76th Annual Report 2005/06: an overview

26 June 2006

Chapter I: Introduction: resilience to mounting strains

Global growth last year was again very rapid, in spite of higher prices for energy and other commodities. Moreover, core inflation generally stayed low even as headline inflation rose. Yet, as the year wore on, fears began to grow about prospective inflationary pressures. Concerns also began to mount about the growing imbalances in the global economy, not least the low saving and high investment levels in the United States and China, respectively, and record current account imbalances. Against this backdrop, monetary policy tightened in a number of industrial countries. Financial markets for the most part continued to have a very upbeat view of the future, especially for emerging market economies, although in mid-May 2006 uncertainty and volatility both increased. The US dollar, whose longer-term downward movement had been interrupted in 2005 in response to relatively high US policy rates, also began to weaken more sharply.

Chapter II: The global economy

The world economy grew strongly in 2005 while inflation remained subdued. This outcome exceeded the optimistic forecasts of early 2005 despite headwinds from changes in the macroeconomic environment. First, inflationary pressures remained muted even as commodity prices rose further in the third consecutive year of buoyant world growth. Second, the US economy retained considerable strength despite the energy price hike and hurricane-related disruptions. Third, global financing conditions continued to be very supportive of growth, notwithstanding the progressive removal of monetary accommodation in the United States and, albeit less advanced, in the euro area. Finally, financial markets stayed calm despite the further massive and unexpected deterioration of the US current account balance during 2005.

The consensus forecast for 2006 is for a continuation of strong growth and low inflation worldwide. Strengthening business confidence and low or declining unemployment support this optimism about the near-term outlook for growth. However, several features of the current global upswing are less positive: fiscal deficits are large; household savings seem unsustainably low in a number of advanced economies; investment levels remain low; and global current account imbalances have reached unprecedented levels. At the same time, the inflation outlook has become more uncertain, as oil prices have risen to new record highs and output gaps are narrowing or even closing in many economies. One key question in this regard is whether the global disinflationary forces that have resulted from the international integration of major emerging economies will persist.

Chapter III: Issues in emerging market economies

The expansion in emerging market economies consolidated further in the period under review. In many countries, strong growth was accompanied by increasing export values and large current account surpluses. External debt burdens fell, foreign currency reserves rose further, fiscal positions improved, and balance sheets strengthened. Partly in response, consumer and investor confidence remained buoyant and growth was remarkably resilient in the face of higher oil prices even in oil-importing countries.

External conditions were unusually favourable during the period, including strong global demand, large terms-of-trade improvements for many countries and much easier external financing. In spite of these favourable circumstances, further policy measures are required. Some countries need to secure lasting improvements in fiscal positions. Also, while there was some degree of monetary tightening or exchange rate appreciation, particularly in countries that target inflation, monetary conditions in emerging market economies remained comparatively easy, and inflationary pressures became apparent in a number of cases. A major challenge for the monetary authorities in many countries is how to avoid policy mistakes that might put macroeconomic and financial stability at risk.

Chapter IV: Monetary policy in the advanced industrial economies

The overall thrust of monetary policy in the G3 economies remained accommodative, but took a distinctly firmer tone during the period under review. As signs of price pressures accumulated, the Federal Reserve continued to tighten policy with consecutive rate hikes. The ECB began to raise its policy rate, as headline inflation exceeded its target and momentum in economic activity strengthened; in addition, money, credit and asset price developments heightened concerns about longer-term price stability. As deflationary pressures faded, the Bank of Japan announced the end of its unconventional quantitative easing policy but initially left its policy rate unchanged at zero. The Bank also adopted a new two-perspective policy framework distinguishing between short- and long-run risks to price stability. Policies across smaller industrial economies with inflation targets were more diverse, with most central banks tightening. External developments once again played a major role in shaping the policy environment. High oil and other commodity prices fed concerns about worrisome second-round inflationary effects, while at the same time low-cost imported consumer goods raised prospects of underlying inflation running below target.

A special section of the chapter delves further into the implications of greater global integration ("globalisation") for the conduct of monetary policy. While supporting the global disinflation process over the last decade or so, globalisation has also complicated monetary policymaking by altering the policy environment in various ways, influencing traditional policy guideposts and restricting policymakers' room for manoeuvre. Challenges facing monetary policymakers are discussed in the light of such trends.

