Speech Globalisation, Liberalisation and the Challenges for Small Island Central Banks
Talk to Reserve Bank of Fiji 25th Anniversary Symposium
Thank you for the opportunity of being present at the celebration of the Reserve Bank of Fiji's 25th Anniversary. The family of central banking certainly has a wide span of ages – from the Swedish Riksbank, which this year is 330 years old, all the way down to relatively young central banks, such as a number of us in the Pacific region. I would have to include the Reserve Bank of Australia as one of the younger ones – we have only been a separate entity for 39 years – not much older than the Reserve Bank of Fiji.
Over the 25 years that the Reserve Bank of Fiji has been in existence, relations between it and the Reserve Bank of Australia have always been close. Many members of the staff of the Reserve Bank of Fiji have visited us in Australia for training, and in turn we have seconded a number of our people to the Reserve Bank of Fiji. Some of you may remember Paul Talbot who spent a few years here recently – he is now in charge of our Information Office. Our latest Reserve Bank of Australia export to Fiji is Steve Morling, who is finding the work so interesting and the lifestyle so congenial that we will have difficulty getting him back. Leaving that aside, I am sure the close relationship between our institutions will continue over the next 25 years and beyond.
I should now turn to the more serious business of today's seminar. The topic I have been asked to speak on is actually a rather wide one – ‘Globalisation, Liberalisation and Challenges for Small Island Central Banks’. I will be doing so from the perspective of a large island central bank – the Reserve Bank of Australia. A lot of the problems we all face are similar, but, as you know, the lessons learnt in developed countries may not always be entirely appropriate for other countries. I am conscious of that, and I will do my best to take into account the unique challenges facing small island economies in what I have to say today.
The term globalisation is one which is in frequent use but is rarely strictly defined. In part, globalisation means the increasing tendency for enterprises to operate across national borders, thus generating trade in goods, services and flows of capital. Another part is the tremendous advances in the transmission of information, so that ideas, fashions and popular tastes move much more quickly between geographically distinct regions. This same capacity for transmission of information also means that capital markets, which are populated by large firms that are managed on a global basis, react literally instantaneously to changes in economic news – as well as to rumour and speculation.
Liberalisation is easier to define – it means the freeing up of product, labour and financial markets to respond to price incentives. In some ways, this liberalisation is facilitating globalisation; they certainly seem to go together. The best example of liberalisation is the tendency for protection to decline for most products since the 1940s which has led to greatly increased trade flows. This is, in fact, a return to the trend seen before the outbreak of the First World War, which was sidelined by a retreat into protectionism during the 1930s.
At the same time, pursuit of reasonably liberal policies is seen as the best way to extract value from globalisation. For economies, whether large or small, which start with a technological disadvantage, openness to foreign direct investment allows the accumulation of capital, technology transfer and the acquisition of new skills by the domestic workforce. Openness and liberal policies allow countries to move more quickly towards the productivity levels of the advanced countries. Since productivity is the ultimate source of wealth, with this trend come higher living standards. This approach, together with a commitment to upgrade education, explains the bulk of the growth in incomes per head in the east Asian countries over the past generation, which, recent severe problems notwithstanding, remains one of the most remarkable economic transformations in history.
Fiji has been undergoing a process of gradual liberalisation and reform that is having an impact upon both the real and financial sectors of the economy. These reforms will affect the way in which the Government provides services and produces goods; the financial sector is already largely deregulated. As I understand it, the main aims are to improve the delivery of government services and to empower the private sector. The objective is to increase efficiency in key areas of the economy. This will ultimately reduce costs and increase the level of service provided to private businesses and individuals. Many government enterprises are in the process of being corporatised and privatised, and with time these measures will lead to greater competition and, hence, lower prices for private businesses and consumers.
