Glenn Stevens: Some observations on recent economic and financial trends
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Institute of
Chartered Accountants in Australia, Financial Services Seminar, Melbourne, 22 February 2006.
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Accounting
Today's program shows that you are looking intently at some of the big forces shaping the
environment for the financial services industry. There are a number of forces at work, including
changes to regulation, accounting, technology and attitudes in the community.
In the accounting field, Australian entities are, of course, working to implement the change to
International Financial Reporting Standards. There is a host of issues associated with all of this, some
of which have been quite contentious, particularly for some parts of the banking and finance
industries.
So I am relieved to say that the Reserve Bank has no role in developing or enforcing accounting
standards, though we do of course have to produce our own accounts consistent with the relevant
standards. It may interest you to know in this context that the Reserve Bank has itself made the
change to IFRS, and will present its 2005/06 accounts on this basis in the Annual Report later this
year, just like any listed company. To our knowledge, we are the only major central bank to adopt
IFRS in full, as yet. This continues the RBA's practice for many years of adopting commercial
standards of financial disclosure.
For the most part, the effects of IFRS on our accounts are fairly small. The main one of substance is
the recognition of the surplus in the staff superannuation fund on the balance sheet. This potentially
adds some volatility to annual results as measured by the accounting standard, as the position of the
fund alters with market prices. But sensibly applied, and combined with the wise provisions of the
Reserve Bank Act 1959, which govern the way in which the Bank's earnings are distributed to the
Commonwealth, there should not be too much additional variability in the dividend.1
There is an important general point there. Differing accounting treatments have the potential to affect
the behaviour of decision-makers in different ways, the more so when combined with regulatory
requirements.
A number of commentators have suggested, for example, that one factor behind the extraordinary
demand for long-dated government securities we currently observe in several European countries
reflects, at least in part, the attempt by trustees and managers of defined-benefit pension plans to
restructure their portfolios in response to changes in accounting conventions and regulatory
requirements. In the UK, perhaps the most striking case, index-linked government securities have
recently traded at real yields of less than half of 1 per cent for a 50-year security. Pension fund buying
is prominent among the explanations on offer for this phenomenon.
Graph 1
The accounting difference between the discounted value of a fund's future obligations and the value of
its assets is these days (quite properly) recorded on the sponsoring company's balance sheet. A
market bond rate is used to discount liabilities, as opposed to the older convention of using an
assumed fund earning rate. Unless the fund's assets are also placed in bonds, movements in bond
rates will affect the solvency position from year to year, which in turn will affect corporate results. At
the same time, stricter pension rules now require any measured funding gap between assets and
liabilities to be made good more quickly than used to be the case. Perhaps it is not surprising that UK
pension trustees have changed asset allocations in the direction of holding more indexed bonds. This
lessens the likelihood of nasty solvency surprises in any one year, though the associated downward
pressure on bond yields has itself weakened the average solvency position, as measured.
One can, of course, see why accounting rules stipulate that valuations of assets and liabilities should,
for most purposes, use market prices and interest rates. Equally, pension rules requiring plan
providers to fund adequately their obligations protect the plan beneficiaries against the risk of the
company failing and leaving insufficient funds.
But if the behavioural response to all this is a rush into assets yielding a real return of half of 1 per cent
per year for 50 years, there will be a very large increase in the long-run cost of providing the pensions
which are the whole object of the exercise. That increase in costs will, in turn, eventually place a
question mark over the viability of the schemes. Hence, the question in the UK is whether the
combination of regulatory and accounting reforms is ultimately going to strengthen the private pension
system or hasten its demise.
The point I am making from this foreign example is that accounting matters, and not only to
accountants. It doesn't just inform us of the state of an enterprise, it affects behaviour - hopefully for
the better, but either way can often have unforeseen interactions with regulatory signals. Stated
accounts are also viewed through the lens of market or media perceptions, which all too often are
focused on the very short run. These sorts of considerations are, in practice, quite important.
Let me turn now to some remarks about general economic trends, beginning with the external
environment.