Chapter V: Foreign exchange markets

The broad appreciation of the US dollar, the stability of the euro and the overall downward trend of the yen were salient developments in foreign exchange markets over most of 2005. Starting in early December 2005, however, the upward trend of the US dollar reversed. As in previous years, three main factors underpinned exchange rate developments during the period under review: interest rate differentials, the current account deficit and rising net international liabilities of the United States, and continuing reserve accumulation in China limiting the dollar's depreciation against the renminbi. In contrast to earlier years, reserves grew more slowly in other emerging market countries in Asia. The change in China's exchange rate policy introduced in July 2005 received much attention, but by mid-May 2006 had only had a modest impact on foreign exchange markets.

A special section explores trends and determinants of net income in the United States and other industrial countries and the possible implications for the sustainability of external imbalances. The United States has typically reported a positive net income balance, despite a deteriorating net foreign asset position. This is partly because a higher proportion of its assets are in high-yielding asset classes, such as foreign direct investment, and partly because it earns a higher yield on its direct investment abroad than foreigners earn on their direct investment in the United States. Simple sensitivity analysis highlights the importance of an improvement in the trade balance for the sustainability of the net foreign asset position. Moreover, valuation effects can have significant, albeit one-off, effects on the external balance. Changes in relative yields have an important effect on net income, but only a second-order one on net foreign assets.

Chapter VI: Financial markets

Conditions in global financial markets remained calm and accommodative during most of the past year. This reflected the surprisingly strong performance of the world economy and still abundant liquidity. Up to the end of 2005, lower term premia - or a narrowing wedge between forward and expected short rates at long maturities - appeared to be responsible for flattening yield curves in the United States and the euro area. The prospect of additional monetary tightening due to higher growth and inflationary pressures resulted in higher long-tem yields starting in early 2006. However, its impact on the prices of other assets was only evident from mid-May, when volatility increased and equity and emerging debt markets fell sharply.

Equity prices and credit spreads benefited from upward revisions to the growth outlook in 2005 and early 2006. In the main industrial countries, changes in firms' capital structure also supported equity markets, on the back of an impressive pickup in share buybacks and merger and acquisition (M&A) activity. Stocks responded more positively to the latest M&A wave than they had to previous ones, rewarding shareholders of both target and acquiring companies. Credit spreads stayed close to their cyclical lows despite the releveraging activity. Investors' high appetite for risk helped to keep spreads down. This was especially evident in emerging markets, where the tightening of spreads in 2005 and early 2006 appeared to proceed more rapidly than the improvement, admittedly sizeable, in fundamentals.

Chapter VII: The financial sector

Financial firms in the advanced industrial countries registered strong performance during the year under review. Banks continued to harvest the benefits of past years' cost savings, a continuing benign credit environment and healthy volumes of retail business, which contributed to higher profits despite further compression in interest rate margins. The balance sheets of life insurance companies strengthened while the property and casualty sector managed a year of record claims without major problems. A boom in the activity of private equity funds was accompanied by intensive fund-raising and borrowing to finance leveraged buyouts. Hedge funds experienced a slowdown in inflows as performance slumped.

The main risks confronting the financial sector are of a macroeconomic nature. They are related to the potential effects of higher interest rates, a turn in the credit cycle and, possibly, associated declines in real estate prices and aggregate expenditure. The current environment places a premium on system-wide risk management. It highlights the importance of making available information about risk as well as the interplay, and need for consistency, between financial reporting standards, risk management practices and the overall prudential framework.

Chapter VIII: Conclusion: coping with risks, today and tomorrow

The best bet for next year is that strong, non-inflationary growth will continue. Yet there are considerable uncertainties and associated risks, not least concerning inflationary pressures on the one hand, and a possible unwinding of accumulated economic and financial imbalances on the other. These could lead to financial market turbulence or a long period of relatively slower global growth developments, or both. Fortunately, policies might be suggested that could reduce these risks materially. While the current phase of monetary tightening seems clearly justified, the issue of how higher rates and financial imbalances might interact needs careful consideration. This is particularly so against a backdrop of globalisation and shifts in relative prices which have, in any event, made it more difficult to gauge how much tightening is actually required. The burden placed on monetary policy, and the associated risks, could be reduced by concurrent fiscal tightening, particularly in countries like the United States with large current account deficits. Such support would also help reduce the risk of disorderly exchange rate movements. Structural reforms to aid internal adjustments between the tradable and non-tradable sectors in various countries would serve the same purpose.

