one such bout of anxiety in the middle of this year, when financial markets displayed increasing nervousness about the finances of the Spanish banking system and the Spanish sovereign. The general increase in risk aversion saw yields on bonds issued by some European sovereigns spike higher, while those for Germany, the UK and the US declined to record lows. This “flight to safety” also saw market yields on Australian government debt decline to the lowest levels since Federation. Meanwhile, many European economies saw a further contraction of economic activity. Share markets declined sharply. Over the past couple of months, assessments of near-term global growth, having gone up a bit between February and May, have been marked back down. Bodies such as the International Monetary Fund are forecasting world GDP growth of about 3½ per cent this year, before picking up a little next year. These seem reasonable estimates at this stage, although the risks still seem weighted to the downside. It is worth noting that we still have not seen, thus far, the sort of collapse in production and trade across a wide range of countries that was observed in 2008. The global slowing we have seen has, so far at least, been of the more ordinary variety. That is not to make light of these developments, only to keep them in some sort of perspective. The kind of growth envisaged for the world as a whole is close to its long-run average. Of importance to Australia, and as we noted at the February hearing, the Chinese economy looks like it has slowed to a pace of growth that is likely to be more sustainable. This is, though, clearly below the pace seen for much of the recent past and the implications of this new pace of growth for the trajectory of demand for various commodities are still being worked through in the relevant markets. Commodity prices have declined. Australia’s terms of trade peaked about a year ago. However, they remain high in comparison with most of the past century. Overall, the developments in key commodity prices do not seem out of line with what we can observe about the progress of the global economy. Of late, financial market sentiment has again recovered somewhat. This is seen most clearly by share prices in most markets recovering the losses seen in mid-year, while interest rates on “peripheral” European debt have fallen. It could not be said that confidence is strong: uncertainty is high and much of this stems unavoidably from the situation in Europe. European policymakers have continued their efforts both to stabilise the immediate situation, and to craft stronger pan-European structures for financial management so as to provide a more enduring stability. Their actions and commitments to future actions have been BIS central bankers’ speeches important but expectations for further progress are high. Realistically, it will be quite some time before the Europeans will be able to say these problems have been put behind them, even if things go well. Turning to the domestic economy, the sequence of changes in assessment has tended to be the obverse of what we have seen internationally. At the previous hearing we believed, on the basis of the available data, that overall growth had been close to trend over 2011. Subsequently we could not avoid revising that view downwards a bit, as there seemed to be some emerging evidence that growth had been weaker than that. The most recent data, on the other hand, are suggestive that the earlier assessment may, in fact, have not been too far off the mark. As recorded, domestic final demand rose by 5 per cent in real terms over the year to the March quarter, even with a small contraction in public spending. The strongest growth was by business investment in the resources sector but even consumption spending by households rose by about 4 per cent, according to the national accounts. A good deal of the growth in demand was supplied from abroad but, nonetheless, output is recorded as having expanded by a little over 4 per cent over the year to March. That result includes recovery from the flooding of Queensland coal mines in the summer of 2011, so it overstates the underlying pace of growth. Even so, and allowing for a more moderate expansion of real GDP in the June quarter than in the March quarter, an assessment that economic activity has been growing “close to trend” over both the second half of 2011 and up to the middle of 2012 seems reasonable. Consistent with this, the rate of unemployment remains essentially unchanged from this time last year. Inflation, at the same time, has declined. The Consumer Price Index (CPI) rose by just 1.2 per cent over the past year. This was the lowest result for some years, though it partly reflects the unwinding of the large rise in some food prices that occurred in the first half of 2011 and which had pushed up the CPI. Using the various measures we have for underlying inflation, we would put it at about 2 per cent over the past year, which is still down a bit on the figure a year earlier. The rise in the exchange rate, most of which occurred over 2009 and 2010, has had a significant impact on prices for traded goods and services, but this dampening effect on the rate of change of those prices looks like it has now started to wane. As it does, the more moderate growth of domestic costs and prices that we have seen will need to continue, in order for inflation to remain consistent with the monetary policy objective. At present our forecast remains that this will be the case. In May and June, the Board eased monetary policy, lowering the cash rate by a total of 75 basis points, following the two adjustments made last year. These decisions were made based on the Board’s assessment of economic conditions and the outlook, and with regard to the balance of risks. They have resulted in borrowing rates being a little below their mediumterm averages. Since then, with growth close to trend and inflation consistent with the target, but the global outlook weaker than it was earlier in the year and confidence a bit on the subdued side, we have judged this to remain the appropriate stance. It is too early to tell how much difference the sequence of decisions to lower interest rates late last year and in the middle of this year has made to the economy, though we can observe that dwelling prices may have stopped their earlier gentle decline, and business credit has been growing at its fastest pace for three years. Consumption spending has been stronger over the first half of the year, but recent strength may in part be due to the effects of government compensation payments associated with the introduction of the carbon price. The exchange rate remains quite high, even with the decline in the terms of trade over the past year. Looking back, then, the economy appears to have been recording reasonable overall growth, relatively low unemployment, and low inflation. Looking ahead, the peak of the resource investment boom as share of GDP – the highest such peak in at least a century – will occur within the next year or two. After that the rate of resource investment is likely to decline, while the export shipments of the resources themselves will pick up. By then we might expect that BIS central bankers’ speeches some other sectors that have been weak of late, like residential and non-residential construction, might be starting to pick up. Overall, growth is forecast still to be close to trend, albeit with a different composition from that seen in the past year or two, and inflation consistent with the target. That is the central forecast. It is conditional, of course, on a range of assumptions and there are, as always, risks and uncertainties, some of which we spell out in the Statement on Monetary Policy. At a time of significant global uncertainty, and of important structural changes in the Australian economy, the degree of confidence we can attach to particular forecasts is, unavoidably, reduced. We remain prepared to respond to significant deviations from the central outlook, to the extent that it is prudent and possible to do so, within the framework that aims to foster sustainable growth and inflation at 2–3 per cent over time. Madam chair, I feel that it is important for me to make an additional statement, anticipating that the Committee will be interested once again in the matters that we have been discussing for some time now in Note Printing Australia (NPA) and Securency, and which have been prominent in the media over the past few days. The Reserve Bank condemns corrupt or questionable behaviour of any kind. We have done a lot of work to tighten controls in the two companies. We have sought at all times to deal appropriately with all the issues that have arisen, and to cooperate with the legal authorities. We have also sought to respond honestly to questions from this Committee. I have previously given evidence to the Committee on the sequence of events as we saw them unfold. It is worthwhile to try to draw that together. In so doing, it is important to keep clear the distinction between the two companies in that sequence. In 2006, following the events at the Australian Wheat Board, the Reserve Bank Board asked questions about the policies for the use of overseas agents by the two companies. In the case of NPA, the Bank’s questions prompted the company to begin a process of developing stronger policies. RBA management asked for an update on progress at NPA in early 2007, and the NPA Board appropriately sought a paper from management on dealings with sales agents. After considering that paper, the NPA Board decided that an audit should be undertaken of past practices and compliance. That audit raised several very concerning things. It recommended that, apart from discontinuing the use of agents, the NPA Board undertake an urgent investigation of the role of relevant management and staff in dealing with agents to ensure compliance with Australian law. On receiving this report, the NPA Board took the decision to cease the use of agents, and through a Board sub-committee commissioned Freehills to provide an assessment of the standards and compliance questions. It was while all these processes were under way that concerns held by a member of NPA’s management over the company’s conduct became known to a Reserve Bank Assistant Governor who sat on NPA’s Board. The NPA manager was asked by the then Deputy Governor to make a written statement. This document was part of the material examined by the Freehills team that was asked by the NPA Board to examine the matters. I have conveyed these facts to the Committee over the course of questioning at previous hearings. The document provided by the manager at NPA was held in strict confidence at his request. This was a condition required by him, and the Bank agreed to it because it valued his willingness to come forward. Seeking professional legal expertise to assess the matters contained in this document, and the concerns raised in the audit, was a mark of how seriously they were taken. The decision to seek an external legal review was an important one. In the Bank’s view, it was imperative to establish a process to investigate the issues thrown up by the audit findings and to ascertain and evaluate the facts regarding the NPA manager’s concerns. This required an assessment by qualified experts on the legal questions. The Bank did not believe that it should itself seek to make such an assessment. There are many precedents in the BIS central bankers’ speeches private and public sectors for organisations adopting similar processes in such circumstances. In the Bank’s view, this represented a proper, independent and rigorous process. That was the intention. The Freehills report was highly critical of NPA’s practices, which were in need of major reform. It also concluded, based on the material then available, that there was no evidence of a breach of Australian law. That assessment was provided in good faith, and relied on in good faith. It was not proposed by Freehills or anyone else at that time that, having been through a process that concluded there was no evidence of a breach of the law, the next step should be to approach the police. When the Australian Federal Police (AFP) were called in 2009 by the Chairman of Securency regarding the allegations made about Securency at that time, the 2007 NPA matters were all disclosed to the AFP in a timely way. The Freehills report and audit reports were provided to the AFP when requested. There was no attempt to hide any information. It has been claimed by some that the written statement by the NPA manager contained clear evidence of corrupt behaviour. In 2007, two senior legal practitioners from a leading law firm, who received this material directly from the author as part of their review and interviewed the author and others, did not view it that way in coming to their conclusion that there was no evidence of a breach of the law. Even if it were ultimately to be concluded at some later time, with the benefit of hindsight, that the report reached an incorrect conclusion, it is completely without foundation to suggest that this process – seeking information, conducting audits, having an independent legal review, implementing the recommendations from the review and the audits, and relying on the independent advice received – represented an attempt at a “cover up” by anyone in the Reserve Bank. I turn now to Securency. The RBA Board asked Securency for its policies on agents in 2006 and the company put in place additional and stronger policies and procedures. Following the audit at NPA in 2007, the Securency Board requested a similar audit and terminated one of its agents (which it shared with NPA). That audit found that, unlike NPA, Securency had a “good and robust process” in place in relation to overseas agent contracts and payments. A follow-up audit was conducted in 2008, which made the same finding. It is for this reason that the Securency Board, and the Reserve Bank, had no reason at that time to discontinue the use of agents, as had occurred at NPA. With those audits having returned those findings, the Reserve Bank was completely surprised by the allegations that were published in the middle of 2009. We now know, including from a report conducted by KPMG for the Securency Board later in 2009, that critical information regarding the use of agents was withheld from the audit teams and the Securency Board in 2007 and 2008. Finally, I turn to the question of the provision of materials to this Committee. Currently, there are a number of court orders in place that place restrictions on the documents that the Bank is permitted to disclose. The non-publication orders have been made as a result of applications by the individuals facing criminal charges and are designed to protect their right to a fair trial before an impartial jury. Further non-publication orders have been sought and obtained by the Department of Foreign Affairs and Trade (DFAT) and the AFP. Among the material subject to such orders is the statement of the NPA manager. I received legal advice in relation to whether I could table the statement. The advice was that I could not. The Reserve Bank is, however, committed to transparency with this Committee and with the community. To that end we are compiling a folder of the documents the Bank has in relation to these matters, with the intention of tabling it for the Committee at the earliest opportunity. This will include relevant excerpts from minutes of meetings of the Reserve Bank Board, the NPA Board and the Reserve Bank’s Audit Committee in the 2006–2007 period, papers prepared for the NPA Board on the use of agents, the audit reports on the use of agents in NPA and Securency, the statement by the NPA manager referred to above along with associated documents, the terms of reference for the Freehills review, the Freehills review BIS central bankers’ speeches itself, and the report to the NPA Board by its sub-committee that examined the issue. We are taking steps to seek the permission of the Court to allow the Bank to table those materials subject to orders. To the extent that I can shed further light today, while still respecting the legal processes, I am of course more than willing to do so. My colleagues and I are here to respond to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 8 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Financial Services Institute of Australia, Adelaide, 18 September 2012. | Guy Debelle: Regulatory reforms and their implications for financial markets, funding costs and monetary policy Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Financial Services Institute of Australia, Adelaide, 18 September 2012. * * * Matt Boge provided invaluable help in the preparation of this speech. It is a pleasure to speak here today in my home town. Neil Grummitt has spoken about some of the details of the regulatory reform process currently underway in Australia and globally. My aim is to consider some of the broader implications of the reforms. Before doing so, there is an important point to make. The changes we all see the banking and financial system undergoing are not purely the result of regulatory changes. Rather there are a number of forces all pushing in the same direction. Some of the changes we see are self-imposed, as financial institutions look at the lessons learned over recent years and seek to increase their own resiliency to future developments. Some are being imposed by the market in terms of the availability of both the quantity and price of particular channels of financing. Others reflect pressure from rating agencies. Currently, all of these forces are generally aligned in changing the structure of the financial system in the same direction, although they may vary in terms of degree. In that sense, the impact of regulation may not be as large as it appears on the surface. Rather regulation is, in many cases, serving to reinforce the other forces at work. But the regulatory changes will be more binding when these other forces are no longer all pushing in the same direction. The experience over many years is that some of these forces are certain to wane when the credit cycle is in full upswing. In the good times, self-discipline can falter under the weight of competitive pressures, as can market discipline. Hopefully in those circumstances, the regulatory framework will continue to impart the necessary restraint. Today, I’m going to focus on the Basel III reforms. Other reforms, such as those around central clearing and OTC derivatives are also having a significant impact on the way many of you do business, but I will leave them for another time. The Basel III measures will strengthen the requirements for financial institutions’ liquidity and capital. It is the impact of some of these reforms on financial markets and on funding costs that I would like to address today. In thinking about this issue, it is important to remember that the intent of the regulatory reforms is to alter the incentives for financial institutions and thereby bring about changes in behaviour. The prices of various financial products will change from their pre-crisis levels. This is not an “unintended consequence” (a phrase which personally I think is overused) but a desired outcome. So let me give a quick summary of the Basel liquidity reforms. The 40 or so largest deposit-taking intermediaries in Australia will be required to hold high-quality liquid assets in quantities sufficient to withstand a 30-day period of stress. This liquidity coverage ratio, or LCR, is a much tougher metric than that used in the past, both in terms of the severity and length of the stress period for which sufficient liquid assets need to be available, and in the criteria for what qualifies an asset as liquid. The test of whether an asset is liquid and of high quality is whether the asset would be able to maintain its value in the private markets during periods of severe stress. The financial crisis revealed that the universe of such assets was a lot smaller than banks (and some of their regulators) had previously assumed. In particular, the liquidity-generating capacity of private sector debt deteriorated significantly during periods of market stress, even where such debt had been highly rated. This was the case for both securitised assets – such as asset-backed commercial paper and residential mortgage-backed securities – as well as BIS central bankers’ speeches unsecured paper. For many of these assets, the only source of liquidity proved to be the central bank. This was true in the Australian market as well as internationally. In recognition of this, the intent of regulatory reform globally is to require financial institutions to hold more of their liquidity in debt securities issued by sovereigns or other official sector bodies, subject to the requirement that these issuers are themselves highly rated and their securities are liquid. All else equal, this would be expected to widen the spreads between the yields on high-quality sovereign debt and the yields on private debt securities. However, to a large extent, such repricing occurred globally during the financial crisis as the market itself reached the same conclusion as to what constituted a liquid asset. That is, the self-evident lesser liquidity of much private sector debt prompted financial market participants themselves to adjust the liquidity risk premia they required on this debt, quite independently of any direction from regulators. Within the Australian market, a reassessment of risk and changes in investors’ tolerances for assuming such risk have been important in driving the spreads between Commonwealth Government Securities (CGS) and yields on highly rated private debt securities. Since the financial crisis, there has been a considerable widening in these spreads (Graph 1). Graph 1 It is unlikely that any regulatory initiatives, and certainly not those related to Basel III liquidity requirements, have been behind the strong demand for CGS we have seen in recent years. Indeed, the major source of demand for CGS has come from foreign investors, including central banks, sovereign wealth funds and pension funds attracted by the comparative strength of the Australian economy and the sovereign’s credit standing. Non-resident investors now hold more than three-quarters of outstanding CGS. In contrast, the Australian banks own very few CGS (Graph 2). BIS central bankers’ speeches Graph 2 Within the Australian market, the only assets deemed to meet the Basel standard for liquidity are CGS, semi-government securities, cash and exchange settlement balances at the Reserve Bank. As is well known, under any conceivable scenario, the supply of CGS and semis in Australia will be insufficient for ADIs’ liquidity requirements. For this reason, the Reserve Bank has announced it will establish a committed liquidity facility (CLF). 1 On the payment of a 15 basis point fee, ADIs will be able to obtain a commitment from the Reserve Bank to provide liquidity against a broad range of assets under repurchase agreement. Eligible assets will include a range of highly rated private debt securities, including an ADI’s self-securitisations. The Bank’s commitments to ADIs to provide liquidity against these assets will be recognised by APRA for the purposes of compliance with the Basel III liquidity standards. Central bank committed liquidity facilities will also be used to meet the Basel standards in certain other jurisdictions with insufficient liquid assets. As I have said before, this arrangement is, to a large extent, the formalisation of the pre-existing liquidity arrangements in Australia and is very much consistent with the principles of central banking described by Bagehot. The imposition of the fee ensures that the intent of the Basel standard will be met. By charging ADIs for the liquidity insurance the central bank provides, the appropriate incentive is established for ADIs to manage their liquidity risk. At the same time, the design of the CLF will contain the impact of regulatory-induced demand for liquid assets, in an environment where so few outside assets exist. 2 As noted already, CGS yields have fallen well beyond levels that could have been induced by the liquidity regulations. This is evidenced by the fact that banks own so few of them. For banks, the spreads to interbank rates at which many CGS currently trade implies that See RBA (2011), “The RBA Committed Liquidity Facility”, Media Release No 2011-25, 16 November, and Debelle G (2011), “The Committed Liquidity Facility”, Speech to the APRA Basel III Implementation Workshop, Sydney, 23 November. Outside assets are those not issued by the banking system. BIS central bankers’ speeches settlement balances at the Reserve Bank would be a higher yielding investment and at least as free of risk. Similarly, the large negative spread to swap is confirmatory evidence of the shortage of CGS relative to the strong demand for the asset. 3 Recent trends within the Kangaroo bond market also illustrate that broader market dynamics have had a greater influence on the relative prices of debt securities than prospective regulatory developments. When APRA was making its initial assessment of what securities would qualify as liquid assets for the Basel III framework, there was concern expressed in some quarters about the consequences for the Kangaroo market if supranational and foreign agency debt were not considered level 1 assets. Seen from the perspective of today, it is apparent that these concerns were overstated. As AAA rated Kangaroo debt will be eligible for the CLF, it is only the payment of the fee, or liquidity premium, that distinguishes these securities from CGS and semis for regulatory purposes. The subsequent repricing of much Kangaroo debt far exceeds the size of the fee. In many cases, this repricing has rather been due to altered perceptions of their creditworthiness by ratings agencies and market participants. More generally, great store is often placed in terms of whether an asset is eligible for repo with the central bank or not. Reliance on repo eligibility does not strike me as the cornerstone of a resilient issuance program. But in recent months, we have seen a number of non repo-eligible Kangaroo issues come to market, including from some first-time issuers. This indicates that there are other more important elements that determine investor demand than being considered a level 1 asset or repo eligibility. In addition to the issue of which securities can be held as liquid assets, the other dimension to liquidity regulation is how many of these assets need to be held. In this regard, the Basel III liquidity framework makes certain assumptions about the likely calls on liquidity that a bank would experience during a 30-day period of stress. One assumption, based strongly on the experience of the past five years, is that any liquidity commitments ADIs have made to other financial institutions, including structured investment vehicles and conduits, will be called upon in full during the stress scenario. This has significantly lessened the incentives for structures designed to exploit opportunities for regulatory arbitrage, such as the conduits that issued asset-backed commercial paper. Again, though, the decline of many of these structures can hardly be attributed solely to regulatory change. Their viability was undermined when investors and ratings agencies also came to the view that the quality of such instruments was largely tied to the quality of the supporting institution. This has also seen a decline in the number of mortgage warehouses, as the providers of the warehouses have significantly increased the price to account for the much greater liquidity risk. Most non ADI mortgage providers don’t really have a balance sheet to warehouse the mortgages on, so we have seen a marked decline in their number and market share over the past five years. In terms of the support that an ADI provides to its internal business units, changes to the regulatory framework will alter how ADIs price liquidity and capital usage across the different components of their businesses. By their nature, these internal prices are rarely transparent to outside observers, but the incentives created by such transfer prices can have significant implications for financial markets. This repricing across all product lines is going on currently and still has some way to run. We have already seen its effect on the pricing of undrawn lines of credit, for example, where the increase in the price resulting from their increased liquidity cost has seen a marked reduction in their prevalence. Heath A and M Manning (2012), “Financial Regulation and Australian Dollar Liquid Assets”, RBA Bulletin, September, pp 43–52. BIS central bankers’ speeches Another example, observed by the RBA through our market operations, has been the tendency for government bond dealers to fund their positions at rates that exceed the unsecured borrowing rates in the interbank cash market. To the extent that unnecessarily high internal funding rates on these trading desks have fostered such an outcome, the new liquidity regulations may well encourage some revision to these practices. Calls on a bank’s liquidity will also arise when they are unable to roll over or maintain their existing funding. Assumptions regarding the likelihood of this are based on the regulators’ views about what forms of funding are more stable than others. Going forward, these “run-off” assumptions should be expected to influence the funding strategies adopted by ADIs. To give one example: the incentive for ADIs to issue short-term debt to other financial institutions will be considerably reduced under Basel III, as funds borrowed with less than 31 days to maturity would need to be invested entirely in liquid assets. Thus there will be a marked decline in the provision of such debt by banks. At the same time, the demand for liquid bank debt from other financial institutions, such as insurance companies and pension funds, is increasing, in part as a result of regulatory developments in those sectors. So there is a decrease in supply and an increase in demand for liquidity. Normally, in economics, such a situation would result in a change in the price (of liquidity in this case) to clear the market. My concern is that it is not clear that the demand and supply curve for liquidity provided by the regulated financial system will intersect at any reasonable price. How this is resolved is not entirely clear. If it were to push the supply of liquidity outside the regulated system, that would not be a good development. In any case, it is quite probable that new funding instruments will emerge that seek to accommodate the new regulations. In some other jurisdictions, a greater reliance on debt with 31-day notice periods (given the 30-day liquidity stress scenario) has already been observed. Regulators and financial institutions will need to ensure that this does not create a new stress point at 31 days as funding piles up at that maturity. One product where we are yet to see the effect of the new liquidity regulation on pricing is at-call deposits. Relative to other types of deposits, these products are very expensive from a liquidity point of view, but they still offer interest rates that are a large spread above the cash rate. As banks focus on the liquidity costs of such products, I would expect to see these rates decline relative to those on other types of deposits. Indeed, it would be surprising if the repricing doesn’t occur fairly soon given the liquidity regulations take full effect at the beginning of 2015. However, our liaison with banks suggests that these deposits are particularly sensitive to changes in pricing, so there is a big disadvantage in terms of losing deposits to your competitors if you are the first to reprice for the new regulations. But if an institution has a large reliance on this source of funding, it won’t be able to change that reliance overnight on the 31st December 2014. Just like supertankers, funding structures take a long time to change direction, and that change of course needs to be occurring around now. On the subject of funding, one notable feature of banks’ funding over the past three or four years has been the shift away from short-term debt securities toward deposits, in particular, term deposits (Graph 3). This shift has been a deliberate strategy on the part of the banks and has been brought about by significant changes to their pricing structure. The interest rates offered on term deposits to both retail and wholesale customers are now priced well above the rates at which the banks issue equivalent maturity debt securities, such as certificates of deposit (Graph 4). BIS central bankers’ speeches Graph 3 Graph 4 Given the forthcoming liquidity regulations, a shift toward deposits certainly makes sense. The Basel III framework views deposits as a much more stable source of funding, and has lower run-off assumptions for most types of deposits than it does for wholesale debt securities. BIS central bankers’ speeches However, as with the relative price of liquid assets, one can’t explain all of the movement in deposit pricing in terms of prospective liquidity regulations. The intensity of the competition and the rates paid on some of these deposits far exceed the implied regulatory incentive. Why, then, are banks willing to pay such high rates for this type of funding? To a large extent, the impetus has come from an internal reassessment of funding resiliency, the rating agencies and the broader market, where a bank’s ability to attract deposits has received greater attention since the financial crisis. Quite possibly, some of the focus on deposit-to-loan ratios and similar metrics is misplaced. Regardless, while term deposits appear to be a very expensive source of funding, in the current environment, banks presumably believe the alternatives would be even more expensive for their overall cost of funds. Nevertheless, the effects of changes in funding composition on the total change in funding costs for ADIs in the past five years has been fairly marginal. The increase in the cost of funding for banks and, ultimately, their customers, has been driven considerably more by a fundamental reassessment within financial markets of the risks associated with credit and liquidity exposures. The regulatory effort towards promoting more stable sources of debt funding and greater capital buffers for financial institutions is driven by a desire to foster financial system stability. As has been noted before, and as is apparent from the intense competition for deposits, changes in this direction have also been pursued by the banks on their own initiative, presumably in the belief that this will lower their overall cost of funding in the market. To the extent that regulations push ADIs to adopt a funding structure that market discipline would not make them otherwise adopt, the difference is likely to be small and the effect on overall funding costs would be smaller still. Moreover, as both APRA and the Reserve Bank have argued, any costs of this magnitude are well worth paying for a more stable financial system. 4 As regards the broader macroeconomic impact of the increase in ADIs’ funding costs, it is important to remember that in the setting of monetary policy, the Reserve Bank Board is conscious of the various rates at which credit is being priced. Consequently, where there has been an overall rise in the funding cost structure for intermediaries, the Board is able to set its cash rate target to appropriately take into account the effect on lending rates. In the current environment, there has been ample scope to lower the cash rate sufficiently so as to bring these other rates to where they need to be to achieve the desired stance of monetary policy, be they mortgage rates or business lending rates. In this regard, it is important to stress that the transmission of monetary policy is still very effective in Australia. Not only do lending rates respond to changes in the Board’s cash rate target, there is no sense in which the aggregate supply of credit appears to have been constrained by the ongoing changes in ADIs’ funding patterns. Finally, it has been suggested that while the regulations may not have a large impact on the supply of credit in the current environment, banks may have difficulty funding an increased demand for credit. However, I think this concern is misplaced. In an environment where the demand for credit has picked up because the world is a better place, funding conditions for intermediaries are also likely to be much easier. Moreover, from a macro perspective, there is unlikely to be a funding problem for the system as a whole when the world is a happier place, even if an individual institution is not 100 per cent sure where the next funding dollar is coming from. See, for example, Laker J (2012), “Bank Regulation and the Future of Banking”, Remarks to the 41st Australian Conference of Economists, Melbourne, 11 July. BIS central bankers’ speeches So, to conclude. There have been a number of significant changes to the structure of financial markets over the past five years, in terms of pricing as well as the composition of funding and lending. Regulatory reforms have certainly played a role in those changes, but one of the main points I hope to leave you with today is that the regulatory reforms have often served to reinforce changes resulting from a self-reassessment or resulting from market pressures. While these forces have all been working in the same direction in the current environment, the regulatory reforms will aim to ensure that these changes to a more stable financial structure endure when the environment is less conducive to self-discipline and as market pressures abate. 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Text of the 2012 Richard Searby Oration by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at Deakin, Melbourne, 25 September 2012. | Guy Debelle: Credo et fido – credit and trust Text of the 2012 Richard Searby Oration by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at Deakin, Melbourne, 25 September 2012. * * * It is a pleasure to deliver the Richard Searby Oration here at Deakin University. I feel honoured to follow the esteemed speakers who have preceded me. Dr Searby has had a singularly impressive career throughout which he has made a great contribution to the community of Australia in many different arenas. As I read his record, one area with which he has had little direct involvement has been that of finance, perhaps unfortunately, as it could well have benefitted from his guidance. It is the current state of the financial sector that I will talk about today. As you are all aware, the global financial system has been in a state of turmoil for more than five years now. The repercussions of this have been widespread, although thankfully Australia has been spared the worst of the impact. In other parts of the world, most obviously Europe, the United States and the United Kingdom, the fall-out from the financial crisis has seen millions lose their jobs, many for a number of years. This is most stark in Greece and Spain where around one quarter of the workforce is unemployed. Young people entering the workforce in those two countries have little prospect of finding meaningful employment any time soon; an experience that can scar their income prospects over their whole working lives and runs the risk of leading to a dangerous breakdown in social cohesion. The crisis has been very much financial in its genesis but with losses that have extended to all parts of the global economy. Unlike some recent downturns, the recovery in a number of countries has been particularly protracted this time around. In a number of countries, even some five years on, the level of output in 2007 has still not yet been reattained. This represents a sizeable loss of income and wealth. Tonight, I am going to talk about one of the elements that has contributed to this financial crisis being so long-lasting, and which might mean that there is still some way yet for it to run. The issue I want to focus on is the importance of trust in banking, and finance more generally. Hence the title of my talk today. Credo is the Latin for “I believe”, from which we get the word credit, while fido is the Latin for “I trust”, from which we get fiduciary and fidelity. 1 So credit is fundamentally an issue of trust. Without trust, we don’t have credit. That lack of credit is a phenomenon which is playing out in a number of countries around the world at the moment, again, thankfully, not here in Australia. The lack of trust is contributing to the unwillingness of financial institutions to extend credit and the difficulty some governments are having in obtaining funding. In turn, the lack of credit growth is exerting a major restraint on the economic recoveries in a number of countries around the world. In the post-war period, easier monetary policy has invariably helped foster a rebound in economic growth following a recession. An important transmission channel for monetary policy to take effect has almost always been a pick-up in lending to businesses and households. That is clearly not happening in many countries at the moment. Central banks in those countries are reaching deep into their toolkits to revive lending and foster economic recovery. But the lack of trust is significantly curtailing the ability of the normal implementation of macropolicy tools, both monetary and fiscal, to engender a sustainable economic recovery. My high school Latin teachers will be pleased to see some return, if a few decades after the fact, from their efforts. BIS central bankers’ speeches The outline of my talk is to firstly discuss the role that the financial sector plays in the economy. Then I will examine the crucial role that trust plays in financial intermediation and in ensuring the financial system runs smoothly. Following that, I will document the breakdown of trust that has occurred over the past five years. To finish on a more positive note, I will outline some of the avenues that might be taken to restore trust in the financial system. Some of these themes were addressed in a speech entitled “Credit is Trust” delivered by my colleague at the Bank of England, Andy Haldane, in September 2009. 2 Andy highlighted the reduction in trust that had taken place in the previous two years – what was then the first two years of the financial crisis. But three years on from 2009, the situation is even worse. The lack of trust in the financial system has intensified. Distrust has spread beyond the finance system to other institutions. This is particularly evident in Europe, where there is a lack of trust in some quarters in the longevity of the euro, and a lack of trust by bondholders of some European governments that they will be repaid in full. In the case of Greece, this lack of trust proved to be well-founded. This diminished trust in political and economic institutions is a particularly worrying development. I fear that the path back will be a long one. In all walks of life, including finance, trust takes a long time to build, but can be quickly and easily shattered. The financial sector and the economy To set the scene, I will start with a brief description of what the financial sector does. I hope I can avoid being too jargonistic, but please forgive me if I lapse into economists’ speak every once in a while. The financial sector plays an important role in the functioning of the economy, primarily through intermediation. Simply put, the financial sector sits between savers and borrowers. It takes the funds it raises from the savers through, for example, deposits, and then lends it to those who wish to borrow, be they businesses, governments, or households. If the system is working well, it allocates the funds to their most productive use. This benefits the savers whose money is being invested profitably, and the economy and society at large. It is important to note that the financial sector is an intermediate sector. It is not at the end of a production chain producing something which directly generates utility for society. It is a critical link along the way, the oil that keeps the economy ticking over. When the oil dries up, the economic engine starts to malfunction and can ultimately grind to a halt. In that regard the financial sector is different from other parts of the economy. It is one of the reasons it is subject to considerably more regulation and oversight, although clearly the experience of the past few years indicates that in many parts of the world the oversight and regulation were deficient. When the finance sector stops functioning properly it has knock on effects to all parts of the economy in a way that other sectors generally don’t. The experience at the end of 2008 following the collapse of Lehman Brothers demonstrated this point starkly. The contraction in the global economy was breathtaking in its rapidity, but also in its simultaneity, in a way that hadn’t been seen before. I will now step a bit deeper into the process of financial intermediation to provide a better sense of where trust comes into the process. Again, apologies if this gets a bit too arcane, but hopefully you can bear with me. Why do financial intermediaries exist? Why don’t I as a saver lend directly to you the company? Haldane A (2009), “Credit is Trust”, Speech given at the Association of Corporate Treasurers, Leeds, 14 September. BIS central bankers’ speeches One of the main reasons is because of the presence of what economists refer to as asymmetric information. Asymmetric information arises when I know more about my own situation than you do. It would be difficult for individual savers to know whether they were lending to a business that was going to put the funds borrowed to a productive purpose and be in a position to repay the loan when it became due. A financial institution such as a bank that is practised in credit assessment can reduce these information asymmetries. When a bank makes a loan, it does the due diligence on the lender and assesses the capacity of the lender to repay. While the due diligence cannot completely eliminate the information asymmetry, it can allow the bank to make a reasonable assessment of the risk incurred in making the loan. On the basis of that risk assessment, the lender charges the borrower an interest rate to compensate for the risk incurred. With an appropriately diversified portfolio of loans then, the bank should not be overly exposed to any particular development. The risk is mutualised. If there is a problem with one loan, the lender should be earning sufficient interest on the rest of its loan portfolio to cover the loss. The lender, and thereby the savers who provide the funds to the lender, are compensated for the risk incurred. Relative to lending their own funds directly, the savers are benefiting both from the (hopefully) professional risk assessment that reduces the information asymmetry and the risk mutualisation. One difficulty in this process that is apparent from what I have just said is the possibility that the risks in a portfolio of loans are correlated. In plain English, when one loan goes bad, how likely is it that other loans will go bad at the same time? For example, in an economic downturn where there is a rise in unemployment, a lender might find that more loans are becoming problematic than expected, because they are all being affected by the realisation of the same risk. The interest rate charged may have been sufficient to compensate the lender for one realisation of the risk but may not have been adequate for a large number of simultaneous realisations of risk. In addition to intermediating funds, one can also think of the financial sector intermediating risk. As I’ve just said, a financial institution has a wide range of loans on its books. By holding a diverse portfolio of risk, the institution is, in theory, less vulnerable to the realisation of any of those risks. But a financial institution doesn’t always hold all the risks on its own books. Through channels such as securitisation, a financial institution can also distribute the risk around the financial system to other institutions that are, again at least in theory, better placed to hold that risk. Who might be better placed to take on these risks? Some possible candidates are pension or superannuation funds and insurance companies that should have long horizons and a diversified portfolio of assets. It is an interesting question as to whether it is better for a bank to pool the risks on its own books or whether it is better for the risk to be off the books of the banks and instead be distributed round the system. If the risks are distributed around the system, the bank making the loan may be less inclined to do the appropriate amount of due diligence, as they are no longer so directly exposed to the consequences. In principle, the entity which buys the risk from the bank should also do an appropriate amount of due diligence. But the experience of the past few years shows that the more chains there are in this process, the more removed the end-holder of the risk is from the originator of the risk and the worse the process of due diligence becomes. On the other hand, if the bank holds too much risk on its balance sheet, and if too many of those risks crystallise, the bank is likely to find that its ability to continue to intermediate funds is severely curtailed. It will cut back on its lending – what’s commonly referred to as a credit crunch – worsening the economic environment. There are plenty of examples of this through history, including in the current crisis. So conceivably, risk should be intermediated as much as funds. BIS central bankers’ speeches These considerations are currently at play in the debate over the Volcker rule in the United States and the “ring-fencing” proposed in the Vickers report on the UK banking system. The conclusion reached in both those cases is that it is better to separate the investment banking (or risk generation) arm of financial institutions from the commercial banking or regular lending arm of the institution. Then, if some risk blows up in the investment arm, there is not a detrimental spillover to the commercial bank that crimps its ability to continue lending, thereby limiting the impact on the economy. Alternatively, one can consider a world of fractional risk banking, analogous to fractional reserve banking. With fractional reserve banking, I refrain from lending some portion of the funds you, and others, deposit with me so that I can repay you, should you decide to withdraw the funds at short notice. As long as all the depositors don’t want their funds back at the same time, that is, as long as there isn’t a bank run, then I am fine. In the case of fractional risk, I would retain some part of the exposure on my own balance sheet rather than pass it all on to you, to give me some incentive to monitor the risk and continue to do due diligence. This is often described as “skin in the game”. Trust and finance Having spent a bit of time setting the scene by describing how the process of financial intermediation works, I will now focus on the main argument: the role that trust plays in finance. Trust is pervasive at many levels of the financial system, in large part because of asymmetric information. There is the trust between the depositor and the bank. The depositor is trusting that her funds are safe with the bank. This is embodied in Frank Capra’s famous movie, It’s a Wonderful Life, where Jimmy Stewart saves the day with a paean to trust, to stop the run on the bank. Trust of this sort is particularly important because banks undertake maturity transformation, that is, borrow short and lend long. For example, banks are willing to let you deposit your money “at call”, but lend the money for periods considerably longer than that. If depositors all lost trust in a bank at the same time, as in a bank run, the bank would be unlikely to be able to repay the funds immediately. It could not call in all its loans. It would be forced to engage in a fire sale of its assets, which are mostly illiquid loans. To prevent this situation occurring, central banks provide a liquidity backstop, where they stand ready to lend money to banks if needed, against the bank’s assets (collateral). The trust in these arrangements is almost always enough for them not to be needed. There is trust between the borrower and the bank. The bank is trusting that the borrower will repay the loan. The bank can do a lot of due diligence on the borrower to be reasonably confident that the lender will repay. But ultimately there will be some trust involved. The bank needs to trust that the borrower has provided accurate information and will act in good faith. There will, however, always be a gap between what the bank can learn through its due diligence and what it needs to be completely confident the loan will be repaid in full. Because the process of financial intermediation often has a number of links in the chain, there also needs to be trust between financial institutions. Many financial transactions don’t just involve one bank lending out its deposits to the end-borrower. Often the funds are on-lent to one financial institution after another, before ultimately finding its way to the end-borrower. So trust needs to be present at every stage in the chain. One breakdown in this chain of trust between counterparties can throw a spanner in the works of the whole process. Ultimately there is only so much due diligence that can be done. Risk is always present in the financial system. Information asymmetries will always be present between the two parties in a financial transaction. Transparency can reduce but not eliminate the risk from these asymmetries. BIS central bankers’ speeches Finally, there has historically been trust between regulators and financial institutions. (I am not sure there is all that much of this trust at the moment, as I will discuss later.) “Trust me, I know what I’m doing”, was the banker’s exhortation for the light touch approach to regulation that was pervasive prior to the crisis in many countries, most obviously the UK. The argument was that banks should be broadly left to their own devices, with the discipline provided by the market deemed sufficient to keep them on track. The breakdown of trust Having described the critical role that trust plays in the process of financial intermediation, I will now describe how trust has broken down over the course of the financial crisis. The period leading up to the financial crisis saw what might be labelled, in the context of my talk today, the development of lazy trust. Things were generally going along fine, so my due diligence was that I will take you, the lender, at your word. I won’t really bother to verify that what you are telling me is true. I won’t bother to consider the possible circumstances that might hinder your ability to repay me. Moreover, with long chains of intermediation involved, there was often too much distance between the ultimate holder of the risk and the source of the risk. Too many links means that details get lost or misheard. If the due diligence is necessarily incomplete by the very nature of financial transactions, then that incompleteness is likely to get magnified, the more chains there are in the transaction. The due diligence gets dissipated along the chain. There is a presumption that someone further up the chain did the due diligence. And when times were good, no-one thought to challenge that presumption. So complacency set in, encouraged by the seemingly benign growth in the world economy. That benign environment led to an incorrect pricing of risk. Now this need not be the case, but it does seem to be a trait of human behaviour that has been evidenced many times in financial history. Good times begets complacency. Let me take a quick detour here. Taken to the extreme, this line of argument leads to a view of the world most famously associated with some Austrian economists. Good times are always setting us up for the next disaster. It is not clear to me what the appropriate policy response should be to this. Certainly one should always remain alert to the possible dangers. And certainly it may be difficult to take away the punchbowl when the party is in full swing. (Maybe that is why central bankers are never invited to good parties…) But surely it doesn’t mean we should never have good times, and instead endure a constantly mediocre performance so that no-one ever gets carried away. Obviously there needs to be a balance. To some extent, one can do the calculus. The large costs of the current financial crisis does make one think hard whether one should have let the previous boom persist for so long, as great as the benefits of it were while they lasted. But another aspect of human nature is the belief that one can avoid the mistakes of the past by learning from them. Inevitably therefore, there is the ubiquitous assertion that this time it is different. And in many aspects, each time it is different. It is easier to assess the differences than the similarities in real time. The similarities only generally become apparent after the fact. Thus, as mentioned earlier, we actually do need some level of distrust, at least initially, for the financial system to function effectively. I shouldn’t take you completely at your word. I should do some background checking to make sure that what you are telling me is true. I should check whether your circumstances have changed so I can be confident that you will still be able to repay me. So back to the breakdown of trust. Some time around 2007, it became clear to many in financial markets that there had been a major mis-assessment of risk in many parts of the financial system. While some had been warning about this mis-assessment of risk prior to this, and some had even positioned themselves to benefit from this mis-assessment, as BIS central bankers’ speeches Michael Lewis described in the Big Short, it wasn’t until the middle of 2007 that this became a more widely held opinion. Interestingly, through the second half of 2007, there was a marked disconnect between equity markets and credit markets. Credit markets came to the realisation significantly earlier that something was going badly wrong in the financial markets, but for quite a considerable period of time, equity markets assumed nothing worse than a garden variety economic slowdown was in prospect. Lazy trust evaporated. The financial system switched rapidly from complacency to deep mistrust in a short period of time. In particular, trust broke down between financial institutions, best illustrated by the final days of Bear Stearns in March 2008, and then Lehman Brothers in September of that year (see House of Cards by William Cohan and Too Big to Fail by Andrew Ross Sorkin, that are amongst the many books written about those two events). Both institutions experienced a run on them by their financial counterparties, who were unwilling to roll over their funding because of the concerns that the poor quality of the assets on their balance sheets might render the two institutions insolvent. The crucial distinction between uncertainty and risk came to the fore. I can assess the riskiness of an asset or an institution by assigning a probability to its likely value. I can then manage that risk appropriately. But if I am uncertain and unable to make a firm assessment about the value, the situation is a lot worse. I am likely to pull back and be unwilling to provide any finance to you, except on steep terms and probably only for a short term. Uncertainty is much more pernicious than risk. As I have spoken about earlier, 3 the famous Rumsfeld quote very much applies to the financial crisis. Risk is very much about the “known unknowns” but uncertainty is about the “unknown unknowns”. But maybe Mark Twain puts it a lot better: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Financial institutions and investors knew that many assets in the financial system were badly mispriced. In the case of some financial institutions, they knew about the mispricing on their own books and rightly assumed that the same was probably going on with their competitors. But they didn’t know how much. They did not know what exposure various financial institutions had to these mispriced assets. So what is termed “counterparty risk aversion” became all pervasive. The lack of trust meant that financial institutions were only willing to lend to one another for increasingly shorter periods, ultimately only overnight. A financial markets version of the bank run portrayed in It’s a Wonderful Life took place. In the UK, in the case of Northern Rock, a traditional bank run occurred as depositors became concerned about the safety of their savings. They no longer trusted the institution because they were uncertain about its ability to fund itself, given its reliance on mortgage-backed securities for funding – a market that was no longer functioning at all because of a lack of trust in the value of these securities. This breakdown in trust led to a breakdown in intermediation. Central banks stepped into this hole to play their historical role of intermediary of last resort. Central banks can replace, to a reasonable extent, the decline in the intermediation of funds by the banking sector. But it is considerably more difficult for central banks to replace the lost trust. The extent to which central banks have needed to be intermediary of last resort is evident in the vast size of central bank balance sheets in major advanced economies: the euro area, the United States, Japan and also the UK. The central banks are standing between financial institutions that are unwilling to lend directly to each other. The euro area provides a particularly clear example of this. In the second half of 2011, banks in the euro area became increasingly unwilling to lend to each other. First of all, banks would only lend against collateral (secured lending) rather than lending directly to another bank Debelle G (2010), “On Risk and Uncertainty”, Address to Risk Australia Conference, Sydney, 31 August. BIS central bankers’ speeches without any security (unsecured lending). In plain English, this means that banks would only lend to another bank if the borrowing bank would provide something like a government security or a portfolio of mortgages as collateral to the loan. Then even if collateral was provided, the length of time they were willing to provide the loan for shortened, because of a concern that the borrower would not survive long enough to repay. This placed some financial institutions in significant financial difficulty. Concerns mounted as to whether some institutions would be able to fund themselves at all. As a result of this, the European Central Bank (ECB) announced that it would provide as much funds as banks in Europe required through three year loans. So the European central bank has become the intermediary of last resort for the European banking system because the banks do not trust each other. More recently, as the lack of trust of some of the governments of Europe has intensified, the ECB has had, in effect, indicated its willingness to act as intermediary of last resort to these governments too. One of the main reasons the ECB has decided to do this is because of the lack of trust in the longevity of the euro. Investors are concerned about the possibility of redenomination risk: the possibility they are left holding an asset whose value is markedly decreased, when a country leaves the euro area and re-introduces its own currency. As a result of this mistrust, we are witnessing a balkanisation of the financial system in Europe. Investors in one European country don’t trust banks or governments in other countries. They pull back from financing across borders, preferring instead to invest their money close to home. This almost certainly is not an optimal allocation of funds to their most productive use. On top of this dangerous state of affairs in Europe, and amplifying the diminution of trust in the financial sector, recent controversies in the banking sector have hardly provided any justification for the public regaining trust in the banking system. To the extent that trust was slowly being restored in some parts of the banking system over the past few years, it was shattered by the recent revelations surrounding the LIBOR scandal, allegations of money laundering and the like. The restoration of trust So all in all, the state of the financial system in many parts of the world is not in good shape. So what is to be done about it? As in the old Irish saying, the first response is to say I wouldn’t start from here. But unfortunately, here is where we are. Using the recent experience in Europe as an example, we can consider a number of possible avenues as to what might be needed to rebuild trust. When it comes to the distrust of the state of banks’ balance sheets, transparency about the true nature of the assets on the balance sheet will clearly help. But the transparency and the disclosures clearly need to be credible to reduce the information asymmetries. Stress testing of the balance sheet by a credible independent party such as the prudential regulator (APRA in the case of Australia) can give depositors, and other investors, confidence that their money will be safe. These sorts of actions work to take the solvency risk off the table. For depositors, this is reinforced by the presence of deposit guarantees. But often it is the sovereign who is providing the deposit insurance. So if there is a lack of trust in the solvency of sovereign, this interlinkage between the financial sector and the government can amplify the problem, as has been evident in the case of Ireland and Spain, for example. The willingness of the central bank to provide a liquidity backstop, very evident in Europe at the moment, reduces liquidity risk concerns. Investors are not so concerned that they will be the ones left in the burning building when everyone else has already run to the exit. The quid pro quo for this support is that banks will be subject to more comprehensive regulation and, at least as important, more intensive supervision and scrutiny by their BIS central bankers’ speeches prudential supervisors than was the case before the crisis. The light touch is no longer acceptable. One can make a reasonable case that in Australia’s case, this doesn’t require much change. APRA has long exercised intensive scrutiny over the banks it supervises. But even here in Australia, there are a number of lessons learned through the crisis that are in the process of being applied. The regulatory regime for financial institutions has tightened considerably. While this might impose some costs on the financial sector and increase the cost of financial intermediation, the benefits are sure to outweigh those costs. This is particularly the case when we see the terrible costs of the high unemployment being experienced in a number of countries around the world at the moment in the aftermath of their financial crises. A change in management practice at financial institutions is surely also necessary in a number of cases, and this must start at the top. The culture around risk management and risk tolerance clearly is an important element of this. The practices that became pervasive throughout the first part of this century that contributed to the excesses need to change. What was considered an acceptable way of doing business will no longer suffice. Given the role that the financial sector plays in the economy, there is a form of social contract between it and the general public. As I have mentioned earlier, the financial sector enjoys a level of support that is not present for other sectors of the economy, because of the crucial role it plays. But leverage implies financial institutions are more vulnerable. We need to consider what the safe degree of leverage is. That is a debate that is being had currently. The rate of profitability in the financial sector is also a debate society needs to be having. If financial institutions are perceived to be earning too high a rate of profitability, particularly if the institution is enjoying a degree of support from the public sector, that too will impede the restoration of trust. It will be a long road back to restore trust. Without trust, the process of intermediation and credit provision will be greatly curtailed. In turn, this will impede the path to global economic recovery with costs to all. We have to lay out the road ahead, put down the road rules in the form of regulations and other curbs on the financial sector. But then the journey still needs to be taken. There are no short cuts. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 9 |
Remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Regional Policy Forum on Financial Stability and Macroprudential Supervision, hosted by the Financial Stability Institute and the China Banking Regulatory Commission, Beijing, 28 September 2012. | Malcolm Edey: Macroprudential supervision and the role of central banks Remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Regional Policy Forum on Financial Stability and Macroprudential Supervision, hosted by the Financial Stability Institute and the China Banking Regulatory Commission, Beijing, 28 September 2012. * * * One of the consequences of the financial crisis of recent years has been a re-examination of the role of central banks in financial stability policy, and the associated notion of “macroprudential supervision”. I’ve been asked to talk today about the interaction between micro and macroprudential supervision, and how we reflect that in the design of our regulatory institutions. The first thing to say is that the distinction is in my view somewhat artificial. In concept, the micro/macro distinction corresponds roughly to the difference between idiosyncratic risk and market risk in finance theory. One refers to risk specific to a firm and the other to risks affecting all firms. Microprudential supervision might be thought of as the management of the first type of risk, and macro the second. But while that distinction is conceptually clear, I think it would be overly simplistic to try to build a supervisory structure around it in practice. Certainly in Australia we don’t try to do so. External observers sometimes use the shorthand that the RBA is the macroprudential agency and APRA the micro, but we wouldn’t ourselves see it as being so clear-cut. APRA, as the bank supervisory agency, has a mandate to use its powers to promote financial stability for the system, not just to focus on the idiosyncratic risks faced by individual banks. And conversely the RBA as the central bank can’t avoid taking some interest in individual institutions even though its financial stability mandate relates to the system as a whole. The more meaningful distinction, I think, is not between the objectives of the key regulatory agencies (micro versus macro objectives) but between the powers available to them. APRA is the regulator of institutions – it supervises the banks, sets prudential standards and holds a wide range of directive and resolution powers. The RBA is the liquidity provider to the financial system, it has regulatory powers of its own in respect of clearing and settlement facilities and the payments system, and it incorporates financial stability assessments in its monetary policy decision process. Both agencies have a mandate for macro financial stability, though obviously APRA has the more specific mandate for risk management at the level of the individual institution. With that background I want to ask two questions about the design and conduct of macroprudential policy arrangements in general. 1. Is there a single right way for these powers to be allocated between the central bank and other regulatory agencies? And 2. Is there a single best practice framework, in terms of instruments and objectives, for these powers to be used? I want to suggest that the answer to both of these questions is No. I’ll then suggest a couple of important positive principles we need to stay focused on, regardless of the specifics of our national frameworks. To start with the institutional question: is there a “right” way to allocate prudential responsibilities between the central bank and other agencies? Certainly a number of jurisdictions have come to the conclusion that they needed to bring more of the supervisory powers under the central bank. This has been perhaps clearest in the UK, where the supervisory functions of the FSA are to be brought fully within the Bank of BIS central bankers’ speeches England. A similar but less comprehensive shift in the same direction has been an important part of the regulatory response in the US and the euro area. In some ways these developments seem like a natural response to the crisis. Cooperation between the holders of traditional central banking powers and those holding institutional regulatory powers is very important. Where that cooperation is considered to have been inadequate, it is natural that institutional reforms would be directed towards fixing the shortcomings. Bringing supervisory powers into the central bank is one way of doing that. But it’s not the only way these things can be arranged, and I can see both advantages and disadvantages to the more centralised approach. Clearly the centralised approach maximises the scope for formalising the coordination between the two sets of functions. But a large institution with both central-banking and supervisory powers may be hard to manage, and it may still be susceptible to a “two culture” problem. I think this was one reason for the earlier trend towards separation of these functions a decade or more ago. My general observation is that we don’t yet know how these more formalised arrangements will perform. The centralised model has to be made to work and to build up its own culture and track record of success. That will take time, and it’s far too early to say that any of the post-crisis arrangements represents a new norm of best practice. That is especially so when we consider the length of the typical financial cycle, where episodes of serious stress might be separated by intervals of a decade or more. It will be a long time before these new arrangements are tested by the next cycle. I would also stress that the centralised model is not the only way to get effective coordination. In Australia we retain a model of separate policy agencies, with a coordinating structure to ensure they work together effectively. Our four main regulatory agencies (the RBA, APRA, ASIC and the Treasury) together comprise the Council of Financial Regulators, under the chairmanship of the RBA Governor. The Council has no statutory powers of its own, but works to coordinate the activities of the agencies in exercising their own powers. Where existing powers to act are inadequate, the Council will typically make recommendations to the government for legislative action to remedy that. In Australia we’ve found that these cooperative arrangements worked well during the crisis period. People sometimes ask us how we’ve achieved that without a formalisation of cross-agency relations, or giving one agency primacy over the others. How has the informal coordination been possible where other countries have found it difficult to make that kind of arrangement work? Are we just nicer people? I’d like to say that the answer is Yes, but I think the less frivolous answer is that institutional history matters. We’re fortunate to have built up a culture across the regulatory agencies where we regard cooperation with the other agencies as an important part of our job, and there is a strong expectation from the public and the government that we will continue to do so. That being the case, we’re not inclined to disrupt an arrangement that’s working. But clearly every country needs to tailor its institutional arrangements to its own circumstances and history. My second question was about the framework of instruments and objectives for macroprudential policies. Here again I think we need to be suitably modest as to what we can say constitutes best practice. I’ve spent much of my career working on monetary policy, and it strikes me that there are certain parallels between the current desire for a more rigorous framework for prudential policy and the search for rigor in monetary policy that occurred after the breakdown of old certainties in the 1980s and 1990s. The result of that search on the monetary policy front was a broadly agreed framework with a single instrument (the short-term interest rate) and a well-defined objective (inflation control), linked by a forecasting framework and an understanding of the feedback between instrument and objective. This broad schema has been thoroughly researched, and lies behind much of the thinking in actual monetary policy decision processes. There is also a well understood case for independence of the monetary BIS central bankers’ speeches policy process, and for transparency and clarity of objectives which has been widely built into institutional structures around the world. It strikes me that there is nothing commensurate with this schema in the field of financial stability policy. Instead of a single instrument, we have a multiplicity of instruments (e.g., capital rules, some of which may be time varying, risk weights, LVRs, liquidity rules, infrastructure requirements, supervisory intensity) whose effects are difficult to quantify. And the objective of financial stability has no simple metric. It can’t be summarised in a continuously observed number like the inflation rate, though obviously we know financial instability when we see it. Further, as I have argued, there is no single best practice model for the design and allocation of decision-making powers. The obvious conclusion is that the pursuit of financial stability is a much more subtle and complex undertaking than the traditional monetary policy function of central banks. It necessarily involves not just quantitative frameworks, but detailed surveillance of risks guided by the perspective of historical experience. I expect these are things that central banks will be devoting increasing attention to in the years ahead. I want to finish by emphasising two elements that must be at the core of effective macroprudential policies, regardless of the institutional arrangements in a given country. The first is effective cooperation between those involved in traditional central bank activities and bank supervisors. Combining these functions in an expanded central bank is not in itself a guarantee of effective coordination, though it may obviously help. Key aspects include an effective flow of information across staff in the market operations and macroeconomic departments of a central bank and those working in the areas of financial stability and bank supervision. Regular meetings among these groups to focus on risks and vulnerabilities and to highlight warning signs can be very valuable. A culture of coordination among these areas is very important in a crisis because, in many instances, a stress situation is first evident in liquidity strains visible to the central bank, and the first responses may be calls on central bank liquidity. The second element is effective bank supervision. By this I mean not just the standards and regulations but the capacity of supervisors to understand the risks that are being taken, to query them, and to ensure that they are being appropriately managed. This is a point that I know my APRA colleagues have been emphasising. A great deal of effort in recent years has gone into upgrading the prudential requirements on banks through revisions to the Basel standards and other measures. As important as these things are, their effects around the world will be only as good as the quality of implementation and the quality of supervision that builds on them. