Speech by Mr Nout Wellink, President of the BIS, to the 74th Annual General Meeting
on the occasion of the Bank's Annual General Meeting in Basel on 28 June 2004
Ladies and Gentlemen
It is a great privilege and pleasure for me to open this meeting and to extend a warm welcome to you all: to the delegates from our shareholding central banks, to the representatives of non-member central banks and international institutions, and to our distinguished guests from the international banking and financial community and elsewhere.
As in previous years, there will be two speeches at this meeting: a commentary on the world economy, followed by a report on developments at the BIS delivered by the Bank's General Manager, Malcolm Knight.
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Let me begin with a review of the world economy. The global economy has performed much better than many feared a year ago. Current projections are that global growth will reach 4½% in 2004, the highest rate since 2000. Once again the major impetus has come from the United States. But the extremely rapid industrialisation of China has also stimulated global growth. Japan finally appears to have emerged from many years of stagnation, and expansion in the rest of Asia has been very vigorous. Growth in Latin America and Africa has also begun to pick up, partly thanks to stronger demand for primary commodities. In the euro area, recent data suggest a gradual recovery.
Growth in much of the world economy since 2001 has repeatedly exceeded expectations. The downturn proved to be comparatively mild by historical standards, despite all the stresses and strains over the past three to four years. Signs that business investment is reviving in several countries suggest confidence in the current upturn. Why has it turned out better than expected? Two broad explanations might be ventured, one of which is more reassuring than the other.
A first explanation is simply the globalisation of market forces. An increasing proportion of economic activity is being governed by the market. In the space of only 15 years, large command economies have become market economies. In addition, several heavily regulated economies in the developing world have introduced important reforms. All this has unleashed a dynamic for growth that remains very strong, especially in China, India and Russia. In several more advanced countries, labour market reforms, the liberalisation of product markets and the development of financial markets have lifted growth.
The major euro area countries, however, have lagged behind in reform, and productivity growth has suffered. It is true that several countries have made progress in implementing the programme of reforms that was agreed in Lisbon in March 2000. But others still have much to do. The accession of 10 new members to the European Union is likely to provide a major stimulus to trade and to the movement of capital and labour within Europe. The transitional adjustment costs this will involve should not detract from the potential gains of greater integration.
The second explanation is less reassuring. It is that growth over the past few years has been brought about in no small measure by very expansionary macroeconomic policies. These have included: massive fiscal stimulus in the United States; policy interest rates in the major countries held at or near postwar lows for some time; and an unprecedented amount of foreign exchange intervention by monetary authorities in Asia. Unlike structural reforms, the effects of such policy stimulus are only temporary, and the current stance of policies cannot continue indefinitely.
As evidence accumulates that output is rising relative to capacity, macroeconomic policies will need to be tightened. A key challenge will be to do this without putting what has been achieved at risk – the so-called policy re-entry problem. Fiscal policy, monetary policy and exchange rate policy all need to be considered in this light.
First, fiscal policy. The weakening of fiscal positions has in recent years become a near global trend, in many cases reversing progress made during much of the 1990s. Let me start with the industrial world. The US government budget, which was in surplus to the equivalent of 1½% of GDP in 2000, is this year likely to register a deficit of 5% of GDP, a deterioration of the US fiscal position without precedent since the Second World War. Japan's general government deficit remains at around 8% of GDP. Deficits in some large economies in the euro area are still above the ceiling set in the Stability and Growth Pact. Early action to curb such deficits is all the more important because the costs of health and pension commitments will, under present arrangements, rise strongly in the medium term in almost all industrial economies.
In the emerging economies, despite action to limit fiscal deficits, the level of public sector debt as a whole has still tended to rise, and now exceeds 50% of GDP. In addition, several governments are exposed to significant contingent liabilities due to potential losses in state-owned enterprises or banks. In other cases, large debts denominated in foreign currency leave borrowers exposed to a fall in the exchange rate.
It is of some concern that fiscal deficits and debt levels have risen in spite of circumstances that would normally facilitate fiscal consolidation. Interest rates have been falling. And some commodity-exporting countries have had windfall gains in government revenues as the prices of raw materials have boomed. Fiscal deficits in many economies are now too high even to stabilise debt-to-GDP ratios. Sooner or later this is bound to put upward pressure on long-term interest rates – which is why a credible medium-term strategy of deficit reduction is essential. One cannot but regret the recent relaxation of fiscal rules or guidelines in Europe, in the United States and elsewhere.
Second, monetary policy. There is no immediate prospect of generalised inflation that would require a substantial tightening of policies. Comparatively high unemployment is limiting nominal wage increases; and spare capacity in manufacturing worldwide reinforces the competitive pressure on prices. Perhaps most important, clear policy commitments across the globe to contain inflation have been made credible by more than a decade of declining inflation rates. But there are signs that inflation is edging higher. A comparison of yields on nominal and inflation-linked bonds in the United States suggests a modest upward drift in inflation expectations. Japan is slowly emerging from deflation. The pace of consumer price inflation in China has increased sharply in recent months, and there is evidence that prices are beginning to rise faster in some other Asian economies.
