Reserve Bank of Australia Annual Report – 1986 The Bank's Policies

The Setting

It was not expected at the beginning of 1985/86 that Australia's current account balance would deteriorate to the extent that it did. Increased competitiveness following the heavy depreciation of the Australian dollar was expected to make a major contribution to improving the balance of trade in goods and services. In support, budgetary measures announced in August promised to lower demands on the capital market and monetary policy was seeking to restrain borrowing and lending.

The 1985/86 Budget provided for significantly slower growth of Commonwealth outlays and a reduction in the net public sector borrowing requirement. The Government also decided to seek further restraint in wages. The budget strategy was built around an assumption that growth of domestic demand would slow but that growth in net external demand would broadly offset the decline, thereby maintaining economic growth overall as well as improving the current account balance.

Only part of these expectations was borne out. Domestic demand slowed and net external demand increased. But, while export volumes grew strongly for much of the year, low export prices were a source of weakness in the current account. Further, the weakening in domestic demand and production was greater than expected. Some slowing was in train as a natural consequence of deteriorating export returns and the lagged effects of generally tighter policies since early 1985. The process was hastened, however, when monetary policy was brought to bear more firmly in the December quarter of 1985.[¹]

Against the trend in production, employment grew strongly through the year, though demand for labour drew people back into the labour force, moderating the extent of the decline in unemployment.

The substantial depreciation of the Australian dollar in 1984/85 wrought much of its effects on prices in 1985/86. The impact was, for a time, cushioned by existing fixed contracts and by foreign exchange hedging. It seemed also that importers and foreign suppliers were absorbing part of the price increases in order to maintain their markets. As time went on, with the Australian dollar continuing weak and the currencies of major sources of imports such as Japan and Europe strengthening markedly, large price increases became inevitable. Because of these influences, Australia's inflation rate was about 8½ per cent over 1985/86. This was higher than in the previous year and widened the gap with our trading partners.

Internationally, there was a marked decline in inflation in the past year. The fall in commodity prices was a major factor, though not the whole of the story. It would be unwise, of course, to dismiss the possibility of a revival of inflation, but results in 1985/86 offer some prospect that the major countries could be entering a period of non-inflationary growth. If this proves to be so, all countries, including Australia, will benefit in the long run. In the short run, the general reduction in world inflation draws attention to the need for Australia to deal adequately with the pace of increase of prices.

Other domestic costs besides those directly induced by depreciation also rose in 1985/86. The aggregate of wages, salaries and supplements per employee, including labour “on costs” (such as superannuation and workers' compensation), grew more strongly than award wages which were restrained by delay in the decision in the April National Wage Case. The cost of employing labour also grew more strongly than comparable costs in our major trading partners.

There was nevertheless a significant net improvement in competitiveness, offering the prospect of a longer-run improvement in Australia's external accounts. In the short run, a number of factors conspired to widen the current account deficit. One was the impact of devaluation on the domestic-currency equivalent of import payments and transfers, including interest payments on external debt. Another was the unexpectedly severe deterioration of conditions in traditional export markets, related in part to falls in the price of oil and to heavy agricultural subsidies in Europe and the United States. Added to the weak demand for exports was the continued strong growth in imports in the second half of 1985.

1 Current Account and Terms of Trade

Opportunities for higher domestic production following increases in the prices of imports and some new export opportunities were taken up only slowly. It is not yet clear whether this tardiness will prove more pronounced than past experience would lead us to expect. Whatever the cause, the lag underlines the magnitude of the problem facing Australia. The creation of new and expanded productive capacity is fundamental to achieving external balance without a prolonged period of sluggish growth. This requires, among other things, confidence on the part of businesses that inefficient work practices and overly-optimistic income expectations will not erode the recent gains in competitiveness.

The heavy depreciation of our currency has already given notice that continued external borrowing is no answer to our problems. Our international debt has risen sharply in recent years and the cost of servicing it, with depreciated Australian dollars, was a major factor in the worsening of our balance of payments in 1985/86. There is now widespread recognition that the debt burden cannot be allowed to continue growing at its pace of recent years. This has highlighted the need for greater restraint on the part of governments, to make way for private demands on capital markets without excessive calls on foreign sources of funds.[²]

2 Capital Markets

Monetary Policy in 1985/86

Entering 1985/86, activity was strong and money and credit were still growing faster than expected. Deregulation and financial innovation continued to complicate judgments about the appropriate pace of monetary growth. The Board's view was that monetary policy, which had been tightened progressively over the first half of 1985, would have to remain firm for some time.

