Annual General Meeting: 69th Annual Report 1998/99
On the occasion of its Annual General Meeting held in Basel today, 7 June 1999, the Bank for International Settlements released its 69th 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
This chapter provides an overview of recent economic and financial developments as well as the policy response to them. It notes that the worst of the crisis in emerging and financial markets seems to be over. Nevertheless, given that current difficulties remain deeply rooted in excessive capital formation and credit expansion, and that significant imbalances remain within the global economy, further turmoil cannot be ruled out. Reductions in interest rates helped ward off excessive disinflation and effectively soothed financial markets in the second half of last year. However, they may also have stimulated asset price increases and lessened the pressure for corporate and financial restructuring in some countries. Ongoing official efforts to make the financial system safe as well as efficient are briefly described and welcomed.
Chapter II: Developments in the advanced industrial countries
There were sharply divergent patterns of output growth across the industrial world. While the US economy expanded strongly and European countries generally saw moderate to strong growth, Japan's economy contracted. To a significant degree, these cyclical differences reflected the extent to which households benefited from wealth gains and were willing to spend in the face of the economic and financial turbulence evident through much of last year. These cyclical differences also meant that the fiscal surplus rose in the United States while the fiscal deficit expanded sharply in Japan, and other internal and external imbalances also widened. The United States alone has absorbed about one-half of the marked swing in Asian external balances. In spite of these cyclical differences, consumer price inflation trended downwards virtually everywhere, reflecting wage moderation, sharply lower commodity prices and excess capacity in global goods markets. Some evidence suggests that inertia in wage and price formation rises as inflation falls. However, this inertia is not in itself a sufficient argument for expansionary policies aimed at reducing unemployment, as such policies might actually cause inflation to begin rising again.
Chapter III: The spreading crisis in emerging markets
The principal stages of the emerging market crisis are described, followed by an analysis of two key influences on these developments: volatile international capital flows and swings in the underlying determinants of trade balances. The BIS quarterly banking statistics are used to chronicle the swift reversals in capital flows, and previously unpublished data show how changes in sentiment (particularly after the Russian debt moratorium) affected different borrowers according to their assessed creditworthiness. In the absence of external financing and with record low commodity prices, domestic demand in many regions had to be squeezed hard to generate a positive swing in the trade account (Asia) or to stop further deterioration (Latin America). In many countries external deficits remain a continuing source of vulnerability. In addition to analysing recent developments in each of the major regions, the chapter considers specific issues: corporate and financial sector restructuring in Asia, the continuing absence of the basic elements of a market economy in Russia, and the difficulty experienced by Brazil in maintaining a tightly managed exchange rate in the face of significant macroeconomic imbalances.
Chapter IV: Monetary policy in the advanced industrial countries
This chapter considers in turn the unusual challenges facing monetary policy in the three largest economies. In the United States, the failure of low unemployment to generate inflationary pressures has been remarkable. In Europe, the transition to the euro was extremely smooth; nevertheless, associated structural change and the divergent cyclical positions of different countries will complicate future policy-making, in spite of the possible usefulness of some simple indicators (monetary aggregates and the Taylor rule). In Japan, the limitations of monetary policy when short-term rates are essentially zero and prices are already falling are analysed. Monetary policy in countries with explicit inflation targets is also considered. So too are some of the problems posed by relying too heavily on a rising exchange rate to fight inflation, and possible limitations to the use of monetary conditions indices (MCIs). Given how near many countries currently are to price stability, attention is paid to the likelihood of generalised deflation today (limited) and to an assessment of the historical record (using data dating from 1882 for 10 countries) for possible dangers associated with falling prices. Interestingly, and with the Great Depression the notable exception, past episodes of falling prices were typically not associated with falling output. Finally, the chapter examines special problems of conducting monetary policy when price changes are oscillating around zero. The possible merits of targeting price level stability to anchor price expectations and reduce real long-term interest rates in such circumstances are considered.
Chapter V: Turmoil in asset markets
The chapter begins with a review of asset market developments in the industrial countries. Equity prices in most countries set records, fell back, and then rebounded to reach new highs in some cases. Traditional valuation techniques are shown to imply overvaluation, although expectations of a "new era" of enhanced dividend growth and reduced dividend volatility could still provide some justification for current price levels. Bond rates generally trended downwards up to October 1998 but have since been rising subject to different national cyclical positions. Property prices have continued to fall in Japan but elsewhere they are firming, often substantially in cyclically advanced countries. Attention then turns to a detailed analysis of the dynamics of financial markets in the immediate aftermath of the Russian moratorium. An index measuring investors' changing attitudes to risk is constructed which indicates that crises generally coincide with periods of heightened risk aversion. It may be significant that swings in sentiment often seem to be correlated with the level of interest rates in the major industrial countries. The chapter then examines the way in which various forms of risk, previously thought of as largely independent, interacted during the second half of last year. A heightened aversion to credit risk caused liquidity premia to rise sharply. Subjected to these common shocks, prices in many markets moved similarly, diminishing the benefits of portfolio diversification and leading to renewed efforts to seek safety in quality and liquidity. Finally, special consideration is given to how this market turbulence was aggravated by heavily leveraged position-taking and the particular problems of Long-Term Capital Management.
