Reserve Bank of Australia Annual Report – 1987 The Year in Brief

Economic policy over the past year was again dominated by the continuing severe deficit in the current account of the balance of payments.

World economic conditions were generally unhelpful. There was a further sharp fall in Australia's terms of trade. This had been expected, but declining world economic growth and the spread of export subsidies and discriminatory trading practices by some of the most mature industrial countries compounded Australia's difficulties.

Economic strategy was directed to shifting resources into net exports and lowering pressures on the balance of payments. Domestic consumption, calls on capital markets by the public sector and costs, particularly labour costs, all had to be further restrained.

This general strategy proved appropriate and policy measures taken under it had some success as the year progressed: the balance of payments was less adverse with indications of fundamental improvement in the current account; domestic activity was flat; growth came wholly from a useful rise in net exports; and employment grew broadly in line with the growth in the work force.

Adjustment still has a long way to go. The current account deficit, though seemingly now on a downward course, is still large; our international indebtedness and debt service commitments continue to rise uncomfortably; and maintenance of our international competitiveness requires constant vigilance. All in all, policies and trends have been moving in the right direction, but steady and firm policy pressure — and patience — will be required to bring about the necessary restructuring of the economy.

Monetary policy was firm throughout the year, more so at some times than others. This reflected the priority given to correcting the balance of payments. At the same time, it was recognised that prolonged use of tough monetary policy could constrain essential investment in export and import-replacing industries.

There were two periods when monetary policy had to be tightened abruptly. The first was early in the financial year when there was considerable public pessimism about the adequacy of impending policy measures. The second was in January. This latter episode had little to do with domestic conditions but rather was related to the international re-alignment of currencies at that time. It provided a vivid indication of Australia's increased integration into the international financial structure and the potential volatility of short-term capital flows.

At other times, there were quite lengthy periods of rising optimism which generated opposite pressures on financial markets. The decline in the U.S. dollar against most currencies in the second half of the year had a similar effect.

A key operating objective throughout the year was to maintain a degree of stability in the foreign exchange market. This was seen as an essential precondition for maintaining business confidence.

With other policy instruments less readily adaptable, for most of the year a heavy burden fell on monetary policy. High interest rates, and at times substantial involvement by the Bank in the foreign exchange and domestic money markets, were prices that had to be paid for this.

Open financial markets imply considerable volatility from time to time and a need for official intervention on occasions.

This was the experience of many central banks over the past year. The reasons are varied and include imbalances among major economies and the lack of an agreed international exchange rate regime or system.

Australian financial markets reflected these disturbances. The Bank was involved in heavy market intervention for these as well as for domestic reasons.

In the result, the scale of the Reserve Bank's participation in the markets, and the consequent impact on the free operation of those markets, was much greater than the Bank would think appropriate as a continuing practice. The better balance in the setting of overall economic policy instruments now in train should be helpful in that regard.

Despite the restrained economy, the financial sector continued to expand strongly in 1986/87. This owed much to financial deregulation and to the high financial turnovers associated with balance of payments financing; restrictions on foreign investment in Australia were further relaxed during the year.

As in other countries, the sharemarket boomed with Australian prices moving broadly in line with overseas markets when allowance is made for exchange rate movements.

The monetary aggregates, as conventionally measured, rose only moderately in 1986/87 but other forms of financing, including bill finance, intermediaries' off-balance-sheet transactions and offshore borrowing, all grew quickly. Aggregate credit provided to the Australian community continued at a high though steady level. To date, this has not spilt into an excessive growth of spending but has boosted growth in asset values.

Theoretical debates about the setting of monetary policy have been overborne in Australia as elsewhere by the pressure of events stemming, for the most part, from financial deregulation and imbalances in international payments. New modes of financing are part of this process. Some of these changes reflect relative cost factors and also the continuing impetus from financial innovation in the more open market environment.

One consequence is that norms for monetary growth, which hitherto had served as intermediate objectives for policy, have been progressively discarded in many countries. In their place there is now routine reference to a wide range of financial and non-financial indicators to be weighed and judged in determining the appropriate direction for monetary policy and the intensity with which it is to be applied; in short, considerable pragmatism.

Other dimensions of financial development relate to heightened risk and allocation of risk among the parties. In the nature of things, management tends to lag behind practitioners in these developments and supervisory authorities behind management. Prudential supervision is an area where authorities in most countries are having to devote increasing resources. This is no less true in Australia than elsewhere. The Government recently announced the welcome intention to provide legislative backing to the Reserve Bank's role in prudential supervision of the Australian banking system.

For the foreseeable future, the focus of Australian economic policymaking will continue to be the balance of payments. The process of correcting the current account deficit will require continuing adjustment and restructuring of the domestic economy. Restraint in fiscal and wages policies and the removal of institutional and other structural rigidities are essential in maintaining competitiveness and reducing pressures on the capital markets.

Towards the close of the year, additional emphasis was put on fiscal and wages policy adjustments. These changes should allow some moderation of monetary policy. However, the scope for this will be limited by the need to continue with a very firm setting overall, of economic policy instruments.