3 Exchange Rates

There was no marked change in the general stance of monetary policy over the period July to November. The objective was to slow the demand for credit by steady application of the policy being followed. There was nevertheless some concern that the lagged effects of rising interest rates might slow economic activity abruptly. Either way, evidence was slow to appear; in the case of credit, the figures suggested some acceleration.

November was a watershed. News on money and credit, oil prices and the outcome of the National Wage Case triggered a sharp fall in the Australian dollar. Later in the month, poor balance of payments figures exacerbated the decline in confidence in foreign exchange and money markets.[³]

Statistics continued to show economic activity at a very high level and credit growing at a fast pace. After assessment of the available indicators, it was decided that the process of adjustment was proceeding too slowly, while unexpectedly large monthly current account deficits were adding rapidly to external debt. Monetary policy was tightened, taking advantage of the natural tightening already occurring in the marketplace.

The tightening of policy was, in some degree, an attempt to buy time for underlying adjustments in the economy to occur. There was still the possibility that these might produce an early slowing in the growth of economic activity and that more favourable trends in the balance of payments might emerge. Of course, the further turn of the screw ran the risk of slowing activity too sharply, but the risks associated with allowing the economy (and external imbalance) to run ahead unchecked were even greater.

Throughout the second half of 1985/86, monetary policy took more of the burden of adjustment to changing economic circumstances than might normally be desirable. In part this reflected the exigencies of the situation and in part it reflected the greater flexibility of monetary policy relative to other policies. At the same time, the Board was always conscious that monetary policy bears most heavily on the private sector — a characteristic that posed an uncomfortable dilemma.

Each passing month in which the tightened monetary policy was maintained increased the likelihood that economic activity could slow abruptly. Housing activity faced sharp restraint and the plight of some farmers was exacerbated by the tight financial conditions. National accounts figures, on the other hand, confirmed a substantial fall in Australia's terms of trade during 1985. Not only had this contributed to the sluggish response to the earlier depreciation but, with little prospect of an early improvement in export prices, the longer-run outlook for the balance of payments had deteriorated significantly. Moreover, Australia's inflation was still running at a high level, at a time when major countries abroad had all but achieved price stability. Increasingly, there seemed a need for other policies to be modified in the face of adverse developments. In its recurring reviews of monetary policy, the Board decided that a restraining influence on financial conditions continued to be appropriate, although some moderation of the degree of tightness in policy became possible as the year progressed.

Early in 1986, the balance of probabilities was that a moderate slowdown in activity was in the offing. Growth of money and credit also seemed to be slowing. With lower demand for credit and reductions in interest rates overseas, some interest rates in domestic markets were falling and there was keen demand from abroad for Australian dollar securities. Against this background it was possible for the Bank to acquiesce in some downward movement in market yields; at the same time, the Bank was reluctant to get ahead of the market. Still, by the end of March, market interest rates and yields generally had fallen to their October levels.[⁴]

4 Interest Rates and Security Yields

This general experience did not apply to housing, where a long-standing ceiling on housing interest rates had been kept unchanged while other rates rose. Consequently, the flow of finance for housing began to dry up and the industry languished. Parts of the rural sector, which were hit by weak export prices, high interest rates and rising costs, were also coming under considerable strain.

In April, the Government announced policy packages to encourage the flow of finance to housing and to give some assistance to the rural sector. Included among the housing measures was the removal of the interest rate ceiling on new home loans by savings banks. These policy changes, together with continuing declines in interest rates, improved the chances for a more even and perhaps milder slowdown in the economy, reducing some of the short-run concerns about monetary policy.

Very poor balance of payments figures for April prompted a sharp fall in the Australian dollar in May and halted the tendency for security yields to fall. Increasing public awareness and debate about Australia's economic problems led to further bouts of nervousness in the foreign exchange and securities markets. There was another sharp depreciation of the Australian dollar in June.