The rapid rise in commodity prices has created perhaps the most visible threat to global price stability. Oil has been trading in recent weeks at around 35 to 40 dollars a barrel, and futures markets indicate that prices are expected to remain high for some time. Non-oil commodity prices are also much higher – indeed, the price of virtually every major commodity has risen appreciably over the past two years. It is therefore essential to monitor commodity price developments very carefully.
One factor boosting the prices of some commodities appears to have been a lack of investment in some primary industries. A second factor is the vigour of global demand. The rapid pace of industrial expansion in China has driven up demand for a wide range of raw materials. This is likely to continue in the medium term, and will perhaps raise the level of commodity prices relative to other prices in the years to come. Whether this change in relative prices leads to generalised inflation depends largely on monetary policy and global demand pressures.
Financial innovation and development around the world has stimulated global demand. In many countries, it has added to the supply of – and perhaps reduced the cost of – credit to households. Low interest rates on government bonds have encouraged some investors to seek instruments carrying a higher yield. Investors have engaged in various “carry trades” by borrowing cheaply short-term to finance investments in longer-term or more speculative paper. Quantifying such exposures is difficult, but corporate reports from the major investment banks do suggest that exposure to interest rate risk has risen sharply since mid-2002. It is also clear that the activity of hedge funds has picked up rapidly. In short, monetary ease and the greater willingness of the financial industry to accept both market and credit risks have interacted in ways that have had a powerful effect on the real economy.
The financial markets know that monetary policy will need to become less accommodative as the world economy strengthens. In April and May this year, signs of stronger growth and increasing expectations of an eventual increase in US policy rates added a full percentage point to the yield on US Treasuries. Credit spreads on emerging market paper rose sharply, and there was a more modest adjustment for lower-rated corporate bonds. Leveraged investors reacted by closing or hedging some of their positions, accentuating the decline in bond prices. The careful monitoring of market and credit risk exposures of the financial industry will be required for some time.
A third aspect of recent macroeconomic policies that is of global importance has been massive intervention to resist exchange rate appreciation. Official foreign exchange reserves in Asia rose by around 480 billion dollars during 2003. There is no historical parallel for intervention on such a scale, and one can only guess at the longer-term implications. One possible consequence is that the eventual movement in exchange rates may be more abrupt than if a greater degree of flexibility had been allowed earlier. The adjustment might be particularly painful if false signals have led to a misallocation of resources. Another possible consequence is that the increasing presence of the Asian monetary authorities in the markets for high-grade US dollar bonds could affect pricing across different market segments. Yet another is that the expansion in domestic liquidity associated with this policy may ultimately lead to inflation. Finally, markets could become too dependent on continued foreign intervention, and could then be destabilised by even a hint of a change in policy. For this reason, it was reassuring that the Japanese authorities managed to extricate themselves from their heavy intervention for a prolonged period from March this year, without creating volatility in foreign exchange markets.
There is little doubt that the correction of global imbalances will require fiscal policy adjustments in the United States, as well as stronger growth in Europe and a greater degree of exchange rate flexibility in Asia. China is obviously key. It is no secret that growing trade within Asia, increasingly centred on China, is nurturing a greater willingness to stabilise cross rates in the region. China has recognised for some time the medium-term need for exchange rate adjustment. But it is rightly concerned to avoid any precipitous move that could destabilise its fragile financial system or stifle its dynamic economy. The challenge is to develop workable measures of transition that provide both a more effective exchange rate mechanism and a more supple instrument of monetary control.
The growing integration of China and India into the world economy presents both an opportunity and a challenge. The vast range of consumer goods produced cheaply in China, now available in shops everywhere, is perhaps the clearest illustration of the opportunity. The challenge is not difficult to see. As vast new supplies of labour are drawn into the international economy, the world's capital-to-labour ratio could fall and this could put downward pressure on wages. The unskilled may be hardest hit. Governments must of course resist pressure to restrict imports, and should instead take measures that enhance the adaptability of local production structures to take advantage of a more dynamic world economy.
Let me conclude this review of the world economy with one note of optimism and two words of warning – perhaps the right balance for a central banker. The note of optimism is that current economic prospects are excellent – not just because growth has picked up across the globe, but also because world productivity is rising as more and more people are drawn into the market economy. The first word of warning is that the stance of macroeconomic policies cannot remain as expansionary as it is now if stability is to be maintained in the medium term. There is a need to begin to realign policies in some countries. The second word of warning is that global imbalances must at some point be reduced. In doing this, it would be better to avoid the two extremes of either putting all the burden on exchange rates or not allowing exchange rates to move at all.
The lesson of the sharp movements in global financial markets over the past couple of months is that investors react very quickly to any hint that market expectations about the stance of policies are shifting. Risks that may seem to have a comfortable medium-term horizon at present could materialise all too suddenly, leaving policymakers with much reduced room to manoeuvre. Such issues are, of course, at the centre of central bank deliberations at the BIS. I hope that these deliberations will continue to contribute to the spirit of international cooperation that is all the more needed as globalisation deepens.
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And now, ladies and gentlemen, I would like to hand over to Malcolm Knight, who will report on developments at the BIS over the past year. Thank you very much.