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 10 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 8 October 2012. | Glenn Stevens: Reserve Bank of Australia reviews Note Printing Australia and Securency Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 8 October 2012. * * * Madam Chair Members of the Committee Thank you for the opportunity to meet with you today. This is an occasion on which we can convey a good deal of information and answer questions. In line with the commitment I made to the Committee in August, we have provided a folder of documents which shows the process that the Board of Note Printing Australia and the Reserve Bank conducted in 2007 when concerns were raised inside NPA regarding that company’s use of sales agents in some foreign jurisdictions. As the Committee knows, criminal prosecutions have been launched about these matters and the legal processes have some time to run. It is very important that the Reserve Bank does not say or do anything which would improperly impinge on any legal process, most particularly not in a public forum. There are accordingly documents which, I am advised, we should not table at this time. Others have had to be redacted. A number of the individuals accused have expressed concerns regarding the possibility of publication of this material and the Bank has decided we should not publish it. But there is a list of documents that are relevant. If at some stage the constraints are able to be lessened, then the Committee will know what documents may be of interest. We have also provided a covering memorandum which does several things. First, it provides some background to two companies: • Note Printing Australia (NPA), which prints banknotes; and • Securency, which produces polymer substrate. This history dates back to their respective establishments in the 1990s. For Committee members or members of the public who want some general understanding of who these companies are and what they do, this may be helpful. Second, the memorandum goes through in detail the sequence of events that began with the Reserve Bank Board asking about the use of foreign sales agents by both the companies in April 2006. Thirdly, it gives an account of the way Securency, NPA and the Reserve Bank behaved after the allegations, initially only about Securency, were aired in the media in May 2009. The memorandum shows how the various documents we have identified, many of which we have provided, fit into the chronology. I would like to go through that now. Request to see policies on the use of agents in 2006 The Reserve Bank Board discussed the issue of the use of agents by the two companies at its meeting in April 2006. As a result of that discussion, the two companies were asked to provide the Reserve Bank Board with their policies on agents. Mr Thompson, at that time Chairman of the Boards of both NPA and Securency, responded to this request in July 2006, and provided the policies and associated documents for both companies. This correspondence noted that the companies had recently reviewed and strengthened their BIS central bankers’ speeches policies. While each company had its own policies and procedures, both articulated the following key elements: • the respective boards reaffirmed the companies’ policies against any direct or indirect involvement in corrupt, unethical or otherwise questionable practices, and asked management to ensure that all agents formally acknowledge and commit to this policy. The agency agreements provided for termination when this commitment was breached; • a process was established to inform the respective boards about the appointment of agents, the applicable commission rates and payments made; and • a process of annual review of these policies was established. The NPA Board sought updates on implementation of its revised policies at the February 2007 NPA Board meeting. On hearing management’s responses, the NPA Board requested that faster progress be made and that an Information Paper on the state of play with agents be prepared for the May 2007 meeting. The RBA, through the Assistant Governor (Corporate Services) and director of NPA, Mr Campbell, also sought or received updates on the implementation of the policies from the NPA Manager of Corporate Service. in November 2006 and March 2007. No probity concerns were raised in response to these requests for updates. The May 2007 NPA Board Paper, the audit at NPA and the memo from the NPA manager During the course of implementing the revised agent policies at NPA, in about mid April 2007, the NPA Manager raised concerns with Mr Campbell (Assistant Governor (Corporate Services) of the Reserve Bank, and director of NPA) about comments that had apparently been made by two of NPA’s agents and about the conduct of certain NPA management. Mr Campbell encouraged the NPA Manager to seek answers to the queries he raised and to include his concerns in the May 2007 NPA Board paper on agents which had been requested by the NPA Board. The paper, authored by the NPA Manager (as Company Secretary) and the CEO, was presented at the 16 May 2007 NPA Board meeting. It noted that two of three agents had yet to sign on to the new arrangements. The paper raised issues as to whether the management of NPA’s agents was occurring in accordance with the strengthened policies put in place in 2006. It expressed the concerns about the two agents, partly based on things that they had apparently said to the NPA Manager. In one case the agent had replied to questions in writing denying any improper conduct. In the other case a verbal explanation had been offered but no written response. There were some other irregularities noted. The paper’s recommendation was simply that “Directors note this paper”. The NPA Board in fact expressed deep concern as to the management of NPA’s agency agreements. The NPA Board at that May 2007 decided, among other things, to: • terminate the contracts of two agents; and • ask that a review of all agent files be undertaken by management. After the NPA Board meeting Mr Campbell advised the Governor and the Deputy Governor of the NPA Board’s decisions. After discussion they formed the view that NPA’s response could be strengthened if, rather than simply a review by NPA management being conducted, the Reserve Bank’s Audit Department were asked to carry out an audit of NPA’s use of agents. This was conveyed to Mr Thompson, who agreed and made a request to the Head of the Audit Department. The Reserve Bank Board was advised at its 5 June meeting about this. BIS central bankers’ speeches The draft audit report of NPA agents was received by the Chairman of NPA, Mr Thompson, on 5 June 2007. It was also received by Mr Battellino in his capacity as Chair of the Reserve Bank Audit Committee, which served as the Audit Committee of NPA. The draft report contained findings of poor business practice and controls and noted that the behaviour of some agents should have raised suspicions by NPA staff and management. Based on these findings, the draft report made a number of recommendations. Two key ones were that: • the use of agents should be limited to the extent possible; and • NPA staff should be counselled on the risks associated with the use of agents in some countries. The draft report also contained a number of recommendations for tightening controls in relation to agents. Mr Battellino as chair of the Audit Committee of NPA discussed the draft audit report’s recommendations with the Head of Audit Department and suggested that the recommendations should be strengthened to say that NPA should cease all use of agents, and that the NPA Board should conduct an urgent investigation on the role of management and staff in dealing with agents, to ensure that there had been compliance with Australian laws. These suggestions and some other proposed drafting changes were accepted. Mr Battellino also asked that the NPA Manager, who had played a key role in preparing the May 2007 NPA Board paper, had assisted the audit, and who had voiced concerns to Mr Campbell in April, be requested to come to the Reserve Bank’s Head Office in Sydney and to put any concerns he had directly to the Bank, and to do so in writing. The NPA Manager agreed to do so, but only on the condition that his visit be kept strictly confidential and having been assured that his statement would be read only by a very small number of people – the Deputy Governor and perhaps the Governor. (It was not provided to the Governor.) The meeting between the NPA Manager and the Deputy Governor took place on 5 June, the same day as the draft audit report became available. At the request of the Deputy Governor, on 8 June the NPA manager supplied a written statement through his lawyer to the Reserve Bank’s legal counsel on strict terms of confidentiality required by him. The Deputy Governor read it. The same document with some very minor changes was, at the Bank’s request, subsequently provided by the NPA Manager’s lawyer directly to the Freehills team who were engaged by the NPA Board sub-committee, also on terms of strict confidentiality and on the basis that it would be returned to the NPA Manager’s lawyer which it was. On 7 June 2007 the Reserve Bank senior management discussed the draft audit report with Mr Thompson. It was agreed that the draft audit report contained serious findings and that the NPA Board needed to meet and put in place a detailed response to the matters raised. It was agreed that, in line with the audit recommendations, the NPA Board should establish a sub-committee to investigate NPA management and staff in their dealings with agents. It was also agreed that a similar audit of the use of agents by Securency should be requested, pending which payments to Securency’s agents would be suspended. The final NPA audit report, which contained the strengthened recommendations, was provided to the NPA Board on 8 June 2007. On that day, Mr Battellino sent to the Reserve Bank Audit Committee a copy of the audit report, as well as a copy of a file note of the meeting with the NPA Chairman the prior day. The response to the audit The NPA Board met on 12 June 2007. In response to the audit, it decided to cease the use of agents. It also decided to establish an NPA Board sub-committee to investigate the conduct of NPA management in the use of agents, to implement the recommendation in the audit report. The sub-committee was to be chaired by Mr George Bennett, former KPMG BIS central bankers’ speeches managing partner and independent member of the Reserve Bank’s Audit Committee. Other members were Mr Warburton, a non-executive director of NPA and former Reserve Bank Board member, and Mr Campbell. Since NPA had no legal counsel, the Reserve Bank’s General Counsel was appointed legal counsel for the NPA Board for the investigation. The Reserve Bank Board secretary, who also acted as secretary of the Reserve Bank Audit Committee, was secretary of the sub-committee. A special meeting of the Reserve Bank’s Audit Committee (which, as noted above, served as the Audit Committee of NPA) was convened on 13 June 2007 to consider the audit report. The Audit Committee endorsed the decisions taken by the NPA Board. It also took the view that the terms of reference of the sub-committee should be widened to include an assessment of compliance with appropriate business standards and conduct, as well as Australian law, and that independent legal advice should be sought. Minutes of the Audit Committee were, as per normal practice, provided to the Reserve Bank Board at its next meeting, which was in early July. The Reserve Bank Board was informed at that July meeting of the results of the audit and the steps that were being taken in response. It asked that the investigation be carried out quickly and that, if necessary, serious disciplinary action be taken. The Reserve Bank Board was also informed that a similar audit at Securency had been commissioned. The NPA Board sub-committee decided to engage Freehills to carry out an independent investigation into the question of whether Australian law had been breached and into NPA’s business standards. The sub-committee had an initial meeting with the Freehills team on 18 June 2007 and subsequent meetings on 16 July, 25 July and 10 August 2007. The Freehills team had access to documents, including the audit report and the NPA Manager memo, and a substantial volume of emails held at NPA, including materials that the auditors had not reviewed. It also interviewed several NPA managers including the NPA Manager who had been invited to prepare the memo, the CEO and others. Mr Bennett provided an update on progress of the NPA Board sub-committee’s work to the Reserve Bank Audit Committee at its 30 July meeting. The Freehills team provided their final report to the NPA Board sub-committee on 10 August 2007. The sub-committee considered the report. On 13 August the sub-committee Chair, Mr Bennett, provided the final report to the Chairman of the NPA Board, Mr Thompson, together with a cover note. Mr Bennett noted that the inquiry had not found evidence of a breach of Australian law, but had found deficiencies of varying seriousness in relation to business practices. By this time the NPA Board had, as noted above, already taken the decision to cease using agents. A copy of the sub-committee’s report including the Freehills report was also reviewed by the Deputy Governor. At its 7 August 2007 meeting, the Reserve Bank Board was briefed about the draft findings of the Freehills report. It was also informed about the results of the audit at Securency, which are discussed in more detail below. Mr Bennett attended the NPA Board meeting on 16 August to brief the NPA Board on the sub-committee’s findings. On 29 August 2007, the NPA Board met again to discuss the report of the NPA Board sub-committee in more detail. It concluded that after an extensive investigation with assistance from external lawyers, the sub-committee had identified instances of weakness in controls and documentation, and in contract management, but it had found no evidence of illegality or impropriety by NPA managers and staff. The NPA Board resolved that proper process meant that the NPA employees who had been interviewed as part of the sub-committee’s investigation should be given the opportunity to read relevant parts of the Freehills report, and to provide comments to the NPA Board if they wished. Subsequently, extracts of the Freehills report were shown to those NPA employees. BIS central bankers’ speeches The NPA Board met again on 13 September 2007 to consider the comments received from the employees. 1 A follow up review of NPA agent arrangements was conducted by the Reserve Bank Audit Department in late 2008. That report concluded that NPA had implemented all the recommendations of the May 2007 NPA audit report. The 2007 audit of Securency Given the results of the audit of NPA, and given that Securency also used agents, it was considered necessary to have a similar audit at Securency. Although Securency had its own external auditors, the senior management of the Reserve Bank agreed with Mr Thompson that, in his capacity as Chairman of Securency’s Board, he would ask the Reserve Bank Audit Department to conduct the audit, due to their experience with the NPA audit. Mr Thompson subsequently emailed the Head of Audit, asking for the audit to be undertaken, with the scope of the audit to be similar to that carried out at NPA. The Securency Board meeting on 3–4 July noted this had occurred. It also endorsed a decision that had been taken by the Securency management to terminate the Malaysian agent. The same audit team that had conducted the audit at NPA conducted this audit at Securency. The audit began on 18 June. At the same time, Securency also suspended its payments to agents, pending the result of the audit. The Securency audit report was issued on 1 August 2007. The conclusion was that Securency had a “good and robust process” in relation to the use of agents, and that Securency’s practices were consistent with the company’s policy. The audit made a number of recommendations. The audit team supported Securency’s termination of the Malaysian agency agreement, which took effect from 15 July 2007. The Securency board was informed at its 11–12 September 2007 meeting that the audit recommendations had been implemented. The findings provided no basis to insist on the termination of Securency’s other agents. The suspension of payments to agents was therefore lifted. A copy of the Securency audit report was forwarded by Mr Battellino to the Reserve Bank Audit Committee and the results of the audit were also noted at the August 2007 meeting of the Reserve Bank Board. The following year – in December 2008 – a further audit of agent activity at Securency was undertaken. It reached similar conclusions as the 2007 Securency audit. Post-termination payments to agents by NPA The NPA Board considered what payments were due to agents who had been terminated. It sought legal advice on the question of payments to one agent in particular. After a lengthy process of legal advice which concluded that the agent would likely succeed in a legal action claiming an entitlement to commission, NPA management proposed at the 26 September 2007 NPA Board meeting that a commercial settlement be sought. On the basis of the legal advice received, the NPA Board approved the recommendation and further discussions took place through the respective lawyers of NPA and the agent. A settlement was finally agreed between the agent and the CEO of NPA, and advised to the NPA Board in May 2008. Following the September 2007 NPA Board meeting, Mr Thompson resigned as Chairman. The Reserve Bank then appointed Mr Campbell as interim Chairman. A new CEO of NPA was appointed in early 2008. In April 2008, Mr Campbell was succeeded by Dr Bob Rankin. Dr Rankin also took on the chairmanship of Securency after Mr Thompson resigned from that role in March 2008. BIS central bankers’ speeches Post-termination payments to agents by Securency Securency sought legal advice from its external legal advisers on its obligations to the agent that it terminated. On the basis of this advice, the Securency Board at its 11–12 September 2007 meeting decided that the agent should be paid for work done prior to termination in terms of the contract. The 2009 allegations about Securency On or about 20 May 2009, The Age sent Securency a number of questions regarding Securency’s use of agents, which Securency responded to on 22 May 2009. On 21 May 2009, the Chairman of Securency, Dr Bob Rankin (who had succeeded Mr Thompson as Chair of the Board of Securency) contacted KPMG to discuss conducting a review of Securency’s agent policies and procedures. The Age subsequently indicated, on 22 May 2009, that it was going to run a story on the matter. On 22 May 2009, Dr Rankin contacted the Australian Federal Police regarding the matter and proposed that an investigation be conducted. On 23 May 2009, The Age published articles regarding Securency’s use of agents. Subsequent stories noted that NPA had discontinued the use of agents in 2007. That same day, Dr Rankin formally requested that the AFP conduct an investigation in connection with the allegations made in the media. Dr Rankin consulted with the Reserve Bank prior to making this request. At his first meeting with the AFP on 26 May 2009, Dr Rankin referred to the audit conducted at NPA in 2007 and the Freehills report and made them aware of the documents and the AFP indicated that it would request those documents if and when they were required and that they had a certain process to follow. Those documents were subsequently requested in approximately January 2010 and provided on 1 February 2010. At the meeting on 26 May 2009, Dr Rankin also raised with the AFP the prospect of Securency obtaining an independent review of Securency’s agent policies and procedures by KPMG. At the request of the AFP, Securency did not immediately retain KPMG, so as not to hinder the AFP’s initial access to documents. In early June 2009, the Reserve Bank Board was provided with an update on Securency’s referral to the AFP for investigation. The Reserve Bank Board was informed that the AFP’s investigation was in an assessment phase, during which the AFP would determine whether a further investigation was necessary. The AFP informed Securency around the end of June 2009 that the AFP would proceed with a full-scale investigation and that it did not object to Securency engaging KPMG. Securency offered full cooperation to the AFP, as did NPA when the AFP inquiry was subsequently widened to include possible wrongdoing at NPA. In July 2009, with the AFP’s agreement, the Board of Securency approached KPMG and asked them to conduct an independent investigation of Securency’s policies and procedures regarding agents. The Reserve Bank Board was subsequently informed at its July 2009 meeting that Securency had engaged KPMG to conduct an independent review of Securency’s agent policies and procedures. In October 2009, KPMG informed Dr Rankin that KPMG had discovered documents indicating that a former employee of Securency had raised concerns over the use of overseas agents in early 2007. A progress report was provided by KPMG to the Securency Board in November 2009 which confirmed that their forensic work had discovered material which indicated concerns about possible corrupt payments had been raised by a Securency employee with Securency senior management in early 2007. These concerns had never been made known to the Securency Board or the Audit Department when it conducted either BIS central bankers’ speeches the 2007 or 2008 audits. At the time the CEO and CFO of Securency were stood down and the use of agents suspended pending further inquiry. The preliminary findings reported by KPMG also indicated that there had been failures to fully implement the procedures specified in Securency’s agent policies and procedures. KPMG’s final report was released publicly by Securency in March 2010. It contained a number of recommendations, which have been implemented. The charges Charges were laid against a number of individuals who were former employees of NPA and Securency from July 2011. The companies were also charged. Further charges were laid against Securency in August 2011, and NPA in September 2011. The charges alleged conspiracy to offer to pay, or pay, a benefit to a foreign official not legitimately due, in a total of four foreign jurisdictions. Malaysia (October 2001 – December 2003, both NPA and Securency), Indonesia (December 1999 – February 2001, both NPA and Securency), Vietnam (January 2001 – September 2004, Securency only) and Nepal (February 2000 – May 2002, NPA only, with no individuals as yet charged over Nepal). At the time of writing, matters remain before the Courts. What has been done at the companies? While this is perhaps not really a question for today, it is worth recounting what steps have been taken to strengthen arrangements at both companies. I outlined in July 2011 a number of these. Of course the persons charged with wrongdoing are no longer with either company. The use of foreign sales agents at NPA ceased in 2007 as a result of the NPA audit at that time. NPA these days operates under a tighter charter to keep its focus more closely aligned with the Bank’s core objectives and risk tolerance. The Bank has changed the composition of the Board. NPA’s principal focus over the years ahead will include the production, later this decade, of a series of upgraded banknotes for Australia. In the case of Securency, the use of sales agents was also discontinued after the KPMG report. Policies were overhauled as recommended in that report. We have also, as you know, announced our intention to exit our shareholding in Securency. Both companies are of course continuing to cooperate with the authorities in resolving the issues. The Bank has continued to give a good deal of thought to its overall governance of the two companies. The Reserve Bank Board has had discussion on these issues over the past year or so, and has benefited from advice from external experts on corporate governance. I am of course happy to provide any further information that the Committee may wish on these matters. That concludes my opening remarks. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 10 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Financial Services Institute of Australasia (FINSIA) Leadership Event, Hobart, 9 October 2012. | Philip Lowe: The labour market, structural change and recent economic developments Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Financial Services Institute of Australasia (FINSIA) Leadership Event, Hobart, 9 October 2012. * * * I would like to thank Patrick D’Arcy for his valuable assistance in the preparation of this talk. It is a pleasure to be in Hobart today and I would very much like to thank Finsia for the invitation to this lunch. My remarks this afternoon are largely centred on the Australian labour market. They pick up on two important issues. The first is one that the Reserve Bank has spoken about at length over recent years, and that is structural change. Today, I would like to focus on how this change has been affecting the operation of the Australian labour market. The second issue is a more timely one, and that is how recent developments in the labour market can help us better understand the current balance between supply and demand in the economy. Structural change No doubt, you have all heard much discussion over recent times about structural change in Australia, and why it is occurring. At the centre of a number of the changes that are taking place is the industrialisation and growth of Asia. This has resulted in high prices for Australia’s commodity and food exports, as well as a high exchange rate. The most obvious effect is the rapid expansion of the resources sector that has been underway for some time. Another important factor has been the marked change in Australians’ propensity to borrow to buy assets, especially houses. And then there is the ongoing growth in our demand for services as our incomes grow and the population ages. Just as other forces have done so for more than 200 years, these forces are reshaping our economy. But the concept of structural change – which is talked about a lot by economists – is a fairly abstract one for many people. It does become very real though when it affects people’s jobs – the nature of their work, the industries they are employed in, the security of their employment, their career opportunities and the wages they get paid. The Reserve Bank must, by the nature of our responsibilities, focus primarily on aggregate outcomes. However, we also try to understand what is going on beneath these aggregates, and how people’s lives are being affected. Before I talk about the detail, it is worth starting with the aggregate unemployment rate (Graph 1). The key point here is that unemployment remains low. In the past 30 years, there have only been four years in which the unemployment rate has averaged below its current 5¼ per cent. Australia has one of the lowest unemployment rates among the advanced economies, an outcome that seemed improbable for much of my professional career. Underneath this low and steady unemployment rate, there is a great deal of movement at the individual worker level. Although it is still typical for most people to have relatively long tenure in a single job, a large number of people change jobs each year. The latest data available from the Australian Bureau of Statistics (ABS) show that at February 2012 around 2.3 million people – almost one-fifth of the total number of employed people – were newly employed, having been in their job for less than a year. While a little under half of these were starting work for the first time or were not previously working, 1.2 million people moved from one job to another. And this is in a year when the net growth in published employment was just 23,000. This changing in jobs occurred for a range of reasons. Around three-quarters were voluntary, including for personal reasons or to take advantage of new opportunities. The BIS central bankers’ speeches remaining quarter was involuntary, including because the previous employer went out of business or the nature of the business has changed. Graph 1 The structural changes in the economy are clearly one factor contributing to this movement of people. This is of course nothing new. There is always a degree of structural change occurring, and the strong growth in the resources sector is but the latest example. Nevertheless, there is some evidence that the changes taking place have led to a higher rate of job turnover in recent times than has been the case for the past two decades (Graph 2). The number of people who left a job over the year to February 2012, as a share of those employed some time during the year, was the highest in two decades, with fairly high rates of both voluntary and involuntary separations. Graph 2 BIS central bankers’ speeches This high rate of turnover, with relatively modest aggregate employment growth, is consistent with a lot of new job opportunities opening up in various parts of the economy and, at the same time, other jobs ceasing to exist. Another indication of this is that the official measure of job vacancies has remained relatively high, yet employment growth has been relatively subdued. An additional way of looking at these changes is to examine the dispersion – or standard deviation – in employment growth across the 19 industries for which the ABS publishes data (Graph 3). For a number of years now, there has been a high dispersion in employment growth across these industries, with especially strong growth in the mining sector. Graph 3 The cumulative effect of this dispersion in growth rates can be seen in total employment growth in different industries (Graph 4). Since 2007, around 300,000 net new jobs have been created in the health care sector, 200,000 jobs in professional and scientific services and around 130,000 jobs in each of the mining and education sectors. In contrast, the number of manufacturing jobs has declined by around 70,000, and the number of jobs in retailing is largely unchanged. Graph 4 BIS central bankers’ speeches These disparate trends have added to a general sense of uncertainty in many parts of the community. Job losses can be very disruptive when they occur. They tend to be more visible than job gains. And they often take place all at once when firms are downsizing or closing, rather than the more gradual process of job creation. The large variation in experience across industries is probably one reason why many people view the labour market to be quite weak. Over the past year, we have had the rather unusual situation in which consumers have become quite concerned about rising unemployment, yet the overall unemployment rate has been steady (Graph 5). Graph 5 More positively, and to the surprise of many people, the significant variation in employment growth across industries has not led to greater variation in the unemployment rates across the country. One way to see this is to compare the distribution of unemployment rates across the 68 regions for which the ABS publishes data with the distribution of unemployment rates 10 years ago (Graph 6). The picture is pretty clear: the average unemployment rate is lower and the variation across the country is also lower. Today, around half the regions have unemployment rates below 5 per cent and 50 of the 68 regions have an unemployment rate below 6 per cent. In only three regions is the unemployment rate above 8 per cent, compared with 13 regions a decade ago. Graph 6 BIS central bankers’ speeches One factor that has played at least some role in these outcomes is the willingness of people to travel or move to where the jobs are. The most high-profile example of this is perhaps the FIFO – Fly In Fly Out – and the DIDO – Drive In Drive Out – workers. Industry estimates and recent census data suggest that there are currently upwards of 50,000 such workers. Internal migration, of course, has also played some role, with the rate of net interstate migration to Western Australia over the past year is the highest for around 25 years (Graph 7). It is also worth noting that interstate migration has played an important role in the Tasmanian economy, with the situation switching from sizable net inflows to net outflows and back again over the course of just a few years. For a period in the 2000s, internal migration was adding around ½ per cent to Tasmania’s population annually. Today, it is subtracting almost this amount. Graph 7 The structural changes that have taken place across the economy have also altered the relative wages in different industries. Workers in the resource sector have long been paid higher wages than in many other industries, and this gap has widened over recent years (Graph 8). Since 2004, average wages in mining have increased by about 10 per cent relative to the average for the economy as a whole. Workers in professional services have also experienced faster-than-average increases, partly due to spillover effects from the resources sector. Conversely, relative wages have declined in the manufacturing, retail and the accommodation industries, each of which has experienced difficult conditions over recent times. These divergent trends since the mid 2000s stand in contrast to the period immediately before that, when there was less structural change. The overall impression from these various facts and figures is that the labour market has coped reasonably well with the significant changes taking place in the Australian economy. While there have been shortages of skilled workers in some areas, these have been fairly limited. Workers have moved in large numbers to the industries that are benefiting from growth in Asia and the increasing domestic demand for services. They have done this at a time of close to full employment and larger divergences in unemployment rates across the country have been avoided. The adjustment of relative wages has helped, and this adjustment has occurred without igniting the type of economy-wide wages blowout that contributed to the derailment of previous mining booms. BIS central bankers’ speeches Graph 8 One reason that things have worked out this way is that the industrial relations system is more flexible than it was two decades ago. The exchange rate appreciation has also been an important factor, helping to maintain a reasonable balance between demand and supply during what has turned out to be a once-in-a-century investment boom. Another factor has been Australia’s monetary policy regime, which has provided a strong anchor for both inflation and wage expectations. After two decades of the inflation-targeting regime there is a fairly broad understanding that unsustainable aggregate wage growth is likely to lead to higher inflation, and thus higher interest rates. Looking forward, it is clear that the structure of the economy will continue to evolve. Over time, the strong growth in investment in the resources sector will give way to a large increase in exports of resources. This will likely mean some moderation in the demand for labour in the resources sector, and other forms of activity and employment will need to pick up. As this transition occurs, the types of new jobs that are created will also continue to evolve. Inevitably, there are uncertainties as to what these new jobs will be, and where they will be located. In the face of this uncertainty, it is essential that the labour market retains its flexibility. The industrial relations laws and practices are important here, but they are by no means the full story. Flexibility also comes from having an adaptable workforce – one that has the right general skills, the right training and the right mindset. Over the medium term, whether or not Australia fully capitalises on the opportunities that the growth of Asia presents depends critically upon the ability of both workers and businesses to adapt, and to build and use our human capital. Many of these opportunities lie beyond the resources sector – in areas like the unique tourism experiences that are possible here in Tasmania, in high-end manufacturing, in high-quality food and in professional services. If we are to take advantage of these opportunities, a highly skilled and outward-looking workforce is critical. Recent outcomes I would now like to shorten my gaze a little to look at quite recent developments in the labour market and what they tell us about the overall balance between supply and demand. As I discussed at the outset, the current national unemployment rate is 5¼ per cent, and has been in the 5 to 5¼ per cent range for two years now. As I said, this is a very good outcome by international standards. BIS central bankers’ speeches Notwithstanding this, the labour market appears to have generally softened in recent months, with only modest growth in total employment, a decline in average hours worked, and a decline in the employment-to-population ratio (Graph 9). Various indicators also suggest a lower rate of job creation than was the case a while ago. Graph 9 Two industries stand out as having particularly weak employment growth over recent times (Graph 10). The first is the construction industry where, according to the ABS, there has been a net decline in employment of 70,000 over the past 12 months. Activity in important parts of the industry – including in house building and commercial construction – remains subdued, as does the immediate outlook, and this has led to a fair amount of job shedding. The second industry is public administration, where employment has fallen by 50,000 over the past year, with governments cutting back due to budgetary pressures. Graph 10 One interesting aspect of the recent outcomes is that despite only modest overall employment growth, the unemployment rate has not moved up, as had been widely expected. Part of the reason for this is that there has been a decline in labour force BIS central bankers’ speeches participation – that is, in the share of the working-age population either with a job or looking for a job (Graph 11). While one always needs to interpret short-run movements with caution, the current participation rate is around ½ a percentage point lower than the average of the past five years. This stands in contrast to the general upward trend in participation over the past 30 years. Graph 11 The Reserve Bank has recently spent some time trying to understand what is happening here and what it says about the balance of supply and demand in the labour market. On the supply side, demographic changes are potentially an important factor. As with many other countries, the Australian population is ageing. This tends to reduce labour force participation, as older people are less likely to have a job, or be looking for a job, than are younger people. Our estimate is that this ageing effect, by itself, has reduced the participation rate by around 1 percentage point since the mid 2000s. Over this period, however, this effect has been more than offset by the higher participation of successive generations of women in the workforce as well as a tendency for older workers in general to participate in the workforce longer than their predecessors. Taking account of this so-called cohort effect, as well as the ageing effect, it would appear that these longer-term supply-side factors are not a central part of the recent decline in participation. A second potential factor is the relatively high rate of structural change in employment that I talked about earlier. With the increased rate of job turnover, it may be the case that workers who have left a job have decided not to re-enter the labour market immediately. This could be for a variety of reasons – perhaps employment prospects are poor or perhaps they are seeking to update their skills before re-entering the labour force. Unfortunately, the existing data make it difficult to assess how important these effects are. To the extent that they are playing some role, there is likely to be a bit more capacity in the labour market than indicated by the unemployment rate alone. A third possibility is that the decline in participation is linked to the recent fall in demand for construction workers. There has been a large decline in the number of people who identify themselves as being self-employed and many of these worked in the construction industry. It may be the case that some of these people are not recorded as unemployed, despite actually not working in the reference week and being available for additional work. Again, if BIS central bankers’ speeches this were the case it would suggest that there is a bit more capacity in the labour market than suggested by the unemployment rate alone. This weakness in the construction sector, particularly of new homes, has been one of the bigger surprises in the economic outcomes over recent times. Looking forward, a pick-up in construction activity is one of the factors that could provide an offset to the eventual moderation in the current very high level of investment in the resources sector. A pick-up in other forms of investment could also play this role. With the peak in mining investment now coming into view, it is not surprising that attention is turning to the questions of what forms of activity might pick up, where the future jobs might come from, and what combination of interest rates and exchange rates might keep the overall economy on an even keel. No doubt, international developments will have an important bearing on the answers to these questions. Recently, the global outlook has softened somewhat and the various indicators that I have just mentioned suggest the labour market also has moved in this direction. Given these developments, and the outlook for contained inflation, the Board judged at its meeting last week that it was appropriate for the stance of monetary policy to be a little more accommodative than it had been. Despite the recent focus on the weaker global economy, it is important not to lose sight of the longer-term benefits to the Australian economy of the growth of Asia. It remains the case that this growth provides Australia with tremendous opportunities. Over recent years we have seen these in the resources sector. But in coming years we are likely to see them more clearly in a wide range of other areas. Our flexible, adaptive and well-trained workforce will be the key to taking advantage of these opportunities. Thank you for listening and I would be very happy to answer any questions. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 10 |
Keynote address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the International Swaps and Derivatives Association (ISDA) Conference, Sydney, 18 October 2012. | Malcolm Edey: OTC derivatives regulation Keynote address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the International Swaps and Derivatives Association (ISDA) Conference, Sydney, 18 October 2012. * * * I would like to thank Mark Manning for his assistance in preparing this speech. Good morning, and thank you once again for the opportunity to speak to you today. A great deal has happened since I last addressed this gathering a year ago. Markets around the world remain under pressure, with the sovereign debt crisis and fears over the future of the Euro continuing to weigh on confidence. Australia has been somewhat sheltered from these developments. As reported in the Bank’s recent Financial Stability Review, Australian banks’ asset quality has held firm, their usage of wholesale funding has been wound back, and overall bank funding costs have fallen over the past year. While Australia’s financial sector and the condition of the real economy remain favourable by international comparison, many of the lessons of the global financial crisis remain as relevant in Australia as elsewhere. The Australian authorities have continued to be involved in both domestic and international debates over refinements to regulatory settings. The aim of course is to reduce the likelihood of further distress, and to ensure that in the event that problems do emerge the authorities have the appropriate tools to deal with them effectively. Over the past year, the agencies that comprise the Council of Financial Regulators have progressed a number of regulatory initiatives, consulting extensively with industry participants on matters such as the implementation of Basel III in Australia, enhancements to the resolution regime for banks, and reforms to the regulation of financial market infrastructure. But today I’d like to focus again on the area of reform I discussed here a year ago: the regulation of OTC derivatives markets. As everyone in this room is aware, at the Pittsburgh Summit three years ago the G-20 leaders agreed that, ‘all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements’. When I spoke to this group last October, the Council of Financial Regulators was engaged in a consultation on central clearing of OTC derivatives. I talked about a number of policy challenges that the Council agencies were grappling with, including whether central clearing of Australia’s most systemic OTC derivatives markets should be mandatory, and whether such clearing should be required to take place through a domestic central counterparty. Consultation on these matters continued through the remainder of 2011 and the early part of this year. At the same time, arrangements in other international jurisdictions, most notably in the United States and Europe, were becoming clearer and domestic financial institutions were beginning to examine and adapt to the third-country reach of the prospective new rules. Also, in part reflecting strong views expressed by the Australian authorities, the Financial Stability Board developed the notion of ‘four safeguards’ for a resilient global framework for central counterparties. This work recognised that, in meeting the G-20 commitments, market participants in some jurisdictions may be reliant on offshore-based central counterparties. Authorities and market participants alike therefore needed to have confidence that such arrangements would protect their interests, both for domestic financial stability and for the effective functioning of markets. BIS central bankers’ speeches Specifically, the four safeguards comprise: ensuring effective international cooperative oversight of global CCPs; fair and open access criteria; appropriate liquidity arrangements in all relevant currencies; and procedures for effective resolution. The Principles for financial market infrastructures, released in April by the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions (IOSCO) this year, embed some elements of the four safeguards; other elements are left to domestic authorities to implement in their own regulatory frameworks and approaches. Having considered the views of stakeholders and assessed the implications of developments internationally, the Council delivered a policy recommendation to the Deputy Prime Minister and Treasurer in March this year. The recommendation had three main elements: 1. Don’t mandate immediately, but establish the power to do so The Council agencies recommended that, where possible, industry-led solutions – in part reflecting appropriate regulatory incentives – should be relied upon to steer the market towards the desired outcome. Nevertheless, they also recommended that the authorities should be granted a legislated power to mandate outcomes in the event that the incentives prove insufficient to drive the necessary change on an acceptable time frame. One concern would be if there were perceived to be an opportunity for regulatory arbitrage between the Australian regime and those of other jurisdictions. Another would be if, in assessing the sufficient equivalence of the Australian regime, other jurisdictions took into account whether or not a regulatory mandate was in place. Reliance in the first instance on market incentives is particularly relevant in the case of central clearing. Premature regulatory intervention could interfere with the competitive and commercial responses of central counterparties, clearing participants and other service providers. A flexible approach should allow for the transition to occur with maximum choice available to participants on issues such as the commercial terms of agreements, the choice of counterparties and central counterparties, and operational changes that might be needed. The Council’s assessment was that higher capital requirements for non-centrally cleared transactions, as well as the implementation of emerging international standards for margin requirements on non-centrally cleared OTC derivatives, should create a sufficiently strong economic incentive to channel trades through a central counterparty. Once a critical mass of market participants have begun to clear centrally, it is likely that other market participants will follow, so as to be able to trade with counterparties who have already shifted to central clearing. The policy responses of other jurisdictions are also important in this regard. To the extent that financial institutions headquartered in other jurisdictions are required to centrally clear by their local regulators, they are likely to – or, in some cases, may have to – also centrally clear transactions executed in the Australian market. 2. A qualifying central counterparty may be either domestic or overseas-based A central counterparty operating in Australia must have either an Australian Clearing and Settlement Facility Licence or a valid exemption. The regulatory regime in Australia specifically permits an overseas-based central counterparty to operate in this jurisdiction, as long as its home regulatory regime is deemed to be sufficiently equivalent to that in Australia. The consultation last year sought views on whether it should be mandated that any central counterparty clearing OTC derivatives markets of systemic importance to Australia be located in Australia. Having given this further consideration during the consultation process, the Council agencies concluded that to do so would unduly constrain market participants’ choices, reduce the effectiveness of economic incentives in driving outcomes, and potentially have other unintended consequences. In the Council’s view, any additional risks associated with reliance on an overseas-based central counterparty may be managed through implementation of the Financial Stability Board’s four safeguards. In the spirit of these safeguards, the Council has developed a framework for regulatory influence over cross-border clearing and settlement facilities. BIS central bankers’ speeches Specific requirements would be expected to be applied in a graduated and proportional manner and would include the following: • all licensed CCPs must demonstrate legal compatibility of the facility’s rules with Australian regulatory objectives, and have adequate mechanisms to demonstrate compliance with all licence obligations; • where licensed CCPs have material Australian-based participation and/or provide services in Australian-related products, they must have governance and operational arrangements that promote stability in the Australian financial system; • where a CCP is deemed to be systemically important by the Reserve Bank, it must hold an Exchange Settlement Account (ESA) at the Bank to better manage liquidity and settlement risks around Australian dollar obligations. The Australian regulators are also closely engaged with ongoing international work on the recovery and resolution of financial market infrastructure. This work will be a key input into the development of a fully articulated recovery and resolution regime for financial market infrastructure in Australia. It will also establish a benchmark for assessment of the recovery and resolution regimes applicable to overseas-based facilities seeking to operate in Australia. 3. Establish a licensing regime for trade repositories The Council recommended that a licensing regime for trade repositories be established, largely modelled on the existing licensing regimes for market operators and clearing and settlement facilities under the Corporations Act. ASIC will have primary responsibility for administering this regime and overseeing any trade repositories licensed under the regime. These elements have since been reflected in draft legislation issued by Treasury for consultation in July and introduced to Parliament in September. It is anticipated that the framework will be in place by year-end. Under the proposed framework, the Minister for Financial Services and Superannuation will have the power to prescribe certain classes of derivatives as subject to mandatory reporting to a trade repository, mandatory clearing by a central counterparty, or mandatory execution on a trading platform. To give effect to any mandate, ASIC will be tasked with developing “derivative transaction rules”. These rules will clarify matters such as the institutional and product scope of the obligation. Among the regulators, therefore, ASIC will have the primary role in implementing the new framework and in doing so will work closely with the Bank and APRA. The Bank, in particular, will have three main functions in the new regime: • A market-monitoring function. In carrying out its market operations and in its financial stability role, the Bank will need to understand the implications of market developments in response to the new rules; and in particular the evolution of participant behaviour and the participation structure of the market. This will include the analysis of data sourced from trade repositories, monitoring the interaction between the centrally cleared and non-centrally cleared segments of the market, and observing changes in collateral demand and usage. • An advisory function. Before prescribing a class of derivatives under the framework, the Minister must seek the advice of the Bank, as well as APRA and ASIC. ASIC must also consult with both the Bank and APRA before issuing any derivative transaction rules. • An oversight function. In its role in overseeing clearing and settlement facilities operating in Australia, the Bank will, with ASIC, advise the Minister on any licence applications from central counterparties seeking to provide OTC derivatives clearing services in Australia. And, once a licence has been granted, the Bank will oversee any newly licensed central counterparty against the Financial Stability Standards. BIS central bankers’ speeches In parallel with the passage of the legislation through Parliament, the Council agencies are monitoring developments in the Australian OTC derivatives market to establish whether economic incentives are already beginning to work. A comprehensive survey was circulated to market participants in July, and an analysis of the results is expected to be published towards the end of this month. The results of this assessment will be an important input into possible recommendations to the government around mandatory obligations. The Australian agencies currently anticipate that additional assessments will be undertaken over the next year or so, in order to monitor the Australian market’s progress in making the transition to central clearing, along with the other G-20 commitments around OTC derivatives reforms. Even if these assessments conclude that the industry is making adequate progress, the Australian agencies will also continue to examine whether the existence of mandatory obligations could deliver other benefits. For instance, there could potentially be a case to impose a mandatory obligation for central clearing if to do so would make it more likely that other relevant jurisdictions considered the Australian regime to be sufficiently equivalent, and therefore reduced the compliance burden for domestic market participants when trading with overseas-based counterparties. The current assessment is likely to confirm the previous position that Australian dollar interest rate swaps, cross-currency swaps and other foreign exchange derivatives are likely to be the priority asset classes for the purposes of meeting the G-20 commitments. Developments in these asset classes are likely to be monitored most closely in future assessments. In the near term, the priority for any recommendations around mandatory obligations is likely to be trade reporting. As noted elsewhere, the Council agencies regard trade reporting to be not only good practice, but also a means of ensuring the availability of good data to monitor market developments in support of regulators’ financial stability and market conduct objectives. However, given the time-frames required to consult on and pass the relevant legislation, it could be some months before a definite move towards mandatory reporting obligations could be made. ASIC would then have to develop the associated derivative transaction rules, which would be subject to a regulatory impact study and further industry consultation. It would also be necessary to license at least one trade repository to operate in this jurisdiction. As a result, it could be well into next year before any mandate is actually in force. The effectiveness of the regime will also require a range of responses from market participants. If the transition to new arrangements, whether or not triggered by the issuance of a mandate, is to occur on an acceptable time-frame, institutions should already be making the operational and organisational changes needed to move towards greater use of centralised infrastructure. Based on the Council agencies’ market assessment and ongoing dialogue with stakeholders, I’d like to identify five areas in which more work will need to be done. First, international banks and the large domestic banks have already had to begin making the transition, in part in response to regulatory reforms already underway in some jurisdictions. In the case of central clearing, efforts to date also reflect the economic incentive of an emerging price differential between cleared and non-cleared transactions. This work is ongoing. International banks active in the Australian market are generally already actively clearing Australian dollar-denominated interest rate swaps via offshore entities that participate in LCH.Clearnet’s London-based SwapClear service or CME Clearing in the United States. In most cases, the large domestic banks have taken the initial step of concluding client-clearing agreements for some of their OTC derivatives business. For several of these institutions, the transition to central clearing for this segment of their business is having profound implications for the organisation of their operations. Indeed, these institutions have been confronted with a number of legal and operational issues, such as clearing agreements that often contain more restrictive contractual terms than in their existing ISDA Master Agreements with BIS central bankers’ speeches bilateral counterparties. They have also had to adjust to new operational dependencies on the clearing participants through which they channel their business. For the Council agencies, the experience of these institutions has illuminated a number of issues that may warrant further consideration, and which may shape the design of derivative transaction rules should mandatory clearing be imposed. Second, it is evident that in the absence of similar pressures, smaller and more domestically focused institutions are generally at an earlier stage in this process. Given the complexity of the required adjustment, these institutions are encouraged to accelerate their transition plans. In the case of central clearing, it is likely that these institutions will be reliant on a relatively limited number of large, probably international, providers of client-clearing services. Recognising these dependencies, the Council agencies continue to examine matters such as client monies rules, so as to ensure adequate protections for Australian institutions. Client monies remain an important area of focus for regulators around the world, with international work under way under the auspices of IOSCO. Third, the scope for Australian-domiciled institutions to access central counterparties directly to clear Australian-dollar denominated derivatives is limited by the fact that no central counterparty is yet licensed to provide these services in Australia. Similarly, no trade repository is yet licensed to operate in Australia. ASIC and the Bank acknowledge their responsibility for dealing with any licence applications received from central counterparties or, once the new regime is in place, trade repositories seeking to provide services in Australia. The large Australian banks continue to discuss operational, legal and commercial terms of access with both domestic and overseas-based central counterparties that are interested in providing services in this area. An important consideration is how any international services would be adapted to the Australian market and time zone, including in relation to the provision of operational support, valuation methodology, margin collection and collateral eligibility criteria. The tax treatment of payments to an overseas-based central counterparty has also been identified as a potential issue. Ultimately, any central counterparty offering services to Australian-domiciled institutions will need to meet the needs of the Australian market place, the requirements for cross-border regulatory influence articulated by the Council, and possible future requirements that might be set out in derivative transaction rules in support of any mandatory clearing obligations. Fourth, at the November 2011 Summit in Cannes, the G-20 leaders called for international standards for the margining of non-centrally cleared OTC derivatives. In accordance with this request, an international working group led by the Basel Committee on Banking Supervision and IOSCO released, in July, a set of draft principles for consultation. The principles propose harmonised margining arrangements, consistent with those in place for central counterparties. While variation margin is already typically exchanged in respect of non-centrally cleared trades, the application of initial margin is less widespread. Implementation of the principles is therefore likely to lead to a substantial increase in demand for collateral assets that are eligible to meet initial margin requirements. The working group has conducted a quantitative impact study to assess the possible magnitude of the increase globally, the results of which will inform the group’s final proposal. The Council agencies have been considering how the new arrangements might be implemented in the Australian context, a key area of concern being the increase in demand for high-quality collateral. Finally, the Council agencies will continue to assess how best to enhance transparency in OTC derivatives markets, within the parameters of the new regulatory framework. This work will consider the role platform-based execution might play in enhancing pre- and post-trade transparency. It will also examine any legal and confidentiality constraints to making aggregated trade-repository data on OTC derivatives market activity publicly available. So, clearly, there has been a lot of progress over the past year. But our work is far from done. While the Council’s direction is clear and the legislative process underpinning the framework is well underway, there remains a fair amount of work ahead to complete the BIS central bankers’ speeches transition; for market participants, infrastructure providers, and regulators alike. I hope that when this group meets in a year’s time, many of these outstanding issues will have been resolved. Once again, thank you very much for the opportunity to speak today, and for your attention. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 10 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Securitisation Forum, Sydney, 22 October 2012. | Guy Debelle: Enhancing information on securitisation Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Securitisation Forum, Sydney, 22 October 2012. * * * Thanks to Christian Vallence and David Olivan for their help. Today I would like to do two things. Firstly, I will discuss the current state of play in the securitisation markets. Then I will describe some prospective changes to the Reserve Bank’s repo-eligibility criteria for asset-backed securities. These changes will improve the information available to the market about Australian asset-backed securities. The current state of play I have noted on several occasions at this forum that securitisation markets were likely to take a considerable period of time to adjust to the post-crisis environment. More than five years on since the first wave of investor concerns about structured finance, securitisation issuance is still struggling to recover in most countries. Graph 1 In the US, new issuance in 2012 to date is a little over half the level seen since issuance peaked in 2006 (Graph 1). RMBS issuance is still exclusively by the government-sponsored enterprises. Private-label issuance of RMBS remains dormant. Some other segments of the market appear to be recovering, particularly securities backed by auto loans and credit card receivables. Australian issuers are tapping this segment of the US securitisation market, as are some European issuers. In Europe, issuance sold into the market has been negligible since 2008. There has, however, been a large number of securitisations put together that have been retained on the balance sheet of the issuer for use as collateral with the ECB and the Bank of England (Graph 2). BIS central bankers’ speeches Graph 2 In Australia, RMBS issuance in 2012 has recovered to the point where new issues are replacing maturing issues so the stock outstanding is no longer declining (Graph 3). The issuance in the year to date has totalled $10 billion. By way of comparison, in the second quarter of 2007, at its peak, issuance amounted to $25 billion. Given we are now five years on from that, and although amortisation rates have slowed somewhat from their pre-crisis rate of around 20 per cent per annum, only around 10 per cent of the pre-crisis issuance remains outstanding. Most of the pre-crisis stock comprises issues that have yet to amortise below the 10 per cent threshold required before clean-up calls can be executed, while around 15 per cent was issued by entities that aren’t around anymore, such as the old RAMS. Graph 3 This year we have seen positive signs in the Australian securitised market, particularly over the past several months. First, despite the periodic bouts of turmoil in offshore markets, there BIS central bankers’ speeches has been a steady flow of new issues. Primary spreads have gradually tightened this year and a number of deals have been fully placed with external investors (that is, no tranche has been retained by the issuer), including junior tranches. More recently, several issues have been completed with little or no support from the AOFM due to strong private investor demand. And, of course, the collateral underlying Australian asset-backed securities (ABS) continues to be of high quality, with arrears rates on Australian mortgages remaining low. The structure of RMBS deals continues to evolve. Issuers have reduced their reliance on lenders’ mortgage insurance (LMI), for instance, as credit ratings agencies have discounted the credit enhancement LMI brings to a deal. Instead, issuers have lengthened seasoning periods and increased subordination to enhance credit quality. The average seasoning of 2012 issuance has been 48 months, compared to an average of 36 months over the preceding three years. Some preference has emerged for bullet structures to minimise prepayment and extension risk for investors. Offshore investors in particular have shown a preference for bullet features, while the domestic investor base is generally more comfortable with pass-through securities. Issuers have looked to incorporate arrangements such as liquidity underwriting and roll-over features to provide bullet-like structures to deals. Of course, there is a limit to the ability of issuers to incorporate bullet-like structures into issues without significant over-collateralisation or liquidity underwriting costs. ABS have always been about passing through cash flows, and prepayment risk must ultimately always be borne (and be paid for) by someone. This preference has also been evident in the demand for non-RMBS asset-backed securities. Issuance of ABS backed by assets such as auto loans and trade receivables, with their shorter maturity and more predictable cash flow profiles, has quickly returned to (and exceeded) pre-crisis levels (Graph 4). Graph 4 BIS central bankers’ speeches At this forum last year, 1 I said that I thought covered bonds were likely to be used to access funding offshore, while RMBS would continue to be the main vehicle used to raise asset-backed funding onshore. That wasn’t quite how it panned out earlier this year, when there were a few very large covered bonds issued domestically. But I think that had mostly to do with the price. Local buyers found it hard to resist the yield on offer on those early covered issues. The wide spreads on the first covered bond issues also repriced primary RMBS spreads to uneconomic levels for both bank and non-bank issuers (Graph 5). Graph 5 But since then, pricing levels on covered bonds have tightened considerably. Issuance patterns have been more along the lines I expected to occur, with the bulk of recent covered issuance occurring in the offshore market, and at much longer tenors. At the same time, we have seen RMBS issuance pick up in the domestic market, with only a few issues into the offshore market. Twelve months after their inception, banks have issued, on average, around a quarter of their covered bond issuance caps (Graph 6). Covered bonds seem to be performing their expected role of attracting a different investor base and providing an important source of funding diversification for financial institutions. Debelle G (2011), “The Present and Possible Future of Secured Issuance”, Address to Australian Securitisation Forum, Sydney, 21 November. BIS central bankers’ speeches Graph 6 Enhancing Information on securitisation While the RMBS market has gradually improved, there clearly remains scope for further improvement, though, as I have said on a number of occasions, you shouldn’t expect the market to return to its pre-crisis levels. One avenue which should help facilitate improvement is enhancing the information available to the market about the securities on issue. With that in mind, I will talk about some changes the Reserve Bank is announcing today that aim to increase the information available. There is an increasing demand for more transparency in securitisation from both investors and regulators alike. One objective for improving transparency is to ensure that investors, other market participants and regulators all have access to relevant and reliable information in order to monitor risk. Another aim is to improve document standardisation, which can help to stimulate liquidity in securitisation markets. There are a number of initiatives in various countries, some ongoing and others already in force, that seek to increase transparency of securitisation. This is encapsulated in the IOSCO report on Global Developments in Securitisation Regulation. 2 In relation to standardisation of information, the report proposes that IOSCO members encourage industry to develop best practice templates and encourage industry bodies to work with their counterparts in other jurisdictions to ensure harmonised treatment. The announcement by the Bank today is consistent with the objectives contained in the IOSCO report, and is supported by ASIC. Similarly, in Europe and the UK, loan-level reporting has also been introduced by the ECB and the Bank of England. As is the case in Australia, the main drivers of this initiative were the need for these central banks to get standardised information on securitisations for internal risk analysis and to provide broader transparency in the market. In the US, the SEC is currently considering what information needs to be provided by issuers as a result of the IOSCO (International Organization of Securities Commissions) (2012), Global Developments in Securitisation Regulation, Consultation Report, June, available at <http://www.iosco.org/library/pubdocs/pdf /IOSCOPD382.pdf>. BIS central bankers’ speeches Dodd-Frank legislation. Proposed rules would require loan-level data underpinning pooled assets being lodged with the SEC in computer readable, standardised format. So, the changes we are making today are part of a global development. As you are all aware, for around five years now, the Reserve Bank has included asset-backed securities amongst the range of collateral eligible for our domestic market operations. The self-securitised RMBS proved to be beneficial during the height of the crisis in 2008, as the RBA was able to quickly stabilise funding markets by providing liquidity against them (Table 1). The advantage of having these securities in place is that the Reserve Bank is able to assess their value and quality ahead of time, rather than in the midst of a crisis. 3 Similarly, in recognition of the role that these assets can play in stressed circumstances, APRA has encouraged both large and small ADIs to self-securitise some of their assets and put arrangements in place with the RBA, such as RITS membership (although most ADIs already had them). For large ADIs, these securities will be important from 2015 when the new liquidity regime and the Committed Liquidity Facility (CLF) are in place. 4 Even though none of these assets (and few unrelated RMBS) are held on the Reserve Bank’s balance sheet now, the fact that they are eligible for repo means that the Bank must always be fully cognisant of the risks these assets carry. This allows us to lend against good collateral in stressed circumstances, a core function of central banks. Debelle G (2011), “The Committed Liquidity Facility”, Speech to the APRA Basel III Implementation Workshop 2011, Sydney, 23 November. BIS central bankers’ speeches The information currently required for RMBS repo-eligibility is largely about the core attributes of the security. This includes, for example, the information memorandum, high-level data relating to the asset pools backing the securities and a list of mortgage insurers present in the pool. A AAA credit rating is also required. In part because we felt it was an appropriate time to do so five years after their inclusion on our collateral list, and in part ahead of the introduction of the CLF, the Bank has been conducting an internal review of its reporting requirements for RMBS. As a result of this review, today the Bank is announcing some enhancements in the information requirements for repo-eligibility of RMBS. In a nutshell, these will require that issuers provide the Reserve Bank and the broader public with more comprehensive and up-to-date information on the securities. While some information on RMBS is generally available in the market, reporting standards can vary significantly across issuers, since there is currently no regulatory standard for RMBS reporting in Australia. The available data also tend to be dispersed in a number of different locations, making it difficult to gather. Hence, in consultation with the Australian Securitisation Forum (ASF), we have sought to achieve some uniformity and greater depth in the information reported. Broadly speaking, the new information requirements cover both transaction-related data as well as information on the underlying assets, such as anonymised loan-level data. 5 Details of the information that will be required at least every quarter on both existing and new RMBS issuance are set out in reporting templates, which are available today on the Bank’s website. These templates are aligned with the ASF’s current best practice RMBS reporting and disclosure standards. They are also consistent with those developed by the ECB and the Bank of England. These reporting templates standardise reporting of RMBS data across Australian issuers who seek repo-eligibility of their issues. They will help the Bank to more precisely value the securities held on its balance sheet in terms of both price and risk. They will also decrease the Bank’s reliance on credit rating agencies in assessing the securities. As well as applying to those securities issued in the market, these requirements will also apply to self-securitised RMBS. But just as importantly, these data will also be of benefit to the broader market by providing more transparency to Australian RMBS. The Reserve Bank will also require that issuers make these reporting templates available to the public, free of charge. Issuers will have to inform the Reserve Bank of where their data are being stored and being made available to the public. It will also be a requirement that issuers ensure that these data are accurate. The proposed reporting templates we’ve put out today are open for comment until end-December. Again though, I would note that we have worked with the ASF in putting these information templates together. Having taken account of any comments, we will provide final reporting templates early next year. Once that has been done, issuers will have a transition period in which to provide the information. At the end of that period, if the information is not available, the security will no longer be repo-eligible. RMBS issues that do not meet the reporting requirements during the transition period will remain repo eligible. I encourage issuers to use this transition period to develop the reporting systems and the data handling infrastructure needed to comply with the new requirements. This will not involve reporting of data on any individual borrowers, thereby mitigating privacy concerns. BIS central bankers’ speeches Furthermore in 2013, the Bank will also make available for comment reporting templates for other ABS, such as securities backed by auto loans or credit card receivables, asset-backed commercial paper (ABCP) and commercial backed securities (CMBS). In terms of managing public availability of the data, the Bank is placing no specific requirements on where issuers must make these data available, and this is one area of the new requirements on which the Bank is keen to receive industry feedback. Conclusion In conclusion, the securitisation market is continuing its gradual recovery. But there is scope for it to recover further yet. One avenue that may facilitate further growth is the availability of more information, and more standardised information, than exists currently. Today, the Reserve Bank has put out some enhanced information requirements for repo-eligibility of asset-backed securities. These information requirements should not only benefit the Reserve Bank in assessing the quality of the securities provided to it as collateral, but also be of benefit to the market as a whole. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 10 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at the Commonwealth Bank Australasian Fixed Income Conference Dinner, Sydney, 30 October 2012. | Philip Lowe: Australia and the world Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at the Commonwealth Bank Australasian Fixed Income Conference Dinner, Sydney, 30 October 2012. * * * I would like to thank Tom Rosewall for his valuable assistance in the preparation of this talk. Thank you very much for the invitation to join you tonight. It is a pleasure to be here. This evening I would like to talk about some developments in the international economy and their implications for Australia. Clearly, this is not a new topic. Developments abroad have long had a profound impact on the Australian economy and financial markets, and, no doubt, they will continue to do so. But the unusual nature of recent developments, particularly in the advanced economies, is changing the way in which global outcomes affect Australia. I would like to spend some time this evening talking about these changes. It is useful to start off with the “big picture” and the key global influences on the Australian economy over recent times. Here, I would point to just two. The first is very much a positive influence – that is, the strong growth over a number of years in many emerging market economies, particularly those in Asia. The second is a negative influence – that is, the fiscal, household balance sheet and banking problems in many of the world’s advanced industrialised countries. Together, these two influences are reshaping the contours of the global economic landscape. They are also changing the configuration of interest rates and exchange rates we are seeing in Australia. The Asian story and its implications for us are well known. The strong growth in the region has led to a marked increase in the prices of resources and agricultural commodities, relative to the price of manufactured goods. This has been to our considerable advantage, given our natural resource base and our stable investment climate. It has meant that at a time when many of the advanced economies have been experiencing what is close to an investment drought, Australia has had the highest level of investment, relative to GDP, in over a century, and a further increase is expected (Graph 1). While the growth in Asia is clearly a positive story for Australia, there are inevitably ups and downs in the region and these are having a bigger influence on the Australian economy than was previously the case. Reflecting this, we have recently seen Chinese economic data being discussed much more in Australia than they were just a short time ago. Earlier in the year, growth in China was slowing, but the recent data have had a more positive tone and suggest that growth in China has stabilised, albeit at a lower rate than over the past decade or so. The story in the advanced economies is also well known, but is much less positive. For too many years, public spending ran ahead of taxes, with the difference financed at low interest rates in the bond market. In some countries, private-sector debt also grew too quickly and banks mismanaged their balance sheets. The result has been, and continues to be, a costly period of adjustment. Public finances have to be put on a sounder footing. Households are reducing debt levels. And financial institutions are strengthening their balance sheets. These adjustments take considerable time and it is likely to be some years before they are complete. If this is so, then a protracted period of disappointingly slow growth seems in prospect for a number of these economies. These two stories are, of course, interlinked. The ongoing momentum in the Asian region has provided some boost to the advanced economies over recent times, and conversely the problems in these advanced economies have contributed to a slowing in Asian growth. BIS central bankers’ speeches This co-dependence is very much the way of the world. But co-dependence does not mean that it is inevitable that the sluggish growth in the advanced economies must cause the world as a whole to experience sluggish growth. With the right policy settings, it is not inconceivable that strong growth in Asia – driven by domestic demand – could continue despite the problems in the advanced economies. Australia obviously has a very strong interest in this outcome, not least because we have benefited more from the growth in Asia than has any other advanced industrialised economy. So much for these big-picture influences. I would like to focus on the channels through which the problems in the advanced economies are affecting the rest of the world, including Australia. The most obvious is the trade channel, with weaker demand from the advanced economies weighing on exports from the rest of the world, including from Asia (Graph 2). This has acted as a drag on growth in the Asian region, although it is important to point out that the experience is nothing like that in late 2008 and 2009. For Australia, the direct trade links with the troubled advanced economies are not as large, although we face important second-round effects through our trade with Asia as well as through softer commodity prices. A second channel through which the problems in the advanced economies are having an effect is through adding to uncertainty, for uncertainty leads to decisions being delayed. The two big uncertainties that have attracted attention over recent times centre on the looming “fiscal cliff” in the United States and the question of how Europe resolves its fiscal and banking problems. At least in terms of the European question, some progress is being made, albeit frustratingly slowly. A year ago, it was unclear whether the ECB would be prepared to buy sovereign debt in large quantities. It was unclear how the funding stresses in the banking system would be resolved. And it was unclear just how much political support there was for more centralised bank supervision as well as the various European financial support mechanisms. Yet, in each of these areas, important decisions have been made. Collectively, these decisions have lessened the probability of a very adverse outcome, though clearly more work needs to be done. Investors rightly want to see more than just high-level decisions from European summits. They want to see agreement on how these decisions are to be implemented. And then they want to see further progress on actual implementation. This uncertainty stemming from problems in the advanced economies is having an impact here in Australia. It has adversely affected confidence and has led to the deferral of some decisions and more cautious behaviour. But the subdued level of confidence also has domestic roots. Employment growth, the rate of asset price increases and consumption growth are all lower than they were over the decade to the mid 2000s. During this earlier period the outcomes in these areas were very strong as the economy adjusted to low inflation and the increased availability of credit. But this adjustment is now complete, and the return to more normal patterns has come as a disappointing surprise to many who thought that the previous outcomes were the norm. This gradual realisation that the future is likely to be different from the past is an important factor weighing on sentiment in Australia. A third channel through which the problems in the large industrialised countries are having an effect is through the very accommodative stance of monetary policy in these economies. In the United States, the euro area, Japan and the United Kingdom, official interest rates are either at, or very close, to their lower bound, and the size of the central bank balance sheets has increased markedly. From one perspective, this setting of monetary policy is hardly surprising. The sluggish growth in many of the advanced economies means that little, or no, progress is being made in reducing high rates of unemployment. At the same time, core inflation is subdued. As a result, monetary policy is accommodative. And with official interest rates effectively at zero, this accommodative setting is being achieved through expansion of central bank balance sheets. BIS central bankers’ speeches But from another perspective, what we are seeing is highly unusual. Since mid 2008, four of the world's major central banks – the Federal Reserve, the ECB, the Bank of Japan and the Bank of England – have all expanded their balance sheets very significantly, and further increases have been announced in a couple of cases (Graph 3). In total, the assets of these four central banks have already increased by the equivalent of around $US5 trillion, or around 15 per cent of the combined GDP of the relevant economies. We have not seen this type of planned simultaneous very large expansion of central bank balance sheets before. So in that sense, it is very unusual, and its implications are not yet fully understood. This type of monetary expansion is supposed to work through a number of mechanisms. At the risk of oversimplifying things, I want to focus on just two of these. The first is that it increases the prices of assets that the central bank is buying, thus lowering the yields on those assets. With the Fed, the Bank of Japan, and the Bank of England all buying their own government’s bonds, it is hardly surprising that yields on those bonds are at very low levels (Graph 4). Similarly, in Europe, the prospect of the ECB buying the bonds of troubled sovereigns has seen yields on those bonds decline. Also, in the United States, the Fed’s decision to purchase mortgage-backed securities has seen the yields on those securities fall. In general, these lower yields should help provide some boost to spending, just as would lower interest rates from more conventional policy. The second mechanism is through asset allocation decisions, as banks and investors adjust their portfolios following the sale of assets to the central bank. These sales lead to an increase in the balances that banks hold at the central bank. In addition, where the ultimate seller of the assets is a non-bank, they also lead to an increase in bank deposits. At some point, the institutions holding these higher balances, which earn zero or very low interest rates, could be expected to conclude that there were other assets somewhere in the world that earned a risk-adjusted return above zero. As institutions seek out these other assets, their prices would be expected to rise. The ever-larger size of these balances increase the incentive for institutions to seek out these other assets. There is evidence that this transmission channel of quantitative easing is working. Market participants report that, at least in some areas, the appetite for risk is slowly returning, with some investors looking at how to improve their returns. Global stock markets have rallied since the middle of the year. Corporate bond spreads in the United States and Europe have narrowed, and yields are around their lowest levels on record (Graph 5). Corporate bond issuance in the United States has been strong recently and issuance has also picked up in Europe. Of course, these developments may not be sustained. Any appetite for increased risk taking can easily be diminished again by a bad outcome somewhere in the world. But for the time being, in some market segments, conditions are slowing improving. It is not unreasonable to attribute some of this to quantitative easing. Indeed, this is what the textbook tells us should be happening. There is an important international dimension to all of this as well. When institutions look for alternatives to holding large deposits earning a near zero return, they look not just at domestic assets, but at foreign assets as well. Not surprisingly, with the rest of the world doing better than the troubled advanced economies, many of the assets earning positive riskadjusted returns are located outside the countries undertaking quantitative easing. As a result of this, there is an incipient outflow of capital from these countries, and by extension downward pressure on their currencies. Of course, this means that the currencies of some other countries are under upward pressure, which, by itself, weighs on growth in these countries. This is not the end of the story though and there are some potential offsets. The first is that if quantitative easing is successful in boosting growth in the countries in which is it occurring, then the world economy will be stronger. The second is that any rise in asset prices that occurs because of the capital flows might also provide a boost. And the third is that the contractionary effects of an appreciation can be countered with more BIS central bankers’ speeches stimulatory domestic policy-setting – including through lower interest rates – than would otherwise have been the case. This has, by necessity, been a quick tour through the effects of quantitative easing (perhaps not quick enough for a dinner!). One key point, though, is that quantitative easing and weak growth in the large industrialised economies is likely to lead, for a time at least, to upward pressure on other currencies and lower interest rates around the world. For the countries whose currencies are under upward pressure, this can be uncomfortable. However, it should not come as a surprise that the countries that are doing relatively well see their currencies gain value relative to those that are not doing so well. And it is this movement in exchange rates that is one of the ways in which low interest rates in the large financial centres are transmitted around the globe. Clearly, the real world is considerably more complex than this. But over recent times a number of the non-crisis countries with floating currencies have indeed found themselves in this general position – that is, they have had low nominal interest rates and a relatively high exchange rate (compared with what was expected). This list here could include, to varying degrees, Canada, South Korea, Switzerland, New Zealand, and some of the Nordic countries. In each of these cases, interest rates are very low by historical standards, and in a number of them the central bank has recently drawn attention to the upward pressure on its currency (Graph 6). This configuration of low interest rates and a high exchange rate is a consequence of the problems in the advanced industrialised economies. It is inevitably affecting the composition of growth in the countries concerned, although it need not be inconsistent with trend growth. Industries producing traded goods and services tend to be disadvantaged relative to the nontraded parts of the economy. And low interest rates help create an environment where investors are prepared to borrow to buy assets. To some extent this is desirable, and it is one of the channels through which monetary policy works. But it can also increase the probability of imbalances developing in credit and asset markets, with potential implications for financial