75th Annual Report 2004/05: an overview
27 June 2005
Chapter I: Introduction: so far, so good
Looking back over the past two decades, several global economic trends can be identified. Lower and less volatile inflation, accompanied by higher and less volatile output growth, were welcome features. Less welcome were growing external and internal imbalances, the latter leading to more frequent periods of financial stress often associated with rapid increases in credit, asset prices and fixed investment. All these trends have their roots in three major structural changes: the spread of liberalisation throughout the global economy; the development of more complete financial markets; and the increased focus of central banks on low inflation. Looking back over the last fiscal year, strong growth and low inflation were maintained, but so too were external imbalances. Financial markets showed further evidence of overextension, reflecting the search for yield given very low policy rates, and house prices in many countries set new records.
Chapter II: The global economy
The world economy grew strongly in 2004, supported by expansionary monetary policies and unusually accommodative financial conditions. Sharply rising commodity prices failed to spark generalised inflation, but helped to moderate the global expansion in the latter part of the year. After a synchronised upswing in the first half of 2004, growth differentials widened again as commodity importers experienced a slowdown - with the notable exception of the United States and China - while activity in commodity-exporting countries generally continued to grow apace.
The consensus view for 2005 is for further robust global growth and generally subdued inflation. Yet recent developments in commodity and financial markets serve as reminders of key risks to this scenario. Oil prices may well remain high for some time. Further rises may hurt the global economy more than is currently expected. A return of unusually low long-term interest rates to more normal levels could curtail spending by households. Moreover, there has been little progress in tackling internal and external imbalances. Household debt has continued to rise and savings have declined in many advanced industrial countries while fiscal deficits have remained high. The reduction of current account imbalances, which have widened further since the beginning of the year, remains a major global challenge.
Chapter III: Issues in emerging market economies
During the year under review, growth in all the major emerging market regions was surprisingly strong, reflecting a better balance between external and domestic demand. Rapid growth put pressure on many critical raw materials, such as oil, but higher commodity prices did not lead to a marked resurgence of inflation. Interest rates in Asia and elsewhere remained low.
Have emerging market economies become more resilient to shocks? A number of considerations indicate that the answer is "yes". First, domestic demand has become less dependent on external demand. Second, there have been improvements in fiscal positions, in some cases supported by legislative reforms and the development of local bond markets. Third, inflation appears to have become more stable, in some instances reflecting greater monetary policy credibility. To the extent that countries have become less committed to an explicit exchange rate target, this too reduces their vulnerability to shocks. Fourth, many emerging market economies now have significant current account surpluses. Fifth, there have been improvements in banking performance.
Favourable cyclical factors have played a role, and a global slowdown could set back some of the recent progress. In contrast, should growth be maintained, inflation expectations in some countries might rise. The debt of some countries is still too short-term and this creates a vulnerability to a change in interest rates. But risks from external shocks have been considerably attenuated by high levels of official foreign reserves. Finally, banking sectors are still exposed to various risks, and improvements in the regulatory environment need to go further in some cases.
Chapter IV: Monetary policy in the advanced industrial economies
With the US economic expansion continuing strongly and risks shifting towards possible inflationary pressures, the Federal Reserve began reducing the degree of accommodation in a series of measured increases in the federal funds rate target. The ECB kept its policy rate unchanged as sub-par economic growth and the appreciation of the euro continued to hold back inflationary pressures. The Bank of Japan held its policy rate at zero as economic and financial headwinds proved sufficiently strong to rule out an end to deflation. Implementation of its quantitative easing policy became more complicated as changing liquidity demands emerged. In short, then, the stance of monetary policy in the G3 economies remained accommodative in the period under review.
Policies across smaller industrial economies with inflation targets were more differentiated, with some central banks choosing very accommodative policy stances while others moved to more neutral settings. External developments, especially movements in the prices of oil and other commodities, dominated the last financial year. There are some striking parallels between current developments and movements in the late 1960s and early 1970s: a special section of the chapter therefore reviews the historical record and seeks to clarify the risks monetary policymakers might now face.
Chapter V: Foreign exchange markets
The continued broad depreciation of the US dollar and its subsequent partial reversal were the salient features of foreign exchange markets. In 2004 the dollar again depreciated against the euro, the yen and a number of other floating currencies. A new development last year was that the dollar also lost ground against several Asian emerging market currencies. Since January 2005, however, the currency's downward trend has partly reversed. Three main factors appeared to underpin exchange rate movements: market participants' focus on the widening US current account deficit and on rumours of changes in the currency composition of Asian central banks' portfolios; shifting expectations for relative output growth and interest rate changes; and official foreign exchange reserve accumulation in Asia.
A special section considers whether the pattern of current account balances or the pattern of currency shares in global portfolios pose problems for the international monetary system.
