Speech by Mr Nout Wellink, President of the BIS, to the 75th Annual General Meeting
27 June 2005
Ladies and Gentlemen
It is a privilege and pleasure for me to open the proceedings on this special occasion of the 75th BIS Annual General Meeting. I extend a warm welcome to the delegates from our shareholding central banks, the representatives of non¿member central banks and international institutions and, of course, our distinguished guests from the international banking and financial community.
In a short while, Malcolm Knight will provide us with a report on the activities of the BIS over the past year. First, however, I would like to offer a brief commentary on the global economy.
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In many respects, the world economy did remarkably well last year. Despite a sharp and sustained increase in oil prices, the global economy proved surprisingly resilient. With world growth at almost 5%, 2004 was the best year in nearly three decades, with emerging market economies performing especially strongly. Headline inflation edged up in several countries, but core inflation remained generally subdued. The pass-through from energy prices to inflation was much more muted than in previous episodes of sharp oil price increases. And financial institutions across the globe posted some of their best results for years.
Measured by the same metrics, near-term prospects appear, on balance, good. Notwithstanding the more uncertain outlook for the euro area, world growth is still expected to decelerate only modestly in 2005, further absorbing economic slack. Inflation prospects call for continued vigilance; but with inflation expectations well anchored and wage pressures subdued, the consensus forecast is for inflation to remain under control. The strength of banking systems generally suggests that they are well placed to support the expansion further. And the progress made by several emerging market countries in their macroeconomic and structural policies in recent years should make them less vulnerable to any external unforeseen developments.
What are the reasons for this comparatively strong performance? And how sustainable is it?
To some extent, from a longer-term perspective, we have recently been reaping the benefits of better structural and macroeconomic policies followed since at least the early 1990s.
On the structural side – and despite important cross-country differences to which I will return shortly – much of the credit goes to the greater acceptance of market principles and the associated wave of deregulation in the world economy. This has ushered in a new historical phase of globalisation and innovation, financial and real, in some respects comparable to the era that prevailed under the gold standard almost a century ago, but arguably deeper. The wave has brought with it great efficiency gains; has raised world growth potential; and has imparted a downward tilt to price pressures, by making markets for both outputs and inputs more contestable.
On the macro side, better monetary policy has helped to establish a credible anti-inflation commitment, manifested in mandates more tightly focused on price stability and underpinned by a shift towards greater central bank independence. This has allowed market participants to plan ahead in the conviction that central banks will not allow a repeat of the traumatic Great Inflation experience of the 1970s and 1980s; has reduced inflation risk premia; and, by improving the quality of price signals, has supported a better allocation of resources.
On this basis alone, the prospects for non-inflationary, long-term growth would seem bright. Nevertheless, a closer look reveals some more disturbing signs that counsel caution. Let me highlight three such signs, evident in the pattern of the recovery since the slowdown in the early part of the decade.
First, the geographical distribution of demand and growth has been very uneven. At one end, the United States and emerging Asia have grown very fast: since 2001, the United States and China alone have accounted for almost half of world growth. At the other end, the euro area and Japan have expanded much more slowly. This has contributed to growing current account imbalances across regions. In particular, and despite a substantial effective depreciation of the dollar since late 2002, the US current account deficit reached an unprecedented 5.7% of GDP last year; on current trends, it is expected to widen even further.
Second, the expenditure composition of world demand has been less than ideal. Despite differences across countries, household demand (including residential investment) not only helped sustain activity during the slowdown but was also very strong thereafter; in the industrial world alone, it accounted for an estimated 80% of growth between 2001 and 2004. Partly as a corollary, household debt/income ratios have risen to unprecedented levels in many industrial and emerging market countries, supported by unusually brisk residential property prices. By contrast, business fixed investment has been quite weak, accounting for only 3% of total global growth over the same period. And despite buoyant profits, and recent signs of a pickup in the United States, a continued revival in global investment is not assured. Across the world, China stands out as one major exception, with sustained investment rates of the order of half of GDP; but the quality of financial intermediation and the country’s large state sector raise questions about the efficiency of this capital accumulation.
Third, major policy stimulus has played a crucial role in the strength of the recovery; and this stimulus will at some point either fade or have to be withdrawn. There has been a sharp deterioration in fiscal positions in several major industrial countries, not least the United States, well beyond cyclical factors. This has raised questions about medium-term sustainability. Likewise, monetary policies have been and remain generally very accommodative. Inflation-adjusted policy interest rates have not been so low for so long in so many countries since the late 1960s and early 1970s. They have been hovering around zero in many jurisdictions, including the United States, the euro area and much of Asia, and have generally remained well below estimates of long-term neutral levels elsewhere; in Japan, policy rates have been at zero in nominal terms for some years. This unusual configuration reflects, in part, a response to the economic slowdown early in the decade, as the equity market bubble burst and investment plunged. It has also resulted from attempts to resist currency appreciation in several countries, sometimes supported by unprecedented foreign exchange intervention. Arguably, this policy stimulus has also contributed to the widespread search for yield in financial markets, encouraging exceedingly accommodative financial conditions and frothy property prices. Its medium-term consequences are hard to predict.
Against this background, the short-term challenge is to address these three sources of potential unsustainability without, in the process, inducing a marked slowdown in world growth. In the absence of timely policy action, the risk is that a more disruptive market-driven adjustment might take place further down the road. At least five policies deserve attention.