Chapter VI: Developments in foreign exchange markets
Up to August 1998, the strength of the dollar against the yen and the mark fundamentally reflected cyclical divergences. The subsequent sharp fall in the dollar, particularly against the yen, may have been exacerbated by the decision of highly leveraged investors to close out yen carry trade positions in the light of losses elsewhere and changes in sentiment about the yen/dollar exchange rate. Some indirect evidence from changes in the net asset value of a major hedge fund and from the 1998 Central Bank Survey of Foreign Exchange and Derivatives Market Activity is consistent with this hypothesis. Options prices are used to describe the sharp swings in sentiment in early October. The subsequent strengthening of the dollar, also against the newly introduced euro, seems primarily due to cyclical divergences. The possible effect over time of the overhang of US external debt on the value of the dollar is discussed. Consideration is also given to the longer-term prospects of the euro as a transaction, reserve, investment and anchor currency. Finally, developments in the foreign exchange markets of emerging markets are analysed. Whereas stability has returned in most cases, new data reported in this Annual Report show that turnover generally remains very subdued.
Chapter VII: International financial markets
International bank credit to Asia fell sharply in the first half of 1998 but credit continued to flow to Russia and Brazil almost to the day of the Russian moratorium. Subsequently, bank lending resumed, but on a much more selective basis. International loans to borrowers within the reporting area (essentially industrial countries and offshore centres) dropped sharply in the second half of the year as deleveraging accelerated. Banks' unwillingness to extend credit was in part a reaction to the sharp reduction in international deposits by non-banks as the crisis unfolded, accompanied by an increasing preference for deposits with more creditworthy banks. The strains induced by this process were well handled by the market for interbank deposits. In contrast, new issues of securities reached record levels in 1998 in response to corporate restructuring and the desire to establish new euro-compatible benchmarks. Yet the influence of the crisis could be seen in the preference of buyers for more liquid securities. The average size of issues rose sharply, with US and German borrowers benefiting while emerging market borrowers fell back. Activity in the derivatives market soared from the third quarter onwards as positions had to be covered in the light of changing circumstances. The chapter finishes by drawing some lessons from the central bank survey of over-the-counter derivatives markets at end-June 1998 in the light of the market events last fall. It is now quite evident that non-bank financial institutions are major participants in these markets and that there remain significant gaps in the information available about both credit exposures and the concentration of exposures.
Chapter VIII: Conclusion
A central conclusion is that efforts are needed across a wide front if macroeconomic stability and financial stability are to be both restored and maintained. As to the former, attention is drawn first to complications inherent in the conduct of monetary policy in a world which may have a variety of downside risks. Various issues relating to exchange rate regimes and fiscal policy are also addressed, and some possible qualifications to commonly held views are suggested. Finally, given the overhang of capacity in many industrial sectors, it is recommended that greater efforts be made to provide earnings opportunities in other sectors through deregulation and labour market reform. Policies to promote financial stability must begin with the effective resolution of current problems. In many countries this calls for effective restructuring of both the corporate and banking sectors. Several impediments, principles and implications of such restructuring are examined. The recent renewal of capital inflows into emerging markets may indicate a need for domestic authorities to consider measures to minimise the disruptive effects of inflows and to protect themselves against potential outflows. In both emerging market and industrial countries, the role of safety nets in encouraging excessive lending needs to be reassessed, as do the effects of sharply enhanced competition and increased concern with shareholder value in the financial sector. The chapter also discusses the growing recourse to markets to obtain credit and to hedge risks, as opposed to using financial intermediaries, and some of the special issues this raises for safeguarding financial stability. Risk management systems need to be reassessed along with the oversight role of public authorities in this area. Finally, it is noted that the implementation of international standards of good practice in the financial area will be difficult, but a number of ways forward can nevertheless be suggested. The establishment of the Financial Stability Forum, which will bring regulators, treasury officials and central bank officials together for the first time, can play an important role in ensuring that effective actions follow on from good intentions.
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 four different sets of meetings of officials. There is also a growing tendency for meetings to be held outside Basel, especially at the Bank's new representative office for Asia and the Pacific in Hong Kong, and increasingly to involve participants from emerging market economies. First, there is a regular set of consultative meetings 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 (commonly including treasury representatives) and other international financial institutions. Fourth, many meetings take place at the Bank centred on technical areas (security, IT, the Year 2000 issue, 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 began marketing asset management services as well as a Medium-Term Instrument to provide central banks with a longer-dated yet liquid investment outlet. Within the framework of an international support programme for Brazil, the Bank also coordinated a Credit Facility in favour of the Banco Central do Brasil.