Reserve Bank of Australia Annual Report – 1979 The Reserve Bank and Economic Policy in 1978/79
Monetary Policy
Summary
In its conduct of monetary policy during the year, actions by the Bank were directed at pulling back the expansion of money and seeking to contain the development of too much ease in financial conditions.
Demand for all but the shortest Government securities dried up after October; with many bondholders trying to reduce their portfolios, the Bank limited its purchases of bonds and sought, for much of the period unsuccessfully, for opportunities to renew its sales. The trading banks operated throughout the year under moderately restrictive lending guidance, and a watchful eye was kept on the pace of lending by other major institutions. In the second half of the year the Bank initiated moves to have some of the Australian Wheat Board's financing requirements diverted from the Rural Credits Department to private lenders. It also made calls to Statutory Reserve Deposits (SRDs) to restrain growth in trading bank free liquidity.
The outcome was growth in M3 of 11.8 per cent, compared with 8 per cent in 1977/78; M1 grew by 16.7 per cent, compared with 8.6 per cent the previous year. The expansion of domestic credit (the change in M3 plus the deficit on private external transactions) was 12.4 per cent, a little more rapid than in 1977/78. After declines in the first few months of 1978/79, yields on official securities increased during the second part of the year.
The year in detail
After July, private holdings of LGS (which comprise cash, free deposits with the Reserve Bank and Commonwealth Government securities) increased quite quickly. Compared with the corresponding period of the previous year, the greater early strength of the run-up in 1978/79 reflected a considerably reduced loss of funds externally and, notwithstanding a collection of company tax in August 1978, a slightly bigger Government deficit.
In mid August the Commonwealth offered a cash and conversion loan; this was its first public cash loan since July 1977. Yields offered were 0.1 of a percentage point below those in the conversion loan of May 1978. The issue yield on 26 week Treasury notes was also reduced. Savings Bonds Series 12 was introduced with an interest rate unchanged from that on the previous series.
Response to the loan was strong: total subscriptions came to $780 million, well above the previous high in July 1976. The value of subscriptions coming from non-bank groups, with the authorised dealers and money market corporations prominent, was $576 million, also a record. The bulk of subscriptions was in the medium and long stocks.
Apart from its being the first cash loan in some time, the heavy subscription to this loan probably reflected a favourable reaction in money markets to the Budget which was brought down while the loan was open. In the wake of the Budget, the community had enhanced expectations that inflation would continue to decline and saw prospects of further early reductions in bond yields.
The 1978/79 Budget envisaged an aggregate deficit of $2,813 million and a domestic deficit of $1,669 million; these were about $520 million and $780 million lower than results for the corresponding aggregates in the previous year. Although it appeared that the projected lower domestic deficit would ease somewhat the job of containing monetary growth during the year, the implied financing task was substantial.
Because of large subscriptions to the August loan (spread into September by use of the instalmentfacility), coincident payment of company tax and continuing net purchases of Government securities from the Bank, money markets tightened late in August. After having fallen in July, private short-term interest rates rose to a slightly higher level for a couple of months. Over September/October, the Bank made sizeable net sales of bonds, mostly to the banks and official money market dealers and mostly of shorter securities; with demand strong, bond prices were raised a little.
Terms of a Commonwealth conversion loan to handle a mid-November maturity were announced at the end of October; the Government decided not to have a concurrent cash loan. Once again, yields offered were lower than in the previous loan, with the rate on medium and long bonds 0.2 of a percentage point lower at 8.8 per cent. The issue yield on 26 week Treasury notes was also moved down slightly. Series 13 of Australian Savings Bonds was introduced with an interest rate of 8.75 per cent, a quarter of a percentage point lower than that on Series 12.
At the beginning of November, the trading banks announced reductions in some interest rates; these moves extended to other areas the reductions which had been made by banks to rates on their housing loans in February 1978. Over the early months of 1978/79, issue yields on certificates of deposit and interest rates on large fixed deposits with the banks had come down a little. In addition, finance companies and money market corporations had been trimming their rates. In this context, the trading banks announced reductions of half a percentage point in rates applying to overdrafts drawn under limits of less than $100,000 and to new term and farm development loans of less than $100,000. Rates on larger loans, which are negotiated between banks and their customers, subsequently tended to decline as well. The banks also reduced the highest interest rates charged on new personal instalment loans.
