Excerpts from the speech delivered by Alfons Verplaetse to the 68th Annual General Meeting of the Bank
8 June 1998
BANK FOR INTERNATIONAL SETTLEMENTS, CH-4002 BASLE
On the occasion of its Annual General Meeting held in Basle today, 8th June 1998, the Bank for International Settlements released its 68th Annual Report . The Report provides an overview of global economic and financial developments as well as a review of the Bank's own activities over the last year. The Report is available in English, French, German and Italian from the Bank's Information and Documentation Services. It is also available in English on the BIS World Wide Web site (http://www.bis.org).
The following are excerpts from the speech delivered by Alfons Verplaetse, Chairman of the Board of Directors and President of the Bank, to the Annual General Meeting.
I should now like to discuss the overall economic situation and some of the major challenges it poses for both central bankers and others concerned with international financial and economic stability. I shall do this by first reviewing recent economic events and then identifying some areas of more immediate policy concern. I will conclude with an assessment of the tasks required over the medium term to foster international financial stability.
The past year has been exceptional for the combination of both good news and bad news that it has contained. Among the positive developments, one would have to include growth rates in most industrial countries. They have either remained at high levels or are starting to build significant momentum, and this within the general context of continued low inflation. In continental Europe, the smoothness of the path of transition to the euro has also been remarkable and welcome. In addition, structural reforms and more disciplined policies have generated more solid growth in Latin America, many countries in Eastern Europe and significant parts of Africa. All of this is clearly to the good.
However, the year has contained darker elements as well. The Japanese economy has thus far failed to respond to repeated policy initiatives, and the crisis among trading partners elsewhere in Asia raises the possibility of mutually reinforcing weakness in the region as a whole. The sharp decline in commodity and oil prices will place a heavy burden of adjustment on a number of already fragile economies. The buoyancy of stock markets and bond markets in industrial countries, and the strength of capital inflows into non-Asian emerging markets, could in themselves be described as good news. Yet the enthusiasm of financial markets also raises another spectre: that it may not last, and that the economic effects of such a change in sentiment might be difficult both to predict and to manage.
The economic expansion in the industrial world is still being led by the United States, where the economy has continued to grow rapidly under the influence of strong domestic demand and healthy productivity gains. Developments in the United Kingdom have mirrored the US experience in some respects. The sustained vigour of both economies has been exceptional in that it has gone hand in hand with a degree of capacity utilisation in labour and capital markets that, in earlier decades, would invariably have generated supply bottlenecks and strong upward pressure on wages and prices. Growth has also begun to pick up in continental Europe, and in several countries this pick-up has been accompanied by some decline in unemployment from very high levels. The progress made in some of the smaller European economies in reducing unemployment through structural reforms also provides a promising example for others.
In sharp contrast to other industrial economies, the Japanese economy has moved to the edge of recession in the past year, and producer prices have been falling. Domestic confidence has been severely affected by a combination of rising unemployment, concerns with regard to the implications of a rapidly ageing population and worries about the financial system. While credit rationing and the recent events in Asia have exacerbated these contractionary forces, recent fiscal measures and steps taken to recapitalise the banking system should in principle help to forestall recession. The impact of these policy initiatives would, however, be much increased were there to be greater clarity as to how and when they are to be implemented in practice.
The economic and financial drama unfolding in Asia over the last year or so has understandably puzzled and preoccupied both policy-makers and market participants. The deterioration in the economic fortunes of many of the affected economies has been extraordinary, particularly given the widespread belief that their earlier successes were based on sound fundamentals. Unfortunately, these earlier successes seem to have contributed as well to a climate of excessive optimism among both borrowers and lenders. As a result, inadequate attention was paid to the rapid build-up of domestic and foreign debt by domestic corporations. Also ignored was the significant threat this would pose to the stability of local banking systems should heavily managed exchange rate regimes come under pressure. Once difficulties emerged, a sharp and simultaneous reassessment of exposures to liquidity risk, market risk and credit risk then turned what might otherwise have been an orderly adjustment into a prolonged crisis. A more sober sense of realism is now influencing economic policy-making in the region. While the road ahead remains long and difficult, the courageous reorientation of policies in several countries deserves to be applauded. Indeed, confidence in the region is slowly being rebuilt.
Despite divergent performances with respect to economic growth, inflation in most regions of the world has tended to converge to a low level. To a large extent, this commendable inflation record can be seen as the reward for a broadening and deepening commitment to price stability on the part of monetary authorities worldwide, and the increasingly supportive role played by fiscal policy in recent years. Heightened competition and the globalisation of markets have also played a role, as have productivity gains from heavy investments in computer-based technologies and related industries worldwide.
Congratulations on this generally happy state of affairs might seem in order, yet central bankers should not be complacent. One can easily imagine a number of scenarios in which it might be appropriate to reassess the current stance of monetary policy. For example, we should not forget that a counterpart to strong growth with low inflation in both the United States and the United Kingdom has been a firming of the exchange rate and a widening of the trade deficits. So far such deficits have been easily financed. However, a greater degree of hesitancy on the part of foreign investors could alter this situation and, in turn, the role played by the exchange rate in keeping domestic inflation subdued. Monetary policy might then need to take more of a leading role in maintaining price stability, and this would be all the more likely were the recent downward trend in commodity prices to reverse.
