Mr. Macfarlane's statement to the House of Representatives Standing
Committee on Financial Institutions and Public Administration Statement by the Governor
of the Reserve Bank of Australia, Mr. Ian Macfarlane, to the House of Representatives Standing
Committee on Financial Institutions and Public Administration in Sydney on 6/11/97.
Thank you, Mr Chairman. It is a pleasure to be here in front of your Committee
for the second time under the new arrangements set out in the Statement on the Conduct of
Monetary Policy. On the basis of the first hearing, we think the new arrangements are working
very well. On that occasion, we received some very penetrating and constructive questioning
from Committee members, and there seemed to be quite a lot of public interest in the
proceedings.
Of course, we should always be trying to improve our procedures, but the only
improvement we have been able to make on this occasion is to get our half-yearly report to the
Committee two hours ahead of the hearing, compared with one hour last time. You will
appreciate that in order to follow due process we cannot finalise the document until after our
Board Meeting which was on Tuesday. I should also say that I was hoping that we might have
been able to have this hearing somewhere other than Sydney. While it is very convenient for us
to be meeting again in the New South Wales Parliament House about 100 metres from my
office, we see merit in this hearing moving to other State capitals and Canberra on a regular
basis if that is possible.
The main reason for these hearings is to improve the accountability of the Reserve
Bank, both directly to Parliament, and via the press coverage to the public more generally. In the
spirit of increased accountability, I should, I suppose, be accountable for what I said to this
Committee at the previous hearing, as well as for what I am going to say today. I covered a
number of subjects at the previous hearing which I thought were important for an understanding
of how the economy was going to perform over coming years. I also mentioned a couple of
outcomes we expected for 1997. It is those which will probably be of the most immediate
interest. I said that, after a sluggish 1996 where GDP had grown at about 3 per cent -- at one
point, it got to not much more than 2 per cent on a 12-months-ended basis, we should expect it
to pick up to about 4 per cent in 1997. I also said that I expected inflation to stay at the bottom
of the 2-3 per cent range, with the possibility that it could go a little lower for a while.
Now I think I could be excused for wanting to walk away from earlier forecasts as
a result of the current turmoil in Asian and world financial markets. While I intend to say quite a
lot about those events later on, I do not propose to invoke that excuse at this stage, because they
have not had any effect on the economy to date. They have affected financial markets, but not
the economy yet. Instead, I want to start by saying that the baseline we have to work from, i.e.,
the growth of the economy in the first three quarters of 1997, has been at least as good as I was
pointing to in May, if not a little better.
• We now have the GDP growth rates for the first two quarters of 1997, which show the
economy grew at an annual rate of nearly 4 per cent during that time. And we have
further monthly figures for the September quarter which are somewhat stronger than
those recorded during the first half of the year. This is true for the major monthly
indicators such as retail trade, imports and exports. It is also true for the labour market,
especially for vacancies, and to some extent also for employment. There is also evidence
from the business surveys that confidence is picking up, but these surveys were generally
compiled before the Asian headlines of a fortnight ago.
• On inflation, the outlook changed a little. New figures brought underlying inflation
below 2 per cent, and our on-going assessment caused us to lower our forecasts. As a
result, we have had two further easings of monetary policy -- one in May and one in July.
An important reason for the lower inflation forecasts was the better outlook for wages.
You may recall that shortly after the previous hearing in May we received revised figures
on earnings from the ABS that suggested not only that they were lower in the quarter in
question -- the March quarter of 1997 -- but that an upward trend had been revised away.
This better picture was confirmed again in the June quarter figures, but the picture has
been muddied somewhat by the recent September quarter figures which show an
unexpectedly strong rise.
On balance, therefore, we at the Bank judged that the information becoming
available over the past six months was tending to confirm this relatively benign view of the
future -- GDP growth of about 4 per cent (enough for some further reduction in unemployment
from the 8.8 per cent we had at the time of the last hearing) and inflation a little below 2 per cent
(enough to justify the May and July easings in monetary policy).
The picture was not all rosy -- the slower output growth of 1996 was still making
its presence felt in the form of sluggish employment growth in the first half of 1997, there were
some doubts about the strength of investment, and the effects of El Niño were around the corner.
But economies nearly always present a mixed picture, and this mixture was a lot better than
most. In addition, financial conditions had become clearly easier than in May. The overnight
cash rate had come down from 6 per cent to 5 per cent as a result of the two easings of monetary
policy, and yields on 10-year bonds were down from 73⁄4 per cent to 6 per cent. The exchange
rate against the US dollar has come down from 77.7 US cents to 70.3 US cents; against the
trade-weighted index, it has come down from 60.2 to 57.0.
