Glenn Stevens: Recent financial developments
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to ACI2010
49th World Congress, Sydney, 26 March 2010.
* * *
Welcome back to Sydney.
The last time that this body met here was in 1992. At that time the Australian economy was
in the early phase of a recovery from a deep recession. Pessimism about the future was
deeply rooted. The financial system was under considerable strain. Unemployment was in
double digits and still rising. Inflation had fallen significantly, but many people thought this
was a temporary impact of the downturn. They thought that if we did get a recovery - and
some despaired of that - we would return to our old bad habits of high inflation. People
worried a lot about Australia's substantial current account deficit. There were relatively few
optimists. You might notice some of that sort of thinking today, in some other countries.
I imagine that among the participants of that 1992 meeting one could have gotten some
pretty long odds against Australia having a long upswing, with inflation averaging "two point
something", surviving the financial crisis and ensuing global downturn with one of the mildest
domestic downturns we have seen, and facing the future with a fair degree of confidence.
This shows how hard it is to forecast, of course. But perhaps it also demonstrates that with
time, effort, discipline, good policies and a bit of luck, economies can be returned to health
and their citizens to prosperity.
Financial market recovery
To that end, it is helpful that the global financial system is gradually recovering its poise, after
a near-death experience eighteen months ago. Perhaps like a patient that has suffered an
acute cardiac event, there has been some lasting tissue damage, but quick intervention
avoided something much worse. A period of emergency life-support has been followed by a
period of recuperation, with some ongoing medication, during which the patient has been
able gradually to resume normal activities.
Certainly the functioning of money markets has improved substantially. Extreme counterparty
risk aversion has abated and spreads of LIBOR rates to equivalent maturity OIS rates have
come down to about the lowest levels since mid 2007. The dramatic expansion in the
balance sheets of central banks in major economies has largely ended, though policy interest
rates remain at 50-year lows.
Australia's situation is more advanced in this regard. The expansion in the RBA's balance
sheet was unwound nearly a year ago and the policy rate has been increased somewhat,
reflecting the very different circumstances facing the Australian economy. But we are not the
only country seeking to manage the "return to normality". An increasing number of countries
outside those most directly affected by the crisis have begun this process - though the speed
of adjustment naturally depends on national conditions.
Capital markets have also improved, with spreads to sovereign bond yields for private
borrowers across most of the risk spectrum back to "pre-Lehman" levels, and for the best
rated borrowers back almost to mid-2007 levels. They are not quite back to pre-crisis levels,
but then, they probably should not have been at such low levels anyway. Similarly, spreads
for emerging market sovereigns are well down from their peaks. In fact overall borrowing
costs for quality corporates and emerging market sovereigns are similar to or slightly below
what they were in 2006. This finer pricing is being accompanied by a gradual pick-up in debt
issuance.
Appetite for risk has increased significantly since the end of 2008, albeit with some
occasional setbacks. Of course we should expect that it would have increased, since
September and October 2008 were characterised by sheer panic - there is no other word -
and a flight from virtually any risk at all. Once the global financial system did not actually go
over the precipice, there was going to be some re-appraisal. Hence, even as evidence
continued to emerge in the first half of 2009 of the dramatic fall in demand for goods and
services, share prices and spot commodity prices began to recover. Share prices are now
about 60 per cent higher than the "priced for disaster" low point, while commodity price
indexes have increased by a third. Some individual commodity prices have risen by much
more.
Similarly, we have seen a preparedness to take foreign currency risk, and flows into
emerging markets involving both foreign currency and credit risk have increased. Again, risk
appetite has not returned to the heady days of the mid 2000s, but nor should it. Even the
flows we have seen have begun to raise concerns among policy makers in some of the
emerging countries about potential risks of asset market excesses and eventual capital flow
reversal.
The banking sector
For major financial institutions, the picture has also improved. The general decline in risk
aversion has eased funding problems, and some countries have been able to terminate or
scale back their government guarantee programs as banks are increasingly able to access
term funding markets under their own names. Share prices for those financial institutions that
are still privately owned have generally increased by more than the broader market. A
number of large American and European banks that accepted public-sector capital injections
during the crisis have moved to repay them.
The challenges that remain ahead for the banking system in major countries nonetheless
remain considerable. The outlook for some of the remaining government ownership stakes
remains unclear. While losses coming from write-downs of securities slowed some time
back, losses are still occurring in lending books as a result of the normal effects of big
recessions, not least in the area of commercial property. This will continue for a while. In
addition, banks, particularly large internationally active banks with big trading operations, will
require additional capital over time under proposed changes to global prudential standards.