The Global Environment
We have been living through some remarkable developments in the world economy over the past
decade. Growth performance has improved, with global GDP growth averaging 3.8 per cent since
1996, compared with 3.4 per cent for the preceding two decades. That doesn't sound like a big
difference but it is: almost half a percentage point extra growth on average, every year, is definitely
worth having. What's more, the variability of growth has declined, with the standard deviation of annual
growth falling from about 1.1 per cent to 0.9 per cent. The mean growth rate has risen substantially,
while variability has declined: any portfolio manager would like to deliver that combination. While all
this has occurred, moreover, global inflation rates have declined, become less variable and less
dispersed among countries. There are very few countries with seriously high inflation now.
Graph 2
Yet while the aggregate performance has improved, we hear more talk than ever before about
socalled 'imbalances'. By this, people mean that the expansion in the world economy has been
associated with a largish and growing deficit on trade and current accounts for the United States, the
counterpart of which is a string of surpluses in a number of other countries. (Indeed, one of the few
countries with which the US does not run a trade deficit is Australia.) It is historically a bit unusual for a
country as large and wealthy as the US, issuer of the world's main reserve currency, to sustain deficits
of this size, and increasing, over a lengthy period.
Graph 3
There are three questions worth posing about all this. First, how did it come about? Second, was there
an alternative path available for the United States (and the world) which would have been more
attractive? And third, what might happen from here?
It is worth recalling that rising US trade deficits were regarded as a concern as far back as the mid
1980s.2 It was a common view then that deficits much smaller than today's were unsustainable. There
has been a trend going on here for 20 years at least. Hence, we should be wary of explanations that
rely only on factors which have been at work just lately; something structural in American behaviour,
prompting a lower rate of saving out of current income, has been going on for a long time. That is a
topic for a whole speech on its own. For today, I will take it as a given.
But if that were all there was to it, one would expect that long-term interest rates would be rising: other
things equal, a lower rate of saving by the world's largest economy ought to be reflected in a higher
scarcity value for saving. Yet over recent times, as the US current account deficit has continued to
grow, long-term interest rates have remained low, and are lower today than 10 years ago. How so?
Over the past seven or eight years, it seems that behaviour in other countries has had a lot to do with
the pattern of capital flows. Internationally mobile capital that had flowed into east Asia earlier in the
1990s reversed course and flowed out after mid 1997. (Something similar happened a little later in
Latin America.) Domestic investment activity collapsed, and there was a surplus of saving over desired
investment.
Subsequently, the Asian countries also made voluntary outflows of official capital. Seeing the crisis as
a result of not having had enough foreign reserve assets to defend their currencies against speculative
attack, and judging that the international insurance offered by the IMF was insufficient and came at
unfavourable terms, many policy-makers in Asia decided to self-insure against another crisis of the
same kind. They did so by intervening to build up large holdings of US dollars (and, in the process,
offering their traded-goods producers a competitive advantage as a way of fostering recovery from
recession). China was not badly affected by the crisis but nonetheless for its own reasons has been
following a similar strategy. While China's investment rate is extremely high, its saving seems even
higher, and it has accumulated a large stock of dollar assets.
So it appears that there has been in a number of countries an excess of saving over national
investment needs, which has flowed abroad looking for returns. All other things given, this puts
downward pressure on the international cost of capital.
In which regions of the world would such capital end up? The answer is that it would be expected to
gravitate to those regions where the demand for capital is most likely to rise in response to a decline in
its price. Those regions have tended to be mainly (though not exclusively) the English-speaking
countries with well-developed and innovative financial systems, optimistic populations and high levels
of home ownership, the US foremost among them (but also including the UK and Australia). The
households of these countries responded to a decline in the cost of capital by using more of it.
Countries where populations were inherently pessimistic rather than optimistic about the future - some
parts of continental Europe, say, or Japan - seemed less interested in using that cheaper capital.
Other factors have also been at work, of course. No single cause ever explains everything. But the
above, I think, explains a lot of the pattern of global growth and the payment 'imbalances' that have
characterised it in recent years.
Was there a more 'balanced' path of global expansion that could have been taken instead?