As the financial year drew to a close, it could be said that some of the objectives of monetary policy were being achieved. The pace of economic activity had slowed substantially. Growth of money and credit had also slowed, though from high levels. In more normal times, these developments might have paved the way for less restrictive financial policies. These, however, were not normal times. The future remained clouded by the prospect of a protracted period of adjustment to correct external imbalance, the success of which would be determined largely by the Government's ability to reduce public sector borrowing and by the ability of Australian industry to remain internationally competitive and to use that competitiveness. Conditions in the market for foreign exchange remained fragile. Monetary policy therefore continued to exercise some restraint. It would have been premature to ease monetary policy before necessary adjustments elsewhere in the economy were achieved. To have done so could have risked a destabilising cycle of depreciation and inflation. In the circumstances, the Board judged it necessary to maintain moderately restrictive conditions in financial markets as 1986/87 began.

Other Central Banking Issues

Deregulation and monetary policy

Developments in 1985/86 provided further experience of the workings of monetary policy in a deregulated financial system and threw further light on the relationships between monetary policy and other economic policies. Two important but related issues were the difficulties of judging the effectiveness of monetary policy and the extent to which monetary policy should carry major responsibility for short-term stabilisation policy.

The transmission of monetary policy depends, in the first instance, on the speed of adjustment of private sector lending rates to changes in cash conditions. It also depends on the reactions to changes in rates by different groups of borrowers. The linkages are influenced by perceptions about the permanence of interest rate changes and the capacities of different groups to offset these effects and to refinance debt positions. Strong competition among financial institutions for market share and the varying ability of both intermediaries and borrowers to tap external sources of credit can affect the timing and sureness of the transmission process. With further experience of a deregulated system, more reliable readings of the likely size and speed of financial market responses may emerge. But, at present, there is still much uncertainty. Of course, much of the apparent certainty in a regulated system can be spurious if the more volatile elements move outside it.

The transmission of monetary policy actions to financial conditions can also be complicated by the tendency for markets to overshoot. Swings in confidence and in market prices are a natural feature of active markets where pricing decisions involve continual assessment and reassessment of both the past and the future. There was ample illustration in 1985/86 of the ability of markets to become, at least for a time, very bearish or bullish in response to (sometimes small) accretions of new information or changing expectations. To the extent that short-run volatility can sometimes mask changes in longer-run trends, it can complicate attainment of monetary policy objectives. While official actions may seek, at times, to dampen excessive swings, they cannot prevent short-run market volatility completely. Regulation which attempts to prevent volatility can cause significant inefficiencies or transfer the volatility to other markets (and can carry a potential for even greater long-run instability). There has nevertheless been a need to recognise the complications introduced by the natural volatility of deregulated markets and to take them into account in the Bank's market operations.

Notwithstanding these uncertainties in the transmission of policy actions to financial conditions, deregulation has made monetary policy more pervasive. This has not increased the scope for “fine tuning” the economy through monetary policy. Information is usually incomplete and different indicators can give different signals. More importantly, although changes in monetary policy have the capacity to produce quick responses in financial conditions, the economy more generally responds with a lag.

While the Bank eschews “fine tuning”, it is to be expected that monetary policy, because of its flexibility, will be the first to respond to major changes in economic conditions. However, as was demonstrated in 1985/86, monetary policy cannot always provide an adequate substitute for general policy responses in other than the very short run.

Monetary policy “checklist”

To some extent, the use of a “checklist” of indicators when determining the stance of monetary policy guards against excessive attention to any one aspect of economic and financial events. The main indicators included in the Bank's “checklist” are money and credit aggregates, interest rates, the exchange rate, the external accounts, economic activity and inflation. In the course of reviewing monetary policy, the Bank first assesses both the current and prospective state of each of these indicators and then the implications of these readings for any change (and the extent of change) in the direction of monetary policy. Final decisions based on the “checklist” require careful judgments — and a healthy humility about powers of foresight.

The Bank does not have any targets for the “checklist” items. At no time has any item, or group of items on the “checklist”, been raised to the status of a policy objective. Commentators sometimes profess to know or to judge that the Bank does, in fact, have a target for some item on the “checklist”, e.g. the exchange rate. Although exchange rates (and the balance of payments) are important indicators for deciding policy, the Bank has not sought to establish any particular exchange rate or to go past its well-documented practice of testing and smoothing transactions in the market.