Chapter VI: Financial markets
Conditions in global financial markets eased during the financial year, despite a significant tightening of monetary policy in the United States; long-term rates in the major markets fell, equity prices rose and credit spreads narrowed. Investors in credit and equity markets were confident about corporate profits and the macroeconomic outlook, underpinned by significant improvements in fundamentals. In credit markets, structural changes that have facilitated hedging and promoted liquidity may also have contributed to the low level of spreads. The willingness of investors to accept greater risk was also a key source of support for credit and equity valuations. The juxtaposition of low yields with a seemingly robust economy and rising policy rates was something of a puzzle. Contained inflation expectations and diminished uncertainty about the course of monetary policy helped to keep yields down; more technical supply-demand factors may also have played a role.
Chapter VII: The financial sector
Banks and insurance companies in industrialised countries registered stronger performance during the year under review. Lower costs, the improved credit environment and healthy revenues from retail business contributed to higher profits. Structural improvements meant that better performance was also evident in jurisdictions that had experienced strains in the past. The search for yield continued to compress spreads in credit markets and risk-taking by investment banks persisted, helped by liquid funding conditions. The hedge fund sector experienced large inflows, while returns have declined.
The financial sector nevertheless faces significant macroeconomic risks. They are related to the potential effects of higher interest rates and possibly associated declines in real estate prices and household expenditure. The current environment highlights the importance of making further progress in developing an operational macroprudential framework, especially as regards the identification of systemic vulnerabilities and the calibration of prudential tools.
Chapter VIII: Conclusion: how might imbalances be fixed?
While the global economy performed very well in the fiscal year ending March 2005, worrisome signs began to emerge reminiscent of the inflationary pressures that built up in the late 1960s. Fortunately, closer analysis reveals enough differences, and lessons drawn from that earlier period, to conclude that history is not likely to repeat itself. Yet these differences give some hints about the likely nature of future problems. Internal and external imbalances, rooted in major structural changes in the global economy, could unwind with a potentially disruptive impact. What might seem evident policy solutions for each country considered alone often stand in mutual contradiction. This raises the issue of whether cooperative solutions might not have a role to play in current circumstances. Those who worry about the unwelcome interaction of otherwise desirable structural changes ask whether the policy framework might not also have to be modified in response. Suggestions can be made as to how both a domestic and an international macrofinancial stabilisation framework could be put into operation. Given the reality of vested sovereign interests, however, an international framework will be much harder to implement.
Organisation, governance and activities of the Bank
This chapter summarises the role of the BIS in international cooperation directed towards greater monetary and financial stability. It describes the institutional framework in which this cooperation is pursued, as well as the various related activities that marked the past year. In addition to its regular activities, the Bank will also be staging its first ever public exhibition, publishing a book on the history of central bank cooperation and hosting an academic conference as part of the festivities organised to celebrate its 75th anniversary in 2005.
The bimonthly meetings of Governors of BIS member central banks remained a key mechanism through which the Bank contributed to international cooperation in 2004/05. In this context, the Global Economy Meeting monitors economic and financial developments and assesses the vulnerabilities in the world economy and financial markets. The meetings of the G10 Governors and those of Governors of key emerging market economies - the latter initiated in March 2005 - explore conjunctural themes of special relevance to the respective groups. In addition, various meetings were organised during the year on issues of central bank interest, in several cases with the participation of a broad range of senior non-central bank and private financial sector officials. In providing the necessary analytical support to these meetings, the topical and country coverage of the economic, monetary and financial statistics compiled by the Bank was also expanded. A new international initiative was the launch of the International Journal of Central Banking (IJCB), sponsored widely within the central banking community and by the BIS.
The Bank continued to host and support the secretariats of the Basel Committee on Banking Supervision (BCBS), the Markets Committee, the Committee on the Global Financial System and the Committee on Payment and Settlement Systems. The Bank also remains active in assisting the work of a number of independent organisations that have their secretariat at the BIS, namely the Financial Stability Forum, the International Association of Insurance Supervisors and the International Association of Deposit Insurers.
With the release of the revised capital adequacy framework ("Basel II") last year, a significant part of the activities of both the BCBS and the Bank's Financial Stability Institute will be devoted to supporting regulatory and supervisory authorities in their preparations for Basel II implementation.
With safety and liquidity as the key features of its credit intermediation services, 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. Following the creation in 2003 of the first Asian Bond Fund (ABF1), in December 2004 EMEAP member central banks and monetary authorities launched the second stage (ABF2), for which the BIS acts as administrator.
In the course of the past financial year, the balance sheet grew significantly to stand at SDR 180.5 billion, representing a year-on-year increase of 7.5%. Largely as a result of lower average interest rates, which depressed income from securities financed with the Bank's equity, net profits declined by 25% compared with the previous financial year.