Reserve Bank of Australia Annual Report – 1978 The Economy and the Reserve Bank

The Environment for Policy in 1977/78

The news on the Australian economy was mixed in 1977/78. Growth in output was lower, unemployment rose further, and the deficit in the balance of payments of the private sector in the early part of the year was large. But there were also bright spots. Inflation and the growth in nominal earnings slowed, and final spending on goods and services maintained a fairly solid growth.

During the first half of 1977/78 final spending, except on dwellings, expanded firmly but a substantial shedding of stocks on the one hand, and a marked fall in farm output on the other, held back the growth in total product. With private consumption and business fixed investment a little stronger, and an apparent ending of the downturn in farm output, there seems to have been a slightly better overall growth performance in the second half of 1977/78. But, for the year as a whole, total product grew a good deal less than in the previous twelve months, and at about half the average rate of the last decade.

Domestic economic activity was helped in 1977/78 by changes in the current account of the balance of payments. Against the background of subdued international trading conditions, the quantity of goods and services exported was not much greater than in 1976/77 but, with the effects of the November 1976 devaluation coming through in the first half, imports of goods and services were noticeably lower than in the previous twelve months.

The modest growth in output was associated with virtually unchanged employment. Within the total, higher employment in the public sector offset a further decline in private employment; there was modest growth in part-time employment. After several years of quite strong growth, there appears to have been little further change in numbers self-employed in 1977/78. Output per head grew more slowly than in 1976/77. Unemployment rose again in 1977/78. The increase seems to have been concentrated in those looking for full-time employment; unemployment among both males and females looking for part-time jobs was much less affected.

1 Economic Indicators

Inflation, although still high, moderated further in 1977/78, to a level near the average for the world's major industrial countries. In both halves of the year, domestic price increases were at single digit annual rates. Growth in average wages and salaries moderated in 1977/78, but real earnings held firm. Corporate incomes grew a good deal faster than prices, but the corporate share of total income, while showing some recovery, remained low.

Despite progress, a number of the problems and imbalances in the Australian economy were only partly corrected by the end of the year. Some of these are looked at in more detail later. Their resolution appears to require further adjustments to relative incomes and prices, and is unlikely to be quick or simple. Their existence has greatly added to the complexities confronting monetary policy.

Monetary Policies

Apart from seasonal elements, monetary conditions in Australia during 1977/78 mainly reflected:

• a further large Commonwealth deficit;
• a considerable private sector balance of payments deficit;
• another large take-up of government securities by the non-bank private sector.

The net of these three factors, together with movements in Reserve Bank and other bank balance sheets, produced a year of mostly restrained growth in the conventional monetary aggregates. The full-year increase in M3 of 8 per cent — the lowest since 1970/71 — was generally in accord with the strategy of achieving monetary growth in 1977/78 a notch or so lower than in 1976/77. However, growth in M1, at 8.5 per cent, and in domestic credit, at about 11 per cent, in 1977/78 were both much the same as in the previous financial year. Wider monetary measures also grew faster in 1977/78 than the M3 measure which tends to be the more common focus of attention.

2 Financial Indicators

Monetary and financial conditions were unusually tight in the early months of 1977/78, with pressures coming from both a growing private sector balance of payments deficit, and an increased appetite for bonds. With some evidence of a more moderate rate of inflation, expectations had emerged late in 1976/77 that the next move in interest rates was likely to be downward; the demand for government securities had strengthened, with strong support for the Commonwealth loan in May. Treasury note yields were shaded down on 1 July. The Bank was approached to make sizeable sales of bonds early in the new financial year. Subscriptions to the July Commonwealth loan — which carried substantially unchanged interest rates — were very large, particularly from the non-bank sector.

The Bank's policy was to seek to maintain conditions which kept the overall provision of finance at a level consistent with sustainable growth in economic activity while bearing down on inflation. While adhering to that policy, the Bank took some actions to prevent financial conditions in these months from becoming unduly stringent. The Statutory Reserve Deposit (SRD) ratio of the major trading banks was cut by a percentage point on 1 July. On 9 September, there was a further cut of 1.5 percentage points, of which 1 percentage point went to increase banks' free liquidity, and the remainder to replenish banks' Term and Farm Development Loan Funds. There were also substantial short-term borrowings by eligible institutions from the Reserve Bank, and these helped to smooth periods of particular tightness.

Finance for housing was the focus of some attention early in the financial year. Dwelling construction had risen at an unsustainable pace from mid-1975 through much of 1976, and substantial stocks of unsold dwellings had built up in a number of states; subsequently, the rate of private dwelling construction had begun to fall away. The Bank made it clear to savings banks and building societies that it was not seeking restraint in their lending for housing. Within a general climate of encouragement, it was for individual lenders to determine their lending in the light of their particular balance sheet positions, and their assessment of the housing situation in their areas of operation. Other institutions were also made aware of this policy towards lending for housing.