and macroeconomic stability. Given the experience of the past decade, it is hardly surprising that the central banks in a number of countries have recently indicated that they are watching developments on this front very closely. So what are implications for Australia of all of this? It is perhaps useful to make four brief points. The first is that the primary reason the Australian dollar is high compared with its historical average is the large shift in the relative price of commodities I spoke about at the outset. This shift has been to Australia’s advantage, and the high exchange rate has helped us navigate our way through a once-in-a-century investment boom. The economy has recorded solid growth, the unemployment rate remains relatively low, inflation is consistent with the target, public debt is low and the banking system is sound. Few countries can make such claims. The second is that the types of portfolio flows I talked about earlier do appear to be having an effect here. This effect is perhaps clearest in the government bond market, with yields near historic lows. But it is also evident in the credit markets, with credit spreads paid by banks having fallen recently. It is also likely that these portfolio flows help explain why the exchange rate has changed little since mid year despite a general softening of the global outlook and a decline in key export prices. The third point is that Australia’s interest rates remain above those in other developed economies. The main reason for this is that the rate of return on new investment in Australia is higher than in many other countries, as evidenced by the high level of investment. The very low interest rates in many other economies should not be seen as a good thing or something to aspire to. They reflect those countries’ difficult economic circumstances, and particularly the low risk-adjusted returns available on new investment. BIS central bankers’ speeches The fourth and final point is that while our interest rates are relatively high compared with other countries, they are relatively low compared with historical averages. The international connections that I have talked about tonight help to explain this. These lower-than-average interest rates are providing some support to demand in the economy. There is also some sign that they have led to a slight improvement in the property market, although there has been little change in the appetite for debt. It would appear that, for the moment at least, the lower interest rates, rather than encouraging household borrowing, have allowed many households with mortgages to repay their loans slightly more quickly than was previously the case. These trends will obviously need close monitoring over the period ahead. So to conclude. These competing influences from Asia and the troubled advanced economies are having a significant effect on the Australian economy, the exchange rate and interest rates. They are creating challenges for both policymakers and investors, and they have added to the sense of uncertainty. What seems clearer though is that Australia’s strong trade links with Asia, our solid financial system, our flexible markets and our credible policy framework mean that we are in a better position than many other countries to deal with these challenges. I wish you the best of luck as you navigate your way through this complex world. Graph 1 BIS central bankers’ speeches Graph 2 Graph 3 BIS central bankers’ speeches Graph 4 Graph 5 BIS central bankers’ speeches Graph 6 BIS central bankers’ speeches | reserve bank of australia | 2,012 | 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, 20 November 2012. | Glenn Stevens: Producing prosperity Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 20 November 2012. * * * Thank you for the invitation to join you for your Annual Dinner. Financial markets and policymakers have been living in a more or less continual state of anxiety for over five years. While it was poor-quality lending in the US mortgage market that proved to be a key cause of problems, from quite early on it became apparent that European banks also had serious difficulties, because of their exposure to securities of doubtful quality, their high leverage and their need to fund US dollar portfolios on a short-term basis. It was in August 2007 that those acute funding difficulties first became apparent in European markets. Five years on, US banks have made a lot of progress in working through their asset quality problems and their capital deficiencies. At times the process was not pretty, but the US system is in better shape today as a result. US taxpayers have earned a positive return on the investments in major banks that were made at the height of the crisis. In Europe progress has been much slower. There are various reasons for that, not least the sheer complexity of coordinating the process of evaluating and strengthening balance sheets across so many countries, where the national capacities to assist are so different, and within the strictures of a currency union. This exacerbates, and in turn is compounded by, the deterioration in economic conditions in Europe, which feeds back to bank asset quality and sovereign creditworthiness. It is perhaps no surprise then that the news seems to have been dominated by the ebb and flow of anxiety over things like: whether or not the “troika” will recommend further funding for Greece; whether a national constitutional court will strike down a government’s participation in initiatives that will assist other countries; or whether the populace in a country under pressure will reach the end of its tolerance for “austerity” – and so on. There is “event risk” almost weekly. This is the European drama. Unfortunately, it is, I suspect, set to continue that way for quite some time. Over recent months financial market sentiment has improved, from despair to mere gloom, as a result of a number of important steps that have been taken and commitments that have been made. It is right that this improvement in sentiment has occurred – it recognises the determination of the Europeans to save the euro, which should not be underestimated. But there is much more to do, and it will take a considerable time. So while good progress is being made, we will not, any time soon, see a point at which the “euro problem” can be seen as past. The world will have to live with euro area anxiety for some years yet as a normal state of affairs. In the meantime the US economy has continued its slow healing. The US housing sector has, it would appear, finally turned. Now the election is past, the so-called “fiscal cliff” is rapidly coming into focus – a new source of event risk. But if one is prepared to assume that the US political system will not, in the end, preside over an unintentional massive fiscal contraction next year, the risks to the US economy probably look more balanced than they have been for a while. An upside surprise would be as likely as a downside one. It would be fascinating if, in another year, we find ourselves looking back at a US economy that had outperformed expectations. (There is still of course a critical need for the US to craft a measured and credible path back to fiscal sustainability. That particular drama could continue as long as the European one.) BIS central bankers’ speeches But it is appropriate to turn our gaze to our own part of the world, especially in the current period of discussion about “the Asian Century”. Two years ago, when I last spoke to CEDA’s Annual Dinner, a key feature of my presentation was this chart.1 Graph 1 This evening I can show how the chart looks when updated for two more years of data and our revised estimates for the near-term outlook. The terms of trade ended up rising further than assumed two years ago, and have then fallen back from the peak, though the level recorded in the most recent quarter is about 7 per cent higher than was in the forecast two years ago.2 The event is sufficiently unusual that we can add one twist to the chart. Instead of a five-year average, we can show a decade-long average. The chart in fact shows an eleven-year average, which allows the measure to be centred on the current year. To do this of course we need to make a five-year-ahead assumption. We have assumed that the terms of trade decline steadily, at a pace a little faster than implied by forecasts of private analysts. What is unusual about this event is not just the peak level observed, but the apparent persistence of high levels. The terms of trade will very likely record over a decade an average level 50 per cent higher than the previous long-term mean. That is a big deal. Even with a more pessimistic assumption – say that commodity prices fall by twice as much over the next five years – there is no doubt that this is easily the biggest, and the most persistent, terms of trade event for a very long time. See Stevens G (2010), ‘The Challenge of Prosperity’, RBA Bulletin, December, pp 69–75. I noted two years ago that a ship load of iron ore, which five years previously had had the same value as 2,200 flat screen television sets, was by late 2010 buying 22,000 such TVs – an increase in that particular “terms of trade” of a factor of ten. As of the current quarter the figure is 28,000. At the peak, it reached 38,000. BIS central bankers’ speeches Graph 2 Still, the terms of trade have peaked, and will probably have fallen by about 15 per cent by the end of this year. Further declines over time are likely. So while a high level of the terms of trade continues to add to the level of national income, we can no longer expect that a rising terms of trade will be adding to growth in living standards. We are entering a new phase. This is not so much because of the “end of the mining boom”. As a matter of fact, talk of the “end of the mining boom” has been somewhat overhyped. The “boom” is not so much ended as simply evolving, as these events would be expected to. Thoughtful commentators have already pointed out on a number of occasions that there are three phases to the “boom”. The first was the rise in prices – something that began as far back as about 2004. The peak in prices was more than a year ago now. The Reserve Bank began noting that prices had declined in our monthly interest rate announcements in October 2011. But relative prices for natural resources are still high. At this point, the terms of trade are down to the “peak” seen in the September quarter of 2008, which was of course a fifty-year high. The second phase of the “boom” is the rise in resource sector physical investment. This is aimed at taking advantage of expected high demand for iron ore, coal, natural gas and other commodities over the medium term, at prices which are attractive relative to costs of production, including the cost of capital. The peak in this build-up lies ahead. It has, for some time, been our expectation that it will occur in 2013 or 2014; that expectation seems to be firming up. The actual level of the peak is probably going to be a bit lower than we thought six months ago, in view of the somewhat lower, and more variable, prices for iron ore and coal observed in recent months. But it’s worth putting that downward revision into perspective. For fifty years, resource sector investment was typically between 1 and 2 per cent of GDP, with cyclical peaks at about 3 per cent (Graph 3). The uncertainty now is over whether it will peak at closer to 8 per cent of GDP than 9 per cent. What isn’t uncertain is that either number is very high by any historical standard. BIS central bankers’ speeches Graph 3 It’s also worth observing that, in any episode of this nature, there will always come a point when some potential projects, conceived at the time when prices were at their highest and when costs were about to start mounting quickly as well, have to be shelved. Actually, if projects that rely on extremes of pricing and optimism can be shelved before they get too far, that is preferable to having them continue. More generally some important parts of the resources sector have now reached a point where the costs of further expansion in capacity, relative to those that might be expected elsewhere in the world, are a much more important factor in investment decisions than they were a couple of years ago. The third phase of the “boom” is when the capacity to extract and export higher quantities of resources is actually used. This phase has begun for iron ore but it is mostly still ahead of us, especially for gas. The main uncertainty is really over the prices that will be achieved as higher supply – and not just in Australia – comes on stream. Such uncertainty is, and always has been, part and parcel of the business of investing in resource extraction. Perhaps what people have found a little unnerving over the past year is that as the prospect of rising supply of key natural resources gets closer, and prices have declined from their peaks, the Chinese economy has been in transition to slower growth. It was inevitable that China would slow to some extent, from the very rapid pace seen for much of the past decade. The signs it needed to do so were quite evident: increasing general price inflation, escalating property prices, doubts about the process of credit growth and credit risk management, and so on. But just how big a slowing was occurring? For much of this year, that was the question that people have been trying to answer. My assessment is that the slowdown has been more material than had been expected a year ago, but not disastrously so. There are some signs that the moderation may have run its course, though further data are needed before such a view could be offered with confidence. So the Chinese economy has not crashed. But neither is it likely to return to the sorts of double-digit percentage rates of growth in real GDP, and 15 per cent growth rates for industrial production, that we saw for some years. People expecting that to resume are likely to experience disappointment. These trends are entirely consistent with two propositions that we have advanced over the past several years. The first was that China’s economy would have an important and BIS central bankers’ speeches increasing weight in the regional and global economies. China’s economy is nearly three times the size it was a decade ago. One corollary of this is that even “moderate” growth in China is quantitatively significant. If China grew by, say, “only” 7 per cent in 2013, that would add more to global GDP than the 10 per cent growth recorded in 2003.3 The second proposition was that China, like all economies, has a business cycle. It is affected by what happens elsewhere in the world, and by its own internal dynamics, including the decisions of its policymakers. Swings in China’s economic performance are increasingly affecting Australia’s economy and that of the region – and the world. Hence the focus on monthly data reports from China these days in our business press, in addition to the focus on the Chinese political situation. The Chinese “purchasing managers index” is now as keenly awaited, and is as potentially market moving, as the original US PMI measure, known these days as “ISM”.4 There is some tentative evidence that Chinese data “surprises” have become increasingly influential in driving movements in Australian financial prices such as the exchange rate and share prices. Turning then to Australia, two years ago I noted that we could not know how much of the rise in the terms of trade would be permanent, and that there was therefore a case to save a good proportion of the additional national income until it became clearer what the long-run prospects might be. In a manner of speaking, we have, as a community, done something like that. The marked rise in the rate of saving by households in 2008 and 2009 has been sustained. Corporations have also increased their saving considerably over the past five years, opting to repay debt and lower their gearing ratios. Admittedly, government saving has been lower for a time, for countercyclical purposes, though that is now scheduled to rise as well. For the nation as a whole, the fact that the current account deficit has been lower on average in the past few years than in the period from 1985 to 2005, at the same time as the share of business investment in GDP has been exceptionally high, indicates that national saving has been higher. In fact it has been at its highest share of national income since the late 1980s. This change can be seen as a sensible response to an unusually high level of the terms of trade. Something else has also been at work, though, in household behaviour. I have spoken about this before but it bears saying again, because it is fundamental to understanding the current economic situation.5 After a period in which high levels of confidence, macroeconomic stability, easy availability of credit and rising asset values saw Australian households borrow more and save less, households have over recent years changed their behaviour in respect of spending, saving and borrowing. They have gone back towards what was once considered as “normal”.6 This really had nothing to do with the resource boom. But it has had important implications for some key business sectors. Financial institutions are finding that growth in credit is now a single-digit number, not a double-digit one as it had been for so long. Businesses that in the earlier period of optimism derived earnings from high rates of turnover in asset markets – real estate agents, stock brokers, for example – face challenges, given that turnover is now greatly reduced. In 2003, China’s growth in real GDP of 10 per cent added 0.8 of a percentage point to global GDP. If China’s growth in 2013 is 7 per cent, that will add a full percentage point to global GDP. I am old enough to remember when the ISM index was referred to as the “NAPM” index, compiled by the National Association of Purchasing Management. Stevens G (2011), ‘The Cautious Consumer’, RBA Bulletin, September, pp 77–82. The focus on households is not to deny that businesses have also become more circumspect about debt as well. But corporate leverage did not really rise much in the preceding decade, at least outside a few celebrated instances. It was the change in household debt that was the defining feature of the period from the early 1990s to about 2008. BIS central bankers’ speeches The retail sector now faces different consumers. It is not actually that consumers have no income to spend, nor that their confidence levels are that low, nor that their saving rate is that high. Measures of confidence that date back to the 1970s show it to be roughly at its long-run average. The household saving rate as measured by the Australian Statistician, at just over 10 per cent, is not, in fact, high in the broader sweep of history (Graph 4). Graph 4 To be sure, confidence was persistently very high for years up to 2008, and saving was very low – even falling to about zero, as measured, at one point. But that period was unusual. I don’t think it will return. Moreover consumers are much more knowledgeable about prices as a result of information technology, and have at their disposal ways of responding to that information that a decade or more ago they did not have. This is putting pressure on retail business models, on wholesaling and distribution, and also on segments of the retail property sector. Given that the change to household behaviour was probably inevitable, the income boost from the terms of trade arrived at a rather fortuitous time. It helped to accommodate a rise in household saving and a slowdown in the build-up of debt in a fairly benign fashion. The weakness of some other parts of private demand, and openness to imports with a high exchange rate has also meant that a very large expansion in mining investment has been accommodated without overheating the economy overall. As it was, total real private final demand in Australia rose by 6 per cent in 2011/12, well above trend. With the peak in the investment phase of the mining boom now coming into view, the question naturally arises as to how the balance between the various types of demand in the economy will unfold. Mining investment will contribute less to growth in domestic demand in the current fiscal year than it did last year, and less again next year. Working in the other direction, it is likely that export volume growth will begin to strengthen as the capacity being installed in the resource sector is used. That would show up as GDP growth, though it may be predominantly reflected as higher measured productivity rather than generating a large volume of extra employment. The question will be whether other areas of domestic demand start to strengthen. Many households have made progress in reducing debt burdens. At some point that might be BIS central bankers’ speeches expected to lead to such households feeling more inclined to spend. But a complex interaction of factors – asset values and expectations about job security to mention two – will be at work in ways that are not amenable to accurate short-term forecasting. Overall, our assumption is that consumption will probably continue to grow at about trend pace, in line with income. Public demand is scheduled to be subdued as governments seek to return budget positions to surplus. The near-term outlook for business investment spending outside the resources and resource-related sectors is subdued, judging by currently available leading indicators. In most cycles, it takes time for this sort of investment to turn; this episode looks like no exception. The exchange rate may also have some role in helping the needed re-balancing. While it’s not surprising that the Australian dollar has been very strong given the terms of trade event we have had, it is surprising that it has not declined much, at least so far, given that the terms of trade peaked more than a year ago. A lower exchange rate would, of course, need to be accompanied by a pace of growth of domestic unit costs below that seen for much of the past five years, in order to maintain low inflation. One area of stronger potential demand growth is dwelling construction, which has been unusually weak. It is not clear, actually, that the degree of weakness has been adequately explained. Various explanations have been offered – interest rates too high, housing prices falling, zoning restrictions, planning delays, construction costs, lack of “confidence”, all have featured. At present, at least some of the pre-conditions one might expect to be needed for higher construction seem to be coming into place. Interest rates have declined, dwelling prices seem to have stopped falling, rental yields have risen, and the availability of tradespeople is assessed as having improved. We have, moreover, seen a rise in approvals to build. So there is some evidence of a turning point, albeit a belated one. Will the net effect of these developments mean that aggregate demand rises roughly in line with the economy’s supply potential over the next couple of years, or will a significant gap emerge? That is the question the Reserve Bank Board is trying to answer every month when it sits down to decide the stance of monetary policy. As of the most recent meeting, as the minutes released earlier today show, the Board felt that further easing might be required over time. The Board was also conscious, though, that a significant easing of policy had already been put in place, the effects of which were still coming through and would be for a while. In addition, the latest inflation data, while not a major problem, were a bit on the high side, and the gloom internationally had lifted just a little. So it seemed prudent to sit still for the moment. Looking ahead, the question we will be asking is whether the current settings will appropriately foster conditions that will be consistent with our objectives – sustainable growth and inflation at 2–3 per cent. Over the long run, though, the bigger question, for all of us here tonight and in the business and policy making community generally, isn’t about the monthly interest rate decision. The big question is: what is the sustainable growth rate of the economy? Beyond its role of preserving the value of money, monetary policy can do little to affect that sustainable growth rate. Moreover, the initial contribution of rising mineral prices to our standard of living has now run its course. To be sure, a higher capital stock devoted to extracting resources at high prices, assuming they continue, will make its contribution for many years – to the extent that Australians own some of that capital, work with it or receive tax revenues. But the biggest contribution to growing living standards will be what it has always been other than in periods (usually not long-lived) of exceptional luck, and that is productivity performance. I noted two years ago that while our terms of trade are handed to us, for better or worse, by international relative prices, the efficiency with which we work is a variable we can actually do something about.7 See Stevens G (2010), ‘The Challenge of Prosperity’, RBA Bulletin, December, p 75. BIS central bankers’ speeches For some years there had been evidence of a slowing in productivity growth, beyond the unusual factors clearly at work in a couple of sectors (mining and utilities). The most recent data on productivity show signs of a pick-up in the year 2011/12, which is encouraging (Graph 5). Graph 5 It is much too soon to conclude that a new, stronger trend is emerging – in this field much longer runs of data are needed. In my opinion, the accelerated structural change we are seeing in the economy for various reasons is likely to result in some improvement in productivity performance. But the most that can be said, at this stage, is that the data are not inconsistent with that hypothesis. At this point when talking about productivity, I usually become circumspect. One reason is that I know that people might ask what we might do to improve productivity performance, and I am acutely aware that the improvement has to be delivered in enterprises all around the country – the ones associated with CEDA and millions more. Productivity does not rise simply because of exhortation or official pronouncements. As for policy measures, at a meeting in Brisbane earlier this year, I said: The Productivity Commission has a long list of things to do. My answer to what we can do about productivity is: go get the list and do them.8 The background to this is that, as part of our preparations for possible questions about productivity from the House Economics Committee, I had at one stage asked the Reserve Bank staff to compile a list of areas of reform that the Productivity Commission had covered at various times. It was this list I had in mind when I made the comment in June. At one hearing of the House Economics Committee I in fact read from such a list. See House of Representatives Standing Committee on Economics (2011), Reserve Bank of Australia Annual Report 2010, HRSCE, Melbourne, 26 August. Available at <http://parlinfo.aph.gov.au/parlInfo/download/ committees/commrep/306ee889-2f7e-4661-964b-5264b58b7169/toc_pdf/Standing%20Committee%20on%20 Economics_2011_08_26_393_Official_DISTRIBUTED.pdf;fileType=application%2Fpdf#search=%22committe es/commrep/306ee889-2f7e-4661-964b-5264b58b7169/0001%22>. BIS central bankers’ speeches That comment elicited some attention. The Chairman of the Productivity Commission was, I am led to understand, inundated with media demands for “the list” and had to explain that it didn’t quite exist in that form. But Chairman Gary Banks has very kindly drawn one together, in his final public speech at the end of a very distinguished tenure in that position.9 His list is a rather more complete one than mine. In fact it is a set of lists, under three headings: things that affect incentives, things that affect capabilities and things that affect flexibility. What was perhaps most striking was the comment in the conclusion that no single policy offered the secret to success. To quote: Rather, what is needed is an approach to “productivity policy” that embraces both the drivers and enablers of firm performance, and is consistently applied. That in turn requires policy-making processes that can achieve clarity about problems, reach agreed objectives and ensure the proper testing of proposed solutions (including on the “detail” and with those most affected). The beneficial and enduring structural reforms of the 1980s and 1990s are testimony to the value of these policy-making fundamentals. Good process in policy formulation is accordingly the most important thing of all on the “to do list”, if we are serious about securing Australia’s future productivity and the prosperity that depends on it.10 It couldn’t have been better put. As the “mining boom” moves from its second to its third phase over the next year or two, the world economy will continue to present its own challenges. Australia will, as always, need to adapt to the changing circumstances. Looking much further ahead, to “the Asian century”, our opportunities are large. But to grasp them, that same adaptability, combined with a clear focus and steadiness of purpose will be key. We need to produce our sought after prosperity; it won’t just come to us. All of us have our role to play, CEDA and its members included. I wish you every success. See Banks G (2012), ‘Productivity policies: The “to do” list’, Speech at the Economic and Social Outlook Conference, ‘Securing the Future’, Melbourne, 1 November. Available at <http://www.pc.gov.au/__data/ assets/pdf_file/0009/120312/productivity-policies.pdf>. See Banks G (2012), op. cit. p 20. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 11 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Parliamentary Joint Committee on the Australian Commission for Law Enforcement Integrity, Canberra, 30 November 2012. | Glenn Stevens: Remarks to Parliamentary Joint Committee on the Australian Commission for Law Enforcement Integrity Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Parliamentary Joint Committee on the Australian Commission for Law Enforcement Integrity, Canberra, 30 November 2012. * * * Madam Chair Members of the Committee Thank you for the opportunity to attend today and for the opportunity to make a few introductory remarks. The Committee posed a number of questions to the Reserve Bank, some in relation to the lessons from the corruption allegations against Note Printing Australia (NPA) and Securency, and the majority in relation to the Bank’s offshore operations. The Bank responded to these questions in late May. In regard to the corruption allegations, the companies have extended their full cooperation to the legal authorities. They have also done a great deal of work to reform policies and compliance over the past several years. Of course, these matters remain before the Courts. A key learning point for the Reserve Bank from these events is the extent of possible risks that can come from operating commercial ventures which export to a range of foreign jurisdictions. This has caused the Reserve Bank to re-evaluate its risk appetite insofar as such entities are concerned. As for the offshore operations of the Reserve Bank itself, there are three of them: in London, New York and, recently, Beijing. Of those three, the operations in London and New York are the largest and carry the greatest risks for the Bank. Those risks are overwhelmingly of a financial and operational nature, since a major part of those offices’ function is to manage the bulk of the Bank’s foreign currency assets. The key people in those offices are Australian staff well trained in the Bank’s policies and controls for such activities. The Beijing office is, at this stage, small, purely representational, and is operated out of the Australian Embassy there, with the various protocols and controls associated with that. The staff there, who are bound by the Bank’s Code of Conduct, also received appropriate training from the Department of Foreign Affairs and Trade. The Bank’s control environment for the London and New York offices has been configured appropriately for the risks these offices take, with detailed policies, procedures and controls. As a general observation, given the nature of the operations and the jurisdictions in which they are operating, the risks of corruption in the London and New York offices are considered generally to be inherently no more, and no less, than associated with like activities in Head Office. That said, risks of any operation can increase with remoteness and, for this reason, there is, on a daily basis, close monitoring from Head Office of all transactions undertaken in London and New York. Extensive, on-the-ground auditing of these operations occurs every year. As to the integrity framework generally, the Bank has a Code of Conduct, which governs all the staff. Staff receive training in the requirements of the Code and additionally are required periodically to re-familiarise themselves with it. As it happens, a new version of this Code has recently been rolled out, following an extensive review. There is also a comprehensive Fraud Control Framework, which includes a Fraud Policy and a Reporting Fraud and Unethical Behaviour Policy. The Bank has drawn upon the relevant Australian standards and best practice guidelines, including the Commonwealth Fraud Control Guidelines and the BIS central bankers’ speeches Commonwealth Procurement Rules, in preparing and implementing its policies and its fraud risk management framework. Those policies place an obligation on staff to report any concerns they may have regarding compliance or unethical or illegal behaviour. There is an automatic process of escalation of such concerns, once expressed, to the Deputy Governor, and there are externally operated phone numbers staff can call if they wish to remain anonymous. The Bank undertakes to protect those who raise such concerns in good faith. Staff operating in the overseas offices, including locally recruited staff, are bound by these policies and the Code of Conduct. Staff in overseas offices are also, of course, bound by the laws of the country in which they reside. There is more detail in our responses to the Committee’s questions on notice, supplied in late May. The Committee also asked about corruption risks associated with the Reserve Bank’s participation in global and regional forums, in which participation has increased considerably over recent years. These are forums such as the G-20, the Financial Stability Board, the Asian central bank group known as EMEAP, and international institutions such as the Bank for International Settlements, the IMF and so on. We believe the risks of corruption in such activities are inherently low, and made lower by appropriate controls on the way participation is conducted. I would be pleased to respond to any questions members of the Joint Committee might have. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 12 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 5 December 2012. | Philip Lowe: What is normal? Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 5 December 2012. * * * I would like to thank Jonathan Kearns for valuable assistance in the preparation of this talk. Thank you for the invitation to speak at tonight’s dinner. This is the second time that I have participated in the ABE’s annual forecasting conference and it is a pleasure to be here once again. The title of my remarks this evening is in the form of a question. And that question is, “What is Normal?” The Oxford Dictionary defines the word “normal” as “conforming to a standard; usual, typical or expected”. 1 The question of “what is normal” therefore seems an appropriate one for an annual forecasting conference. For many of us, our days are spent looking at economic and financial developments and asking whether they are “usual, typical or expected”. And if we conclude they are not, we ask ourselves will things return to normal, and if so when, or has normal changed? Like many of you, I often get asked if what we are seeing is “normal”, “the new normal”, “the old normal” or is it something different? In many areas of life our perceptions of what is normal are crucial to how we feel about what is going on around us. There are, for example, a range of human behaviours that were once considered normal but would cause many of us considerable angst if we saw them today. What is considered normal, and entirely unremarkable in one context, can be viewed very differently in another. So context and experience are important. With that in mind, my remarks tonight are split into two parts. First, I would like to look back over Australia’s recent economic performance and what it means for people’s perceptions of what is normal. And then second, I would like to talk about some issues related to monetary policy and what is considered normal. Australia’s recent economic performance On a number of fronts, the past 20 years have been very good ones for the Australian economy. During the early part of this period, the economy was recovering from the sharp downturn of the early 1990s recession. We then had the boom in housing prices and credit. That was followed by the sharp rise in the terms of trade, which was only temporarily interrupted by the financial crisis in the North Atlantic. And most recently, we have seen a boom in investment in the resources sector. Over these 20 years, we have experienced almost uninterrupted growth, a feat not matched by any other developed economy. The banking system has remained strong. The fiscal accounts have been kept in good order. And inflation has remained under control. It is fair to say that these outcomes are better than was widely expected 20 years ago. If we use our own history or overseas experience as a guide, these outcomes, collectively, could hardly be described as usual, typical or expected. Indeed, they have been better than what might reasonably be described as normal. Importantly, this experience leaves us with a very positive legacy. See <www.oxforddictionaries.com>. BIS central bankers’ speeches More of us have jobs than ever before. Our incomes are noticeably higher. We are wealthier. And our economy has moved up the global league tables. But this experience has also affected how Australians view our current economic situation. After such a good run, there is a sense of dissatisfaction in parts of the community that we are not repeating all aspects of this earlier experience. Twenty years of good economic performance and rising asset prices raised our expectations of what is normal and many in the community are a little disappointed that these higher expectations are not being met fully. I suspect that this is one factor that explains why the public mood has been a bit flat over recent times, despite many observers outside our country viewing the Australian economy with some envy. This change in what is considered normal is adding to the adjustments that are going on in the economy. To illustrate this change and the unusual nature of the events that preceded it, I would like to show you six graphs. The first graph is of growth in consumption per capita (Graph 1). If the volatility in the data is smoothed out, you can see that the period from the mid 1990s to the mid 2000s was an unusual one. Consumption growth per person was consistently strong; it was faster than over the preceding years and faster than over recent years. This is true for both retail trade and for the consumption of services. Graph 1 The second graph is really a corollary of the first and is of the household saving rate (Graph 2). From the mid 1980s up until the mid 2000s, the saving rate was on a downward trend. Put differently, growth in consumption was consistently faster than growth in income. For part of this period we spent every extra dollar we earned, and then a bit more. This could hardly be said to be normal, or sustainable. More recently, the saving rate has increased and it is back to the level it was in the mid 1980s. BIS central bankers’ speeches Graph 2 The third graph shows household debt and household wealth relative to household disposable income (Graph 3). Here, the story is similar. From around the mid 1990s to the mid 2000s, the value of both our assets and our liabilities grew much more quickly than our incomes. But because the value of our assets increased at a faster rate than the value of our liabilities, there was a large increase in measures of household net wealth relative to income. Again, such a large adjustment is unusual. In recent times, the steady rise in the various ratios has stopped and they are now roughly back to where they were a decade ago. Graph 3 BIS central bankers’ speeches The fourth graph is of the share of the dwelling stock that is sold each year (Graph 4). During the latter part of the 1990s and the first part of the 2000s, turnover in the property market was much higher than average. More than ever before, we moved houses or bought and traded second properties, either as an investment or as a holiday property. The high rate of turnover boosted many parts of the economy, including the real estate sector and parts of the retail sector. It also boosted state government finances due to higher stamp duty revenue. Over the past few years, turnover has declined and has been around half the rate that it was in the early 2000s. Graph 4 The fifth graph is of the share of the working-age population that has a job (Graph 5). Again over the period from the mid 1990s to the mid 2000s, employment consistently grew much more quickly than the working-age population. While this partly reflects a rise in labour market participation by females, this type of experience, sustained over a long period, is unusual. And, as in some of the other graphs, we see a levelling out in this ratio over recent years. BIS central bankers’ speeches Graph 5 Finally, the sixth graph shows the increase in our living standards – measured by the rise in real income per hour worked – together with the increase in productivity (Graph 6). Something rather unusual has happened here too, although the timing is a little different from that in the previous graphs. Over the past decade there was a decoupling of the link between advances in our living standards and growth in productivity, with living standards increasing more quickly than productivity. We found ourselves in this favourable situation because of the very material rise in Australia’s terms of trade that occurred over this period. Graph 6 The developments in these six graphs have their roots in a number of influences. The first is financial liberalisation and the return to low interest rates in the 1990s after the high inflation of the 1970s and 1980s. And the second is the large increase in Australia’s terms of trade, BIS central bankers’ speeches due to strong growth in Asia, and China in particular. 2 The strong productivity growth in the 1990s and the recovery from the early 1990s recession also played some role. Importantly, financial liberalisation and lower nominal interest rates gave households increased access to debt, with many households taking advantage of this. This pushed up the price of housing, and some households used their increased equity to fund higher consumption. Financial liberalisation and rising house prices were also associated with the greater turnover in the property market. Financial institutions were among those that benefited from this, with rapid balance sheet growth and unusually low levels of problem loans. Collectively, these developments also helped generate strong employment growth. This boosted fiscal revenues, as did the large increase in the terms of trade, and this boost to revenues made possible frequent cuts in personal income tax rates. The process of adjustment to financial liberalisation and lower interest rates took a long time to play out – at least a decade and probably longer. This long period of adjustment made it more difficult to determine what was normal. If something happens year after year, there is a tendency to think it can continue to happen and some people start to make their plans accordingly. However, when the adjustment is finally complete there can be a period of disappointment when previous trends do not continue. At least with hindsight, the response to financial liberalisation and lower interest rates looks to have run its course around the mid 2000s. At the time we largely avoided a sense of disappointment because of the second influence I mentioned earlier – that is, the large run-up in the terms of trade that was then starting to take place. One concrete example of how the past influences the interpretation of current developments is our interpretation of the behaviour of consumers. In particular, it has become commonplace to talk about the “cautious” consumer, and I myself have done this frequently, including when I last spoke at this dinner. But increasingly, I wonder whether or not this is the best description. Certainly, using these earlier years as our benchmark, consumers do look to be cautious; consumption growth is slower than it was previously; the saving rate is higher; and credit growth is lower. But are these earlier years the most suitable benchmark? I suspect they are not. Over the past couple of years, consumption has been growing broadly in line with income. That does not look to be particularly cautious, although it is different. Growth in household borrowing has also been broadly in line with household income. Again, this does not look to be particularly cautious, but it is different. It may be more appropriate to describe this type of behaviour as “prudent”, rather than “cautious”. Indeed, it might be described as “normal”. The general point here is that there is a recalibration going on regarding what is considered normal. Having consumption, credit and asset prices grow broadly in line with incomes should probably be viewed as usual, typical or expected. So too should the rate of increase in our living standards being determined by productivity growth. I want to make it clear that I am not saying that we have to accept inferior economic outcomes from those that we have had on average over the past 20 years. Indeed, Australia is very well placed to continue to benefit from the growth of Asia and we have many advantages, including our skilled workforce. But, on the financial side, we are unlikely to repeat this previous experience, and nor should we aspire to. There was an adjustment to take place and that adjustment has occurred. Whether we can take advantage of the opportunities that lie ahead and continue to enjoy the rate of increase in our living standards that we have become used to depends upon productivity growth. The contribution the The effect of the large increase in the terms of trade is discussed in more detail in Stevens G (2012), “Producing Prosperity”, Address to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 20 November. BIS central bankers’ speeches Reserve Bank can make here is to maintain low and stable inflation and to keep the economy on an even keel. Beyond that, it is in the hands of businesses, workers and governments to deliver the type of changes that will drive the next round of productivity improvements. As a number of people have noted recently, this needs to be high on our national agenda. Monetary Policy I would now like to talk about the concept of normal as it applies to four issues related to monetary policy. The first of these is inflation. The key point here is that low inflation has become normal in Australia (Graph 7). Most consumers and businesses now view it as usual, typical or expected that inflation will average 2 point something over time. Australians, and those doing business here, can make their investment and spending decisions without having to worry about the possibility of rapid and unexpected increases in the general level of prices. This is quite different from the 1970s and 1980s. It is perhaps the most important benefit of the medium-term inflation target that has been in place in Australia for the past two decades. Graph 7 The second issue is one where the news is not so good, particularly for many in this audience. The unfortunate reality is that in the area of forecasting it is normal for forecasts of economic activity to be wide of the mark. This is evident in work recently undertaken by two of my colleagues at the RBA who looked at the history of our own forecasts. 3 They conclude that “the RBA forecasts explain very little of the variations in GDP growth, medium-term changes in unemployment, or the medium-term deviations of underlying inflation from the target”. This conclusion is obviously challenging for those of us involved in the forecasting process! See Tulip P and S Wallace (2012), “Estimates of Uncertainty around the RBA's Forecasts”, RBA Research Discussion Paper 2012–07. BIS central bankers’ speeches The reason I raise this issue is that we are very cognisant of the limits of forecasting, and that it is normal for outcomes to vary materially from what was expected. Outcomes often deviate from what was considered usual, typical or expected as global events occur and the structure of the economy changes. This means, as Glenn Stevens said in a speech to this audience last year, that monetary policy decisions should not be rigidly and mechanically linked to forecasts. 4 Of course, this does not imply that the process of forecasting is unimportant. This process forces questions to be asked and issues to be analysed, and is a central part of good monetary policy. But because it is commonplace for there to be fairly high levels of uncertainty around the point forecasts, there is also an important role for judgement by policymakers. The third issue that I would like to touch on is the normal level of interest rates. For much of the decade or so before the financial crisis it was normal for headline mortgage rates to move in near lock step with the cash rate. This has obviously changed over recent years, as bank funding costs – and hence mortgage rates – have risen relative to the cash rate. As we have noted many times, the Board of the RBA has taken account of this in its monthly policy decisions. As a result, the cash rate today is around 1½ percentage points lower than it otherwise would have been. The fact that the Bank has offset the effect of higher funding costs on lending rates means that the normal level of the cash rate is lower than it otherwise would have been. A 3 per cent cash rate today is not the same as a 3 per cent cash rate in the past. A more difficult issue to assess is the normal level of lending rates, as opposed to the normal level of the cash rate. It is difficult to be definitive here, but there are a couple of reasons why the normal level of lending rates may be lower, at least for a time, than was the case over the past two decades. The first reason is the international environment. As I talked about in another speech recently, many of the countries that avoided the financial crisis are experiencing uncomfortably high exchange rates and low interest rates. 5 Australia is one of these. With the major economies of the world quite weak, most other countries would see themselves as benefiting from a lower exchange rate to boost their exports. But, of course, given that exchange rates are relative prices, not every country can simultaneously have a lower exchange rate. It should not really come as a surprise that countries that are in relatively good shape and have not seen large-scale expansion of the central bank balance sheet are experiencing stronger currencies than those that are in relatively poor shape. This is one of the mechanisms through which the weak conditions in most of the advanced economies are transmitted to the rest of the world. And in response to this, interest rates are lower than they otherwise would be to offset some of the effects of an uncomfortably high exchange rate. The second factor that might have an influence on the normal level of lending rates is related to the issues that I spoke about at the outset. For most of the past 20 years we were benefiting from either the credit boom or the terms of trade boom. Under the influence of these two factors, one might expect, all else constant, higher average lending rates than otherwise, as both factors boost aggregate demand relative to supply at least for a period. Another way of thinking about this is that in the earlier period there was an increase in the rate of time discount and correspondingly an increase in the normal level of interest rates. Although the high terms of trade are still boosting aggregate demand, the aftermath of the credit boom and the gradual realisation that this experience is unlikely to be repeated is See Stevens G (2011), “On the Use of Forecasts”, Address to Australian Business Economists Annual Dinner, Sydney, 24 November. See Lowe P (2012), “Australia and the World”, Address to Commonwealth Bank Australasian Fixed Income Conference Dinner, Sydney, 30 October. BIS central bankers’ speeches working in the other direction. All else constant, this might be expected to lead to lower average lending rates than during the earlier period. Of course, all else is not constant, including the amount of spare capacity in the economy, the nature of capital flows and the rate of productivity growth. But it is possible that normal lending rates will be somewhat lower for a period owing to the combination of global factors and the legacy of the credit boom. Whether or not this turns out to be the case depends upon a whole range of factors, including how cost and price pressures in the economy evolve. This brings me to the fourth and final issue. And that is whether we are seeing a normal response of the economy to the reductions in interest rates that have occurred over the past year or so. Assessments in this area are difficult, not just because there is a very wide range of historical experience, but also because of the challenge of determining what is the normal level of lending rates. However, the current response, across a large number of indicators, is falling within the range of outcomes that we have seen in the past. There do appear though, to be some differences in the behaviour of the household and the business indicators. In particular, while a number of household indicators have picked up somewhat, business confidence and conditions have not. This difference will obviously bear close watching over the period ahead. One other area where the response has been smaller than typical is the exchange rate, which has remained high. The more important conclusion, though, is that monetary policy still looks like it is working. There are lags and different parts of the economy respond differently, but lower interest rates are still effective in providing a boost to the overall economy. Conclusion So to conclude, I wish you all the best of luck on your journey of discovery of what is normal; of what is usual, typical or expected. One difficulty that I suspect we all face is when we think we have found the answer, it seems to change again. Perhaps the one constant is that uncertainty is normal! Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,012 | 12 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Melbourne Institute 50th Anniversary Conference, Melbourne, 6 December 2012. | Guy Debelle: Macroeconomics at the Melbourne Institute Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Melbourne Institute 50th Anniversary Conference, Melbourne, 6 December 2012. * * * It’s a pleasure to be here today to celebrate the 50th Anniversary of the Melbourne Institute. The Institute has performed a pre-eminent role in the economic research and policy advice of the country. My brief today is to focus on its contributions in the area of macroeconomics. But before I get to that, I will take a detour onto the cricket field. In reading Ross Williams’ excellent book on the Institute, it is clear the important position that cricket occupied at the Institute. My association with a sizeable number of the staff members of the Institute, both past and present, is on the cricket field, or to be more precise, on the indoor cricket field. Now many of you know that a significant number of the Melbourne Institute staff spent their formative years at the National Institute of Labour Studies (NILS) at Flinders University. Indeed, NILS was somewhat of a feeder for the Institute for quite a while. Back in the mid-80s, being the economic geek that I am, I used to work at NILS during my uni vacations. As a result, I was a member of the highly acclaimed NILS indoor cricket side. Let me run you through some of the key members of the team. I used to open the batting with Robert Leeson, in his pre-Friedman days. Bob and I were renowned for our kamikaze running between the wickets, particularly when we failed to lay bat on ball (which was most of the time). The next pair was one Peter “Dawkie” Dawkins, fresh off the boat from England, and Mark Wooden, recently minted national surf lifesaving ski champion. Our esteemed captain was NILS chief Dick Blandy, renowned for his innovative field placing. Other members of the team were Garry Goddard, now Deputy Under Treasurer in South Australia. Meredith Baker also made the odd cameo appearance. You may be surprised to hear that we were unable to coax the then NILSite, and future Productivity Commissioner and Australian Economics Editor, Judith Sloan, onto the pitch. As you can see, playing on that cricket team was a good leading indicator of employment at the Melbourne Institute, and indeed even a pretty good indicator of actually running the Melbourne Institute. This seamlessly takes me to my main topic today which is the Institute’s contribution to macroeconomics. I will focus on three main areas of contribution by the Institute to the greater good of Australian macroeconomics. The first is indeed leading indicators and business cycle analysis. The second is modelling and forecasting. The third is surveys. Leading indicators and business cycle analysis For many years, the Institute has been associated with its series on leading indicators, a summary statistic that aims to predict economic activity. I am not a particularly big fan of leading indicators as a general rule. Personally, I prefer to look at and think about all the components of a leading indicator individually, rather than attempt to summarise the information in one index, particularly given that what matters most at different points in the economic cycle varies through time. (The NILS leading indicator of employment at the Melbourne Institute that I was just talking about probably does a better job of forecasting than the GDP leading indicator.) That said, if one were going to use one leading indicator series in Australia, then it would be the Melbourne Institute’s. As an aside, I was intrigued to learn from reading Ross Williams’ book that the Institute was the first body in Australia to publish seasonally adjusted and trend data, some time before the ABS began to do so. BIS central bankers’ speeches Through the work of Ern Boehm, Don Harding and Adrian Pagan, the Institute has also made a significant contribution to business cycle analysis. Those three gentlemen have generated a number of great papers on the topic of measuring and dating business cycles. They have produced the definitive body of work for the Australian economy. Out of that research has come the most cited dating of Australian business cycles. Modelling and forecasting The Melbourne Institute has been synonymous with modelling, particularly during the reign of Peter Dixon. The modelling by Peter Dixon, as well as that done by Peter Brain was, of course, more of the CGE world than the macroeconomic world. Now a critical question is whether those two worlds overlap. I am told by those who can still remember, that a fair bit of time was spent trying to marry the short-term macro forecasting models at the Treasury and the RBA with the CGE model of the Institute. Many conferences were held on the issue. I am not sure the question was ever really answered. But besides the modelling side of things, the Institute regularly publish an assessment of the Australian economy in the Australian Economic Review, as well as discuss the outlook for the economy. I can recall assiduously reading those assessments during my undergrad days in the Eric Russell Room in the Adelaide University Economics Department. At that time, there was little in the way of such assessments emanating from the official sector, this being in the days before quarterly Statements on Monetary Policy. There was also little available from the private sector, as economic research in the banking sector was only in its infancy. So the Institute’s assessment was an important contribution to the policy discussion in Australia, as well as an important part of the education of a generation of budding macroeconomists. Surveys It is in the area of surveys that I think the Melbourne Institute has made its most significant and enduring contribution to the state of Australian macroeconomics. Its name is synonymous with some of the highest profile and longest running surveys in Australia. Much of that contribution can be attributed to the foresight and work of Duncan Ironmonger. The first of these were the surveys of consumers, which were based on the surveys conducted at the University of Michigan. The survey of consumer sentiment has a longrunning history back to 1974. I am pleased to note that the Reserve Bank of Australia provided some of the funding for the survey at its inception. The length of that data series means that for consumers, we have a time series that spans a number of business cycles, something that cannot be said of quite a few other time series, including most business surveys. In addition to the time series information, there is also invaluable cross-sectional information that has proven useful in informing macro policy setting. Out of the survey of consumers also comes the series on inflation expectations. The behaviour of this time series has long befuddled many macroeconomists, and complicated the life of those inclined to estimate Phillips curves, as I have been known to do in an earlier existence. As you can see from the time series (Graph 1), for a fairly long period of time, one could broadly describe the series as a horizontal line with a structural shift downwards in the early 1990s. BIS central bankers’ speeches Graph 1 My colleague at the Reserve Bank, Jacqui Dwyer, spent a lot of time working with Don Harding in the mid-1990s to try to understand the behaviour of this inflation expectations series. From the Bank’s point of view, we were in the infancy of inflation targeting, and we were after a clean read on the public’s assessment of the credibility of the new policy regime. As a result of that delving by Jacqui and Don, they came up with a number of refinements to the nature of the survey. One of the problems was a round number problem. Respondents tended to answer either 0, 5 or 10. This was probably a reasonable response in the 1970s and 1980s, but didn’t really make much sense in the 1990s and beyond. Also, it turns out that people were not that great with percentages and found it hard to distinguish between levels and changes when it came to prices. As a result of their digging, the survey methodology was updated to better reflect the low inflation environment. Consequently, the time series since the early 1990s is more nuanced and explicable. There is now quite a reasonable cluster of responses at 2 and 3 per cent. This suggests that households accept and understand the overall framework of monetary policy. Now that the inflation expectations series has been cleaned up, we only need to come up with a decent measure of the output gap and the estimation of Phillips curves would be a breeze! Don Harding’s other contribution in the area of inflation was his work with Stephen Koukoulas (then at Toronto Dominion) in generating the monthly series on inflation. This series is published jointly by the Institute and TD. Australia remains one of only two advanced countries (the other being New Zealand) without an official monthly CPI series. Don and Steve worked on generating a monthly series, including through some innovative use of electronic data. The final survey that the Melbourne Institute is most associated with is the HILDA survey. This longitudinal study was based on the similar surveys around the world, including the PSID in the United States, and tracks a set of households through time. While much of the BIS central bankers’ speeches information in the survey is more useful for social policy rather than macro policy, there is still a wealth of information in it that has been, and continues to be, of great use to the Bank and Treasury in their macro policy decision making and policy advice. It has enabled an analysis of macro issues to be conducted by aggregating from the micro data in a way that simply wasn’t possible before. In the end macro behaviour is, of course, purely the summation of a whole set of micro decisions. The HILDA survey is very much in the tradition of Ronald Henderson. It is a very rich source of data that can be used to analyse a vast number of socio-economic questions. Others will talk about it more over the course of the day, but it is to the Institute’s great credit that it took on the coordination of this important component of understanding the Australian economy. The Bank funded a wealth module in the HILDA survey in its first round, which has subsequently been incorporated into the survey every four years. Many of my colleagues, particularly in the financial stability area, have made extensive use of the HILDA data in gaining a better understanding of the distribution of household debt in the Australian economy, as well as households’ saving patterns. This in turned has enhanced the Bank’s understanding of the transmission of monetary policy to the household sector. Quite a sizeable share of the recent research paper output of the Bank’s Research Department has involved analysis of the HILDA data. Finally, one noteworthy contribution to the macro policy debate that doesn’t completely fit within my taxonomy is that of Peter Dawkins in injecting the Melbourne Institute squarely into the debate around unemployment with his critical role in the Five Economists Letter in 1998. Peter’s very prominent advocacy on this topic built on the foundations laid by Dick Blandy in refocusing the Institute on the labour market. Conclusion The Melbourne Institute has reached its half century. While these days the Institute is most associated with its work in the areas of the labour market and social policy, over its 50-year history, the Institute has made a substantial contribution to Australian macroeconomics. In particular, as I have described today, I think its most significant and lasting contribution has been in instituting a number of important surveys, most prominently the consumer sentiment series, the inflation expectations series and, more recently, the HILDA panel data series. These surveys have facilitated a better quality of macroeconomic analysis, through the wealth of data contained in them. In doing so, they have undoubtedly improved the quality of macro policymaking and outcomes, which was one of the founding goals of the Melbourne Institute. So, on behalf of the macro policymaking community of Australia over the past 50 years, I would like to thank the Melbourne Institute, and particularly the staff, for their contribution. I trust the Institute will be able to convert this half century into a ton! BIS central bankers’ speeches | reserve bank of australia | 2,012 | 12 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Bank of Thailand's 70th Anniversary and 3rd Policy Forum, Bangkok, 12 December 2012. | Glenn Stevens: Challenges for central banking Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Bank of Thailand’s 70th Anniversary and 3rd Policy Forum, Bangkok, 12 December 2012. * * * Monday marked the 70th anniversary of the commencement of operations of the Bank of Thailand, on 10 December 1942. Conceived under war-time occupation, the Bank has grown to be a key institution in Thailand. It is a pleasure and an honour to come to Bangkok to take part in one of a series of events to mark the anniversary, and I want to thank Governor Prasarn for the invitation. The Reserve Bank of Australia has long enjoyed a strong relationship with the Bank of Thailand. In 1997, the RBA was among those central banks to enter a swap agreement with the Bank of Thailand shortly after the crisis broke. This was the first part of Australian assistance to the regional partners who were under pressure, which later extended to Korea and Indonesia. In fact, Australia and Japan were the only countries that offered direct financial support to all three countries. It was a predecessor of mine, Bernie Fraser, who made the suggestion 17 years ago that cooperation in the Asian region might be improved by the establishment of a dedicated institution, along the lines of the Bank for International Settlements in Basel – the “Asian BIS”. 1 Such a body has not come to pass – at least not yet! – but it is fair to say that this suggestion and others like it helped to spur the Basel BIS to reach out to Asia. 2 The central banks of the region, taking the initiative through the Executives Meeting of East Asian and Pacific central banks – EMEAP (not the most attractive acronym) – have improved cooperation substantially over the years. Thanks to long-term efforts at building relationships, and the vision of key governors and deputy governors, including at the Bank of Thailand, EMEAP has developed into a mature forum for sharing information, and continues to develop its ability to find common positions on global issues and to promote crisis readiness. Yet as the central banks have grown closer and become more effective in their cooperation, the challenges we face have only increased. Today I want to speak about three of them. 3 First, I will talk about the framework for monetary policy and the need to allow that to consider financial stability. Secondly, I will make some observations about the more prominent role for central banks' own balance sheets that we are seeing in some countries. Then, thirdly, I will offer some observations about international spillovers. In so doing, I am not seeking to deliver any particular messages about the near-term course of monetary policy in either Australia or Thailand. Fraser B (1995), ‘Central Bank Cooperation in the Asian Region’, Address to the 24th Conference of Economists, Adelaide, 25 September. There was a round of new shareholdings taken up by Asian central banks in the late 1990s, including Thailand in 2000. The BIS established an Asian office in Hong Kong in 1998, and the Asian Consultative Council in 2001. Admittedly, the major shareholdings of the BIS remain overwhelmingly North Atlantic in their focus. But the BIS has made a good deal of progress – more than many institutions perhaps – in addressing the imbalances in global financial governance, even if there is further to go. The Bank of Thailand quite recently held a conference on exactly this topic, with a number of distinguished speakers. My remarks draw on some of their insights. See Challenges to Central Banks in the Era of the New Globalisation, Bank of Thailand International Symposium 2010, available at <http://www.bot.or.th/Thai/ EconomicConditions/Semina/Pages/Inter_Symposium.aspx> BIS central bankers’ speeches Monetary policy and financial stability It is more than two decades since the framework of Inflation Targeting (IT) was pioneered in New Zealand and Canada. The United Kingdom was an enthusiastic early adopter from 1992. Australia adopted IT in 1993. Among the early adopters, the move to IT was driven by a mixture of principle and pragmatism. The key principle was that monetary policy was, in the end, about anchoring the value of money – that is, about price stability. The pragmatism arose because one or more previous approaches designed to achieve that – monetary targeting, exchange-rate targeting, unconstrained discretion – had proved at best ineffective, and at worst destabilising, for the countries concerned. Hence many of the adopters shared a desire to strengthen the credibility of their policy frameworks. As the initial adopters came to have a measure of success in combining reasonable growth with low inflation, other countries were attracted to the model. According to the IMF, more than 30 countries now profess to follow some form of IT. 4 The euro area could also be counted among this group though it also professes adherence to the “second pillar” of “monetary analysis”. Even the United States can, I think, be counted as a (fairly recent) IT adopter, since the Federal Open Market Committee is these days quite explicit about its desired inflation performance. 5 The Bank of Thailand was one of a number of emerging economies that adopted IT around the turn of the century. Twelve years on, Thailand can boast an impressive record of price stability under this framework. A high level of transparency has ensured that financial market participants understand the framework, and view it as credible. Moreover, price stability has not come at the cost of subdued economic growth, with output expanding at a brisk pace in the 2000s. While inflation targeting is not for everyone, the Thai experience illustrates that, when done well, it can enhance economic outcomes. I can endorse the favourable verdict offered on the Thai experience delivered by Grenville and Ito (2010). 6 So I think that the adoption of IT, including in Thailand, can be seen as a success in terms of the straightforward objectives set for it. To make such a claim is not, however, to claim that controlling inflation is, alone, sufficient to underwrite stability in a broader sense. If there were any thought that controlling inflation over a two or three year horizon was “enough”, we have been well and truly disabused of that by experience over the past half decade. Price stability doesn't guarantee financial stability. Indeed it could be argued that the “great moderation” – an undoubted success on the inflation/output metric – fostered, or at least allowed, a leverage build-up that was ultimately inimical to financial stability and hence macroeconomic stability. The success in lessening volatility in economic activity, inflation and interest rates over quite a lengthy period made it feasible for firms and individuals to think that a degree of increased leverage was safe. 7 But IMF (2012), Annual Report, Appendix II, pp 14–16, available at <http://www.imf.org/external/pubs/ ft/ar/2012/eng/pdf/a2.pdf>. The Fed points out, quite properly, that it has a dual mandate – “full employment” being the other component. I don’t think this precludes being an exponent of IT: the Reserve Bank of Australia has always insisted that it is quite compatible to combine an objective for medium-term inflation performance with the notion that we give due weight to the path of economic activity. Grenville S and T Ito (2010), “An Independent Evaluation of the Bank of Thailand’s Monetary Policy under the Inflation Targeting Framework, 2000–2010”, available at <http://www.bot.or.th/Thai/MonetaryPolicy/ Documents/GrenvilleItoV10(Oct22).pdf> Stevens G (2006), “Risk and the Macroeconomy”, Address to the 2006 Securities & Derivatives Industry Association Conference, RBA Bulletin, June, pp 8–17. BIS central bankers’ speeches higher leverage exposed people to more distress if and when a large negative shock eventually came along. This explanation still leaves, of course, a big role in causing the crisis – the major role in fact – for poor lending standards, even fraud in some cases, fed by distorted incentives and compounded by supervisory weaknesses and inability to see through the complexity of various financial instruments. That price stability was, in itself, not enough to guarantee overall stability, should hardly be surprising, actually. It has been understood for some time that it is very difficult to model the financial sector, and that in many of the standard macroeconomic models in use, including in many central banks, this area was under-developed. Mainstream macroeconomics was perhaps a bit slow to see the financial sector as it should be seen: that is, as having its own dynamic of innovation and risk taking; as being not only an amplification mechanism for shocks but a possible source of shocks in its own right, rather than just as passively accommodating the other sectors in the economy. 8 Notwithstanding the evident analytical difficulties, the critique being offered in some quarters is that central banks paid too little attention in the 2000s to the build-up of credit and leverage and to the role that easy monetary policy played in that. It is hard to disagree, though I would observe that this is somewhat ironical, given that IT was a model to which central banks were attracted after the shortcomings of targets for money and credit quantities in the 1980s. It could be noted as well that the ECB always had the 2nd pillar, but the euro area still experienced the crisis – in part because of credit granted in or to peripheral countries, and in part because of exposures by banks in the core countries to excessive leverage in the US. The upshot is that the relationship between monetary policy and financial stability is being re-evaluated. As this occurs, we seem to be moving on from the earlier, unhelpful, framing of this issue in terms of the question as to whether or not monetary policy should “prick bubbles” and whether bubbles can even be identified. The issue is not whether something is, or is not, a bubble; that is always a subjective assessment anyway in real time. The issue is the potential for damaging financial instability when an economic expansion is accompanied by a cocktail of rising asset values, rising leverage and declining lending standards. One can remain agnostic on the bubble/non-bubble question but still have concerns about the potential for a reversal to cause problems. Perhaps more fundamentally, although the connections between monetary policy and financial excesses can be complex, in the end central banks set the price of short-term borrowing. It cannot be denied that this affects risk-taking behaviour. Indeed that is one of the intended effects of low interest rates globally at present (which is not to say that this is wrong in an environment of extreme risk aversion). It follows that broader financial stability considerations have to be given due weight in monetary policy decisions. This is becoming fairly widely accepted. The challenge for central banks, though, is to incorporate into our frameworks all we have learned from the recent experience about financial stability, but without throwing away all that is good about those frameworks. We learned a lot about the importance of price stability, and how to achieve it, through the 1970s, 80s and 90s. We learned too about the importance of institutional design. We shouldn't discard those lessons in our desire to do more to assure financial stability. We shouldn't make the error of ignoring older lessons in the desire to heed new ones. Some central banks have given a lot of thought to the question of how to manage financial stability concerns within a standard IT-type framework, though definitive answers have been hard to come by. See for example Bean C (2003), “Asset Prices, Financial Imbalances and Monetary Policy: Are Inflation Targets Enough?”, in A Richards and T Robinson (eds), Asset Prices and Monetary Policy, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 48–76; Svensson L (2012), “Differing Views on Monetary Policy”, Speech delivered at the SNS/SIFR Finanspanel, Stockholm, 8 June, available at <http://www.bis.org/ review/r120612c.pdf>. A significant problem is that financial cycles may have a much lower frequency than normal business cycles so incorporating them into a usual two or three year horizon for policymaking is difficult. BIS central bankers’ speeches Rather, we have to keep both sets of objectives in mind. We will have to accept the occasional need to make a judgement about short-term trade-offs, but that is the nature of policymaking. And in any event, over the long run price stability and financial stability surely cannot be in conflict. To the extent that they have not managed to coexist properly within the frameworks in use, that has been, in my judgement, in no small measure because the policy time horizon was too short, and perhaps also because people became too ambitious about fine-tuning. We also must, of course, heed the lesson that, whatever the framework, the practice of financial supervision matters a great deal. Speaking of supervisory tools, these days it is, of course, considered correct to mention that there are other means of “leaning against the wind” of financial cycles, in the form of the grandly-labelled “macroprudential tools”. Such measures used to be more plainly labelled “regulation”. They may be useful in some instances when applied in a complementary way to monetary policy, where the interest rate that seems appropriate for overall macroeconomic circumstances is nonetheless associated with excessive borrowing in some sector or other. In such a case it may be sensible to implement a sector-specific measure – using a loan to value ratio constraint or a capital requirement. (This is entirely separate to the case for higher capital in lending institutions in general). We need, however, to approach such measures with our eyes open. Macroprudential tools will have their place. But if the problem is fundamentally one of interest rates being too low for a protracted period, history suggests that the efforts of regulators to constrain balance-sheet growth will ultimately not work. If the incentive to borrow is powerful and persistent enough, people will find a way to do it, even if that means the associated activity migrating beyond the regulatory perimeter. So in the new-found, or perhaps re-learned, enthusiasm for such tools, let us be realists. The limits of central banking That policy measures of any kind have their limitations is a theme with broader applications, especially for central banks. The central banks of major countries were certainly quite innovative in their responses to the unfolding crisis. 9 Numerous programs to provide funding to private institutions, against vastly wider classes of collateral, were a key feature of the central bank response to the situation. In essence, when the private financial sector was suddenly under pressure to shrink its balance sheet, the central banks found themselves obliged to facilitate or slow the balance-sheet adjustment by changing the size of their own balance sheets. This is the appropriate response, as dictated by long traditions of central banking stretching back to Bagehot. Conceptually, at least initially, these balance-sheet operations could be seen as distinct from the overall monetary policy stance of the central bank. But as the crisis has gone on such distinctions have inevitably become much less clear as “conventional” monetary policy reached its limits. It was fortuitous for some, perhaps, that the zero-lower bound on nominal interest rates – modern parlance for what we learned about as the “liquidity trap” – had gone from being a text book curiosum to a real world problem in Japan in the 1990s. Japan subsequently pioneered the use of “quantitative easing” in the modern era. This provided some experiential base for other central banks when the recession that unfolded from late 2008 was so deep that there was insufficient scope to cut interest rates in response. So in addition to programs to provide funding to intermediaries in order to prevent a collapse of the financial system I note parenthetically that several important cross-border initiatives to manage liquidity pressures were put in place very quickly by key central banks. This kind of cooperation at a technical level is something at which the central banks are actually quite good. BIS central bankers’ speeches when market funding dried up, there have been programs of “unconventional monetary policy” in several major countries over recent years. These have been varyingly thought of as operating by one or more of: • reducing longer-term interest rates on sovereign or quasi-sovereign debt by “taking duration out of the market” once the overnight rate was effectively zero • reducing credit spreads applying to private sector securities (“credit easing”, operating via the “risk taking” channel) • adding to the stock of monetary assets held by the private sector (the “money” channel, appealing to quantity theory notions of the transmission of monetary policy) • in the euro area in particular, commitments to lower the spreads applying to certain sovereign borrowers in the currency union (described as reducing “re-denomination risk”). As a result of such policy innovation, the balance sheets of central banks in the major countries have expanded very significantly, in some cases approaching or even surpassing their war-time peaks (Graph 1). Further expansion may yet occur. Graph 1 It is no criticism of these actions – taken as they have been under the most pressing of circumstances – to observe that they raise some very important and difficult questions for central banks. There is discomfort in some quarters that central banks appear to be exercising an unprecedented degree of discretion, introducing new policies yielding uncertain benefits, and possible costs. One obvious consideration is that central banks, in managing their own balance sheets, need to assess and manage risk across a wider and much larger pool of assets. Gone are the comfortable days of holding a modest portfolio of bonds issued by the home government that were seen as of undoubted credit quality. Central bank portfolios today have more risk. To date in the major countries, this has worked well in the sense that long-term yields on the core portfolios have come down to the lowest levels in half a century or more. Large profits have been remitted to governments. But at some point, those yields will surely have to rise. BIS central bankers’ speeches Of course large central bank balance sheets carrying sizeable risk is hardly news around Asia. Once again, the Bank of Thailand has made an excellent contribution to the international discussion here, having recently held a joint conference with the BIS on central bank balance sheets and the challenges ahead. 