Later in November, at the request of the heads of the Commonwealth and State governments, the Bank initiated discussions with banks and permanent building societies directed toward further reductions in a number of deposit rates and rates on housing loans. Contingent on similar moves by building societies, banks undertook to reduce by half a percentage point the interest rates on most existing loans, and on the generality of new loans, to individuals for housing. Rates on investment deposit accounts with savings banks would also be reduced with some flow-on to small fixed deposits with trading banks. Subsequently, the Bank participated in talks with the building societies and over the next month or so, after consultation as necessary with their State governments, most announced reductions, similar to those made by the banks, in their lending and borrowing rates.
Housing finance received close attention in 1978/79. In his Budget Speech, the Treasurer said the banks and building societies were being reminded of the Government's desire that they lend to homeseekers to the maximum extent. He also announced that, to expand savings banks' capacity to lend for housing in 1978/79, the proportion of their deposits required to be held in public securities and liquid assets would be cut from 45 to 40 per cent; and that, as a longer term measure, the present method of controlling the investment of savings banks' funds was being reviewed with the intention of giving them more flexibility in determining the composition of their assets. Lending levels would, of course, remain subject to lenders' own commercial judgements.
3. FINANCIAL INDICATORS
Amounts of new finance approved for housing by the banks and permanent building societies increased strongly through much of the year. New construction responded after the September quarter; there were also rapid rises in some prices in the housing sector. The effect on activity of large additions in available finance was the less because of the continued strong preference of borrowers for established dwellings as well as some residual influence of unsold stocks due to over-building in previous years. Demographic developments have reduced the required rate of expansion in Australia's housing stock.
The strong growth in private holdings of LGS was interrupted in November, when, due mainly to the second instalment of company tax, liquidity contracted slightly. The rise in LGS over the December quarter as a whole was only half that in the previous three months. Despite this less rapid expansion, the state of money markets was comfortable and private short-term interest rates declined again.
From this time, the previously strong appetite of the private sector for Commonwealth securities virtually disappeared for several months; some relevant factors are mentioned in the chapter on financial markets. After the announcement of the terms of the November conversion loan, the Bank became for a brief period, and reluctantly, a fairly heavy net purchaser of bonds. Private holders were much more prepared than in some previous times to quit bonds to make tax and other payments, and most private holders of the maturing stocks chose to redeem rather than convert. Cumulative take-up of Commonwealth securities by non-bank groups was $800 million for the four months to October but, following reductions in portfolios over November/December, their cumulative take-up for the first half of 1978/79 came to below $400 million.
In December, the yields at which bonds were traded between private participants in the market began to rise above the levels at which the November loan stocks had been issued. The Bank was buying only very short bonds to meet the community's immediate needs for liquidity and refrained from purchasing other bonds which were offered from time to time. It also declined to engage in transactions to help holders of long bonds switch to shorter securities. For a brief period late in January and for part of February, the Bank tested the strength of the selling pressures in the market by buying some of the bonds offered to it. Purchases by the Bank were for this short period substantial; some increase in trading yields was accepted, moving these toward rates at which non-official transactions had been occurring. Holders remained more prepared to sell than to buy.
From the middle months of the financial year, the Bank was able to sell little beyond the shortest stocks at ruling yields. Treasury notes were in demand, with the banks heavy purchasers. The Bank effected some of these sales by tender.
The rise in market yields on securities was reflected in terms for medium and long bonds issued in a conversion loan in mid February; the long rate was 9 per cent, the same as that offered in August.
In announcing the terms of the conversion loan, the Treasurer noted that the Bank had for many years been trading in Commonwealth bonds on and off stock exchanges and that, in recent years, the volume of such transactions had grown considerably. This already involved some elements of similarity to a “tap” issue system. He said that the Bank would continue to engage in bond market transactions which had elements of a “tap” operation. Similarly, the Bank's transactions in Treasury notes from its own portfolio would continue to involve elements of tendering. The Treasurer said further that the Government had for some time been considering the present system for marketing Commonwealth securities and would be bringing forward certain proposals in that regard for the consideration of the Loan Council. At meetings in April and June the Loan Council made some decisions which are described briefly on page 28.
Despite the increases, little trading was done at the yields announced for the February conversion loan and rates in non-official trading moved up further. Reflecting the market's strong preference for very short securities, the closing stages of the run-up in liquidity saw demand directed almost entirely to Treasury notes. In contrast, there was some further quitting of bonds, other than Savings Bonds for which subscriptions picked up modestly after December.