There are indeed many challenges which flow from these developments. The challenges are not only for central banks, of course: the implications of globalisation are profound for governments and business communities in all countries. Not least among these are the requirement for governments to explain to the general public the benefits which flow from these changes. Reforms associated with liberalisation typically imply a difficult transition period. The benefits of liberalisation take time to permeate through the economy, and in the intervening period some members of the community will experience economic hardship. Liberalisation can cause a significant, though temporary, dislocation of factors of production from old and inefficient enterprises (both public and private). Yet it takes time for new employment opportunities and more profitable enterprises to become apparent. All too often, the debate is captured by those who lose from the process – and, as with any evolutionary change, there always are losers. Since these tend to be concentrated, vocal and well organised, and the beneficiaries dispersed across the population, debate can be one-sided.
There is also a tendency when the economy suffers a setback to blame the process of reform, when a moment's thought should remind us that setbacks happened in the past independently of whether reforms were occurring. Small island economies of the region are currently experiencing difficult economic times. For example, Fiji is simultaneously being affected by a severe drought which has reduced sugar production, a lower price of gold, and the Asian crisis which is causing difficulty for the tourism industry. In addition, the Asian crisis has created concerns of financial distress spreading to other countries in the region. It is inevitable that some will ask, therefore, whether this is an appropriate time to be undertaking further reforms. But there never seems to be a right time to reform – we are all like Saint Augustine who pleaded ‘God, grant me purity, but not yet’.
There is a common misconception that the trend towards liberalisation and globalisation means that policy authorities have to abdicate their role completely. To the contrary – they do not abdicate their role, they change the manner in which they perform their role. They have to give greater attention to establishing the general set of institutional arrangements within which the private sector operates, rather than to directing individual decisions. This is particularly so, in my view, in the case of the financial sector of the economy. I want to spend the rest of my time making some observations about these issues.
1. Institutional Structure
A sound institutional framework is the cornerstone of sustainable and stable economic development. This is largely the responsibility of government and the public sector. An efficient legal structure combined with well-defined property rights are essential to creating the incentives needed to generate new job opportunities and encourage investment, particularly from overseas. Developing transparency in financial and business transactions is important. Transparency permits more rational decision making, particularly with regard to assessing the levels of risk associated with transactions. The adoption of internationally recognised accounting and auditing systems helps in this regard. Further, regulations are required to ensure the adequate provision and dissemination of information, either to the appropriate government organisation, or to the general public.
Increasingly, governments are understanding the benefits of enhancing both transparency and credibility of public institutions. This has been especially evident in the worldwide trend towards greater independence of central banks from day-to-day political interference. In part, this move has been driven by the growing realisation that sustained easy monetary policy does not generate greater output in the long run. Instead, easy monetary policy leads to higher inflation; when inflation is very high, this can even detract from the long-run growth rate. Eventually, inflation has to be brought back into line, and this is always and everywhere a costly process. So it is better not to let it get away in the first place.
In many developed economies, the move to greater central bank independence and more explicit recognition that the appropriate long run-goal for monetary policy is price stability, have gone hand in hand. In some instances, including Australia, this has meant the adoption of a numerical target for inflation. Central bank independence should always be counterbalanced by an appropriate degree of transparency and accountability – to Parliaments and the general public. In our case, and most others, this has been achieved. Greater transparency and, if the central bank does its job well, heightened credibility together make it easier to reach this inflation objective.
One challenge, then, for central banks of the small island economies is to maintain and enhance their independence and to defend the case for sound monetary policy. No doubt, this cause will be helped by continuing to provide thorough and professional economic analysis, and by emphasising the benefits of good monetary policy – including low inflation and a more stable real economy – that can flow from an appropriate mix of independence and accountability.
2. Monetary Policy and Liberalisation
The primary operational goal of monetary policy in small island economies of the region has been, and continues to be, a stable exchange rate. Central banks in the region generally operate a fixed exchange rate, with the level of the exchange rate pegged either to a single major currency, or to a basket of currencies based on their major trading partners. Occasionally, the level of the exchange rate peg is adjusted in response to a major shock hitting the economy.
