24 June 2007
Chapter I: Introduction: piecing the puzzle together
The favourable global economic performance seen in recent years extended into the period under review. Global growth was strong and there were even welcome signs of better balanced demand. The US economy slowed somewhat, largely due to a weaker housing sector, while domestic demand in Europe, Japan and a number of emerging market economies picked up. Although output in many countries seemed to be close to potential, and commodity prices rose still further, overall inflation pressures remained muted. In this environment, there was a moderate tightening of monetary policies in many countries, although overall monetary and financial conditions remained highly accommodative. In part this was due to real policy rates remaining rather low, with associated effects on long-term interest rates. But it was also due to an increased willingness of lenders to advance credit to high-risk borrowers with less onerous conditionality than in the past. While the credit cycle has peaked in the subprime mortgage market in the United States, the expansion has continued in most other areas. As a result, global asset prices either continued to rise or were maintained at unusually high levels. Moreover, financing for the US current account deficit, as well as private capital outflows from the United States, continued to be available at terms that seemed to factor in expectations of only a very moderate further depreciation of the dollar.
Chapter II: The global economy
The strength of the global economy surprised again in 2006. US consumption was unexpectedly resilient given the substantially weaker housing market, while there was a broad-based upswing in other advanced industrial countries alongside continued rapid growth in emerging market economies. Inflation remained subdued, with headline inflation receding in the second half of the year. However, underlying inflation pressures persisted, reflecting high, or rising, rates of resource utilisation in major economies.
The consensus view for the current year is for a continuation of the broad-based economic expansion – although at a slightly slower pace than in 2006 – easing inflation pressures and gradually receding current account imbalances. This scenario is supported by growing evidence of a classical recovery in the euro area and Japan, with export growth leading to rising investment, and in turn to rising employment and consumption. Healthy domestic demand in major emerging economies is also encouraging.
The baseline scenario remains subject to significant near-term risks, however. The impact of the downturn in the US housing market might not yet have been fully felt. Admittedly, Europe and Asia appear less dependent on US growth than a few years ago. Even so, there are questions regarding the strength of consumption in these regions and advanced industrial countries in general. At the same time, it remains to be seen whether inflationary pressures have been contained. Underlying inflationary pressures are still visible in major economies, and it is not clear whether the projected moderation of growth will be sufficient to significantly reduce resource pressures. Financing conditions, which have remained supportive to growth, might also eventually tighten, especially if inflationary risks were perceived to increase.
Chapter III: Emerging market economies
Emerging market economies (EMEs) continued to record strong growth, moderate inflation and current account surpluses in 2006 and into the first quarter of 2007. Yet inflation pressures raised concerns in some countries, in part because of robust demand and in part due to uncertainties about commodity prices. Despite moderate monetary tightening, credit growth has remained strong in a number of EMEs. At the same time, fiscal consolidation and improved debt management have enhanced the resilience of EMEs.
Asset prices in EMEs have surged. Gauging the influence of foreign investors is not straightforward: for one thing, net private capital inflows are small relative to foreign exchange inflows arising from large current account surpluses. Foreign investors have, however, boosted their holdings of emerging market assets to a greater extent than net financing data show, and may have acquired positions in EME assets through derivatives. While there is some evidence that EME asset prices are moving more with global asset prices, it is not yet clear whether foreign influences have added to asset price volatility.
The emergence of China in world trade, as an importer of intermediate goods and exporter of final goods, is relevant globally and particularly within the Asian region. Commodity exporters have tended to benefit from increased demand from China. However, the gains to its neighbours and other emerging market trading partners are not as clear-cut. Some have lost market share in third markets, although this has been offset to a greater or lesser extent by increased exports of intermediate and capital goods to China. A rise in the relatively low level of China’s demand for imports to satisfy domestic final demand would provide further opportunities to its trading partners, and would also increase the extent to which Chinese growth could offset any potential slowdown in US demand. Finally, China’s emergence also has mixed implications for the exchange rate policies of its neighbours.
The stance of monetary policy in the advanced industrial countries became less accommodative during the period under review, although the overall stance remained supportive. The Federal Reserve further raised its policy interest rate early in the period and then kept it on hold, despite lingering concerns about upside inflation risks. The ECB significantly reduced the degree of policy accommodation during the period as economic activity picked up, economic slack diminished and money and credit grew rapidly. Using its newly adopted two-perspective policy framework to explain its actions, the Bank of Japan ended its zero interest rate policy with two modest moves during the period, arguing that the ongoing recovery had gained sufficient traction, that underlying inflation fundamentals had strengthened and that maintaining a near-zero interest rate environment had raised medium-term risks of unsustainable investment trends. In smaller advanced industrial economies with inflation targets, there was a general tightening of monetary policy in the face of a diverse set of domestic and external forces, including uncertainties about the global outlook, dwindling slack, high commodity prices, robust money and credit growth, and strong capital inflows.
The evidence of rapid growth of monetary and credit aggregates has been attracting considerable attention, but there are varying central bank perspectives about the monetary policy implications. Some central banks assign prominence to the aggregates while others are more sceptical about their relevance. The stakes of the debate are high. Assigning too much weight to the aggregates runs the risks of overreaction and confusing the public about the central bank’s priorities. Too little weight could leave central banks behind the curve with respect to inflation or insufficiently attuned to the possibility of boom-bust economic fluctuations. Even though the issues surrounding the debate are far from resolved, the ongoing evaluation of the appropriate role of monetary and credit aggregates in the conduct of monetary policy is helping to clarify the monetary policy challenges facing central banks.