It is far from clear that there was. Suppose, for example, that the authorities in the US, concerned
about a rising trade deficit, had slowed their economy in order to reduce imports. All other things
equal, the world economy would have grown more slowly as a result. The recovery we have seen in
Asia from the crisis would have been slower and more difficult, and there would have been insufficient
global demand to utilise the available productive resources. It is possible that the surplus countries
would have reacted by expanding their domestic demand sufficiently to offset the weaker demand
from the US, but in my judgement this would have been unlikely. Hence, what might perhaps have
been a more balanced global path with smaller current account deficits and surpluses would almost
certainly have been a weaker one for all countries.
As it was, policy-makers in the US (and a number of other countries) sought to combine full
employment and price stability by allowing domestic demand to run ahead more strongly. This
provided enough demand both to absorb the Asian trade surplus and keep the output of their domestic
economies near full capacity. These policy-makers didn't do this out of altruism; they did it because
they judged it to be in their nations' best interests. Nonetheless, their behaviour was, in my view, a
stabilising force. 'Unbalanced' growth has, so far, been better than the likely alternative.
Has this strategy carried risks? Yes, it has. In the faster growing countries, household debt levels have
increased, and asset prices have risen. Higher leverage, other things equal, means that households
would be more exposed if economic activity turns down than they would have been otherwise. These
risks have been weighed against the risks in the alternative path, and policy-makers are managing
them as best they can.
As for what might happen from here, it is common for observers to warn against the risk that the
'imbalances' may unwind in a disruptive fashion. Often this is not spelled out. What is sometimes
meant, I think, is that those currently accumulating dollar-denominated claims suddenly change their
minds, precipitating abrupt movements in exchange rates and interest rates. Such developments
might, in this view, lead to a pronounced weakening of domestic demand in countries like the US if
long-term interest rates rose abruptly, while a big decline in the dollar might affect the ability of areas
like Europe to export.
One can never rule out the possibility that financial markets will suffer a sudden and dramatic loss of
confidence. But it is not as though markets are unaware of the various 'imbalances' or the associated
risks - they read about them on a daily basis. Yet the actual pricing for risk in markets apparently
suggests an assessment that risks in general are of relatively little concern at present.
Graph 4
In the event that there is some market discontinuity, I suspect that it is more likely to be sparked by
some sort of credit event that prompts a change in appetite for risk in general, than by reactions to
current account positions per se. It is not obvious that US interest rates would rise, or the dollar fall, in
the face of such an event.
That is not to say that there are no adjustments to various national strategies which would be in the
interests of the countries concerned, and which would assist in re-balancing global growth while
retaining global full employment. But that proviso - retaining full employment - is key. If the adjustment
is undertaken only by the countries with large current account deficits, it is hard to see how it could not
be contractionary for growth everywhere. That would not be the ideal solution.
Australia's Domestic Economy and Monetary Policy
There is not very much I can say that is new on the domestic economy, given the recent release of our
Statement on Monetary Policy and our appearance before the House Economics Committee last
week. Let me reiterate the main themes.
Graph 5
Growth in domestic demand in Australia has moderated somewhat over the past year and a half. This
is not unwelcome, as continued expansion at an annual pace of 6 per cent, which we saw for several
years, was unlikely to be able to continue without causing overheating. As it was, some individual
sectors were overheating at times. The residential construction sector, for example, operated at peak
levels over a few years, and saw shortages of tradespeople, construction delays and substantial
increases in costs. Pressure was also transmitted to those parts of the manufacturing sector which
supply materials. Had this been a more general story across the economy, we would have witnessed a
significant rise in overall inflation, necessitating a much more active tightening of monetary policy. But
because some other parts of the economy were for a time growing more slowly, and because prices of
tradeable goods were reduced owing to global competition (and an appreciation in the currency), the
policy response was very gradual. It was essentially limited to returning interest rates to approximately
normal levels after a period in which they had been unusually low.
