Annual General Meeting: 70th Annual Report 1999/2000
5 June 2000
On the occasion of its Annual General Meeting held in Basel today, 5 June 2000, the Bank for International Settlements released its 70th Annual Report . The Report is also available on the BIS website (www.bis.org).
The BIS Annual Report is in two parts. The first, main part (Chapters I to VIII) discusses the major developments in the world economy in the period under review and their policy implications. The second part, entitled Activities of the Bank, summarises the financial operations of the Bank and describes the work carried out by the BIS staff and the large number of committees of national experts who regularly meet at the Bank. This work has expanded significantly in recent years. The following synopsis presents highlights from each of the chapters.
Chapter I: Introduction
In the period under review, growth rates in most parts of the world, including those affected by earlier crises, were significantly faster than expected, while underlying inflation continued to be unusually subdued. Moreover, there were increasing grounds for believing that this might be a longer-term trend based on some combination of continuing deregulation, new technology and capital deepening in many countries. Nevertheless, significant macroeconomic imbalances could be identified. In countries like the United States where the expansion was furthest advanced, underlying inflationary pressures were of increasing concern, as were rising debt levels. Historically high current account imbalances and global stock market valuations went hand in hand with large and often volatile movements in the value of major currencies. In this context, and with global excess capacity narrowing, monetary policy was tightened in the major industrial countries (except Japan). However, by the time the Report went to press (17 May), there had been little effect on economic growth rates, prices in major financial markets or the flow of capital to emerging markets. Recognising remaining vulnerabilities in the global financial system, the chapter refers to recent work to promote financial stability and to help manage crises should they occur.
Chapter II: Developments in industrial countries
Output growth in the industrial countries rebounded in 1999 by more than expected. Despite many countries nearing, or temporarily exceeding, sustainable output levels and a sharp rise in oil prices, core inflation remained subdued. This reflected growing competition in global markets and stronger productivity growth restraining unit labour costs. Some evidence suggests that inertia in wage and price formation is higher when inflation is low. This could ease central banks' ability to maintain a desired rate of inflation, but might complicate the task of restoring price stability once lost. Unemployment generally fell; the decline was most pronounced in the euro area countries, apparently assisted by wage moderation and more flexible labour markets. However, financial imbalances worsened as strong demand and wealth gains led to lower saving and a widening current account deficit in the United States, while in Japan both private saving and the budget deficit increased. World trade appeared to have increased only moderately. However, a marked rise in the global current account discrepancy may indicate that export growth has been underreported.
Chapter III: Recovery from the crisis in the emerging markets
Despite a wide cyclical divergence both within and between regions, macroeconomic performance was generally favourable in the emerging economies, with growth strong and inflation generally remaining under control, even in economies such as Brazil and Russia that had faced large devaluations. Financial markets were buoyant; credit spreads narrowed and bond and equity prices rose. External deficits remained high in many countries, notably in Latin America, with higher oil prices and weak food and other agricultural prices as contributing factors in many cases. The contraction in net capital flows to the emerging economies was halted, with a significant increase in the proportion of foreign direct investment. Substantial progress has been made in strengthening banks in Asia but corporate restructuring is lagging. More flexible exchange rate regimes have been accompanied by moves towards monetary policy based on inflation targeting in a number of economies.
Chapter IV: Monetary policy in the advanced industrial countries
Monetary policy in the advanced industrial countries, except Japan, was tightened as the year progressed. In the United States, the unusual behaviour of productivity growth and the state of financial markets, not least an extraordinarily buoyant stock market, played an important role in conditioning monetary policy. A main concern in Japan was whether and, if so, how further stimulatory measures could be taken given that short-term nominal interest rates had already been reduced virtually to zero. The Eurosystem faced the issue of establishing credibility and conducting policy in a new and rapidly changing economic environment. In countries with explicit inflation targets, the inflation outlook prompted a widespread tightening.
