Mr Thiessen reviews the Canadian economy and monetary policy in unsettled times  (Central Bank Articles and Speeches, 7 Dec 98)
Central bank: boc | Type: speech | Date: 1998-12-07

## Mr Thiessen reviews the Canadian economy and monetary policy in unsettled timesSpeech by the Governor of the Bank of Canada, Mr Gordon Thiessen, to the Greater Vic Chamber of Commerce in Victoria, British Columbia on 7/12/98.When

the Asian crisis erupted in the summer of 1997, few observers anticipated international financial markets would still be under its influence more than a year expected that the crisis would be contained and resolved relatively quickly.

But then have foreseen a year ago that the Japanese situation would deteriorate as much as it h Russia would declare a debt moratorium, jolting markets everywhere, and increasing fi pressure on parts of Latin America?All these unexpected developments have slowed world economic activity.

Canada's very economy has not been immune to these forces.

The sharp decline over the past year demand for, and the prices of, the key primary commodities we produce has taken its tol Columbia has been particularly hard hit because it produces and exports a larger shar goods than other Canadian provinces.

These developments have been reflected in the va our currency, which has declined substantially against the U.S. dollar.All this seems to have provided fertile ground for some pessimistic scenarios.

Inde commentaries have raised the spectre of global recession and deflation, implying a co downturn for Canada.

Are such concerns justified, or are they an overreaction to events?I believe that the pessimistic commentary has been overdone.

Given the global uncerta financial market volatility of the past year, Canada has been coping relatively well. for people to feel queasy and to fear the worst when caught in the kind of stormy sea encountered in the past year.

But the important thing to remember is that these days better positioned to ride out the storm.

And we will feel much better if we can keep o the horizon - for there are signs that the sky is clearing.What I would like to do this morning is to put the recent changes in the global econ financial environment in perspective.

Next, I will look at the implications for the wor and for Canada in particular.

I will finish with a discussion of the Bank of Canada's the international turbulence.

## Global financial problems in perspectiveI will spare you the detailed chronology of the past year's events.

You are probably a familiar with it.

Rather, I intend to focus on what has made this latest episode of glo turbulence more troublesome than others in recent history.

This should help us se developments in the Canadian economy and in monetary policy in a clearer light.

It sho provide some insight on what needs fixing in the international financial system a mistakes to avoid in the future.So, why has the 1997-98 financial turmoil been more widespread and long-lasting?

The see it, there were two main reasons.

First, with the benefit of hindsight, it is clear incautious international portfolio investments were made in the wake of the g globalization of capital markets.

Second, it has taken Japan much longer than expecte with its serious economic and financial problems, problems that long predated the AsianLet me explain why I think these factors have had such an impact this time around.First, the matter of incautious international investment practices - what was the problem here?

With the opening up of financial markets and with the decline in interest rates in countries, a growing number of investors were attracted to higher returns abroad. 'Abro meant the so-called emerging market countries, particularly those in Asia.

With their of economic growth year after year, these countries seemed to have great investment poteBut foreign investments, especially in emerging markets, are far more complex than d ones.

And assessing these investments can be very tricky.

For one thing, investors ar with companies operating far away, in a very different economic and political environm another, financial regulatory and supervisory practices in some of these countries are developed and transparent.

In addition, investors may have felt rather well 'protected' - for a couple of reasons.

First, past assistance packages by the International Mone (IMF) and other international agencies may have led them to believe that the inte community would always come to the rescue if worst came to worst.

Second, many investm advisers evidently were not terribly fussed about the exchange rate risk because mo currencies were fixed to the U.S. dollar.

It is all too easy to forget that having a rate is not in and of itself a guarantee that a currency will not decline in value - w what many of these currencies have done.In the end, huge amounts were placed in emerging markets in the 1990s by mutual f pension funds, financial institutions, and their clients, evidently without full appre risks involved.

Moreover, many banks in these emerging markets were also taking large They were borrowing short term from foreign banks, in U.S. dollars, at relatively low lending out long term, in domestic currency, at high rates - often to domestic r developers.When pegged exchange rate systems in Asia broke down under pressure, because they were f at levels that had become incompatible with changing economic fundamentals, both loca foreign investors rushed for the exits.

