Reserve Bank of Australia Annual Report – 1984 The Economy and The Bank's Policies


In 1983/84 the Australian economy returned to forward gear, with strong growth and lower inflation. The breaking of the drought, the stimulus inherent in the large Commonwealth budget deficit and the turnaround in the stock cycle combined to produce a substantial rebound in domestic demand. A concurrent though modest improvement in the international environment gave some support to exports. The resumption of economic growth, at a pace much sharper than had been expected at the start of the year, meant that Australia's recession was shorter, though no less severe, than in other industrial countries. Wage moderation, helped by the wages pause and the Prices and Incomes Accord, was a major contributor to the general improvement in the economy. Inflationary pressures were reduced and employment rose strongly. A significant part of the early fruits of recovery reflected in company profits, forming a basis for future investment.

Some legacies of the recession linger. The unemployment rate – though it has declined – is still very high by any post-war standard. Business investment fell to its lowest level in four years. Nonetheless, there are signs of a pick-up in investment, giving greater confidence that prospects for a sustainable recovery in activity and lower unemployment are firmly cast.

The main task for policy will now be to maintain reasonable momentum in activity without generating inflationary pressures or damaging investor confidence. As the private sector strengthens, the risks of a clash between its demands for credit and the public sector's still heavy borrowing requirement may loom larger. Strong upward pressures on interest rates at this stage of the recovery would not be favourable to activity or to external trade. Australia has also entered the upswing with inflation still high both absolutely and relative to our major trading partners. Continued moderation in labour and other costs is essential if the grip of inflation is to be broken to the same extent as in other industrial countries.

For monetary policy, the first half of 1983/84 was a continuous and not entirely successful battle to maintain appropriately firm conditions in the face of volatile and substantial foreign exchange flows. Although these disturbances were not comparable with those at the time of devaluation in March 1983, they highlighted how, in the circumstances then existing, financial conditions could become hostage to exchange flows. For a period, the official response was to manage the exchange rate more vigorously – to change the trade-weighted index of value of the Australian dollar more often and in slightly bigger steps on the average. In late October, this was supplemented by some changes to foreign exchange procedures designed to allow market influences a greater role. These measures moderated but did not check inflows, which again rose strongly in early December. On 9 December the Government, with the Bank's support, decided to allow the exchange rate to float and to remove most exchange controls.

Floating the rate was critical to bringing monetary conditions under control over the second half of 1983/84. Initially, there was a degree of uncertainty and nervousness evident as the community adjusted its patterns of financing to take account of the new foreign exchange arrangements. This gradually settled but, given the novel seasonal effects at work, it was not clear until well into the final quarter that the Government's revised monetary projection was likely to be achieved.

Domestic interest rates declined slightly over the course of 1983/84 and were noticeably less volatile in the second half of the year. The period of seasonal liquidity rundown was negotiated without undue drama. However, this greater steadiness in domestic financial markets was accompanied by increased volatility in the foreign exchange market. The Australian dollar was subject to wide fluctuations in value. Over the course of the year it strengthened very slightly on a trade-weighted basis but weakened against the U.S. dollar.

Regulatory changes during the year gave further impetus to the process of innovation in Australian financial markets. The floating rate and the concurrent removal of most exchange controls reduced official influence in foreign exchange transactions and enhanced the scope and the need for private decision-making. The admission of additional foreign exchange dealers increased the community's width of choice and over time could provide some additional depth and resilience to the foreign exchange market. The process of innovation seems set to continue in 1984/85. The Government's decision, in light of the Martin Report, to remove deposit controls on banks will have an important influence. There also appear to be stronger prospects of new entrants to the banking industry, involving both domestic and foreign interests.

This changing market environment does not alter the objectives of monetary policy but has called for some rethinking on the techniques of monetary management.

Monetary policy in 1983/84

The year opened with a moderate recovery in economic activity in prospect. The task for monetary policy was to leave adequate room for this recovery while providing restraint on inflation. Though chary of over-emphasising any single indicator, the Bank's view was that sensible policy in the circumstances would be consistent with growth in M3 over the year of about 10 per cent. At the same time, an element of flexibility was seen as important in view of possible changes from innovation and deregulation in financial markets. These changes seemed likely to encourage a further shift of financing back towards banks, a factor which had contributed to the overshooting of the M3 projection in 1982/83.

The Government's monetary objectives, announced by the Treasurer in the Budget Speech, were consistent with these views. The range of M3 growth projected then was 9–11 per cent for the year to the June quarter 1984. This was to be reviewed against developments as the year progressed and due account was to be taken of a range of financial aggregates in monitoring policy.

