Annual General Meeting: 71st Annual Report 2000/01
11 June 2001
The scale and the nature of the slowdown in the world economy was still unclear as the 71st Annual Report went to press. Although an earlier tightening of monetary policy and higher oil prices have played a role, major shifts in equity prices and in investment associated with the IT and telecommunications revolution have been crucial. This experience recalls some aspects of pre-1914 cycles, when upswings were characterised by heavy investment in sectors favoured by new technology, low inflation and large-scale international capital flows.
Monetary policy has been eased in most industrial countries, with the reaction in the United States being particularly swift and substantial. Although long rates and equity prices have failed to respond decisively, consumer spending in most countries has held up even as investment spending weakened sharply. The extremely rapid adjustment of inventories in the United States also augurs well for the future.
Yet some concerns have surfaced. The corporate and bank restructuring still needed in Japan and many emerging market countries remains unfinished. While financial institutions in the other major industrial countries seem very healthy, the possibility of inadvertent and hidden risk exposures after such a long period of credit expansion cannot be ruled out. Nevertheless, a significant and positive factor which distinguishes recent decades from earlier periods has been the efforts made to improve the functioning and stability of the international financial system. This work continued in the period under review, most notably with the Basel Committee on Banking Supervision developing a more risk-sensitive Capital Accord.
Chapter II: Developments in industrial countries
A sharp slowdown in the United States has clouded the near-term outlook for the global economy. Future prospects depend to a significant extent on the resilience of productivity growth and on a recovery in profits and capital spending. Growth in Japan has slowed as lower export demand exacerbated domestic weaknesses. In the euro area, however, a less indebted corporate sector and a sounder banking system appear to have made Europe's prospects more resilient to the global downturn.
Despite higher oil prices, inflation in the industrial countries remained moderate in 2000. Influenced to an important degree by stability-oriented monetary policies, this outcome continues a trend of unexpectedly low rates of inflation that had been evident throughout the 1990s. Even so, the chapter analyses other temporary and possibly reversible factors that have influenced inflation behaviour.
The chapter also analyses the sustainability of several imbalances, international and domestic. Persistent current account imbalances imply that national investment ratios in the industrial countries have become more independent of national saving ratios, perhaps because international financial markets are now more focused on allocating capital to countries where the rates of return are expected to be higher. A significant widening of financial imbalances raises questions about the sustainability of the build-up of private debt in the United States. In Japan, such concerns are focused on the progressively rising public debt and the health of the financial sector. The interesting similarities often noted between the recent expansion in the United States and that of Japan in the late 1980s should not obscure the striking differences between the two experiences.
Chapter III: Developments in the emerging market economies
Average growth in the emerging market economies in 2000 rose to its highest rate in four years, with particularly large increases in Latin America and central and eastern Europe. However, growth slowed towards the end of the year, notably in the Asian countries reliant on electronics.
Average inflation fell to just over 6%, with inflation in Asia actually below that of the industrial countries. Reducing, and then containing, inflation has been one of the most striking successes of the emerging market economies in recent years. An analysis of the inflation process in the emerging market economies suggests that tighter fiscal policies, a switch to stability-oriented monetary policies and structural reforms have all played a part. Yet keeping inflation low still poses a challenge to policymakers. An approach based on inflation targeting can bring long-term benefits if adequate account is taken of the potential pitfalls which the chapter analyses.
The pace of structural reforms continues to differ across countries. In Latin America, the banking sector was further strengthened last year and measures to enhance fiscal sustainability have been enacted. In contrast, only a few countries in central and eastern Europe have managed to reduce structural unemployment and, in some countries (notably Turkey), weak banking systems still pose a risk to macroeconomic stability. The Asian countries have addressed some of the structural weaknesses uncovered by the crisis, but their resilience to shocks remains to be tested. Attracting much-needed investment in Africa requires confidence in the rule of law as well as sound macroeconomic policies.
