Chapter I: Introduction: time to rebalance?
The global slowdown earlier this decade was met with unusually strong fiscal and monetary stimulus in the industrial countries, especially in the United States. Policy was also eased in many emerging market economies, often in association with attempts to prevent the appreciation of their currencies against the US dollar. Higher asset prices and more favourable conditions in global financial markets, for much of the period under review, amplified the effects of policy easing and contributed to global economic growth that was much stronger than expected earlier. The United States and China were two particular poles of growth, with positive effects on Japan as well as many emerging market economies, while continental Europe continued to lag behind. Industrial countries with relatively rapid rates of economic growth showed the clearest evidence of deterioration in their external accounts but also witnessed the clearest improvements in the health of domestic financial institutions. Faster growth in the global economy did not lead to any generalised inflation pressures, despite higher commodity prices and increasing evidence of reductions in excess production capacity. Closer to the end of the period under review, financial markets became more cautious as they contemplated the implications of a likely tightening of monetary policy, particularly in the United States.
Chapter II: Developments in the advanced industrial economies
The recovery in the advanced industrial countries firmed in 2003, with the support of substantial policy stimulus in the United States and stronger demand in Asia. The upturn spread to many of the main economies via a sharp acceleration in global trade, although growth in the euro area remained subdued. A salient feature of the recent expansion was the gradual shift of demand growth from household to corporate spending, while fears of deflation eased.
Looking forward, a key question is the sustainability of the recovery in the near term and beyond. In the near term, the consensus view is for the recovery to gain further strength, with global growth expected to reach 4½% this year and inflation to remain moderate. At the same time, the outlook for demand is still clouded by several uncertainties, especially in the context of recent developments in financial markets and commodity prices. In the medium term, some risks remain, given in particular high debt levels of both private and public agents and large external imbalances. Assumptions about productivity trends play a crucial role in assessing whether these risks need be seen as a source of serious concern. The improved performance of productivity in the United States gives some grounds for optimism about prospects. Indeed, US labour productivity appears to have been rising the fastest among the major industrial countries in the recent past, reflecting a higher rate of technological progress, which was also maintained during the latest recession.
Chapter III: Developments in the emerging market economies
Ample global liquidity, reflecting easy monetary conditions and a greater willingness on the part of investors to bear risks in international capital markets, contributed to stronger growth in emerging economies from mid-2003 and to significant increases in commodity prices. Growth was supported by a strong rebound in private capital flows to emerging markets, which rose to their highest level since 1996. These flows were accompanied by large increases in foreign reserves in some countries, notably in Asia, raising concerns about future challenges for monetary policy. In some countries, expansion in credit to households supported consumer spending and growth. China played a major role in the current expansion, as its rapid growth boosted demand in East Asia and other regions.
There are a number of uncertainties in the outlook. First, now that US long-term interest rates have risen and emerging market bond spreads have widened, capital flows to emerging market economies could reverse, not least since they have largely taken the form of more volatile portfolio investments and loans. Second, questions remain about the sustainability of domestic demand growth in a number of emerging market economies. In China, overinvestment, weaknesses in the banking sector and higher inflation are sources of concern; in those countries that have relied on credit-led consumer spending, possible problems in risk management need to be addressed. Finally, the recent rise in commodity prices raises the question of whether the period of global low inflation is over, and of possible fiscal imbalances among commodity producers. However, high commodity prices give commodity exporters an opportunity to turn terms-of-trade gains into sustainably higher growth. In the near term, commodity prices may be kept up by supply constraints and strong demand from China and India. At the same time, supply uncertainties may contribute to commodity price volatility.
Chapter IV: Monetary policy in the advanced industrial economies
The central banks in the major advanced industrial economies maintained their accommodative stance of monetary policy over the past year in support of the economic recovery. In the United States, the Federal Reserve kept its short-term interest rate at 46-year lows, as inflation pressures became more balanced and the recovery more widespread. The ECB also kept rates low, balancing support for the fragile recovery with its concerns over inflation being relatively elevated at this point in the cycle. The Bank of Japan continued its policy of quantitative easing, as tentative evidence emerged that deflation pressures were waning and the economic revival was gathering momentum. In contrast, smaller industrial economies faced more varied policy concerns. Some central banks lowered policy rates to help support growth, while others raised them in response to domestic demand pressures and, in some cases, risks associated with the build-up of financial imbalances.