The tender system for issuing Treasury bonds and Treasury notes offered the prospect of funding the Government's need for finance responsibly and in a timely fashion. That was an important prerequisite to establishing appropriately firm monetary conditions. Other uncertainties remained, however, and the prospects for interest rates were not clear. Much hinged on whether private credit demand revived from its then subdued level. Given the exchange rate regime, particularly the Bank's obligation to clear the market each day at a rate of exchange fixed each morning, much also depended on the external sector. Volatile and heavy foreign exchange flows had bedevilled monetary management in 1982/83 and had, on occasions, produced very sharp fluctuations in short-term interest rates. Against the backdrop of continued unsettled conditions in international financial markets, it was possible that these problems could recur.

The exchange rate regime adopted in 1976 emphasised small and frequent adjustments to the trade-weighted index of value of the Australian dollar. This had been appropriate to conditions at the time and had produced an exchange rate which followed a smooth but flexible course. However, changes in the financial environment had added increasingly to the problems of exchange rate management. The growing integration of overseas and Australian financial markets, the expansion of currency “hedge” facilities and greater sophistication in financial management, had all served to heighten market sensitivity to developments overseas and especially to expected movements in exchange rates.

In this environment, exchange rate adjustments were frequently out of line with market perceptions, leading to large foreign exchange flows in one direction or the other. The outcome over most of 1983 was a substantial net inflow of overseas funds.

The problems for monetary management engendered by the exchange rate regime were a continuing matter for study during the first half of 1983/84. At times, the trade-weighted index was moved from day to day in larger steps than had been the practice. This was aimed at reducing divergences between actual and expected exchange rate movements and at adding to the risks faced by those seeking to anticipate official actions. The approach had limited application since, in the circumstances, the size of rate movements necessary for full effect would hardly have been consistent with the smooth management concept embodied in the 1976 arrangements.

Further changes designed to limit flows of speculative funds were made at the end of October. The Bank's rates for settling U.S. dollar transactions with banks were announced at the end of each day, rather than in the morning. The Bank also withdrew as underwriter of official forward exchange facilities and effectively allowed the forward exchange rate to float. The later setting of the exchange rate reduced the scope for traders to take advantage of movements in currency relationships during the day on Asian markets while the official Australian dollar rate was fixed. The move had no effect on other factors contributing to volatile foreign exchange flows. Strong inflows from these factors developed again in November and particularly early December.

The authorities could have sought to deal with these unwanted flows through direct controls. The Bank saw these as a last resort, prone to create distortions in financial markets and likely to have limited and only short-run effectiveness.

Another option was to float the Australian dollar. Following discussions with the Bank, a decision to do this and to remove most exchange controls was taken by the Government on 9 December. The floating rate meant that monetary management would no longer be disrupted by unexpected and unpredictable shifts in domestic liquidity resulting from private external transactions. There would be a firm basis for controlling growth of monetary aggregates and, ultimately, inflation. A cost of this would be less influence, in the short run, over the exchange rate; in the longer run there are limits to the authorities' ability to determine the exchange rate whatever the system. Removing the exchange controls was a very important adjunct to the decision to float. It recognised, and took a step further, the integration of Australian and overseas financial markets.

Following the float, the Government's monetary projection was reviewed to take account of developments in the first half of the year and reactions to the changes in the exchange rate system. In late December the Treasurer announced that, in the climate of stronger growth and generally restrained wage and price increases, the conditional projection for growth of M3 over 1983/84 would be raised to 10–12 per cent. The progress of aggregates other than M3 would continue to be monitored.

With the exchange rate floating, the Bank announced it would not generally intervene but retained discretion to do so; it would enter the market from time to time to test market trends or smooth large movements; it would also undertake normal transactions for its clients. In placing these transactions in the market, the Bank would not be aiming at a particular exchange rate outcome.

The heavy foreign exchange inflows in the first half of 1983/84 had created a special situation. It was clearly in the interests of the economy that these flows should be offset or neutralised as far as possible. The Bank announced that it would be taking opportunities to sell in the market some particular accretions of foreign exchange and would be funding the Government's overseas payments directly from reserves during the remainder of 1983/84.

That left it for domestic market operations, along with primary issues of Commonwealth securities, to deal with the remaining overhang of liquidity injected immediately prior to the float. Additionally, monetary policy had to address the uncertain impact of the floating exchange rate on monetary conditions during the June quarter liquidity rundown and over the longer haul, now that the “safety valve” of net foreign exchange inflows had been turned off.

The immediate task was to bring monetary movements into line with the desired growth over the year but to do so without exacerbating market pressures during the seasonal rundown (in April/May). This required careful handling: with financial markets still unsure of the outlook, an “at all costs” pursuit of a particular M3 outcome might have aroused fears of a credit squeeze and thus run the risk of setting back the incipient recovery. As things progressed, concern was seen to be unfounded.