And as exchange rates tumbled and interest rate host of other long-standing problems, especially related to weak banking systems unearthed.

Investors that got burned in Southeast Asia tried to reduce their expos emerging markets.Initially, emerging countries outside Asia managed to withstand the pressure - until th of the Russian crisis.

That Russia was running into serious fiscal difficulties had known for some time.

But its decision to declare a unilateral moratorium on its debt l shook markets everywhere, and even the most sophisticated investors became very agitate resulting global reassessment of risk, and the greater weight placed by investors on s to a movement of funds out of emerging market bonds and corporate bonds into more se U.S.

Treasury bonds.

Interest rates rose in the markets for riskier securities, a tightened - hence, the concerns through the autumn about a global 'credit crunch' and reThe second factor that has exacerbated the global financial turbulence this time is th severity and intractability of Japan's long-standing economic and financial problems.

R Japan is the second largest economy in the world.

Most of us expected that, once the recognized the seriousness of their problems, they would move quickly and decisivelythem.

A stronger Japanese economy would have made a significant difference to the outl the world economy.

And it would have helped to speed up the turnaround in Southeast A much as a strong U.S. economy facilitated the adjustment in Mexico, following the 1 crisis in that country.

The deterioration of the Japanese economic and political cli spring and early summer of 1998 was an important factor in the intensified market press precipitated the Russian crisis last August.

## What to do about the global turmoil?So what are we to conclude from all this?The last thing we should do is retreat behind national borders and start placing restri free flow of international capital.

That would be very unfortunate.

Even though capital sometimes prove difficult to handle, especially for small countries, there is much to from access to world savings - provided those savings are used prudently and productivel we must do is find ways to minimize the costs, without giving up the benefits.The Bank of Canada believes that a flexible exchange rate is very useful in this cont such a system, borrowers and lenders are constantly aware of the exchange rate risk, an of pressures that built up behind the fixed exchange rates in Asia last year are much l emerge.I should also note that a good deal of work has already been done by the international to strengthen the global financial system and reduce the risk that these recent pro recur.

In their October communiqué, the Finance Ministers and Central Bank Governors G-7 countries outlined a series of initiatives.

These are designed to: increase the tr the international financial system; promote international standards of good practice; incentives to meet such standards; provide assistance to developing countries to re reinforce their economic and financial systems; and put in place a process for crisis m that envisages the involvement of private lenders at an early stage.But all this, you may say, is to improve the international navigation and radar syst future.

Meanwhile, we are still in difficult seas, wondering what's up ahead and worry may hit us next.How worried should we be about the world economy and the outlook for Canada?

## Keeping our eyes on the horizonI can tell you that there are positive factors in the picture as we look ahead.

Let starting with the global environment.

Perhaps the most reassuring element is that the expansion in the main industrialized countries, except Japan, is still well sustained that these countries account for more than half of world output.

The U.S. economy, in p remains strong, growing much faster than anticipated in the third quarter.

So even if i economy - Canada's main export market - will still be operating at relatively high le major European economies, as a group, are also expanding moderately.

And a number industrial countries, including the United States, the United Kingdom, and many coun continental Europe, have lowered their interest rates to help sustain domestic spendingJapan is still the main uncertainty at this point.

But the recent legislation to r banking sector, which is at the core of Japan's problems, and other measures prop stimulate the economy are grounds for cautious optimism.

If these are implemented in a systematic fashion, the world economic outlook will brighten considerably.Another factor that added to the pessimism through the early autumn was the concern 'credit crunch' in the United States that could spread elsewhere, including here in However, the recent interest rate reductions by the U.S. Federal Reserve have elimin worst scenarios envisaged at the time.

Some of the rise in interest rates on 'lessdebt, which occurred during the autumn because of concerns in global markets about r liquidity, has reversed.

And the availability of credit is slowly improving.This is not to say that we are completely out of trouble yet; or that there is no longe uncertainty out there.

But, for the reasons I have discussed, I certainly do not bel scenarios of worldwide recession and deflation are very likely as we look ahead.As for Canada, it is true that we have been hit hard by the more than 15% decline in c prices over the past year.