Developments in the period under review highlighted the constraints that deep-seated uncertainty imposes on the design, implementation and communication of policy. The faster pace of structural change, the heightened significance of asset prices, the increased emphasis on transparency and accountability and the greater role played by formal inflation forecasts in policymaking are all factors which have put a premium on the explicit recognition of these constraints, especially in communicating with financial markets and the public at large. A special section discusses these issues, distinguishing between different forms of uncertainty.
Chapter V: Developments in foreign exchange markets
The period under review was characterised by marked yen strength and euro weakness, with the dollar appreciating strongly against the euro and depreciating against the yen. These developments were largely driven by current and prospective cyclical positions and by portfolio and foreign direct investment flows. In addition, the euro's weakness appeared to reflect market perceptions of lagging structural reforms and the dynamics of traders' expectations. While the dollar co-moved quite closely with US stock markets in 1999, overall the relationship between stock markets and the major exchange rates has been weak. Foreign exchange markets in emerging market countries returned to calmer conditions.
In the last two years foreign exchange markets have been affected by significant structural change, including the introduction of the euro, consolidation among market players and the growth of electronic broking. These changes have been accompanied by a general reduction in trading activity and some rise in exchange rate volatility, although it is still too early to ascertain their effect on volatility and liquidity. The period under review was an especially eventful one for the gold market. After trending downwards, the price of gold rose sharply following the September central bank agreement limiting official gold sales. While there were occasions when news about central bank gold sales seemed to influence the gold price in 1999 and early 2000, this relationship was by no means systematic.
Chapter VI: Financial markets
In 1999 financial markets returned to risk-taking with increasing eagerness. Prices of many stocks, especially in the technology sector, reached new highs and borrowing spreads on private debt securities eased gradually despite episodes of liquidity pressure, as long-term interest rates rose. In the first quarter of 2000, however, both equity and credit markets wavered, especially in the United States, reflecting concerns about excessive valuations, uncertainty about the extent and impact of monetary tightening and supply developments in US government debt. The chapter analyses equity price valuations and the implications for the pricing and liquidity of fixed income securities markets of current and prospective changes in the relative supply of government and private debt securities.
Changes in relative asset prices encouraged a reallocation of capital between economic sectors. Technology start-up companies raised record sums through initial public offerings, while traditional companies retired equity. Fiscal surpluses in the United States and the United Kingdom and diminishing deficits in continental Europe made room for a remarkable rise in corporate bond issuance. Stock markets supported directly or indirectly the bulk of capital flows, including direct investment in the form of cross-border acquisitions paid for with equity rather than cash. In the meantime, the shift away from direct lending to securities purchases continued in the international markets. The world's major banks invested heavily in the surging debt securities markets and relegated their traditional international lending activity to the sidelines. Emerging market borrowers accelerated their loan repayments. As a result, the international interbank market was flush with funds. However, except for acquisition-related syndicated loans, banks seemed to have difficulty finding new borrowers.
Chapter VII: The euro and the European financial architecture
The single currency had its most obvious and immediate effects on financial markets, especially those segments that were characterised by sufficient harmonisation in market infrastructure and practices or where these elements had been put in place ahead of the euro's introduction. Cases in point are the interbank deposit market, where cross-border activity increased, and the international corporate bond market, where issuance hit new records. By contrast, progress towards the development of pan- European repo and equity markets has been markedly slower given more limited integration of the national legal, trading and post-trade settlement frameworks. The remaining small spreads on government bond yields mainly reflect technical factors rather than credit risk. The new currency catalysed the ongoing trend towards financial sector consolidation but has not yet transformed its mainly domestic character. The final section of the chapter describes the current institutional framework for safeguarding financial stability in the euro area, as it has adapted to take into account the centralisation of monetary policy under the Eurosystem. It considers the blend of centralisation/harmonisation of some functions and considerable national discretion in others, and analyses the implications for the "levelness of the playing field" and the safeguarding of financial stability in the euro area.
Chapter VIII: Conclusion
There remains considerable uncertainty as to whether the global economy is at the beginning of a long boom, driven by technology and deregulation, or whether it is significantly exposed to the possibility of a downturn through which long-standing macroeconomic imbalances will eventually be resolved. There is also an unusual degree of uncertainty about how financial markets, which have been evolving rapidly, might react to possibly adverse macroeconomic shocks.