I come now to the point where I should say a few things about what has been
happening in Asia and the rest of the world. I will do my best to be specific, but you should bear
in mind that the ground is constantly changing. The first thing I would like to say is that in the
long run I am still very optimistic about Asian growth prospects. These countries still retain a set
of characteristics that are conducive to long-run growth:
• they can still achieve rapid productivity growth through technology transfer, i.e., they
have started from a long way behind and have a fair way to go;
• they are oriented towards international trade;
• they have high savings rates and high investment and a relatively small government
sector;
they have generally sound fiscal and monetary policies -- although they have got some
•
way to go in terms of the soundness of their banking and financial sectors; and
• they have great respect for, and devote considerable effort to, education.
I do not see the end of the Asian miracle, partly because I do not think it ever was
a miracle; it was just the application of some tried and tested rules of good economic policy. It is
still fortunate for our long-run prosperity that we have strong links to Asia.
Having declared my optimism about the long run, I should now turn to the short
run. Clearly, there are going to be difficulties here, in particular among four ASEAN
countries -- Thailand, Malaysia, Indonesia and the Philippines. From the moment the Thai baht
was floated on 2 July, attention quickly broadened to encompass these four. Their currencies
have fallen sharply, as have their stock markets and property prices. These countries are
battening down the hatches -- in two cases with the help of the IMF -- to sort out their problems.
The principal problem, it is now apparent, concerns how to handle the fall of previously
over-inflated asset prices, undisciplined lending by local banks and foreigners, and some very
opaque inter-relationships between business and government which have obscured the true
financial position of a lot of companies and banks. There also appears to have been
over-investment in some areas. Property played its usual major role, but on this occasion there
were also more contemporary avenues, particularly electronics and semi-conductors, where there
is clear over-capacity and intense competition among these countries (and with Korea and
Taiwan). Of course, these problems have been around for years -- they did not just start on 2
July.
A part of this adjustment must inevitably involve a sharp curtailment of growth in
the short run and a contraction of credit. Imports will fall, and so the effects will be spread to
other countries. The good news for Australia is that these four countries account for only 10 per
cent of Australia's exports. If the difficulties remain confined to these four countries, the effect
on Australia's exports, and hence our growth, would be modest.
The rest of Asia is, in fact, a lot more important to Australia. Japan -- our largest
market -- has been limping along at an average annual growth rate of about 1 per cent now for
about five years. Our exports to Japan have virtually not increased at all during that period. The
other big Asian markets for Australia are Korea, China, Taiwan and Hong Kong. These are
collectively much more important than the ASEAN four. Of course, some of the underlying
problems that afflict the ASEAN four also apply, although more modestly, to some of these
countries. For a time, it looked as though the ASEAN problems would spill over to these in a big
way, but that seems less likely now, although we should not speak too soon. Even so, we should
build in the assumption of some slowing in aggregate for these countries.
To judge the effects on Australia, we should, in principle, have a view on how
each country will fare in regard to economic growth, imports and the health of their banking
systems (and we should look outside Asia, which I will do later). It is never easy and some sure
bets turn out to be wrong. For example, virtually everyone thought the simultaneous share
market crash of 1987 and associated company failures would presage at least a slowdown, if not
a recession. In the event, 1988 turned out to be a boom year for the OECD economy and for
Australia.
Let us hope we can be a little closer to the mark this time. Most analysis to date
has consisted of a relatively mechanical application of lower growth and lower imports among
the ASEAN four to lower Australian exports and lower Australian GDP growth. The orders of
magnitudes are quite small and the most commonly cited figure for GDP growth in Australia is a
reduction of about a quarter of a percentage point. According to press reports, the OECD has
recently suggested figures of 0.3 per cent for Australia in 1997 and 0.4 per cent in 1998. Quite
how they got an effect on 1997, which we are already 80 per cent through, I do not know, but, as
I said, I am only relying on newspaper reports. These sorts of figures can become considerably
larger if we also bring in lower growth rates for Korea, China, etc., but we are getting into the
realms of speculation if we do so.
The only guide that we have is that this will not be the first time that it has
happened. In 1984 and 1985 we saw a big drop in Asian currencies and a big drop in their
growth rates. It had the predicted effect and our exports to Asia for a time were quite weak.
Again, last year -- in calendar 1996 -- there was zero growth of imports in the ASEAN four, and
our exports to them slowed. I think we will have to put up with a period of weakness again.
Frustrating as this instability may be, it seems to be an inevitable part of an open competitive
economic system which is the only type capable of achieving strong growth in the long run.