The heavy demand for bonds following the July loan put downward pressure on yields, and the Bank raised its bond prices, especially at the longer end, from early September. The Bank, although rationing in the face of heavy bids, made substantial sales of bonds from its portfolio at this time.

The Commonwealth's Budget, brought down in mid-August, aimed at a deficit of about $2.2 billion but, mainly through a shortfall in receipts, the full year figure was about $3.3 billion, nearly $0.6 billion greater than in 1976/77. The deficit of the public sector as a whole — including state and local and semi-government authorities — seems to have been around $5.5 billion in 1977/78, a little over $1 billion greater than in 1976/77.

The task for monetary policy of moderating the potential monetary stimulus from the Commonwealth's deficit appeared formidable. In the event, the private sector's net purchases of foreign currency, and of government securities, were such that the task for the monetary authorities became at times more one of taking care to avoid excessive stringency than of pressing strenuously to secure restraint. But purchases of foreign currency and government securities by the private sector, while working towards desired monetary restraint in 1977/78, both have limitations. Monetary policy cannot rely indefinitely on losses of funds abroad and, should expectations of improved price performance fade, views about security yields could change quickly.

With monetary conditions relatively tight in the months following the Budget, it was judged appropriate for the Commonwealth to forego a cash loan in October, and to offer only a conversion loan to handle maturing securities. Yields on medium and long bonds in the conversion loan were about 0.2 of a percentage point lower than in July. This modest shading, together with the fall in inflation suggested by the September quarter consumer price index, further whetted the appetite of asset holders for government paper; sales from the Reserve Bank's portfolio, in response to heavy demand, were substantial in mid to late October. The rate on Australian Savings Bonds, which had been attracting a considerable volume of funds, was cut by 0.25 of a percentage point in mid-October, and by a further 0.5 of a percentage point, to 9.25 per cent, in mid-November. Treasury note yields were adjusted downwards slightly again in October and November, though the falls in bond yields acted to enhance the relative attractiveness of notes somewhat as the year wore on.

The tight conditions in financial markets reflected in the intake of funds by financial intermediaries. The relatively large take-up of government securities by the non-bank private sector put pressure on the banks. Confidence in some building societies was disturbed towards the end of September, when a substantial Queensland society was placed in the hands of an administrator, and by mid-October the building society situation in Queensland had deteriorated seriously. The authorities reminded the community of the continuing policy that sound, well-managed societies could look with confidence to the commercial banks for support through temporary liquidity difficulties. This would be against the background of Reserve Bank support of liquidity of the banking system. The bankers of one large Queensland society made available, with the support of the Bank, a substantial line of credit to that society. Confidence was fairly quickly restored, and the intake of funds by societies returned to more normal levels towards the end of 1977. In the wake of these events, the Commonwealth Government foreshadowed a proposal for a deposits insurance scheme to strengthen building societies and protect depositors. Work is proceeding on this matter.

3 Volume of Money Contributions to Change

(half-yearly — not seasonally adjusted)

The terms of Reserve Bank guidance to trading banks on lending were interpreted more liberally in the early part of 1977/78; however, with trading bank advances rising strongly during the six months to December, banks were told subsequently that the pace of their lending could not continue unchecked. Lending guidance to trading banks over this period came to focus more on net new limits, i.e. new overdraft approvals net of cancellations and reductions, rather than on gross approvals as previously, though still in the setting of a desirable rate of growth in bank credit outstanding.

Several other actions in the first half of 1977/78 touched on institutional lending. In October, the Government announced a number of steps to assist small business. The Bank drew the attention of the major groups of financial institutions to the Government's wish that adequate finance be available for small business. Subsequently, the role of the Commonwealth Development Bank was expanded to enable it to lend to all sectors of business. In November, legislation was passed to provide for an institution which, by refinancing loans made by banks and other lenders, is designed to help the provision of longer-term credit to primary producers. The new institution, under the name Primary Industry Bank of Australia, is scheduled to begin operations early in 1978/79.

Generally restrained demand for large institutional loans for investment purposes led to review of the request, made towards the end of 1976, that financial corporations moderate the growth of their lending. In late 1977, the Bank told finance companies, and money market corporations, that there were no longer any specific suggestions it wished to make, from the point of view of monetary policy, about the pace of growth in their lending.

