Excerpts from the speech delivered by W F Duisenberg to the 67th Annual General Meeting of the Bank

The following are excerpts from the speech delivered by W.F. Duisenberg, Chairman of the Board of Directors and President of the Bank for International Settlements, to the sixty-seventh Annual General Meeting of the Bank held in Basle on 9th June 1997.

I should like to turn now to a brief review of recent economic developments and to the policy issues that they raise. The global macroeconomic picture last year had several very positive aspects and the prospects for the world economy are now probably better than they have been for some time. Even so, the year was by no means an unqualified success and, looking to the future, the risks to the short-term outlook and the longer-term challenges facing policy-makers should not be underestimated.

The most significant positive feature of 1996 was the buoyant growth recorded in emerging economies: average growth rose in Latin America on the strength of the recovery in Argentina and Mexico, improved in the countries in transition and was the fastest for two decades in Africa. Only in Asia did it slow down, albeit from generally very high levels. Equally encouraging was the further decline in inflation in industrial and emerging economies alike. It is noteworthy that inflationary pressures remained less evident than might have been expected even in some of the countries where capacity limits were being tested, most notably in the United States. This may well be a sign of the quickening pace of technological change and globalisation, but it arguably also reflects the fruits of the authorities' longer-term efforts to bring inflation under lasting control.

At least two developments, however, contribute to qualifying such a positive assessment. First, in several industrial countries, particularly in continental Europe, growth was still subdued, although a cautious recovery was in evidence from the second quarter onwards. Second, against this background, the unemployment situation remained grim. Despite significant declines in those countries more advanced in the cycle, the unemployment rate was flat in the industrial world as a whole and rose further in the slow-growing economies. At the same time, and regardless of cyclical influences, developments last year provided further confirmation that flexible labour and, I would add, product markets are a precondition for a successful longer-term reduction in the number of jobless. The experience of the United States, the United Kingdom and, in continental Europe, the Netherlands and Denmark among others, illustrates how policies designed to tackle structural rigidities in labour and product markets can provide a sound basis for more sustained employment growth.

Looking ahead, in several respects the prospects for the world economy now appear more promising than for some time. In the short term, in industrial countries inflation is expected to remain generally subdued and growth, on balance, to strengthen, as those economies less advanced in the cycle catch up. Similarly, the overall growth and inflation prospects in the non-industrial world are very positive. In the long term, the fact that the main inflationary pressures in industrial countries have been contained has laid the foundations for a sustained expansion. The progress made in structural reform in many parts of the non-industrial world works in the same direction. Finally, the remarkable wave of technological innovation seen in recent years and the quickening process of globalisation should provide a powerful engine for growth.

Nevertheless, this benign outlook is not free from risks. Some of these risks relate primarily to the shorter-term prospects. It cannot be ruled out that in the United States the incipient signs of inflationary pressures might prove more stubborn than anticipated, potentially posing a threat to further rapid expansion. In Japan, headwinds arise from continuing weakness in segments of the financial sector and from the need for fiscal restraint. In parts of continental Europe, prospects remain vulnerable to a sudden reversal of market sentiment or to policy shortcomings. In those non-industrial countries where progress in reducing inflation has resulted in a marked real appreciation of the currency, and particularly where financial systems contain elements of fragility, the erosion of competitiveness could make it harder to reconcile strong growth with control over inflation. And linking several of these concerns is the remarkable buoyancy of financial markets, generally driven by a relentless search for higher yields. The question is whether the macroeconomic risks have been correctly evaluated and factored into asset prices or whether the materialisation of any of them could trigger some broader form of retrenchment.

In the longer term, the main policy challenge is to come to grips with the process of rapid change in the world economy, exploiting its vast opportunities while avoiding its pitfalls. Several factors complicate considerably the future task of policy-makers: the globalisation of product and financial markets; the dislocations arising from the uneven incidence of technological advances and heightened competition; the need to ensure sustainable fiscal positions, under strain from past excesses and demographic trends; and the lingering imprint of past inflationary decades. In my remaining remarks, let me elaborate on some of these themes from the perspective of central banks.

To discuss the policy challenges from the perspective of central banks means focusing on two objectives which, to various degrees, have been associated with central banking since its inception, namely monetary stability and financial stability. The expression "to various degrees" has a geographical as well as a temporal connotation. Geographically, the specific role of central banks in safeguarding financial stability varies across countries according to institutional arrangements, notably their role in prudential supervision and regulation. In any event, their necessary and more general involvement reflects in no small measure their ultimate control over liquidity. Temporally, the relative importance of the two objectives has changed throughout history along with evolving economic and political circumstances as well as intellectual frameworks. Inevitably, in the wake of episodes of financial distress of a magnitude not seen since the interwar years, the need to preserve financial stability has in recent years once again come to the fore of policy agendas, both nationally and internationally.

Recent experience has confirmed how intimately related monetary and financial instability are. First, each can cause the other. Inflation in industrial and non-industrial countries has all too often sown the seeds of financial distress. It has done so by contributing to misalignments in asset prices, distorting real and financial decisions and setting the stage for major contractions in economic activity. Similarly, widespread latent instability has in the past sometimes encouraged the pursuit of misguided inflationary policies as a means of bailing out financial institutions. Second, the roots of both types of instability often lie in excessive credit creation. This can either generate inflation in product markets or facilitate excessive increases in asset prices, whose subsequent reversal can lead to financial strains and undermine the quality of loan portfolios. Finally, and for much the same reasons, instability in one sphere can complicate the task of preserving stability in the other. To mention just two examples, how should central banks respond when the adjustments in interest rates needed to contain inflation are deemed inconsistent with financial stability, or when those required to restrain excessive buoyancy in asset prices may risk undue contraction in product markets?