So far I have only talked about Asia, but the outcome for the world economy will
depend on more than Asia. We have to bring in two bigger regions -- North America and
Europe. North America (mainly the United States but also including Canada and Mexico) is
growing quite strongly. The recent disturbances in financial markets which were imported into
North America from Asia do not seem to have had a lasting impact. If anything, their main
effect seems to have been to hose down some overheated asset markets slightly, and hence to
reduce the likelihood of an imminent tightening of US monetary policy. Such a tightening in the
next six months cannot be ruled out, however.
Europe is finally recording some gains after years of disappointingly slow
recovery from the early 1990s recession. In fact, European growth has picked up to the point
where six European central banks recently tightened monetary policy slightly to head off
possible inflationary pressures down the track.
So far, I have talked about Asian and world economic events as though their only
effect on Australia was via our exports. Of course, that is only part of the story. The other
important part is that we now have to face the possibility of further financial market instability.
For better or for worse, through knowledge or through fear, the international investment
community is taking a more sceptical look at things Asian, and that includes all countries in the
Asian region, including Australia. That means they have become more risk-averse, and more
likely to judge countries and their policies harshly. We have already seen some of the effects on
some Asian countries:
• falling exchange rates;
• falling share prices;
• rising risk margins in interest rates;
• downgrades by rating agencies.
We are in a better position to handle this financial instability than we have been at
any stage in the last 30 years. We formerly had a reputation as a boom-bust economy, and
investors used to build in quite a large premium for risk when holding Australian assets. We
have come a long way in convincing investors that this is largely a thing of the past. A good
example of this is that our bond yields are now virtually the same as US bond yields, whereas
five years or ten years ago it was not uncommon for the gap to be as high as five percentage
points; some of this was a risk premium and some of it reflected our higher inflation. Another
example is that the Australian dollar used to be one of the most volatile currencies in the world,
whereas in the 1990s it has been no more volatile than the major currencies such as the US
dollar, the yen or the Deutsche Mark.
Over the past four or five months, this has served us well. While the Australian
dollar has gone down a fair amount against the US dollar, it remained relatively steady in
trade-weighted terms. It is true that over the last fortnight the Australian dollar has declined in
trade-weighted terms, but it has done this in a relatively orderly fashion, and it is not an
unreasonable market response given that our export markets have weakened.
This new-found reputation for stability may surprise some people, because there
is still a tendency to read so much into the small month-by-month or quarter-by-quarter
variations in economic statistics. But if we take a longer sweep, we can see how many of the
economic problems that used to concern us have now been eliminated, or are at least under some
reasonable sort of control. The headlines are no longer full of stories about the current account
deficit or the level of foreign debt. The budget deficit is small. High inflation and its inevitable
twin, high interest rates, no longer fill the papers. This does not mean, of course, that we have
solved all our economic problems, but we have clearly narrowed them down. This has also
tended to concentrate minds on the one that remains -- namely, the level of unemployment.
This is a reasonable priority because less progress has been achieved on
unemployment than on the other imbalances in the economy that came to the fore in the
mid-1970s and persisted through the 1980s. It is not as though no progress has been made -- the
unemployment rate has come down from a peak of 11.2 per cent to its present 8.6 per cent -- but
it has been disappointing progress. With six years of the expansion now behind us at an average
growth rate of 3.6 per cent per annum -- the third highest in the OECD area -- we could have
hoped for more. I think some further progress can be made over the next year, although we have
to accept that it will probably be slow, and monetary policy will only be part of the story -- in
the long run, only a small part. History suggests this will remain the case.
Australia moved from 2 per cent unemployment to over 10 per cent in the decade
from 1973 to 1983. The damage was really done during that period. Despite good output and
employment growth in the 1980s expansion, the unemployment rate was back to 11 per cent
following the 1990 recession. So in net terms no progress had been made in a decade.
What we want this time is good growth in output and employment, with a
difference -- we want it to last a lot longer. The six-and-a-half years that the previous two
economic expansions lasted was not good enough. Although progress was made in reducing
unemployment -- particularly in the second one -- it was all lost in the ensuing recession.
This time around we must make sure we have a much longer expansion, reducing
the likelihood and severity of any future slowdown as much as possible. I do not know how that
will be possible, but the surest way of ameliorating the business cycle in this way is to avoid the
imbalances occurring during the later stages of the expansion. The main imbalance in Australia,
as elsewhere, has always been the emergence of inflation. The story is never exactly the
same -- inflation can be accompanied by a wage push, an asset price boom or an external
imbalance -- but the result has been the same following each of the past three booms. That is
why we need to have a more medium-term focus in our monetary policy and why the inflation
target is such a central part of it. The inflation target is not anti-growth; low inflation is not an
end in itself, we are interested in sustaining a good inflation performance because we are
interested in growth and employment. Keeping inflation in check is the key to longer
expansions.