There is a considerable contrast between that picture and the one for banks in most other
countries. It is important to note that the majority of countries have not had a banking crisis
as such. Everyone was affected by the seizing up of markets in late 2008, but most were not
afflicted with the sorts of asset quality and capital issues that so bedevilled large US, UK and
continental European banks. This in turn meant that once the panic had subsided, the banks
in most countries were able to continue to carry out their functions - albeit under more
difficult circumstances and facing much more subdued demand for credit, particularly from
corporations.
Australia is a good example of this, though not the only one. The lowest rate of return on
equity earned among the major banks here over the past two years was about 10 per cent in
underlying terms; among smaller banks the lowest was 3 per cent. When markets for
securitisation closed the major banks stepped into the gap by increasing their rate of housing
lending, albeit at higher prices. These banks were able to support some business customers -
again at a price - that in previous cycles they might have chosen to cut. The rate of
provisioning for bad loans has stopped rising for several banks, and non-performing loans
are likely to peak at a considerably lower share of loans than earlier expected. This general
picture, even if not the exact numbers, would, I suspect, be replicated across much of Asia.
These differences in experience are an important backdrop for the international work on
regulatory reforms. There is no question that there must be some significant reform. To use
the medical analogy again, the recovering patient is usually advised to consider some dietary
and lifestyle changes, and perhaps to submit to some ongoing monitoring, in order to avoid
further emergency procedures. These changes involve:

removing the scope for taking on excessive leverage via regulatory arbitrage;
 making sure that adequate capital is held against risk that is being incurred;

ensuring better management of funding liquidity;

countering, to the extent possible, the inherent tendencies in both human nature and
regulation to form assessments of risk in a pro-cyclical way;

and improving resolution processes to ensure orderly and rapid crisis management
and to help manage the issue of "too-big-to-fail" institutions.
These are all very important goals. The Australian authorities support them. But as we have
said before, the really serious problems were generated in a relatively small number of very
large, internationally active banks. They did not stem from the thousands of other banks
around the world which have not needed to be "bailed out" and whose capital resources
have, in most cases, proved adequate to cover normal losses in a cyclical downswing.
Hence it is important not to shackle unnecessarily the latter group in our efforts to constrain
the relatively small number which caused much of the problem.
Challenges from sovereign debt
Turning from banks to markets more generally, a recent development has been the
increasing focus on sovereign debt and creditworthiness. The initial manifestation of this was
late last year when Dubai World requested a six-month standstill agreement on its debt
repayments.
More recently, the focus has been on Greece, after it was revealed that the Greek
Government's current borrowing requirement was much larger than had been previously
disclosed. Greece is a small country - accounting for only half of one per cent of the world's
GDP. The significance of Greece is that it is a euro area country, which means two things.
First, its adjustment to its predicament cannot involve currency depreciation (unless it were to
leave the single currency). The only way it can grow out of the problem is by gaining
competitiveness against other European economies via domestic deflation, which will be a
difficult and lengthy process. A very large fiscal consolidation is an unavoidable part of this
path. Second, the euro area has an interest in this effort succeeding, which is why there has
been intense discussion about whether, and in what form, European assistance might be
forthcoming. Any assistance would of course have to pass the test of credibility more
generally in Europe, and would need to be applicable under similar terms to other euro area
countries if needed. This is obviously a difficult problem, on which the policymakers
concerned are continuing to work.
Perhaps the broader significance is that the difficulties facing Greece, while unusually stark,
are a reminder of the challenges facing many governments in Europe, and for that matter the
United States and Britain, over the long haul. Ratios of debt to GDP are rising quite
significantly in all these cases. There are several reasons.
The first is the size of the recessions being experienced, which obviously reduces revenues
and adds to some categories of spending - the so-called "automatic stabilisers". This effect
is relatively larger in some European countries but it occurs everywhere to some extent.
The second factor is the discretionary budgetary decisions aimed at stimulating demand and
injecting capital into banks. In the circumstances, the former was understandable; the latter
was unavoidable.
The "automatic stabilisers" will presumably "automatically" move budget positions in the right
direction as economies recover. The costs of stimulus and bank rescue measures, while
one-off in nature, do leave debt permanently higher. But without such measures, economies
might have suffered much deeper downturns and so the extent of budget deterioration could
have been much greater, itself leaving an even bigger debt legacy.
If that was the end of the story, we would not want to get too worked-up over debt ratios.
Unfortunately, though, there is more to the story.