It is also true that those lower prices, together with the economy, are affecting our export industries - a fact that this audience probably know well.

It is also evident that the nervousness and volatility in financial markets hav Canadian consumers and businesses less confident, affecting domestic spending plans. result, the Canadian economy has expanded much more moderately this year than in 1997, it grew by more than 4% (fourth quarter over fourth quarter).As we look ahead to 1999, the considerable degree of global uncertainty that is stil makes all economic forecasts more tentative than usual.

Because financial stabili important for household and business confidence, the expansion of our economy wil influenced by how quickly global financial markets stabilize.

Still, with accomm monetary conditions and recent solid employment gains, spending by Canadian households businesses, while slowing, should continue to contribute to an expanding economy.

And, on the Bank's current assessment of the world economic outlook and Canada's impro competitiveness, our exports should continue to grow.

## The monetary policy response to the international turbulenceLet

me now turn to monetary policy.

You will not be surprised to hear that through period, the conduct of policy has been influenced by these exceptional inter developments.The sharp drop in commodity prices has inevitably meant lower incomes and wealth Canadians.

And we have had no choice but to adjust.

Because we are on a floating exchan much of the adjustment has taken place through a decline in the external value of the dollar.

Had we been on a fixed exchange rate, we would still have had to adjust. adjustment would have been more difficult, since it would have had to come mainly t downward pressure on output, employment, and wages.The depreciation of the Canadian dollar since the fall of 1997, while distressing, had part been relatively orderly before the Russian crisis in August.

At that point, pres currency intensified because of a frantic worldwide capital flight to more secure U.S.an exaggerated sense internationally of the importance of commodities for Canada.

The mo of 'commodity currencies' was intensified by fears that Russia would start du commodities on world markets.As the decline in the Canadian dollar accelerated through August, medium- and long interest rates, including mortgage rates, began to rise sharply at a time when compa rates were falling.

We took this as a signal of potential loss of confidence in Cana investments that could prove very costly for the economy.

To head that off, we raised Rate by one percentage point in late August.Our action, and the subsequent return of some stability to markets in the United S elsewhere, helped to restore confidence in Canadian dollar assets.

And medium- and long interest rates came back down.When the U.S. Federal Reserve lowered its target interest rate three times between S and November, because of concerns about a possible 'credit crunch' and an expected slow their economy, we followed with similar reductions in our Bank Rate.

These cuts appropriate, given the importance of the U.S. economy to Canada, our continued low in rate, and the improving international financial climate.I know that the depreciation of the Canadian dollar has been a source of concern and d many people.

One concern is that a weak currency blunts the incentives to improve prod in the export sector.

I must say that this is more likely to be a problem if the wea currency reflects an inflationary environment.

But such is not the case in Canada today is low and stable, and the Bank of Canada is formally committed to keeping it that way.At the same time, I most certainly agree that we should always be looking at our e policies from the perspective of their likely impact on the growth of productivity. productivity is what matters for a sound economic performance and for rising standards over time.

Currently, the low Canadian dollar provides an opportunity for Canadian busi expand their presence in foreign markets.

But they must also continue to work hard to productivity and to ensure that they stay competitive as our currency regains strength.What about monetary policy - what is it doing to further productivity?

The focus of C monetary policy is on domestic price stability.

This means keeping inflation low and s time - currently within a target range of 1% to 3%.

The Bank aims to avoid both infla deflation.

And if we are successful, we will have provided Canadians with greater predi fewer cyclical fluctuations, and sustained low interest rates.

I believe that a monetar seeks to provide this kind of environment is the most conducive to productivity gro time.

## Concluding remarksTo conclude, let me just say that Canada cannot escape the uncertainties that have cl global economic outlook.

The pace of economic expansion in Canada is not as robust as i year ago.

But our economy should continue to grow over the next year, supporte accommodative monetary conditions and sustained U.S. demand.Although it may be difficult to see while we are still battling the waves of global in fact is that we are coping better this time around because our economy is in sounder s this gives me reason to remain rather positive about our economic future.