It has sometimes been said that we are too cautious in following this policy. I
think that is a little unfair. Of course, we are cautious in that we like to look at a range of
information and think carefully before we make a move on monetary policy. But we try to be
forward looking and pre-emptive. For example, we did not wait till measured inflation was
below 2 per cent before easing -- in fact, it was 3.1 per cent when we first eased in July last year.
Similarly, there have been suggestions that the Reserve Bank has a speed limit
above which the economy cannot be allowed to grow (the figure usually cited was 31⁄2 per cent).
Such a suggestion is, of course, incorrect and I have pointed this out on several occasions. In
case there is still any doubt, you only have to look at our behaviour in 1997. As I said earlier, the
economy has been growing at 4 per cent per annum so far in 1997, yet it did not stop us easing
monetary policy twice this year. If we are getting reasonable news on inflation and our inflation
forecasts are in good shape, we have no objection to the economy growing by 4 per cent or 4 per
cent plus.
When looking at the whole picture of employment and unemployment, monetary
policy is only a small part of the story, and it mainly concerns the cyclical aspect of
unemployment. If you look at the really big changes in employment or unemployment over
decades, rather than years, monetary policy plays a very small role. The biggest change in
employment performance of which I am aware is the contrast between the United States and
continental Europe. In the United States, the unemployment rate is back to its 1960s level,
whereas in Europe it is about five times as high as it was in the 1960s. A few European countries
have done better than that -- including the United Kingdom -- but others have done worse.
If you try to explain the superior US employment result by faster economic
growth you get nowhere. Europe has grown as fast as the United States over three decades -- it
just has not generated jobs. The explanations for the poor European performance on jobs all
centre around various types of rigidities, especially in wages and conditions of employment, but
also the social security system and the difficulties involved in starting businesses and the
subsequent lack of entrepreneurship.
I do not intend to go into this in any depth because it is a huge topic. I only raise
it to point out that there is much more to the story than the growth of demand, and the role that
monetary policy plays in it. In other words, even if we succeed in having good economic growth
and sustaining it for a longer period than in earlier expansions, it will not solve all our
unemployment problems. We will make some progress, but it is too optimistic to think that we
will be able to emulate the Americans and return to the 1960s level of unemployment through
macro-economic policies alone.
I saw in the paper yesterday someone from ACOSS saying that the big challenge
for Australia was to achieve US-style economic growth and low unemployment without
US-style inequality and poverty. I think this is a realistic way of looking at it. It shows an
awareness of the current trade-off, and I suspect a hope that, with some ingenuity, we might be
able to improve on it somewhat. My only quibble is that we already have achieved US growth
rates -- in fact, exceeded them -- it is the US unemployment rate that has eluded us. This is
something that people like myself, who studied economics in the 1960s, find surprising. In the
1960s it was the United States that was always criticised by countries like Australia and most of
Europe for their high unemployment. Now the boot is on the other foot.
There is a lot more that I could talk about, but I will confine myself to only one
further topic. That is the subject of bank lending and bank margins, particularly bank lending to
small business. This is a subject that this Committee has taken a particular interest in. In fact, the
first large-scale inter-country study of Australian banks' margins and banks' profitability was
undertaken by the Reserve Bank at the request of this Committee in August 1994. We did
another study at the Committee's request recently which was published in our October Bulletin.
As Committee members also know, the Reserve Bank has been meeting with its Small Business
Finance Advisory Panel since 1993 to discuss the provision of finance to that sector. We formed
this Panel because we were worried that banks had become excessively risk-averse and were
reluctant to lend to small business in the early part of the recovery from the 1990/91 recession.
It has been a slow process, but competitive pressures have been gradually working
their way into banks' margins, i.e., the difference between the average rate they earn on their
loans and the average rate they pay on their deposits. These margins are now lower than at any
time since we have been collecting the statistics, and the biggest fall has occurred over the past
two years. Clearly, the entry of mortgage originators into the housing market was a very
important development, and it led to the margin on housing lending falling from a level which
was high by international standards to one which is about average. We are now beginning to see
hotter competition in lending to small and medium-sized businesses. Partly this is a result of the
need felt by many banks, particularly the regional ones, to reduce their reliance on the now much
less profitable mortgage market. In this sense, it shows how competition slowly works its way
through the system. I confess that it has taken longer than I expected, and longer than I hoped,
but we are finally getting there. That brings me to the end of my introductory remarks. We have
certainly had a very eventful period in the month leading up to this meeting and we have all been
working hard to keep up with events, particularly in the international scene.