For several important countries there was a trend increase in debt-to-GDP ratios going on
before the crisis occurred. For the domestic audience, let me be clear that Australia has
been a conspicuous exception. Particularly in mainland Europe, the pattern has tended to
be for debt ratios to rise quickly in periods of recession, then to stabilise for some years,
before rising again in the next recession. No doubt multiple factors are at work but the
interaction of changing demographics and generous welfare, health and retirement systems
is prominent. The same factors also work, other things equal, to lessen future potential
economic growth.
It is certainly not unprecedented for countries to have debt stocks much larger than their
annual GDPs. This has usually been seen when they faced the requirements of fighting
wars. Those ratios subsequently came down over time. But the situation now is different. The
decline in debt ratios seen after the Second World War, for example, driven by rapid growth
in output as population expanded and productivity surged, will not easily be repeated in many
of the major countries.
It is these more deep-seated trends, which were in place before the crisis, that are really the
greater cause for concern; the crisis has brought them more sharply into focus. The
demographic drivers will continue for the foreseeable future, while the unwillingness or
inability to tackle the structural trends in earlier "good times" has significantly reduced future
flexibility.
So a number of advanced industrial countries face some difficult fiscal decisions over the
years ahead. At some point, significant discretionary tightening will be required. Of course
policymakers need to get recoveries well entrenched, which is why many observers warn
against attempting an early fiscal consolidation. But unless a credible path to fiscal
sustainability can also be set out, growth could easily be stunted by rising risk premia built
into interest rates as markets worry about long-run solvency. This is not happening as yet;
long-term rates in many of the major advanced countries remain quite low. That provides a
window within which to plan the eventual consolidation. Since markets can be fickle and
things can change, governments will surely want to use the window.
Economic recovery
In the mean time differences persist in the pace of economic recovery across regions. In the
United States growth spurred by a swing in the inventory cycle is thought to have marked the
turning point in the second half of 2009, but most observers still expect only moderate growth
this year. In Europe, the momentum of the recovery has been less certain. In both cases the
old forecasting cliché about uncertainty applies in spades.
In contrast, it is apparent that the letter "v" is a reasonable description of the trajectory, to
date, of important emerging countries like China, India, Brazil and a number of smaller east
Asian countries. We should expect to see some moderation in the pace of growth of
production in some of these cases this year. This is usually the case in "v-shaped"
recoveries, since the initial pace of expansion is considerably higher than the long run
sustainable growth rate.
The question of what happens to demand in these countries is of course distinct from that of
what happens to production. Full employment in parts of the emerging world will probably be
reached before full employment in North America or Europe. Productive capacity therefore
would remain to meet further demand from the emerging world, via imports of goods and
services from the "old world". That is, emerging Asia and some other parts of the world could
see their living standards rise a bit faster than the increase in their own productivity, for a
time, if they were prepared to meet some demand through imports. Facilitating this most
efficiently would of course involve, among other things, allowing exchange rates to change.
The alternative approach would be to seek to slow growth in demand in the emerging world
as production there approaches full capacity, so as to maintain internal balance at a given
set of exchange rates. But that would leave unused capacity in the industrial countries and
emerging world living standards lower than they could be. These are polar cases - it would
of course be open to policymakers to steer some path in between.
Among Asian policy makers many factors go into thinking about exchange rates and trade
and capital flows. They have a degree of suspicion of rapid capital flows and large
movements in exchange rates, which is understandable after the experiences of the late
1990s. It is also understandable that the smaller economies, some of which are extremely
open, with trade shares of more than 100 per cent of GDP, do not wish to see volatile
exchange rates because it is disruptive for their economies. Moreover, the issue goes well
beyond just exchange rates per se; it involves saving and investment patterns, and national
policy approaches to growth, the speed with which these can be adjusted and so on. The
point, nonetheless, is that the current and prospective differences in economic circumstances
between significant parts of the world are likely to put strains on the relative settings of
macroeconomic policies and exchange rate arrangements. This will need careful
management, by all concerned, over the next few years.
Conclusion
The stabilisation of financial markets and banking systems over the past year or more is a
welcome development for all of us. There are still difficulties to overcome for financial
institutions in some key countries as a result of the depth of recessions, and these will be the
subject of attention over the coming year. Looking ahead, the differences in the speed of
economic recovery are starting to present challenges of their own, showing up as they do in
capital flows, asset valuations and exchange rates. When we add to all that the looming
longterm requirement for fiscal consolidation in a number of major countries, there is plenty for
markets and policy makers alike to think about.
I'm sure your conference will take up these issues with great energy. I wish you every
success in doing so.