In this area, Australia and New Zealand have taken a different route. For example, the Australian dollar was floated in the early 1980s as part of a broader package of ongoing liberalisation and reform. Our practical experience has been that this regime change has played an important role in helping to create macro-economic stability. However, like most other countries with floating exchange rates, we have found that the exchange rate can at times overshoot its fundamental level in response to large swings in market sentiment. The process of learning to live with this additional volatility has been lengthy, and at times difficult, but for Australia I believe that a floating exchange rate has been, for us, the only way to proceed.
I have not come here, however, to try to convert you to floating exchange rates. Exchange rate regime is a choice each country must make in light of its own circumstances. Small economies often have a number of characteristics which make a fixed exchange rate the more attractive regime. Firstly, small island economies are often very specialised and rely on high levels of exports and imports (as a share of total production). This means that domestic prices move closely with the prices of traded goods, which in turn depend closely on the value of the exchange rate. In this way, the exchange rate acts as an anchor, helping to stabilise the behaviour of most wages and prices in these economies. Therefore, fixing the exchange rate can be an effective way of achieving low and stable inflation in these small island economies.
The second point is that the size of these island economies tends to hinder the development of deep and liquid financial markets necessary to generate stability and reduce uncertainty. Illiquid financial markets can cause small volume transactions to result in substantial price changes. A freely floating exchange rate under these conditions could mean large and prolonged movements away from any fundamental level.
For these reasons, choice of exchange rates has tended towards fixed rather than floating. Fixed exchange rates do mean that there are issues which have to be taken into account in monetary policy, especially in a climate of global capital flows and financial liberalisation. In the case of Fiji, capital controls, which are now being gradually unwound, have no doubt helped to simplify the central bank's task of fixing the exchange rate in the past. Against this must be set the fact that openness to beneficial international capital flows can better support the development of small island economies. I am referring here to foreign direct investment and long-term capital, as opposed to very short-term flows. Countries such as Fiji typically have many profitable investment opportunities and infrastructure needs, and yet they do not necessarily generate sufficient domestic savings to support this level of investment. Financial capital from overseas can help to realise these longer-term opportunities. More liberalised trade in financial capital can also benefit domestic savers through diversification. Because small island economies are subject to large shocks, there is likely to be a substantial benefit to domestic residents holding some foreign assets in their portfolios.
At the same time, capital market opening – even for big economies – is a double-edged sword. The challenge for central bankers is to capture the benefits that come from openness to financial flows, while avoiding many of the risks associated with increased volatility caused by sharp changes in the direction of capital flows. I believe that developing countries should have the option to exclude short-term capital inflows if they think that the risk of volatility outweighs the benefits, or that these flows will place too great a strain on the balance sheets of banks or businesses. We have seen in Asia recently that large short-term capital flows into countries that have financial infrastructures that are still in the early stages of development can have devastating results. I do not know how any outside observer could look at these developments and not be uneasy about this lethal combination.
In time, when the financial infrastructure has improved, short-term capital may become more attractive again. But it takes a long time to develop a resilient financial infrastructure – most developed countries took many decades to reach their present state. I know from Australia's experience that it took us a long time. We are happy with our present position whereby there are no restrictions on international capital flows, but that does not mean that we want to impose this on other countries in different circumstances.
3. Financial Stability
The banking system should play a central role in the growth of developing countries. An efficient banking system will help to channel limited domestic savings, as well as funds from overseas, into the most profitable and sustainable business opportunities. In other words, banks provide a valuable service by transferring funds from lenders to borrowers and assessing and managing risk. This service is pivotal in small developing countries – many small and unknown businesses rely on intermediated finance to undertake investment because they cannot obtain funds directly from investors (via either issuing equity or bonds). The process of financial deregulation is intended to improve the efficiency of the financial system by allowing banks and other institutions to set interest rates and make loans on a commercial basis.
The problem is that banks and other financial institutions can and do fail, sometimes leading to instability across the whole financial system. This type of instability can cause severe downturns in macro-economic activity, and may require governments to undertake substantial bail-outs, at taxpayers' expense. The experience of many countries is that the financial system is particularly vulnerable to instability in periods following deregulation. In part, this is driven by competition for market share amongst financial institutions, which can lead to excessive risk taking. This can be exacerbated by a significant inflow of funds from overseas that typically results from capital market opening.