Chapter IV: Monetary policy in the advanced industrial countries
There has been a major shift in the stance of monetary policy and many of the uncertainties that marked the period under review persist. Short-term interest rates continued to rise through the early part of last year in the light of strong growth and increasing inflationary pressures. As the period progressed, however, the global interest rate cycle turned in response to perceptions that activity was weakening more sharply than desired. With evidence by early 2001 that a significant slowdown was under way in some countries, many central banks lowered interest rates. The global pattern of changes in conditions was most evident in the United States. In particular, when signs of a dramatic turnaround in activity appeared, the Federal Reserve cut interest rates five times; the cumulative reduction in the federal funds target rate amounted to 250 basis points. With downward pressure on prices and a sharp deceleration of activity around the year-end, the Bank of Japan also further relaxed monetary conditions. Th e situation in the euro area was different. The ECB had continued to tighten policy throughout 2000, given inflationary pressures largely arising from higher oil prices and the depreciation of the euro. With growth prospects worsening somewhat and wage pressures remaining contained, however, the ECB lowered rates by ¼ percentage point in May 2001.
In a special section, the chapter looks at the implications of the increased importance of financial markets for monetary policy. The role of financial indicators in making policy is discussed, as are issues related to communication with financial markets and the tactics of setting interest rates.
Chapter V: Foreign exchange markets
The broad-based strength of the US dollar continued in 2000 and early 2001. The yen remained stable against the dollar at a high level over most of 2000, but began to depreciate towards the end of the year. The euro generally remained weak, notwithstanding a temporary recovery in late 2000. These developments are thought to have mainly reflected prospective growth differentials as well as portfolio and foreign direct investment flows. But the dollar's renewed strength vis-à-vis the euro in early 2001 was puzzling in the light of the sharp reversal of relative growth in the United States and the euro area. It may reflect entrenched market expectations regarding the relative growth prospects in the medium term.
The magnitude of the depreciation of the Canadian, Australian and New Zealand dollars was somewhat unusual by historical standards. After a period of relative stability in 1999, a number of emerging market currencies began to weaken during 2000 in a context of slowing global demand and falling US equity prices. But despite isolated episodes of tension, foreign exchange markets remained broadly calm.
Overall, liquidity in foreign exchange markets appeared not to have deteriorated. Global activity remained well below levels reached in 1998, while bid-ask spreads for the main currency pairs remained tight and short-term volatility increased in some market segments.
Chapter VI: Financial markets
Financial markets reversed course last year. In the world's major equity markets, an extraordinary five-year run of price increases ended with the deflation of what was in retrospect a global asset price bubble. Technology stocks showed the most pronounced boom-and-bust pattern. In bond markets, a narrowing of credit and sovereign spreads in 1999 gave way to a widening of spreads last year. Monetary easing in the early months of 2001 spurred a robust recovery in bond markets and a tentative one in stock markets.
As financial market conditions deteriorated in 2000, fund-raising activity slowed down. Technology start-ups cancelled plans for initial public offerings. Firms with low credit ratings turned from the bond market to their banks. However, highly rated firms - US agencies in particular - stepped up issuance to meet a demand for benchmark bonds. Emerging market economies, especially those in Asia, continued to run current account surpluses and showed little need for external financing. In early 2001, investors again became receptive to bond issues from lower-rated firms.
Markets functioned smoothly in the face of large price swings. Liquidity proved resilient and no major financial counterparty failed. However, asset prices often seemed to be driven by shifts in sentiment rather than new information about fundamentals. Uncertainty about equity valuations in smaller markets led investors to seek quantitative anchors in the major stock markets, involving especially reference to the Nasdaq index. This resulted in synchronised price movements across markets.
Chapter VII: Cycles and the financial system
While financial liberalisation has brought many benefits, it has also arguably increased the scope for pronounced cycles in the financial system. These cycles have all too often ended in stresses in the banking system and contractions in activity. Typically, these cycles have their roots in favourable developments in the real economy which generate a powerful wave of optimism. This optimism contributes to the underestimation of risk, excessive credit growth, unsustainable increases in asset prices and overinvestment in physical capital. Eventually, when more realistic expectations emerge, these imbalances need to be unwound.
Addressing the difficulties created by financial cycles and the development of imbalances in the financial system poses a difficult, yet important, challenge for supervisory authorities and central banks. In principle, policymakers can establish regulatory arrangements that increase the resilience of the economy to these cycles. They can also respond directly to the build-up of financial imbalances through the use of both monetary policy and supervisory instruments. In practice, however, designing and effectively implementing such responses raises a number of delicate issues. The need for coordination between central banks and supervisory, taxation and accounting authorities is particularly important. Without such coordination, there is a risk that appropriate policy responses might not be forthcoming.
Chapter VIII: Conclusion: the recent past as prologue?