The chapter also explores two questions that rose to prominence during the period under review. First, with the prospect of a further strengthening of global economic activity on the horizon, and with the stance of monetary policy generally remaining highly accommodative, were central banks in the largest industrial economies inadvertently contributing to a surfeit of global liquidity? Second, how have central bank communication policies changed over the years and what challenges lie ahead?
Chapter V: Foreign exchange markets
The continued broad depreciation of the US dollar and its subsequent partial reversal were the most notable developments in foreign exchange markets. In 2003 and the early months of 2004, the dollar depreciated markedly against the euro and a number of other floating currencies. By contrast, its depreciation against the yen and Asian emerging market currencies was limited. Between February and mid-May 2004, the downward trend in the US dollar partially reversed, as the market reassessed the probability of policy rate changes in the United States and a number of other countries. Three main factors appeared to drive exchange rate movements during the period under review: the widening US current account deficit and changes in its financing composition; interest rate differentials, against the backdrop of a search for yield; and unprecedented intervention in Japan together with large reserve accumulation in China and several other countries in Asia.
A special section looks at historical episodes of current account adjustments and examines whether changes in the pattern of private financial flows and the split between private and official flows help predict the start of a current account adjustment. It also analyses how capital flows behave once the current account deficit starts to adjust. The last section examines the rationale for holding reserves and what might explain current behaviour. It then discusses the implications of reserve accumulation for the sustainability of the financing of the US current account deficit and considers the possibility of disorderly changes in capital flows.
Chapter VI: Financial markets
Global financial markets in 2003 saw investors regain their appetite for risk. In equity markets, this new appetite set off a rally even before favourable news began to emerge about company earnings and the global economy. In both corporate and sovereign debt markets, credit spreads tightened to near historical lows as investors sought yields higher than those available in safer fixed income instruments. Not even a sell-off in government bond markets in mid-2003 seemed to dampen investors' appetite for risk.
While the improvement in economic fundamentals justified some rise in asset prices, by late 2003 market valuations also seemed to be supported by relatively thin risk premia. Investors appeared to discount the possibility of adverse events or perhaps thought that they could unwind their positions before suffering heavy losses. Indeed, in May 2004, the heightened prospect of a rise in US policy rates led some leveraged investors to retreat quite hastily from equity markets and emerging market debt. The adjustment, however, remained orderly.
Chapter VII: The financial sector
An improved economic environment resulted in a stronger performance for the financial sector in industrialised countries during the period under review. As the signs of a general recovery multiplied and risks to the outlook subsided, commercial bank profits increased almost without exception. The improvement was evident both in countries where the banking sector was building on a strong base and in those where institutions had been under strain. In addition, favourable asset market conditions boosted investment bank earnings and helped insurance companies make progress in repairing their weakened balance sheets. Structural factors, such as investments in a more efficient cost base and the deepening of risk transfer markets, also contributed to the improved performance.
Looking forward, the main concern is whether the financial sector, having escaped the slowdown relatively unscathed, might be moving ahead of the business cycle. In the pursuit of profitable uses for their accumulated capital, some institutions may have undertaken investments premised on tenuous assumptions regarding the outlook for growth and the level of interest rates. Possible signs of such behaviour include a recent narrowing of spreads in the syndicated loan market and the increased importance of proprietary trading income for large banks' earnings. Arguably, the main vulnerabilities of the financial sector relate to possible future changes in interest rates. Higher rates could affect the ability of households to cope with increased indebtedness, not least through their impact on asset prices, while an unexpectedly strong flattening of the yield curve could have repercussions for institutions that are currently taking advantage of persistently low short-term rates.