Growth in M3 continued unabated for some time into 1984 as savings bank deposits expanded rapidly. However, from March onwards, the evidence grew that the monetary situation was coming on track and M3 ended within the Government's projected range. The course of M3 over this period was not wholly representative of financial conditions generally; non-bank financial aggregates tended to grow at a slower rate than M3 until the final months, when growth rates moved closer together. At year end, financial conditions overall were appropriately firm.

During the seasonal rundown, short-term money market rates were high but stable; they did not reach the peaks of 1982/83. Longer-term market yields, including bond yields, also fluctuated within narrower bands. For most of June, rates declined somewhat as it became apparent that growth in M3 would be within the Government's projections without the need for further policy action.

The general firmness in financial conditions and the climate of monetary restraint at the close of 1983/84 provided a solid foundation for 1984/85.

Monetary policy – the future

As the financial year closed, the economy was growing strongly. Some broadening of the recovery was expected but many factors that had been important to growth during the year were expected to provide less stimulus in 1984/85. There were, however, some risks to the general outlook. Internationally, there were doubts about the pace of economic recovery in the major countries and concerns at the potential effects of any major loss of confidence in the international financial system. The main domestic risks were that private fixed investment would lag unduly or – as seemed more probable – would accelerate with the prospect of a clash between public and private demands in capital markets; or that income restraint might weaken.

The recovery itself has provided the Government with a much improved basis on which to formulate its budget for 1984/85. The cyclical component of the deficit has been wound back and the case for budgetary stimulus which had existed in 1983/84 much reduced. The Bank offered the view that the Government should take the greatest possible advantage of this situation to reduce the size of the deficit for 1984/85 and hence the Government's demands on the capital market.

It will again be important that the Government's net spending be financed on the basis of primary sales of Commonwealth securities, essentially bond tenders and net sales of Australian Savings Bonds (ASBs). The Bank's market operations will need to adjust the community's stock of cash as a necessary foundation for appropriate credit expansion. This is a somewhat simplified expression of the complementary roles of debt management and monetary policy.

As explained earlier, after the exchange rate was floated the Bank funded the Commonwealth's further foreign exchange requirements in 1983/84 from accumulated foreign currency reserves. This offset part of the unwanted earlier inflows of foreign exchange and was consistent with the objective of slowing growth of the money supply. Obviously, however, there are both policy and practical limits to how far this could continue.

It is not easy to make confident predictions about conditions in the capital market in 1984/85. However, a sizeable reduction in the budget deficit would reduce the bond selling programme and ease that source of upward pressure on interest rates. That in itself would be conducive to recovery in business investment. Beyond that, market conditions will be affected by borrowings of state and local government authorities, which have contributed strongly to the considerable increase in the level of total public debt in recent years. Rising debt service requirements can affect investor confidence here and abroad as well as become a burden on budgets of the borrowers. It will take time to arrest such trends and it is important to take every opportunity to do so.

The combination of sales of primary securities by tender and the floating exchange rate means that the authorities now have much greater day-to-day flexibility in responding to financial pressures. Monetary outcomes should be more predictable. This is not to say that the authorities hold all the cards. Indeed, conditions will continue to be influenced fundamentally by such factors as the budget and the balance of payments and by international financial trends.

Some further modest slowing in the rate of growth of money and credit over 1984/85 seems desirable and is not likely to prejudice the expected growth in activity. With activity and prices expected to grow less rapidly during 1984/85, keeping suitable monetary conditions through the year should go with growth in a range of monetary aggregates somewhat lower than last year.

That leaves the question of how the appropriate monetary outcome should be measured or expressed. Experience in 1983/84 showed the difficulties of attempting to target particular financial aggregates such as M3. Unexpected changes in the strength of economic activity can influence the appropriateness of the target. The process of innovation and deregulation in financial markets can mean that the chosen aggregate may turn out to indicate a very different quantum of financial activity by the time the financial year is finished. Over much of 1983/84, for instance, growth in M3 appeared stronger than cyclical factors alone would have suggested. A shift in market shares was obviously a factor. Changes in regulations from 1 August 1984, which are described later, will probably lead to further shifts in market shares in 1984/85. These uncertainties illustrate some of the problems of monetary targeting and argue strongly against too simple a reliance on a single aggregate. On the other hand, provided the necessary qualifications are well to the fore, a published monetary projection can be an earnest that policy will keep a firm grip on the economy.