The recent weakening of growth in many industrial countries confirms that economic fluctuations are not a thing of the past. Downturns can arise from a variety of sources, and even the welcome absence of inflation will not suffice to avoid all setbacks.
At this juncture, given its size and the variety of links with other countries, the US economy is the key to global economic prospects. Unfortunately, plausible arguments based on competing economic paradigms can be used to support a wide range of forecasts. The recent signs of inflation and further evidence of the extent to which debt levels had built up in the United States indicate that some slowdown was desirable. But it would surely be appropriate for policy to react vigorously to a recession protracted by an overhang of excessive IT or other investments. In Japan, corporate and financial restructuring must be part of any policy package. Supply side reforms focused on labour and product markets would also be a welcome complement to the well balanced macroeconomic performance seen in Europe over the last five years.
Weak growth in the major industrial economies would directly affect many emerging market countries, particularly those tightly linked into the global supply chain for IT products. These effects could be magnified further in cases where needed financial restructuring arising from previous crises remains unfinished. Fortunately, the adoption of more flexible exchange rate regimes should make emerging market economies less vulnerable to changes in the relative values of the currencies of the major industrial countries.
Economic slowdowns which have been preceded by rapid credit growth and rising asset prices are often exacerbated by financial instability of various sorts. Comfort can be taken in this cycle from the limited role of property speculation and the ease with which lower equity prices and higher risk spreads have been absorbed. Moreover, decade-long efforts to improve risk management practices can also be expected to bear fruit. Conversely, it is a simple fact that the recent sharp decline in profits is of very recent vintage and that the full implications for lenders remain to be seen.
Looking beyond current concerns, the New Capital Accord under preparation by the Basel Committee on Banking Supervision is a significant step forward. Recent suggestions about fair value accounting and forward-looking loan loss provisioning for financial institutions deserve careful consideration. As for market functioning and the infrastructure supporting markets, various sources of concern have recently been identified, fortunately accompanied by continued good performance and concrete suggestions as to how weaknesses may be addressed.
The breakdown in the barriers between different financial sectors and different countries, along with the growing recognition that financial instability may in part have macroeconomic origins, implies the need for greater dialogue and cooperation between all parties concerned. At the national level, the complementary roles of monetary authorities and regulators need to be better understood. At the international level, various measures have been proposed to help prevent financial crises and manage them more effectively.
Whether enough consensus can be achieved at the level of principle, and enough resources mustered to ensure their effective implementation in practice, is yet to be seen. This remains a great challenge for the international community.
Activities of the Bank
At the heart of the Bank's contribution to international financial cooperation last year remained the regular meetings of Governors of BIS member central banks and the work supported by the secretariats of the various committees reporting to the G10 Governors. As BIS membership expanded markedly over the past six years, the meetings, discussion themes and cooperative efforts took on an increasingly global character. This trend towards greater inclusiveness was reinforced by the growing activities of the Bank's Financial Stability Institute, the development of the BIS Representative Office for Asia and the Pacific in Hong Kong SAR and the decision to establish a Representative Office for the Americas in Mexico City. A further building block of cooperation in Asia was the establishment of the Asian Consultative Council in March 2001.
During the period under review, Governors and senior officials of the BIS member central banks met on a bi-monthly basis to discuss the current state of the world economy, developments in financial markets and topical issues of special interest or concern to central banks. The work of the committees continued to focus on three of the main pillars of financial stability: soundness of banks (Basel Committee on Banking Supervision), efficient functioning of markets (Committee on the Global Financial System) and a robust payments infrastructure (Committee on Payment and Settlement Systems). In addition, the Bank contributed significantly to the work of broader sets of national authorities and other international institutions: this encompassed secretariat assistance to the Ministers and central bank Governors of the Group of Ten and to the Financial Stability Forum. Finally, cooperation remained active with central banks and other financial institutions on various statistical issues and on a broad range of tech nical subjects (including security, information exchange and IT).
The Bank 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. Competitive pricing and active marketing of BIS financial products helped bring about a further increase in the Bank's balance sheet over the course of the financial year. In October 2000, the BIS opened a new Regional Treasury dealing room in its Representative Office for Asia and the Pacific.
An Extraordinary General Meeting in early January 2001 decided to restrict for the future the right to hold shares of the BIS exclusively to central banks. The Statutes were amended accordingly and a mandatory repurchase was effected by the Bank of all BIS shares held by private shareholders, against payment of 16,000 Swiss francs for each share.