The role of capital flows

Some interesting questions follow from the large net inflow of private capital during the year.

One relates to the substantial proportion of borrowed funds. As opposed to equity, where returns (and the servicing task) tend to vary with our economic fortunes, debt is an unrelenting charge which continues even if the funds are not well-used. If the choice between equity and debt in the composition of foreign capital, and indeed in the overall structure of financing, is the outcome of individual decisions about commercial advantage, it is usually assumed that efficiency will be well served. Of course, judgments have to be made in an increasingly complex and uncertain environment, in which it is increasingly difficult to foresee the future and, indeed, the consequences of decisions about relative risks. Nationally, the burden of aggregate international debt is a factor of increasing significance.

The prevalence of heavy overseas borrowing caused some to wonder how much the deficit on current account reflected domestic economic developments and how much it was, in effect, “driven” by capital inflow bearing no close association with current economic activity.

In a situation such as that faced by Australia, where export industries have been declining and a major source of investment goods is imports, it is not surprising that the current account is in deficit. Given these pressures, there will be an inevitable need for capital inflow; in a sense, its form and the channels it uses are of subsidiary importance. Of course, the ease with which the funds are made available by the rest of the world affects the price of finance, the exchange rate and, with a lag, the current account. It would be brave to assert that a ready supply of finance could not in some measure provide a catalyst for overspending. However, various aspects of Australia's recent economic performance — particularly high consumption levels and adverse movements in the terms of trade — provide a ready explanation for the large deficit on the current account and thus the large capital inflow.

Another question relates to very rapid growth of overseas borrowings on the books of Australian intermediaries and whether financial conditions in 1985/86 may have been more expansive than the traditional aggregates would suggest. It is not an easy judgment to make and is another reason why the Bank's assessment of financial conditions goes beyond simple concentration on particular aggregates.

The combination of less financial regulation and more financial intermediaries has substantially altered the nature of financial balance sheets. The removal of exchange controls has provided greater scope for banks and others to fund their lending by borrowing abroad. As a result, a higher proportion of Australia's international financing, swollen by the need to fund a bigger current account deficit, is being handled on the books of Australian intermediaries. This influence has been given a further boost by the injection of foreign capital associated with new banks and merchant banks. On the other hand, new financing instruments have increased the volume of financing handled off-balance-sheet or, at best, included in the notes to intermediaries' accounts. Overall, the growth of credit extended by banks and other financial institutions was stronger than rises in the traditional monetary aggregates. However, two provisos should be entered: part of this was offset by a slower rate of growth in direct finance; and, these developments were taken into account by the Bank in assessing financial conditions and monetary policy needs during the year.

The fact that institutions did not lack customers for loans funded from abroad might suggest that residents borrowing foreign currency and non-residents lending Australian dollars were either protected from exchange risk or were insensitive to it. In the normal course, the cost of covering exchange risk does much to wipe out the apparent advantage from favourable interest differentials. Unsophisticated and ill-advised borrowers and lenders may fail to see the same risk as the market does. Even relatively sophisticated borrowers and lenders may persuade themselves at times to set aside exchange risk as something to face up to in the longer run, if it proves necessary The consequences of misjudgment of course can be severe.

Reserves Management

A question that has exercised the Bank over the past couple of years concerns the level of official reserve assets that should be regarded as adequate with a floating exchange rate. Few would now contend that reserves are not needed. There is general agreement that monetary authorities should operate in their foreign exchange markets, at least for testing and smoothing purposes. While these operations would normally be on both sides of the market, in periods when the exchange rate is under pressure, operations may become heavily one-sided. Reserves are also needed as an element in the nation's financial management; lack of an adequate cushion of reserves can leave us too closely subject to the whim of international investor sentiment.

In the normal course, the Bank also deals in the foreign exchange market, as necessary, to place its customers' transactions. During 1985/86, reserves equivalent to US$1.1 billion were sold to the Commonwealth. The Bank did not replace these with purchases of foreign currency in the market. This was partly to avoid adding to domestic money supply. Although Australia's international reserves are still at a comfortable level, it will not be prudent indefinitely to draw on them in this way.