Chapter V: Foreign exchange markets
The main trends in foreign exchange markets over 2006 and the first four months of 2007 were the gradual depreciation of the US dollar, the more marked depreciation of the yen, and the appreciation of the euro in trade-weighted terms. Foreign exchange markets were characterised by high levels of trading activity and historically low volatility, although there were two episodes of higher volatility: in May–June 2006 and in late February–March 2007.
Three main factors drove exchange rate developments during the period under review. Interest rate differentials influenced a number of exchange rates, in part through the continuing build-up of carry trades. The accumulation of official foreign exchange reserves limited the effects of upward pressure on currencies in the Asian region and in a number of oil-exporting countries. Global imbalances affected the extent to which some currencies responded to episodes of increased volatility across financial markets.
Several trends in central bank foreign exchange reserve management practices potentially have implications for financial markets and raise challenges for central bank decision-makers. The trends include an increased focus on returns, a strengthening of internal governance and risk management, and a greater degree of public disclosure. In turn, these trends have been underpinned by several key developments in the economic and institutional environment, such as the large accumulation of reserves by some countries, advances in financial technology and the development of financial markets, and changes in the external governance environment within which central banks operate.
Chapter VI: Financial markets
Prices of risky assets continued to rise throughout most of 2006 and early 2007. Two sell-offs during the period proved to be short-lived corrections rather than prolonged downturns. A number of equity markets reached historical highs, while various credit spreads touched new lows, despite a weaker economic outlook in the United States and indications that global growth might have peaked. In this environment, government bond yields in the advanced industrial countries levelled off around mid-2006 and then began to edge downwards. The United States, in particular, saw long-term bond yields falling during the second half of the year, reflecting investor concerns about US growth prospects and expectations that monetary policy would be easing. The economic outlook in Japan remained more positive, lending some support to bond yields, while the economic outlook for the euro area brightened progressively and eventually brought about rising euro bond yields.
An important ingredient behind the gains in developed equity and credit markets was continued strong earnings growth. Moreover, ongoing changes in capital structure boosted equity markets, as share buybacks rose further while merger and acquisition activity grew substantially. Similarly, gains in emerging markets coincided with improved credit ratings and generally strong macroeconomic conditions. However, in all these markets, increasing risk appetite probably helped fuel the upward trend in prices.
The strong overall performance of financial firms in advanced industrial countries continued during the year under review. Banks benefited from another year of a generally benign credit environment and strong retail business. Once again, investment banks registered record profits driven by growth in capital markets activities and a boom in private equity. Investor inflows into hedge funds were moderate by past years’ standards, in response to the declining rates of return registered by the funds. Hedge funds are, however, increasingly integrated in the international financial system as a result of requirements placed on them by a broadening range of investors, and of intensified pressure for enhanced disclosure or compliance with more detailed regulatory requirements. The balance sheets of life insurance companies strengthened, while the property and casualty sector continued to recover from a costly 2005 without major problems.
Current profits add to already healthy capital cushions, suggesting that financial firms are well placed to withstand the likely sources of strain over the near term, and financial systems should be able to deal with idiosyncratic episodes of stress. Banks are generally in a stronger position today than they were at a similar point of previous cycles. The major potential sources of vulnerability are indirect and linked to the business cycle. The implications of past risk-taking related to property investments and to the leveraged financing boom will depend critically on the future path of interest rates and overall economic conditions.
Financial globalisation has been a major structural trend with important implications for the organisation of banking firms, the nature of their business strategies and their risk profiles. Cross-border mergers and increased exposures outside home markets have created a network of international capital flows which offer profit and diversification opportunities. At the same time, these strategies carry risks that relate to the performance of both individual institutions and national economies. As a result, the internationalisation of banking also has implications for prudential policy, as regards both the design of the institutional structures and the calibration of policy instruments.
Chapter VIII: Conclusion: prevention rather than cure?
The consensus economic forecast expects the recent excellent global performance to continue. Yet at least four sets of concerns can be raised, even if our capacity to calculate both their likelihood and possible interdependence remains limited. First, a rise in global inflation pressures cannot be ruled out. Second, the current slowdown in the United States might prove more significant than expected and the global implications greater. Third, global current account imbalances, together with large and volatile capital flows, indicate an exposure to disruptive exchange rate changes with potential implications for financial markets as well as asset prices. And finally, with most asset markets already “priced to perfection”, any unwelcome shock might have unexpected consequences.
In the face of such uncertainties, formulating macroeconomic policy in a forward-looking way is not easy. Moreover, the difficulties are compounded by ongoing debate about the appropriate role for monetary and credit aggregates in conducting monetary policy, as well as the desirability of pre-emptive action in responding to procyclicality in the financial system. That said, against a backdrop of concern about both overall global inflation and evidence of increasing financing imbalances in many areas, tighter monitoring and financial conditions would seem called for. Similarly, more fiscal restraint could have welcome short- and medium-term implications. Evidently, countries with large current account deficits should be in the forefront of such tightening moves. The chances of reducing global current account imbalances in an orderly way would also seem to be enhanced by more exchange rate flexibility, and by structural changes. Countries with current account deficits need to focus on the production of tradables, and those with surpluses on non-tradables. In this respect, neither the past strength of the housing sector in the United States nor the current strength of the export sector in Asia can be judged wholly welcome.
The BIS focuses on promoting cooperation among central banks and other financial authorities, and on providing financial services to central bank customers. To further these ends, during the year the BIS acted to:
With respect to the Bank’s financial statements, the balance sheet totalled SDR 270.9 billion (USD 410 billion) at the end of March 2007. Nearly SDR 222 billion (USD 336 billion) of official foreign currency reserves are deposited with the BIS, around 6% of the world’s total. The Bank reported a net profit of SDR 639.4 million (USD 968.7 million) for the financial year 2006/07.