The shift in the composition of demand is also welcome. Household spending had risen rapidly for
several years, outstripping income gains, boosted in part by the exuberance associated with the
housing boom. As that boom subsided - as it turns out, so far, in a very benign way - so household
demand has gradually slowed. Businesses, meanwhile, have continued to ramp up investment
spending, in response to the widening incidence of capacity constraints in the economy - something
which has been an increasingly prominent theme in our regular discussions with companies across the
country in the past couple of years. With global demand for resources strong and prices high, the
resource sector is prominent in the pick-up in investment, but other sectors too are responding to the
need for more capacity. Business profitability, though squeezed in some areas by rising costs of
materials and labour, remains in good shape, and of course the cost of external finance remains quite
favourable. So conditions seem quite propitious for further growth in investment.
Over the medium term, the resulting increase in capacity will help to accommodate good,
noninflationary growth. In the short term, though, the act of adding to capacity itself adds to demand,
potentially putting pressure on productive resources. So it is fortuitous that household demands have
moderated at the same time as business investment has increased.
Inflation is well contained at present, despite a number of forces being at work which ordinarily could
be expected to push it noticeably higher. A tight labour market has been putting pressure on labour
costs. A strong world economy has pushed up demand for various commodities, whose prices have
responded, raising input costs for businesses.
Graph 6
Through all that, CPI inflation has risen to 2.8 per cent in 2005, from 2.4 per cent in 2003. The Bank
computes a range of measures of core or underlying inflation, designed to abstract from temporary
price movements so as to show the longer-term trends. In our most recent Statement on Monetary
Policy, these were characterised as running at about 21⁄2 per cent, little changed from the outcomes of
the preceding couple of years. In summary, despite a fully employed economy and higher oil and raw
materials prices, overall inflation has remained quite well behaved. If anything, it is probably running
slightly lower than we expected six months ago. While small deviations in outcomes from those
forecast are not unusual and are not necessarily of significance - we are talking about fractions of a
percentage point here, which certainly are not significant in the statistical sense - it is worth
contemplating what might account for lower than expected inflation.
There are two hypotheses on offer. The first is that the steady internationalisation of trade in goods
and services continues to exert pricing discipline on domestic producers, and that this discipline is, at
the margin, a bit more powerful when growth in demand has softened, as it seems to have done.
Hence, this hypothesis holds, while a number of costs are rising, firms are working hard to find
offsetting savings and absorbing some of the impact in their margins. It might be argued that this price
discipline coming from international trends will persist, as the emergence of China and India continues.
The alternative hypothesis is one of lags: that the full impact of the cost increases seen over the past
couple of years will show up in time even with the discipline of foreign competition. Unless demand
conditions are particularly weak, firms will manage to pass on cost increases and restore margins. On
this view, noticeably higher inflation is not far away, even if it is taking a little longer to arrive than
initially expected.
In forming its judgement about the outlook, the Bank has contemplated both these possibilities. The
forecast for inflation we set out in the recent Statement is one that allows for some passing on of
higher costs that have already been incurred, but not by as much as historical experience would
indicate. This sees inflation running at 21⁄2 to 3 per cent for the next couple of years. The risks around
this forecast could be described as balanced. It is possible that a rise in inflation in response to the
cost imposts of the past few years will arrive more suddenly; but it is also possible that the
international and domestic competitive forces will be strong enough for long enough that those imposts
will be offset elsewhere, and never show up in prices.
Given this outlook, it follows obviously that the Bank is more likely to tighten policy than to ease in the
foreseeable future. An assessment of balanced risks, around a forecast of 21⁄2 to 3 per cent inflation,
means that it is more likely that a surprise will take inflation above the target of 2-3 per cent than below
it. Hence, a rise in rates is more likely than a fall. That is a statement of probabilities, rather than one
of near-term intent.
In fact, that has been our thinking for some time. Through most of last year, we felt that inflation would
probably tend to rise, and we would probably need to tighten further at some stage to limit the rise. But
we also thought that the rise would be gradual, against a backdrop in which inflation expectations
were pretty well anchored. Hence, we felt that in formulating our policy response, we had time on our
side, a luxury previous generations of policy-makers usually did not have. We took advantage of that
to wait, evaluating further information before acting. Thus far, I judge that to have been an appropriate
strategy, especially given the inflation outcomes of late. Nonetheless, the Bank has to remain watchful
in the face of a number of factors which obviously could push inflation higher. We will be ready to
respond as needed so as to maintain low inflation.