Bank Supervision

The Reserve Bank has responsibilities relating to the protection of depositors with banks authorised under the Banking Act. This responsibility, and the Bank's concern for financial stability generally, underlie its prudential supervision of banks. Although the Reserve Bank does not have formal responsibility in respect of State banks, it looks for parallel relationships with them.

Financial deregulation, improvements in communication and other technologies, development of new instruments in financing and a general upsurge in competition in financial services have combined to complicate the task of sensible and effective prudential management of banks.

Banks in many countries are facing similar situations. With deregulation, there is a wider field open to them but, after first fruits are gathered, competition tends to be tougher. For many, there is a choice to be made between becoming an all-purpose bank or aiming at a degree of specialisation. Certainly, pressures of competition and anxieties to gain market share in new markets are powerful forces at present. It is important that banks do not yield to temptation to lower their credit or other operating standards or enter fields for which, for one reason or another, they are unfitted.

These issues raise problems for the supervisory authorities too. In a fundamental sense the challenges facing supervisors are different only in scale from those facing bank managements. Stability of the system is importantly the sum of the prudent behaviour exercised by individual managements.

Supervision must be even-handed but must also allow for soundly-based variations in business among competing institutions. If initiative and innovation by bankers are not to be stifled, supervisory arrangements need to provide for prompt and adequate consultation.

Banks from countries such as Australia, whose home currencies are not major international currencies, face the problem of holding a capital base suitable to the mixture of risks on their books. Abrupt and substantial changes in currency values can be especially difficult to handle in any short-run period. In such circumstances, it can at times be difficult to hold to standards of capital adequacy. In principle, difficulties of supplementing and maintaining capital, or in servicing it from earnings, point to the need to lower expectations for expansion.

Supervisory measures taken by the Bank during 1985/86 are discussed in some detail later in this Report. There was heavy use of resources in supervising the entry of new banks.

With the emphasis of supervision on the need for banks to have management systems which limit risks to prudent levels, it is important that these systems be followed. The Bank is making arrangements with banks and their external auditors for the banks' auditors to provide this assurance. The auditors are also being asked to assess the reliability of certain statistical data provided by banks and to provide opinions on the observance by banks of prudential standards set by the Reserve Bank.

Prudential supervision inevitably places some burdens and constraints on the banks being supervised. The Board acknowledges the need to hold these as light as is consistent with effective discharge of its responsibilities. One factor of some importance in the overall cost of bank deposits in Australia is the Statutory Reserve Deposit requirement. The SRD mechanism is not now actively used as an instrument of monetary policy and, with the introduction of PAR arrangements, is higher than necessary for prudential purposes. At its present level it is distorting patterns of financing between banks and non-banks and between domestic and foreign fund raising by banks. The Bank will be ready to take opportunities to reduce the ratio when possible without adverse consequences for general policy settings.

Some burdens of supervision will nevertheless remain. Encouraging banks to maintain appropriate prudential standards does not erode the gains from deregulation; to the contrary, it can help to make sure those gains are enduring, not ephemeral.

The Bank's Accounts

The Bank's financial statements for 1985/86 are provided in a later section of this Report. After almost doubling to $1,956 million the previous year, the Bank's net operating earnings increased further to $2,685 million in 1985/86. After provision for contingencies and reserves, the net profits of the Note Issue Department and the Central Bank are paid to the Commonwealth.

The main factor in the increase in earnings was again sales of foreign exchange from the Bank's portfolio. Sales were made at current market prices and yielded a substantial margin over the average purchase price at which the foreign currency had been acquired by the Bank. As set out later in this Report, the difference between original cost and market value is held in the Bank's asset revaluation reserves. Upon the sale of foreign exchange, this difference in value is crystallised and taken to profit and loss account.

In recent years, the market value of the Australian dollar has fallen sharply and the Bank has been preponderantly a seller of foreign exchange. The gap between average cost and selling price has been wide and the realised gains on the Bank's operations have been substantial. In a period of greater exchange rate stability, or where the Bank's purchases and sales were more closely matched, e.g. if it relied more on market purchases as a source of exchange to meet sales to government, the situation could be different.

Hence there can be no assurance that substantial (or indeed any) profits on the Bank's foreign exchange operations will continue.