Payment in November of the first instalment of company tax, under the re-introduced quarterly arrangements, dampened what was already a comparatively subdued seasonal run-up in private sector liquidity. While this change also helped to reduce the extent of the seasonal rundown in the final months of the year, that prospective run-down nevertheless still seemed likely to be large; in discussions with institutions the Bank mentioned a concern that they may have been insufficiently aware of the need to prepare for the financing task to come. With yields on government securities falling, and widely expected to fall further, the appetite of institutions for longer-dated paper was tending to cause a neglect of investments more closely related to seasonal needs. There was fairly sustained pressure on the Bank to sell bonds through December and January; the Bank heavily rationed its sales of all but the shortest maturities. A subscription of $150 million to a special issue of Commonwealth securities for defence purposes in January helped replenish the Bank's portfolio of bonds in some maturities, which had been reduced by the continuing demand.

The Government early in 1978 asked the Bank to hold discussions with the banking system regarding bank interest rates. This was in a situation where there had been reductions in government security yields, including the rate on Australian Savings Bonds, and in some private sector rates. The Government indicated that it had judged that some reductions within the structure of interest rates of the banking system should now be feasible. Maximum rates on overdrafts of less than $100,000 had been cut by 1 percentage point in February 1976, but other comparable interest rates had not moved commensurately at that time. With discussions taking place between state authorities and building societies and other financial institutions within the sphere of state government influence, savings and trading banks in February agreed to drop by 0.5 of a percentage point the interest rate on new, and virtually all existing, loans to individuals for owner-occupied housing. Interest rates on savings bank investment accounts, and on small short-term fixed deposits with trading banks, also came down 0.5 of a percentage point. Rates paid and charged by building societies generally followed suit. Although the timing of these reductions varied a little between institutions, and in some cases between states, the adjustments to housing interest rates were substantially completed by the end of March.

While the discussions on interest rate reductions were taking place, the Australian Savings Bond was temporarily withdrawn from the market. The security was re-issued on 15 February, with the interest rate cut by a further 0.25 of a percentage point to 9 per cent. As a contribution to the management of the seasonal swing in liquidity, no cash loan was offered by the Commonwealth in February. The conversion loan announced on 10 February carried rates which were 1 percentage point lower at the long end, tapering to 0.75 of a percentage point lower at the short, than those on comparable maturities in October. Rates on private fixed interest issues also came down. Rates on one or two issues of this type had fallen by about 0.5 of a percentage point in November; in December and January there were more substantial falls, of a percentage point or so, on most issues of longer-dated securities.

Towards the end of January, the appetite of the non-bank sector for bonds eased and, partly as a result, the intake of funds by banks grew. Nevertheless, the relatively small run-up in aggregate liquid assets and government securities (LGS), and the large proportion in non-bank hands, meant that bank liquidity was constrained. Banks began to seek funds more actively in March, and rates on bank certificates of deposit, and large fixed deposits, edged up.

The seasonal run-up in primary liquidity (LGS plus SRD) of the private sector in 1977/78 was only about half as large as in 1976/77. As a timely step to ensure that the subsequent transfer of funds to the government was handled in an orderly fashion, and without any change in underlying monetary and banking policy, the SRD ratio was reduced by a percentage point on 3 April, in anticipation of heavy provisional tax payments. Banks were made aware that the lending guidelines would take account of seasonal pressure, and that they would be able to respond to genuine demands for funds.

The early weeks of the seasonal downturn in April passed smoothly in financial markets, with only seasonal increases in short-term interest rates. In anticipation of heavy company tax payments, the SRD ratio was cut by 1.5 percentage points to 4.0 per cent on 3 May. Again no alteration to underlying monetary and banking policies was involved.

With publication of the favourable result for the March quarter consumer price index, buying interest in government bonds strengthened late in April. The Commonwealth conversion loan announced on 9 May carried short yields unchanged from those offered in February, and long yields a little lower at 9.1 per cent. Although the supply of long bonds available to the market was supplemented by a substantial conversion of maturing securities, buying interest remained. With the liquidity rundown abating, and no official trading of significance, long yields were marked down below the 9.1 per cent offered in the loan. Subsequent testing sales by the Bank, in response to substantial offers to buy, saw long yields firm a little in late May through early June. However, demand for medium/long bonds was lower from the middle of June; yields remained steady.

As 1978/79 began, the Bank's policy continued to be to provide for a level of financing which allowed adequate availability of funds to underwrite recovery in activity while, at the same time, contributing to a further reduction in inflation.

External Policies

The main features of Australia's balance of payments in 1977/78 were:

• a private sector deficit which was very large in the September quarter but diminished greatly later in the year;
• a partially offsetting surplus in government transactions, reflecting a substantial programme of official borrowing abroad.