Given these various concerns, it would seem appropriate to aim for growth in the chosen indicator somewhat lower in 1984/85 than in the year past. It will, however, be necessary to be conscious of signals coming from a number of monetary aggregates as well as from interest rates and the exchange rate. It will also be necessary to recognise the likelihood that market shares will change and that monetary projections will need to be kept under review as the extent of changes becomes apparent.

Some broader issues

Deregulation and financial innovation have been moving the Australian financial system towards more competitive conditions. During 1983/84, this process was given extra impetus by the conclusions of the Review Group on the Australian Financial System (the Martin Report). This Group had been asked by the Government to take a fresh view of the recommendations of the Campbell Committee in light of the Government's economic and social objectives as well as the need to improve the efficiency of the financial system. The Board welcomed the thrust of the Report towards further deregulation.

The Government's initial response to the Martin Report came in April, when it announced the removal of deposit controls applying to trading and savings banks (from 1 August 1984) and its decision to grant foreign exchange dealing authorities to non-bank financial institutions satisfying certain capital and expertise requirements.

Of the major issues raised by the Martin Report, two that remain unresolved at year end concern controls on bank interest rates on small loans and policy on participation in banking. As last year's Annual Report indicated, the Board regards the interest rate controls as inimical to efficiency and equity in financing, and serving no useful monetary policy purpose. It believes the controls should be withdrawn.

The Board also considers that there is scope for more competition within the banking sector and welcomes the initiatives already taken in this area. Any new arrangements for the establishment of banks should be such as to maintain stringent prudential and operating standards for banks. Participation by foreign banks could be expected to contribute to the development of the Australian economy in a number of ways, not least in aiding the expansion of our overseas trade and our ability to tap new sources of investment capital. This argues for structuring some new banks in a way that draws on foreign participants' international standing and combines this with an Australian orientation of policy.

The changing environment inevitably involves competitive stress, which impinges on the Bank's concern for the stability and efficiency of the financial system. One outcome of greater competition has been the blurring of the distinction between banks and non-bank financial intermediaries – in many areas the services they offer have become very similar. The Board supports the view of the Martin Group that confidence in banks should be at the core of a well-functioning and stable financial system, and that a basic distinction between the two groups should be maintained.

The Bank's responsibility for prudential supervision of banks assumes greater importance in a more deregulated market, in which banks may take on greater risks and where stronger competition may lower profit margins. Adequate bank liquidity is one essential in this environment. The Statutory Reserve Deposit (SRD) ratio and the LGS convention were reviewed in the Martin Report. Whatever their remaining usefulness for monetary management, the SRD/LGS arrangements also serve prudential purposes and some such standard will still be needed in the future. The Bank is examining these matters. Other initiatives to strengthen the Bank's role in bank supervision are discussed in a later chapter.

The pivotal position of banks means that the final settlement of most financial transactions will continue to involve the receipt and payment of banking funds. Nonetheless, there are many layers to the mechanism. The Government has accepted the view of the Martin Group that the development of Australia's payments systems should not be left solely to market forces. Development should be consistent with the Government's economic and social objectives, including the objective of maintaining a stable financial system. Accordingly, the Treasurer in June 1984 announced arrangements for the establishment of an Australian Payments System Council. Its functions will be to monitor the development of the domestic payments system, promote the implementation of standards for electronic funds transfer systems and foster interconnection between payments systems. In undertaking its functions, the Council is to keep clearly in mind the principle of ensuring fair competition amongst all financial institutions. The Bank willingly accepted the Treasurer's invitation to chair the Council.

The Government has indicated that, as a matter of priority, the Council should consider how best to facilitate arrangements between banks and non-banks by which the latter gain access to the cheque payments system. In the Government's view, the terms of access should desirably be resolved through commercial negotiations, subject to appropriate prudential arrangements.

The Government's decision to remove deposit controls on banks will increase competition among groups of financial intermediaries. For merchant banks, this decision and the permission granted them to deal in foreign exchange may mean a significant change in their operations. Authorised dealers in the short term money market will be another group affected. After discussions with the dealers, the Bank has moved to alter its relationships with them and with the securities markets more generally. The changes, which are discussed later, should support the continued effectiveness of the authorised dealers in the short term money market, and establish a more appropriate framework for the Bank's domestic market operations.

The structure of ownership of some merchant banks appears unwieldy and is unsatisfactory to the shareholders themselves. In some instances there are overlapping shareholdings and inequalities in financial resources between major shareholders. Such structures could be a source of concern in adversity. Provisions for shareholders to extricate themselves from such structures, or to rearrange their participation, could promote greater stability and better management of this important sector of the financial system. The extent to which official policies may be restraining desirable adjustments deserves close consideration.