What is more certain is that the current growth rate of the US economy is unsustainable; against this background, the recent tightening of monetary policy is welcome. The potential vulnerability of many asset prices is a complicating factor, but not one so great as to preclude sensible anti-inflationary policies. It is arguable whether the limits of monetary and fiscal stimulus have been reached in Japan, but some suggestions concerning the efficiency of fiscal stimulus can be made. In Europe, while some progress has been made, further reforms in labour and product markets are called for; these might also help to strengthen the external value of the euro. In many emerging markets, exchange rate movements continue to complicate domestic policy formulation, and the dangers of slipping back into a fixed rate mentality should not be underestimated. In some countries, interest has recently been expressed in adopting an inflation targeting regime. Accordingly, the chapter considers some of the particular advantages and disadvantages of such regimes when applied to emerging market economies.
Deregulated financial markets provide great efficiencies over time but are subject to periodic crises. The chapter explores several issues surrounding crisis prevention, management and resolution. In the area of crisis prevention, there are three kinds of financial instability (short-term volatility, medium- term misalignments and contagion), three major pillars of the international financial system (institutions, markets and infrastructure) and three sets of incentive systems (internal governance, supervision and market discipline) which can help foster good practice in each pillar. Within this framework, the chapter makes specific recommendations which build on ongoing work by the various Basel-based committees, in particular the Basel Committee on Banking Supervision. The practical implementation of some of these recommendations is crucial, but is likely to be very demanding. As for crisis management, the need to trade off the provision of liquidity against moral hazard deserves particular attention, and this applies to both the domestic and international arenas. The chapter considers differing viewpoints on this issue as well as their possible implications for the modalities of lending by the IMF. Crisis resolution often requires debt reduction, whether the problem is one of restructuring domestic banking systems or of helping put very poor countries on a higher growth path. To avoid the recurrence of old problems, priority also needs to be given to ensuring the future profitability of restructured banks as well as to improving the political governance of countries whose debt has been forgiven. Debt reduction may be necessary, but it is clearly not sufficient for sustainable growth.
Activities of the Bank
One of the Bank's main objectives is to foster international monetary and financial cooperation. It does this primarily by organising and providing analysis for various sets of meetings of officials. A salient feature of last year's meetings was the growing involvement of central banks from systemically important emerging market economies. The BIS Representative Office for Asia and the Pacific in Hong Kong SAR has been an important catalyst in this respect. In addition, the establishment of the Financial Stability Institute in early 1999 has helped to disseminate the standards and best practices of sound financial activity discussed and developed in many of these meetings.
A first set of regular consultative meetings are those among central bank governors and senior officials on conjunctural issues and on matters affecting financial stability. Second, standing committees of national experts and their subgroups meet at the BIS to formulate standards or recommend best practices to promote financial stability. The scope of the work of these committees is comprehensive, in that it covers aspects of the three main pillars of the international financial system: institutions, markets and infrastructure. Third, the Bank contributes materially to meetings involving broader sets of national authorities and other international financial institutions. Of particular importance in this area over the past 12 months were the meetings and the work carried out under the auspices of the Financial Stability Forum, whose Secretariat is located at the BIS. Finally, many meetings take place at the Bank centred on technical areas (security, IT, information exchange) of central bank activities.
The Bank also continued to serve as a counterparty to central banks in their financial operations, and to provide agency and trustee functions for a variety of financial transactions. In the course of the year, the Bank introduced new financial instruments to meet the increasingly sophisticated investment needs of its central bank customers. Particularly during the transition to the year 2000, central bank customers valued highly the safety and liquidity of deposits with the BIS.
In line with the Bank's more global focus, the Board of Directors invited several central banks to become shareholding members of the Bank in November 1999. By the close of the financial year, the Banco Central de la República Argentina, the European Central Bank, Bank Negara Malaysia and the Bank of Thailand had taken up the Board's offer and made the share subscriptions, thereby becoming members of the BIS.