With a sharp worsening in the terms of trade offsetting volume movements, the value of imports grew faster than that of exports in 1977/78, leading to a smaller trade surplus. With further growth in the net deficit on invisibles, the deficit on current account was nearly one-quarter greater than in 1976/77. Apart from retained earnings, there was a net outflow of private capital; there was also a net outflow of capital from marketing authorities' transactions. After government loan raisings abroad, the overall balance of payments deficit was slightly over $0.5 billion.

Following the devaluation of November 1976, some restraints had been introduced on overseas borrowings to help maintain firm control over domestic monetary conditions. By the middle of 1977, net private capital inflow had diminished substantially. In early July, the embargo on short-term borrowings reverted to apply to borrowings for less than six months, and the variable deposit requirement applying to certain borrowings of two years or more was suspended. The limits for exemption from the borrowing controls were raised.

There were no changes in the trade-weighted exchange rate for the Australian dollar between mid-February and July 1977 — a period during which strengthened controls on overseas borrowings were in force. With reserves falling sharply, on 3 August the trade-weighted value of the Australian dollar was reduced by 1.5 per cent. Following this devaluation, the “group of three”, operating in terms of the arrangements announced by the Treasurer in November 1976, effected more frequent small adjustments to the trade-weighted exchange rate. After an initial small appreciation, the trade-weighted rate was moved down fairly persistently through the year, except for a temporary pause in late April 1978. With unsettled conditions in foreign exchange markets, and a sharp weakening of the US dollar against the yen and, to a lesser extent, most other major currencies, the Australian dollar was not allowed to appreciate against the US dollar to the full extent that would have occurred if the trade-weighted value of the Australian dollar had been held constant. Over the year, the Australian dollar was devalued against the trade-weighted basket by a net 6.8 per cent; its value against the US dollar appreciated by 2.9 per cent.

Uncertainties over much of 1977/78 about likely movements in international currency values led to a good deal of activity in forward exchange markets. This reflected in increased demand for cover by Australian traders, with demand by importers predominating.

4 Australia's Exchange Rate and Balance of Payments

In September 1977, reserves were bolstered by the first instalment of funds raised in the context of the Government's overseas borrowing programme to support the balance of payments through temporary difficulties. The Treasurer had announced in August a US$200 million Euro-bond issue (subsequently increased to US$250 million) and foreshadowed further borrowing during the year. On 27 September, an expanded programme of overseas borrowings and facilities was announced, amounting in all to some $1.7 billion. Included in this amount were two placements, each of US$100 million, with the Reserve Bank by the Bank for International Settlements (BIS), and a twelve-month standby facility (undrawn) with that institution for a further US$200 million. The two BIS placements were each renewed for a further six months in late March/early April 1978.

This borrowing programme was completed with a Euro-market operation at the end of March. However, in February the Treasurer, commenting on the external situation, had noted the role the Government saw for official capital raisings, and had added that the Government would not hesitate to raise whatever additional funds might be necessary to insulate the Australian dollar from pressures that could arise from short-term fluctuations in the level of international reserves. There were two further official raisings abroad, in May and June.

Overall, new borrowings overseas by the government in 1977/78 totalled about $1.8 billion, excluding the BIS arrangements with the Reserve Bank. Repayments of government overseas debt totalled about $148 million during the year and there was, in addition, a part repurchase — equivalent to $92 million — of Australia's 1976 drawing under the Compensatory Financing Facility of the International Monetary Fund (IMF).

Reserves were affected by several other measures during 1977/78, including two relating to gold. In August, the basis on which the Reserve Bank valued its gold holdings was changed to the monthly average of current prices in the London gold market. This revaluation had the effect of adding $0.7 billion to the published value of Australia's reserves. There was also a minor addition to gold holdings in December from the 1977 instalment of Australia's share of the restitution to members of one-sixth of the gold holdings of the IMF. At the end of February, as part of Australia's obligations to the IMF, holdings of Special Drawing Rights were reconstituted through the purchase of SDR 100 million in exchange for US dollars.

Among the measures affecting the balance of payments during the year were several actions to protect some sections of Australian industry. Quotas on passenger motor vehicle imports, designed to keep 80 per cent of the market for Australian manufacturers, were reimposed in July 1977, and protection for textiles, clothing and footwear was increased during the year.

The Government, in June, changed some aspects of the foreign investment guidelines to allow companies which are largely foreign owned, but with a minimum 25 per cent Australian equity, to proceed more easily with their investment plans. The Government also raised the thresholds at which proposals become subject to scrutiny under foreign investment policy. In addition, the embargo on overseas borrowings for less than six months was suspended. These changes will tend to facilitate foreign investment in Australia.

There was a substantial net inflow of private capital in the second half of 1977/78, apparently largely of a short-term nature, and related to trade financing and, perhaps, end-of-year tax payments. A number of longer-term projects likely to involve substantial capital inflow are in the pipeline, but time lags are lengthy in most cases.