10 The difference is that in Asia the risks arise from holdings of foreign-currency assets which have been accumulated as a result of exchange-rate management. There is obviously valuation risk on such holdings. There is also often a negative carry on such assets since yields on the Asian domestic obligations which effectively fund foreign holdings are typically higher than those in the major countries. In effect the citizens of Asia continue to provide, through their official reserves, very large loans to major country governments at yields below those which could be earned by deploying that capital at home in the region. For the major countries a further dimension to what is happening is the blurring of the distinction between monetary and fiscal policy. Granted, central banks are not directly purchasing government debt at issue. But the size of secondary market purchases, and the share of the debt stock held by some central banks, are sufficiently large that it can only be concluded that central bank purchases are materially alleviating the market constraint on government borrowing. At the very least this is lowering debt service costs, and it may also condition how quickly fiscal deficits need to be reduced. There is nothing necessarily wrong with that in circumstances of deficient private demand with low inflation or the threat of deflation. In fact it could be argued that fiscal and monetary policies might actually be jointly more effective in raising both short and long-term growth in those countries if central bank funding could be made to lead directly to actual public final spending – say directed towards infrastructure with a positive and long-lasting social return – as opposed to relying on indirect effects on private spending. The problem will be the exit from these policies, and the restoration of the distinction between fiscal and monetary policy with the appropriate disciplines. The problem isn't a technical one: the central banks will be able to design appropriate technical modalities for reversing quantitative easing when needed. The real issue is more likely to be that ending a lengthy period of guaranteed cheap funding for governments may prove politically difficult. There is history to suggest so. It is no surprise that some worry that we are heading some way back towards the world of the 1920s to 1960s where central banks were “captured” by the Government of the day. 11, 12 Most fundamentally, the question is whether people are fully understanding of the limits to central banks' abilities. It is, to repeat, not to be critical of actions to date to wonder whether private market participants, and perhaps more importantly governments, recognise what central banks cannot do. Central banks can provide liquidity to shore up financial stability and they can buy time for borrowers to adjust. But they cannot, in the end, put government finances on a sustainable course and they cannot create the real resources that need to be found from somewhere to strengthen bank capital. They cannot costlessly correct earlier misallocation of real capital investment. They cannot shield people from the implications of having mis-assessed their own life-time budget constraints and as a result having consumed See BIS (2012), “Are Central Bank Balance Sheets Too Large?”, Proceedings from the 2011 Bank of Thailand-BIS Research Conference: Central Bank Balance Sheets in Asia and the Pacific: The Policy Challenges Ahead, Chiang Mai, 12–13 December 2011, available at <http://www.bis.org/publ/ bppdf/bispap66.pdf>. Goodhart C (2010), “The Changing Role of Central Banks”, BIS Working Paper No 326, available at <http://www.bis.org/publ/work326.pdf>. A further question is whether significant parts of private markets for which central banks are de facto a more or less complete substitute today will actually resume when central banks seek to step back, or whether those market capacities will have atrophied. This is something the Bank of Japan has long worried about – since it has been involved in QE for more than a decade. It will also be relevant in European inter-bank markets and probably elsewhere. Of course some may not mourn the loss of such markets, but that would be short-sighted. BIS central bankers’ speeches too much. They cannot combat the effects of population aging or drive the innovation that raises productivity and creates new markets. Nor can they, or should they, put themselves in the position of deciding what real resource transfers should take place between countries in a currency union. One fears, in short, that while the central banks have been centre stage – rightly in many ways – in the early responses to the crisis, and in buying time for other adjustments by taking bold initiatives over the past couple of years, the limits of what they can do may become more apparent in the years ahead. A key task for central banks is to try to communicate these limits, all the while doing what they can to sustain confidence that solutions can in fact be found and pointing out from where they might come. Challenges with spillovers Talking about the challenges associated with large balance-sheet activities leads naturally into a discussion about international spillovers. In one sense, this is not a new issue. It has been a cause of anxiety and disagreement since the latter days of the Bretton Woods agreement at least. The remark attributed to the then Secretary of the US Treasury in regard to European concerns about the weakness of the US dollar in the 1970s of “it's our currency, but your problem” was perhaps emblematic of the spillovers of that time. There have been other episodes since. 13 In a much earlier time there was, of course, the “beggar thy neighbour” period of the 1930s – something which carries cogent lessons for current circumstances. In recent years, as interest rates across a number of major jurisdictions have fallen towards zero and as central bank balance-sheet measures have increased, these developments have been seen as contributing to cross-border flows of capital in search of higher returns. The extent of such spillovers is still in dispute. And, to the extent that they are material, some argue that a world in which extraordinary measures have been taken to prevent crises may still be a better place for all than the counterfactual. 14 The degree of disquiet in the global policymaking community does seem, however, to have grown of late. 15 Perhaps one reason is the following. In past episodes expansionary policies in major countries, while having spillovers through capital flows, did demonstrably stimulate demand in the major countries. It is open to policymakers in those countries to claim that unconventional policies are having an expansionary effect in their own economies compared with what would otherwise have occurred. But the slowness of the recovery in the US, Europe and Japan, I suspect, leaves others wondering whether major countries are relying more on exporting their weaknesses than has been the case in most previous recoveries. One response to that can be efforts in emerging economies to make their financial systems more resilient to volatile capital flows, such as by developing local currency bond markets The very high US interest rates of the late 1970s and early 1980s had major spillover effects, not least in the western hemisphere. The US bond market sell-off of 1993 and 1994 affected many other countries and was a major point of debate in international meetings of the time. The re-unification of Germany had spillover effects within Europe. Bernanke B (2012), “U.S. Monetary Policy and International Implications”, Address to Challenges of the Global Financial System: Risks and Governance under Evolving Globalization, a High-Level Seminar Sponsored by Bank of Japan-International Monetary Fund, Tokyo, 14 October, available at <http://www.federalreserve.gov/ newsevents/speech/bernanke20121014a.htm>. See Caruana J (2012), “International Monetary Policy Interactions: Challenges and Prospects”, Address to the CEMLA-SEACEN Conference on “The Role of Central Banks in Macroeconomic and Financial Stability: the Challenges in an Uncertain and Volatile World”, Punta del Este, Uruguay, 16 November, available at <http://www.bis.org/speeches/sp121116.pdf>. BIS central bankers’ speeches and currency hedging markets. 16 This type of work is underway in various fora, such as the G-20 and EMEAP. But that takes time. Meanwhile people in the emerging economies, and for that matter several advanced economies, feel uncomfortable about the spillovers. At the same time, it has to be said that spillovers go in more than one direction. While it was common for Asian (and European) policymakers to point the finger at the US for many years over the US current account deficit, with claims that the US was absorbing too great a proportion of the world's saving, the fact was that those regions were supplying excess savings into the global capital market because they did not want to use them at home. That surely had an impact on the marginal cost of capital, to which borrowers and financial institutions in parts of the advanced world responded. We may want to say, in hindsight, that policymakers in the US and elsewhere should have worried more about the financial risks that were building up by the mix of policies that they ran. But we would also have to concede that the US policymakers sought to maintain full employment in a world that was conditioned by policies pursued in parts of the emerging world and especially Asia. Not only do spillovers go in more than one direction, but those which might arise from policies in this region are much more important now than once was the case. The rapid growth in Asia's economic weight means that policy incompatibilities which partly arise on this side of the Pacific have greater global significance. The traditional Asian strategy of export-driven growth assisted by a low exchange rate worked well when Asia was small. Asia isn't small anymore and so the rest of the world will not be able to absorb the growth in Asian production in the same way as it once did. More of that production will have to be used at home. This is understood by Asian policymakers and progress has been made in reorienting the strategy. I suspect more will be needed. For central banks in particular, there has been talk about spillovers from monetary policy settings being “internalised” into individual central banks' framework for decision making. Exactly how that might be done is not entirely clear, and discussion is in its infancy; a consensus is yet to emerge. The IMF does useful work on spillovers and the IMF offers, at least in principle, a forum where incompatibilities can be at least recognised and discussed. One more far reaching proposal is for there to be an “international monetary policy committee”. 17 That seems a long way off at present. For spillovers to be effectively internalised, mandates for central banks would need to allow for that. At the present time most central banks are created by national legislatures, with mandates prescribed in national terms. (The ECB of course is the exception, with a mandate given via an international treaty). It would be a very big step to change that and it certainly won't occur easily or soon, though national sovereignty over monetary policy within the euro area was given up as part of the single currency – so big changes can occur if the benefits are deemed to be sufficient. Whether or not such a step eventually occurs, it is clear that spillovers are with us now. All countries share a collective interest in preserving key elements of the international system, even as individual central banks do what it takes to fulfil their current mandates. It is vital, then, that central banks continue to talk frankly with each other about how we perceive the interconnections of global finance to be operating. We may be limited at times by the national natures of our respective mandates, but those limitations need not preclude cooperative action altogether, as has been demonstrated at various key moments over the past five years. In this region, the EMEAP forum offers great potential to further our mutual Nishimura K (2012), “Future of Central Bank Cooperation in Asia, Latin America, and Caribbean States”, Remarks at the BOJ-CEMLA Seminar on Regional Financial Cooperation, Tokyo, 11 October, available at <http://www.boj.or.jp/en/announcements/press/koen_2012/data/ko121011a1.pdf>. Committee on International Economic Policy and Reform (2011), “Rethinking Central Banking”, September, available at <http://www.brookings.edu/research/reports/2011/09/ciepr-central-banking> BIS central bankers’ speeches understanding and ability to come to joint positions on at least some issues. Internationally, the BIS of course is also a key forum for “truth telling” in a collegiate and confidential setting and one in which the central banks of this region are playing an increasingly prominent role. There will need to be much more of this in the future. Conclusion The Bank of Thailand and the Reserve Bank of Australia have, in our respective histories, faced challenges, some of them severe ones. We have learned much from those experiences. In recent years, we have had our own distinct challenges. Fortunately, we have not been directly at the centre of the almost unprecedented challenges faced by our colleagues in major countries, though we have all been affected in various ways. The future in Asia is full of potential, but to realise that we have to continue our efforts to strengthen our own policy frameworks, learn the appropriate lessons from the problems of others, and continue our efforts to cooperate on key issues of mutual interest. As the Bank of Thailand moves into its eighth decade, I am sure you will rise to the challenge. Thank you again for the invitation to be here, and Happy Birthday! BIS central bankers’ speeches | reserve bank of australia | 2,012 | 12 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Committee for Economic Development of Australia, Perth, 15 February 2013. | Christopher Kent: Reflections on China and mining investment in Australia Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Committee for Economic Development of Australia, Perth, 15 February 2013. * * * I would like to thank James Bishop and Tom Cusbert for valuable assistance in the preparation of this talk. I would like to thank CEDA for the invitation to speak here today. Let me also express my gratitude by saying that we continue to learn a lot about the mining industry through our many liaison contacts in Western Australia, and I’m guessing that includes a number of you here in the audience. I thought this would be a good chance to reflect on two important developments that have stood out in my mind over the past year. One is what’s been happening in China. The other, which is closely related, is the change to the outlook for mining investment in Australia. Both have an important bearing on the economy here in Western Australia. China’s economic development China’s economic development has been truly remarkable by any measure. For three decades now it has sustained growth at an average of around 10 per cent per annum. China now accounts for a substantial and increasing share of global economic activity. Over the past 10 years, it has almost tripled its share of the global economy to become the second largest economy after the United States.1 China now uses a large share of the global output of commodities, not only because it’s a large economy, but also because it makes relatively intensive use of raw commodities. This reflects the high rate of investment in China as it adds rapidly to its stocks of capital and housing. One driver of this has been the rapid urbanisation of China. This requires the construction of new housing and places of work, as well as transport, communications, power, and water storage and treatment facilities. Graph 1 Figures are projections for 2012, based on market exchange rates, from the IMF World Economic Outlook, October 2012. BIS central bankers’ speeches China now uses about half of the world’s production of iron ore, coking coal and thermal coal. Not surprisingly then, the growth of China has seen the price of Australia’s commodity exports rise to unprecedented levels. Accordingly, Australia’s terms of trade – the price of our exports relative to the price of our imports – started rising rapidly from the mid 2000s to an historic peak in late 2011 (Graph 1). This has led to a dramatic increase in investment in the resources sector in Australia. Even though the terms of trade have declined since then, they remain well above their level of a decade ago. The decline in Australia’s terms of trade since late 2011 coincided with a slowing in the pace of China’s economic growth and a degree of concern about its near-term outlook. So, for much of the past year we have been looking for signs that China’s growth might stabilise. A broad range of indicators suggest that this has now occurred, with economic conditions improving through the second half of 2012, and the national accounts data indicating that growth is running at around 8 per cent in year-ended terms (Graph 2). Graph 2 Still, the path of growth in China has not been a smooth one, and China will continue to experience cyclical variation in economic conditions that will need to be carefully managed. Such cycles will have important implications for the prices of commodities because of the size and makeup of China’s economy. Changes in commodity prices will in turn influence the outlook for the resources sector in Australia. I’ll come back to this issue in a few minutes. For now though, let me turn to the question of what rate of growth China might be able to sustain in the years ahead. Prospects for Chinese growth A gradual slowdown in the trend growth rate of China’s economy is to be expected as the process of economic development runs its course. What the path for trend growth will look like though is very hard to know. One way to think about this is to break China’s productive capacity into its key elements – its supply of labour, its stock of capital and how productively it can combine these to produce goods and services. The growth rate of the labour force is perhaps the easier of these elements to forecast because it is driven by slow moving and relatively predictable demographic forces. The working-age population for the country as a whole is expected to peak sometime around the BIS central bankers’ speeches middle of this decade. Absent a significant increase in the rate of labour force participation, including by older workers, this implies less growth in the overall labour force (and eventually some decline). However, perhaps the more important question is what will happen to the growth of the urban workforce. This is critical because urbanisation is the means by which relatively unproductive labour in the rural sector finds its way to more productive activities in urban centres where much of the capital resides. It seems that urbanisation still has a way to go – particularly in the central and western regions of the country (Berkelmans and Wang 2012) (Graph 3). Nevertheless, the pace of urbanisation is likely to slow over time. Graph 3 Growth of the capital stock is also likely to slow, in part because there has already been a substantial rise in the capital stock as a share of labour, but also because households are likely to want to consume an increasing share of the country’s rising income. Even so, the capital stock per worker is only a small fraction of the US level so there is clearly scope for continued rapid growth in China’s capital stock. Perhaps the greatest source of uncertainty though is the speed with which the level of productivity in China will approach that of the advanced economies. History suggests that as a country draws a little closer to the “productivity frontier” it often becomes more difficult to sustain the same pace of productivity growth. It tends to get a little harder to pursue the reforms that help to drive productivity growth. Those reforms that yield the best returns, and are the easiest to pursue, have already been done; the low hanging fruit has already been picked.2 In a similar vein, it is easier to emulate – and even improve upon – a range of production processes that have long been in use somewhere else in the world. But it is harder to adopt newer, more advanced, technologies and efficient ways of organising production processes across a wide range of activities, including the provision of services (which account for a substantial share of economic activity in advanced economies). Still, by Lardy (2012) and the World Bank (2012) emphasise further reforms of banking and financial markets more generally, hukou reform and liberalisation of energy prices. BIS central bankers’ speeches any reasonable estimate, China remains a long way from the productive frontier. So there is considerable scope for it to continue to catch up with the advanced economies.3 A range of estimates for potential output growth have been constructed based on predictions of these three elements of production. The OECD (2012) predict that potential output growth for China will decline from around 10 per cent seen during the 2000s, to 9½ per cent in 2013, and then gradually to 5 per cent by 2025.4 Last year, the Chinese authorities themselves lowered the official growth target from 8 to 7½ per cent, though the economy had for years consistently overshot even the higher target. Another way we can try to gauge the potential output of the economy is to look at the relationship between growth and inflation. The idea is that high and rising inflationary pressures tend to follow a period when demand is growing faster than potential output, and vice versa. Over recent years, inflationary pressures have tended to ease in China whenever growth slowed substantially towards 8 per cent or lower, and conversely, around 2010, we saw inflation pressures building when growth was turning up to around 10 per cent or higher (Graph 4). Moreover, this was a growth rate that did not appear to cause undue inflationary pressures in the mid to late 2000s. Taking all of this, and noting also the behaviour of inflation more recently, suggests that potential output growth might be somewhere around the current growth rate of GDP of about 8 per cent. Graph 4 Implications for demand for commodities The prospects for Chinese demand for commodities will depend not just on the growth rate of the economy, but also on the composition of that growth. IMF (2012) data imply that output per worker is only about 15 per cent of that in the United States. Also, GDP (PPP) per capita for China is one-quarter of the average of advanced economies (IMF 2012). Other estimates are broadly consistent with these, although the estimates in Lee and Hong (2010) are lower with a 2011–2020 average of 6 per cent in the baseline scenario and 7 per cent in a scenario with more substantial reform. BIS central bankers’ speeches As growth in China, and elsewhere in the world, was slowing through 2012, growth in the demand for steel slowed, leading to sharp declines in the spot prices of iron ore and coking coal from July through to early September. But through 2012, the more accommodative stance of financial policies and increased public spending in China have helped to support an increase in the growth rate of investment in infrastructure and dwellings and thereby helped to stabilise growth of the economy overall (Graph 5). Graph 5 Graph 6 In line with the stronger outlook for infrastructure investment and residential construction, the demand for steel has picked up. The price of steel in China has increased by around 20 per cent since its low point in September last year; the spot price for coking coal has also picked BIS central bankers’ speeches up a little over recent months (Graph 6). The spot price for iron ore has increased by around four times as much from its low point last year. In part, this appears to reflect recent efforts by Chinese steel mills to rebuild their inventories and most observers don’t expect iron ore prices to be sustained at current high levels. Residential construction has been a key source of demand for steel in the Chinese economy. It currently accounts for around 15 per cent of total steel use. By our estimates, the quantity of steel used in residential construction has roughly doubled over the past eight years. This has been driven by urbanisation and rising incomes, which in turn drive the demand for newer, larger and higher-quality buildings. While we would not expect growth to continue at such a rapid rate, steel use from this sector is not expected to peak for some years. Of course, we should not overlook other sources of demand for steel. An obvious one is the expansion in rail networks. The demand for steel for this purpose looks likely to continue to grow strongly, with much work yet to be done to develop rail links both between and within cities. Indeed, the Ministry of Railways plans to increase spending in 2013, and maintain this at high levels in 2014 and 2015. This is but one example of the still considerable scope for China to add to its infrastructure, which underpins a range of forecasts for Chinese steel production to continue to grow for another decade and a half.5 In short, with a lower rate of trend economic growth, Chinese demand for commodities will grow somewhat less rapidly than in the past. But the expectation is that it will still grow strongly for quite some time. And because the Chinese economy is so much larger now, even a somewhat slower rate of growth represents a large quantity of new demand for raw materials. To help understand the importance of this point, it is worth looking at the example of steel production, which increased by about 9 per cent in 2011. This was equivalent to an extra 58 Mt of steel output. In 2004, the much higher growth rate of about 23 per cent was equivalent to only 50 Mt of extra output. The outlook for mining investment in Australia Despite the potential for further growth in the demand for commodities, from China and other developing economies, we expect commodity prices to gradually decline over the next few years. This reflects the extra supply generated by the substantial amount of mining investment underway in Australia, and elsewhere. Nevertheless, commodity prices are expected to remain at what are historically high levels for a considerable period. The very high price for bulk commodities has helped to drive mining investment in Australia to around 8 per cent of GDP currently, some four times larger than its long-run average. This has led to a significant increase in the share of economic activity accounted for by the resource sector since the mid 2000s. While the share of the workforce directly employed in the business of mining has doubled since then, it remains relatively modest (at around 2½ per cent). However, there has been a substantial spillover of activity to other parts of the economy, including to a wide range of businesses that help mining companies to extract resources or to build up their capital infrastructure. The Bank will soon publish some research providing estimates of the contribution of mining and mining-related activity to GDP and employment (Rayner and Bishop, forthcoming). This work suggests that the resource sector as a whole currently accounts for around 18 per cent of GDP, with about a third of this owing to resource-related activities. Similarly, the resource sector accounts for almost Rio Tinto and UN projections suggest a peak in 2030. Projections by the Bureau of Resources and Energy Economics (BREE) show demand increasing through to 2025. BIS central bankers’ speeches 10 per cent of employment, with a bit more than two-thirds of this owing to resource-related activities.6 The sharp fall in bulk commodity prices from the middle of last year prompted mining firms to reassess their expenditure and the viability of some investment projects that had been under consideration. Some uncommitted projects were deferred. Much exploration activity was curtailed. Spending on machinery and equipment was scaled back significantly. And some existing operations were shut down, primarily smaller, older, higher-cost coal mines. This turnaround in sentiment came about in part because lower prices reduced cash flows and external financing became harder to come by, making it more difficult to finance resource investment. The recent sharp rise in iron ore prices, as best we can tell, has not yet made much of a difference to investment plans, presumably because the price is not expected to stay at its current high level. As you are all no doubt well aware, a large share of mining investment currently underway in Australia is in the liquefied natural gas (LNG) sector. LNG projects require significant investment over a 3–5 year period, and a very long period of production to recoup the initial investment. As a result, commitments to invest in these projects are made on the basis of long-term contracts signed with the buyers of LNG (with those buyers often even taking an equity stake in the project). For this reason, investment in LNG has been resilient to the significant changes in sentiment affecting other parts of the resource sector. Of greater concern for LNG projects are rising costs, which reduce the returns on projects underway and reduce the prospects of future expansions. Some of what has been reported as higher costs by mining companies reflects the appreciation of the Australian dollar. Some companies had budgeted for these projects in US dollar terms at a lower exchange rate than we face currently. Still, there’s no denying that costs have increased over time even in Australian dollar terms. Graph 7 The estimates for GDP and employment shares of the resource sector as a whole in the mid 2000s are 10 per cent and almost 5 per cent, respectively. BIS central bankers’ speeches Graph 8 We can try to look at some data from the Australian Bureau of Statistics to gain some understanding of changes in costs over time, although it will not pick up important differences across different projects in different industries. There is evidence in the aggregate data of higher inflation of wages in the mining industry, and across Western Australia more generally (Graph 7). While the growth of these wages has picked up a little recently, this is unlikely to be sufficient to account for the magnitude of some of the cost overruns being reported. Nevertheless, the level of wages in the mining industry remains relatively high, though this reflects the relatively high capital-to-labour ratio in this industry (Graph 8). One plausible explanation for at least some of the cost overruns is logistical problems affecting a number of projects. It seems that the engineering challenges for some projects are even more complex than initially thought. There are cases of projects taking longer to complete, and/or requiring more investment to bring them to fruition. In other cases, the scope of the project may have changed. All of these things can alter the profile for mining investment by affecting both the timing and the amount of expenditure. Graph 9 BIS central bankers’ speeches So, what’s been the net effect on the outlook for mining investment overall of these changes in sentiment, timing, scope and costs? As best we can tell, mining investment now appears likely to reach a peak a bit earlier – sometime this year – and at a lower level – of around 8 per cent of GDP – than we had earlier expected (Graph 9). This is broadly consistent with the latest ABS survey of firms’ capital expenditure plans, which shows that in the mining sector, the growth of nominal investment in 2012/13 was revised from around 40 per cent to 20 per cent from the June quarter 2012 survey to the September quarter release (after adjusting for the realisation ratio). Like all forecasts, the profile for mining investment is subject to considerable uncertainty. We cannot be sure about when the peak will occur, nor can we be sure about the pace at which mining investment will decline as a share of GDP. This will depend not just on the outcome of decisions regarding uncommitted projects, but also the rate of progress on existing projects and the extent and nature of any further cost overruns. Notwithstanding this uncertainty, there is still a large amount of work in the pipeline, and so mining investment is likely to remain quite elevated for a time. And as mining investment tails away, we’ll increasingly move into the operational phase of the mining boom. This is when exports will increase significantly in response to all of the investment that’s been undertaken. Strong growth of iron ore, coal and LNG exports has been evident for some time now, but further strong growth is anticipated, particularly for LNG, which is expected to grow much more rapidly starting from around 2015 (Graph 10). Graph 10 The revised outlook for mining investment and our predictions for bulk commodity exports have been incorporated into our latest forecasts for economic growth in the Statement of Monetary Policy published last week. Our expectation is that growth of economic activity will be a little below trend over 2013 before picking up a little in 2014. These forecasts assume that growth from sources outside of the resource sector picks up gradually, so we’ll be looking closely for signs of this over the months ahead. Looking further ahead, as I have suggested in my remarks about China’s economy, Australia is well placed to benefit from the ongoing development there as well as in other developing economies in the region. BIS central bankers’ speeches References Berkelmans L and H Wang (2012), “Chinese Urban Residential Construction to 2040”, RBA Research Discussion Paper No 2012-04. Bureau of Resources and Energy Economics (2012), Australian Bulk Commodity Exports and Infrastructure – Outlook to 2025. Available at <http://www.bree.gov.au/documents/ publications/_other/Export-Infrastructure-Report.pdf>. IMF (2012), World Economic Outlook, October. Available at <http://www.imf.org/external/ pubs/ft/weo/2012/02/weodata/index.aspx>. Lee JW and K Hong (2010), “Economic Growth in Asia: Determinants and Prospects”, ADB Economics Working Paper Series No 220. Available at <http://www.adb.org/sites/ default/files/pub/2010/economics-wp220.pdf>. Lardy NR (2012), Sustaining China’s Economic Growth after the Global Financial Crisis, Peterson Institute for International Economics, Washington DC. OECD (2012), “Medium and Long-term Scenarios for Global Growth and Imbalances”, in OECD Economic Outlook, Vol 2012/1, OECD Publishing, pp 191–224. Available at <http://www.oecd.org/berlin/50405107.pdf>. Rayner V and J Bishop (forthcoming), “Industry Dimensions of the Resource Boom: An InputOutput Analysis”, RBA Research Discussion Paper No 2013-02. Rio Tinto (2012), “Outlook for Metals and Minerals: Half Year Results 2012”, 8 August. Available at <http://www.riotinto.com/documents/FinancialResults/120808_Outlook_for_ Metals_and_Minerals_-_half_year_results_2012.pdf>. World Bank (2012), China 2030: Building a Modern, Harmonious, and Creative High-Income Society, Conference Edition, The World Bank, Washington DC. Available at <http://www.worldbank.org/content/dam/Worldbank/document/China-2030-complete.pdf>. United Nations Development Programme: China (2010), China and a Sustainable Future: Towards a Low Carbon Economy and Society, China Translation and Publishing Corporation, Beijing. Available at <http://planipolis.iiep.unesco.org/upload/China/ China_HDR_2009_2010.pdf>. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 2 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 22 February 2013. | Glenn Stevens Global economic overview and 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, Canberra, 22 February 2013. * * * In the six months since the August hearing, economic and financial conditions abroad have generally improved. We can see three key sets of developments. First, the threat perceived in the middle of last year of extreme financial instability arising in the euro area – and, in the eyes of some, possible disintegration of the euro – has abated. This followed various important steps taken by European policymakers. Interest rates faced by some of the key sovereigns which were under acute pressure have declined markedly, and funding conditions for many European banks have improved to the point where some of the central bank funding that had been supplied has been repaid. These countries, and Europe generally, still face immense challenges and it is, as usual, important to stress that sentiment remains vulnerable to setbacks. But a truly disastrous outcome was, once again, avoided. Second, the United States has continued its gradual recovery and has avoided the worst of the so-called “fiscal cliff”. Some of the headwinds for the US economy are subsiding – the housing market seems to have turned, for example. There are still some key decision points in the fiscal area ahead, but if they can be satisfactorily managed, the US has as good a chance of delivering an upside surprise as a downside one over the period ahead. Third, the slowdown in China’s economy has come to an end. The medium-term outlook for China is for a less hectic pace of growth than we saw on average over the past decade, and with more attention paid to the various risks – financial and environmental included – associated with that growth. Having said that, the greater absolute size of the Chinese economy now means that even less hectic growth is still of global significance and of importance to Australia. Conditions have improved in international financial markets as the perceived probability of very bad events occurring has declined and as major central banks have maintained highly accommodative policies. Share prices have risen around the world, with global indexes up by about 20 per cent from the lows in June last year. Borrowing conditions in capital markets for creditworthy borrowers internationally remain extraordinarily favourable. For investors, conversely, returns on “low risk” assets are very low and the “search for yield” has intensified. World GDP growth is thought to have been about 3¼ per cent in 2012 – a little below average. Forecasts for 2013 are for something a bit higher than that, with a further pick-up in 2014. Those seem reasonable guesses at this point in time. Risks now seem less tilted to the downside than they were. Australia’s terms of trade have declined by about 17 per cent since their exceptional peak in the middle of 2011. We are assuming they will fall further over the next couple of years. Even with that, however, they will probably be more than 50 per cent above their twentieth century average over that period. This amounts to an external environment for Australia that, while not without some challenges, is still broadly positive. Turning to the Australian economy, the information we have at present suggests that growth was close to trend over 2012 as a whole. There was, though, some softening around the middle of the year, and sentiment among many businesses, including some that had seen important positive spillovers from the mining boom, became less optimistic. Associated with this, the labour market softened in the second half of the year, with job vacancies declining, employment growth slowing, and unemployment increasing somewhat. Labour force participation also declined. BIS central bankers’ speeches Looking ahead, it appears that the peak in the level of resource sector investment is now close. It is a very high peak, but we do not think that there will be a rapid decline in the near term after the peak. However, it seems pretty clear that this type of investment will not be adding to demand for much longer. Investment spending by businesses in other sectors has thus far remained somewhat subdued in comparison. There are good reasons to expect it will strengthen in due course, but the available indicators at present do not suggest that is going to happen in the very near term. We will get another reading on the investment outlook next week. The outlook for public spending is being constrained as a result of the budgetary restraint being pursued by governments. It is also noteworthy that in several sectors of the economy a combination of factors is putting pressure on business models, and firms have been responding with an emphasis on lifting productivity and paring back costs. This process, while unavoidable, doubtless feeds into measures of sentiment. Sentiment of households, in contrast, has improved. Despite continual commentary that households are very cautious, actual measures of confidence have in fact shown an upward trend since the middle of last year and are currently a bit above longer-run average levels. Admittedly, households do not feel the same ebullience they did for some years prior to the financial crisis in the major countries. But that degree of confidence, with its associated patterns of saving and increasing leverage, was unusual, and is not likely to recur. Our expectation is that consumer demand will record growth roughly in line with the trend rise in income over the period ahead. Housing investment should strengthen given that several factors are supportive – interest rates are low, housing prices are tending to rise, gross rental yields have increased, population growth remains strong and is even picking up a little. Admittedly, we are as yet very early in this phase. The increased capacity to extract and ship raw materials will see export volumes continue to strengthen, probably quite substantially, over the next couple of years. Some other categories of exports seem to have stopped declining, notwithstanding that the exchange rate remains high. Putting all that together, while growth was probably about trend in 2012 as a whole, our sense is that the economy has entered 2013 at a pace a little below that. We have been inclined to think that the near-term outlook could be for more of the same, but things are likely to strengthen further out. We are, of course, conscious that forecasts have a considerable margin of error. We have put some emphasis on this point in the way we present our forecasts in recent times. Stepping back from the numbers, in broad terms, the economy will be adjusting to the peak of the mining boom and some other areas of demand will have room to grow more quickly than they have in recent years. This transition will not necessarily be seamless – these things seldom are – but there are reasonable prospects of it occurring over time. As we go through this period, the pressures to adapt business models, contain costs, increase productivity and innovate will remain. But such adjustments are actually positive for longer-run economic performance. Inflation is currently consistent with the target. The high exchange rate has lowered prices for tradable goods and services and so helped to hold down measures of inflation over the past couple of years. But some domestic costs have also slowed, in response to softer demand conditions in some areas, even as prices for things such as utilities have risen sharply. The effect of the carbon price on the CPI so far has, as best we can judge, been broadly as expected. Our assessment is that inflation will be consistent with the target over the next one to two years. Taking account of the evolving outlook for growth and inflation, the Board eased monetary policy further in the last quarter of last year, following up its easing actions in mid year, and earlier actions in the last quarter of 2011. The cash rate has been reduced six times over the past sixteen months, for a total decline of 175 basis points. Allowing for some change in the gap between the cash rate and other rates, lending rates nonetheless have fallen to be not far from their historic lows. The share of household income devoted to interest payments has BIS central bankers’ speeches likewise declined considerably. Indeed housing “affordability” as conventionally measured, for purchasers, has improved a lot over the past two years. That represents quite a substantial change in policy settings. It is having an effect. Housing prices have been rising since last May, having declined for a period prior to that. Share prices have also risen quite significantly, and if anything by a little more than in comparable markets overseas. The returns available to savers on safe assets – like bonds and bank deposits – have fallen by enough to prompt Australian savers to consider shifting their portfolios towards other assets. These are channels of monetary policy at work. At the same time, as we have noted repeatedly, the exchange rate remains somewhat higher than one might have expected given the decline in export prices so far observed. This has been a relevant factor in the setting of interest rates. It is not that interest rates are seeking a particular exchange rate response, but they are being set with a recognition of the exchange rate’s effect on the economy. Overall, there is a good deal of interest rate stimulus in the pipeline. At its meeting earlier this month the Board judged that it was sensible to allow it time to do its work. The Board believed that the inflation outlook, at least as we assess it at present, would provide scope to ease further, should that be necessary to support demand. But for now, the Board decided it was prudent to sit still. Turning briefly to other areas of the Bank’s responsibilities, in June last year the Payments System Board released the Conclusions from its Strategic Review of Innovation in the Payments System. The review identified areas in which innovation in the Australian payments system could be improved through more effective cooperation between stakeholders and regulators. One of the gaps identified in the review was the inability of businesses and consumers to make payments through the banking system that are received immediately, including when the payer and receiver have their accounts with different institutions. The Payments System Board believes that Australia should develop such capability over the medium term, and proposed a target for the payments industry to achieve that goal by the end of 2016. The Board met last week and reviewed an industry proposal for real-time payments that was submitted to the Bank in late 2012. The Board considers that the industry has made good progress and endorsed the proposal in an announcement earlier this week. There are many details to be resolved that will require the Bank and industry to work closely together over the next few years, within a governance framework that gives appropriate voice to the various stakeholders. But we view this as a very positive development and we welcome the industry’s commitment to deliver world-class improvements to the payments system by the end of 2016. My colleagues and I are here to respond to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 2 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the University of Adelaide Business School, UniBreakfast, Adelaide, 26 February 2013. | Guy Debelle: The Reserve Bank’s operations in financial markets Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the University of Adelaide Business School, UniBreakfast, Adelaide, 26 February 2013. * * * I'm very pleased to be back in my home town to talk to you today about the Reserve Bank’s dealings in financial markets.1 Why might you be interested in this topic? I will talk about how the Reserve Bank actually implements the target interest rate set by the Reserve Bank Board at its monthly meetings. I will then describe how this interest rate, known as the cash rate, affects all the other interest rates in the economy, including mortgage rates, business borrowing rates and deposit rates. So that affects you one way or another. I will also talk about the Reserve Bank’s transactions in the foreign exchange market and finish with some thoughts about the exchange rate more generally. Domestic market operations As you all know, on the first Tuesday of each month (except January), the Board of the Reserve Bank meets to determine the appropriate stance of monetary policy in Australia. At 2.30 pm, just after the conclusion of the meeting, the Governor issues a press release announcing the Board’s decision, along with an explanation for the decision taken. The decision takes the form of a target for the cash rate. It is the job of part of my area, Financial Markets Group, to ensure that the Board’s target for the cash rate is actually achieved. So how do we do this? And how does that affect the interest rate on your mortgage, your business loan and your deposit? The cash rate is the interest rate on overnight unsecured borrowing in the interbank market. That is, it is the interest rate banks charge each other to borrow and lend funds overnight. (Unsecured means that there is no security, such as a government bond, tied up in the loan as collateral.) The Reserve Bank’s ability to affect this interest rate comes from the fact that we control the amount of funds or liquidity in this market. Banks have deposit accounts with the Reserve Bank called exchange settlement accounts. These are the accounts across which the myriad of transactions in the economy are settled each day. When you pay your electricity bill by direct debit, the funds are effectively transferred from your bank account, across the exchange settlement account of your bank to that of your electricity company’s bank and into the electricity company’s account. These exchange settlement accounts at the Reserve Bank must always have positive balances. At the end of each day, the balance in these accounts is paid an interest rate of 25 basis points (a quarter of one per cent) below the cash rate. If a bank finds that its projected balance is below zero, it borrows from the Reserve Bank at an interest rate of 25 basis points above the cash rate. So banks have a strong incentive to manage their liquidity so that they have just enough funds, but not too much, in these accounts. If they think they are likely to have too much funds, they will lend the excess funds overnight to another bank at the cash rate, which earns them 25 basis points more than leaving it in their Details of the Bank’s operations in financial markets are described in detail each year in the “Operations in Financial Markets” chapter in the Reserve Bank Annual Report. BIS central bankers’ speeches account. Conversely, if they think they are not going to have enough funds, they will borrow at the cash rate from another bank with excess funds, which saves them 25 basis points from not borrowing the funds from the Reserve Bank. The control the Reserve Bank has over the cash rate comes from the fact that we determine the total amount of funds in this market. We have complete control of the supply. The total demand comes from summing the amount all the banks want to hold in their ES accounts overnight. The interaction of this supply and demand each day determines the cash rate. If, in aggregate, the banking system wants to hold more ES balances, we increase the supply to stop the cash rate from moving up as the banks bid more aggressively to borrow from each other. If they want to hold less, we would decrease the supply; otherwise banks would start trying to lend below the cash rate to offload their excess funds. The Reserve Bank controls the supply of funds through our daily open market operations. In your textbooks, this was probably described in terms of purchases or sales of government securities by the central bank. While we do do a bit of that, most of our open market operations take the form of what are known as repurchase agreements (repos), where we lend cash to a bank in return for a security (generally a government security) for a period of time, generally a week or two, at the end of which, they return the cash and we return the security. These repo transactions allow the Reserve Bank to manage the day-to-day fluctuations in liquidity caused primarily by cash flows in and out of the Australian Government’s deposit account with us. These cash flows are the result of government spending and tax payments, which inject and withdraw liquidity from the economy every day.2 Our daily market operations aim to ensure that we offset these liquidity flows so that the overall supply of liquidity and the banking system’s total demand for it clear at the cash rate target set by the Board. The fact that we ourselves deal in the market every day means we get a very good sense of developments in the cash and repo markets, as well as bank funding markets more generally. Certainly, this direct market liaison was invaluable at the height of market stress in 2008 and 2009. So now to the question you’re probably more interested in. How does that cash rate affect all the other interest rates in the economy? The cash rate is effectively the anchor point for all interest rates in the economy. Banks fund only a very small part of their operations in the cash market, but ultimately all their funding can be arbitraged back to the cash market. Their borrowing at terms longer than overnight is the weighted average of the expected future path of the cash rate plus some premia for risk. If this were not the case, a bank would be better off funding itself overnight and rolling that funding every day. A bank will similarly price its deposit rates based on the cash rate for an at call deposit, as they are alternative sources of overnight funding. For term deposits, again a bank will price them based on the expected future path of the cash rate. In recent times, there has been a lot of competition for deposits, which has seen interest rates paid on deposits rise quite considerably relative to the cash rate. This competition has arisen from a desire by banks to increase the share of deposit funding resulting from a number of factors including lessons learned during the crisis, pressure from ratings agencies and the market, as well as regulatory changes. I spoke about this at some length here in Adelaide last year.3 So, See Baker A and D Jacobs (2010), “Domestic Market Operations and Liquidity Forecasting”, RBA Bulletin, December, pp 37–43. Debelle G (2012), “Regulatory Reforms and their Implications for Financial Markets, Funding Costs and Monetary Policy”, Address to the Financial Services Institute of Australia, Adelaide, 18 September. BIS central bankers’ speeches fluctuations in these competitive forces mean that deposit rates do not move in lock step with the cash rate. Where long-term interest rates are priced above the expected path of the cash rate, it is usually to compensate the lender for the greater risks they are taking on in lending for longer periods of time. For example, lenders demand more compensation for credit risk when lending to banks for longer periods than just overnight. This risk premium increased significantly during the financial crisis. Today, credit premia are nowhere near as high as they were in 2008 and 2009, but the risk premia faced by banks remain significantly higher than they were in the years leading up to 2007, when they were extremely small. While these risk premia move around independently of the cash rate, it is still the case that the cash rate has a very large influence on the whole structure that underlies the interest rates faced by banks and others looking to borrow funds. Hence the cash rate is still a very large determinant of the banks’ costs of funding. If the cash rate were 3 percentage points higher, the whole structure of funding costs for the banking system would shift up by around the same amount. This effect of the cash rate on the cost of banks’ funding translates into a large effect on the structure of lending rates for both households and businesses. The banks base these lending rates on their cost of funding, along with a risk premium to compensate them for the riskiness of the loan being made; that is, how likely the mortgage will be repaid. In addition, there is a mark-up to generate a rate of return for bank shareholders. So the cash rate has a large influence on lending rates. But there are other factors such as credit risk premia, competitive pressures in the deposit market, as well as changes in the mix of funding banks use which mean that the relationship between the cash rate and lending rates may not always be one for one. In the years before 2007, these other factors did not move around much, so changes in lending rates did tend to move in line with the cash rate. But over the past five years, there has been quite a material change in a number of these factors, so that while changes in the cash rate are still the predominant determinant of changes in lending rates, the relationship between them is not one for one. The Reserve Bank will again be publishing a detailed analysis of developments in banks’ funding costs and lending rates in the next RBA Bulletin which is released on 21 March.4 Foreign exchange transactions I’ll now talk about the Bank’s transactions in foreign exchange markets. The Bank transacts in foreign exchange markets for a number of reasons. The principal one is because we do all the Australian Government’s foreign exchange transactions. For example, when the Department of Foreign Affairs needs to pay its embassy in Washington in US dollars, the Bank sells the necessary US dollars to the government (in exchange for Australian dollars). Generally, the Bank purchases the US dollars in the market prior to settlement, although it does have the option of funding its sale of US dollars out of its foreign currency reserves. On average, the Bank does around $30 million of these transactions each day. One benefit of this regular interaction with the market is that we are able to get useful intelligence about developments in the market. This flow of information helps us to form a view about market conditions in real time and can prove invaluable in times of market stress. I use this information to provide some background colour to my monthly briefings of the Reserve Bank Board on financial market developments. The 2012 analysis of funding costs can be found in Deans C and C Stewart (2012), “Banks’ Funding Costs and Lending Rates”, RBA Bulletin, March, pp 37–43. BIS central bankers’ speeches Most of the other transactions the Bank undertakes in global financial markets result from the fact that the Bank holds and manages the country’s foreign exchange reserves. Currently these amount to $36 billion. 45 per cent of these are held in US dollars, 45 per cent in euros, with the remainder split between yen and Canadian dollars. The Bank has a conservative approach to managing the reserves, with the vast bulk of the portfolio invested in government securities. The day-to-day management of the reserves portfolio is undertaken by RBA staff in New York (for the US and Canadian dollar portfolios) and London (for the euro portfolio) as well as in Sydney. The transactions that are conducted each day in managing the portfolio again provide us with very useful market intelligence, particularly in times of market stress. Why is it that we hold $36 billion in foreign currency? Why not some other amount?5 One reason is that some of the reserves are held to fund Australia’s potential commitments to global financial institutions such as the IMF. But the primary motivation is to provide the capacity for the Bank to intervene in the foreign exchange market when necessary. Over the past two decades, we have, on occasion, intervened to facilitate an orderly depreciation of the Australian dollar, when conditions in the market warranted.6 The most recent episode of intervention was in 2008–2009. At that time, there were various bouts of illiquidity as stresses flared in global markets particularly following the failure of Lehman Brothers. Many participants stepped back from the market, particularly because of concerns about the viability of their counterparty to any transaction. The Bank was able to deploy its reserves to inject liquidity into the market in these disorderly conditions. We were willing to be the counterparty on the other side of the transaction and market participants were willing to deal with us when they weren’t with others. We were not trying to prevent the depreciation of the currency in that episode. From a macro policy perspective, the depreciation was desirable. Rather, we were trying to ensure the depreciation was orderly, without excessive price gapping; that is, avoiding the exchange rate moving by large amounts from one transaction to the next, which only tends to exacerbate market dysfunction. In that intervention episode, the Reserve Bank only utilised around A$3.8 billion of reserves, with most of our transactions in the market being very small, because no-one was looking to trade large amounts. By contrast, in the 2001 episode, when the Australian dollar reached an all-time low of US 47c, A$1 billion of reserves was used on one day alone, with some hedge funds taking very large positions against the Australian dollar. The 2008–2009 episode, as well as the one in 2001, were very profitable for the Bank and hence the Australian taxpayer. We bought Australian dollars low and sold them high, generally a good investment strategy. Or to put it the other way round, we sold foreign currency at a high price and were able to rebuild our reserves later at a cheaper price in Australian dollar terms. More recently, in the second half of last year, there was discussion about some of the Bank’s transactions in the foreign exchange market. I’ll take this opportunity to run through the details of this with you, which might be of some interest. The Bank offers foreign exchange services to all of its official customers, not just the Australian Government. Very occasionally, one of the Bank’s foreign customers lets us know that they would like to buy some Australian dollars to invest and they ask to purchase them through the Reserve Bank. After we have sold them the Australian dollars for foreign currency, we have to decide whether to retain the foreign exchange or sell it in the market. For more, see Vallence C (2012), “Foreign Exchange Reserves and the Reserve Bank's Balance Sheet”, RBA Bulletin, December, pp 57–63. See Newman V, C Potter and M Wright (2011), “Foreign Exchange Market Intervention”, RBA Bulletin, December, pp 67–76. BIS central bankers’ speeches With the Australian dollar trading at the high end of our assessment of fair valuation at the time (based on determinants such as the terms of trade, domestic economic and financial conditions), we decided on this occasion it would be appropriate to retain the foreign exchange in our reserves portfolio rather than sell it. That is, we thought the foreign exchange was on the cheap side of fair value. Moreover, if we had sold the foreign exchange in the market, we would have been buying back Australian dollars putting further upward pressure on the A$ at the margin, which we didn’t think was appropriate given our assessment was that the currency was already somewhat on the high side.7 The exchange rate So having said that the Australian dollar is somewhat on the high side, let me now talk about why that might be. The primary explanation, I think, for the currency being higher than the state of the domestic economy and the terms of trade would suggest is the weak state of many advanced economies and the resulting policies being pursued by the central banks in these countries. Having lowered interest rates as far as they can, effectively to zero, these central banks have embarked on a large expansion of their balance sheets, buying assets, mostly government securities, from the private sector. One of the main channels by which this quantitative easing is expected to work is by encouraging the private sector to use the cash they have received from the central bank for the government securities to buy other assets, which includes foreign assets. Their actions are understandable and defensible from their own domestic policy perspectives. However, these policy actions do have an impact on other countries.8 As some of this quantitative easing generates capital outflows from the country doing the easing, the exchange rate depreciates, boosting local economic activity. But an exchange rate is a relative price. When one country’s exchange rate depreciates another’s must appreciate. The exchange rate movement transfers demand from one country to another. There is an income and substitution effect at work here. Quite likely, these policy actions boost demand in the world as a whole. But if the exchange rate appreciation is large enough in a particular country or if a country doesn’t trade all that much with the one doing the QE, the effect of that appreciation may outweigh the positive effect of stronger global demand. That is, for a given economy, the substitution effect may dominate the income effect. This is particularly likely to be the case for a smaller country, where the size of the capital inflows it attracts may be large relative to the size of its economy, even if the capital flows are small for the large country that is easing its policy.9 So while it may be the case that the monetary For those who are interested, these transactions are evident in a couple of statistical tables on the RBA website. In table A4, the RBA’s transactions in foreign exchange markets are recorded. The first column shows the Bank’s dealings with the market, the second, our transactions with the government, and the third, our dealings with other customers, as well as the interest earned on the reserves. The net of all these three columns are the Bank’s additions to its outright foreign reserve holdings. Most of the time, the number is a low positive one, reflecting the monthly earnings on the reserves. (Columns one and two tend to offset reflecting the way in which sales of foreign currency to the government are funded in the market.) But in the second half of 2012, the number is a larger positive number which reflects the transactions I am referring to here. The RBA’s balance sheet is published weekly, and you can also see the effect of the transaction in temporarily boosting customer deposits through this time. The Governor covered some of these issues in “Challenges for Central Banking” (2012), Address to the Bank of Thailand 70th Anniversary and 3rd Policy Forum, Bangkok, 12 December. The starkest case of this recently is the experience of Switzerland, where the size of the capital flows they received from Europe, when concerns about euro a break-up were at their height, was huge relative to the size of the Swiss economy. This was reflected in the accumulation of foreign reserves by the Swiss central bank, which amount to more than 80 per cent of GDP now. To put that in context for an Australian audience, if the RBA accumulated a similar amount of reserves, they would amount to over A$1 trillion! BIS central bankers’ speeches policy settings we see at the moment might be good for the global economy as a whole, they may not be beneficial for every country. This can leave the countries that are receiving these inflows with a difficult choice. They can decide to offset the effects of the higher exchange rate with expansionary policy too. A number of commentators say this is clearly a good thing for the global economy,10 and is in stark contrast to the 1930s, where countries responded with tighter policy.11 The argument is that given a deficiency in global demand, further expansionary policy elsewhere helps to redress the fact that there is no scope in the major economies for lower rates, given they are already at zero. But lowering rates to such low levels can cause some problems. It can generate excess credit expansion or asset price inflation or imbalances elsewhere in the economy. The current experience of Canada, Hong Kong and Switzerland is salient in this respect. The next line of argument is that such concerns can be alleviated by the appropriate deployment of “macroprudential” policy tools. But there are large uncertainties about how effective such tools really are. To date in Australia, we have been able to counter the effects of the higher Australian dollar with lower interest rates, as my colleague Phil Lowe described recently.12 We still obviously retain scope to lower interest rates further, should the need arise, including to counterbalance the pressures of an elevated exchange rate. So, I hope that has given you a sense of how the Reserve Bank sets the cash rate and how that affects the structure of interest rates in the economy. The cash rate still has the largest influence over lending and deposit rates, even if the relationship is not exact. I’ve also described how the Reserve Bank operates in the foreign exchange rate and discussed some of the forces affecting the exchange rate at the moment. See Krugman P (2013), “Currency War Confusions”, The New York Times, 15 February. Available at <http://krugman.blogs.nytimes.com/2013/02/15/currency-war-confusions/>. This was the archetypal “beggar thy neighbour” scenario, with competitive devaluations. See Eichengreen B (1992), Golden Fetters: The Gold Standard and the Great Depression, 1919–1939, Oxford University Press, New York. Lowe P (2012), “What is Normal?”, Address to the Australian Business Economists Annual Dinner, Sydney, 5 December. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 2 |
Address to Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Australian Institute of Building, Sydney, 14 March 2013. | Christopher Kent: Recent developments in the Australian housing market Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Australian Institute of Building, Sydney, 14 March 2013. * * * I would like to thank The Australian Institute of Building for the invitation to speak here today and the opportunity to discuss recent developments in the housing market. Housing is important in our lives in many ways, including as a secure place to live, a key asset and an important vehicle for saving. Housing is also a source of employment for a lot of people, including for those in the business of developing, building and renovating, as well as for those who help us to trade and move between dwellings, and oversee the legalities, insurance and financing of housing-related transactions. Hardly surprising then that it’s a frequent topic of conversation, including among economists. And it is not surprising that central bankers pay it close attention, given that it plays an important role in the business cycle, in the transmission of monetary policy and, as we’ve seen in many advanced economies of late, in the health of the financial system. My plan today is to add to this conversation, reviewing what’s been happening over the past year or two and discussing some of the factors affecting the outlook for the Australian housing market. The established housing market Overall, the data over recent months suggest that demand in the established housing market is strengthening gradually, and this should help to underpin further moderate growth in dwelling construction. This general strengthening has been helped, no doubt, by 175 basis points worth of cuts to the cash rate since late 2011, and the decline in mortgage interest rates that has followed from these cuts.1 Apart from a brief period after the onset of the global financial crisis, required mortgage payments on a new home are at the lowest level as a share of disposable income for the past decade (Graph 1). An assessment of what’s been happening to housing prices will depend somewhat on which market you are looking at and over what time period. For the country as a whole, housing prices have been rising gradually since about May 2012, and are now about 4 per cent higher than they were at that time (Graph 2). However, if you were a developer who had made plans and purchased land for development around October 2010, when housing prices last peaked, then you might be forgiven for focusing on the fact that house prices are still below their previous peaks in many locations. In particular, prices are still quite a way below their peak in Brisbane and Melbourne, while prices have been quite flat for a few years in Adelaide and outside of the capital cities in the mainland states. With interest rates low and housing prices having picked up in much of the country, more people are now confident that either housing prices will keep rising or at least not decline. We can see this in some of the available survey measures of housing price expectations. This is important for prospective entrants to the market, particularly for developers and investors, who might otherwise be wary of undertaking a new venture or purchasing a house Standard variable housing loan rates have declined by 135 basis points on average since late 2011, as bank funding costs have risen relative to the cash rate. The Board of the RBA has taken this into account in its monetary policy decisions and as a result, the cash rate is lower than it otherwise would have been. See Lowe P (2012), “What is Normal?”, Address to the Australian Business Economists Annual Dinner, 5 December. BIS central bankers’ speeches for fear of a capital loss. But again, not all markets across the country are in the same boat. In Melbourne, for example, there is some question as to whether supply has moved ahead of demand, particularly in the market for apartments in the inner-city area. This possibility is certainly consistent with the fact that prices for houses and units in Melbourne are quite a bit lower than the peaks of early 2011. The general improvement in sentiment is also apparent in auction clearance rates. After falling sharply in 2011, these rates recovered to around average levels in both Sydney and Melbourne in late 2012 and they appear to have increased further early this year. This move may in part have been helped by a tendency of vendors to adopt more realistic expectations, as evidenced by a rise in vendor discounts – that is, the extent to which a property sells below its listed price. These discounts had risen gradually as the market weakened through 2011; more recently, the degree of vendor discounting has returned to more normal levels. Despite the improvement in conditions in the established housing market, turnover remains quite low, at least by comparison with most of the previous decade (Graph 3). However, it may be that the experience of that era is not the right comparison. Perhaps we shouldn’t expect to see turnover sustained at those very high rates again. If that is right, it means that those who make a living from turnover – real estate agents being the most obvious example – are unlikely to see a return to the easier days of the first half of the previous decade. Financing Over the past 20 years or so, upturns in the housing market have been accompanied by an increase in the growth rate of credit. But those years were also a period of structural change as the economy moved to a higher level of household indebtedness (Graph 4). Generations of households yet to buy their first home, or still wanting to trade up, were taking advantage of easier access to credit, which among other things had been facilitated by the shift to lower inflation and lower interest rates in the early 1990s.2 As part of this change, the household saving rate declined and housing prices increased, at times quite rapidly. With household indebtedness no longer moving up since 2006, this long period of adjustment now seems to have run its course. Indeed, in recent years we have seen a rise in the household saving rate and relatively stable household debt as a share of income. This suggests that we should not expect housing credit to grow anywhere near as rapidly as it had in previous upturns. Moreover, while the recent pick-up in housing prices would tend to imply growth in housing loans – since buyers typically fund those purchases with debt – this effect will be lessened by the low level of turnover in the established housing market. Even so, the availability of credit does not appear to be a constraint for most homebuyers and investors. The decline in mortgage interest rates since 2011 has underpinned a moderate increase in the value of total housing loan approvals over the past six months (Graph 5). This has been driven by demand from repeat-buyer owner-occupiers as well as investors.3 Despite the moderate pick-up in new lending, growth in housing credit has not increased significantly and remains broadly in line with growth in incomes at an annual rate of around 4½ per cent. Lower interest rates have given households more scope to make payments on For further detail on the adjustment to a higher level of household indebtedness, see Bloxham P, C Kent and M Robson (2010), “Asset Prices, Credit Growth, Monetary and Other Policies: An Australian Case Study”, RBA Research Discussion Paper 2010–06. Discerning the strength of demand from first home buyers has been complicated by recent changes to government grants and tax exemptions. These changes have significantly increased the assistance for purchasing new dwellings relative to established dwellings in some states. BIS central bankers’ speeches their mortgages ahead of schedule. This means that for a given growth rate of new lending, credit growth will be a bit lower than otherwise. We can see this effect in the behaviour of owner-occupier housing credit. From early 2012, shortly after mortgage rates started to decline, owner-occupier housing credit has been growing at a slower pace than investor housing credit (Graph 6). This makes sense because the incentive to make excess mortgage payments is greater for owner-occupiers than investors given the different tax incentives they face. While finance is available to households on relatively favourable terms, some developers continue to report difficulties in obtaining finance for new construction, with banks requiring a higher proportion of pre-sales than was typical prior to the global financial crisis. According to the Reserve Bank’s industry liaison, large developers that have a good reputation and a strong balance sheet have access to credit, while small developers have tended to experience more difficulty in borrowing funds. Dwelling investment The availability and relatively low cost of finance for home purchasers combined with improving conditions in the established housing market have been supporting dwelling construction in recent quarters. The expectation is that dwelling investment will continue to pick up from here. However, it is hard to know how strong this pick-up is likely to be. Private residential building approvals, though volatile, have picked up noticeably from their trough in early 2012 (Graph 7). This recovery has been driven by an increase in higherdensity approvals, mainly apartments, and was seen in all the larger states. Across almost every major region in Sydney, building approvals since mid-2012 have been higher than they were in the previous five years (Graph 8). In Melbourne approvals have also picked up, though by somewhat less and not across all regions. There has been some pick-up in approvals in Western Australia, although changes in building approvals processes in that state around the middle of last year have made it more difficult to discern the underlying trends. Approvals in Queensland have been subdued, particularly on the Gold Coast and in the south-east of the state more generally; however, even builders in that region have indicated to us that there are tentative signs of some improvement in demand more recently. While building approvals for higher-density housing have picked up, as yet there has been little sign of a rise in approvals for detached houses.4 Indeed, building approvals for detached houses are currently at levels seen during the low points of previous cyclical downturns, while approvals for higher-density housing are at, or even above, previous cyclical peaks. This may be an early indication of a new trend in the housing market. There are a number of reasons why this might be so. First, as the price of land has increased relative to incomes over the past few decades, it makes sense that there is an incentive to economise on the use of land – that is, by living in higher-density housing. Second, it may be that the utility of living in detached houses on the fringes of many cities has decreased with increased congestion and the difficulties of travelling into cities to access job and other opportunities there. The third and closely related possibility is that there may have been a shift in people’s preferences towards living closer to the centre of cities and the existing infrastructure there. In any case, if this is a durable, structural change in the market, it will have important implications for builders and developers, particularly those whose business model is focused on detached housing. To understand what the strength of the increase in overall residential construction activity is likely to be, it is helpful to take a step back from the most recent few months’ worth of data Also, alterations and additions have continued to fall. The low level of dwelling turnover may help to explain some of the weakness in the level of renovation activity. This is because when people are selling their dwelling, or have bought a dwelling, they often undertake work of this sort. BIS central bankers’ speeches and look at developments over a longer period. The thing that really stands out over the past few years is that, despite the recent pick-up, dwelling investment as a share of the economy remains close to the troughs of over a decade ago (Graph 9). This relatively low level of dwelling construction raises the question of whether demand has been particularly weak or whether supply issues have constrained construction activity. Factors affecting the supply of land for development will obviously have an important bearing on the cost of new housing, and the speed with which any increase in demand for housing can be accommodated by a rise in construction. I’ll come back to a discussion of some of these factors in just a minute. But the key point I want to make is that whatever these supplyside constraints might be, they don’t seem to have prevented an increase in construction across much of the country in 2009 and 2010. At that time, a general increase in incentives for first home buyers (for both new and existing dwellings), and the support provided for a time by lower interest rates, led to a sharp run-up in construction in New South Wales, Queensland, Victoria and Western Australia (Graph 10). Further evidence that the supply of land is not the whole story can be found by looking across different regions within the states. If supply has been the critical constraint, we might have expected construction trends to have been very different across inner and outer parts of cities and the regional areas beyond the cities. For example, development in the outer suburbs tends to be on greenfield land, while development in the inner suburbs tends to be higher-density dwellings on brownfield land. However, for Victoria at least, the pick-up in building activity in 2009 and 2010 was relatively broad based across these different areas (Graph 11). For New South Wales, it does appear that there was a larger and more sustained pick-up in approvals in the inner and middle regions of Sydney, than in outer Sydney and the rest of the state. This may have reflected some limitations in access to land on Sydney’s fringes, but nonetheless, there was a relatively rapid pick-up in approvals in 2009. Even so, this doesn’t mean that supply-side issues have not had an important bearing on the housing sector. This point was made in research published in one of the Bank’s Bulletin articles last year.5 Many public reports and the Bank’s own liaison with industry participants pointed to a range of supply-side impediments in the Australian housing market. These included the length and complexity of the planning process, the provision and funding of infrastructure, land ownership and geographical constraints, as well as the challenges for development within those city regions that are already well developed. While these factors may impose some constraints on the cost and responsiveness of new supply, it is less clear that they have been restraining the level of new construction more so now than in the past. One way that is often used to assess the possible outlook for dwelling construction is to compare the number of dwellings that have been built over a period of time with a measure of what is termed “underlying demand”. The notion is that if we can assess the prospects for the average number of people living in each household, then we can gauge the strength of “underlying demand” by looking at what’s happening to population growth. The problem with this sort of analysis is that the average number of people in each household changes over time in response to a range of things, including the cost of housing. Over the 20th century, demographic and social factors, such as a declining birth rate and rising separation rate, were accommodated by growth in the dwelling stock outpacing that of the population. In other words, there was a downward trend in the number of people in each household (Graph 12). A very similar change was also evident across advanced economies. However, over the past decade or so, these trends have abated and we’ve seen the average household size stabilise. Indeed, the higher level of house prices and rents (relative to See Hsieh W, D Norman and D Orsmond (2012), “Supply-side Issues in the Housing Sector”, RBA Bulletin, September, pp 11–19. BIS central bankers’ speeches incomes) may have been somewhat of a constraint on household formation and therefore demand for new housing. This leads me to what I think is arguably a better way to judge the strength of demand versus supply, which is to look at what prices and rents have been doing. What this suggests is that demand has shown some signs of strengthening relative to supply. In particular, housing prices are no longer declining relative to incomes (Graph 13). Also, the rental market appears to be relatively tight. Vacancy rates have been quite low since 2006 in comparison to the average since the early 1990s, and (with a small delay) this has led to rents rising relative to incomes and remaining relatively stable at around levels seen during previous cyclical peaks (Graph 14). The growth in rents has also meant that conditions for investors have become more favourable, with (gross) rental yields increasing across the capital cities. Our liaison with the housing industry confirms that demand for new housing has been more positive over recent months. At the same time, however, our contacts note that conditions still remain relatively subdued in most states. In particular, they report that prices for the construction of new dwellings have been held down in response to weak demand, with discounting still reported across the market, including for new developments. Not surprisingly, developers have found a lack of buyer urgency during the earlier period of declining dwelling prices. In addition, they note instances of some earlier sales made off the plan falling through ahead of settlement, apparently due to caution by lenders regarding valuations and strict lending practices for new developments. Summary Let me conclude then by drawing some of these threads together. A range of indicators suggest that low interest rates have been supporting the established housing market, and prices have been moving higher in many markets, though they remain below earlier peaks in most. Also, finance is available on reasonable terms for households. With these conditions in place, dwelling construction is beginning to pick up and leading indicators point to further growth in the months ahead. In line with this, our expectation is that there will be a further gradual increase in dwelling construction activity over this year and the next. This moderate growth in dwelling investment will play some role in helping to support a gradual pick-up in economic growth more broadly from what is expected to be a rate a little below trend this year. But it is hard to know exactly how strong the recovery in the housing market might be, so we’ll continue to analyse these developments closely over the period ahead. