|
I. Introduction: an uncomfortable soft spot
As the Annual Report went to press, improved confidence in financial markets
was beginning to be reflected in surveys of business confidence but there was no clear evidence of a
decisive improvement in macroeconomic trends. The global economy once again failed to make the
transition from hesitant recovery to robust expansion during the period under review. Growth in most
of the large industrial countries failed to meet earlier expectations, in spite of ample policy
stimulus, with much of continental Europe showing particular weakness. Consumer spending in both
industrial and emerging markets held up relatively well, but corporate investment remained weak
given an overhang of debt and excess capacity which weighed on profits. Disinflationary forces were
evident almost everywhere, and deflation either emerged or threatened in a number of economies.
The financial vulnerabilities that might have been expected in such an
economic environment remained muted, even if some strains did emerge. With the exception of Japan,
banking systems in major countries appeared quite robust although insurance companies and pension
funds generally suffered as a result of lower equity prices. Until late in 2002, capital markets
were virtually closed to lower quality credits, including some sovereigns, but have recently become
much more welcoming.
II. Developments in the advanced industrial economies
Despite significant policy stimulus in the advanced industrial economies,
output recovered only modestly in 2002. Household spending remained resilient, supported by rising
property prices and buoyant mortgage refinancing in several countries, while firms continued to
scale back investment. In addition, heightened concerns about developments in the Middle East
probably held back the expansion in the most recent past. The recent improvement in profits and
continued technical progress have created favourable conditions for a revival in capital spending.
Yet repairing corporate balance sheets is a slow process and may require further deleveraging. The
household debt burden has risen in recent years, suggesting that household saving rates may now
begin to rise as households seek to rebuild assets following substantial past declines in their
financial wealth.
Recent economic developments have underscored many important policy
challenges. The United States had a pivotal influence on global growth in 2002, partly because of
significant longer-term weaknesses in some other major countries and regions. Inflation has remained
moderate but downward pressures on the prices of goods worldwide have prompted some to focus on the
dangers of global deflation. The deterioration in fiscal balances and the prospect of ageing
populations in many industrial countries highlight the need for maintaining confidence in the
long-term sustainability of fiscal positions, particularly as fiscal rules have been effectively
relaxed. A final issue is the widening of current account imbalances observed in recent years. This
has reflected major shifts in the position of countries or regions as suppliers or users of saving.
While lower fiscal deficits in the medium term would be helpful, a sustainable reduction in the US
current account deficit may also need to be associated with a higher household saving rate in the
United States and higher levels of demand in other countries.
III. Developments in the emerging market economies
2002 was marked by sharp divergence in the growth rates of emerging
economies, with growth in Latin America being particularly weak. In 2003, growth prospects in Asia
have been hurt by the spread of the SARS virus; the economic outlook for Latin America has
brightened as exports have rebounded following large real currency depreciations and improved
external financing conditions. Growth is also expected to rise in central Europe and Africa in 2003.
The chapter reviews the policy challenges confronting emerging economies in
each major region. The first is the feasibility of growth-supporting macroeconomic policies in Asia.
Favourable investor sentiment allows some scope for expansionary fiscal policies in the short run,
even if ratios of public debt to GDP are comparatively high. But continued debt accumulation over
the medium term in a number of countries could create difficulties. In addition, the easing of
monetary policy in a number of Asian economies has been associated with a property market boom and
an overly rapid growth in household credit. Secondly, there are the policy dilemmas created by
external financing constraints in Latin America. In 2002, sovereign spreads for Latin American and
other heavily indebted economies widened, capital inflows dried up, currencies depreciated and
inflation rose sharply. Policymakers sought to reassure investors by measures of fiscal
consolidation and reform. In formulating monetary policy, policymakers had to set interest rates
high enough to curb inflation, but low enough to keep the economy growing and reassure investors
that debt would be serviced. The policy challenge for central and eastern European countries is
eventual EMU membership. Excessive budget deficits have contributed to high interest rates in some
countries that have attracted large capital inflows, creating dilemmas for the monetary authorities.
IV. Monetary policy in the advanced industrial economies
Monetary policy was stimulative in industrial economies during the period
under review. This was due, in part, to the tepid recovery in 2002 and, in part, to risks of a sharp
downturn in economic activity in an environment of heightened uncertainty. In the United States, the
Federal Reserve held its policy interest rate roughly steady at a low level for most of the period,
as prospects for a robust recovery remained in doubt. The ECB initially held rates steady at a
higher level, as inflation remained a concern, but eventually cut them as growth slowed
unexpectedly. Persistent economic weakness in Japan prompted the monetary authority to intensify its
policy of quantitative easing. Conditions were more mixed in countries with explicit inflation
targets, with some central banks tightening rates in the face of rising inflationary pressures.
