Reserve Bank of Australia Annual Report – 1989 The Year in Review

Private spending grew much more rapidly in 1988/89 than had been expected. This led to severe pressure on resources in some parts of the economy, concern at the emergence of stronger inflationary pressures, and a further deterioration in the current account deficit. Though Australia's economic growth in the year was high, it was more than accounted for by domestic demand; net exports fell.

On the policy front, government budgets introduced in the early part of 1988/89 represented further fiscal tightening. Monetary policy, having been tightened in the final quarter of 1987/88, became progressively more restrictive throughout 1988/89. Wage increases remained moderate when measured against inflation. Nonetheless, the momentum of demand, coupled with buoyant business sentiment, was such that only towards the end of the June quarter was there any confidence that a slowing had commenced.

Broad economic policy for several years has aimed to establish conditions favourable to increased private sector investment. Wage moderation and the consequent shift in income shares towards corporate profits raised rewards to investment. Fiscal restraint was intended to subtract from overall spending growth and make room for private investment spending. The role of monetary policy was to encourage financial stability, internally and externally, and to discourage excessive growth of aggregate demand.

This package of policies produced a marked increase in investment spending in 1988/89. While much of the investment should contribute to future productive capacity, some of it — in response to price signals which reflect tax and inflation considerations — was in areas not especially oriented to increasing output in the traded goods sector. More importantly, it came at a time of widespread unexpected strength of domestic spending, adding to the pressure of demand on resources.

The rapid growth of spending also added to the current account deficit through the spillover into higher imports and reduced supply of exports. Our international indebtedness rose in consequence, resuming the upward trend as a ratio to GDP that it had followed in the years up to 1986.

As the economy moves into 1989/90, monetary conditions are tight with short-term interest rates high in both nominal and real terms. While the indicators are still mixed, the Bank believes the current setting of monetary policy is now dampening growth of private demand. Higher interest rates gradually seem to be having an impact on all categories of spending. However, the general buoyancy of the economy has been such that rates may need to remain high for quite some time to achieve the desired effect.

The size of the task should not be underestimated. Inflation appears set to remain above the average for industrial countries, even if demand pressures are contained. The inevitable rise in debt servicing costs will add to the turnaround required in our trade performance if the current account deficit is to be reduced. Nevertheless, it is imperative that there be a return to progress on reducing both the rate of inflation and the current account deficit over the coming year. The Bank does not share the opinion expressed in some quarters that, since most of the debt is owed within the private sector rather than by government, it is a matter of little consequence. The extent to which resources must be diverted to its future servicing is the same whether the debt is publicly or privately owed, and the investment which it has enabled will not automatically ensure that these resources are available.

The role which monetary policy should play in the overall policy setting has been a subject of considerable debate. It has, of course, been a major element of policy in the past year. Excess demand and its prospective spin-off to inflation made that inevitable, as did the strength of demand for credit in the first part of 1988.

Monetary policy remains a potent demand management tool, though its effects are distributed unevenly. It will reduce, or even reverse, a surge in aggregate demand if applied vigorously enough and for long enough. This should, with a lag, cut into the demand for imports and thus the current account deficit. However, this is not the primary objective. In fact, in the short run, there may be perverse effects on the balance of payments if higher interest rates produce an exchange rate appreciation. Some of those effects were evident in 1988/89.

On its own, monetary policy will not produce the longer-term structural benefits Australia is seeking. Beyond a point, it may even inhibit the structural change because of the effect of high interest rates on investment of all types. Nevertheless, monetary policy has an essential role in supporting structural reform.

Australia needs a major shift of resources into the traded goods sector to stimulate increased exports and, more importantly, to replace imports. This cannot be achieved if domestic demand is growing faster than productive capacity; but simply slowing demand is not enough either. There is also a need for greater productive capacity, improved productivity and a better overall price performance, at least as good as our competitors. We need also, if possible, to fund a greater proportion of investment from our own resources and not by borrowing abroad; in other words, more savings, less consumption.

Fiscal policy was tightened further in 1988/89 and a continuation of that trend is to be encouraged. Equally, income moderation must continue to be pursued in the interests of lower inflation and the increased competitiveness of our goods and services. The setting of incentives and disincentives at the microeconomic level has played a role in creating some of our present economic imbalances. Changes there are essential if we are to avoid a re-emergence in the next upswing of the problems of the past year, but the vital key is inflation. Restructuring is much more difficult, even impossible, in a high inflation environment which destroys competitiveness and discourages saving. Altering this situation must have top priority.

The process of institutional change was taken further by some important steps during 1988/89. Adjustment by the financial sector to the new arrangements distorted the financial aggregates and created some difficulties of interpretation. However, the difficulties facing the authorities, on occasions, in forecasting and anticipating market reactions stemmed not only from problems with data but also from an imperfect perception of the dynamics of the deregulated financial system. Australia now has a very alert and sophisticated financial sector closely integrated with international markets. It is a feature of markets to act promptly and vigorously on the basis of expectations. Over recent years in Australia, expectations have from time to time run well ahead of events in the real economy and have sometimes been at odds with them.

Replacement of the Statutory Reserve Deposit requirement met by trading banks finally got under way in September 1988. This had been foreshadowed for some time.

An immediate result of the process of replacement was an acceleration of growth in trading bank deposits and hence of monetary aggregates. This did not indicate a significant change in monetary growth, rather a shift between different categories of bank liabilities. Statutory Reserve Deposits imposed an additional cost on raising deposits in Australia and thus were an incentive for banks to raise non-deposit liabilities, to borrow overseas or to direct business through non-bank subsidiaries.

Differences between trading banks and savings banks were removed, for all practical purposes, during the past year. As well as the non-callable deposit requirement, all banks are now subject to the same Prime Assets Ratio requirement and other restrictions on savings banks have been reduced. Proposals are before Parliament which would do away with legislative distinctions between trading and savings banks.

The “risk ratio” approach to the adequacy of banks' capital, foreshadowed in last year's Annual Report, was introduced in 1988/89.

The Bank's net operating earnings in 1988/89 were well down on other recent years. Net losses were realised on sales of securities and foreign currency and there was a further, though small, shift in the composition of assets towards foreign currency securities on which yields are lower than on domestic securities. Most of the earnings were retained by the Bank to replenish reserves and provisions. An amount of $140 million is being paid to the Commonwealth compared with $786 million from 1987/88 earnings.

Last year, the Bank reported that it had been reviewing the range and effectiveness of its activities. That process was taken further in 1988/89, leading to enhanced productivity and lower staff numbers. The staff reductions were achieved only partly by natural attrition. The major contribution came from voluntary redundancies, the additional one-off costs of which are reported in the Accounts.