Reserve Bank of Australia Annual Report – 2008 Governor's Foreword

2007/08 was a turbulent year for the world economy. Large increases in oil and other commodity prices disrupted growth and inflation rates, while serious problems in international financial markets further complicated the tasks facing central banks.

For some years, long-time observers had expressed concerns about underpricing of risk, the build-up of leverage and the growing complexity of financial instruments. But, despite these general misgivings, it was not possible to predict with any accuracy how or when the process of unwinding would occur, or what its economic consequences would be. It was apparent by the middle of 2007 that loss experiences in US sub-prime mortgages were severe and that financial institutions with exposures were going to be badly affected. But no-one foresaw the sudden loss of confidence displayed in the world's largest financial houses, manifested in a severe disruption in interbank markets, beginning in August last year. As the financial year unfolded, very large write-offs had to be made and new capital raised. By the middle of 2008, it was clear that the US economy and banking system had been seriously weakened, and there were concerns about conditions in some other major countries as well.

As a result, the past year has presented some of the most demanding circumstances for the domestic market operations of central banks, including the Reserve Bank of Australia, seen for many years. Practices that had been largely settled since the mid 1980s had to be adapted quickly in the face of very unusual and fast-moving developments.

The Reserve Bank moved early to expand the scope of its daily operations, accepting a wider variety of collateral in repurchase operations, dealing at considerably longer terms than usual and, for brief periods, significantly pushing up the quantity of settlement funds in the system. The intention of this was to maintain liquidity in the domestic financial system, as local and international markets underwent the difficult and potentially disruptive process of re-pricing risk. There was never any doubt about the solvency of any Australian bank. Indeed, the very sound position of the local banks was a major source of strength for the Australian financial system during this period. Overall, the rise in term funding spreads to the official yield curve has generally been smaller in Australia than in continental Europe, the United Kingdom or the United States. The Reserve Bank's balance sheet changed considerably as a result of these factors and also because the Future Fund drew down its deposits with the Bank as it invested its funds in line with its mandate. The details of these developments and the Bank's response are set out in the chapter on The Balance Sheet and Operations in Financial Markets.

When measured according to Australian equivalents to International Financial Reporting Standards, the Reserve Bank earned a profit of $1.4 billion in 2007/08, following a loss in the preceding year. Underlying earnings, at over $2 billion, were the highest yet recorded. However, a rise in the exchange rate of the Australian dollar against other currencies once again resulted in unrealised valuation losses on the Bank's portfolio of foreign assets. As was explained in last year's annual report, a central bank has to accept these exposures as part of maintaining its country's official reserve assets. As well as reducing total profits, the unrealised valuation losses, consistent with the Reserve Bank Act 1959 and sound accounting practice, reduced the quantity of distributable profits since, this year, there were no offsetting previously unrealised gains. Hence, the dividend payable to the Australian Government was less than underlying earnings on this occasion, though higher than in the preceding four years.

Monetary policy was adjusted through the year as required, consistent with the long-established framework of flexible inflation targeting. The basis of those decisions was, as usual, set out in the statements announcing the decisions and the quarterly Statement on Monetary Policy. The Board also decided late in 2007 to change its disclosure practices. It now releases a statement each month regardless of whether or not the cash rate is to be changed, and releases minutes of the monetary policy meeting of the Board with a two-week lag, which is now common practice among many central banks. In a related change, the timing of the announcement of the policy decision was brought forward to be shortly after the conclusion of the meeting. From a governance perspective, this is far preferable to waiting nearly 24 hours to make the announcement.

During the year, the Board welcomed John Akehurst as a new member and Jillian Broadbent was re-appointed to a third five-year term.

The regular work on assessing financial stability continued – and the Financial Stability Review, published every six months, ranks alongside the Statement on Monetary Policy as one of the Reserve Bank's premier publications. In addition, the payments policy area worked on a major review of payments reforms, which will be the subject of separate reporting by the Payments System Board in due course.

The Reserve Bank reviewed and restructured its currency activities during the year. An Assistant Governor (Currency) now has responsibility solely for currency matters, which involves overseeing note issue, research on note design and chairing the Boards of Note Printing Australia and Securency.

The Reserve Bank's staff, led by a very talented team of assistant governors and department heads, responded to demanding circumstances with their customary skill, professionalism and dedication. On behalf of the Board, I thank them most sincerely for their efforts.

Glenn Stevens

Chairman, Reserve Bank Board
14 August 2008