The risk of deflation became a concern during the period under review. With
the attainment of a low-inflation environment, the stalled global recovery has raised the
possibility, however remote, of generalised deflation. Deflation presents a challenge for monetary
policy because it can be very disruptive, especially when accompanied by sharp asset price declines.
Deflation can also constrain the effectiveness of conventional monetary policy as nominal interest
rates approach the zero lower bound. A special section of the chapter examines past episodes of
deflation, focusing on the 19th and early 20th centuries.
V. Foreign exchange markets
The weakening of the US dollar was the salient feature in the foreign
exchange markets during the period under review. By mid-May 2003, the dollar had fallen from its
early 2002 peak by around 25% against the euro; the movement against the yen was some 12% over the
same period. In nominal effective terms, the dollar lost about 16%. Against the backdrop of
disappointing growth prospects and the continuing decline in equity prices, interest rate
differentials seemed to re-emerge as an important factor behind exchange rate movements. In
addition, concerns about the growing US current account deficit weighed on the dollar. Changes in
the composition of the deficit suggested a rising risk premium on US assets.
A historical review of major current account reversals in a large number of
industrial countries since 1973 reveals that these adjustments were associated with slower domestic
growth but only relatively minor currency depreciations. In contrast, an analysis of the US current
account adjustment around 1987 indicates that the decline of the dollar played a much larger
equilibrating role. Yet there are also important differences between current conditions in the
global economy and those that prevailed in the 1980s. This implies that a similar pattern of dollar
adjustment cannot be predicted with confidence, even though a significant correction of current
account imbalances still seems likely.
Several non-EMU European currencies, as well as the Australian, Canadian and
New Zealand dollars, derived support from their interest rate differential over US dollar- or
euro-denominated assets. The appreciation of these currencies also seemed to be underpinned by the
relatively good performance of the respective economies. By contrast, the appreciation of the Swiss
franc between January 2002 and March 2003 mainly reflected the currency's traditional safe haven
role, which to some extent offset the Swiss National Bank's policy ease. Nonetheless, following the
monetary easing in early March 2003 and the attenuation of geopolitical tensions, the Swiss franc
depreciated against the euro.
The search for yield by international investors also lent support to some
emerging market currencies during the period under review, although global economic prospects and
various domestic factors also exerted a considerable influence.
VI. Financial markets
Global financial markets suffered extraordinary blows to confidence during
the period under review. A series of corporate governance improprieties, the most prominent of which
was a financial restatement by the US telecommunications firm WorldCom in late June 2002, heightened
risk premia across financial markets. As a result, equity markets suffered deeper losses in 2002
than during the previous two years. Even the once resilient corporate bond market experienced an
episode of severe dislocation. Volatility in the major financial markets spilled over into emerging
markets, with global investors' changing appetite for risk appearing at times to dominate local
developments.
As investors regained confidence, markets staged rallies starting in October
2002 - first the corporate and emerging bond markets, and later the equity markets. Corporate
efforts to strengthen balance sheets underpinned a narrowing of credit spreads in late 2002. While
lower yields in government and swap markets indicated some questioning of this confidence, it did
help to extend the rally in credit markets. Even traditionally conservative investors appear to have
sought higher returns in corporate and emerging market bonds. In spring 2003 equity markets joined
the rally, buoyed by the rapid end to the war in Iraq and by encouraging earnings reports.
Housing markets continued to show remarkable strength more than three years
after equity market prices peaked. In the past, housing prices had tended to turn down around two
years after an equity market peak. One explanation is that, in recent years, central banks have been
able to cut policy rates sharply, thus supporting housing prices. In the past, by contrast, the
monetary authorities had often raised interest rates in an effort to restrain aggregate demand and
inflation.
VII. The financial sector
Financial systems in industrialised countries came under additional pressure
last year, as expectations of an early economic recovery were dashed and equity prices fell further.
Nonetheless, financial institutions generally appeared to weather the economic downturn
successfully, and financial sector pressures did not impede the supply of credit in most countries.