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches BIS central bankers’ speeches Graph 9 BIS central bankers’ speeches Graph 10 Graph 11 BIS central bankers’ speeches Graph 12 Graph 13 BIS central bankers’ speeches Graph 14 BIS central bankers’ speeches | reserve bank of australia | 2,013 | 3 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Industry Group 13th Annual Economics Forum, Sydney, 19 March 2013. | Philip Lowe: Internal balance, structural change and monetary policy Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Industry Group 13th Annual Economics Forum, Sydney, 19 March 2013. * * * I would like to thank David Orsmond for valuable assistance in the preparation of this talk. It is a pleasure to participate again in the Australian Industry Group’s Annual Economics Forum. This is the fourth time I have participated in this Forum, having spoken in 2010, 2011, 2012 and now 2013. Over this period, the Australian economy has undergone very significant adjustment. My central message today is that, overall, this adjustment has proceeded pretty well, particularly in light of the extraordinary developments that have occurred in the global economy over these years. This message is not meant to downplay the disruptive and sometimes painful effects of the changes that are taking place. At the Reserve Bank, we have spent much time trying to understand the stresses and strains facing parts of the economy as a result of structural change. But we have also spent time trying to understand the benefits that can come from this change, including an increase in our average living standards and higher productivity. From an overall perspective, it is important that we do not lose sight of what has been achieved in Australia. We have managed to maintain a fair degree of internal balance during a period in which there has been considerable structural change, a very large shift in world relative prices, a major boom in investment and a financial crisis in many of the North Atlantic economies. Our economic performance has been much better than many other countries and we remain well placed to benefit from the shift of economic weight towards the emerging market economies, particularly those in Asia. While I understand that many companies face challenges, we should not lose sight of this bigger picture – a picture I suspect that many other countries wish they shared. Internal balance and structural change I would like to begin this morning by briefly summarising the broad economic outcomes in Australia since I first spoke at this Forum in March 2010. Since that time, output in the Australian economy has increased by 9 per cent. The number of people with jobs has risen by over half a million. The unemployment rate today, at 5.4 per cent, is exactly the same as it was three years ago. And underlying inflation has averaged 2½ per cent over this period, which is the midpoint of the medium-term inflation target. So over these three years we have seen growth close to trend, a stable and relatively low unemployment rate and inflation at target. By the standards of most other countries, this represents a very good outcome and a high degree of internal balance. Remarkably, we have achieved this balance despite experiencing the biggest boom in business investment and the largest rise in the terms of trade for over a hundred years (Graph 1). In the past, much smaller investment and terms of trade booms caused outbreaks of inflation and the emergence of other imbalances in the economy. On this occasion this has not happened. The investment boom has not led to a large increase in the current account deficit. There has not been an explosion in credit. Increases in asset prices have generally been contained. And the average level of interest rates has been below the long-term average, despite the very significant additional demand generated by the record levels of investment and the terms of trade. BIS central bankers’ speeches Graph 1 There are a number of factors that are important to understanding how domestic or internal balance has been maintained, with generally low interest rates, despite the very large shocks experienced by the Australian economy. This morning, I would like to focus on just two of these. The first is the flexible exchange rate. The high levels of investment and commodity prices have been associated with a high value of the Australian dollar. This has clearly caused some difficulties for parts of our economy, including the manufacturing, tourism and education sectors. But from an overall macroeconomic perspective, the appreciation of the exchange rate has played an important stabilising role. Had we not experienced the sizeable appreciation over recent years, it is highly likely that the economy would have overheated and that we would have had substantially higher inflation and substantially higher interest rates. This would not have been in the interests of the community at large or, I might add, in the interests of the sectors currently being adversely affected by the high exchange rate. It is also worth adding that, in any case, it is unlikely that we would have avoided a substantial real exchange rate appreciation, with it coming through the more costly route of higher inflation. This, of course, does not mean that, at each and every point in time, the exchange rate is at its ideal rate from a domestic balance perspective. We should not forget that exchange rates are relative prices between two countries’ moneys. This means that they are determined both by what is happening domestically and by what is happening abroad. This has been obvious over recent years, with the very accommodative monetary conditions in many of the developed economies tending to put downward pressure on the value of their currencies, including relative to the Australian dollar. As we have said a number of times, the Reserve Bank has responded to this development by lowering the cash rate. It is also worth repeating that this lowering of the cash rate has not been with the direct intention of achieving a lower exchange rate, but rather with the intention of offsetting some of the contractionary effects on the Australian economy of the high value of the Australian dollar. Over recent times, our extensive discussions with Australian businesses confirm that they are adjusting to the high value of the currency. When I spoke at this Forum in 2010 and 2011 BIS central bankers’ speeches my sense was that many businesses were hoping that the high exchange rate was just a temporary development, that it would pass, and that business models wouldn’t have to change too much. Today, I have quite a different sense. Nowadays, there is a greater recognition that the high exchange rate is likely to be quite persistent and firms, including in the manufacturing sector, are adjusting to this. Many are looking to improve their internal processes and address inefficiencies. They are focusing on products where value added is highest and where the quality of the workforce is a strategic advantage. We hear from businesses right across the country that they are looking for improvements and that many are finding them. This adjustment in business processes and models is often painful. But the fact that it is occurring is one reason why the Reserve Bank has been tentatively optimistic for some time that productivity growth would pick-up from the low rates experienced over much of the previous decade. We are now seeing some tentative evidence of this in the aggregate productivity data (Graph 2). While these data tend to be volatile from year to year and subject to sizeable revisions, productivity growth in 2012 was better than it has been for quite some time. Of course, we cannot be sure that this will continue, but the structural changes that are now occurring mean that there are reasonable prospects for a sustained lift in productivity growth. Graph 2 We can also see evidence of adjustment in the detailed industry data, including in the manufacturing sector. While there has been little net growth in either aggregate output or exports from the manufacturing sector for some years, some parts of the industry have done quite well. Output of machinery and equipment and of metals have both trended higher over recent years, and exports of specialised mining-related and other machinery have increased, as have exports in some other categories (Graph 3). Many of these are areas where Australia does have a comparative advantage and where value added is high. It is by focusing on these comparative advantages that we can best build a strong and successful manufacturing sector, while at the same time living with a high exchange rate. BIS central bankers’ speeches Graph 3 I would now like to turn to the second broad factor that has helped maintain domestic balance during the once-in-a-century investment boom. And that is the increase in household saving. Since the mid 2000s, the household sector net saving ratio has risen from around zero to around 10 per cent (Graph 4). In today’s money this represents about an additional $90 billion that is saved, not spent, by households each year. Graph 4 Now I know that this increase in household savings has not been universally welcomed by the retail sector. It has caused difficulties for some businesses, including those that based their business models on a continuation of the earlier trends. But consider how the economy might have looked over the past few years had households spent an extra $90 billion each BIS central bankers’ speeches year. It is likely that there would have been significant overheating. The exchange rate would have been higher. There would have been more borrowing from the rest of the world. And both inflation and interest rates would have been higher. I suggest that these are not developments that would have been warmly welcomed by most in the community. So, somewhat ironically, two of the factors that have created difficult challenges for many businesses over recent years – the high exchange rate and increased household savings – are the very same factors that have been critical to Australia’s good macroeconomic performance. Importantly, these factors have helped Australia to digest a huge investment boom without generating substantial imbalances in the economy. At the same time, these factors have prompted significant structural change which, while difficult, is critical to achieving higher overall productivity and higher living standards. There is clearly a lot of change going on in the Australian economy at the moment. How you view this change depends critically upon where you stand. However, no matter what one’s perspective, we should not lose sight of the fact that maintaining overall macro balance through this period of change has been a significant achievement. And it is an achievement that has benefited the entire community. The contribution of monetary policy So far I have discussed structural factors, but monetary policy has also played some role in helping maintain this overall internal balance. In particular, Australia’s credible medium-term inflation targeting framework has served us well through this period of change. It is important though to point out that monetary policy cannot make the various global factors driving our economy go away. Monetary policy cannot, nor should it attempt to, prevent structural change from occurring. What we can do is deal as best we can with the hand that the global economy has dealt us. We can help ensure that aggregate demand and supply remain in broad balance, so that when firms are making employment, investment and production decisions they can do so with reasonable confidence about the health of the overall economy. Importantly, we can ensure that inflation remains low and stable so that uncertainty about the overall level of prices is not added to the list of things that the community has to worry about. Since November 2011, the Board of the Reserve Bank has lowered the cash rate six times, by a cumulative 1¾ percentage points. These reductions have brought the cash rate down to 3 per cent, which is equal to the lowest level on record. Lending rates have also come down substantially, although a number are still above earlier lows given the general rise in bank funding costs that has occurred since the global financial crisis. Recently, there has been some discussion as to whether these low rates are actually working. This type of discussion is not surprising given that there are lags between when monetary policy is changed and when the full effect is felt in the economy. It is not a matter of simply changing interest rates today and seeing an immediate response tomorrow. Another complication is that the environment in which interest rates are being adjusted is not the same from one interest rate phase to the next. As a result, the exact way that movements in interest rates are transmitted to the economy can change over time. All this means that, as always, we need to monitor things very closely. At the moment though, the available evidence does suggest that lower interest rates are doing their work broadly as expected. In general, the initial responses to a loosening of monetary policy would be expected to include stronger asset prices, improved conditions in the housing market, a lift in consumer confidence and a lower exchange rate. Much of this does appear to be occurring. Nationwide measures of house prices have increased by around 4 per cent since mid last year, after having declined for around BIS central bankers’ speeches 18 months. Home lending approvals and auction clearance rates have both risen. Equity prices are up over 20 per cent since the middle of last year. And the level of consumer confidence is now well above its long-run average level (Graph 5). Despite what one often hears, households do appear to be feeling better about both their finances as well as Australia’s medium-term prospects. Graph 5 The one notable exception to the expected responses following a substantial easing of monetary policy is that there has been little movement in the exchange rate. However, this reflects the global factors that I talked about earlier, and the Reserve Bank has attempted to calibrate the setting of monetary policy to take account of this. Now, if the monetary transmission mechanism works broadly as it has in the past, then an improvement in consumer sentiment and higher asset prices should feed through, in time, to higher spending by households. There are some signs, albeit still tentative, that this is beginning to occur. ABS data and the Bank’s liaison suggest slightly firmer retail spending over recent months than over the second part of last year, though conditions remain mixed across the industry. There are also signs of a pick-up in the forward indicators for new dwelling construction across many areas of the country. In addition, a number of labour market indicators, after having softened last year, have had a slightly firmer tone of late. Another critical element in the monetary transmission process is a pick-up in private business investment. This is often the last link in the chain, and typically follows increased confidence and higher spending. Given the nature of the investment boom we are currently experiencing, it is non-mining investment where we are looking for this pick-up to occur. As mining investment inevitably peaks and then gradually declines, a critical question for the outlook is the strength of this expected pick-up in non-mining investment. We cannot know the answer to this question yet. What we do know is that other parts of the transmission mechanism appear to be working broadly in line with our expectations and that there are some tentative signs of a lift in investment intentions outside the resources sector. The most noteworthy of these was the capital expenditure data published by the ABS a few weeks back, which show that firms expected to increase spending on non-mining construction and on machinery and equipment investment in the next financial year. Whether the increases will be sufficient to offset the expected lower levels of mining investment is something that we will be watching very carefully over the months ahead. BIS central bankers’ speeches So let me conclude by restating the main message that I started with – that is, that the Australian economy has adjusted pretty well to some very large shocks in the global economy over recent years. We have been able to maintain a high degree of internal balance, while at the same time accommodating significant change in the structure of the economy. Businesses right across the spectrum, including in the manufacturing sector, are adjusting to the new realities. This adjustment is often difficult, but it does hold out the prospect of higher productivity and higher living standards. Monetary policy has played an important supporting role in this adjustment by keeping inflation low and stable and the Reserve Bank of Australia is committed to continuing to play that role. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 3 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the KangaNews DCM Summit 2013, Sydney, 19 March 2013. | Guy Debelle: Some recent (and not so recent) trends in Australian debt markets Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the KangaNews DCM Summit 2013, Sydney, 19 March 2013. * * * Thanks to Christian Vallence and Tom Williams for their help. Thank you for inviting me to speak here again. Today, I’m going to talk about the local debt market. I’ll talk about the current state of play as well as a bit of history. Market Developments This time last year, debt markets globally weren’t in great shape, though the local market wasn’t faring too badly. A year on, global debt markets are in a much better position, with issuance strong across most parts of the market, spreads considerably lower and the absolute level of yields very low by historical standards. The market’s assessment of the likelihood of extreme outcomes has declined. The risks in Europe are still predominantly negative, but in China, the US and non-Japan Asia, the risks are much more balanced – one can even conceive of upside surprises! Australia’s financial markets have been influenced by these global factors. At the same time, domestic markets have benefited from strong international demand for Australian dollar assets. Local issuers continue to be viewed favourably by offshore investors looking to diversify credit exposures. Yields on Commonwealth Government securities have moved in line with global government bond yields. They are around post-federation lows, as this very long-run graph demonstrates (Graph 1). Semi-government spreads have tended to move in a fairly tight range. Yields on state government debt are also around their lowest since Federation, notwithstanding the occasional ratings downgrade. Graph 1 BIS central bankers’ speeches Demand for CGS from offshore investors remains strong (Graph 2). The share of foreign ownership has come off its recent peak but net purchases have still continued, just not in line with the pace of issuance. There have been reports of Japanese investors selling, in large part because of the high level of the AUD/JPY exchange rate, but these sales have been more than compensated for by increased purchases by other investors.1 The foreign ownership of semis has been relatively constant, partly reflecting the preference the foreign official sector generally displays for sovereign or highly rated supranational paper rather than state or provincial debt. Instead, much of the increase in semi supply over the past couple of years has been met by the demand from domestic bank balance sheets looking to boost their liquid asset holdings. Graph 2 For financial institutions, the cost of unsecured wholesale debt has fallen sufficiently to make it economical for them to replace some of their government guaranteed securities. As we noted in a recent box in the Statement on Monetary Policy,2 banks began repurchasing this debt in large amounts towards the end of last year, and buybacks have totalled around $19 billion since the end of September (Graph 3). As a result, the contingent liability the scheme generates for the Australian Government has fallen more quickly than implied by the maturity profile of guaranteed securities, and currently stands at $53 billion. Some of the demand for these assets has come from the official sector. Reflecting these increased official holdings, the IMF recently announced that it will separately identify the Australian and Canadian dollars in its reserve assets report, alongside the five major reserve currencies. Given the IMF move reflects decisions already taken by reserve managers, it is unlikely that the reclassification will generate a new source of demand for Australian dollars. Nor is the IMF classification a benchmark for reserve asset allocation decisions for major reserve asset managers. Instead, the move reflects the realities that have been evident for some time. See RBA (2013), “Box D: Buybacks of Government Securities”, Statement on Monetary Policy, February, pp 54–55. BIS central bankers’ speeches Graph 3 The ability to issue covered bonds has also helped in the repurchasing of guaranteed debt, as banks can offer investors with AAA mandates an alternative asset to invest in. Covered bonds have enabled banks to diversify their investor base, and have provided issuers with a wholesale funding source less sensitive to risk events than traditional unsecured funding. After strong issuance in the beginning of 2012 as the banks ramped up their programs, covered bond issuance by Australian banks slowed as the year progressed, in large part reflecting banks’ desire to spread out the maturity profile. The major banks have utilised around 30 per cent of their issuance caps to date. Spreads on these covered bonds have tightened significantly since the first transaction in late 2011, reflecting not only the general improvement in global risk sentiment, but also increased familiarity with the product and a widening investor pool. Australian covered bonds now price at a level close to much longer established covered bond programs (Graph 4). BIS central bankers’ speeches Graph 4 Graph 5 BIS central bankers’ speeches The general decline in borrowing costs in the second half of 2012 has helped entice a number of issuers back to the wholesale market, with volumes picking up across all markets towards the end of last year and into the first quarter of 2013 (Graph 5). In the unsecured market, banks continue to keep their stock of term debt relatively constant, that is, issuance is broadly in line with maturities. This strategy is the result of a number of different considerations, including the relatively subdued growth in balance sheets. But one dominant cause is the desire to maintain a strong rating, with the latent threat of a downgrade if wholesale issuance were to grow “too large”. This reflects the somewhat misplaced assessment of “deposits good, wholesale funding bad”. As a result, banks are currently paying about the same price for a 3-month term deposit as they are for a 5-year debt issue. Banks have taken advantage of the increase in risk appetite by lengthening the tenor of their issuance. The average tenor of unsecured issuance has been 5 years since the middle of last year, compared with a little over 4 years since the beginning of the financial crisis. Increasing tenor has also been a feature of other markets. For example, the Australian Office of Financial Management (AOFM) extended the average tenor of CGS issuance in 2011/12 by over a year to 7.7 years,3 while over the past 12 months the tenor of corporate issuance has increased to nearly 11 years, compared with an average of 8 years since the beginning of the financial crisis. The securitisation market has only recently caught up to these trends, lagging behind most other segments of the debt market. Issuance has picked up of late and spreads have tightened considerably following the earlier sizeable tightening in covered bond spreads. Encouragingly, recent issuance has been completed with little or no support from the AOFM due to strong private investor demand, and primary market spreads are at their tightest level since 2007 (Graph 6). This spread tightening will lower the cost of mortgage lending for small banks and non-bank lenders who rely on securitisation for a large part of their funding. Graph 6 See AOFM (2012), Australian Office of Financial Management Annual Report 2011–12. Available at <http://www.aofm.gov.au/content/publications/reports/AnnualReports/2011-2012/index.asp>. BIS central bankers’ speeches Conditions have also picked up in the Kangaroo market. Ten kangaroo issuers debuted in the market in 2012. The diversity of new issuers was also a notable feature, and included Asian names and non-financial corporates. Another positive development has been the reemergence of some non-SSA issuers not seen since the start of the global financial crisis, while more recently a number of European issuers have returned to the market after being absent for much of 2012. Kangaroo issuance has been supported by the broad-based reduction in spreads, the attractive basis, and foreign investors looking beyond AAA instruments for Australian dollar exposure. These foreign investors have been notably active and Asian investor participation in particular continues to grow. Some recent RBA initiatives in Australian debt markets I will now briefly discuss two recent RBA initiatives concerning the local debt market. Firstly, the Reserve Bank is in the process of signing two-way credit support annexes with all of its swap counterparties. A number of these agreements are already operational, including those with the Bank’s largest counterparties, and we expect agreements to be in place with all counterparties in the coming weeks. This move is in line with best practices in risk management. As more market participants collateralise their exposures in both directions, this should also free collateral for the system (in aggregate), and enhance liquidity and the resilience of the Australian derivatives markets. Secondly, late last year, the Reserve Bank announced new data reporting requirements for repo-eligible RMBS. The information required by the Bank includes loan-level and other transaction specific data that issuers must also make publicly available. These initiatives are designed to help the Bank assess the quality of RMBS provided as collateral and will also improve the transparency of the market as a whole. For investors, the data will be easier to access and because the reporting templates are standardised, investors can better compare the underlying credit characteristics of different deals, and also use the data in their own analytics. The consultation period for the proposed reporting templates closed at the end of last year. The Bank is currently reviewing the consultation findings and will finalise the reporting templates over the next month or so. A long-run perspective on Australian corporate bond issuance I will now turn to the corporate bond market. Non-financial corporate issuance has also been robust, and was particularly strong towards the end of last year, led by some large deals from the mining sector. The December quarter was the strongest on record for domestic activity, with BHP’s $1 billion transaction receiving significant interest. The deal is the largest ever non-credit wrapped transaction in the domestic market by a corporate issuer. To place these more recent trends in a longer-term context, I’d like to take a moment to consider how Australia’s corporate debt markets have evolved into their present form. The current corporate bond landscape is the result of a number of significant developments over the past century, outlined in a recent Reserve Bank Research Discussion Paper published in late 2012.4 This paper was the result of a substantial data collection exercise and extends our understanding of Australian bond issuance back to 1917. Broadly speaking, trends in bond issuance by Australian corporations can be broken down into three distinct periods (Graph 7). The first, which extended throughout the first half of the See Black S, J Kirkwood, A Rai and T Williams (2012), “A History of Australian Corporate Bonds”, RBA Research Discussion Paper No 2012–09. BIS central bankers’ speeches 20th century, actually saw the peak in the size of the corporate bond market relative to GDP. This period, particularly prior to World War II, was characterised by significant issuance by government-owned Public Trading Enterprises (PTEs). Private investment, on the other hand, was largely financed through internal funds, and the modest private bond issuance that did occur was mostly to fund mining investment, much of it by corporations that later went on to become BHP. Graph 7 The bulk of the issuance by government-owned corporations took place in the 1920s. The proceeds were used mostly to fund public works programs, with investment by these PTEs accounting for as much as 7 per cent of GDP. Half of the bond issuance was by Victorian water and sanitation boards alone. Public works projects undertaken here in Sydney, on the other hand, including the building of the Sydney Harbour Bridge and Sydney’s underground railway system, were mostly funded directly by governments. Over the 1930s and 1940s, the stock of corporate bonds outstanding declined as governments reallocated resources away from the PTEs to finance war-related expenditure. By the end of the Second World War, the corporate bond market had shrunk to around 18 per cent of GDP. As the economy expanded following World War II, the stock of corporate bonds remained relatively small as a share of GDP. At the same time, the corporate bond market began to shift towards a larger share of private issuance, in part to fund mining investment, and as corporations looked to source capital from outside the heavily regulated banking system (Graph 8). BIS central bankers’ speeches Graph 8 Graph 9 BIS central bankers’ speeches Bond issuance trends changed significantly from the early 1980s onwards as the Australian economy and financial system underwent large structural changes. Financial deregulation and liberalisation in the late 1970s and early 1980s saw banks rely less on deposits and instead turn to the capital markets to fund balance sheet growth. As we know, bank bond issuance has since grown rapidly, and banks have become the largest issuers of Australian bonds (Graph 9). Some other notable trends since the early 1980s have included the large number of privatisations, which has resulted in the share of quasi-government bonds falling to close to zero, and the growth of the asset-backed market. On the investor side, compulsory super and increased offshore issuance caused a shift away from direct holdings by households towards indirect holdings through superannuation funds and non-resident investors. Another important development was the abolition of capital controls and the floating of the Australian dollar. Prior to the 1980s, there were a range of constraints on capital flows that were intended to prevent or discourage firms from undertaking foreign borrowing. Since these controls were relaxed, banks and other corporations have obtained a significant proportion of funding from offshore bond markets. Since 1986, the stock of bonds issued offshore by Australian residents has exceeded the size of the onshore market (Graph 10). Graph 10 The liberalisation of the capital account also contributed to the development of the “Kangaroo” bond market. Kangaroo issuance was also encouraged by, and contributed to, the development of an active cross-currency interest rate swap market in Australia. I will finish with a few thoughts on the current state of the domestic corporate bond market. There is a fair amount of discussion about the size, liquidity and functionality of the local market. Let me raise three issues worth considering: • Is the local corporate sector too banked? The US is often held up as the comparator here, but in some respects the US is the exception, with the size of the Australian corporate bond market similar to that in Europe and the UK for example. That doesn’t mean the local market shouldn’t be bigger, just that it’s not that unusual. • In many of the recent discussions about the state of the local market, I have been in the room with both issuers and investors. The issuers say there is not enough BIS central bankers’ speeches demand for their paper. The investors say there is not enough supply. But what actually seems to be going on here is that the bid-ask is too wide. It is basically an issue of price. Ironically, those very same discussions are often chaired by investment banks, whose mandate, I would have thought, would be to intermediate between the issuers and the investors. • Finally, there is a nascent level of activity in developing different means of financing for sub-investment grade corporates other than traditional bank financing. Banks would still do the credit process but then potentially package a pool of subinvestment grade loans into a security that would be attractive to investors. Two of the issues around this strategy are: first, whether the margin would be attractive enough to the investor, after the bank has charged for its credit process; and second, whether the investors, particularly in the super sector, have the credit skills to appropriately assess the risk and price of such a product, given the super sector’s corporate skills have traditionally been confined to the listed corporate sector. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 3 |
Remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Australian Centre for Financial Studies (ACFS) and Financial Services Institute of Australasia (Finsia) Leadership Luncheon Series, Melbourne, 22 March 2013. | Malcolm Edey: The financial system in the post-crisis environment Remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Australian Centre for Financial Studies (ACFS) and Financial Services Institute of Australasia (Finsia) Leadership Luncheon Series, Melbourne, 22 March 2013. * * * I want to talk today about how the financial system has changed in the post-crisis environment. In order to think about that, it is useful first to look back at the enormous changes that took place in the roughly quarter-century period between financial deregulation and the onset of the global financial crisis (GFC). Then I want to ask how far those earlier trends might be expected to reassert themselves as conditions normalise. Perhaps the most obvious aspect of that earlier period of change was in the financial sector’s relative size. To give a few summary measures: • The ratio of credit to GDP increased from around 50 per cent in the mid-1980s to around 160 per cent in 2007. • Over the same period, the total assets of the banking system rose from around 50 to around 200 per cent of GDP (Graph 1). • Measures of financial market turnover increased dramatically on a range of fronts. To give just one example, foreign exchange turnover increased by a factor of more than 30 in nominal dollar terms over that quarter-century, when the nominal economy itself expanded only by a factor of 4½. Graph 1 BIS central bankers’ speeches The system also changed profoundly in other ways than just size. One was in its degree of openness to competition and in the nature of that competition. The post-Campbell reforms allowed market forces to work, and opened up the system to new competitors. The Wallis reforms followed that up by placing the regulation of banks and non-bank intermediaries on a more equal footing. We can see the consequences of these forces in the cost and availability of financial services to end users. Deregulation ended the artificial rationing of bank loans, making credit much more widely available. Another consequence that we are apt to forget is that the cost of financial intermediation came down very substantially. In the late 1980s the average net interest margin of the major banks was more than 5 percentage points. By the middle of the last decade it had fallen to a level less than half that – where, broadly speaking, it still is today. So finance became both cheaper and more widely available (Graph 2). Graph 2 These forces also had the effect of changing the focal point of competition. The rationing that existed in the old regulated environment had encouraged banks to compete on a “whole of institution” basis, rather than at the level of individual product lines. In effect, banks offered a package of loan, deposit and payment services and competed for customers at the level of the package as a whole. In this situation, wide interest margins were used to cross-subsidise payment services, and customer mobility was limited because loyalty to a bank was one of the critical factors in obtaining access to scarce loans. Deregulation changed that model by allowing innovators to compete separately for the most profitable lines of business. Cross-subsidies in the banking system were competed down, and this helped to drive the reduction in net interest margins. It is interesting to note that for much of the pre-crisis period, competition among financial intermediaries was focused mainly on the lending side of the business. In effect, intermediaries could operate with a business model that assumed the availability of funding, and mainly competed for market share in lending out the available funds. This is one of the things that has changed since the GFC. With investors now much more discerning in their risk assessments, banks have had to compete harder in the deposit and other funding BIS central bankers’ speeches markets, and this is changing the way they do business. I will return to this point later when I conclude. A final area to mention in briefly rounding up the pre-crisis environment is the growth of the wealth management sector. Funds under management (principally in superannuation and life offices) expanded from around 30 to around 130 per cent of GDP between 1985 and 2007, broadly matching the growth rate seen in the deposit and loan sector. And, of course, there has been a huge growth in services related to asset and risk management, including securities and derivatives trading. Many of these developments had their counterparts in overseas financial systems, which is not surprising because the same sorts of forces were at work. The majority of high-income economies experienced high rates of credit growth and in some cases financial activity expanded even faster than was the case in Australia. In the post-crisis environment these trends have slowed down, halted or in some cases partly reversed. In Australia the credit and debt measures that I cited earlier have been broadly stable for the past five years. Internationally, credit has contracted in nominal terms in some markets. There has also been a big change in attitudes and perceptions about financial risk. Although confidence in global markets has partly returned, risk appetite now is clearly not what it was. And certain kinds of financial activity, particularly in wholesale, securities and derivatives markets have settled at much lower levels than they were in the pre-crisis period. All of this raises the question as to what the new normal might look like in our financial systems. Has the world changed forever? To what extent can we expect the earlier causal factors driving financial change to reassert themselves? In thinking about this, I find it useful to categorise these causal factors into three groups. I see these as being conceptually distinct even though they are likely to interact in complex ways in practice. In the first group are the long-run forces driven by trends in incomes, technology and demographics. Viewed in the abstract, there are a number of reasons to think that financial activity might be able to grow faster than the general economy for sustained periods, and even that this configuration might be some kind of norm. On the demand side it seems plausible that, as people get richer, more of their income can be spent on financial services, including debt servicing, as proportionately less needs to be spent on necessities. Associated with this, the relative value of scarce assets that are financed by debt might be expected to rise over time. And the combination of increasing wealth and greater longevity in our societies is likely to generate rising demand for services in the wealth management and retirement income sector. On the supply side, the key point is that finance is an information-intensive industry. Its key outputs depend on the capacity to store, analyse and transmit information securely. We’re not actually very good at measuring the real value of financial outputs and hence not good either at measuring productivity in the sector. But it would be surprising if the ongoing advances in information technology were not generating significant growth in finance industry productivity relative to that in less information-intensive sectors. This is a process that can continue as long as the technology itself goes on improving. So there are some valid reasons to think that both supply and demand for financial services can grow faster than nominal incomes over time, other things being unchanged. The second set of forces to consider are the one-off factors that made this particular quarter century, in financial terms, unique. One of these I have already alluded to: the financial deregulation that took place around the world mainly in the late 1970s and early 1980s. Fundamentally, we have moved from a situation where credit was price-controlled and quantity-rationed, to one where credit availability is market determined. It is probably fair to say that the credit expansions that followed this shift around the world were larger and more BIS central bankers’ speeches protracted than many had expected. Nonetheless, it was by nature a one-time adjustment, and one that has probably now run its course. Another factor in the one-off category is the transition to low inflation and the consequent fall in nominal interest rates. In the late 1980s, mortgage interest rates in Australia reached a now unimaginable 17 per cent. Although that peak was partly cyclical, it also partly reflected the inflation premium built into the interest rate structure. As inflation expectations and nominal interest rates came down in the 1990s, there was a corresponding increase in the average household’s capacity to borrow. As a simple illustrative calculation, if we assume a debt service ratio of 30 per cent on a standard 25 year mortgage, a household’s borrowing capacity would have gone from around two times annual income in the late 1980s to something like four times income a decade and a half later. Taken in combination with the removal of regulatory constraints on credit supply, this would go a long way towards explaining the quarter-century rise in household debt ratios.1 The adjustment to this new reality seems to have been spread over a fairly lengthy period of time. But again, with inflation having been low and stable for more than two decades now, it can be seen as essentially a one-off factor that has probably run its course. My third category of forces are those associated with the cyclical dynamics of credit and asset prices. The financial sector has a well-documented capacity to engage in bouts of overexpansion, driven by self-reinforcing expectations and followed by periods of readjustment and consolidation. Credit cycles of this nature can be unpredictable in duration, ranging from the short and sharp to longer episodes spanning a decade or more. But we can think of these dynamics as being superimposed on the longer-term forces that I’ve already described. Even though these forces might be conceptually distinct, they are in practice likely to be highly interconnected. A financial bubble doesn’t usually come out of nowhere. Typically it starts as a well-based reaction to some genuinely new event, but then develops a selffulfilling momentum of its own, often with elements of irresponsibility, dishonesty and outright fraud as part of the mix. Globally, there were certainly elements of bubble-like behaviour in the few years leading up to the GFC. But we can also pose the question of whether the world financial system overexpanded on a longer timescale, maybe a quarter-century scale, in reacting to the various forces that I’ve been describing. Did the financial sector in aggregate become too big relative to the size of the real economy? And if so, does that mean we are in for a period of ongoing correction to restore the balance? It is hard to be definitive about these things, but a few observations seem relevant: • First of all, it seems clear that at least some parts of the world financial system did overexpand by a significant margin. To cite some extreme cases, the total assets of the Irish banking system peaked in 2009 at a ratio of 9 times that country’s annual GDP, a figure way outside its own (and other countries’) historical experience. Iceland’s ratio peaked at 7 times. In the UK, the peak was around 5, and in France 4. All of these numbers are high by the standards of longer-run experience (Graph 3). This is a point that the Bank has been making for some time. See RBA (2003), “Household Debt: What the Data Show”, RBA Bulletin, March, pp 1–11 and Ellis L (2005), “Disinflation and the Dynamics of Mortgage Debt”, BIS Papers No 22, pp 5–20, available at <http://www.bis.org/publ/bppdf/bispap22b.pdf>. BIS central bankers’ speeches Graph 3 • Behaviour in the post-crisis period in most economies is consistent with a period of private sector financial consolidation. Ratios of credit or banking assets to GDP have tended to stabilise or decline, particularly in the countries where they had previously been highest. • The combination of regulatory and private sector responses around the world seems likely to result in reduced financial risk-taking in the foreseeable future. Regulators are taking much-needed action to ensure that risks are better managed, and the appetite for financial risk in the household and business sectors now is clearly much less than it was. • In Australia the banking sector did expand relative to the economy, but it remains significantly smaller than many others. On the rough metric of banking assets to GDP, Australia’s ratio is about 2, which is well within the international range and well below those in the euro area, the UK and Japan. So to the extent that any generalised financial overhang exists, it is less likely to be a problem here than elsewhere. • That said, attitudes to risk and debt accumulation in the Australian household sector have clearly changed. Saving rates are up, the appetite for new debt is down, and attitudes to both the level and composition of household saving have become more conservative (Graph 4). BIS central bankers’ speeches Graph 4 So what of the future? To return to my three sets of causal factors: • There are some reasons to think that longer-run trends in income and demographics can contribute to further growth of the financial sector over time. • However, much of the expansion over the pre-GFC quarter-century was driven by one-off factors, notably the adjustments to deregulation and low inflation. These adjustments have now run their course. • And, while we can’t be definitive, it is plausible that the world financial system has overexpanded in relative terms and needs a period of readjustment, though this is less likely to be a major factor in Australia than elsewhere. The ongoing development of the financial system in the post-crisis period will depend on the interplay of those three factors. On any reading, it seems clear that this will be an environment where it is harder in general for banks and for the system as a whole to grow. While it is difficult to specify what that might mean in numerical terms, a return to financial sector growth rates consistently higher than the growth of nominal GDP seems unlikely for the foreseeable future. That is my first concluding comment. My other comment concerns the nature of competition. The pre-GFC quarter century was an unusual period, in that competition in financial intermediation came to be focused mainly on the lending side of the balance sheet. That now looks to have been an aberration, and we seem to be entering a period where significant competition on both sides of the balance sheet becomes the norm. It might take some time to get used to this new reality. But in general I see it as a healthy development because it will mean banks being under greater market discipline to manage their risks. And of course, regulators will be doing their part on that front as well. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 3 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Securities and Investments Commission (ASIC) Annual Forum, Sydney, 26 March 2013. | Glenn Stevens: Financial regulation – Australia in the global landscape Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Securities and Investments Commission (ASIC) Annual Forum, Sydney, 26 March 2013. * * * The title of this session is “Australia as a Global Citizen”. Accordingly, I will seek to set financial and regulatory developments in Australia in a global setting. This is worth doing for its own sake, since local discussion is better informed if we can see how the various initiatives fit in to the broader setting. It is also important to remember that Australia, along with all other jurisdictions that sign up to international standards, will be evaluated by our peers. So it’s worth spelling out our approach to some key issues. In addition, from the end of this year Australia will have responsibility for chairing the G20 for a year, and financial reform and regulation have been prominent on the G20’s agenda in recent years. So Australia’s political leadership will have some responsibility for shaping, for a brief period, the oversight of the process. It is worth starting to think about how this might be done. As a “global citizen”, Australia has the responsibilities and rights of that “citizenship”. The responsibilities are to uphold and play by the rules that are globally agreed, which include implementing global standards in regulation and oversight, and encouraging others to do so. The rights we have are the same as those of others: to have our say and to play our own part, however modest and small, in the development of those standards. Something that is a bit new and, overall, refreshing is that Australia actually does have a place at more of the relevant tables than it used to. ASIC has long been a member of the International Organization of Securities Commissions (IOSCO) as were its predecessor organisations the ASC and the NCSC. It is quite a feather in the cap for ASIC that its chair has this month assumed the chair of the IOSCO Board. The expanded membership of the Basel Committee on Banking Supervision (BCBS) now allows Australia two members – APRA, naturally, and the Reserve Bank – where we had none before. The Financial Stability Board (FSB) likewise allows us two seats, compared with one previously, and membership of some of the key committees. The international financial landscape In the wake of the crisis that swept Europe and North America, the international regulatory environment for the financial system has changed significantly. An expanded Financial Stability Board, with the political backing of the G20 Leaders, has acted to coordinate this process, working with existing standard-setting bodies and also by developing its own processes. There have been several main streams to the reforms. The first is the Basel III prudential reforms, which aim to improve the resilience of financial institutions by strengthening capital and liquidity requirements. Compared with Basel II, minimum capital ratios are higher, capital has been defined more strictly to refer to genuinely loss-absorbing instruments, and use of counter-cyclical capital add-ons is contemplated, all supplemented by a simple constraint on overall leverage. More attention is focused on liquidity management by banks. The second key stream of work has aimed to address the problem of “too big to fail”. Global systemically important banks (G-SIBs) have been identified, and capital surcharges will be set to strengthen their resilience, beginning in 2016. Cross-border crisis-management groups have been established for nearly all of these institutions, and one of their key tasks is to review the recovery and resolution plans that are being developed for these firms. Intensity of BIS central bankers’ speeches supervision is also being increased. For domestic systemically important banks, a principlesbased regulatory framework has been developed. While banks have been the major focus thus far, the overall policy framework for systemically important financial institutions (SIFIs) applies more broadly, and an identification methodology is close to being finalised for global systemically important insurers. A third element is aimed at improving the functioning of markets for over-the-counter (OTC) derivatives, so as to reduce risk of contagion in the financial system. This is to be achieved by promoting or mandating central clearing of standardised OTC derivatives contracts, and adding to transparency through requiring trade reporting. A fourth stream is aimed at addressing risks arising from shadow banking – that is, those entities and activities outside the regulated banking system that are associated with credit intermediation and maturity transformation. The FSB released key proposals last year for consultation and they are being refined on the basis of feedback received, for consideration at the G20 Leaders’ Summit in September 2013. What has Australia done? Australia was not as badly affected by the crisis as some other countries. Our banking system overall, though hardly without blemish, stood up fairly well. This was testament to generally sound management in most institutions and a robust supervisory approach. But there were still lessons to be drawn for Australia and the regulators here have given careful thought to them and to the associated global reforms. APRA finalised its prudential standards to implement the Basel III capital standards in late 2012. Australia, along with 10 other jurisdictions, adopted the capital elements of Basel III as from 1 January this year. Some major jurisdictions – the EU and the US in particular – are a little behind, though all the BCBS member jurisdictions had at least released draft regulations by mid-February. Australia is considered an “early adopter” of the Basel III reforms. Given the relatively healthy capital positions of authorised deposit-taking institutions (ADIs), APRA is requiring ADIs to meet a number of the main capital measures two or three years earlier than the rather extended timetable required under Basel III and it is not using the discretion available under Basel III to provide a concessional treatment for certain items in calculating regulatory capital (e.g. deferred tax assets).1 APRA has also moved ahead on the liquidity standard, in conjunction with the Reserve Bank. We have established the Committed Liquidity Facility (CLF) – a mechanism by which the Basel III liquidity standard can be met, in a world in which government debt in Australia is relatively scarce compared with other jurisdictions. Let me say a little about this facility. It is not a “bail-out” fund for banks. “Bail-outs” usually mean stumping up public funds to inject capital to an institution whose solvency is in question. The CLF does no such thing. It is a facility, for which the institutions concerned will pay a fee, which would provide cash against quality collateral pledged by institutions that the Bank and APRA judge to be solvent. The fee structure is designed to replicate the cost the institutions would incur if there were sufficient ordinary high quality collateral – i.e. government debt – for them to hold to meet the Basel liquidity requirements – which, of course, there is not. If we are to meet the global standards, we either have to have a facility like this, or have the government issue a few hundred billion dollars in extra gross debt so As part of international monitoring implementation of Basel III, Australia will undergo a so-called Level 2 assessment conducted by the BCBS later this year, which will assess the regulatory consistency of Australia’s implementation of the Basel III minimum requirements. BIS central bankers’ speeches the banks can hold it. The relevant ADIs will pay a fee of 15 basis points per annum for the facility whether they use it or not. If they do use it, any funding will be at an interest rate that is 25 basis points above the market rate. This has been developed openly, and under the scrutiny of the international regulatory community. It was approved by the Reserve Bank Board in November 2010. With regard to the “SIFI” reforms, Australia’s large banks cannot realistically be assessed as globally systemic. Hence there was no good reason for them to be classed as G-SIBs. But it cannot be denied that they are domestically systemic, which is why it is appropriate that the Basel Committee’s domestic systemically important bank framework capture them. This will involve some additional minimum loss absorbency on the capital side but also an intensity of supervision that is greater than applied to the “average” ADI – an aspect that is already a key part of APRA’s supervisory approach. In the area of resolution, a number of steps have been taken in recent years, including a strengthening in APRA’s crisis management powers in 2008 and 2010. So far as derivatives markets are concerned, legislation was passed in Australia in December 2012 to help meet emerging international standards. Given uncertainties around both the final shape of key regimes internationally, and the broader market and economic effects of regulation in this area, the final legislative framework contains considerable flexibility. In particular, the legislation does not directly introduce any trade reporting, central clearing or trade execution obligations for OTC derivatives transactions. What it does do is create a mechanism by which such obligations may be implemented by supporting regulations, which would be developed and administered by ASIC. There is more focus generally on what are known as “Financial Market Infrastructures” (FMIs). In April last year, the Committee on Payment and Settlement Systems (CPSS) and IOSCO released new Principles for Financial Market Infrastructures, the culmination of two years of detailed standard-setting. The Reserve Bank has revised its own Financial Stability Standards for Central Counterparties and Securities Settlement Facilities, so as to align them with the Principles. It has also committed to assessing Australia’s high-value payment system, RITS, against the Principles on an annual basis. ASIC similarly updated its Regulatory Guide for Clearing and Settlement Facility licensees to reflect the new Principles and aims to ensure consistency with the Principles in the regime it is designing for trade repositories. With regard to shadow banks, the Reserve Bank presents an annual review of shadow banking developments to the Council of Financial Regulators. Our assessment is that the shadow banking system in Australia is relatively small compared with the formal ADI sector, which means that the recommendations being developed internationally are not as important an issue here as they may be for other jurisdictions, at least from a stability perspective. Separately, there is the dimension of investor protection. Here ASIC and APRA are working on strengthening the regulatory framework for retail debenture issuers. ASIC has proposed minimum capital and liquidity requirements, while APRA’s proposals, which are forthcoming, will aim to make clearer that the products offered by these entities are not the same as the deposit products offered by banks. Remaining challenges From this very quick tour of the key regulatory themes, it should be obvious that much has been achieved, but that significant challenges remain. It is, I think, fair to say that as time has passed and implementation has come into focus, various difficulties and complications are coming to the fore. Some aspects of the Basel standards are being tweaked. It has been BIS central bankers’ speeches necessary for standard-setting bodies to issue additional guidance, to provide further clarity regarding new reforms, and to ensure consistency in interpretation and implementation.2 To some extent this was to be expected. Reforms that seemed so simple and obvious, so bold and so sweeping in the immediate aftermath of the crisis of 2008, have turned out to be harder to implement than first expected. This is hardly surprising really, since so much is being attempted at the same time. It is not that attempting much is a mistake: there were serious problems to be addressed and a lot needed to be done. But in so doing, there was always a pretty good chance that the compounding effects of multiple reforms would contain some unexpected and unintended consequences. To take one example, there is concern in some quarters about a potential shortage of highquality collateral. This arises because regulatory reforms around bank liquidity and centralised clearing are likely to add to demand for high-quality liquid assets. This is spawning great interest by intermediaries to offer collateral transformation services – turning relative risky assets into ostensibly safe ones – that could present new risks. OTC derivatives reforms have been a particularly thorny issue, not least because of the cross-jurisdictional reach of international regulation in this area. European OTC derivatives regulation and US regulation under the Dodd-Frank Act are clear examples of measures that potentially have a strong impact on other jurisdictions. A grouping of market regulators, including ASIC, has been convened to develop some common understandings around the cross-border application of rules. Particularly in a global market such as that for OTC derivatives, consistency with other jurisdictions’ rules is an important consideration in the development of the domestic framework. As OTC derivatives markets make this transition to central clearing, interest is emerging from overseas-based central counterparties in providing their services directly to Australian-based participants. Many international participants in the Australian interest rate swaps market already clear their trades through the UK-based global central counterparty, LCH.Clearnet Limited (LCH). LCH has announced that it will be seeking a licence to provide these services directly to Australian-based participants, alongside a competing offering being developed by the domestic derivatives central counterparty, ASX Clear (Futures). To the extent that participants in smaller markets choose to clear via overseas-based central counterparties it is important that they can do so on appropriate terms, and also that the interests of regulators in these jurisdictions be given due weight. In July last year, ASIC and the Reserve Bank jointly published a document setting out the measures that would be taken to ensure appropriate regulatory influence where an overseas-based central counterparty was operating in Australia. These measures would be applied in the oversight of LCH or any other overseas-based central counterparty that might obtain a licence to provide such services.3 In a world of more central clearing, the question of how the official sector would deal with a situation of FMI distress assumes more importance. As a result of a review by the Council of Financial Regulators in 2011, work is in progress to develop legislative proposals that would An example of this was recent guidance by the BCBS on the usability of high-quality liquid assets under the liquidity coverage ratio. Another is the technical guidance by the FSB to assist national authorities and crossborder crisis management groups in their recovery and resolution planning. In accordance with this approach, the Reserve Bank has already assumed a seat on a new cooperative oversight arrangement for LCH. This will provide a vehicle for representing Australian interests in the design and operation of this important piece of infrastructure. BIS central bankers’ speeches give effect to a “step-in” power as part of a comprehensive resolution regime for FMIs. This is to be designed in accordance with international standards.4 These are just a few examples of how the world of regulation and financial oversight is growing more complex. Whether it is the additional demand for high-quality collateral arising from reforms on bank liquidity and centralised clearing, or the extra-territorial reach of US reforms under the Dodd-Frank Act, or the likely difficulties in maintaining systems of reference interest rates in a world where banks are now extremely wary of the legal risks involved in voicing an opinion about where market pricing might be, or the likelihood that some activities will migrate beyond the regulatory net, complications from regulatory activism are in evidence. My guess is that we don’t yet know what all the compounding effects of multiple reforms may be and it may be years before we do. A principle that the Reserve Bank, for its part, has sought to uphold in our own participation in the various reform streams is that we should proceed with all appropriate urgency where needed, but with deliberate care wherever possible, being conscious of the limits to our own knowledge as regulators and the likelihood of unintended consequences from steps we might take. Further ahead The financial reform agenda post 2008 has been very large and comprehensive. There has been a prodigious amount of work across a wide front. It is worth thinking about how this agenda might be managed in the future. It is of course inappropriate to discuss in detail how Australia might approach its responsibilities in the G20 in 2014. The Russian G20 presidency is in full swing and will remain so until at least November. Our job until then is to assist in any way we can for a successful conclusion to that presidency. On financial regulation, the Russian chair has, to date, focused on the G20 working towards completion and implementation of previously announced reforms. This is a multi-year task and one we will inherit. One area the Russian presidency has identified for particular attention is the possible effects of regulatory reforms on the supply of long-term financing, given that one of their major themes is promoting longterm financing for investment. To date the FSB has found little evidence to suggest that global financial regulatory reforms have significantly contributed to current long-term financing concerns, but they have been asked to continue to monitor the possible effects. Australia’s approach will, of course, be a national one, adopted by government, not simply one established by the Reserve Bank. Subject to all those constraints, I would simply observe that, in my opinion, by 2014 we will have reached a point in the financial regulatory sphere where the G20 should be looking for careful and sustained efforts at implementation of the regulatory reforms that have already been broadly agreed, but being wary of adding further reforms to the work program. Absent some major new development, which brings to light some major reform need not hitherto visible, to task the regulatory community and the financial industry with further wholesale changes from here would risk overload. Lest this be considered too weak a position, let us remember how much is being attempted. And since we are already seeing the need to “tweak” some earlier agreed proposals, it is surely clear that the details of implementation should increasingly be our focus over the next few years. The G20 will need to remain open to the possibility – the likelihood even – that as experience is gained with implementation and we grapple with the inevitable difficulties, and as we learn more about how the financial The relevant standards are the FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions. Work is also underway by CPSS-IOSCO to establish how best to apply the Key Attributes to financial market infrastructures. BIS central bankers’ speeches system is likely to operate in a new world, we will want to make occasional adjustments to the rules. None of that ought to be seen as a retreat from the high level objectives that have guided efforts to date: the desire for a more stable, more resilient and simpler financial system, that is better able and more inclined to play its “handmaiden of industry” role and better able to withstand failures of individual institutions. But in pursuing these goals, it is important that we: • strike the right balance between more regulation and more effective enforcement of existing regulation. Inadequate enforcement and supervision was as big a problem as deficient rules • recognise the cross-border aspects of the financial system, with the associated need for cooperation and, yes, compromise. Recognition of the legitimate interests of smaller markets is clearly of importance to Australia but many other jurisdictions as well. This often coincides with the role of pushing for a principles-based approach instead of a one-size-fits-all heavy-handed, rules-based approach. It may also involve working to develop a “regional voice” on some issues • consider the combination of reforms in their entirety, and keep a lookout for unintended consequences. Given the breadth and speed at which reforms have been introduced in recent years, careful analysis of how the various initiatives will interact is becoming more important. Keeping the regulatory structure fit for purpose across a broad range of jurisdictions around the world is in fact a task that will never be complete, since the financial system evolves – in response to technology and innovation, but also in response to regulation itself. It is important for Australia not only to keep abreast of the developments and implement the key elements of global regulation here, but also to continue to play our own part in helping to develop them, and refining them in light of experience. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 3 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Asia Pacific Financial Market Development Symposium, Sydney, 10 April 2013. | Glenn Stevens: Financing the Asian century Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Asia-Pacific Financial Market Development Symposium, Sydney, 10 April 2013. * * * Welcome to Sydney. We are here this evening at the Royal Sydney Yacht Squadron, founded in 1862 for the enjoyment of sailing by its members. I am not a sailor; aviation is more my hobby. But one can see that in sailing, key elements to a successful voyage would be similar to those in aviation. These would include: • an adequate amount of training and proficiency on the part of the skipper and crew • a realistic assessment of the capabilities and limitations of your craft • a clear destination and a route to get there, though with some flexibility in amending the route should circumstances change • a realistic assessment of the risks involved, including a respect for the weather1 • compliance with the rules • a plan B in case something goes wrong • in the worst case scenario, the availability of rescue to protect human life – though not the financial interests of the boat’s owner. All these are important. Without wanting to push the analogy too far, many elements of policy making and financial development could be said to share many of these attributes. We need to understand how systems work, and their limitations. We want the participants, regulators and supervisors to have appropriate training and skill. We need to keep in mind our desired destination and retain some flexibility of choice in the route depending on circumstances. We need to think about how to respond in the event problems occur and to have a clear idea of whose interests need to be protected. We need a realistic assessment of how much we can’t know. And so on. Meetings such as this one are good opportunities to learn about how the system is developing, to improve our understanding of how it works, and to have a conversation about desired destinations and routes to get there. And I think after the events of the past five years, we are all conscious of the limits of our knowledge. It would be apparent from your deliberations today that Asia’s financial markets are continuing to develop rapidly. To take the market for fixed interest securities, the total size of the bond market in Asia, excluding the very large Japanese market (which has been highly developed for a long time), now amounts to about US$7 trillion, having increased substantially over the past five years. This is an amount equivalent to around 60 per cent of the area’s GDP. While in absolute terms a lot of this growth has been in China, in many of these countries debt markets are equivalent to at least 50 per cent, and in some cases well over 100 per cent, of national GDP. Issuance of corporate debt in 2012 was about In aviation and, I imagine, in sailing, a good weather forecast is invaluable. My observation is that those weather forecasts are actually pretty good. Unfortunately, the same cannot be said for forecasts in economics and finance. This doesn’t mean we don’t set out on the journey – we have no choice – but it means we should do so with due care. BIS central bankers’ speeches US$700 billion, which is not far short of the amount in the euro area, though still a long way below the pace of issuance in the United States. Metrics of liquidity suggest an improving trend, with reasonable turnover and in most cases bid-ask spreads on sovereign debt coming down to a handful of basis points. Equity markets are likewise of substantial size. For several Asian countries, and leaving aside markets like Singapore and Hong Kong, market capitalisation relative to GDP is broadly similar to or even larger than in the United States. The Chinese equity market is considerably smaller in relative terms, but that is not surprising given the history of being a centrally planned economy. Banks in Asia continue to play a central role in providing finance, which is reflected in the relatively large size of banking systems in the region. A number of countries in the region, including China and Japan, have banking system assets exceeding 200 per cent of GDP – although some other countries, where financial deepening and liberalisation still has some way to run, have relatively smaller banking systems. After being severely affected by the Asian financial crisis in the late 1990s, the region’s banking systems were fairly resilient to the more recent (global financial) crisis and are today well capitalised with sound asset performance. So the size of Asia’s financial system has grown substantially. Some have said that Asia’s financial development and integration lags behind the progress being made on the trade and economic fronts. The striking growth of intra-Asian trade reflects the general trade orientation of the Asian growth strategy but also, in recent years, the growing organisation of production processes across borders. Where it is possible to adopt a set of agreed technical standards – global standards for IT components, or communications protocols might be examples – and impediments are removed, it seems that economic networks spanning national borders can quickly emerge. If it is true that this has outpaced financial integration, perhaps that is because it may be harder to align and streamline legal and regulatory processes insofar as they bear on financial activity than it is for trade. Having said that, I’m not sure that growth in Asian finance is lagging all that far behind. The statistics on growth of markets seem a bit too compelling to push that argument too far. Moreover, further growth in Asia’s capital markets is surely likely. The region continues to have, in the main, high rates of saving and investment. So its real “wealth” is growing. (So is its human capital, which will improve the productivity of its physical capital stock.) In addition, many countries continue to see the normal pattern in which the markets that intermediate the flows of saving and investment, and that develop the tradeable financial claims over the stock of real wealth, grow faster than income. The experience of the advanced countries suggests that this process of “financial deepening”, while it may ultimately have some limit, has a long way to go in the emerging world. So the task for policy might be not so much to promote growth per se, as to shape the growth. What sort of financial system do we want to see develop in the region? What, in other words, is our destination? Three desirable descriptors come to mind. We want a financial system that is sound, efficient and integrated. “Sound” does not mean refusing to take any risk. The yachts outside are probably safest when tied up to the mooring. If that’s all that ever happens, though, they are not fulfilling their purpose. Similarly we want some prudent risk-taking in the financial sector – that is its job. It could be argued that the world’s financiers swung in 2008 from insufficient regard for risk to excessive risk aversion. But as is the case when the yachts move off from their moorings to catch the winds in the open water and perform as they were designed, a degree of risk is involved. And, like sailing, BIS central bankers’ speeches the context for that risk-taking has to give due weight to safety. In years past, excessive leverage, inadequate attention to liquidity and funding risk, and poor lending standards all played a part in a serious erosion of confidence in banks and various “shadow banks” in the United States and Europe. We would have to say as well that supervision was found wanting. Once the crisis hit, the complexity of operations across borders then greatly complicated efforts by policymakers to address the resulting problems. The financial system in this time zone, in contrast, has come through this episode in much better shape. Thanks partly to the painful lessons of the Asian crisis and other episodes, banks had generally stronger capital positions and higher lending standards, while supervisors had also done their job in the years prior to 2007. Moreover, several banking systems in the region are among the earliest adopters of the new, tougher, Basel standards. It goes without saying that we want this prudence to continue. But unlike the case in some other countries, the financial sector in the region is well placed to play its role in supporting the sustainable growth of economic activity and trade. It is noteworthy that as European banks sought to pull back from some activities in the region, including trade finance, banks from within the region have stepped up. So this is a point for confidence. This is not to say that there are no sources of vulnerability. In particular, concern has been expressed about the risks that may be growing in the “shadow banking” system in China. In recent years, an increasing share of financing in China has been provided by non-bank entities and through banks’ off-balance sheet activities. In no small part, this growth in shadow banking reflects restrictions on both the quantity of bank credit, and controls on loan and deposit rates. Such restrictions lead to demand for credit exceeding the formal banking sector’s ability to supply it, and also provide an incentive for savers to seek alternatives to low-yielding bank deposits. The Chinese authorities have introduced a number of measures to mitigate the risks, and many types of shadow banking activities in China are now subject to some regulatory oversight. Hopefully, this will lead to a stable outcome. But China’s experience is one that others have had at various times: as long as there are incentives to by-pass the formal banking sector, the shadow banking system may keep on growing together with the risks. More generally the risks associated with prolonged low interest rates globally are very much on the minds of policymakers right around the region, and will be for a while, I would think. Turning to the second and third on the list of desirable attributes for finance, namely efficiency and integration, it may be that these will naturally go together. An efficient financial system intermediates savings at a low cost, and directs them to the uses that are expected to produce the highest risk-adjusted return. As in most industries, a degree of competition in the system is helpful in producing this efficiency. Competition from foreign firms can be a powerful force in this regard. So openness to cross-border investment flows will remain important, as will openness to the innovative new domestic entrants. Of course, as in any industry, and perhaps more so in finance, there have to be boundaries to competition. We don’t want lending standards to be competed down too far, for example, any more than we would want competition between airlines to lead to lower maintenance standards in pursuit of lower costs. That is where the regulatory framework and the supervisors come in. Moreover, greater integration in the region, insofar as that is possible and remains consistent with legitimate national sovereign objectives, offers efficiency gains as well. A large regional capital market would be expected to offer a greater field of choice for savers and borrowers and lower intermediation costs. Progress towards this is being made through efforts to make regulatory frameworks more consistent and improving infrastructure across regional markets, even as demand increases for locally issued debt securities. These developments have been aided, in part, through regional cooperation on initiatives such as the Asian Bond Fund and BIS central bankers’ speeches the Asian Bond Markets Initiative. Ongoing cooperation will help to continue the development of regional capital markets.2 I would simply observe that it may take a degree of commitment to keep progress occurring, not least because some responses to the financial crisis around the world may work towards a lessening of the degree of globalisation of finance. End-piece To these observations about safety, efficiency and integration, I would add two further thoughts. The first is that Asia will in all likelihood continue to have multiple currencies for a long time yet. A decade ago it was becoming fashionable for Asia to look at Europe and wonder whether that was a model for an Asian currency area in due course. But we can now see all too clearly how demanding it is to be in a currency union, and how much supporting financial and political structure is needed for it to work. This may one day be built in Asia, but it takes a long time: Europe’s prodigious efforts over 50 years or more did not, as it turns out, produce fully the conditions for currency union. It follows from this that Asian markets for foreign exchange in Asian currency may need to continue developing. It probably means as well that unless something serious goes wrong in China, the RMB will eventually become the dominant currency in the region. That may be stating the obvious, but there could be a profound adjustment for many countries in the region from membership of what is, at present, a de facto US dollar zone, to membership of an RMB zone. To some extent this has begun with the use of RMB for trade settlement, which is growing quickly. Full development will require liberalisation of the Chinese capital account. This will presumably continue to occur, but on a timetable decided – as it should be – by the Chinese authorities. The second and final observation is related to exchange rates in some ways. It is that Asia surely will want to see its own financial sector doing more of the intermediation of its own saving. That is, Asia will want to send less of its saving abroad to hold supposedly “low risk” – and certainly low return – obligations issued by the “old” world, and do less re-importing of that saving, in the form of risk capital intermediated by the major financial centres at higher cost. Why not deploy the region’s own saving at home, for higher return? It is not as though there are no productive opportunities in the region. By most accounts Asia’s infrastructure needs over the next couple of decades are very large. Moreover, as the region’s own financial sophistication and strength grows, and as its capacity to accept risk grows commensurately, the need for costly self-insurance against capital flow disruptions surely lessens. That does not deny the logic for what Asia did for many years in building foreign reserves, but the cost benefit analysis is surely looking different today from 15 years ago. So to use the language from the beginning of my remarks, perhaps there are now more direct routes to the destination of development and prosperity for Asia than there were a decade or two ago. All of this is tied up with the debate about “global imbalances”, the reorienting of Asia’s growth towards domestic sources, the role and governance of the international institutions, and so on. These are issues worthy of discussion, including in the G20 process as well as in regional fora. But that is a discussion for another day. Once again, welcome to Sydney and I hope your deliberations will be a great success. For example, market depth and liquidity would likely benefit from increased access for non-resident investors as well as the growth in complementary market segments such as repo markets. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 4 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Melbourne Institute Public Economic Forum, Canberra, 16 April 2013. | Guy Debelle: Funding the resources investment boom Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Melbourne Institute Public Economic Forum, Canberra, 16 April 2013. * * * Thanks to Ivailo Arsov, Ben Shanahan and Tom Williams for all their work and to Rachael McCririck and Florian Weltewitz for their help with the balance of payments data. As you’re all well aware, the Australian resources sector has been undergoing a historically large investment boom. Investment spending in the sector has grown from just under 2 per cent of GDP to around 8 per cent currently. Today, I am not going to talk about the direct macroeconomic impact of this, which has been extensively described elsewhere by my colleagues. 