Sales of Commonwealth securities to non-bank groups in the March quarter were insufficient to have any significant impact in restraining the fast growth in monetary aggregates. In this period, liquidity and money were boosted by a very large injection of central bank money in rural credits advances, while the deficit in the private balance of payments provided an offset smaller than in earlier months. The rural credits advances added a net $940 million to liquidity in the March quarter, largely as a result of loans to the Wheat Board to finance payments to growers for the record crop; the Wheat Board's requirements were the higher as a result of the Government's decision in November, when the crop was forecast to be much smaller, to raise the size of the Wheat Board's first advance per tonne. The Government's deficit, although it looked on a trend basis to be running ahead of the Budget projection for the year as a whole, was further reduced in these months by higher collections of personal income tax resulting from the surcharge introduced in the Budget, as well as by the third instalment of company tax.
Since early 1978, the Bank's lending guidance to trading banks has paid particular attention to the level of net new overdraft approvals and the rate of growth in total advances outstanding. In the seasonally tight period around the start of the financial year, the average weekly rate of net overdraft approvals was high, but it declined over subsequent months before picking up again during the second half of the year. From time to time during the year, the banks were reminded of the need to leave scope for this seasonal expansion in demand for finance. They were also told of the Bank's wish that the pace of lending in forms other than overdrafts, and their more general facilitation of lending, should not be inconsistent with policy expressed in the guidance on aggregate advances outstanding. Outstandings rose strongly in the first half of 1978/79 but, over the subsequent six months, expanded at a considerably slower pace.
4. VOLUME OF MONEY: CONTRIBUTIONS TO CHANGE
In September, the Bank had reduced the SRD ratio of the major trading banks by half a percentage point (to 3.5 per cent) to enable them to transfer about $90 million to theirTerm and Farm Development Loan Funds. In January, with lending buoyant, and free liquidity relatively high, the Bank raised the ratio by one percentage point. In taking this action, a particular concern of the Bank was that lending by financial institutions should not be more rapid than was required to meet the needs of the economy for finance. It raised the ratio by a further percentage point in March.
In its regular meetings with the major groups registered under the Financial Corporations Act, the Bank reminded them also that policy called for restraint in their lending. In a context of buoyant lending, some groups were encouraged, where they had surplus funds, to adjust interest rates rather than seek to increase lending further.
Though the onset at the end of March of the tax season was expected to bring some firming in financial conditions, the Government and the Bank were concerned about the rapid underlying pace of growth in the monetary aggregates; strong growth during the first quarter of 1979 had taken the expansion in M3 over the twelve months to March to about 11.5 per cent. The Bank had been seeking to make sales, where possible, of Government securities; any such transactions were at yields above those in the February conversion loan and were of very short securities; net sales of securities to non-banks were negligible. The Bank was still restricting its purchases to short-dated securities. Early in March it was announced that the Wheat Board would be issuing commercial bills to reduce its indebtedness to the Bank's Rural Credits Department. With a view to restraining the growth in financial aggregates, the authorities early in the June quarter acted to tighten conditions further than was expected from seasonal forces alone. The issue yields on Treasury notes were raised by almost 0.7 of a percentage point, matching the rise in yields at which notes were trading in the market. The Government issued a new series of Savings Bonds with an interest rate of 9.25 per cent, half a percentage point above the rate on the previous series; as well, the maximum permissible individual holding of Savings/Special Bonds combined was raised. At the same time, maximum rates on borrowings by local and semi-government authorities were lifted; with rates in secondary markets rising, some of these authorities had been having difficulty in completing their borrowing programmes at the ruling maxima for new issues. Arrangements were also made for the Wheat Board to refinance another $300 million of its advances from the Bank by issuing commercial bills; in total, bills amounting to $455 million were eventually accepted by the banks and placed with other private lenders.
Following market developments, interest rates for a conversion loan in May were once again above those for the previous loan; the issue yield on long bonds was 9.7 per cent. Later in May the Treasurer announced measures to cut Government spending in 1979/80 and to protect revenue, until decisions were taken about the August Budget, against reductions which would otherwise have occurred. Early in June the Bank raised the yields at which it was prepared to sell the stocks it acquired in the May conversion loan by from 0.25 of a percentage point for the shortest maturity to almost 0.4 of a percentage point for the longest.
While total non-official demand for Government securities stayed subdued over the closing months of the financial year, take-up by non-bank groups strengthened. Perhaps reflecting uncertainty about future economic and financial developments, purchases were mainly of short bonds; purchases of Savings Bonds also increased.