Banks generally displayed considerable resilience, reflecting both atypical aspects of the current
cycle (eg accommodative monetary policy, growth in household expenditure and the absence of a
property price bust) and structural factors (eg the use of financial instruments that facilitated
the wider dispersion of credit risk across the financial system). Nevertheless, some sectors were
confronted with difficult challenges. The Japanese financial system continued to face problems of
non-performing loans and low profits. The performance of German financial institutions was weak, due
as much to long-standing structural weaknesses as to cyclical influences. Insurance companies
generally fared less well than banks, as losses on their investment portfolios and low returns on
fixed income assets put considerable pressure on earnings.
Looking ahead, the primary risks to financial institutions are related to
the macroeconomic outlook. A prolonged period of economic weakness would further test the loss
absorption capacity of financial institutions and markets. In addition, some firms may face legal
and reputational risks related to activities undertaken during the late 1990s expansion, and the
increased role of markets for credit risk transfer may yet pose challenges for participants.
The recent resilience of the financial sector can be viewed as an indication
that financial systems with multiple channels of funding, through both market-traded instruments and
balance sheet intermediation, may provide a more flexible response to adverse economic developments.
Nevertheless, such multichannel systems also pose new challenges for prudential supervisors due to
the greater complexity of individual institutions and of the links between institutions and markets.
VIII. Conclusion: towards more balanced global growth
The world economy faces a fundamental dilemma: how can imbalances in demand
and in external accounts be resolved while achieving solid global growth performance? A particular
uncertainty is whether the global corporate sector, still preoccupied with strengthening balance
sheets after earlier excesses, will increase investment. This is crucial as household spending could
weaken given rising consumer debt levels, potentially weaker housing prices and rising unemployment.
Monetary and fiscal stimulus in several countries (especially in the United
States) is providing near-term support, but this could exacerbate existing imbalances, such as
external deficits and historically high asset valuations in some markets. To ensure the
sustainability of a truly global expansion, more needs to be done to strengthen domestic demand
growth in countries with healthy external balances. In Asia, this implies allowing currency
appreciation and eschewing export-led strategies for growth. In continental Europe, it primarily
implies implementing the structural reforms that will allow the industrial sector to respond
flexibly to a stronger euro.
Prudent policymakers should be prepared to address the possible implications
if growth were to falter. First, there could be repercussions on the financial system. Efforts are
required to further strengthen the underpinnings of the financial system, and to ensure that the
risks attendant on greater reliance on markets are being properly managed. A second concern has to
do with the possibility of deflation, which could constrain the effectiveness of conventional
monetary policy as nominal rates approach the zero lower bound. The efficacy of macroeconomic
measures could, in such extreme circumstances, depend to an unusual degree on cooperation between
the monetary and fiscal authorities. In addition, the lesson of recent Japanese experience is that
macroeconomic stimulus might have to be accompanied by structural measures to force companies and
banks to adjust to market realities.
Activities of the Bank
This chapter summarises the various activities of the BIS over the past
year: consultations on monetary and financial matters; the standing committees that meet regularly
at the BIS; and the provision of financial services to central bank customers. In line with its
increasingly global focus, the Bank opened a Representative Office for the Americas in Mexico City
in November 2002.
The bimonthly meetings of Governors of BIS member central banks remained at
the heart of the Bank's contribution to international cooperation in 2002/03. In addition, various
meetings were organised throughout the year on issues of central bank interest, in some cases with
the participation of a broad range of senior non-central bank and private financial sector
officials.
As part of its efforts to promote financial stability, the Bank continued to
host and assist the secretariats of the Basel Committee on Banking Supervision, the Committee on the
Global Financial System and the Committee on Payment and Settlement Systems. These committees are
charged with reviewing basic aspects of the functioning of international financial markets and
financial institutions. A project of prime importance is the development of a new framework for bank
capital adequacy (the New Basel Capital Accord, also called "Basel II"), which is expected
to be finalised by the end of 2003. Spreading understanding of the New Accord was a major area of
emphasis of the activities of the Bank's Financial Stability Institute and is expected to remain so
for the next year.
Through secretariat support and, in some cases, direct involvement in the
deliberations, the Bank continued to assist the work of a number of independent organisations that
have established their secretariat at the BIS. They include the Financial Stability Forum, the
International Association of Insurance Supervisors and, since May 2002, the International
Association of Deposit Insurers.
The Bank continued to serve as a counterparty to central banks in their
financial operations, and to provide agent and trustee functions for a variety of financial
transactions. In the course of the year, the balance sheet remained strong, while underlying profits
showed mild growth.
Among the key administrative matters marking the past financial year,
special reference should be made to the adoption of the Special Drawing Right as the Bank's new unit
of account, and to the amendment of the Bank's accounting policies with a view to providing a better
picture of the Bank's financial position and performance.
|