1 Instead, I will focus on how the investment has been financed. In doing so, I will draw extensively on a recent article published in the RBA Bulletin by Ivailo Arsov, Ben Shanahan and Tom Williams. 2 Their work highlights the fact that the investment boom has been financed almost entirely from the balance sheets of the companies doing the investing. That is, it has been cashfinanced from earnings. There has been very little borrowing associated with the investment spending, and to the extent that there has been any, it has generally been directly from capital markets rather than intermediated through the banking sector. Another important aspect of the financing is that it has constituted a sizeable capital inflow for the Australian economy. This in turn has had implications for the composition of Australia’s balance of payments and also the exchange rate. The resources investment boom I will start by describing some of the main features of the investment boom. Between 2003 and 2012, investment in new projects and expansions of existing capacity in the resources sector is estimated to have totalled $284 billion, according to ABS data. A detailed analysis of project-level data on the projects completed since 2003, or still underway at the end of 2012, suggests that Australian companies have accounted for just over half of this (54 per cent), with the balance coming from foreign entities. 3 Here I am counting BHP and Rio Tinto as Australian companies. The overwhelming majority, over 90 per cent, of the investment has been by publicly listed companies (Graph 1). The investment has been predominately in iron ore, coal, oil and gas (mainly LNG), with these four commodities accounting for 84 per cent of the investment in physical infrastructure during the boom. See, for example, Bishop J, C Kent, M Plumb and V Rayner (2013), “The Resources Boom and the Australian Economy: A Sectoral Analysis”, RBA Bulletin, March, pp. 39–49. Arsov I, B Shanahan and T Williams (2013), “Funding the Australian Resources Investment Boom”, RBA Bulletin, March, pp. 51–61. Arsov et al describe the exact methodology that has been used here. BIS central bankers’ speeches Graph 1 Funding the boom Given that the vast bulk of the investment has been carried out by listed companies, we were able to use the financial statements of the relevant companies, both Australian and foreign, to estimate how the investment was actually funded. This exercise involved examining the financial accounts of all the listed Australian resources companies (around 900) and 37 foreign companies. This analysis shows that since the start of the resources boom in 2003, Australian companies have raised no equity in net terms. While they raised substantial amounts of equity in 2009, the Australian companies have been returning greater amounts of capital to shareholders since 2011. The foreign companies have been consistently returning large amounts of capital to their shareholders, and, as a group, have not resorted to external equity funding during the resources boom. The funds raised by these resources companies have been used overwhelmingly to make new physical investments, with Australian and foreign companies using around 80 per cent of their funding for this type of spending (Graph 2). The rest of the funding has been used primarily to acquire existing assets from other companies, while funding for other investment purposes has been negligible. BIS central bankers’ speeches Graph 2 In general, companies’ funding is fungible. However, certain types of funding are more suited to specific purposes. In particular, this is the case for acquisitions that are usually large relative to the acquirers’ balance sheets, and require large one-off payments. These types of transactions are often funded with syndicated loans. Given their distinct funding requirements, funding for these acquisitions has been excluded. That is, debt raised to fund takeovers is excluded from the subsequent analysis. Graph 3 BIS central bankers’ speeches In terms of the sources of funding, the analysis shows that 80 per cent of investment spending by Australian-listed resources companies, and over 90 per cent by foreign companies, has been funded through internal sources (Graph 3 and Table 1). Operating cash flow has been the predominant source of internal funding, made possible by the historically high level of commodity prices throughout the period. Table 1 Funding of the Australian Resources Investment Boom(a) Per cent of total To the extent that these companies have resorted to external sources of funding, this has been mainly in the form of bonds issued directly into capital markets. Very little has been funded by borrowing from banks. The companies have tapped bond markets rather than banks in part because of the longer tenors available in the bond market which match the long investment horizons of these projects. Another reason is that a number of these resources companies are able to access financial markets at a cheaper price than the banks themselves can. This absence of borrowing from the banking sector is one of the reasons why (intermediated) business credit in Australia remains relatively subdued despite the around trend growth in the Australian economy in recent years. It also means that unlike previous investment booms in Australia’s history, this one has been associated with very little leverage. The other notable fact from Table 1 is that the funding for the Australian resources boom has been sourced extensively from overseas. At face value, given the share of foreign companies involved, the analysis implies that around half of the investment during the boom has been funded from offshore. However, the actual use of foreign sources of funds is much higher than that. This is because wherever companies are partly foreign owned, funding from internal sources is equivalent to partial funding from foreign sources. Consequently, since the Australian listed resources sector is around three-quarters foreign owned, the same large proportion of internal funding is attributable to foreign sources. For instance, the threequarters foreign ownership of BHP implies that three-quarters of BHP’s internal funding is recorded as foreign. Taking all this together suggests that around four-fifths of the investment funding has been sourced from offshore. BIS central bankers’ speeches So while the focus of the effect of the resources sector on the balance of payments has been on its effect on imports of capital goods for the investment and on the export revenue generated, there has also been a material impact on the capital flows to Australia, which I will now discuss. The effect on capital flows The impact of the above developments has been reflected in the Australian balance of payments (BOP) data, which indicate that foreign capital flows into the Australian resources sector have grown from an average of around 1 per cent of annual GDP in 2007 to around 3½ per cent in 2012.4 This constitutes a significant change in the composition of capital flows in the Australian economy; one of three noteworthy changes in recent years. In the decade prior to the global financial crisis, around two-thirds of foreign capital flows into Australia was directed to the financial sector, amounting to an average inflow of around 6½ per cent of GDP over this period. Since 2007, as I have noted on other occasions,5 inflows into the banking sector have declined considerably to the point where the banking sector has been a net repayer of offshore borrowing (Graph 4). Graph 4 At the same time, foreign purchases of Australian government debt have increased significantly, which has seen the foreign ownership share of Commonwealth Government securities increase from 50 per cent to around 70 per cent currently, even as the stock of issuance has risen fivefold. The ABS began publishing an industry breakdown of capital flows data in September 2006. Debelle G (2011), “In Defence of Current Account Deficits”, Address at ADBI/UniSA Workshop on Growth and Integration in Asia, Adelaide, 8 July. BIS central bankers’ speeches Both of these two large changes in the composition of capital flows directly relate to the upheavals in global financial markets over the period. In contrast, the large increase in capital flows to the resources sector is not related to the financial crisis – being obviously a direct product of the resources boom, which is itself a function of the large increase in commodity demand from emerging markets. In thinking about the effect of capital flows on the value of the Australian dollar, it is important to take account of all of these changes in capital flows. Simply focusing on the developments in only one particular type of capital flow can give a partial picture of what is going on. Moreover, I have not talked at all here about changes in the outward flows of capital. While these flows are also large, over the period in question here, changes in their size have not been so noteworthy. So in terms of the effect on the Australian dollar, of the three major changes in capital flows we have seen over the past six years, two of them: the capital inflow to the resource sector to fund investment along with the increased purchases of government debt, have been putting upward pressure on the currency. But at the same time, the reduction in offshore borrowing by the banking system has been putting downward pressure on it. The net effect of all these flows however, is that the Australian dollar is higher than one would expect, given fundamentals such as the terms of trade and interest differentials. Turning to another effect of the pattern of resources investment funding on Australia’s balance of payments, as noted above, around 75 per cent of the foreign direct investment in the resources sector since 2007 has been in the form of reinvested earnings. In the balance of payments statistics, a proportion of the profits earned by resources companies accrue to foreign shareholders and contribute to Australia’s net income deficit (NID; a part of the current account deficit). If the profits on these direct investment holdings are reinvested, this constitutes a corresponding direct investment “inflow” captured in the capital account surplus. In this way the activities of the resources sector are, to some extent, “grossing up” the figures in the capital account and the NID (Graph 5 shows this relationship for the economy as a whole). That is, the reinvested earnings are recorded as a capital inflow, even though the money remains in Australia. As a result, the recorded current account deficit and corresponding net capital inflow are larger than the actual cross-border flows of funds associated with this investment. Graph 5 BIS central bankers’ speeches Conclusion The historic investment boom in the resources sector has not only had a significant impact on the real side of the Australian economy, it has also had a material effect on the financial side. In my talk today I have highlighted two noteworthy aspects of this: Firstly, unlike most other parts of the economy, the investment by resources companies has been almost entirely self-funded from internal cash flows. Very little of it has been funded through the banking sector. Secondly, because a large share of the resource sector is foreign owned, this internal funding has been reflected in large capital inflows into Australia in the form of foreign direct investment. This has had an impact on both the capital and current account sides of Australia’s balance of payments. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 4 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Chamber of Commerce in Shanghai, Shanghai, 24 April 2013. | Philip Lowe: The journey of financial reform Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Chamber of Commerce in Shanghai, Shanghai, 24 April 2013. * * * I would like to thank Patrick D’Arcy and Michelle Wright for assistance in the preparation of this talk. It is a great pleasure to be here in Shanghai today. I would like to thank AustCham Shanghai for the invitation to speak at this lunch. As you may know, the Reserve Bank of Australia’s head office is located in Sydney. I mention this because Shanghai and Sydney share a number of similarities. Both cities are vibrant and cosmopolitan places to live. Both host their country’s main stock exchange as well as futures markets. They are both also centres of banking and funds management and are important financial hubs in the Asia-Pacific region. It is this financial link that provides the cue for my remarks today. The financial sector plays a critical role in both our economies and the financial linkages between our two countries are gradually deepening. These stronger financial linkages hold the promise of significant benefits for both our countries over the years ahead, just as the stronger trade linkages have benefited us both greatly over the past two decades. This afternoon, I would like to begin by highlighting how the financial linkages between China and Australia have grown over recent times and the potential for these linkages to grow substantially further. One of the factors that will obviously influence the speed with which that happens is the pace of reform in the Chinese financial system itself. As Australia’s experience illustrates, the journey of financial reform can be a difficult one. But our experience also suggests that it is a journey that is well worth taking. In particular, it is a journey that can promote the efficient allocation of savings in the economy and enhance overall living standards. In many respects, the issues that China faces are similar to the ones that we confronted. So I thought it might be useful to share with you some of the details of our own journey of financial reform. A deepening financial relationship As is now well understood, Australia and China enjoy a very strong trade relationship. China is Australia’s largest export destination, and it is also the largest supplier of imports into Australia. In the most recent year, 26 per cent of Australia’s exports went to China and 15 per cent of our imports came from China (Graph 1). From the Chinese perspective, Australia is also an important trading partner, accounting for around 5 per cent of total Chinese imports and a much higher share of some categories of imports, most notably iron ore. I recount these facts, because a strong trading relationship provides the basis for a strong financial relationship. As history shows, finance follows trade. As trade linkages increase, firms require an increasing array of financial services. And a strong trading relationship helps businesses in both countries identify and develop investment opportunities in the other. There are five elements of the financial relationship between China and Australia to which I would like to draw your attention. 1. RMB trade invoicing The first is the potential for a substantial increase in the share of trade between our two countries that is invoiced in RMB. The latest available data from the Australian Bureau of BIS central bankers’ speeches Statistics (ABS) suggest that currently the RMB is not widely used as an invoice currency for trade between China and Australia.1 At the same time though, many Australian businesses are beginning to explore this possibility. This is evident in a recent survey organised by the Reserve Bank of Australia as part of the inaugural Australia–Hong Kong Renminbi Trade and Investment Dialogue held in Sydney a couple of weeks ago. From this survey it is clear that many businesses are interested in using the RMB for trade settlement.2 They see it as a way of building relationships with their trade counterparties and reducing costs. There are, however, a number of factors that have been identified as slowing the uptake of invoicing in RMB. Perhaps the most important of these is the availability and pricing of instruments to hedge RMB currency risk. While these instruments have developed significantly over recent years, the relevant markets are not yet as deep and liquid as some others. Another factor constraining uptake of the RMB is the administrative difficulties that some companies have experienced in the settlement process. These difficulties arise not just from the exchange controls in China but also from processing problems that can occur during the transaction. A number of the Australian companies have also noted that some of their Chinese counterparts have, to date, had only limited appetite for invoicing in RMB. In time, it is likely that these constraints will be overcome: deep and liquid markets will develop, settlement processing will be improved and the appetite for invoicing in RMB will grow. If this assessment is correct, then it is likely the RMB will become the invoicing currency of choice for many businesses on both sides of our trading relationship. 2. Direct trading between the onshore RMB and AUD The second element of the financial relationship that I would like to draw your attention to is the announcement two weeks ago of direct trading between the Chinese renminbi and the Australian dollar in the onshore market. There are only two other major currencies – the US dollar and the Japanese yen – for which onshore direct trading with the renminbi (without the use of an intermediate third currency) is possible. Over time, this important initiative should promote trade invoicing in RMB and facilitate bilateral trade and investment. 3. Swap agreement between PBC and RBA The third element is the swap agreement between the People’s Bank of China (PBC) and the Reserve Bank of Australia (RBA). The PBC and RBA have a strong and cooperative relationship. The PBC has an office in Sydney. And the RBA has an office in Beijing. The swap agreement was signed in March 2012 and allows for the exchange of local currencies between the two central banks of up to A$30 billion or CNY200 billion, making it the fourth largest RMB swap agreement. In the event that this swap were to be activated, it is the RBA’s intention to make RMB available to all authorised deposit-taking institutions (ADIs) in Australia through a standing facility, with ADIs being charged SHIBOR plus 25 basis points. ADIs would, of course, need to provide the RBA with Australian dollar collateral, in the same way that they do in our regular market operations. We see this swap agreement as another important piece of the financial infrastructure supporting trade and investment between China and Australia. Its existence provides market participants with greater confidence regarding the availability of RMB liquidity in Australia, ABS data published in June 2012 show that the value of Australian merchandise trade settled in currencies other than the US dollar, Australian dollar, euro, New Zealand dollar, UK pound sterling and Japanese yen was around 1 per cent of total merchandise trade, indicating that the share of Australian merchandise trade invoiced in RMB in the June quarter 2012 was very small. For a summary of this survey, see ‘Corporate Attitudes Towards Renminbi Trade Settlement and Investment’ available at <http://www.treasury.gov.au/RMBDialogue>. BIS central bankers’ speeches particularly during times of stressed market conditions. In turn, this greater confidence should help build a solid platform for the growth in the RMB market in Australia. 4. Investment of foreign currency reserves The fourth element of the growing financial relationship between China and Australia is a recent decision by the RBA to invest some of our foreign currency reserves in China. This decision by the RBA represents the first time that the RBA will have invested directly in a sovereign bond market of an Asian country other than Japan. This decision does, however, build on our existing investments in the EMEAP Asian Bond Fund initiative, which were made in 2003 and 2005. Our current intention is to hold around 5 per cent of Australia’s foreign currency assets in China. The PBC has approved an initial investment quota and we are currently working through the necessary agreements prior to the investment being made. This decision to invest in China is an important one. It reflects the broader economic relationship between China and Australia and our increasing financial ties. It provides greater diversification of our investments and will help with our understanding of the Chinese financial markets. Over the long run, and particularly as capital account liberalisation occurs in China, the RMB is likely to become one of the major reserve currencies of the region. 5. Bilateral investment flows The fifth and final element is an increase in other capital flows between our two countries, including direct investment, portfolio investment and banking flows. These two-way investment flows are still in their infancy, but they have grown rapidly in recent years. According to data from the ABS, Chinese investment in Australia has risen more than fivefold since 2006, with the stock of investment reaching around A$20 billion as at end 2011 (Graph 2).3 Australian investment in China has also risen significantly over this period, with the stock reaching A$17 billion in 2011. It is likely, however, that these data understate the size of bilateral investment, as some funds are intermediated through financial centres including Hong Kong. A significant share of the growth in Chinese investment in Australia thus far has been foreign direct investment. This has been largely in the resources sector, although recently there has been some diversification, including into the services and real estate sectors. Direct investment has also been an important component of Australia’s investment in China including investments in financial services. In recent years, Australian banks have increasingly facilitated Australian investment in China through their provision of cross-border banking services. All of Australia’s major banks – a number of which are represented here today – have a growing presence in China, as is evident in the foreign claims data (Graph 3). Although each bank has its own strategy, all recognise the opportunities that China offers, whether through servicing new Chinese customers or through supporting Australian businesses’ trade with China. Other areas of the Australian financial services industry, including in insurance, are also active in China, although the size of their investments are, at this stage, limited by various regulations. Conversely, three Chinese banks have opened branches in Australia in the past few years, joining Bank of China which has had a longer-standing presence in Australia. Looking forward, increased two-way investment flows have the potential to benefit both countries. Chinese investment in Australia can help to fund important investment projects Data for 2012 are due to be released by the ABS in the next week. BIS central bankers’ speeches and support the long-term trading relationship. It can do this through direct ownership of projects and indirectly through the capital markets. Conversely, Australian investment in China offers the possibility of further diversification of Australia’s large pool of superannuation savings, particularly in long-term infrastructure assets, which are a good match for the liabilities of retirement funds. There are also benefits from sharing financial expertise and technology. The reform journey Together, these five elements – RMB trade invoicing, direct trading between the RMB and AUD, the swap agreement between the PBC and the RBA, the investment of foreign reserves in China and the increase in investment flows – are testimony to the maturing of the financial relationship between our two countries. The financial architecture to support this relationship is incrementally, but inexorably, being put in place. It is being supported by governments in both countries and by businesses, including those in the financial industry. There is still, however, a lot to be done. Both countries are still learning about the business, social and political environment in the other country. A deeper financial relationship requires businesses to gain experience in local markets so that they can recognise and benefit from investment opportunities. This takes time. Businesses also need to understand the regulatory environment, which continues to evolve in both countries. Over recent years, the Chinese authorities have taken steps to liberalise interest rates and parts of the capital account, although the financial system is still highly regulated. Substantial capital controls remain in place. The Chinese currency does not float freely, notwithstanding the gradual widening in the trading band over recent years. And deep and liquid financial markets in the full range of investment and hedging instruments are still some way off. So there is much work ahead if the depth of the financial relationship is one day to match the depth of the trading relationship. The pace of reform in China will have an important bearing on how this work progresses. As we know from our own experience, this reform process is a difficult one. And from some perspectives, China faces an even more daunting challenge than the one we faced. Because of China’s sheer size, the rest of the world is watching very closely and it has a strong interest in China “getting it right”. China is also facing the task of liberalisation at a materially lower level of per-capita income than was the case in Australia. It faces an existing financial sector much larger (relative to GDP) than was the Australian financial sector at the outset of our liberalisation process. And financial systems everywhere are more globally connected than they once were, so the potential pressures on the Chinese system are greater than when Australia went through reforms. From my perspective though, a number of the discussions that are occurring today regarding the Chinese financial system have a degree of familiarity about them.4 I would like to mention three of these. The first is the discussion about “shadow banking”. This is very familiar. In the 1970s, Australia had a highly regulated banking sector – with regulations on interest rates, the rate of bank balance sheet growth and structure of those balance sheets. The result was rapid growth in other types of financial institutions. Indeed, by the early 1980s, the banks’ share of the financial system had fallen to 40 per cent from 70 per cent in the early 1950s. We made various attempts to restrict the activities of the “shadow banks”, but whenever we introduced new rules, other entities emerged. China is experiencing this today. Finance can be very flexible – those who want to borrow money seem to find a way of connecting with those who have money to lend. In our case, the financial stability problems we had in the For discussions of the financial reform process in Australia see the list of references. BIS central bankers’ speeches 1970s were in those parts of the industry that grew up outside the regulatory net. This regulatory net also contributed to inefficiency in the financial system by limiting banks’ ability to respond to the needs of their customers. In particular, the various regulations limited the availability of credit to important parts of the economy. In the end, the only practical solution was to move to a more liberalised system. We had a number of public enquiries to guide the process, including the development of a regulatory framework that sought to strike the right balance between prudential regulation and market competition. Of course, this is an on-going endeavour and the journey is never ending. A second familiar discussion is that about the exchange rate and the openness of the capital account. In the decades leading up to the 1980s, Australia experimented with almost every type of exchange rate regime. We had a peg to the British pound (1931–1971), a peg to the US dollar (1971–1974), a peg to a trade-weighted index (1974–1976) and then a crawling peg against a trade-weighted index (1976–1983). Ultimately, none of these proved sustainable. These various regimes were complemented with a range of capital controls, which provided some degree of control over domestic monetary policy. Over time, however, people got better at finding ways around these controls and true control over domestic monetary policy proved elusive. While the controls were gradually eased, the highly managed exchange rate regime with a partially open capital account was conducive to neither domestic nor external balance. After we had tried everything else, in the early 1980s we switched to a floating exchange rate and an open capital account. This decision has, perhaps, been more important than any other single decision in promoting stability of the Australian economy. It has allowed Australia to run its own monetary policy, to tap into the gains that can come from the international flow of capital, and to benefit from the stabilising properties of a flexible exchange rate in a world where there have been very large shocks, including to our terms of trade. A third familiar discussion relates to the need to develop supporting financial infrastructure before liberalisation takes place. Those who wanted a slower pace of financial reform in Australia would sometimes argue the preconditions were not right – that now was not the time to move; that banks didn’t have the necessary credit assessment skills; that the hedging instruments didn’t exist; and the relevant markets were neither deep nor liquid. What we found, however, was that it was the restrictions themselves that were often preventing this supporting infrastructure from developing. A highly restricted system was simply not conducive to banks building the relevant credit assessment skills, or the development of hedging instruments, or the emergence of deep and liquid markets. When the regulations were lifted, the system began to respond. Allowing prices to move meant that markets developed. And, allowing banks to decide how much to lend, and to whom they would lend, saw them invest in credit assessment skills. It is important though to point out that the process was far from smooth. Mistakes were made. Banks that had become used to lending to just the best-quality borrowers had trouble coping with a world in which they could lend to anyone and there were market pressure to grow rapidly. They took time to develop the skills to assess borrowers lower down the credit spectrum, and while they were learning they made a lot of bad loans. The regulatory and supervisory apparatus was also too slow to develop. Like the bankers, the regulators who learnt their craft under the highly regulated system took time to adjust. While these aspects of Australia’s experience have some similarities with the current Chinese experience, China needs to, and is, charting its own course. There are many possible paths of financial reform and each has advantages and disadvantages. The exact path taken by any country on the journey of financial reform will obviously depend upon its economic and financial conditions. China has seen the mistakes that others have made and it has been able to draw some lessons from these mistakes. China’s early adoption of some BIS central bankers’ speeches of the new Basel regulatory requirements can clearly be seen in this light, as can the gradual liberalisation of the capital account and of domestic interest rates. The point I want to emphasise though is that having undertaken our own broad journey of financial reform, we are glad we did so. The reform process in Australia took many years. At the outset of the journey, as well as at critical points along the way, there was considerable concern about how things would work out. It was often two steps forward, one step back. And even some decades on, the behaviour of financial institutions and the way markets function still raises questions. One current example of this is related to the very high value of the Australian dollar, which is clearly making for difficult conditions in certain parts of the Australian economy. The quantitative easing that has taken place in a number of countries is having a significant effect on exchange rates of freely floating currencies, and this is having ramifications for monetary policy in these economies. No doubt, other issues about the behaviour of markets will arise in the future. But for all of this, the financial reform journey in Australia has been a positive one. The challenges of managing our liberalised financial system are formidable. But they are less formidable than those of managing a system in which key prices had trouble moving, markets were shallow, the terms and availability of credit were restricted, and almost everybody in the system had an incentive to find ways around the multitude of restrictions. In the end, the long process of financial reform in Australia has helped promote economic stability as well as the efficient allocation of domestic savings. It has improved the access by businesses and households to credit and improved competition and innovation in the financial system. It also has allowed Australia to participate more fully in the global economy. And, most importantly, it has helped raise the average standard of living in Australia. I suspect that one day China will be able to make the same claims as it too continues with its own journey of financial reform. Thank you for your time this afternoon. References Battellino R (2007), “Australia’s Experience with Financial Deregulation”, Address to China Australia Governance Program, Melbourne, 16 July. Battellino R and N McMillan (1989), “Changes in the Behaviour of Banks and Their Implications for Financial Aggregates”, in I Macfarlane and G Stevens (eds), Studies in Money and Credit, Proceedings of a Conference, Reserve Bank of Australia, Sydney, 20 June. Davis K (2011), “The Australian Financial System in the 2000s: Dodging the Bullet”, in H Gerard and J Kearns (eds), The Australian Economy in the 2000s, Proceedings of a Conference, Reserve Bank of Australia, Sydney, 15–16 August. Debelle G and M Plumb (2006), “The Evolution of Exchange Rate Policy and Capital Controls in Australia”, Asian Economic Papers, 5(2), pp 7–29. Edey M and B Gray (1996), “The Evolving Structure of the Australian Financial System”, in M Edey (ed), The Future of the Financial System, Proceedings of a Conference, Reserve Bank of Australia, Sydney, 8–9 July. Gizycki M and P Lowe (2000), “The Australian Financial System 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, 24–25 July. Grenville S (1991), “The Evolution of Financial Deregulation”, in I Macfarlane (ed), The Deregulation of Financial Intermediaries, Proceedings of a Conference, Reserve Bank of Australia, Sydney, 20–21 June. BIS central bankers’ speeches Graph 1 Click to view larger Graph 2 Click to view larger BIS central bankers’ speeches Graph 3 Click to view larger BIS central bankers’ speeches | reserve bank of australia | 2,013 | 4 |
Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Thomson Reuters' Australian Regulatory Summit, Sydney, 1 May 2013. | Malcolm Edey: The financial stability role of central bank Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Thomson Reuters' Australian Regulatory Summit, Sydney, 1 May 2013. * * * I have chosen as my subject today the financial stability role of central banks. One of the consequences of the recent financial crisis has been a rediscovery, or at least a renewed appreciation, of that role. If we think back to the pre-crisis period, it seems fair to say that most of the public attention given to central banking was focused on the conventional monetary policy function – that is, the regular adjustment of interest rates for inflation control. Without in any way diminishing the importance of that function, it is certainly the case that the financial stability role of central banks has increased in prominence since the crisis. We can see that in several ways. Central banks played a crucial part in the initial crisis response by providing emergency liquidity support to institutions and markets under strain. In many cases they held direct regulatory responsibilities for dealing with troubled institutions, or else cooperated closely with the agencies exercising those powers. And they have played a key advisory role in helping to shape the post-crisis regulatory environment around the world. During this period, governments in a number of jurisdictions have taken steps to strengthen the financial stability mandates of their central banks and in some cases have given them additional regulatory powers to that end. One commentator has gone so far as to say that the financial stability role of central banks has been rediscovered with a vengeance 1. I want to explore today what that might mean in practice. The first point to make is that the financial stability role of central banks is not new. In his book The Evolution of Central Banks 2 Charles Goodhart argues that financial stability was an original core function of central banks, arising from their unique position as lenders of last resort to the banking system. It is worth focusing briefly on the economic rationale for that role. It derives from the nature of banking itself. Banks are intermediaries that engage in credit evaluation and maturity transformation in order to link borrowers and lenders. In doing so they perform a function that has become vital to the modern economy, but the history of banking shows that, without proper supporting arrangements, the system can be vulnerable to instability. One source of instability that became evident as banking systems developed was their vulnerability to runs and panics. Put simply, even a sound bank could be put at risk if it were forced to liquidate its assets in a panic, and the best defence against that was to give them access to a central source of liquidity 3. Central banks evolved, or were established by governments, to meet that need. Historically this role had important synergies with other central banking functions, and with other aspects of what we now call financial stability policy. Under the gold standard, the lender of last resort (and the related liquidity management) functions were closely intertwined Buiter (2012), The role of central banks in financial stability: how has it changed? CEPR Discussion Paper Series No. 8780. Goodhart (1988), The Evolution of Central Banks, MIT Press. For a more recent discussion, see Goodhart (2010), The Changing Role of Central Banks, BIS working paper 326, http:/www.bis.org/publ/work326.pdf By this I mean a last line of defence. I don't mean to imply that banks should not hold liquid resources of their own in the first instance. BIS central bankers’ speeches with the price stability objective. The gold standard was seen as a general discipline against inflation or deflation. Central banking actions to preserve the gold standard were therefore seen as both promoting price stability and also promoting the capacity of banks to meet their obligations – in other words, financial stability. Part of that general role involved managing monetary systems in a way that would reduce the risk of panic and instability in the first place. But it also meant applying Bagehot's famous principle that central banks should lend freely, at a penalty rate and on good collateral, in the event that a crisis occurred. The liquidity management role of central banks also led naturally to their engagement in other areas of financial stability policy, including exercising a degree of oversight of the banks that they were lending to. Obviously the world now is very different from what it was in Bagehot's day. We no longer have a gold standard, and financial systems are much more complex than they were then. But I began with that background in order to emphasise an important point of historical continuity. Central banks retain a key role as liquidity providers and managers today, and these functions continue to have important synergies with other aspects of financial stability policy. How then should we think about financial stability policy in the modern environment, and how should we think about the central bank's role in particular? I want to provide some general thoughts on that question while acknowledging that this is not an area for simple answers. When economists talk about policy frameworks in a given field, they like to think in terms of a taxonomy that has (at least) the following main elements: • First, the objectives – what is the policy aiming to achieve? • Second, the instruments – what are the tools available for achieving them? • Third, the strategy – what are the logical processes linking the instruments to objectives? • And finally, governance – who are the decision makers, and how are they held accountable? In the case of the monetary policy function of central banks these questions have been well studied, and there is by now a well-established consensus as to what constitutes a best practice framework, at least in general outline. It could be summarised as follows: • The objective is inflation control, possibly defined as a numerical target and possibly broadened to incorporate some element of business cycle stabilisation. • The policy instrument (in conventional circumstances) is the short-term interest rate4. • The strategy could be modelled as something like what economists refer to as a ‘forward-looking Taylor rule’. This essentially says that the interest rate is adjusted to lean against fluctuations in output and inflation, in order to exert a stabilising influence on both. • And the governance structure should involve the government setting the objective and an independent central bank controlling the policy instrument, subject to appropriate accountability. Obviously this summary glosses over a vast amount of detail, but in concept at least the framework is reasonably well studied and well accepted. For financial stability policy, the position is much more complex. I leave aside here the question of ‘unconventional’ measures when interest rates are at or near zero. BIS central bankers’ speeches The objective might be defined as something like avoid financial instability, or perhaps slightly more scientifically, keep the risk of system-wide financial disruption acceptably low. These things of course can't be readily quantified, at least at the level of the system as a whole. There is no simple measure of system-wide financial risk, and the concept certainly can't be expressed as a numerical target in the way that can be done for the inflation objective. That doesn't mean, however, that the task is hopeless. We are better, I think, at identifying particular sources of risk, like excessive leverage, poor credit standards, or leveraged asset booms, than we are at aggregating them or quantifying their likely systemic impacts. We do know financial instability when we see it, and we have a good idea of the kinds of behaviour that can contribute to it. The objective, then, is to manage these risks to an acceptable level. The second element is the set of policy instruments. Here again, the position is much more complicated than it is for the inflation targeting framework. The potential instruments of financial stability policy are many and varied. One component I have already mentioned: the central bank's role in liquidity management. Other instruments include the range of regulatory requirements that influence risk taking in the financial sector, like capital and liquidity standards. These are what might be termed ‘structural’ prudential instruments aimed at promoting a generally robust financial system. In addition there is a growing interest in the potential use of ‘macro-prudential’ tools in a time-varying and targeted way to respond to risks as they evolve. Examples that feature in international debate include things like maximum loan-to-valuation ratios that might be targeted at cycles in property lending, or the counter-cyclical capital buffer incorporated in the Basel III standards, aimed at general credit cycles. In addition to all this must be added the capacity of prudential supervisors to influence and respond to banks' risk taking without the use of prescriptive rules. In Australia's case I think we have been well served by APRA taking a pro-active approach on this front to ensure that risks in the banking sector have been well understood and well managed. I think of this as a policy ‘instrument’ in my general schematic outline, but it is not one that can be easily quantified or formalised. The third element of my outline is the strategy. How are the instruments deployed to meet the objective? It should be clear from what I have said so far that the policy strategy in this area can never be as tightly defined or modelled as it might be in the monetary policy sphere 5. No one would seriously think of trying to use the equivalent of a Taylor rule to summarise financial stability policy. But clearly the policy approach needs to include at least the following components: • Appropriate management of system liquidity, including a framework for providing emergency liquidity in a crisis. • Capital regulation to ensure well capitalised banks. • Supervision to promote sound loan lending standards and guard against imprudent risk taking in the banking sector. • Sound risk controls for other systemically important institutions, including providers of critical financial infrastructure. • Robust crisis resolution frameworks. • Ongoing monitoring and analysis of systemic risks, including in asset and credit markets; and • Appropriate coordination among the key policy makers. Arguably most fields of public policy are unlike monetary policy in this sense. BIS central bankers’ speeches Central banks and supervisors have been working to strengthen all of these elements since the crisis. Internationally, there are clear benefits to collective effort in a number of these areas. In the area of bank regulation, for example, countries have a mutual interest in the development of common minimum standards to promote resilience for the global system as a whole. The Basel III package of capital and liquidity standards represents a major outcome of that cooperative effort 6. That brief outline might be thought of as capturing some important commonalities in the way various countries are approaching financial stability policy in the wake of the crisis. But there are also some significant differences in national approaches, especially in an organisational sense. That brings me to the fourth element of my outline, which is that of governance or, put simply: who controls the instruments? I have already made the point that one part of the instrument set – the management of financial system liquidity, or the last resort lending function – is inherently a function of the central bank. Internationally, one of the areas of recent debate has been on the extent to which this and other central banking functions should be combined with prudential regulation, or whether they are best kept separate. And, if they are not combined, how can they best be coordinated, given the synergies between them? In current international practice there are a variety of different approaches to this question. Australia of course is a jurisdiction that has an integrated prudential regulator separate from the central bank. Other examples of that structure are Canada and Japan. The United States and Europe have complex arrangements that fall somewhere in the middle. The UK has just completed a transfer of the prudential regulation function back into the central bank after separating them in the late 1990s. Indonesia is in the process of shifting in the opposite direction. So clearly there are a variety of different organisational models. In many cases, including Australia, central banks have a general mandate to use their powers to promote financial stability, even if they are not the primary bank supervisor. A key consideration in all of this is the obvious synergy between central banking activities, prudential regulation, and crisis management and resolution responsibilities. The position of central banks in financial markets is likely to give them early visibility of many types of financial stress, and their position as the system liquidity provider gives them an essential role in crisis management. For these and other reasons there is a clear need for ongoing coordination of these various roles. But coordination is not necessarily best achieved by organisational unity. Arguments can be advanced for a range of different institutional structures, and it is perhaps not surprising that countries have come to differing conclusions, depending in part on their own histories and their experiences during the crisis. With that general background, I want to conclude with some observations about how we organise these things in Australia 7. In particular, to come back to my original focal point, I want to ask what is the role of the Reserve Bank in Australia's financial stability arrangements. It is sometimes said in answering that question that the Bank is the macro-prudential authority in Australia and APRA is the micro-prudential authority. The implication is that the Bank looks at stability from the point of view of the system while APRA looks only at the individual institutions. I think that is at best an oversimplification and is an unhelpful way to Other examples include common mortgage underwriting principles, and the development of regulatory standards and resolution regimes for critical financial market infrastructure. For a comprehensive discussion of financial stability arrangements in Australia, see the joint RBA and APRA document Macroprudential Analysis and Policy in the Australian Financial Stability Framework, http://www.apra.gov.au/AboutAPRA/Publications/Documents/2012–09-map-aus-fsf.pdf BIS central bankers’ speeches look at the two institutional roles. It presupposes that it is possible to focus on the system as a whole without taking an interest in the individual components; or, conversely, that an agency can sensibly look at the parts without being interested in how they interact with the whole 8. The difference between the two roles, I suggest, is best understood in terms of their powers and responsibilities rather than their objectives. APRA has powers and responsibilities that relate mainly to individual institutions, but its legislative mandate includes stability of the system, and it can adjust its prudential settings to address system-wide concerns. The Bank has a broad financial stability mandate, existing in conjunction with other macroeconomic objectives and attached to a very different set of powers. In a legal sense the Bank is authorised to provide financial services to the government and to the financial system, and has significant powers to engage in financial activities in the public interest. As I have said, those powers enable the Bank to act as lender of last resort and liquidity manager for the financial system in addition to its better-known role in conducting monetary policy. When bank supervisory powers were shifted from the Reserve Bank to APRA under the 1998 Wallis reforms, the Bank's general mandate to use its powers to promote financial stability was reaffirmed. This was more recently emphasised by the incorporation of reference to the financial stability mandate into the Statement on the Conduct of Monetary Policy in 2010. The Wallis reforms and subsequent legislative changes also gave the Bank significant regulatory powers in relation to the resilience of the payments system and of financial market infrastructure. In summary, then, the Reserve Bank and APRA have different powers but overlapping and complementary objectives in relation to financial stability. It goes without saying that the two institutions have a strong appreciation of the need to work closely together and to coordinate with the other key agencies, especially ASIC and the Australian Treasury. There are a number of mechanisms, both formal and informal, for achieving this. At the peak level the four agencies form the Council of Financial Regulators, chaired by the Reserve Bank Governor. Numerous other coordinating arrangements exist at the staff level. Although the Council is a body without formal powers, it has played an important role in a number of different ways, including information sharing, helping to develop the overall post-crisis response and in making coordinated recommendations to the government. Internationally I find that there is a lot of interest in the Australian coordination arrangements, and it is interesting to observe that a number of other jurisdictions have moved to develop financial stability council structures of their own in the wake of the crisis. To recap briefly, I have tried to outline what I see as the main elements of financial stability policy, to explain why the central bank has a key part in it, arising from its role as system liquidity manager, and to highlight the need for coordination between the central bank and other agencies, especially the prudential regulator. All of that falls well short of a general theory of financial stability, unavoidably so because I don't think such a theory is achievable. Nonetheless, I think the arrangements that I've just described have generally served Australia well. During the recent period of global financial stress, our banking system and our crisis management arrangements have proved more resilient than most. For more details on this point, see Edey, Macroprudential Supervision and the Role of Central Banks, and Ellis, Macroprudential Supervision: A Suite of Tools or a State of Mind? BIS central bankers’ speeches In the end, of course, what counts is not the way financial stability policies are allocated to particular agencies but the quality of their implementation. And that of course remains the focus for the Reserve Bank, as well as for the wider body of financial regulators in Australia and abroad. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 5 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Institute of Global Finance Second Conference on Global Financial Stability and Prosperity, Sydney, 4 July 2013. | Philip Lowe: Some tensions in financial regulation Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Institute of Global Finance Second Conference on Global Financial Stability and Prosperity, Sydney, 4 July 2013. * * * I would like to thank the Institute of Global Finance for the invitation to speak today. It is a pleasure to be here. As I am sure you are all aware, over recent years regulators have looked into almost every corner of the global financial system. Too often they found practices and behaviours that they judged generated unacceptable risks. In response, they have developed a very large and a very complex regulatory reform agenda. Much of this agenda is now being implemented, and other pieces are still being negotiated. It is understandable why this reform is taking place. While financial intermediation can be a force of great good, it can also do much damage if not done well. Indeed, the decisions that were made in the 2000s by some financial institutions ended up causing very real damage to the global economy. These decisions caused many people to lose their jobs and suffer a loss of their hard-earned wealth. There were also serious ethical failings by some of the highly paid staff in a number of these institutions. And a significant amount of taxpayer dollars had to be put at risk to help solve the problems. The societies in which this has occurred have been, and continue to be, rightly angry. I am sure that you have all heard variations of statements that run something like this: “regulators need to make sure that these problems never occur again” or “not one cent of taxpayers’ money should ever again be put at risk to support a financial institution”. Many of you in this room would, I suspect, agree with such sentiments. This afternoon I would like to reflect on the ideas behind both of these statements, which are clearly relevant to the theme of this conference, Global Financial Stability and Prosperity. In the world of finance, implementing what seems like simple and attractive ideas often turns out to be quite difficult. Tensions emerge and trade-offs are inevitable. You touch one piece of the financial system and another piece moves, sometimes quite unexpectedly. This partly reflects the fact that the way in which savers and borrowers connect with one another is constantly evolving. Moreover, views about the role of the public sector in the financial system are not static over time. All this means that it can be problematic to put into practice what seem like simple ideas. “Regulators should make sure it does not happen again” I would like to start with the first of these two ideas: that regulators should make sure that this type of financial instability never happens again. This idea has motivated much of the reform effort. And it is entirely understandable. Good, well-designed regulation can make an important difference. This reflects a number of features of financial intermediation, including the existence of pervasive information asymmetries and the potential for runs if confidence is shaken for any reason. In addition, financial institutions and investors seem too often to underestimate risk in the good times, with sometimes severe consequences for the broader community. This all means that our societies can benefit from a well-designed set of rules and standards to govern how financial intermediation takes place. At the same time, though, we need to be realistic about what can be achieved through the application of rules alone. History provides some salutatory lessons here. As soon as the ink BIS central bankers’ speeches is dry on a set of rules, people start trying to find ways around them, and they generally have some success in doing so. One possible response to this is to write more rules, and this is sometimes the appropriate response. But, as we are discovering (perhaps rediscovering), as we write more rules, new tensions emerge and new difficult trade-offs become apparent. I would like to highlight a couple of the difficult trade-offs that are evident at the moment. The first arises from efforts to shift to a system in which a greater share of banks’ exposures is collateralised. This shift is being encouraged through regulation as well as by financial institutions themselves. It can be seen in the move to secured funding markets, for example, covered bonds. It can also be seen in initiatives to increase the collateralisation of counterparty exposures in OTC derivatives markets, including by having more derivatives novated to central counterparties and by introducing margining where novation is not possible. A common high-level objective of these changes is to reduce counterparty risk. Few would disagree that this is a sensible objective. After all, if more exposures are collateralised, shouldn’t the system be safer? The reality, though, is that there is some uncertainty as to what the end effects of this shift will be. The reasons for this uncertainty are spelt out in a recent report by the Committee on the Global Financial System (CGFS) at the Bank for International Settlements (BIS).1 The report noted that financial institutions are likely to respond to the increased calls for collateral by changing the way they do business. Some change is clearly desirable, given that a number of risks were previously underpriced. But if past experience is any guide, as prices change and the demand for collateral increases, financial institutions will seek to manage their collateral more efficiently and this is likely to increase interconnections in the financial system. The report also noted that the greater collateralisation is likely to increase the procyclicality of the financial system and to increase uncertainty about the strength of the claim that unsecured creditors have over the assets of a financial institution. So there are clearly tensions. Reducing counterparty risk is an appropriate objective. But the BIS report suggests that the side effects of doing so could run counter to achieving other high-level objectives, including reducing interconnectedness, reducing procyclicality and reducing uncertainty. The challenge is getting the balance right so that fixing one problem does not create another one. A second example of where tension between objectives is evident is in the effort to increase the stability of banks’ funding. In this context, it has become common to think of deposits as “good and stable” and wholesale funding as “bad and unstable”. Signs of this thinking are evident in Australia, as they are in many other countries. Many financial institutions have had an explicit objective of increasing the share of their liabilities that are accounted for by deposits. Consequently, they have been prepared to pay large premiums for liabilities that are called deposits relative to wholesale funding liabilities of similar maturity. This has pushed up banks’ overall funding costs and led to increased spreads between lending rates and wholesale rates. It is difficult to argue with the idea that this shift towards deposits is helpful for overall financial stability. While there can be a deposit run on an individual bank, a deposit run on the system as a whole is very unlikely, as deposits tend to get recycled from one bank to another. In comparison, it is easier to think of scenarios in which disruptions to foreign wholesale funding cause system-wide stress. CGFS (Committee on the Global Financial System) (2013), “Asset Encumbrance, Financial Reform and the Demand for Collateral Assets”, CGFS Papers No 49, May. Available at <http://www.bis.org/publ/cgfs49.pdf>. BIS central bankers’ speeches But, once again there is a balance to be struck. The recent problems in Cyprus give us a hint of this. The Cypriot banks were very heavily deposit funded. This turned out to have two distinct disadvantages. The first was that when the value of the banks’ assets fell, depositors had to bear the brunt of losses after the equity holders. This significantly complicated the resolution of the banks’ problems. A similar tension is currently evident in some of the international policy discussions. In particular, some regulators want banks to have more deposit funding because it is seen as more stable. At the same time, others want heavily deposit-funded banks to rely less on deposits and issue certain types of wholesale debt to make it easier to resolve a problem should it occur. The second disadvantage is that with only limited wholesale liabilities, the Cypriot banks were arguably subject to less market scrutiny than were banks with a different funding structure. One benefit of wholesale funding is that the issuing bank needs to keep turning up to the market and selling its story to sophisticated investors. There is no guarantee that this extra scrutiny will prevent problems, but it is likely to help. The general point from both these examples is that there are tensions in financial regulation. Regulations are introduced to address one issue, and another issue emerges. Many countries have had the experience of regulating one aspect of the financial system only for other parts to grow very quickly, and problems to emerge in those other parts. I do not want this to be interpreted as a counsel of despair. But we need to be cognisant of the limits of rules alone. It may well be possible that a set of rules could be introduced to ensure that the specific problems of recent times are never allowed to occur again. But what is much less certain is whether these rules could ensure that a different set of problems, but with broadly similar consequences, do not emerge at some point in the future. I suspect that it is simply not possible, or in fact desirable, to regulate a modern financial system to the point that we can say with absolute confidence that problems will not occur. What we can do, however, is to reduce the likelihood and severity of future problems. If we are to do this on a sustainable basis, we need to look beyond rule-making, as important as that is. In particular, any set of rules needs to be accompanied by strong risk management frameworks, both within financial institutions and within the regulatory community. A critical element of these frameworks, and thus ultimately of a stable and well-functioning financial system, is the undertaking of holistic risk assessments by those who manage financial institutions and by those who regulate them. These holistic risk assessments are not easy to undertake, involving as they do both systemwide and more detailed, disaggregated views. But neither are they impossible. While each situation is different from the one before, there are a number of system-wide variables that need to be monitored carefully. These include, but are certainly not limited to: the rate of increase in the overall level of borrowing in the community; developments in key asset prices, particularly property; the amount of construction activity in the economy; the pace of innovation in financial products; the degree of competition in the financial products; and changes in market-wide lending standards. Obviously, this is only a starting point and managers of financial institutions and supervisors need to keep their eyes and ears open for new developments in the financial system. Both need to ensure that the institutions they manage or supervise comply with the rules but, equally importantly, they need to examine what is going on in the system as a whole. In some cases, supervisors’ perspectives will differ from those of bank management, and supervisors clearly face different incentives from bank management. Where they reach different judgements they need to be prepared to use their discretionary supervisory tools to buttress the rules that are in place. In the end, ensuring financial stability requires as much attention to supervision as it does to regulation. BIS central bankers’ speeches It is important to point out that in this regard the Australian Prudential Regulation Authority (APRA) has done a better job than many prudential authorities elsewhere. It has been able to combine a sensible approach to rule-making with a focus on the big picture. It has been assisted in this by the Reserve Bank with its broad responsibility for financial stability, and the coordination arrangements between APRA and the Reserve Bank have worked well. These arrangements are one of the factors that have supported Australia’s stable financial environment over recent times. “Not one cent of public money should ever again be put at risk” I would now like to turn to the second sentiment: that not one cent of public money should ever again be put at risk. Over recent times, there has been a noticeable swing in international forums against the idea that the public sector’s balance sheet has a role to play in dealing with financial stress. Many people find it difficult to accept the idea that the very same banks that caused the problems have been supported, either directly or indirectly, by the public sector’s balance sheet. A number of the regulatory proposals under consideration aim to ensure that this does not happen again. This response is entirely understandable, particularly where such support is seen to have benefited the management of a troubled bank and/or its shareholders. Societies rightly rail against the idea that those who were responsible for problems receive some benefit at the expense of the taxpayer. A better set of arrangements needs to be found, so that taxpayers are not always drawn into troubles in financial institutions. It would be a mistake, however, to reject completely the idea of the public sector using its balance sheet during a period of financial stress or crisis. Indeed, in some situations the public sector can play an important stabilising role. One example of this is where the central bank liquefies assets in a stressed environment. In a “first best” world, all assets are liquid; they can be bought and sold at any time at a fair price. The real world is clearly not like this. Markets are incomplete, information asymmetries exist and the technology supporting trading is sometimes expensive to put in place. So we are in world of second best, which is sub-optimal from a welfare perspective. Most of the time, this deviation from first best is probably not that costly. But in a stressed environment – when even high-quality assets cannot be bought and sold – it can become very costly. One way of ameliorating this departure from first best is for the central bank to use its balance sheet to liquefy assets in times of stress. It can do this by purchasing assets under a repurchase agreement with a conservative haircut. In doing so, it can provide liquidity when it is most highly valued, and do so with relatively little risk. This type of activity should not be viewed, a priori, as a bailout of the banks. Arguably, it is an efficient solution from society’s perspective to a potentially costly deviation from the first best world of complete markets. Central banks, by virtue of their ability to create money, are uniquely placed to deal with such situations. The alternative solution is for the private financial sector to self-insure fully against liquidity problems. If the objective is to maximise the welfare of the community – as it should be – it is far from clear that full self-insurance is the right policy. A second example of the public sector playing a stabilising role was provided during the 2008–09 financial crisis, when governments issued bank funding guarantees. During that period, risk aversion soared, capital markets shut down, and even the well-rated financial institutions found that they could not raise funding and provide critical financial intermediation services to the broader economy. BIS central bankers’ speeches These types of temporary surges in risk aversion can be very costly for society. At least in principle they can be ameliorated if there is an entity that has a stable risk appetite and that is prepared, and financially able, to play a stabilising role. This was what happened in Australia during the crisis, where the Australian Government was prepared to insure bank debt for a fee. The fee was considerably higher than what the market would have normally demanded for providing such insurance, but was substantially less than the near infinite fee that the market was then implicitly charging. There is a strong argument that the Australian taxpayer was well compensated for the risk that it undertook, with insurance premiums paid to date by financial institutions exceeding $4 billion, and no money has had to be paid out under the guarantee. A third example in which the public sector can play a stabilising role is through the government underwriting a capital injection for a troubled bank when a very risk-averse private sector is not prepared to do so. This example is of a distinctly different character than the other two and the threshold of action is higher. There may, however, be some very limited circumstances where it does make sense for the government to take an institution under public ownership before selling it again when the risk appetite of the private sector has returned to more normal levels. As the Scandinavian experience from a couple of decades ago illustrates, this type of policy can work. I want to emphasise, though, that I am not saying the Australian authorities would or should behave in a similar way, but rather that such a response should not be excluded from the potential toolkit. Importantly, if such a policy were to be used, then private shareholders of the troubled institution as well as its managers would need to be held to full account. The common element in each of these three examples is that the private sector has swung from relatively normal risk preferences to being temporarily very risk averse. In modern financial systems, these swings in risk aversion can be very costly. High levels of risk aversion mean that good assets cannot be bought and sold, that otherwise sound institutions cannot access funding markets and that investors are not prepared to purchase capital in banks. In these situations, the public sector, with its more stable risk preferences and its financial capacity, can play a stabilising role. There are obviously financial risks in doing this, but there are also potential benefits to the broader community. There are two main arguments against such involvement. The first is that financial institutions will change the way they operate if they think that the public sector will provide support, that these changes will make the system less stable. The second is that if the public sector is prepared to play the role of a countercyclical provider of liquidity, insurer or – in limited circumstances – capital, then there is the potential for this role to be misused. One way that this could happen is for support to be provided to avoid confronting problems in a financial institution, with the result that taxpayers take on additional risk. Both of these concerns are real and they need to be taken seriously. But these concerns should not rule out public sector support in some situations. Concerns about adversely changing behaviour can be addressed through ensuring that shareholders are not bailed out and that the managers of financial institutions are exposed to the downside as well as the upside. And governance arrangements can be put in place to address concerns about public decision-making. The critical question needs to be what set of policies best maximise social welfare, not what set of policies best minimise the risk of public sector involvement. It may be the case that the answers to these two questions are the same, but I suspect that there are circumstances where they are not. Once again, the challenge is to find the right balance. Where does this leave us? So where does this leave us? BIS central bankers’ speeches I am afraid that those who want a cast-iron guarantee that financial instability will never be allowed to return, or that the public sector will never have any risk exposure to the financial sector, are likely to be disappointed. Modern financial systems can be a force of great good. But they can be prone to bouts of instability. Attitudes to risk can change abruptly and willingness to extend credit and to trade assets can evaporate almost instantly. Over recent years we have seen too many examples of where investors seamlessly moved from seeing risk nowhere to seeing it everywhere. If we are to live up to the challenge of this conference – Global Financial Stability and Prosperity – we need to find a better way of dealing with these swings. First and foremost, this is a responsibility of the managers of financial institutions. But public policy also has an important role to play in designing a system that is strong enough to cope with these swings. A core set of prudential rules is obviously an important element here. But rules can never be enough. An understanding of how borrowers and investors are viewing risk and how their decisions are affecting the financial system as a whole is critically important. Also, we should not lose sight of the fact that the public sector – with its more stable risk appetite – has a balance sheet that can be used to play a stabilising role. Importantly, if this balance sheet is to be used, we need to be sure that it is done in a way that promotes the welfare of the community at large, rather than just the welfare of the owners and managers of financial institutions. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 7 |
Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Launch of Funding Australia's Future, The Australia Centre for Financial Studies, Sydney, 10 July 2013. | Guy Debelle: Funding Australia’s future Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Launch of Funding Australia’s Future, The Australia Centre for Financial Studies, Sydney, 10 July 2013. * * * Thanks to Chris Stewart for his help with these remarks. The Australian Centre for Financial Studies has put together a very interesting and timely body of work on an important topic.1 It is a good example of a collaborative effort that encompasses academic research with a very applied focus. The financial sector plays a unique role in the functioning of the economy. It acts as the intermediary between the myriad saving and spending decisions of households, businesses and government, both domestic and foreign. In doing so, it is unlike other parts of the economy. As I’ve said before, the financial sector is not at the end of a production chain producing something which directly generates utility for society.2 Rather, it is a critical link along the way, the oil that keeps the economy ticking over. When the oil dries up, the economic engine starts to malfunction and can ultimately grind to a halt. So in that sense, the set of papers that we have here tonight gets right to the heart of the issue of how well that oil is working and whether there’s any risk of it drying up in the future. There’s clearly been a lot going on in the global financial sector over the past few years. At various times, some channels of financial intermediation have actually seized up, much more so offshore than onshore. So the question at the heart of these set of papers is well worth posing. It is also very timely as the financial sector is still undergoing considerable change as it adjusts to the lessons learned from the turmoil of recent years and the regulatory changes that have come along with that. Today, I will try to give a quick overview of the work that has been done as part of this project, and talk a bit about where to from here. But the main point I would like to get across is that you should take the time to read each of these three papers. They each provide plenty of food for thought. Before getting to the papers individually, I’ll step back and talk about the project as a whole. The aims of the Funding Australia’s Future project are to: • assess the future demand for and supply of finance in Australia; • consider the interaction between different participants in the financial system; • identify the potential challenges facing the system; and • outline institutional or regulatory changes that might improve the operation of the system. That’s a fairly hefty agenda, as you can see. In looking at the papers, where I think they are the most useful is in providing a clear, wellarticulated framework to think about these issues. Such a framework has often been lacking in the debate that has gone on at various times over the past few years. <http://www.fundingaustraliasfuture.com> See Debelle G (2012), “Credo et Fido: Credit and Trust”, Deakin University's 2012 Richard Searby Oration, Melbourne, 25 September. BIS central bankers’ speeches Take one current example, which is on the G20 agenda, namely the “lack of infrastructure funding”. To answer this question appropriately, we need to know whether it is a problem for financing different stages of a project, what type of risk is holding any financing back, what type of institutions and instruments might help any shortfall, etc. But there needs to be a coherent framework in mind to be able to do this, and to know what are the right questions to be posing. The papers commissioned for Stage 1 of the project are designed to set the scene. I will give a brief summary of each of the main points I take away from the three papers. Kevin Davis’ paper, “Funding Australia’s Future: From Where Do We Begin?” provides an insightful overview on a number of topics. Let me give a brief disclaimer here. Kevin was my first macroeconomics lecturer at university back in the day, so I am very much in his debt for all he taught me about macro and monetary economics. • The first main point in Kevin’s paper is the identification of the ways in which the Australian financial system differs to other developed economies. • Second, it discusses the main consequences of the financial crisis for financial flows in Australia as well as some of the more fundamental forces influencing the longerterm evolution of the sector. • Lastly, it identifies some of the implications of these influences. For example, it links changes in the competitive advantage of banks in raising deposits to changes in the nature of the loan origination process, the length of the financial intermediation “chain”, and the overall cost of intermediation. Daniel Mulino’s paper, “Improving Australia’s Financial Infrastructure”, provides a comprehensive overview of what the Australian financial system does well and summarises current and prospective issues. • While Daniel notes that the sector performs well in supporting the economy, he argues there are a number of issues that are worth further exploration. In doing so, he highlights, for instance, the potential improvements to the payments system; the financing of greenfield infrastructure and high-risk innovation projects; and the arrangements around post-retirement savings products and the regulation around SMSFs. • Dr Mulino notes that in some areas, such as the payments system, there is already work underway by agencies including the RBA. In other areas, such as infrastructure funding, he notes that Australia is not alone in dealing with some of these challenges. Rodney Maddock and Peter Munckton’s paper, “The Future Demand and Supply of Finance”, considers the longer-term availability of funding for Australia’s economic growth, the composition of these funding flows, and the role of regulation in their determination. • As such, it sits between the other two papers in that it provides a longer-run analysis of the flow of funds in the economy – such as the domestic savings rate back to the 1870s – as well as a broader overview of the role of regulation on these flows. It also places a much greater emphasis on the flows within the system rather than the balance sheet structures. • Overall, it concludes that the demand for and supply of finance should align over coming years, although there are a number of factors that might alter this balance and hence the cost of intermediation. This last point is a particularly important one. The experience over the past few years in Australia shows that even in the most stressed of circumstances, the financial sector can often adapt and re-equilibrate to quite dramatic changes in circumstances. This might involve sizeable changes in prices, but it is important to look at things from a general equilibrium BIS central bankers’ speeches perspective, rather than analysing things in a partial manner. The financial system is very much a system, with a high degree of interconnectedness. A number of other general lessons can also be gathered from the papers. 1. As noted by Kevin Davis, the financial sector influences the amount of aggregate risk-taking in the economy, it affects how that risk is distributed, and in doing so can either amplify or moderate the effects of shocks to the system. 2. The structure and activities of the financial sector are the outcome of numerous forces over long periods of time. 3. Looking at aggregate information, or one aspect in isolation, can often be misleading. This is true when we are looking at the capital flows into and out of Australia. The net flows, which are often the focus of analysis, conceal a lot of important information that is only evident if you look at the gross flows.3 Another example is thinking about the financing of the corporate sector, where the preference for debt versus equity funding varies considerably depending on the nature and size of the business. Just looking at bond and equity financing in aggregate again conceals much of the interesting information. 4. Stocks matter at least as much as flows. Just as a disproportionate amount of analysis is partial rather than general, stocks are very often neglected in favour of flows, as on the price side, are levels rather than rates of change. 5. The financial system is always evolving – in both cyclical and structural senses. 6. – In terms of cyclical aspects, financial institutions currently have a better appreciation of liquidity risk than they did six years ago. But if history is any guide, at some point in the future, that appreciation is likely to wane; for example, the lessons from the runs on some deposit-taking institutions and trusts in the early 1990s or the concerns about liquidity in Sydney’s early days as a colony (there aren’t too many around in the financial sector today who remember that). – The financial system is also continuously evolving in a structural sense. There are a large array of financial products that simply didn’t exist two decades ago. In some cases, their arrival has not always been a good thing. In other cases, such as that of asset-backed securities, or going back a bit further, junk bonds, a new product arrived, the market grew too fast too quickly resulting in considerable dislocation, before settling down to be an important, but much smaller part of the financial landscape. The factors driving evolution are sometimes very similar over the decades, while some factors fade in importance and new drivers emerge. – The increasing size of superannuation funds has played an important role in influencing the shape of the financial sector in Australia for the past couple of decades, and given its current size, is likely to continue to do so for the foreseeable future. – Likewise, government financing arrangements, banking regulations and banks’ liquid asset holdings continue to be strongly related. – In contrast, unlike the 1990s, we no longer talk about how life insurance offices’ mortgage lending activities might return to their 1950s and 1960s levels of importance. See, for example, Debelle G (2013), “Funding the Resources Investment Boom”, Address to the Melbourne Institute Public Economic Forum, Canberra, 16 April. BIS central bankers’ speeches 7. 8. More generally, how the system evolves to these forces is impossible to fully comprehend ahead of time. – Twenty years ago, for example, it would have been very hard to see exactly how the competitive dynamics would play out in the banking sector. In the housing loan market, discounts became increasingly common (and larger) while in the credit card market banks initially competed through loyalty programs rather than through lower interest rates. – Furthermore, there was a view in the mid 1990s that a rapid expansion in the debt market could be driven by the growth of superannuation funds, but it was unclear whether any disintermediation would be most pronounced in the corporate bond or mortgage markets. – Likewise, while people understood that new distribution methods in the banking sector were likely to evolve, few people would have appreciated the move from ATMs and telephone banking to internet banking and banking on our mobile phones. – This reflects the fact that technology progresses in ways that we can’t imagine. – Differences in incentives and the starting position of market participants matter a lot in terms of behaviours and subsequent developments. – Society’s attitudes towards efficiency and risk evolve and are very much shaped by the course of history. Someone born in the Depression had a different attitude to risk than a baby boomer who in turn probably has a different attitude to risk than someone gaining financial literacy in the current environment. A key consequence of this last point is that the industry and regulators have to ensure that institutions are resilient to short-run shocks but are able to adjust to longer-run secular trends with adequate consideration for both competition and financial system stability. With these three papers providing a sound foundation, where to now? Just as there are differences in opinions on some of the issues raised in these papers, there will also be different views about how to prioritise these areas for the next stage of the review. But as I said earlier, I think one of the most useful outcomes of the work to date is the articulation of a coherent framework with which to consider the question. That said, I think one of the key areas that requires more work is one which is very much in a state of flux at the moment, namely the implementation of the vast regulatory reform agenda. A holistic view of how the Australian and global financial system is being transformed by this would be very welcome and is much needed. Finally, a particularly useful outcome of this project is the bringing together of many of the key participants in the sector to discuss the issues and providing a fruitful forum with which to do so. I thank the ACFS for the efforts in coordinating the work and wish the participants luck in this regard as well as again commending the amount of work already accomplished. As I said earlier, my main recommendation is that you spare the time to read these three papers. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 7 |