Looking further ahead, two policy questions present themselves. First, how should policy respond, were some of the current risks to materialise? It is concluded that some preparatory work would pay dividends, particularly since all of the possible policy responses in that event would seem to have both advantages and disadvantages. For example, lowering interest rates again might or might not stimulate aggregate demand, given high debt levels, but would also have negative supply side effects over time. Second, looking still further ahead, how could our policy frameworks be adapted to minimise the likelihood of today's problems of imbalances being repeated in the future? It is concluded that price stability should be pursued more flexibly and using a longer forecast horizon than is currently fashionable, and that more weight should be given to indicators of rising imbalances in conducting monetary policy.

Organisation, governance and activities of the Bank

This chapter summarises the BIS's contribution to international cooperation directed towards greater monetary and financial stability. It describes the institutional framework in which this cooperation is pursued, and highlights activities that marked the past year.

In June 2005 corporate governance was strengthened through a revision of the BIS Statutes approved at an Extraordinary General Meeting of the Bank's shareholders. Based on recommendations of a group of eminent legal experts, the revision abolished the position of President of the Bank, and recognised terms of reference for the Executive Committee as an advisory committee to the General Manager. Charters for the Board of Directors and several operational committees were drawn up.

In early 2006, the BIS announced initiatives to deepen relationships with its strategic partners in Asia following an intensive consultation process with BIS member central banks in the region. The initiatives comprise a three-year research programme on monetary and financial issues in Asia and the Pacific, an expansion of the work of the Financial Stability Institute in the region, and an extension of banking services from the BIS Representative Office in Hong Kong SAR.

The bimonthly meetings of Governors of BIS member central banks in Basel are an important element of the framework for international cooperation. In particular, the Global Economy Meeting monitors economic and financial developments and assesses vulnerabilities, while the meetings of the G10 Governors and those of Governors of key emerging market economies explore topical themes. In 2005/06, special meetings were also organised on issues of interest to central banks, to which a broad range of senior non-central bank and private financial sector officials were invited.

New activities during the period under review included the expansion of the range and country coverage of the economic, monetary and financial statistics compiled by the Bank. The Joint External Debt Hub (JEDH), delivering comprehensive external debt statistics compiled from national and creditor/market sources, was launched jointly by the BIS, the IMF, the OECD and the World Bank in March 2006. Also in early 2006, the Irving Fisher Committee on Central Bank Statistics (IFC), a global forum of users and compilers of statistics at central banks, moved its permanent secretariat to the BIS.

In May 2005, the Bank established the Central Bank Governance Forum, formalising its long-standing activities to foster good governance of central banks as public policy institutions. The IFC and the Governance Forum join the Basel Committee on Banking Supervision (BCBS), the Committee on the Global Financial System (CGFS), the Committee on Payment and Settlement Systems (CPSS) and the Markets Committee as groups operating at the BIS. Independent organisations with secretariats located at the BIS are the Financial Stability Forum, the International Association of Insurance Supervisors and the International Association of Deposit Insurers.

Significant committee publications in 2005/06 included an update of the Basel II capital adequacy framework (BCBS, November 2005), general guidance on payment systems (CPSS, January 2006) and an analysis of housing finance in the global financial market (CGFS, January 2006). Additionally, the Bank's 75th anniversary in 2005 provided new opportunities for disseminating information about the historical and contemporary role of the BIS in promoting international financial cooperation. In January 2006, a new BIS website was launched, providing an expanded research hub featuring analytical work published by participating central banks.

The Bank continued to serve as a prime counterparty to central banks in their financial operations. In addition, it performed agent and trustee functions for a variety of financial transactions. Created at the initiative of EMEAP member central banks and monetary authorities, the two Asian Bond Funds (ABF1 and ABF2) are administered by the BIS under an open-ended fund umbrella.

The balance sheet grew, closing at SDR 220.1 billion at end-March 2006, representing a year-on-year increase of 22%. Net profits for the Bank's 76th financial year amounted to SDR 599.2 million, compared with SDR 370.9 million in the preceding year.