Considerations such as these indicate strongly that the preservation of monetary and financial stability calls for mutually consistent and reinforcing policies. To use a marine analogy beloved by central bankers, the challenge is to define "anchoring" mechanisms in the monetary and financial spheres that will help to safeguard both objectives. And any such policies will need to come to terms with the sea change in the financial environment brought about by the continuing process of deregulation, technological change and innovation. While in recent years we have made significant progress on each of the two fronts, much still remains to be done.

In the monetary sphere, by far the most important step forward has been the growing political and social consensus on the merits of price stability after years of generally painful experience with overly ambitious macroeconomic policies. This has resulted, in particular, in the increased willingness of governments to provide central banks with mandates more clearly focused on price stability together with a greater degree of operational autonomy within a framework of improved public accountability. The steps taken in the United Kingdom are just the most recent illustration of this broader trend. Such arrangements could prove to be the main "anchor" in the future, helping to insulate central banks from pressures that could with time lead to a repetition of past policy errors.

At the same time, there is little doubt that the new economic environment is making it harder for central banks to find a reliable compass in their quest for price stability. The pace of change in the financial field has called for a reappraisal of policy guides. The growing force of capital movements has complicated the maintenance of exchange rate commitments. The greater breadth and depth of markets do not seem so far to have reliably and significantly improved the value of asset prices as predictors of future activity or inflation; indeed, despite their increased economic significance, it is far from clear how these prices can best be incorporated into the overall policy framework. And structural changes in product and labour markets are clouding the reading of traditional benchmarks signalling inflationary or deflationary pressures. These developments have put a premium on central banks' judgement in assessing the future and calibrating the policy response. By the same token, they have highlighted the need for a forward-looking approach and flexibility in adjusting policy rates. Seen from this perspective, the broad trend towards greater transparency about policy should be regarded as an attempt to elicit more predictable responses from financial markets, thereby reducing the uncertainty that inevitably surrounds decision-making.

In the financial sphere, securing stability requires complementary action designed to strengthen both individual firms and the multifaceted linkages between them, that is, action at the micro and macro-prudential level respectively. The more rapid pace of initiatives in recent years to upgrade prudential regulation and supervision, as well as risk management safeguards in payment and settlement systems, is the most tangible sign that this need has been recognised.

At the macro-prudential level, the anchoring principle underlying the numerous policy initiatives has been ensuring "timely settlement". Real-time gross settlement, sounder multilateral net settlement systems, and delivery-versus-payment and payment-versus-payment mechanisms are all ways of giving this guiding notion concrete form. Steps to promote them have been the main policy response to the increase in liquidity and credit risks arising from the unprecedented growth in payment and settlement volumes, which is the other side of the coin of the recent spectacular expansion in financial activity, markets and trading. Since the beginning of 1996, the Committee on Payment and Settlement Systems of the Group of Ten central banks has released four reports covering real-time gross settlement systems and the settlement of foreign exchange, securities and derivatives transactions. This underscores the importance attached to infrastructural issues in maintaining systemic stability.

At the micro-prudential level, the anchoring notion in recent years has been "capital standards", allied with the need to ensure effective consolidated supervision of financial firms, at least in banking. Minimum capital standards have been seen as a vital cushion against potential losses and as a lever to help shift part of the responsibility for ensuring the soundness of institutions away from the authorities and onto market participants: with more of their own wealth at stake, participants are rendered more sensitive to the risk profile of institutions.

Yet, despite the progress made so far, the task ahead is a particularly difficult one. In a world of increasingly global financial markets and blurring distinctions between a full range of financial intermediaries, financial stability cannot be adequately secured through safeguards still largely based on strict institutional divisions (banking, securities, insurance) and national jurisdictions. At a minimum, cooperation has to be upgraded across both institutional and geographical borders. More broadly, a concerted international strategy to promote financial stability in emerging markets has now been crafted in association with representatives from these countries and has been endorsed by the G-10 Finance Ministers and central bank Governors. The landmark consultative document by the Basle Committee laying down 25 Core Principles for Effective Banking Supervision, drawn up in close consultation with banking supervisors from outside the Group of Ten, is just one of the initial, albeit vital, steps along this path.

Just as importantly, enduring financial stability may well prove beyond our reach unless an appropriate balance is struck between the authorities and market participants themselves as a source of financial discipline. The numerous measures taken to improve public disclosure and to make prudential regulations more market-friendly are significant facets of this endeavour. Nevertheless, individual and market discipline cannot ultimately be effective if agents act on the expectation of insulation from losses in the event of distress. Indeed, this is hardly consistent with the free market philosophy underpinning much of the liberalisation seen over the last two decades. At the very least, reconciling prudential safeguards with this philosophy calls for a reduction in the compass of the overly generous safety-net arrangements that, de jure and especially de facto, have operated for so long in a number of segments of the financial industry. The gap between our words and deeds should make us all reflect. Dealing with these issues is a task that clearly goes well beyond the remit of prudential supervisors and central banks. Much like the reconsideration of the affordable limits to long-term public expenditure under way in so many countries, it requires a broader political commitment. In the years ahead, we will have to come to grips with how far this process should and can credibly be taken.

To sum up, experience over the last two decades has helped us to better understand the close and manifold linkages between monetary and financial stability. It has thus hammered home a message that had perhaps been partly forgotten as memories of the difficulties experienced in the interwar period faded. We have also made some real progress in designing complementary anchors for stability in these two spheres, yet it must be admitted that this progress has also been uneven. The gains made in re-establishing price stability have been greater and these at the least must be consolidated. However, major challenges remain in ensuring financial stability and these must now be tackled with still greater determination.