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, 30 July 2013. | Glenn Stevens: Economic policy after the booms 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, 30 July 2013. * * * Thank you for coming out to support the Anika Foundation1 once again. This annual occasion is one of our key fundraising events and your generosity is greatly appreciated. Today would not be possible without the support of The Australian Business Economists and the Macquarie Securities Group, and so on behalf of the Board of the Anika Foundation, I thank them for their continuing contribution to combating adolescent depression and suicide. Introduction We have for the past five years or so lived in “interesting times”. The shocks to which the economy has been subject have had larger magnitudes than had been the case during “the great moderation”. The world economy, our terms of trade and the international availability of credit have been a good deal more variable since 2007. For example, the variability of world GDP has roughly doubled – compared with that in the decade or so prior to 2007 – while the volatility of Australia’s terms of trade has, on some metrics, quadrupled. In response, our interest rates and exchange rate have also been more variable. There hasn’t been much additional variation, though, in the real economy or the rate of unemployment. Depending on your preferred measure, the variability of real GDP has either increased a little, or declined slightly; a similar story holds for the unemployment rate. There was a pronounced cycle in inflation, peaking in 2008, but since then inflation has been much better behaved. This suggests that the various policy responses and the economy’s own adjustment capacity have generally been working as they should towards stabilising overall outcomes, in the face of the much bigger external shocks we have faced. That said, achieving the sort of growth we aspire to has become more difficult. Average output growth has been lower over the past five years in Australia, as it has in all other advanced economies. Moreover, the challenges ahead are substantial and will require the appropriate responses. In shaping those responses, we need to be sure to draw the right conclusions and lessons from the experiences of recent years. In that vein, as I offer some remarks about the period ahead, I will also draw on those conclusions from recent history that seem pertinent. In so doing I shall be reiterating some themes I have touched on before, including at earlier lunches in this series. The resources boom It is now well understood that the “mining boom” is shifting gear, and that we are entering a new phase. The story of the boom has always had three phases.2 In the first phase, commodity prices rose to very high levels. As a result, Australia’s terms of trade rose to levels not seen in a very long time. These prices had a hiatus in 2009 with the global downturn but resumed their upward trend quite quickly. See Anika Foundation. See Stevens G (2012), “Producing Prosperity”, RBA Bulletin, December pp 81–87. BIS central bankers’ speeches In historical context, the high prices have been quite persistent.3 This led to the second phase, in which resource producers ramped up their investment to take advantage of demand for raw materials, in particular iron ore and natural gas, and to a lesser extent coal. Resource sector investment rose from an average of about 2 per cent of GDP, where it had spent most of the previous 50 years, to peak at about 8 per cent. That big rise is now over, and a fall is in prospect, with uncertain timing. It could be quite a big fall in due course. The third phase is now under way, in which we will see investment spending fall back, but a lift in volumes shipped of the various commodities. The latter has already started – for iron ore, volumes are rising at about 15 per cent per year – but shipments will probably increase further yet for some time and then stay high. Shipments of natural gas will not start increasing strongly until 2015, and will probably have several years of very strong growth, and then remain high for a few decades. In that third phase, real GDP will get a lift. National income measured in current dollars will also get a lift from the higher volumes, but that is likely to be offset in part, at least, by lower prices. The lift in real GDP coming from this rise in exports will be driven more by higher output per person; in fact, the level of employment needed to extract and ship the materials will be less than the level needed to build the capacity to do so. Let’s be clear that Australians will continue to benefit from the higher level of resources output for a very long time. There has been a large lift in the global demand for natural resources that our country happens to have in abundance. Most people agree that the rate of growth of that demand will be lower in future than it has been in recent years; some say much lower. But the lift in the level of demand we have already seen is permanent enough, and large enough, to have a quite persistent effect on our economy. Australian production is meeting much of the additional global demand for iron ore and, prospectively, natural gas. This will be at prices that, although lower than prices observed today, are likely to be higher than the average seen for many years up to the middle of the past decade. Even allowing for the high degree of foreign ownership in the resources sector, flows of income accruing to Australians, through a few different channels, will be high over a long period. The end of the second phase, the investment phase, of the boom is nonetheless quite a challenging time. The investment spending by the resources sector will no longer be adding to growth in demand in Australia. In due course it will, instead, be subtracting from it. To be sure, a significant part of that investment spend has been supplied by imports, and to that extent its decline will affect imports rather than domestic production. But even allowing for that, there has still been substantial demand for Australian product and labour from the resources sector, which appears likely to abate over the years ahead. Since we wish to see aggregate demand in the economy sufficient to utilise the productive resources of labour and capital that we have, this means that we would like to see a “rotation” to other sorts of demand as the resources sector demand slows. The “post boom” growth story of the economy would desirably involve stronger expansion in some other sectors, including those that have seen weaker than normal conditions in the past couple of years. It is reasonable to expect that there will be some pick-up in these other areas, for reasons I have outlined elsewhere.4 In brief, business capital spending outside the resources sector has been subdued; housing investment likewise has been on the low side. There is ample scope for both to rise. This is by no means a certainty though and while there are signs of an At this point the terms of trade have fallen by 15 per cent since the 2011 peak (back to their 2008 peak!). Assuming a further fall of 15 per cent over the next few years, the terms of trade will still have a 10-year average level 50 per cent higher than the 20th century average. Stevens G (2013), “Economic Conditions and Prospects”, Address to the Economic Society of Australia (Queensland) 2013 Business Luncheon, Brisbane, July. BIS central bankers’ speeches increase in dwelling investment getting under way, a stronger trend in non-resources business investment looks like it is a while off yet. For a benign outcome to occur, a few things need to be in place. Reasonable global growth outcomes obviously would be a major help. At this stage global growth is sub-par, though not disastrous, with most forecasters saying next year will be better. Most of them quickly add a long list of things that could go wrong. There is nothing we can do about that. The second condition, which we can do something about, is that macroeconomic policy settings need to be appropriate. Fiscal policy is in consolidation mode, and that seems broadly appropriate. Monetary policy is, by historical metrics at least, very accommodative. The exchange rate has also declined since its recent highs, and doubts about whether it will play its normal role as a shock absorber have lessened of late. A third condition is that Australian businesses need to be internationally competitive. The exchange rate is helping here but productivity and cost performance will also be key. On these fronts, I think firms have stepped up their efforts considerably. This combination is a necessary, though not in itself sufficient, set of conditions for the sort of demand rotation likely to be necessary. The fourth ingredient is “confidence”. It is somewhat concerning that the business community’s confidence has been quite subdued in recent times. To the extent that substantial structural change has been occurring, and there is inevitable uncertainty over the international outlook, it is quite understandable that some business segments have found the going hard and don’t feel very confident. Moreover, the phase shift of the mining boom itself is dampening confidence in some areas. That said, it would be good if there was a bit more confidence in the business community about the future. Unfortunately, it is not a straightforward thing to turn sentiment around. There’s no such thing as the “confidence policy lever”. Rather, we have to rely on: clarity of policy frameworks and objectives; consistent application of policies towards well-understood goals; and, attention to avoiding things that can dampen confidence unnecessarily. All the more reason, then, to make sure that the accretion of regulatory actions being undertaken does not inadvertently make it harder for businesses to plan with confidence, to achieve better cost and productivity performance, or to take a chance on a new product, a new investment or a new worker. In the case of households, according to surveys sentiment is neither particularly weak nor particularly strong at present. It is reasonable to expect that households will play a role in driving demand over the years ahead – and in due course that will help to lift business confidence. But in thinking about that role we need to understand the ways in which household behaviour has changed. The credit boom The title of this talk, “Economic Policy after the Booms”, uses the plural quite deliberately. There were two “booms”. Before the mining boom, or at least before its full flowering from about the middle of last decade, there was an earlier boom. It was global, but Australians took part in it. I am referring of course to a boom in credit, which saw a very significant increase in borrowing by households in particular, and a rise in asset values, especially dwellings. This was associated with a lengthy period of unusually strong growth in consumption. BIS central bankers’ speeches This boom did not end in Australia as painfully as it did in some other places, but end it did. Consider two charts I showed at the Anika Foundation lunch two years ago in July 2011. These have been updated, and use revised data.5 Graph 1 Graph 2 The level of household financial assets from June 2002 has been revised almost 15 per cent higher on average, predominantly reflecting upward revisions to estimates of households' holdings of unlisted equity. As a result, the debt-to-assets ratio has been revised lower by 0.8 percentage points on average. Trend growth in household assets was also revised slightly lower. In contrast, growth in household disposable income was revised slightly higher, leading to a small upward revision in the saving ratio in the 2000s. BIS central bankers’ speeches It is even clearer now than it was two years ago that the behaviour of households has changed in a very important way. Real consumption per person had risen faster than real income per person for 30 years, from the mid 1970s until about 2005. (Only the last third of that period is shown here.) That changed some years ago now, and after a noticeable fall in consumption in late 2008 and early 2009, spending and income have grown roughly on parallel tracks. Since 2009, trend growth in per capita consumption has been about 1.4 per cent per annum, half what it had been from 1995 to 2005. One contributing factor is seen in the second of the two charts, where it’s clear why people’s sense of wealth has not been rising at anything like the pace that it had been up until the financial crisis. Financial assets have begun to grow again, since the share market has risen over the past year and households have also accumulated other financial assets such as deposits. But the value of non-financial assets in particular – mainly dwellings – is lower today in real per person terms than it was five years ago. Total assets per person have risen at a pace of 2½ per cent in real terms since the middle of 2009, which is much slower than in the preceding decade, and even a bit slower than in the period 1975–1994. The slowdown in asset values has been associated with a lift in saving and a slower path for consumption, which has had important implications for the economy. The table below suggests that slower consumption growth is prominent in explaining the slower pace of overall demand growth and output since the middle of 2007. Table 1: Contributions to Australian GDP Growth* Per cent per annum 1995–mid 2007 mid 2007–2013 Domestic Final Demand Consumption Business Investment Mining Other Industries Dwelling Investment Public Demand Gross National Expenditure Net exports GDP 4.1 2.3 1.1 0.3 0.9 0.2 0.9 4.0 −0.2 3.7 2.9 1.4 1.1 1.0 0.1 0.0 0.6 2.8 −0.2 2.5 (*) Components are not additive given nature of the chain-volume series. Sources: ABS; RBA One’s assessment of prospects for consumption will be driven mainly by one’s assessment of the outlook for income, but will also be affected by expectations about asset values and in particular one’s view on whether housing prices are overvalued. Those who think they are will be drawn to the conclusion that a number of additional years of flat or declining real per capita asset values lie ahead, for non-financial assets at least; those who are not so worried about housing prices may expect that stronger growth, in real per capita terms, might occur. Either way, however, it would seem unlikely that we could bank on a resumption of sustained growth in assets, in real per person terms, of 7 per cent per year over the next few years. It follows that the saving rate is unlikely, any time soon, to decline back to where it was in 2005. Average saving rates well above that earlier level seem more likely for some time, even though there will presumably be cyclical ups and downs. While current saving rates have been described as “high”, a look at longer-run history suggests that “normal” would be a better description. BIS central bankers’ speeches Implications that might flow from these observations would include the following. First, some strengthening in consumption from recent rather subdued growth rates is a reasonable expectation, but we should not expect a return to the sorts of growth seen in the 1995–2007 period. Nor, surely, should we try to engineer one, at least on the back of borrowing. Households continue to service their borrowings well – the household arrears rate is low and has fallen slightly over the past year – but we would be risking future problems were we to see a big run-up in debt from here. This does not preclude prudent levels of borrowing by new entrants to the housing market, or by investors, nor does it preclude gains to consumers as costs are squeezed out of the system. It doesn’t mean that consumers won’t respond with their customary alacrity to new products offered at attractive prices. Trend changes in habits – more consumption of services and “experiences”, more online shopping and so on – will presumably continue. Moreover, factors that lift disposable incomes – such as higher real earnings on the back of productivity improvements, or sustainable reductions in taxes – could be expected to lift consumption on a sustainable basis. But we are unlikely to see a return to the earlier boom conditions. Second, all other things equal, interest rates are likely to be lower in such a world than they were in a world in which households were extending their finances. This is a global phenomenon, but it holds in Australia too. A higher desired rate of saving ex ante means that the return to saving will, other things equal, be at a lower level as the market clears. Those who have long been savers no doubt feel aggrieved that the returns they have earlier enjoyed cannot be found as easily now. That is in large part because other savers have joined them and the market prices reflect that. Having said that, it is still possible to earn a gross interest rate on a bank deposit that is a bit above the inflation rate. Third, a desire to hold savings in a less risky form means that the yield give-up to hold a safer asset is larger. The way this is usually expressed is that lower risk appetite, or perhaps more accurate assessment of risk that was there all along, means risk spreads are higher. Spreads are well down on their peaks reached at the height of risk aversion a few years ago, but do seem to have settled at a higher level than in the mid 2000s. Absolute borrowing costs for most borrowers are very low despite higher spreads, because the return on one of the least risky assets – the cash rate – is the lowest for 50 years or more. The market yields on government securities, the lowest risk assets of all, have likewise been very low. In other words, with many investors wanting safety, the price of safety has risen. It has to rise by enough to prompt at least some people to start to shift their portfolios in the direction of taking some more risk – by holding equities, physical assets and so on, though obviously we don’t want too much risk-taking. One of the things we have been watching for as we have been reducing interest rates has been an indication of savers shifting portfolios towards some of the slightly more risky asset classes, as that is one of the expected and intended effects of monetary policy easing. There are clearly signs of policy working in this respect, though not, to date, by so much that we see a serious impediment to further easing, were that to be appropriate from an overall macroeconomic point of view. Policy after the booms In the third phase of the “mining boom” and post the credit boom, our economic challenges are changing in nature. In the next few years our task will involve supporting, so far as it is in our power, a change in the sources of demand that affect the economy. As resources sector investment declines, other sources of demand need to strengthen, but in a way that is sustainable. The fact that consumption is likely to provide only a modest impetus to any acceleration in domestic demand suggests that other areas will be important. As I noted earlier, at least some of the conditions are in place for stronger trends in dwelling investment and, in time, non-resources business capital expenditure. And exports of resources will continue to pick up strongly. BIS central bankers’ speeches But successful “rotation” of demand will probably also involve more net foreign demand for other Australian output of various kinds. Given that, the recent decline in the exchange rate seems to make sense from a macroeconomic perspective. It would not be a major surprise if a further decline occurred over time, though of course events elsewhere in the world will also have a bearing on that particular price. The conduct of monetary policy must, and does, take account of the various features of the environment we face. Calibrations drawn from an earlier part of history can’t be assumed to have the same reliability. Elements of the monetary policy transmission process are probably working somewhat differently than on other occasions. To take one example, the fact that policies in major economies have been at very unusual, or extreme, settings for some time is a complication because of the potential effects on the exchange rate – though, as noted, the exchange rate appears to have been behaving more normally of late. The fact that the rest of the world has had such low interest rates, that the desire for safe assets has been so strong, that the spreads between the cash rate and the rates that matter most for the economy have widened, and that people have sought to get to a position of lower leverage – all these have been important in explaining why the cash rate has been so low compared with what we had been used to until the mid 2000s. That this has occurred while we have had the peak of the resources investment boom is all the more remarkable. This has been guided by the flexible inflation targeting framework we have had in place for 20 years now. This framework has prompted appropriate and timely action when needed. It has seen a substantial easing in monetary policy since late 2011. We have been saying recently that the inflation outlook may afford some scope to ease policy further if needed to support demand. The recent inflation data do not appear to have shifted that assessment. More generally, the credible and sensible approach to policies is: to keep our eyes on the main objectives; to preserve sound frameworks; to act consistently with these frameworks and in ways that support confidence; and, to keep looking for ways to enhance the flexibility the economy itself has demonstrated in adjusting to the shocks of recent years. Failure to do this would be costly. But the rewards from consistent application of good policies are known, from our own experience, to be big, even if not immediate. Remembering that is the challenge we face. Thank you once again for coming along today. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 7 |
Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Funding Australia's Future Forum, Sydney, 7 August 2013. | Guy Debelle: Remarks at the Funding Australia’s Future Forum – a look at Australia’s financial system Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Funding Australia’s Future Forum, Sydney, 7 August 2013. * * * As I said at the launch of these papers a few weeks back1, the Australian Centre for Financial Studies (ACFS)2 has put together a very interesting and timely body of work on an important topic. I will make two points, the first about global financial regulation, the second about the way forward for this project. At the launch I talked about the need for a holistic review of global financial regulation. I think this does need to be done at a global level. There is a vast global regulatory reform agenda which is complex and interacting in a number of different ways. We need a better understanding of how some of these interactions occur. As I said before, each of these regulatory changes may well make sense in their own right, and when looked at in terms of their impact on their own particular market segment. I just don’t get the sense that we have a good idea on how they will all interact and affect market functioning. One good example of this is in the demand for collateral. Quite a number of the global reforms require banks, as well as others, to hold more high quality collateral than they did in the past. The shift to central clearing is one such reform. In a number of cases, margin has always been posted, but depending on how the shift to central clearing actually occurs, we may or may not get all the benefit of netting which would mean a greater demand for collateral. Then there are some transactions on which margin has not previously been required. The sort of collateral which can actually be posted is also changing. The liquidity reforms under Basel III also imply a material increase in demand for High Quality Liquid Assets (HQLA). I’ll have some more to say on that in the Australian context next week. The bottom line is that demand for HQLA is going up. As it so happens, this is occurring at a time where the supply is also going up quite a bit, given the fiscal situation around the globe. So how is that greater demand for collateral going to play out? What are the implications? Is it just an issue of price working to clear the market or will there be impacts on market functioning? The BIS Committee on Global Financial Stability3, on which I sit, has published some work on that recently, but there is more to be done. This is just one example where we don’t really know the full implications of the many interacting reforms underway. That said, what I am not saying is that we should delay implementing some of these reforms in Australia, or pick and choose the ones the financial sector likes. I do not agree with that. We do not have that luxury. As the papers we are discussing today highlight, the Australian system is part of the global financial system. The capital inflows are sourced from the global financial system. Given that, we don’t have the option to opt out when we feel like it. Remarks at the Launch of Funding Australia’s Future – 10 July 201. http://www.australiancentre.com.au/. http://www.bis.org/publ/cgfs49.htm. BIS central bankers’ speeches The second point I’d like to make gets right to the heart of the ACFS’ agenda: Funding Australia’s Future. It’s a good question to ask. But I suppose I’m not sure how much further we can go with it. The Australian financial system has undergone a severe stress test over the past five or six years. And it has come through that pretty well. Are there some things that can be done to make it function better and be more resilient? Yes, and some of them have already been put in train over the past few years, so that the system now is more resilient than it was in 2007. Some of them are the reforms that are being done at the global level. The fact that the problems didn’t happen here is also not a good argument for not implementing them. The reforms have been developed with the aim of increasing the resiliency of the financial system, which would seem to make them worthwhile in their own right. I don’t see the logic in not learning from what happened elsewhere rather than waiting to learn the lesson painfully ourselves. Learning from others’ mistakes is a lot less painful approach to life. As the past few years show, the financial system is just that, a system, as Rod Maddock and Peter Munckton’s paper highlights. It is also a set of markets where there is demand and supply and a market-clearing price. As the system evolves and is stressed in different parts, other parts of the system adjust. As supply and demand changes, the price adjusts. Does this always happen seamlessly or painlessly? No. But broadly speaking, the stress test of the past few years shows that it does happen. There were a lot of people worrying throughout that period about where the funding would come from. But in the event, the system broadly speaking coped. The system here didn’t fail, and that is an important point to keep in mind in this whole exercise. Prices did adjust. The exchange rate in 2008 was one of them. Deposit pricing was another. Do markets always get this right? No they don’t, but it’s not clear what the better alternative is. Regulation is motivated at least in part to address some of those deficiencies of markets. Is regulation always going to get it right? Clearly not. So that’s why we need to keep on questioning the appropriateness of the structure of financial markets and their regulation. It’s good to be asking the question in an environment when the system hasn’t failed rather than when it has, as is the case in other countries. And that I see as the value of the work the ACFS is doing, namely asking the question, is the system working as well as it can? In particular, talking about the system, as Rod and Peter do. In terms of the way forward, Kevin Davis had a slide in his presentation which basically mapped the path out. What are the broad structural forces shaping the financial system in the years ahead. Do we want those structural forces to play out? Are they well founded or are they the result of some distortion in the system? So in a nutshell: think about the system, think about the broad structural forces. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 8 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Financial Markets Association (AFMA) and Reserve Bank of Australia (RBA) Briefing, Sydney, 16 August 2013. | Guy Debelle: The impact of payments system and prudential reforms on the Reserve Bank of Australia’s provision of liquidity Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Financial Markets Association (AFMA) and Reserve Bank of Australia (RBA) Briefing, Sydney, 16 August 2013. * * * This speech was co-authored with Matt Boge. Today, I wish to talk about several important changes that will be made to the framework under which the Reserve Bank operates in domestic financial markets. These changes will be introduced at different points during the next 18 months and will have significant implications for the size of the Reserve Bank’s balance sheet and the way in which the Bank provides liquidity to financial institutions. The primary purpose of the Bank’s operating framework is to implement the monetary policy decisions of the Reserve Bank Board. As you would be aware, the Board states its policy stance in terms of a target for the cash rate. To be precise, it’s the rate on overnight unsecured loans between authorised deposit-taking institutions (ADIs). While the Board has been announcing targets for the cash rate since 1990, the Bank’s operating framework has continued to evolve over this time, although the underlying principles haven’t changed. To a large extent, these modifications have been prompted by the need to accommodate structural changes within markets, such as the end of the arrangements for Authorised Money Market Dealers in the mid-1990s and the reduced supply of government bonds during the following decade. In responding to these developments, the Bank has been guided by the need for its operating framework to enable the Bank to meet the Board’s cash rate target and to facilitate the most effective transmission of those policy decisions to the prices of financial assets more broadly, and ultimately, to the real economy. With that in mind, during the global financial crisis, when different segments of financial markets became impaired to varying degrees, the Bank modified several aspects of its operating framework. Some of these changes were only temporary and were discontinued after markets stabilised, such as offering term deposits and US dollar repos to domestic financial institutions. Other changes have been permanent, such as broadening the range of securities that are eligible for the Bank’s repurchase transactions. The Bank’s operating framework has also needed to adapt to changes in the payments system, such as the shift to real-time gross settlement in the late 1990s and the settlement of the Australian dollar leg of foreign currency transactions via CLS Bank a few years after that. Going forward, further innovations to the payments system as well as the introduction of the Basel III liquidity reforms will require more changes to be made. Before describing these changes, it is worth recapping what the core features of the Bank’s operating framework are. Essentially, the Bank seeks to control the supply of settlement funds that ADIs use to meet their payment obligations, so that the rate at which ADIs borrow and lend these funds to each other is equal to the Board’s target for the cash rate. To create the incentive for exchange settlement (ES) account holders to participate in the overnight cash market, the Bank pays account holders 25 basis points below the cash rate target on their end-of-day balances. On the other side, a penalty rate of 25 basis points above the cash rate is charged if an ADI needs to borrow overnight from the Reserve Bank to ensure its ES balance is positive. Together, these rates comprise the 50 basis point interest rate “corridor” that the Bank uses to guide the cash rate to the Board’s target. BIS central bankers’ speeches As payments to and from the Reserve Bank (or its clients) are constantly changing the supply of exchange settlement funds, each day the Bank will transact in the market to maintain the appropriate supply of funds.1 These transactions are almost always repos; that is, the Bank’s counterparty agrees to repurchase the security it has sold to the Bank at some future date. This framework has been successful in achieving its objectives: the interbank cash market is quite active, with usually around $5 billion transacted each day;2 the cash rate consistently trades at the Board’s target; and changes in the cash rate pass through rapidly to the overall rate structure within the domestic market. Given that background, I’ll now turn to the forthcoming changes to the payments system and liquidity regulations and explain what they are likely to mean for the demand for ES balances. At the present time, the demand for ES balances is generally low as ADIs seek to minimise their balances, subject to the constraint that they must be positive. Although ES funds are a risk-free investment, the 25 basis point spread to the cash rate is usually wide enough to discourage ADIs from using them as a store of liquidity. During periods of financial turmoil, that can change. Between 2007 and 2009, the amount of ES funds rose as ADIs became increasingly risk averse and sought to hold larger precautionary balances at the central bank, which the Reserve Bank accommodated with increased supply (Graph 1).3,4 However, for the past three years or so, aggregate ES balances at the end of each day has usually only been around $1 billion, a very small component of the Reserve Bank’s liabilities and of ADIs’ liquid assets. Graph 1 See Baker A and D Jacobs (2010), “Domestic Market Operations and Liquidity Forecasting”, RBA Bulletin, December, pp 37–43. The data on activity in the cash market can be found on the RBA website in Statistical Table F1. See Debelle G (2010), “The Evolving Financial Situation”, Address to the Women in Finance Lunch, Sydney, 16 February. A recent report by a study group that I chaired, “Central Bank Collateral Frameworks and Practices” published by the Markets Committee at the BIS, documents a similar phenomenon globally over this period. The report also highlights the interesting point that banks globally did not generally present the cheapest to deliver collateral to access central bank liquidity over the course of the crisis. This is relevant to the sort of changes that I am talking about in this speech and it will be interesting to see if something similar occurs here. BIS central bankers’ speeches As payments arrangements evolve in the coming years, the demand for ES funds will rise significantly. As you might be aware, the Payments System Board last year established a number of strategic objectives for the payments system, including improving the process for settling electronic “direct entry” (DE) payments. The direct entry system is used very widely, such as for salary payments, the payment of Centrelink benefits, “Pay Anyone” internet transfers and for many dividend payments. While most individual direct credit and direct debit transfers are quite low in value, the total value of such payments averages more than $40 billion per day. At present, like most low-value payments, direct entry payments are not settled on the same day that the details of the transaction are exchanged between financial institutions. DE payments are settled in one batch at 9 am on the following business day. From November this year, DE payments will be able to be settled for same-day value, albeit still in batches. While this should be of great benefit to financial institutions and their customers, some of these settlements will be taking place outside of normal banking hours (Figure 1). Furthermore, at the time the interbank cash market closes at the end of the day, ADIs will not know the size of these payments (or receipts) that they will need to settle later that evening. Potentially, these payments could be quite large. Figure 1 To be assured of having sufficient funds with which to meet payments throughout the evening, ADIs directly involved in the DE exchanges will each need to retain higher balances in their ES account. From November, the Reserve Bank expects ES balances to increase from their current level of $1 billion to be between $20 and $30 billion on an ongoing basis. This is designed to ensure that payments made after the close of the day don’t result in ADIs facing negative ES balances and hence being unable to make the payments. The size of these balances has been calculated by examining the largest payment obligations that have arisen from these later batches in recent times and providing a buffer above that. The size will be reviewed regularly as we see how the payments patterns evolve after November. The Bank will manage this expansion in its balance sheet through its existing liquidity facility for ES account holders. Unlike open market operations (which are conducted by auction), repos via the Bank’s liquidity facility are made available to ES account holders on pre-specified terms. At the present time, ES account holders usually only access this facility for intraday funding; repos used for this purpose carry no interest charge. During the course of a normal day, the pool of ES balances (and therefore the size of the Bank’s balance sheet) tends to expand by around $10 to $15 billion as ADIs use intraday repos to give them the capacity to make payments before the settlement of incoming funds. By the end of each day, BIS central bankers’ speeches these repos are unwound. On the very rare occasions that such repos are carried over to the next day, a penalty interest rate 25 basis points above the cash rate target applies. From November, the Bank will allow ES account holders to access a pre-determined amount of funds through its liquidity facility on an “open” basis; open repos are those contracted without an agreed maturity date. The interest rate on these open repos will be set at the cash rate target. At the same time, the Reserve Bank will change the way that interest on ES balances is calculated. To the extent that account holders retain matching funds against their open repo position, those ES balances will earn the cash rate rather than 25 basis points below. Hence while these changes will increase the size of the Bank’s balance sheet, they won’t change the net income the Bank earns. In net terms then, there need be no cost to holding an open repo position. However, as is the case currently, surplus ES funds, that is, funds held in excess of an open repo position, will earn a rate 25 basis points below the cash rate target. Similarly, any shortfall in funds below the account holder’s open repo position will incur a 25 basis point penalty. An allowance will be made for variations in ES balances arising from direct entry payments that settle during the evening. This arrangement will not only provide the means for ADIs to hold sufficient liquidity to complete their payments throughout the evening, it also preserves the incentive for ADIs to participate in the interbank cash market while it is open, lending surplus balances or borrowing against a shortfall. We would expect the “excess” supply of ES balances to be much as it is now, around $1 billion above the sum of outstanding positions in open repos. Consequently, these operational changes will not alter the way in which the Bank implements monetary policy, as the operation of the cash market will be insulated from the structural increase in ES balances. This framework leaves us well placed to accommodate further innovations in the payments system in the coming years, such as the planned shift to 24/7 settlement for retail payments. One consequence of the new arrangements is that it will largely remove the need for an ES account holder to contract intraday repos with the Reserve Bank. For this reason, the Bank will allow all ADIs that operate ES accounts to contract open repos, not just those participating in the direct entry exchanges. Despite the operational changes the Bank is making, we nevertheless recognise that shifting a large quantity of payments activity to same-day settlement will complicate the task of liquidity managers. It is always difficult to forecast customers’ payments activity; this is not only true for ADIs, it is also true for the Reserve Bank. The size of the Reserve Bank’s daily open market operations each morning are largely based on a forecast of that day’s cash flows across the Australian Government’s accounts with the Reserve Bank. Settling direct entry payments for same-day value will make it more difficult to forecast flows such as tax receipts. It may be that the Reserve Bank will need to conduct operations in the open market late in the day to address any unexpected payment flows and ensure the right amount of settlement funds are in the banking system to allow the cash market to function appropriately. In the past, the Bank has needed to resort to these “second rounds” of dealing only two or three times a year. Going forward, we anticipate that second rounds of dealing will be more frequent. Given this, we intend to formalise the arrangements for these operations, announcing at a set time each day whether further open market operations will be conducted and, if so, on what terms. Where there is a need for an operation, it will be important that there is active participation from ADIs. As with our regular open market operations, it will not be the Bank’s aim to simply supply overnight funds to those individual institutions that are short, or absorb overnight funds from those that are long cash. That is what the interbank cash market is for. As I mentioned a minute ago, the Reserve Bank’s operations are designed to put the appropriate amount of BIS central bankers’ speeches settlement funds in the system as a whole so that, in managing their individual ES accounts, ADIs will transact with each other at the cash rate target. I’ll now turn to the Basel III liquidity reforms, which will be introduced in Australia from January 2015. As is well known, those ADIs to which APRA applies the Basel III liquidity standard will be required to hold enough high-quality liquid assets (HQLA) to withstand a 30-day period of stress. As is equally well known, with only Commonwealth Government Securities (CGS) and semi-government securities (semis) meeting the Basel criteria for HQLA in the domestic securities market, there will not be enough securities to enable ADIs to meet this liquidity standard. At the present time, ADIs own around $130 billion of these securities. A rough estimate would be that this is as much as $300 billion short of where they would need to be to meet the Basel standard, given their current balance sheet structures. Mostly, the ADIs’ holdings are in semis. These holdings of semis have increased almost tenfold since 2007, and now are around 40 per cent of the semi-government market. Our assessment is that ADIs’ aggregate holdings of HQLA are broadly appropriate to the current size of the market. This assessment was contained in a media release put out by APRA last week.5 Should the supply of these securities increase further, as is currently projected, we would expect that ADIs would raise their holdings in line with the increased supply. That said, it is not possible or desirable to be too precise about what is appropriate. The aim is to ensure that the markets for government securities continue to function well. We don’t want to find out the hard way that ADIs are holding too large a share of the market. Compelling ADIs to hold the entire supply of government debt would be counterproductive for the liquidity of these markets. It would defeat the purpose of the liquidity standards which is for banks to hold liquid assets. Notwithstanding that fundamental issue, it would be difficult to actually engineer such an outcome. At some point, the scarcity of available securities would cause their yields to fall to a particularly low level. To some extent this is already the case with CGS, which generally trade in Australia at an expensive price compared to sovereign debt in other jurisdictions.6 If it was the case that the yields on both CGS and semis fell to a particularly low level, this would raise the demand for ES balances, given these balances are also HQLA. While the rate paid on “surplus” ES balances – 25 basis points below the cash rate – generally means that ADIs don’t hold them as a store of liquidity, in the absence of sufficiently attractive alternatives, ADIs would inevitably use them to comply with the liquidity standard. Higher demand for ES balances need not be a problem in itself. However, it is important that it does not interfere with the Reserve Bank’s ability to implement monetary policy. Within the Bank’s framework, it would be quite problematic if the demand for ES balances varied to allow ADIs to comply with a liquidity standard, rather than with changes in their actual cash position. For this reason, in November 2010, the Reserve Bank Board approved the introduction of a committed liquidity facility (CLF) that is consistent with the arrangements for such facilities set out within the Basel standards. The facility was announced publicly the following month.7 The technical details of the CLF were worked out during 2011 in consultation with APRA and APRA (Australian Prudential Regulation Authority) (2013), “Implementation of the Basel III liquidity framework in Australia”, Media Release No 13.25, 8 August. Available at <http://www.apra.gov.au/MediaReleases/ Pages/13_25.aspx>. RBA (2012), “Box E: Yields on Sovereign Debt”, Statement on Monetary Policy, May, pp 59–60. RBA (2011), “The RBA Committed Liquidity Facility”, Media Release No 2011–25, 16 November. And Debelle G (2011), “The Committed Liquidity Facility”, Speech to the APRA Basel III Implementation Workshop 2011, Sydney, 23 November. BIS central bankers’ speeches were announced publicly at the end of that year.8 There was then a public consultation process following APRA’s announcement of the new liquidity arrangements that ran for three months. Put simply, for the payment of a fee, the CLF will commit the Reserve Bank to purchase eligible securities from ADIs under repurchase agreements. As the range of securities eligible to be sold to the Reserve Bank is considerably broader than just CGS and semis, it addresses the problem of there being insufficient securities for ADIs to hold that meet the Basel III standards. Subject to APRA’s approval, an ADI will be able to use the Reserve Bank’s commitment under the CLF to bridge the gap between its holdings of CGS and semis and the amount of HQLA required to meet the standard. When it comes into operation in January 2015, the CLF will work in exactly the same way as the Bank’s existing liquidity facility. Indeed, the CLF is simply a means by which the Reserve Bank will make a contractual commitment to an ADI to provide funding under its liquidity facility. As is the case in commercial lending contracts more generally, the Bank’s commitment under the CLF will be contingent on appropriate conditions being met, namely an assessment that the ADI continues to have positive net worth. As I have said, the CLF simply guarantees access to the Bank’s existing liquidity facility, and ES account holders use this facility every day. At the present time, it is used almost exclusively for intraday funding; after November this year when DE payments are settled for same-day value, it will be used for open repos as well. From 2015, ADIs subject to the Basel III liquidity standards will only be able to use CGS and semis in the Bank’s liquidity facility, unless they have paid the 15 basis points commitment fee for the CLF. In this way, any ES balances acquired from the Bank’s liquidity facility will always represent the exchange of one liquid asset for another and cannot improve an ADI’s compliance with the liquidity standard. The consequence of this is that small “drawings” on the CLF will be a routine event as part of normal operations to manage payment flows. Provided the funds are repaid same-day or, in the case of open repos, are retained in the ADI’s ES account, there need be no cost to using the facility in this way. However, should the funds be used for any other purpose such that the balance on the account is below where it should be, the penalty will be 25 basis points above the cash rate target. Such a use of the CLF is likely to occur in more stressed circumstances. As I mentioned earlier, 25 basis points has long been the penalty rate attached to the Bank’s liquidity facility and it is designed to discourage ADIs from relying upon the facility for funding purposes during normal times. In a stress scenario, of course, this penalty rate of 25 basis points may not appear so onerous. That is by design. In such circumstances, it is appropriate that the central bank provides liquidity support against suitable collateral. This principle of central banking dates back at least to Bagehot: lend against good collateral at a penalty rate but not a penal rate. The experience here in Australia over many years is that this penalty of 25 basis points has been sufficient to ensure that there has not been excessive use of the central bank’s liquidity facility. The usage of this facility is published on the website with a small lag and recorded in the Bank’s Annual Reports in the chapter on Operations in Financial Markets. Even in the stressed environment of 2008 and 2009, the facility was only drawn on a couple of times for small amounts, and for no longer than one day, to deal with unexpected payment flows. Technical details of the CLF and its relationship to the Reserve Bank’s existing liquidity facility can be found on the Bank’s website. BIS central bankers’ speeches To put the rationale for the CLF another way, the purpose of holding liquid assets is to sell them during periods of stress. In the Australian context, this will mean using funds raised via the CLF. This need not be the “last resort”; that is, after all other avenues have been exhausted. The point of liquidity regulations is to avoid fire sales of non-liquid assets and other actions that might have adverse effects on broader financial stability. Again, that a central bank should be prepared to play this role is nothing new. In this sense, the fee of 15 basis points that the Reserve Bank will apply to any commitments made under the CLF can be seen as a means of explicitly charging the large ADIs an appropriate price for a liquidity option they have always implicitly held. In thinking about the appropriateness of such a fee, it is important to remember that under the CLF, the Reserve Bank will only provide funding against the market value of an eligible security at the time the facility is accessed, not the market value at the time any commitment is established. Furthermore, the Bank will haircut the security’s market value by as much as 25 per cent, depending on the type of security involved. So, taking account of the haircut, the effective cost of obtaining this liquidity can be considerably higher than the 25 basis point penalty combined with the annual 15 basis point commitment fee. Consequently, the CLF is only (and not completely) insuring an ADI against the liquidity risk on its securities. The credit and market risks attached to any securities remain with the ADI. As is the case with all repos contracted by the Reserve Bank, should the market value of a security decline, the Bank will require additional securities to be delivered to restore the original value of the repo. Similarly, should the credit quality of a security held by the Bank fall below a certain threshold, the ADI will be required to replace the security with one that meets the eligibility criteria. Deriving the precise value of such a liquidity option is not straightforward. Certainly, as acknowledged in the Basel standards, it is not appropriate to simply look at the yield differential between government bonds and other securities eligible for the CLF. That spread will largely reflect compensation for credit and other non-liquidity risks, as well as that part of the liquidity risk which the Bank is not insuring – the Bank’s haircut. The Bank is only interested in charging for the liquidity component. The credit spread should be retained by the party bearing the ongoing credit risk, the ADI in this case. For example, if we look at the spread between a threemonth bank bill and the expected cash rate, it is around 18 basis points currently. Before 2007, it was in the single digits. Much of this spread is credit risk which implies the liquidity component is small. While this spread rose considerably during the crisis and some of this reflected an increase in the liquidity premium, much of the increase was a result of heightened credit concerns, evidenced by the rise in CDS premia at the same time. Theoretically, some indication of the cost of hedging liquidity risk can be extracted from term repo rates on eligible securities. By way of illustration, since adopting its current haircut schedule for repos, the Reserve Bank has, through its open market operations, contracted one-month repos at an average premium of about 4 basis points above cash, while for a six-month repo the average premium is about 8 basis points over the expected cash rate.9 The CLF is effectively an option with a strike price set 25 basis points above the cash rate. Of course, during periods of stress, the cost of liquidity can rise significantly and it is the potential for this to occur that would give the option some value. Separate to any market-derived estimates, an equally important consideration in pricing the CLF was to maintain consistency with the rest of the Reserve Bank’s operating framework and not compromise the Bank’s ability to implement monetary policy. As I suggested earlier, it is likely that at least initially, the Bank will be making commitments under the CLF of around “Cash” in this context means rates on overnight indexed swaps, which are referenced against the cash rate. This information can be obtained from the RBA website, where information on our daily operations in the cash market is published. BIS central bankers’ speeches $300 billion; we will have a more precise indication of that figure after APRA completes the trial liquidity budgeting exercise that is currently underway. Instead of introducing a CLF and committing to fund assets, the Bank could have opted to purchase the assets ex ante, expanding the supply of ES balances, and the Bank’s balance sheet, by $300 billion. That is, the liquidity provision could be provided for the whole system ex ante, rather than provided to an individual institution when required. Effectively, the CLF requires ADIs to pre-position the securities but retain them on their own balance sheet. The alternative approach would see the Reserve Bank’s balance sheet increase by more than three times over. Such an outcome would not only jeopardise the functioning of the cash market and hence the implementation of domestic monetary policy, but also impair the functioning of domestic securities markets. Moreover, it would not be feasible for the Bank to conduct such large-scale asset purchases through its regular open-market operations. This would mean a large-scale purchase of domestic securities by the RBA, but there simply is not a large enough pool of such assets that the Reserve Bank is willing to hold on an outright basis. Hence, it would have meant a series of bilateral arrangements with ADIs along the lines of the open repo arrangements I discussed earlier, with self-securitised assets serving as the collateral. To implement monetary policy in such an environment, the price of accessing such an arrangement would have needed to be set so as not to create an incentive for ADIs to generate the required ES balances through other means. This is no different to the CLF. The purpose of establishing the CLF was to ensure that ES balances could continue to play their existing role in the Bank’s operations. This means that ADIs seeking to raise their liquid asset holdings should, at the margin, prefer to use additional CGS, semis and/or an increased subscription to the CLF for this purpose instead of ES balances. Our assessment is that a CLF fee of 15 basis points should allow this to be the case. The pre-positioning of these securities, combined with the enhanced information requirements for asset-backed securities the Bank announced last year,10 will allow the Bank to make a much more detailed credit assessment of the securities. Consequently, the Bank will be able to more precisely assess the value of these securities at any point in time and will be able to reduce its use of ratings agencies. To conclude, over the next 18 months, there will be some significant developments in the Reserve Bank’s balance sheet, resulting from some upcoming changes in the payments system and the commencement of the Committed Liquidity Facility. Both of these changes are being accommodated within the general framework for the implementation of monetary policy that has operated successfully in Australia for some considerable time. The payments system changes will see some increase in the size of the Reserve Bank’s balance sheet, but no material change in either the risk or income derived from that balance sheet. The design of the CLF is very much in keeping with the Reserve Bank’s (and other central bank’s) provision of liquidity to the financial system. It should not result in any material change in the size of the Bank’s balance sheet and has been structured to avoid a significant increase in the balance sheet that would have risked the effective functioning of domestic markets. RBA (2012), “New Eligibility Criteria for Residential Mortgage Backed Securities”, Media Release No 2012–31, 22 October. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 8 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian British Chamber of Commerce, Sydney, 18 October 2013. | Glenn Stevens: The United Kingdom and Australia – shared history, shared outlook Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian British Chamber of Commerce, Sydney, 18 October 2013. * * * I thank Alexandra Rush for assistance in preparing these remarks. It could have been the Dutch who started European settlement in Australia. In their journeys to the East Indies numerous Dutch traders saw the western and northern coastlines of the continent and some came ashore. But the conditions were not hospitable and, finding nothing in the way of commodities that they could exchange for value at home, they left. Or it could have been the French: Jean-François de Galaup La Perouse arrived in Botany Bay only a few days after Arthur Phillip’s fleet in 1788. Apparently the English and French mariners, despite the rivalry of their countries, enjoyed cordial relations for a brief interlude before La Perouse sailed off into the South Pacific, never to be seen by Europeans again (Dyer 2009). But it was the English who came to start a colony. Eighteen years after James Cook landed at Botany Bay, the First Fleet anchored there in January 1788. After only a few days, finding the shallow, sandy bay too exposed and short on potable water, they sailed 20 kilometres or so north to Port Jackson, which they regarded as a superior location to found the settlement. Looking at Sydney Harbour today, it appears they made the right call. The contrast with today’s prosperity could not, however, have been more pronounced. In time the Great South Land would help to feed the world, but in 1788 the new arrivals couldn’t feed themselves. Geoffrey Blainey’s book The Tyranny of Distance records how the fledgling settlement nearly starved – and how, later in 1788, HMS Sirius was sent to a suitable supply station to bring back food and seed. That station was the Cape of Good Hope (now Cape Town, South Africa) – 11,000 kilometres away – a measure of the degree of isolation the First Fleeters must have felt. The return journey took about seven months, shorter than it would have been had Captain Hunter not ignored the advice of his superiors. After proceeding south from Sydney, he turned east, rather than west, so picking up a favourable wind for the outward journey. He sailed more miles, but in a shorter time. And so began the inflow of people, capital, and know-how that ultimately resulted in the modern Australian nation. Today Australia is still a nation of immigrants, where almost onequarter of our 23 million inhabitants were born somewhere else (ABS 2012). Just about every nationality is here and we face the “Asian Century” with the sense that – for the first time in our modern history – our geographical position is an economic advantage. For a long time, the economic and financial relationship with the UK dominated, despite the distance. In colonial times, the UK was by far Australia’s most prominent trading partner – in the 1880s the UK was the source of 70 per cent of Australia’s imports and the destination for up to 80 per cent of exports (Vamplew 1987). By the turn of the 20th century still more than half of Australia’s trade was with the UK. Though overall Australia accounted for less than 10 per cent of the UK’s bilateral trade in the 19th and early 20th centuries, Australia was among the UK’s largest sources of wheat imports and at times accounted for more than 50 per cent of the UK’s wool imports (Mitchell and Deane 1962; Mitchell and Jones 1971). The Australian Pound was linked to the pound sterling and the Australian banks kept reserve balances in sterling – “London funds”. In time, Australia created its own central banking arrangements, and by the 1930s the Commonwealth Bank was serving as a basic central bank (though without, at that time, the same full central banking mandate and obligations that the RBA has today). Still, the links with Britain were strong. The decision not to devalue the Australian currency with sterling in 1967 was a departure from previous practice. When BIS central bankers’ speeches Australia got into financial difficulties meeting its obligations in the late 1920s, Sir Otto Niemeyer was despatched from the Bank of England in 1930 to offer advice to the Australian Government. Niemeyer’s diagnosis – that Australia had lived beyond its means, and should accept lower living standards in order to service its international debts – was not, shall we say, universally welcomed, but his influence lived on. The monthly statement of Commonwealth Government finances, which he devised, was still known as the “Niemeyer” statement until well into the 1980s, when I was a junior economist in the Reserve Bank. So the links were strong. But of course the world was changing. Two world wars saw the UK’s financial strength diminish and its weight in the global economy decline, as that of the United States rose. In the 1970s the UK also increasingly turned towards Europe, with EUdirected trade increasing strongly in the two decades after joining the EEC.1 By then, Australian trade had long turned towards first the US, then Japan. Trade with the USA had been increasing steadily since the late 1940s and the USA replaced the UK as Australia’s largest bilateral trading partner in the mid 1960s. Similarly, trade with Japan grew rapidly and overtook that with the UK by the 1970s (and began to rival that with the US as well) (Vamplew 1987; RBA 1996). In the subsequent decades Australia’s trade focus continued its shift towards Asia generally and, in the past decade especially, towards China in particular. Today nearly three-quarters of our trade is with the Asia Pacific, while half of the UK’s trade is with Europe (ABS 2013b; ONS 2013). Historically, the UK was a top destination for Australians travelling abroad – “falling towards England” as Clive James memorably described it. In 1950 around 30 per cent of Australian outbound tourists were destined for the UK and Ireland. That had fallen to 6 per cent by 2013. Australians’ travel to the USA has remained fairly consistent since the 1970s at around 10 per cent. Travel to Asia increased dramatically with destinations in South-East Asia now accounting for more than 30 per cent of the total. The UK is, though, still a major source of tourism for Australia. Despite a decline since the GFC, UK citizens account for around 10 per cent of all arrivals in Australia, remaining close to the historical (post-1950) average of around 15 per cent. These days, China is the biggest source of Australia’s inbound arrivals after New Zealand, and is usually the fastest growing. Interestingly, however, recent data show that in the year to August 2013, UK arrivals grew faster than arrivals from China (Vamplew 1987; ABS 2013c). Those picture postcards of sun and blue skies must be very appealing during the European winter! It will take a good deal more time yet for these shifts in trading relationships to be mirrored in the accumulated stock of invested capital. The UK’s foreign investment in Australia during the country’s formative years was large, even for the UK. Between 1870 and 1913 about 8 per cent of Britain’s total foreign investment went to Australia. As recently as the mid 1950s, the UK’s investment in Australia dwarfed that from any other country, and was more than double the investment of our second largest investment partner, the USA (Vamplew 1987; RBA 1997; Ukhov and Goetzmann 2005). As at the end of 2012 the stock of foreign invested capital that came via the UK amounted to almost $500 billion, and it is still growing (it rose at an annual average compound rate of more than 6 per cent over the past 10 years) (ABS 2013a).2 The stock of Chinese inbound investment has been growing at 20 per cent over the past decade, but is estimated at only 2 per cent of the combined total from the US and UK. Similarly, and perhaps more surprisingly, the stock of Australian investment abroad IMF Direction of Trade Statistics. It should be noted that the country level data in ABS (2013a) are based on the country of residence of the creditor or the debtor. Since London is an international financial hub, for some transactions the ultimate owner or recipient may reside in another country. BIS central bankers’ speeches remains concentrated in the UK and the US – though that is beginning to change now, with a bigger focus on Asia. That accumulated inbound investment has helped Australia become a very affluent nation, augmenting our own national savings to a significant extent. According to Angus Maddison’s data set, within 80 years of the founding of a penal colony on the shore of Sydney harbour, about a kilometre from our present location, Australia’s real GDP per head matched the UK’s (Maddison 2003). Today, Australia’s real GDP per head of about $44,600, measured at purchasing power parity, is noticeably higher than the UK’s ($36,900), though for the UK that comparison is adversely affected by the economic weakness in recent years.3 Such an outcome is perhaps not surprising given the endowment of land and natural resources that Australia has. Opening up of large areas of land for agriculture enabled Australia to enter powerfully the markets for grain and wool. Agriculture was a major source of wealth over most of our history (and many predict will play a big role in future). The gold rush of the mid-nineteenth century helped to propel the city of Melbourne in particular to globally significant size and affluence (though there were later excesses that led to a serious depression). The things the Dutch and others couldn’t see under the ground when they surveyed the inhospitable northwest four centuries ago are the source of massive wealth today. About 1.5 million tonnes of iron ore, valued at about $150 million at current prices, leave those shores each day in ships about 250 times the size of Cook’s Endeavour. A combination of those endowments with a willingness to accept international capital, including very prominently from the UK, has given Australians the opportunity to grow our economy quickly. But it wasn’t just money, land and minerals. There are other countries with resources and land that do not enjoy the same incomes. And there are nations with very little in the way of resources or land that is wealthy. It was other things about the British heritage that were of higher value. It turns out that the English language is just about everyone’s second language, which means even with our broad accent, we can communicate with educated people virtually everywhere and engage in commerce in most places. The common law and parliamentary democracy provide a foundation for the sorts of property rights and governance processes that are widely and rightly regarded as fundamental to building a prosperous modern economy. That property rights could become so well established in a society in which the “immigrants” of 1788 had no such rights is, perhaps, an ironical outcome. And we are still coming to terms with the property rights of those descended from the inhabitants who were here before 1788. But the point is that this heritage, so important for enterprise, is something we have in common with the UK. One has to observe as well that Britain traded with and invested in her former colonies, however imperfectly, rather than simply extracting the rents. The fact that so many prominent English-speaking former colonies are counted among the rich of the advanced world today is perhaps not entirely a coincidence (Grier 1997; Acemoglu, Johnson and Robinson 2001 and 2005).4 In my own field of central banking, we have a good deal in common. The Bank of England and the Reserve Bank of Australia conduct monetary policy using the approach of a mediumterm target for consumer price inflation, endorsed by government, with operational World Bank, World Development Indicators, September 2013; figures are for 2012. Acemoglu et al (2001) assert that “settler colonies” (such as Australia, Canada, USA and New Zealand) have had better economic outcomes compared to colonies set up for resource extraction (giving the example of the Belgian Congo). Recent literature identifies that economic, trade and education policies, as well as the institutions set up by Britain and other colonial powers have been important to economic performance today (see Grier (1997) and Acemoglu et al (2005) as examples). BIS central bankers’ speeches independence for the central bank, and a flexible exchange rate. We are not alone in this – there are quite a few countries that follow a version of this approach these days – but the Bank of England and the RBA were, after the central banks of Canada and New Zealand, fairly early adopters of the approach. There is a very practical level of cooperation between the two institutions, exemplified by staff exchanges as well as contact at the highest levels. I well remember a phone call from Mervyn King on the morning of 15 September 2008, to ask how our markets were absorbing the news of the Lehman failure that had been announced just after trading started. (The answer was: reasonably calmly, initially, but that subsequently changed.) In the ensuing five years, Australia and the UK have both faced the challenges arising from the global financial crisis (GFC). For various reasons the UK has had a harder time of it, with bigger problems in its banking system, which is also bigger relative to its economy, and a higher exposure to a troubled Europe, in contrast to our exposure to a resilient Asia. Hence, while Australia has experienced growth, albeit slower than average, in the years following the GFC, the UK suffered a painful and rather protracted recession. It seems of late though that there are more signs of expansion in the UK economy, which will no doubt be very much welcomed by citizens and policymakers alike. The UK still warrants the label “major economy”. Its GDP is still among the top 10 in the world. Perhaps more significantly London remains easily the world’s pre-eminent international financial centre. New York, being in the US, boasts bigger domestic markets of course, but London services the world. In the councils of global governance the UK holds an important position – in bodies like the IMF, the BIS, the UN and others, it holds its own seat and acts with influence. Australia, with a third the UK’s population and about half its absolute GDP, as the eighteenth largest economy,5 and with a correspondingly more modest stature on international bodies, cannot see itself in quite the same way. We have well-developed financial markets and there are plans to develop more as a regional financial centre, but realistically Sydney will never rival London. Nonetheless we have our contribution to make, and our UK partners have always been welcoming in hearing it. And this has to be because there is so much in common today, in the modern world. The ties that bind are not just history. They extend beyond a fascination and affection among Australians for the royal family – strong though that is – or the longcontested rivalry between “old enemies” for one of the world’s smallest sporting trophies. There is a real sense in which the UK and Australia share an outlook, at a very basic level, on how an economy should be organised and governed. They share a perspective on the role – and the limits – of markets in setting prices and allocating resources. They share a commitment to a world economy in which trade is free and capital, in general, is free to move. We have had some differences of nuance in recent years about matters financial, reflecting mainly our differing experiences of the crisis, but in the broad the perspective of the role of the financial services sector in facilitating the real economy is very much shared. The business communities of the two countries have strong links, evidence for which is your attendance here today. I’m sure that this association will continue to strengthen and mature over the years ahead, even though the two countries are at opposite ends of the globe. Perhaps the most important thing the two countries have in common is the strong belief that societies prosper when policies are debated in an open way, when evidence, reason and judgement can be brought to bear on decisions, and where accountability and evaluation are key attributes of the process. IMF World Economic Outlook, October 2013; figure is for 2012. BIS central bankers’ speeches That set of commonly held values will be important for us over the year ahead, as Australia assumes the chair of the G20. What issues will be on the agenda? And how can the business communities of the two countries contribute? The full agenda is of course for the Australian Government to determine, in consultation with other G20 member governments. It will certainly have a strong focus on growth, and on the role of the private sector in driving growth, including its role in infrastructure investment. So I expect there will be significant call for engagement of the business communities of Australia and the UK, and other member economies, over the year ahead. I will make just two points here. First, in the area of financial regulation, there is a major agenda for reform, on which very good progress has been made, but on which there is still much work to do. In my view, having developed a very substantial pipeline of work since 2008, our energies need now to be devoted to careful and systematic implementation of the already agreed reforms. That is not to preclude new regulatory initiatives, which are still being put forward. But the implementation task arising from the pipeline of reforms already agreed, either in detail or at a conceptual level, is very large indeed. Of these, the most important ones are the Basel III package, the reforms for OTC derivatives trading and clearing, establishing appropriate oversight of “shadow banking”, and work to address the problem of “too big to fail”, including cross-border resolution of systemically important financial institutions. This by no means exhausts the list of work streams, but these are the key ones. Each is individually very demanding for regulators and industry players alike. Taken together, they are, in a word, daunting. We need to avoid reform fatigue, and to sustain our support to those doing the hard grind of devising the new rules and making them work. To do that, we need, in my opinion, to contain the growth in the regulatory agenda, and to respond only to the most important calls for further major work streams, at least for the next little while. Let me be clear this is NOT a call for current reform efforts to stop, or to be watered down. It is about ensuring we focus our finite energies and resources on the most important problems, and getting industry to do the same. The second point is that the business community, both in the UK and Australia, and generally under the auspices of the “B20”, can contribute to meaningful progress towards the G20’s broader goals. That contribution will be most constructive if it can avoid being dominated by particular national or industry interests, if it can adopt a genuinely global perspective, if it can have realistic aspirations and if it can understand the constraints under which policymakers operate. A contribution like that will be key to achieving the G20’s goals: an open world economy, characterised by strong, sustainable and balanced growth. I hope that Australian and UK business leaders, along with their peers from around the other G20 countries, will seize that opportunity and that responsibility. References ABS (Australian Bureau of Statistics) (2012), “Migration, Australia, 2010–11”, ABS Cat No 3412.0, August. ABS (2013a), “International Investment Position, Australia: Supplementary Statistics, 2012”, ABS Cat No 5352.0, Tables 2 and 5. ABS (2013b), “International Trade in Goods and Services, Australia, Aug 2013”, ABS Cat No ABS 5368.0, Tables 14a and 14b. ABS (2013c), “Overseas Arrivals and Departures, Australia, Aug 2013”, ABS Cat No 3401.0, Tables 5 and 9. Acemoglu D, S Johnson and JA Robinson (2001), “The Colonial Origins of Comparative Development: An Empirical Investigation”, The American Economic Review, 91(5), pp 1369–1401. BIS central bankers’ speeches Acemoglu D, S Johnson and JA Robinson (2005), “Institutions as a Fundamental Cause of Long-Run Growth”, in P Aghion and SN Durlauf (eds), Handbook of Economic Growth, Vol 1A, Chapter 6, Elsevier BV. Blainey G (1983), The Tyranny of Distance: How Distance Shaped Australia’s History, Macmillan, Melbourne. Dyer C (2009), The French Explorers and Sydney, University of Queensland Press, Brisbane. Grier RM (1997), “Colonial Legacies and Economic Growth”, Public Choice, Vol 98, pp 317–335. Maddison A (2003), The World Economy: Historical Statistics, Development Centre Studies, OECD Publishing. Mitchell BR and Deane P (1962), Abstract of British Historical Statistics, Cambridge University Press, London. Mitchell BR and Jones HG (1971), Second Abstract of British Historical Statistics, Cambridge University Press, London. ONS (Office for National Statistics) (2013), “UK Trade, June 2013”, Statistical Bulletin, August, pp 1–51. RBA (Reserve Bank of Australia) (1997), “Australian Economic Statistics 1949–50 to 1996–97”, Reserve Bank of Australia Occasional Paper No 8. Ukhov A and WN Goetzmann (2005), “British Investment Overseas 1870–1913: A Modern Portfolio Theory Approach”, NBER Working Paper No 11266. Vamplew W (1987), Australians: Historical Statistics, Fairfax, Sync & Weldon Associates, Sydney. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 10 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the CFA Australia Investment Conference, Melbourne, 24 October 2013. | Philip Lowe: Investment and the Australian economy Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the CFA Australia Investment Conference, Melbourne, 24 October 2013. * * * I would like to thank Gareth Spence and Leon Berkelmans for valuable assistance in the preparation of this talk. I would like to thank the CFA Institute and CFA Societies Australia for the invitation to speak this afternoon. I would also like to acknowledge the work that the CFA and its members have done in promoting the integrity of capital markets and the provision of ethical investment advice. Over recent years we have seen too many ethical lapses in the global financial services industry and the bonds of trust between investors and institutions have been strained. Strengthening these bonds is critical to the financial services sector playing its important role in promoting a strong and vibrant global economy. I wish you all the best in pursuing this important task. Confidence is also, of course, an important factor influencing business decisions to invest and to expand. Indeed, a lack of confidence has been one of the factors holding back investment in many countries over recent years. So given that this is the CFA’s Australia Investment Conference, I thought it appropriate to focus my remarks today on the topic of investment. I would first like to spend time discussing recent investment trends in Australia, particularly the investment outcomes in the non-mining sector. I would then like to look forward and discuss what the outlook might hold. Recent developments It is worth starting off with the global context. As you are no doubt aware, over recent years the Australian economy has performed much better than the economies of most other developed countries. We avoided a recession during the global financial crisis, although growth has been below average recently. Our banks have remained sound. Public debt levels are comparatively low. The Reserve Bank has not had to expand its balance sheet massively. And inflation has been close to target. Very few other countries can make such claims. But my focus today is the story on investment. Since 2008, the developed economies have been in an investment drought. Indeed, the four years from 2008 to 2012 saw the lowest level of investment, relative to GDP, in the developed economies for many decades (Graph 1). For the world as a whole, investment has also been very low. In Australia, the investment picture is very different. Rather than experiencing an investment drought, we have had an investment boom, particularly in the private sector. Recently, business investment peaked at over 18 per cent of GDP, its highest level in more than 50 years (Graph 2). And the nation’s overall capital stock (including both private and public capital) has been expanding at around 5 per cent per annum, the fastest rate of increase since the early 1970s. In contrast, in some other developed economies, the level of investment has barely been enough to offset the depreciation of the existing capital stock. The reasons for this difference are well understood. Most of the advanced economies have been dealing with the fallout of the severe banking and debt problems of the late 2000s. In contrast, we avoided these problems and have been benefiting from the growth in Asia. This growth has pushed up the prices of many commodities, which has encouraged investment in the extraction of Australia’s natural resources, particularly iron ore, coal and natural gas. This BIS central bankers’ speeches investment has boosted our resource exports, and will provide an important source of national income for many years to come. This aggregate picture, however, hides some large differences across sectors. Mining investment has been extraordinarily strong; last year, it was equivalent to around 8 per cent of GDP, which is much higher than in any previous mining boom, at least for over a century (Graph 3). In the non-mining sector, however, investment has been quite weak. Indeed, as a share of nominal GDP, non-mining private business investment is currently around 3 percentage points lower than its average over the period from 2005 to 2008 and it is not much above levels seen in the early 1990s recession. And if we take into account public investment, which is also low, then total non-mining investment, as a share of GDP, is below the trough that was recorded in the early 1990s. In this sense, the profile for non-mining investment in Australia is not dissimilar to the profile for overall investment in many of the developed economies. This weakness in investment outside the resources sector is widespread across industries. According to the most recently available Australian Bureau of Statistics (ABS) data, in 16 of the 18 individual non-mining industries, the level of investment (relative to GDP) is at, or below, the average level of investment for the years from 2005 to 2008. The two exceptions are the utilities sector, where there has been significant private investment in electricity distribution and water supply, and agriculture, which has benefited from high global food prices. The low level of overall non-mining investment has occurred despite corporate balance sheets being in generally sound shape and firms having significant holdings of liquid assets. It has occurred despite financial institutions reporting that they are willing and able to lend. And it has occurred despite lending rates being at record lows for both large and small businesses (Graph 4). So the obvious question is: why is this happening? As usual, there is no single answer, but I would like to highlight four factors. The first is a technical point, but a relevant one nevertheless. The investment figures I have quoted are for nominal investment relative to nominal GDP. Most of the time, this provides a reasonable guide as to what is going on. But over recent years, the price of capital equipment has fallen markedly, partly due to the appreciation of the exchange rate, which has reduced the price of imported goods. The lower prices mean that for a given amount of capital spending, the economy obtains more units of capital. As a result, while total non-mining investment as a share of GDP is lower than it was in the recession of the early 1990s, the non-mining capital stock is increasing a little more quickly than it was at that time. In a sense, we are getting more bang for our buck. The second, and ultimately more important factor, is the exchange rate. As I have talked about on previous occasions, Australia’s floating exchange rate regime has played an important role in stabilising the Australian economy.1 The appreciation of the Australian dollar since the mid 2000s is perhaps the single most important reason why the Australian economy has digested a boom in mining investment without overheating and without developing the imbalances that typically accompany such booms. That is the good news. But in playing this stabilising role, there is also a downside. The exchange rate appreciation has taken pressure off domestic capacity by making it cheaper for Australians to buy imported goods and by reducing the competitiveness of firms in export markets. In so doing, it has reduced the return on capital in those traded sectors that are not See Lowe P (2013), “Internal Balance, Structural Change and Monetary Policy”, Address to the Australian Industry Group 13th Annual Economics Forum, Sydney, 19 March. BIS central bankers’ speeches benefiting from high commodity prices, and thus reduced the incentive to invest. This is perhaps most obvious in the manufacturing and tourism sectors, where the level of investment, as a share of GDP, is very low by historical standards (Graph 5). Indeed, in these industries, the current rate of investment is at, or below, the depreciation of the existing capital stock. The low level of investment in the manufacturing sector is particularly noteworthy, as manufacturing has historically accounted for around one-fifth of total nonmining investment. The third factor that I would like to discuss is the general lack of confidence by business. This lack of confidence can be seen in the various business surveys over recent years and has been clearly apparent through the Reserve Bank’s regular program of meetings with firms across the country (Graph 6). This reported lack of confidence is consistent with firms being uncertain about the future and risk averse in their decision making. So the logical question here is: why has business confidence and the willingness to take risk been so subdued? Again, there is no single answer. But many of the businesses that we have talked with over the past couple of years have cited the uncertainty associated with the structural changes in the economy, including as a result of the high exchange rate. They have also cited the political environment, particularly the previously hung parliament. And they have cited an increased regulatory burden. While we cannot be sure, it is likely that each of these factors has affected the willingness of some firms to expand. A common message from business has been that they thought it was worth waiting a while to see how things worked out before they made decisions that were costly to reverse. In the parlance of economists, the “option value” of waiting has been high. Beyond these Australian-specific factors, I suspect there is also a deeper global factor at work – and that is the legacy of the financial crisis. Recall that prior to the crisis, there was the Great Moderation. During that earlier period, the additional compensation that businesses required for taking a risk was quite small. Confidence was high and volatility was low. The financial crisis changed all this. It reminded us all that bad outcomes were possible. And since then, the frequent news about the problems in the euro area and the possibility of political stalemate preventing the US government from meeting its financial obligations have only served to reinforce this idea. This scarring from the financial crisis is still with us and I suspect it will be with us for some time yet. It not only helps to explain why investment is weak outside the resources sector in Australia, but also why investment is very low in many advanced economies despite generally healthy corporate balance sheets, very low interest rates and large-scale quantitative easing by central banks. While recently we have seen some return to risk taking in financial markets, potential owners of real capital in the developed economies have not yet been prepared to step forward in significant numbers and take a risk. Consumer demand has been soft and businesses have wanted to wait and to see what happens. They have felt more comfortable leaving their money in bank accounts earning very low rates of interest, rather than taking the chance and investing in new capital. This change in corporate attitudes is, I suspect, one of the enduring but underappreciated consequences of the financial crisis. At the aggregate level, the Australian economy has been shielded from its effects by developments in the resources sector, but some areas of the economy are clearly feeling the impact. Finally, a fourth factor that has had an effect on the overall level of investment in Australia is the change in household spending behaviour. Unlike in earlier years, growth in household consumption is no longer running ahead of growth in household income. The step-down in the rate of growth of retail spending in particular has reduced pressure on capacity and affected rents for retail properties. There has also been some reassessment of the appropriate model of retailing. The result can be seen in the ABS’s estimates of total investment in the retail industry which, as a share of GDP, is at the lowest level for many BIS central bankers’ speeches years (Graph 7). The ABS data also suggest that there has been some flow-on effects to investment in the wholesaling industry, which is also at quite a low level. So, in summary, the high exchange rate, uncertainty, risk aversion and the changes in household spending behaviour have all weighed on non-mining investment over recent times. As a result, non-mining investment has made little contribution to growth in the overall economy (Graph 8). This is at a time when mining investment is no longer increasing, with the mining boom transitioning from one based on investment to one based on production. As best we can tell, mining investment declined over the past year, while net exports rose strongly due to lower capital imports and the higher production of bulk commodities made possible by the earlier investment. Looking forward So having looked back at what has happened so far, I would now like to look forward. Over the period ahead, the level of mining investment is likely to decline substantially as existing projects are completed. The exact profile remains difficult to determine, but it would not be surprising if mining investment, relative to GDP, declined by 3 percentage points or more over coming years. A decline of this magnitude should be manageable, just as the earlier rise was manageable. It will, however, require a further rebalancing of the economy. As part of this rebalancing, exports are set to grow strongly, particularly when the large LNG projects come on line. There will also be slower growth in imports of capital goods as projects are completed. But these adjustments on the trade side will not be enough, by themselves, to ensure that growth in output and employment is satisfactory. This means that other forms of spending will need to pick up. One of these other forms of spending is residential construction, and the modest rise that is underway here is a welcome development. Some lift in consumption growth is also expected, although a return to consumption growth faster than income growth for an extended period is unlikely. It would also be unwelcome given the relatively high levels of existing household debt. So this means that a pick-up in non-mining investment is an important part of the story in the return of the Australian economy to trend growth. Indeed, our expectation is that this will take place, with growth in non-mining investment predicted to pick up to at least high single-digit rates within the next couple of years. This is, of course, a forecast and there is the usual wide range of uncertainties. These include uncertainty as to the appropriate steady-state capital-output ratio for the economy and the associated investment ratio. These important structural variables are influenced by a whole range of considerations, including the rate of total factor productivity growth, population growth, the rate of depreciation and the industry structure. But from a more cyclical perspective, there are a number of factors that support the outlook for a steady pick-up in non-mining investment. The three factors I want to list – and they are clearly interrelated – are some depreciation of the exchange rate, an improvement in business confidence and the very low level of interest rates. While the Australian dollar has appreciated over the past couple of months, on a tradeweighted basis, it is around 8 per cent lower than the peak in April this year. It is still too early to see the impact of this on investment, although the depreciation has improved prospects in some areas of the economy. In particular, there are parts of the tourism and manufacturing industries where the outlook is now a bit more positive, especially for firms that had earlier responded to the high exchange rate by doing whatever they could to make themselves more competitive. The more positive outlook in the tourism industry is also being supported by the steadily increasing number of visitors from China. BIS central bankers’ speeches This depreciation of the Australian dollar since April is a welcome development, and a further depreciation would be helpful in rebalancing growth in the economy. Ultimately, floating exchange rates adjust to the relative returns on capital across countries. When investment in Australia was very high and rising, and investment elsewhere in the world was very weak and falling, it was not surprising that the Australian dollar was at quite a high level. This was a textbook response to an investment boom. But the textbook would also predict that as the mining investment boom in Australia unwinds and, hopefully, investment in the developed economies picks up, some realignment of the relative value of the Australian dollar would occur. This process has started, although it has been interrupted recently, partly due to the changed outlook for US monetary policy. Whether we will see a further realignment remains unclear, but, from today’s perspective, a lower value of the Australian dollar would assist in lifting investment and activity in the sectors that have been constrained during the years of the mining investment boom. The second factor on my list is an improvement in business confidence over recent months, which is evident in a graph that I showed earlier (Graph 6). This improvement is also apparent in our discussions with businesses, and there has also been a lift in consumer confidence. These are positive developments. Just as a lack of confidence about the economy can be self-fulfilling, so too can be a recovery in confidence. If businesses are prepared to spend, jobs tend to get created, incomes tend to rise and people see opportunities where previously they saw none. So an important issue here is whether this improvement in confidence will be sustained. A fair amount depends upon international events. If global growth is in line with most forecasters’ central outlook, it is quite possible that confidence, both overseas and in Australia, will be sustained at a higher level than it has been in recent times. There are, however, a range of things that could go wrong, with the latest wrangling over the US debt ceiling providing just the latest example of developments that damage confidence. But beyond international events, domestic policy choices also matter. Business confidence – and thus the preparedness to take risk – is likely to be higher if the policy environment is predictable and there is strong commitment to ongoing reform to make markets work well and to boost productivity. Ensuring that regulation is fit for purpose is also important. So too is ensuring that the general business environment promotes innovation. These are all difficult areas to get right, but doing so is key to creating an environment where business is confident enough to take a risk, buy some new capital, hire a new worker or expand their operations. The third factor on my list is the low level of interest rates. The impact of these low rates is evident across a range of indicators and it has further to run. In the housing market, prices and turnover have risen and, as I noted earlier, dwelling investment is increasing. There are also signs of an increased appetite for borrowing, most notably among those purchasing a property to rent out. More generally, households seem prepared to move out a little along the risk spectrum in an effort to increase their expected returns. These developments are creating new business opportunities. So too is the steady growth in the Australian population, which remains considerably faster than in almost all other advanced countries; at the current pace of growth in five years’ time, the population will be around 10 per cent higher than at present. When businesses are deciding today whether to take advantage of these opportunities, they face a low cost of borrowing and finance is available for sound projects. In time, this should underpin a rise in investment across a range of industries. Of course, none of this is locked in. But, together, a lower value of the Australian dollar, an improvement in business confidence and low interest rates provide the basis for our outlook of a gradual lift in the non-mining economy over the next couple of years. Thank you very much for listening and I look forward to your questions. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches | reserve bank of australia | 2,013 | 10 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Citi's 5th Annual Australian & New Zealand Investment Conference, Sydney, 29 October 2013. | Glenn Stevens: Remarks to Citi’s 5th Annual Australian & New Zealand Investment Conference Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Citi’s 5th Annual Australian & New Zealand Investment Conference, Sydney, 29 October 2013. * * * Welcome to Sydney. As ever, the times remain “interesting”. You will have much to talk about. I will confine myself to some brief remarks, firstly about the global scene, and then about the situation in Australia. From this distance, the US economy appears to be healing. The “headwinds” from the housing sector are lessening, corporations are in a strong financial position and the labour market is improving, albeit slowly. Much financial repair has been made. The new sources of abundant energy in the US will also act as a growth enhancer. The biggest remaining problems are how to put the US budget onto a sustainable long-run footing, and how to manage the exit from extraordinary monetary policy settings. In Europe, numerous downside risks that were top of mind a year ago have not, in fact, materialised – which is no small achievement. Moreover, there are signs of a modest cyclical upturn in economic activity. That said, those downside risks still exist and the recovery has been described by ECB President Draghi as weak, uneven, fragile and starting from very low levels. China, meanwhile, has continued to grow, more or less in line with the objectives of the Chinese authorities. This is more moderate than the double-digit rates China recorded in earlier times. But it is still a robust performance and China is now a big economy whose performance matters for the rest of the world. The key question in China would be whether the “shadow-banking” system, where much of the growth in financial activity has been occurring, can be adequately controlled and kept stable. The “emerging market” economies have experienced some turbulence. Until May this year, their problem was inward flows of capital, resulting in part from “spillovers” from the extraordinary measures taken by the major countries. This put upward pressure on exchange rates, and made for easier financial conditions, which was conducive to rising credit and asset values. It was also a permissive environment for the continuation of any underlying imbalances or weaknesses. When the Federal Reserve began to lay out the conditions under which it would consider scaling back its extraordinary measures, and the possibility became real that such a scaling back might begin this year, capital markets reacted by scaling back their own purchases of assets in emerging markets. The situation then became much less permissive. Financial conditions for a number of countries tightened, exchange rates started to come under downward pressure, and policymakers were faced with the need to accelerate the crafting of responses. That pressure was lessened when the Fed did not, in the end, begin the “taper” in September. Since then, stock markets have advanced, long-term interest rates have edged down and the US dollar has weakened. The outflows from emerging markets slowed. Even in the face of the impending deadline for lifting the US debt ceiling, markets experienced a relatively limited amount of disruption (though it is very doubtful that they would have accepted a default event with the same equanimity). There was a distinctly more relaxed tone to the discussions in and around the IMF and G20 meetings in Washington in October than there had been at like meetings earlier in the year. But it would be a mistake to relax for very long in the face of this delay. Surely the “taper” will come. We should hope it will, since it will signal that the US economy is well established on a BIS central bankers’ speeches recovery track, and it will start to lessen some of the uncomfortable spillover effects unavoidably associated with the present set of policies. For some countries, including Australia, the beginning of a return to something resembling more normal conditions, in at least one major advanced country, would lessen some of the difficulties we face in our own policy choices. For some other countries, this may see some resumption of the less welcome pressures seen earlier this year. The good news is that we have had a dress rehearsal of what the beginning of tapering will probably look like, so we have a sense of the pressure points, and there is now a window within which to address some of them. It would be wise for policymakers to use that window. Turning to the Australian economy, we have seen, over the past couple of months, evidence of a lift in sentiment in the business community. A lessening of political uncertainty has no doubt helped this, though we should note that this follows an improving trend in measures of household confidence that began in the second half of last year. That uptrend had a setback in mid 2013, but then resumed. One force helping household and business confidence has been a positive trend in asset markets. Over the past year, the stock market, as measured by the ASX 200 accumulation index, has returned about 25 per cent.1 The median price of a dwelling in Australia has risen by about 8 per cent over the past 18 months, reversing a previous decline. Overall, the net worth of Australians has increased by around 15 per cent, or more than $800 billion, since the end of 2011. It is not yet clear to what extent, or when, these more favourable trends in “confidence” will translate into intentions to spend, invest and employ. The pace of new dwelling construction is starting to respond to higher prices in the established property market, as we need it to. But at this stage, the available information suggests that broader investment intentions in the business community remain subdued. It may be a while yet before we can expect to see conclusive evidence of a change here. In the interim, some commentators have taken the view that the property market dynamics are worrying. My own view, thus far, has been that some rise in housing prices is part of the normal cyclical dynamic, that it improves the incentive to build, and that a price rise reversing an earlier decline probably isn’t something to complain about too quickly. Moreover, credit growth, at between 4 and 5 per cent per annum to households, and less than that for business, does not suggest that rising leverage is so far feeding the price rise. Hence it has been a little too early to signal great concern. There are, however, two caveats. The first is that, notwithstanding the above comment, credit growth may pick up somewhat over the period ahead. So this is an area to which we will, naturally, pay close attention. Secondly, while overall credit growth remains low at present, borrowing is increasing quite quickly in some pockets. Investor participation in housing in Sydney, in particular, is becoming noticeably stronger. Over the past year, the rate of finance approvals for this purpose has increased by 40 per cent. We have certainly experienced higher rates of growth of finance than that in the past, and it may be that we are seeing some catch-up from a delayed initial response to fundamentals favouring more investment in housing. Nonetheless, as this activity continues, lenders and borrowers alike would be well advised to take due care. It is very important that strong lending standards remain in place, and that decisions be based on sensible assumptions This index, by the way, exceeds the 2007 peak, unlike the more widely quoted standard share price index. The difference comes from the fact that the Australian listed company sector has maintained a dividend yield of around 4.5 per cent, on average, since 2007. BIS central bankers’ speeches about future returns. That’s what we need if we are to experience a long and sustainable expansion in housing investment that houses our growing population at acceptable cost, and pays reasonable returns on the capital deployed. That’s the sort of outcome we want, as part of the more balanced growth path for the economy we are seeking over the years ahead. Another part of the balanced growth path would involve an expansion in some of the tradeexposed sectors that have been squeezed by the high exchange rate. The foreign exchange market is perhaps another area in which investors should take care. While the direction of the exchange rate’s response to some recent events might be understandable, that was from levels that were already unusually high. These levels of the exchange rate are not supported by Australia’s relative levels of costs and productivity. Moreover, the terms of trade are likely to fall, not rise, from here. So it seems quite likely that at some point in the future the Australian dollar will be materially lower than it is today. The high exchange rate has also had a significant impact on the Reserve Bank’s own balance sheet. It led to a decline in the value of the Bank’s foreign assets and hence a diminution in the Bank’s capital, to a level well below that judged by the Reserve Bank Board to be prudent. This has been a topic of some interest of late. Our annual reports have made quite clear over several years now that, while this rundown in capital in the face of a very large valuation loss was exactly what such reserves were designed for, we considered it prudent to rebuild the capital at the earliest opportunity. It has been clear that the Bank saw a strong case not to pay a dividend to the Commonwealth during this period, preferring instead to retain earnings, so far as possible, to increase the Bank’s capital. That rebuilding could in fact have taken quite a few years, given the low level of earnings. That is the background to the recent decision by the Treasurer to act to strengthen the Bank’s balance sheet, in accordance with a commitment he made prior to the election. The effect of this is that instead of it taking many years to rebuild the capital, it will occur in the current year. This results in a stronger balance sheet on average, and makes it likely that a regular flow of dividends to the Commonwealth can be resumed at a much earlier date than would otherwise have been the case. With those few remarks, I wish you well in your deliberations at your conference today. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 10 |
Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the International Monetary Fund Research Conference, Washington DC, 8 November 2013. | Guy Debelle: Remarks to the International Monetary Fund Research Conference Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the International Monetary Fund Research Conference, Washington DC, 8 November 2013. * * * It is a great honour and pleasure to be here. I, like many in this room, owe Stan Fischer a great debt. I was the last graduate student that he supervised. You could argue that I drove him out of academia into policymaking! When Stan was teaching his macro course at MIT, in the very first lecture he used to say: you learn [the] ISLM and Mundell-Fleming [models] in your undergraduate course (and most of us learnt it from [Rudiger] Dornbusch and [Stanley] Fischer), then you come to graduate school and we cover that in half a lecture before moving onto teaching more advanced technologies. But then you go out into the real world of policymaking and your first and best intuition still comes from Mundell-Fleming. So I must say I was struck by Emmanuel Farhi and Ivan Werning’s claim upfront in their paper1 that, to quote, “because our model has explicit microfoundations and a formal treatment of general equilibrium, it is better suited for normative analysis than the traditional Mundell-Fleming models”. That’s a pretty big claim. Call me old-fashioned but I’m not sure that I buy it. Before I get to that, let’s think a bit more about some issues that come with a floating exchange rate. Emmanuel and Ivan talk in their paper about emerging markets, but it’s not just an emerging market issue. I will also draw on the Australian experience. When the exchange rate is moving in line with the terms of trade, the real fundamentals, it plays the appropriate macro stabilisation role. Farhi and Werning have that explicitly in their model. In Australia’s case, over the 30 years of the float, the exchange rate has done just that most of the time. The problem is when financial factors cause the exchange rate to deviate from the real fundamentals. How can that come about? Well let’s think of a country, which I’ll call the Usual Suspect or US for short. That country pursues an extremely expansionary monetary policy, which is completely justifiable from its perspective. This spills over to the rest of the world which experiences an exchange rate appreciation as capital flows to earn a higher yield. Even if the global portfolio reallocation that comes about from this is small from the US’ perspective, it can be large from the point of view of a small open economy that is the recipient of these flows. In the emerging market world, the concern is often that the capital inflows will become capital outflows. In Australia’s case, an exchange rate appreciation that is not in line with the fundamentals, if persistent enough, can lead to Dutch Disease. This is the fundamental problem, be it a Trilemma, or Dilemma, as Hélène Rey labels it. Farhi E and I Werning (2013), “Dilemma not Trilemma? Capital Controls and Exchange Rates with Volatile Capital Flows”, Paper presented at the 14th Jacques Polak Annual Research Conference, Washington DC, 7–8 November. BIS central bankers’ speeches But, you might say, isn’t a stronger US economy good for the rest of the world? Or in other words, “suck it up sunshine”. That may well be true for the rest of the world as a whole, but it is not necessarily true for every other country. There is an income and a substitution effect at work here. The income effect is the boost from a stronger US in terms of greater global demand. The substitution effect is the negative effect of the exchange rate appreciation. The substitution effect can outweigh the income effect, particularly if you don’t trade that much with the US and/or if the capital flows are large relative to the size of your economy leading to a relatively large appreciation of the exchange rate. That is the fundamental problem that the authors are getting at in their paper. Though, so far, Mundell-Fleming has done just as well in getting to this point as their more advanced technology. Now let’s think about what happens when the capital flow reverses. (I would note that the term “sudden stop” maybe isn’t the right term to use, being a hold-over from a fixed exchange rate world.) In Australia’s case, the exchange rate depreciates and the main concern is inflation. This is manageable if the appropriate macro framework is in place, such as an inflation targeting framework. This is one of the points of Fischer’s 2001 lecture at the first incarnation of this conference. In the emerging markets world there are two problems. The first are also inflation concerns, particularly if inflation expectations are less well anchored. The second are balance sheet effects in the form of unhedged foreign exchange denominated liabilities. This is the genesis of the fear of floating and was critical in the Asian crisis. Paul Krugman’s second generation models capture this well. Does the model in the paper here capture this? Mostly. It captures the issue of the exchange rate not moving in line with the fundamentals. It doesn’t capture this balance sheet channel though, where the exchange rate depreciation hurts so much. Why doesn’t the standard macro response work? That is, when the exchange rate appreciates, lower interest rates to ameliorate its impact. Mundell-Fleming would say to do that. It would also say use fiscal policy, which is not discussed in the paper. Extreme reductions in interest rates can cause problems of excessive price rises in domestic asset markets. So could one turn to “macro-prudential” measures? These are effectively domestic capital controls on the locals, rather than the capital controls on the foreigners that the paper proposes. Basically one is trying to make yourself less attractive to foreign capital inflow. That’s the fundamental issue here in this paper. That has posed an interesting conundrum in Australia in recent years. We have been experiencing a “boom with gloom”. We have had the difficult balancing act of trying to tell foreigners that the economy is not as good as they think it is, so stop sending us so much capital, while at the same time trying to convince the locals that the economy is not as bad as they think it is. Now that’s a real dilemma! In the end I see the model in this paper as proposing capital controls to address the distortion of the exchange rate moving out of line with the fundamentals. Basically it boils down to the Tinbergen principle. With only monetary policy, there is one instrument and two objectives. Give me another policy instrument and it is easier to hit the two objectives. But other potential instruments are not considered in the paper. For example, intervention in the foreign exchange market in the form of reserve accumulation, which has been used in many emerging markets. This is helpful on the way in, in terms of dampening the inflows, but it also helpful in dealing with the outflows when they come. BIS central bankers’ speeches Moreover, the paper is silent on how to go about applying the capital controls in practice. Indeed, it is ironic to be discussing the appropriate implementation of capital controls at the IMF, which for a long time has regarded them as a complete anathema. Capital flows are a repeated game, an issue I know the authors have addressed in another paper. If you are a capital importing country, you need capital inflows to sustain growth in the medium term. In the end, the paper does not convince me of their claim to abandon that long-time stalwart, the Mundell-Fleming model. The intuition of Mundell-Fleming gets me to the same point as this more fancy technology. So I’m not sure I’ll invest in the technology upgrade. So the first thing that Fischer said in his macro lecture stands the test of time. In the real world, in the end you always come back to ISLM and Mundell-Fleming. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 11 |
Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Centre for International Finance and Regulation (CIFR) Forum, Sydney, 20 November 2013. | Guy Debelle: Perspectives on financial markets Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Centre for International Finance and Regulation (CIFR) Forum, Sydney, 20 November 2013. * * * I would like to make a few general points about the financial regulatory agenda. A number of the regulatory changes in financial markets have increased the price of financial intermediation and the provision of financial services generally. This has very much been the intent, and not, to re-use one of the most overused expressions around at the moment, an unintended consequence. The price of intermediation was too low before the crisis; now it is higher. It was too low in the sense that risks were underpriced. These risks include liquidity risk and counterparty risk. Reforms such as the Basel III liquidity reforms or the OTC reforms are aimed at ensuring these risks are more appropriately priced. As financial institutions are adapting to these reforms, they are repricing many of the services they are providing to take fuller account of these risks. This repricing is gradually occurring only now in many cases and there is more to come. Hence end users of these services are only now starting to see the impact of these reforms in the form of higher prices. As in many markets, when a price goes up, the quantity tends to go down. Again, this is to be expected, and desired. It is not unintended. What is less clear is whether various regulations are having an impact on the market, above and beyond the effect caused by a higher price. The general aim is for the price element to do most of the work, but in some cases, regulations with a quantitative element are in place as a backstop. Let me give as one example of this, the effect of regulation on dealer inventories of fixed income. Liquidity regulation has caused some repricing in the market, with somewhat lower inventories, particularly of less liquid securities, as a result. So aspects of the regulation have increased the cost and you would expect that to increase the price of providing the service. In this case, that would be a wider bid-ask spread. In turn, you would expect that to lower turnover. Conceptually, the leverage ratio sits there as a backstop limiting the overall size of institutions’ balance sheets. Whether it binds in practice depends on the structure of the whole balance sheet. Given the general tendency to fund inventory with repo, the leverage ratio can affect the size of the inventory a dealer is willing to hold to make a market. Whether there is a quantitative effect above and beyond the price effect I mentioned earlier is an open question which warrants answering. But in answering that question, the benchmark for the appropriate pricing and the appropriate degree of liquidity in the market is not the pre-crisis state of affairs. That was an environment of under-pricing and consequently, oversupply of this service. That said, it would appear that some significant share of the lower inventory in recent months has resulted from self-imposed constraints, rather than those resulting from regulation. A number of institutions appear to have self-limited the size of inventories, because of the resultant mark-to-market risk, particularly in the rising yield environment that was present earlier in the year. So in a number of cases, that was the binding constraint, not the increased liquidity cost of funding inventory or the leverage ratio. The example of dealer inventories of fixed income is reflected in a number of areas of the market. It has often been the self-imposed limit which has been the binding constraint. The regulatory-imposed constraint serves more as a backstop for when memories of the recent BIS central bankers’ speeches crisis fade, as they surely will in time. The regulatory constraint is designed to ensure that risk does not disappear from pricing when the euphoria returns. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 11 |
Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists' Annual Dinner, Sydney, 21 November 2013. | Glenn Stevens: The Australian dollar – thirty years of floating Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists’ Annual Dinner, Sydney, 21 November 2013. * * * I thank Alexandra Rush for assistance in preparing these remarks. Accompanying charts can b e found at the end of the speech. In just a few weeks’ time we will pass the anniversary of one of most profound economic policy decisions in Australia’s modern history. I refer of course to the decision taken by the Hawke Government in December 1983 to float the Australian dollar and to abolish most restrictions on the international movement of capital. The decision had been a long time coming. The possibility of a float had been contemplated for years. But the right combination of intellectual climate and circumstances did not arrive until 1983. When it was taken, the decision was a key part of a sequence of very important decisions that opened up the Australian economy and its financial system to international forces, and which changed it profoundly. Much has been written about that broader reform process. I will speak just about the floating of the dollar itself. I shall pose, and offer answers, to several questions. Why did we float? How has the market developed? How has the exchange rate behaved? What difference did the float make for monetary policy in particular and the economy in general? Has the currency been “misaligned” in ways that have been damaging? And what can be said about intervention? 1. Why did we float? In a nutshell, I think it is true to say that Australia finally floated the exchange rate because the feasible alternatives had been shown to be ineffective. We had tried just about all the currency arrangements that were known to human kind, with the exception of a currency board: a peg to gold/sterling, a peg to the US dollar, a peg to a basket and a moving peg. All proved ultimately unsatisfactory. From first principles it could be questioned whether Australia, a country on occasion experiences quite large shocks in the terms of trade, should have had a fixed exchange rate. The background was the complete breakdown of the international trade and financial system in the 1930s followed by war, which left private capital flows small, central banks and governments dominating capital markets and a distrust of the price mechanism generally. The experience of the early 1950s, however, showed how hard it could be to maintain stability in the face of terms of trade shocks with a fixed exchange rate.1 By the early 1980s the intellectual climate had clearly changed. Things had moved on from the post-Depression set of assumptions. More people were conscious of the shortcomings of the regulated era, and were prepared to argue for allowing market mechanisms to set prices and allocate resources. So there was a case for exchange rate flexibility on “real” or resource allocation grounds. There was also one based on monetary grounds. On the one hand, a fixed exchange rate with a suitable major currency can serve as a “nominal anchor” if we are prepared to accept In the early 1950s the Korean War induced a wool price boom, increasing Australia’s terms of trade dramatically. Under the fixed exchange rate and without the stabilising effect of an appreciation, the associated increases in national income and aggregate demand led CPI inflation to peak at almost 24 per cent. BIS central bankers’ speeches the monetary policy of the other country through all phases of the cycle. The countries to whose currencies we had pegged, however, had their own circumstances and policy imperatives that evolved differently from our own. Private capital flows had become much larger and our commitment to make a price in the foreign exchange market meant we could not control liquidity in the domestic money market. Inflows of funds in anticipation of a revaluation led conditions to become too easy, and outflows in anticipation of a devaluation tightened up the system. By the early 1980s, with inflation quite high, the lack of monetary control was a serious problem. This was the situation in the lead-up to the decision to float.2 2. How has the market developed? Thirty years ago, the Australian foreign exchange market was relatively small and underdeveloped. At the time of the float, the participants in the market were primarily the domestic commercial banks, though this quickly changed after a number of foreign banks were given licences, increasing competition significantly. After the float, the market matured and grew. Today the Australian dollar is one of the most actively traded currencies. Global daily turnover runs at about $460 billion.3 The AUD/USD is the fourth most traded currency pair, accounting for just under 7 per cent of global foreign exchange turnover. Compared with the US dollar, the euro or yen, these are small numbers but compared with currencies of several other countries whose economies are noticeably larger than Australia’s, the size of the AUD market is remarkably large. It offers the full range of foreign exchange products. These days more of the trading activity in our currency occurs outside our jurisdiction than inside it, a pattern that is common to most currencies. This reflects the role of international financial centres such as London, which retains a dominant role as a financial hub. Other centres such as Singapore and Hong Kong have made it part of their national “business model” to provide an environment conducive to major financial firms setting up to offer a full menu of financial services to the global investor community. Most countries that are not themselves international financial hubs find that an increasing proportion of trading in their currency takes place “offshore”.4 3. How has the exchange rate behaved? At the time of the float, the Australian dollar against the US dollar was actually not very different from its current value (Graph 1). It was worth about 90 US cents in December 1983. That was down from its highest point in the 1970s under the fixed exchange rate system, of US$1.4875. The trade-weighted index was 81 (today about 72), down from a high of around 120. People forget how high the exchange rate was for much of our history. Initially after the float, the exchange rate rose for some months before settling back. There was a further very distinct leg down beginning in early 1985. There was quite a lot of drama at the time – this was the era of credit rating downgrades and “banana republics”. I think Remarkably, the decision was taken as the exchange rate was under upward pressure, only a matter of months after a discrete devaluation had been forced on a newly elected government by large capital outflows. Figures from the BIS Triennial Central Bank Survey of foreign exchange and derivatives market activity in April 2013. Should this worry us? At one level it might be concerning that people elsewhere in the world take decisions that have a major bearing on the value of “our” currency. But decisions elsewhere in the world have a major bearing on the price of lots of things we care about: traded products of all kinds, the stock market valuations of our companies, the interest rate on government debt and so on. It is part and parcel of participating in the global economy and being open to foreign trade and capital flows that foreigners have a say in pricing the currency. They can and will do so whether the traders sit in Sydney or Singapore or London. That is a separate question from whether we would benefit from our firms offering more value added in financial services to the investors of the world. BIS central bankers’ speeches there was a genuine fear at various times that the currency might simply collapse to some ludicrously low value. With the benefit of that most powerful of tools, hindsight, one can observe that the currency had by the mid 1980s adjusted to a lower mean value, around which it fluctuated for nearly 20 years. One can further note that those trends had some association with developments in Australia’s terms of trade (Graph 2). From this vantage point, the market might be argued, on the whole, to have moved the exchange rate to about the right place. And despite the occasional worries about large downward movements, there was probably less high drama associated with them than would have accompanied decisions to devalue a fixed exchange rate. Some trends did seem less explicable, such as when the exchange rate fell below 49 US cents in March 2001 and lingered at very low levels for a while. This was in the wake of a slowdown in the Australian economy, but was also the era of excitement over America’s so-called “new economy”, and the sense that Australia was an “old economy”.5 The “old economy” elements like mining would come into their own only a few years later. In 2001, the terms of trade were already rising, and a powerful upswing ensued over the next decade. Even those who were prescient enough to understand the importance of the rise of China have, I suspect, been surprised by the extent of increase in Australia’s terms of trade and its longevity. And of course this trend has carried Australia’s currency to historically high levels – back, in fact, to about where the floating journey began thirty years ago. Has the mean value around which the currency fluctuated from the mid 1980s to the mid 2000s now given way to something higher, or will it reassert itself? That is a fascinating question. 4. What difference did the float make? For the Reserve Bank in its monetary policy responsibilities, the float made all the difference in the world. We no longer had an obligation to stand in the foreign exchange market at a particular price. An earlier decision of the Fraser government to issue government debt at tender meant that the Reserve Bank did not have to stand in the government debt market either. As a result of these two decisions – and they were both important – for the first time the Bank had the ability to control the amount of cash in the money market and hence to set the short-term price of money, based on domestic considerations. This is the hallmark of a modern monetary policy. The extent of short-term variability in interest rates declined while, naturally, that of the exchange rate rose somewhat (Graph 3). A flexible exchange rate is also a critical component of inflation targeting, which is Australia’s monetary policy framework of choice. Admittedly, for some years exchange rate considerations were still sometimes seen as something of a constraint in the conduct of monetary policy. This has been progressively less the case, though, as the credibility of the inflation target has increased. Even if all the flexible exchange rate did was to allow monetary policy to operate effectively, that was a major benefit. But the float did more than just that. Real exchange rates move in response to various forces affecting an open economy, even if the nominal exchange rate is fixed. Given the slow-moving nature of the bulk of prices, allowing the nominal exchange rate to change makes the process more efficient unless there is excessive short-run variability in We found ourselves “out of favour” despite the fact that it was almost certainly the use of information technology rather than its production that made for the biggest gains to a society and on that score Australia ranked highly. The price put on our currency by the market seemed at odds with other things and that episode saw the first use of results from a model in a speech by a Reserve Bank Governor to demonstrate that point (see Macfarlane 2000). BIS central bankers’ speeches the nominal rate. As hedging markets develop the cost of short-run noise is usually lessened. In my view the flexible exchange rate has helped adjustment in the real economy in its own right. The combination of allowing monetary policy to operate effectively and fostering real economic adjustment is very important. One very telling comparison is between the macroeconomic performance in the most recent commodity price upswing and that in the episodes in the early 1950s and mid 1970s (Graph 4). It is obvious that there has been a first-order reduction in macroeconomic variability on this occasion. The flexibility of the exchange rate has been a major contributor to that outcome. 5. Has the exchange rate been “misaligned”? The currency has certainly moved through a very wide range over the thirty years since the float. If our metric were some constant target level of “competitiveness” measured, say, by relative unit costs, then we would be drawn to the conclusion that it has been “misaligned” much of the time. But such a simple calculation alone isn’t the right metric. For a start, over the course of a business cycle the exchange rate should move in ways that help to maintain overall balance between demand and supply. In a period of strong demand it will rise, spilling demand abroad by lowering prices for traded goods and services. This lessens “competitiveness” in the short term, but helps preserve it in the longer term by maintaining discipline over domestic costs. Moreover, the level of relative unit costs in, say, manufacturing, that is “needed” is a function of several factors, including the terms of trade. A country with an endowment of natural resources will find that when those resources command high prices, it will have a high exchange rate and low manufacturing “competitiveness”, compared with the situation when the terms of trade are low. The high resources prices draw factors of production towards the resources sector, pushing up labour costs for other sectors and drawing capital from abroad, so pushing up the exchange rate. The terms of trade rise is an income gain, and may well prompt an expansion in investment in the resources sector. Hence aggregate demand is likely to increase, which among other things will also require a higher exchange rate than otherwise to maintain overall balance. These forces diminish “competitiveness” for other traded sectors. At a later stage, when those adjustments the capital stock have occurred, the exchange rate may be lower than at its peak, though still higher than what would have been observed had the terms of trade not risen. So it is not surprising that the exchange rate responds to changes in the terms of trade. It is nonetheless striking how close the empirical relationship has turned out to be. Of course it is not to be assumed that the parameters of that particular empirical relationship are necessarily optimal. But nor is the contrary to be assumed. Over the thirty-year period since the float, that relationship seems not to have led to long periods of the economy either having excess demand or supply. Australia has had one serious recession in that time, in 1990–91, and the principal cause of the depth of that downturn was asset price and credit dynamics, not the exchange rate. Overall, variability of the real economy has been lower in the postfloat period. While there are several factors at work in producing that result, the flexible exchange rate is clearly one. My conclusion, then, would be that evidence of large and persistent exchange rate misalignments is actually rather scant over the floating era as a whole. Arguably some of the bigger misalignments occurred under previous exchange rate regimes. But what of recent levels of the exchange rate? They have been blamed for many disappointing corporate results and triggered numerous restructurings, instances of “offshorings” and job shedding. The only other factor so frequently offered to explain BIS central bankers’ speeches disappointment is “consumer caution”. One can imagine that many people would see this as prima facie evidence of the exchange rate being significantly misaligned. There are a few difficulties in evaluating that claim. First, very high terms of trade can be expected to lead to some loss of “competitiveness”, as noted above. Just how much of this would be expected depends, among other things, on how permanent the terms of trade rise is, but this episode has been very persistent so far. The euphemism “structural adjustment” hardly conveys the difficulties faced by firms and their workforces affected by these forces. But a big and persistent shift in relative prices, which is what the terms of trade shift amounts to, was always going to produce some such effects. A further difficulty in assessing the exchange rate’s level lies in that very persistence. The relationship between the exchange rate and the terms of trade has, broadly speaking, continued to hold (Graph 5). Nothing looks very unusual right at the moment. But this relationship is estimated over a period in which the changes were generally cyclical. It is at least conceivable that a large and persistent rise in the exchange rate may have effects on the economy beyond those discernible from the experience of the past thirty years, if previous rises in the exchange rate were not long-lived enough to cause significant structural change. This is a possibility the Reserve Bank has noted in the past couple of years.6 There is at least one more complication in assessing the exchange rate’s recent behaviour and that is the extraordinary monetary policy measures that are being undertaken in the major economies of the United States, Japan and the euro zone. These too are outside any historical experience. Such measures are in place because they are required by the circumstances of those economies, but there is no doubt that they have fostered the so called “search for yield”. That, after all, was the whole point. Added to this is the lessening, even if only at the margin, of perceived creditworthiness of a number of sovereigns, while our own sovereign rating has remained at the highest level. This has contributed to an increase in “official” holdings of Australian assets as reserve holders sought diversification. These “yield-seeking” and “diversification” flows have, no doubt, pushed up the Australian dollar. Quantifying that effect is not straightforward. Models suggest that interest differentials have had an effect on the exchange rate, but that effect is dwarfed by the estimated terms of trade effects. But again, the conditions we have seen are unlike anything seen in the period over which the models are estimated. The flows have surely been important at times, though not necessarily lately. The available data suggest that foreign holdings of Australian government debt stopped rising in the middle of last year. Earlier flows into Australian bank obligations have also generally continued to reverse over that time. As my colleague Guy Debelle has noted, the most obvious capital inflows in the past couple of years have been in the form of direct investment into the mining sector. Those flows were of course responding to expected returns, but not ones that were affected very much by the interest rate policies in the major economies. In the end it is not possible to come to a definitive assessment on the extent of currency misalignment at the moment, on the basis of standard metrics (and having regard to the statistical imprecision of such metrics). Having said that, my judgement is that the Australian dollar is currently above levels we would expect to see in the medium term. See Lowe P (2012), “The Changing Structure of the Australian Economy and Monetary Policy”, Address to the Australian Industry Group 12th Annual Economic Forum, Sydney, 7 March. BIS central bankers’ speeches 6. Intervention In the early period after the float the Reserve Bank undertook market transactions for the purposes of so-called “smoothing and testing”. As the market developed and the Bank gained more experience, intervention became less frequent but more forceful. A key motivation for intervention was often trying to avoid the currency moving downwards too quickly. For most of the floating era, until recently at least, a currency that seemed prone to weakness seemed more frequently a problem than the reverse. As has been well documented, the Bank’s intervention strategy has tended to be profitable over the long run.7 The success of this strategy was helped considerably by the fact that, for much of the floating era, the exchange rate’s behaviour could be characterised as fluctuating around a stable mean. If a situation came along that shifted the mean, the strategy might need to be altered. It might be argued that this is what has happened over the past five years or more. The terms of trade event we have lived through is without precedent in its size and duration, at least in the past century. The exchange rate has responded. Notwithstanding that, in my view, the Australian dollar is probably above its longer-run equilibrium at present, it is far from clear that we can assume that the mean level we saw in the 1980s to the early 2000s will be the relevant one in the future. In evaluating the merits of intervention, the Bank has been cognisant that the current episode is unlike the experience of the first twenty or twentyfive years of the float. Some very powerful forces have been at work. A further factor relevant to intervention decisions has been cost. Intervening against the Australian dollar would have been involved selling Australian assets yielding, say, 3 per cent, and buying foreign assets yielding much less – in fact earning almost nothing over recent years at the areas of the yield curve where the Bank operates. This “negative carry” would be a cost to the Bank’s earnings and therefore Commonwealth revenue. Now it might be argued that a negative carry for the Reserve Bank, and therefore the Commonwealth, and an acceptance of the associated very large valuation risks, would be a price worth paying, if it corrected a seriously misaligned exchange rate. If such a policy were effective, it could turn out to be profitable, if a fall in the exchange rate offset the negative carry. The point is simply that costs have to be considered alongside the likely effectiveness. Often those who argue for intervention don’t work through those costs, or they assume it would be entirely costless. That can’t be assumed and the idea should be considered in a cost-benefit setting. Overall, in this episode so far, the Bank has not been convinced that large-scale intervention clearly passed the test of effectiveness versus cost. But that doesn’t mean we will always eschew intervention. In fact we remain open-minded on the issue. Our position has long been, and remains, that foreign exchange intervention can, judiciously used in the right circumstances, be effective and useful. It can’t make up for weaknesses in other policy areas and to be effective it has to reinforce fundamentals, not work against them. Subject to those conditions, it remains part of the toolkit. Conclusion When the foreign exchange market opened on 12 December 1983, without the Reserve Bank making a price for the first time in decades, people would have been uncertain what would happen. Yet policymakers had tried all the alternatives and the float was an idea whose time had come. It was a profound decision – part of a recognition that Australia was See Andrew and Broadbent (1994) and Becker and Sinclair (2004). BIS central bankers’ speeches part of a wider world, and that we had to reform our own policy and economic frameworks in order to have the sort of prosperity that we wanted as a society. On 12 December this year we can expect the exchange rate to move a little, one way or the other, and for this to be reported in a very matter-of-fact way on the news broadcasts. We will be able to get updates on our smart phones and to read seemingly limitless quantities of analysis about why it moved the way it did, and predictions about what it might do next, most of which we shall (sensibly) ignore. We would be able, if we wished, to trade foreign currencies from those devices in a way unimagined thirty years ago. (For the record, I am not recommending the practice.) For the dollar to move around in the market as the various players balance supply and demand is now considered normal, and most of the time it is considered no more newsworthy than the price of milk or petrol, and less newsworthy than the price of houses. Over the past thirty years, the exchange rate has on occasion been the subject of excitement, concern, even shock. It has acted as a shock-absorber, as intended, but it has also served as a disciplining constraint at times. Generally speaking, that was good for us. At various times we have worried that the market was behaving irrationally, believing that the exchange rate should have been somewhere other than where it was. And sometimes we were right about that. Yet, looking back, on balance the evidence suggests, I think, that the market has mostly moved the exchange rate to about the right place, sooner or later. We sometimes didn’t like the pathway. But if I ask the question of whether I would have consistently done a better job setting that price, even had that been feasible (which it wasn’t), I don’t think I could confidently answer in the affirmative. No doubt at some Australian Business Economists’ occasion on a future anniversary of the float, these matters will be re-examined. We cannot know what the conclusions will be. But for now, and probably for quite some time to come, we remain best served by the floating Australian dollar. References Andrew R and J Broadbent (1994), “Reserve Bank Operations in the Foreign Exchange Market: Effectiveness and Profitability”, RBA Research Discussion Paper No 9406. Beechey M, N Bharucha, A Cagliarini, D Gruen and C Thompson (2000), “A Small Model of the Australian Macroeconomy”, RBA Research Discussion Paper No 2000–05. Becker C and M Sinclair (2004), “Profitability of Reserve Bank Foreign Exchange Operations: Twenty Years After the Float”, RBA Research Discussion Paper No 2004–06. Debelle G (2013), “Funding the Resources Investment Boom”, Address to Melbourne Institute Public Economic Forum, Canberra, 16 April. Foster R (1996), “Australian Economic Statistics 1949–50 to 1994–95”, RBA Occasional Paper No 8. Macfarlane I (2000), “Recent Influences on the Exchange Rate”, Address to CEDA Annual General Meeting Dinner, Melbourne, 9 November. Stone A, T Wheatley and L Wilkinson (2005), “A Small Model of the Australian Macroeconomy: An Update”, RBA Research Discussion Paper No 2005–11. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 58 Graph 5 shows the results from a standard model maintained by the Reserve Bank’s staff (Beechey et al. 2000; Stone, Wheatley and Wilkinson 2005). The estimated “equilibrium” level is based on the real exchange rate’s medium-term relationship with the goods terms of trade and the real interest rate differential with major advanced economies. In this sense, the estimated equilibrium is the value of the exchange rate justified by these medium-term fundamentals, based on historical relationships. In practice, the terms of trade has historically been the most important determinant of this estimated equilibrium. At any point in time, divergences between the actual real exchange rate and the estimated equilibrium will reflect some combination of the model’s short-run dynamics, which include a number of variables that account for financial influences on the exchange rate and an unexplained component. The short-run variables include a financial market-based commodity price measure and variables that capture changes in risk sentiment in financial markets. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 11 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the IARIW (International Association for Research in Income and Wealth) - UNSW (University of New South Wales) Conference on "Productivity: measurement, drivers and trends", Sydney, 26 November 2013. | Philip Lowe: Productivity and infrastructure Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the IARIW (International Association for Research in Income and Wealth) - UNSW (University of New South Wales) Conference on “Productivity: measurement, drivers and trends”, Sydney, 26 November 2013. * * * I would like to thank David Jacobs and Michelle Bergmann for their excellent assistance in preparing this talk. I would like to extend a warm welcome to you all to Sydney for this conference on Productivity Measurement, Drivers and Trends. You are meeting in one of the world’s great cities and I hope you enjoy your time here. You are also discussing one of the world’s great challenges – boosting productivity and increasing people’s living standards. The conference organisers have put together a distinguished array of speakers to help us make some progress on this critically important issue and I am delighted to be able to participate in those discussions. I would like to divide my remarks this morning into two parts, both of which will have a distinctly Australian perspective. First, I will discuss recent trends in productivity growth in Australia and the significant challenge that lies ahead of us. And then second, I will discuss the important role that investment in infrastructure can make to boosting productivity growth and our standard of living. Productivity: the challenge that lies ahead I would like to start with a graph that I am fond of presenting (Graph 1). It has two lines. The first shows how real income per hour worked in Australia has increased over the past two decades (the green line) – this is a pretty good proxy for the growth in our real purchasing power per hour worked. The second line shows how the amount of output produced per hour worked has increased over this same period (the blue line) – this is the conventional measure of labour productivity growth. Graph 1 BIS central bankers’ speeches There are two main observations that I would like to make based on this graph. The first is that over the past two decades we have seen unusually strong growth in the average real income generated by each hour of work in Australia. Since 1993, our effective purchasing power for each hour of work has increased by a cumulative 55 per cent, or around 2¼ per cent per year on average. This is much faster than in the previous decade and faster than in almost any other industrial country. The second observation is that the source of this very strong growth in real purchasing power has changed over time. In the 1990s, the source was strong productivity growth, as is evident from the relatively steep slope of the blue line. Over these years, we benefited from a noticeable pick-up in productivity growth, partly due to a period of substantial economic reform. However, the story over the past decade is quite different, with productivity growth being noticeably slower.1 The good news is that this did not lead to slower growth in our living standards (this is apparent in the two lines moving apart gradually). The reason for this is the very substantial increase in Australia’s terms of trade over this period. With rapid growth in Asia pushing up the prices of commodities, Australia’s export prices increased substantially relative to our import prices. As Glenn Stevens has pointed out, over time we have been able to buy more and more flat screen televisions for each ton of iron ore that we have sold overseas.2 It is this increase in the average value of what we produce per hour of work – not so much an increase in the average amount that we produce per hour – that has been central to the increase in our living standards over the past decade. Before I discuss the implications of this, I would like to add one further line to this graph (Graph 2). This third line shows how real income per capita (the orange line) – as opposed to per hour worked – has increased over time. As you can see, the rise in real income per capita has been even faster than the rise in real income per hour worked, which has been faster than the rise in productivity. Since 1993, average real income per capita has increased by almost 70 per cent, or nearly 2¾ per cent per year on average. Again, this is much faster than we experienced in earlier decades and faster than in other advanced economies (Graph 3). By way of comparison, over this same period, there has been a cumulative increase in real income per capita across the G7 economies of just 28 per cent, or around just 1¼ per cent per year on average. The slowdown in productivity growth is discussed in D’Arcy P and L Gustafsson (2012), “Australia’s Productivity Performance and Real Incomes”, RBA Bulletin, June, pp 23–36, and Connolly E and L Gustafsson (forthcoming), “Australian Productivity Growth: Trends and Determinants”, Australian Economic Review, December 2013. See Stevens G (2010), “The Challenge of Prosperity”, Address to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 29 November. BIS central bankers’ speeches Graph 2 Graph 3 An important factor contributing to the strong growth in per capita income in Australia has been our favourable demographics. Over the past couple of decades, we have been in somewhat of a sweet spot. While the population has been ageing, there has been a steady rise in the share of the population in the 15 to 64 age group due to a decline in the percentage of children in the population (Graph 4). In addition, there has been a substantial rise in the share of the working-age population that is in employment, as the unemployment rate has trended down and the participation rate has trended up. As a result of these trends, BIS central bankers’ speeches there has been a noticeable increase in the number of hours worked relative to the population, which has boosted growth in measured output. Graph 4 So in summary, the past two decades have been very good ones for the Australian economy. While not everybody in the community has benefited equally, there has been a very substantial improvement in our average standard of living since the early 1990s. This improvement has exceeded growth in productivity by a substantial margin. For this to occur over such a long period is very unusual as growth in productivity and living standards are typically closely linked. We have found ourselves in this rather fortunate position because of both our favourable terms of trade and our favourable demographics. Looking forward, it is unlikely that these favourable developments will be repeated. While we can’t be sure, it is more likely that the terms of trade will decline from here rather than increase further from what is a very high level by historical standards. And in terms of Australia’s demographics, the sweet spot is now behind us. At some point over coming years, the share of the working-age population in employment is likely to decline, given the ageing of the population that is occurring.3 A hint of what could lie ahead can be seen in Graph 2. Looking at just the past few years, some increase in productivity growth is apparent, but at the same time, there has been little increase in real income per capita – the top and bottom lines are starting to come together again. Recently, we have been producing more output per hour worked, but the decline in our terms of trade and slower growth in hours worked have weighed on growth in our per capita income.4 See Australian Government (2010), Australia to 2050: Future Challenges, Intergenerational Report 2010, Commonwealth of Australia, Canberra. For a further discussion of demographic trends in Australia, see Productivity Commission (2013), An Ageing Australia: Preparing for the Future, Commission Research Paper, Canberra. Some of this slower growth in hours is cyclical in nature. BIS central bankers’ speeches If this pattern were to continue, as seems likely, the Australian economy faces a substantial challenge. Over the next decade or so, if we are to achieve anything like the type of growth in real per capita income that we have become used to, then a substantial increase in productivity growth will be required. We can no longer depend on a rising terms of trade and favourable demographics to make us richer. If this lift in productivity growth does not take place, then we will need to adjust to some combination of slower growth in real wages, slower growth in profits, smaller gains in asset prices and slower growth in government revenues and services – in short, slower growth in our average living standard. So the debate about productivity should not be seen as an esoteric one just for economists. Productivity growth matters and it matters a lot to our future living standards. On the positive side, we have seen some signs that productivity growth has picked up a bit recently. Many firms that we talk with – particularly those affected by the high exchange rate – report that they have made serious efforts over recent years to make their operations more efficient. And, as the resources investment boom transitions to the resources exports boom, stronger growth in productivity is expected, as the production phase is often less labour intensive than the investment phase. There is thus some basis for optimism. Even so, the task of generating a sustained and widespread pick-up in productivity needs to be high on our national agenda. It is a task where monetary policy can make a contribution by keeping inflation low and stable so that people can make decisions without having to worry about the distorting effects of high and variable inflation. Our medium-term inflation targeting framework – which has been in place for two decades now – has achieved this and we are committed to making sure that we continue to deliver. But realistically, the additional contribution of monetary policy to improving productivity growth is only modest. The solutions clearly lie elsewhere, in the hands of both the private and the public sector. Improving productivity is not simply a matter of the “government fixing the problem”. The private sector has a central role to play too, as it is the private sector that is the main developer of new products, the main source of innovation and the main employer of people. Of course, the environment in which private businesses take and implement their decisions is heavily influenced by the public sector. As Gary Banks, the former head of the Productivity Commission, has pointed out, the public sector has an important influence on the incentives that firms face and on their ability to respond to those incentives. In effect, it helps set the “rules of the game”.5 There is no shortage of ideas on how to boost our productivity. Last year Gary Banks also provided us with a very useful “to do” list and the Business Council of Australia has also recently contributed to the debate.6 The difficulties are in deciding which ideas to pursue and in generating the political support for changes that are in the national interest but may disadvantage some sections of the community. Investment in infrastructure Rather than recite the long list of possibilities, I instead want to focus on just one issue – and that is infrastructure. This is not to imply that infrastructure is necessarily the most critical issue. But it is an important one and it is one that is quite closely connected to the world of finance. I also want to make it clear that my comments are primarily about the medium term, rather than being focused on the short-term cyclical situation. See Banks G (2012), “Productivity Policies: The ‘To Do’ List”, Speech at the Economic and Social Outlook Conference, “Securing the Future”, Melbourne, 1 November. See Business Council of Australia (2013), Action Plan for Enduring Prosperity, July. BIS central bankers’ speeches I suspect few of you would disagree with the idea that improving our infrastructure is important if Australia is to compete successfully in international markets in the years ahead. Over recent times, we have done quite well in building the infrastructure needed to export resources to the rest of the world. But we need to do more if we are to achieve that same success elsewhere. In the years ahead, it is unlikely that Australia’s comparative advantage will lie in the production of standardised mass-produced manufactured goods for the global market. Instead, we have tremendous opportunities in a range of more specialised high value-added goods and services, where it is the quality of our ideas and the quality of our execution that is the key. Whether or not we can seize these opportunities depends critically on our human capital and our infrastructure. Looking back at our recent experience with infrastructure, I find it difficult to escape the conclusion that we are falling short in some areas, particularly in parts of our transportation system – both private and public. Many of you have no doubt felt the frustration of moving around our cities. In my own case, when I am experiencing this frustration, I sometimes feel the economist side of my brain turn on. When this happens I can’t help but think that surely there are investments in transport infrastructure that would yield a social rate of return greater than the cost of financing. At other times, I think that better use could be made of the existing infrastructure with a different pricing regime. I suspect that, on both scores, the economist part of my brain is right. The benefits of investment in transportation infrastructure are well known.7 Some of these are quite obvious, while others are more difficult to see, although no less important. Among the more obvious benefits is a reduction in travel times and costs for both people and goods. There can also be favourable social impacts through reducing travel stress and increasing the connectedness of communities. And there are environmental benefits as well. One of the less obvious benefits is what economists sometimes call agglomeration spillovers. Effective transportation networks deepen markets. They bring consumers closer to more businesses, and they bring workers in contact with more opportunities. These deeper markets and connections promote competition. They promote greater specialisation by both firms and workers. And they promote innovation and a more dynamic economy. While the internet has some of these same effects, person-to-person contact remains an essential part of business, education and innovation. Poor transportation makes this contact difficult and hurts our national productivity. Another less obvious effect of transportation systems is on the cost of housing. There are many factors that contribute to the cost of housing, but among these is the nature of a city’s transportation system. When housing prices are high, it is largely because land prices are high. And, land prices are high when there is a “shortage” of well-located land. We cannot do much about the physical supply of land, but investment in transportation infrastructure – by making it easier to move around the city – can increase the supply of “well-located” land. And when supply increases, prices adjust. This means that underinvestment in transportation networks tends to put upward pressure on housing costs.8 Given these various effects, my own view is that there are significant opportunities for additional investment in transportation infrastructure and for using the existing infrastructure For example, see Venables, AJ (2007) “Evaluating Urban Transport Improvements: Cost-benefit Analysis in the Presence of Agglomeration and Income Taxation”, Journal of Transport Economics and Policy, 41(2), 173–188, and SGS Economics and Planning (2012), “Productivity and Agglomeration Benefits in Australian Capital Cities”, Final Report, COAG Reform Council, June. Infrastructure Australia’s approach to the appraisal of wider economic benefits is outlined at <http://www.infrastructureaustralia.gov.au/reform_investment/ submissions/appraisal.aspx>. Kulish M, A Richards and C Gillitzer (2011), “Urban Structure and Housing Prices: Some Evidence from Australian Cities”, RBA Research Discussion Paper No 2011–03. BIS central bankers’ speeches more efficiently. Doing so would promote productivity growth in Australia and contribute to advancement of the overall welfare of our citizens. The potential challenges in this area are, however, significant. I would like to highlight three of these. The first is the governance of project selection. Clearly, not all investments in transport are a good idea, and some ideas are much better than others. There is, I detect, a deal of scepticism in the public’s mind about how projects are selected. This scepticism weakens public support for large-scale investment in infrastructure. Many people are concerned that money will be wasted and that political considerations will trump economic considerations. So strong governance is critical to make sure money is spent wisely in this area. There is no substitute for rigorous and transparent cost-benefit analysis. In Australia, we have made some progress in this area over recent times through bodies like Infrastructure Australia. Building public confidence in the governance process not only helps ensure that the most pressing projects are selected, but also helps build public confidence that the money is being spent wisely. This brings me to the second potential challenge – that of financing. It is no use identifying infrastructure projects with large potential gains if a way cannot be found to finance them. The financing challenge arises not because of a lack of money available to invest in infrastructure. Many private sector investors tell us that there are plenty of funds sitting on the sidelines waiting to be invested in infrastructure assets. The issue is more a reluctance of investors to take on the construction and patronage risks and/or the difficulties of charging for the use of infrastructure. Given these challenges, the public sector can play an important enabling role, either through use of its own balance sheet directly or through risk-sharing arrangements with the private sector. Over recent times, we have seen a number of innovative public-private partnerships that have helped build important pieces of infrastructure in Australia, although some of these have had problems. More broadly, I suspect that one reason that the public sector has been a bit reluctant to play an even larger role is an aversion to public debt. In many important respects, this aversion to public debt has served Australia very well, but it has also limited the appetite to borrow to build public infrastructure. Looking forward, we need to find a sustainable way in which to finance our infrastructure needs. Regardless of whether it is the private or public sector that does the financing, it is likely to be easier if we have mechanisms that generate a flow of revenue from the infrastructure. One obvious option is user charging that promotes the public good. Not only does this provide a revenue source to pay for the infrastructure over time, but it can help ensure that the infrastructure is used efficiently. Another option is the use of levies and other mechanisms to generate revenue from those who benefit most from the infrastructure. Both of these options face obvious political difficulties – few of us like paying tolls or giving up part of a financial benefit that a piece of infrastructure might give us. So, I do not want to underestimate the challenge. But as a society, we have a lot riding on finding a way to pay for the infrastructure that we need to boost our productivity and improve our living standards. Hopefully, the work currently being undertaken by the Productivity Commission will point us in the right direction. And, in an international context, infrastructure financing will be one of Australia’s priorities when we chair the G20 next year. The third potential challenge is that of capacity constraints. Not only do we need to identify the best projects and find a way of financing them, but we also need to have the skilled workers to undertake them. Over recent times, private business investment has been at a record high level as a share of GDP because of the resources boom. At times, this has created pressures in parts of the labour market, including for workers with engineering and specialist building skills. This has meant that we simply have not had the capacity to do much more investment in infrastructure. However, over the next few years, resources investment is BIS central bankers’ speeches expected to decline significantly as we move from the investment to the export phase of the boom. This creates an opportunity for infrastructure investment to rise as a share of GDP without putting undue pressure on domestic capacity. Such a rise could assist in the necessary rebalancing of the economy and help create the basis for a further boost to our national productivity. In conclusion, Australia faces a significant challenge over the coming years. While our exports are set to grow strongly, we will need to lift our rate of productivity growth substantially if we are to continue to enjoy the type of increases in our living standards that we have become used to. Meeting this challenge will require innovation by both the private and public sectors. Infrastructure is just one of the many areas that can play a role here. But if we are to maximise the benefits of our investment in infrastructure, that investment needs to be surrounded by strong governance, sound financing and pricing arrangements and due regard to the capacity constraints in the economy. Thank you for listening and I look forward to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 11 |
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