Here the experience of Asia over the past decade or so is fresh in our minds, and it contains some important lessons. These countries saw very large inflows of foreign capital – in some cases, in excess of 10 per cent of GDP for years on end – which undoubtedly helped to fuel their rapid growth. But the quality of the lending and investment that those inflows supported was in many important instances found lacking. As asset prices rose and corporations and banks became more highly geared, the financial systems of these economies became fragile and were unable to withstand the panic when the footloose foreign capital wanted to leave in a hurry. The ensuing fallout has exposed inadequacies in the institutional structure in these financial systems very clearly. Unhedged foreign currency borrowings by banks and corporates; unduly close relationships between banks, corporations and governments, investment undertaken without due regard to likely return on capital – these provided an environment which, while certainly not causing the panic, did leave the system unable to cope once the panic came. The result has been a very costly adjustment for these societies, and loss of reputation for their policy authorities.
Earlier experience in Australia also showed that the transition to a deregulated and open financial market is not without its difficulties. The knowledge and quality of staff are important, particularly those making lending decisions in the private sector and those working in the central bank as regulators and supervisors. Lack of experience is always going to be a constraint when a country first deregulates its financial system and opens itself up to financial capital flows. Attention to the strength of supervisory and regulatory systems is essential.
A key challenge of central banks in small economies, therefore, is, as they seek to pursue the benefits of capital market liberalisation, at the same time to strengthen their capacity for maintaining financial system stability. Fortunately, a lot of international experience has gone into developing broad principles for supervision of financial systems, and we have the benefit of the so-called Basle Core Principles. For many small economies in the Pacific, of course, a significant share of the banking system is accounted for by foreign banks, whose global operations are subject to oversight by their home country regulators. There are, nonetheless, some domestically owned banks in the islands, and even where the entire banking system is foreign owned and supervised, the authorities have to satisfy themselves that the local operations of the banks are being run prudently. A foreign bank will probably not be allowed by its parent to fail, but it could still be a source of considerable instability in a small economy.
There is not time to dwell at length on these questions, though we may mention a few. Issues such as the legal framework – making sure the central bank or other supervisor has the power to license the operations of banks (and possibly other financial institutions). This means being prepared to say no to some of the less reputable operators who try to obtain a banking licence from the island economies and to use this ‘seal of approval’ elsewhere. I regret to say that some of these operators have been known to come from Australia. The bank supervisor also needs the power to obtain information from individual financial institutions and the capacity to act in times of crisis. Minimum credit standards for banks making loans are needed, and some capacity to ensure that banks comply with these standards.
One of the critical requirements, and one of the most difficult for small economies, is that staff who work for the central bank, and those who work in the private sector, be adequately trained, and upgrade their skills through time. Indeed, it is true to say that there is at present a worldwide shortage of bank supervisors. Foreign financial institutions locating domestically can help in this regard by bringing in their own expertise. The island central banks with which I am familiar have always seen the importance of developing staff skills, so I am saying nothing new here. In general, however, I simply offer the observation that in the past decade, it is in this area of supervision and financial stability that it seems central banks have most quickly suffered damage to their reputation. This is a risk which exists even in regulated financial systems, but it seems to me that the risks are heightened under conditions of globalised, and liberalised, markets. This risk is not a reason for not proceeding down the liberalisation path, but it is something central banks have to contend with.
The challenges for all central banks, then, are many in the globalised world. We do not have, nor should we seek, the option of turning our backs on these trends – they will affect all of us whether we like it or not. The trends bring the odd pitfall, but they also bring tremendous opportunities for our citizens. We need to be careful to avoid the traps, so that we can enjoy the benefits.
On behalf of all your colleagues at the Reserve Bank of Australia, I would like to congratulate the Reserve Bank of Fiji on its 25th Anniversary, and to wish you well in your next 25 years.