External Policies
Australia's deficit on private external transactions in 1978/79 was about $250 million. As well as being considerably below the deficit of $1,200 million recorded the previous year, this figure was the net result of a substantial strengthening in the balance on private transactions between the first half of 1978/79 and the second, when a sizeable surplus occurred. With public sector transactions, including a programme of borrowing by the Commonwealth, the overall deficit on the balance of payments was about $130 million for the year. Including valuation changes and other adjustments, Australia's international reserves at the end of 1978/79 were $660 million higher than at the beginning.
The exchange rate and Commonwealth borrowing
The major elements in Australia's external economic policy in the past couple of years have been a flexible approach to managing the exchange rate for the Australian dollar and a programme of Commonwealth borrowing overseas pending a return of private capital inflow to more normal levels.
The calendar of official actions on page 17 includes information on the overseas borrowing by the Commonwealth during 1978/79. Gross borrowing came to about $1,560 million and repayments to about $210 million; corresponding figures for 1977/78 were $1,760 million and $150 million. The need to raise loans to maintain reserves abated swiftly in the second half of 1978/79, and only about one-third of the year's total borrowing occurred in that period, with no borrowings received after early April. As a proportion of gross domestic product, Australia's outstanding official debt overseas is now about 5.5 per cent, which, despite recent fast growth, remains low by international and past Australian standards.
In the early months of 1978/79, the exchange rate of the Australian dollar against the trade-weighted basket of currencies was lowered in small and frequent adjustments.
This gradual depreciation occurred against the background of great turbulence in foreign exchange markets overseas, when the effects on the U.S. dollar of the still large current account deficit of the United States were exacerbated by very heavy flows of short-term capital. Between end May and end October 1978 the U.S. dollar depreciated sharply against most other major currencies.
5. EXCHANGE RATES AND BALANCE OF PAYMENTS
The United States on 1 November announced a package of measures to support its dollar which subsequently rose strongly against other currencies. In the second half of 1978/79, the U.S. dollar remained stronger than it had been during the period to November and, despite increases in oil prices, exchange markets were generally more settled.
The trade-weighted exchange rate of the $A moved within a relatively narrow range in the second half of the financial year. As a result, the $A underwent a net depreciation against the U.S. dollar over this period but appreciated against the Japanese yen.
During 1978/79 as a whole, the $A was devalued against the trade-weighted basket of currencies by a net 3.6 per cent; this compared with a decline over 1977/78 of 6.8 per cent.
In these two years, changes in the exchange rate were small and frequent; although some increases occurred, the net effect until the latter part of 1978 was to produce some depreciation in the average value of the $A. This was the outcome of a pattern of management designed to prevent the build-up of destabilising expectations that could develop under a less flexible exchange rate regime.
The Government's use of borrowing while the balance of payments was for a time weak allowed a good deal of the pressure on the balance of payments to be absorbed through sales of foreign exchange from official reserves and thus reduced the need for adjustment in the exchange rate. An unduly large adjustment would have been inappropriate in the light of the improvement in Australia's international competitiveness following the currency depreciation which had already occurred and Australia's better record on inflation in recent years; it would also have added to inflationary pressures.
In the second part of 1978/79 the trade balance improved; buoyant rural output, improved terms of trade and enhanced competitiveness were features of the year. In addition, private capital inflow strengthened markedly in the closing months of 1978/79.
Other influences on international reserves
Some other decisions affected the composition of Australia's balance of payments and the level of its international reserves during 1978/79.
In terms of guidelines established at a meeting in June, 1978, the Loan Council in November approved a supplementary forward programme of special additions to normal borrowing programmes of semi-government authorities for the provision of infrastructure. In terms of these guidelines, the Loan Council may in certain circumstances allow authorities to borrow overseas and $143 million was so raised by State authorities in 1978/79.
In December, as part of the programme of restitution to members of part of the Fund's gold stocks, Australia repurchased a quantity of gold from the International Monetary Fund. The effect was to increase the Reserve Bank's gold holdings at market value by about $25 million and to reduce Australia's reserve position with the IMF by $5 million. In January, there was an allocation by the IMF of Special Drawing Rights, adding $93.5 million to Australia's reserves; this was the first allocation in a series of three of about equal size planned by the Fund over 1979–1981.
Australia's reserves were reduced in April when half of a maturing placement of US$100 million by the Bank for International Settlements with the Reserve Bank was repaid; in June, a second maturing placement of US$100 million was repaid in full.