The first is fiscal consolidation in those jurisdictions where medium-term trends look worrisome. This would make room for private investment, thereby re-establishing the more favourable conditions that prevailed earlier in the 1990s, and would help to limit the risk of a delayed but sustained upward shift in real long-term interest rates. It would also contribute to external balance where demand growth has been outstripping supply. Reducing the twin deficits in the United States is critical here.
The second is further progress in returning monetary policy to a more neutral stance, where and as circumstances allow. This would restrain the impulse by households to accumulate further debt and temper risk-taking in financial markets.
The third is a greater degree of exchange rate flexibility, especially in Asia. This would help shift the geographical composition of global demand and growth in the right direction, thereby reducing current account imbalances, and would limit the risk of an excessive adjustment burden falling on those economies operating with more flexible exchange rate regimes. Moreover, it could also contribute to achieving more sustainable growth domestically in those countries showing signs of unbalanced expansion. China plays a key role here.
The fourth is implementing real-side structural policies, especially where greater acceptance of market principles has failed to make sufficient progress. Increased labour and product market flexibility is essential. This would help raise the growth potential of slower-expanding economies. By the same token, it would also contribute to the resolution of global imbalances, especially if effective in eliminating rigidities in the less tradable sectors of surplus countries. Continental Europe and Japan are critical here.
The fifth is further reducing vulnerabilities in emerging market economies, taking advantage of the window of opportunity left open by very accommodative external conditions. This would limit the risk that the world recovery might be derailed, or a slowdown exacerbated, by disruptions in the emerging world. It means combining prudent macroeconomic policies, both fiscal and monetary, with steps to tackle remaining structural weaknesses. In the financial sector, for instance, there is room to strengthen regulatory safeguards, to reduce the presence of the public sector, and to consolidate improvements in addressing foreign currency mismatches.
At the same time, a number of factors, both economic and political, complicate the calibration of this set of policies. Let us consider each type in turn.
The economic factors vary across regions. In the euro area and Japan, for instance, embarking on the required medium-term fiscal consolidation could have unwelcome short-run effects on activity; in addition, there is limited policy room to offset any contractionary impulses that might originate externally. In Asia, and especially China, small exchange rate adjustments by themselves might not contribute much to global rebalancing and might even intensify speculative pressures; large adjustments, though, might be hard to absorb domestically. More generally, high household debt, frothy house prices and signs of excessive risk-taking in financial markets might complicate the central banks’ task of raising rates towards more normal levels without risking unwelcome reactions. For example, while the recent partial widening of credit spreads has, on balance, been orderly and welcome, uncertainties remain, not least in the light of the activities of leveraged players and of the rapid growth of credit transfer products in recent years. Moreover, were house prices to weaken, the response of consumer spending would deserve careful monitoring.
The factors of a more political nature are equally pervasive. First, there is still strong resistance to the needed fiscal consolidation and structural liberalisation. For instance, in the United States the prospects for a reduction of the fiscal deficit are not very encouraging. In Europe, the travails of the Stability and Growth Pact and the obstacles faced by the Services Directive have been all too evident. Political resistance has also hindered reforms in Japan. Second, in emerging market countries there is a clear risk that reforms might lose momentum, as countries are lulled into a false sense of security by the prevailing favourable global conditions. Finally, there are worrying signs of growing protectionist pressures, particularly in response to China’s surging exports.
Policymakers are confronted with these short-term conflicts because, to a considerable extent, they have failed fully to come to grips with two underlying, longer-term challenges.
The first challenge is the major shift in the structure of global production needed to reap the benefits of the integration into the world economy of such potential giants as China and India. This puts a premium on the flexibility of labour and product markets, necessary for the adjustment to take place smoothly, and on the political will to support the required shift. Hence the concerns about the comparative rigidity of certain key economies, especially the euro area.
The second longer-term challenge is understanding better the potential implications of the new environment for the dynamics of the global economy, characterised by the higher growth potential and productivity gains associated with globalisation, by solid anti-inflation credibility, and by liberalised financial markets. The question is whether such an environment might not only reduce medium-term inflation risks but also raise the risk of unsustainable expansions characterised by excessive debt accumulation and asset price increases, both within and across countries. This could be so if the growth in supply potential provided the medium-term disinflationary pressures and the expectations of long-term income gains; if accommodating financial markets supported expansions by spontaneously generating the necessary liquidity to sustain the increase in asset prices and spending; and if anti-inflation credibility helped to delay the emergence of overt inflation and hence the need to tighten policy. Evidence of such dynamics can be seen in the business cycles experienced since the 1980s in Japan, East Asia and the United States, as well as in the current expansion in China and the world more generally. Hence the coexistence globally of unusually low policy interest rates with few indications of overt inflationary pressures but many clear signs of financial exuberance. Concerns about financial overreach could complicate the setting of monetary policy.
How well the world economy will perform in the years ahead will depend to a considerable extent on how policymakers address these two challenges. As argued in the Annual Report, this may require a combination of old and new prescriptions, based on a firm longer-term orientation of policy frameworks and tighter cooperation between monetary and prudential authorities. Finding adequate solutions also puts a premium on international cooperation. The BIS will continue to play its role in support of this cooperation, as it has since its inception 75 years ago.
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That, ladies and gentlemen, concludes my brief overview. Before handing over to Malcolm Knight, it only remains for me to mention that there have been no changes in the Board of Directors since the 2004 AGM.
I would now like to hand over to the General Manager. Thank you for your attention.