Chapter VIII: Conclusion: change, uncertainty and policymaking
Most observers believe that the recovery has now gained a firm hold. Nevertheless, concerns persist about imbalances in the global growth centres of the United States and China and their possible longer-term implications. In the former case, consumer spending was maintained by heavy borrowing in the face of unusually restrained growth in labour income. Associated high levels of debt could weigh on future spending, particularly if interest rates were to rise and asset prices moderated or even fell from current lofty levels. A strengthening of the recovery in corporate investment would of course work in the opposite direction. Similarly, heavy past borrowing from non-residents could weigh on the US dollar, leading both to higher interest rates in the United States and to losses on non-residents' dollar-denominated investments. This latter effect would constrain spending in creditor countries even as currency appreciation was restraining exports. In China, the principal concern is that an extraordinarily high level of fixed investment may contribute to inflation in the short term and to unprofitable excess capacity over time. In global financial markets, further reductions in risk tolerance are possible. Fortunately, many of those potentially vulnerable to such developments have been taking active measures to protect themselves.
The immediate challenge for very loose monetary and fiscal policies in the industrial countries must be to restore more normal policy conditions in a way that avoids catalysing instability in the face of the imbalances just noted. In pursuing this task, clear communication of the authorities' intentions could play a useful role in stabilising market expectations. The longer-term challenge must be to establish more robust policy regimes for promoting monetary and financial stability in a global economy whose structure is changing rapidly. In this context, inflation targeting frameworks have much to recommend them, particularly if subjected to an explicit side constraint allowing a response to perceived excesses in credit creation, asset price increases and investment. Generally, policies to reduce demand and expand supply should be pursued more vigorously in good times. This will increase the room for policy manoeuvre and decrease the potential for instability when times turn bad. In China, the overheating problem has already led the authorities to begin tightening, but they are hampered by the fact that their market instruments are not yet fully effective, while administrative controls have been partially dismantled.
Global trade imbalances primarily require higher saving rates in deficit countries and lower saving rates among creditors, as well as appropriate changes in real exchange rates. Creditor countries that hesitate to change nominal exchange rates could find that real exchange rates rise through inflation. In many countries, especially in Japan, continental Europe and many emerging markets, ongoing reforms are required to improve the functioning of both labour and product markets. Finally, structural reforms in the financial sector need to achieve the proper balance between safety and efficiency. The information needed to strike a proper balance includes accurate estimates of current financial conditions, exposures looking forward, and the degree of uncertainty surrounding all such estimates. Recognising the limits of our knowledge could be key.
Organisation, governance and activities of the Bank
The 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.
The bimonthly meetings of Governors of BIS member central banks remained a key mechanism through which the Bank contributed to international cooperation in 2003/04. 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.
As well as providing the necessary analytical support to these meetings, the Bank's research activity covered a broad spectrum of topics of central bank interest. Moreover, the topical and country coverage of the economic, monetary and financial statistics compiled by the Bank was expanded.
The Bank continued to host and support the secretariats of the Basel Committee on Banking Supervision, the Committee on the Global Financial System and the Committee on Payment and Settlement Systems. The Bank also remained active in assisting the work of a number of independent organisations that have established their secretariat at the BIS, namely the Financial Stability Forum, the International Association of Insurance Supervisors and the International Association of Deposit Insurers.
During the period under review, notable progress was made in the development of a new capital adequacy framework ("Basel II"). The full text of the new framework was released on 26 June. A significant part of the activities of the Bank's Financial Stability Institute will remain devoted to preparing supervisory authorities for the future implementation of Basel II. In this connection, the Institute will launch in mid-2004 FSI Connect, an online information and learning resource developed specifically to support large numbers of banking supervisors.
The Bank continued to serve as a counterparty to central banks in their financial operations, and to perform agent and trustee functions for a variety of financial transactions. To broaden the range of BIS investment outlets, the Bank launched a medium-term tradable instrument with an embedded call feature.
In the course of the past financial year, the balance sheet grew strongly, by over 12% expressed in SDRs (the Bank's new unit of account). Mainly as a result of lower average interest rates last year, which depressed income from securities financed with the Bank's equity, net profits declined by just under 10% compared with the preceding financial year.