A closely related issue is the current buoyancy of financial asset prices in many industrial countries, amid associated concerns that investors everywhere may be underestimating the riskiness of certain kinds of financial investment. In setting monetary policy, the implications of rising asset prices for spending and inflation must obviously be taken into account. However, there may be other legitimate grounds for concern as well. The experience of Japan, the Nordic countries and the United States in the early 1990s, and other parts of Asia more recently, indicates that asset price bubbles fuelled by bank credit can cause lasting damage to the banking system and to the broader economy. While property prices figured prominently in earlier crises, and such prices have only just begun to turn up in many industrial countries, the current rapid expansion of monetary aggregates in a number of countries needs to be closely monitored.
In Europe, the establishment of a large single currency area next year is unquestionably one of the major milestones in its postwar monetary history. It should bring in its wake a significant expansion of competitive forces in Europe, a development which will clearly benefit consumers. Moreover, it should lead in time to regulatory reforms and more flexible product and labour markets given the future impossibility of using intra-European exchange rate adjustments as a buffer for shocks. The euro also seems set to play an important role in international financial affairs. The prerequisite here is the development of a large and liquid financial market in euros, the preconditions for which are already being put in place.
Yet the introduction of the euro will also pose shorter-run challenges for the conduct of monetary policy. The process of convergence of interest rates - leading ultimately to a single set of interest rates on 1st January 1999 - should be towards the lower levels prevailing in a number of countries of the euro area. Subsequently, it will require careful thought to determine what the appropriate stance of monetary policy should be in this newly unified financial area. The effects on the monetary policy transmission mechanism of ongoing structural changes in economic and financial markets will have to be assessed. With time and experience, all these transitional problems should be solved. Similarly, growing credibility of the European Central Bank should provide an anchor to stabilise inflation expectations and in turn inflation itself.
Accompanying these challenges confronting the conduct of monetary policy are issues related to the continuing process of restructuring in global financial markets. The arrival of the euro, the ongoing dismantling of regulatory barriers between previously distinct financial sectors in Japan and the United States, and financial sector restructuring in much of the emerging world are all heralding a new and welcome wave of change and intensified competition. However, we have to be fully alert to the fact that this process - beneficial as it will be over time - can also contribute to financial instability. It will expose participants to new pressures, and may induce some to pursue riskier investment strategies for which they may not be well prepared. Public policy-makers should be aware of these dangers and should step up their vigilance accordingly. The need to adapt regulatory structures, typically built along industry and national lines, to an increasingly global and integrated financial environment must also remain a high priority for the immediate future.
This last point offers a natural transition to the concluding part of my remarks, namely the medium-term agenda for preserving the stability of the domestic and international financial system. The Asian crisis has served as a painful reminder that the potential benefits of open and global financial markets will be realised only if certain preconditions are met. With a view to establishing such preconditions, I believe that public policy should, over the next few years, focus on making progress in three interrelated areas: transparency, incentives for market discipline, and prudential regulation and supervision.
First, with respect to transparency, central bankers have increasingly emphasised that the effectiveness of domestic policy-making depends crucially on markets clearly understanding our objectives, our strategies and even our operational procedures. Transparency is equally vital in the private sector if lenders and borrowers are to make informed decisions about the riskiness of their prospective activities. The public disclosure of meaningful data is a necessary condition to ensure a proper degree of market discipline, but it is not sufficient. Consider how the market for years ignored the existence of BIS international banking data which clearly indicated the potential for liquidity problems in Asia. This implies another necessary condition: that the market should also be capable of monitoring effectively and interpreting appropriately the information that is already available.
Creating the right incentive structure for profitable, yet prudent, financial decisions is a second major policy challenge. In the light of the role played by the international interbank market in the Asian arena, a careful assessment of the effect of implicit and explicit safety nets on the behaviour of both creditors and borrowers is called for. As part of this review, consideration should obviously be given to the impact on market attitudes of official liquidity support for countries in crisis. A review of liquidity support packages is, in any event, necessary since the continuous growth in their size threatens to outstrip available resources. This raises once again the long-standing question of the appropriate balance between financing and adjustment.
Finally, the third item on our medium-term agenda should be to further enhance the regulatory and supervisory framework. The Core Principles for Effective Banking Supervision which were unveiled last year are a landmark achievement in this regard. They offer guidance to domestic policy-makers as to good practice in this area, and should increasingly provide international markets with a benchmark for disciplining those who do not conform. Work is also under way to develop an understanding on sound practices in other areas, with a view to international adoption in a similar way. As experience with implementing the Core Principles grows, there will also be the opportunity for new lessons to be learned and for the Principles to be adapted accordingly. It is through such iterative processes that regulation and supervision will continue to be kept up to date in a rapidly evolving world.
If headway can be made in each of the three areas I have just singled out, and if the underlying payments and legal infrastructure can also be strengthened, a more efficient as well as a more stable financial system can be constructed over the medium term. This challenge goes far beyond the BIS, and those who regularly meet here, to the whole of the international community. There are difficult steps that still need to be taken by national legislators around the world if the resilience of our financial systems is to be further reinforced and the likelihood of future crises reduced. What ultimately remains to be seen is whether enough political will can be mustered to do what needs to be done.