Reserve Bank of Australia Annual Report – 1988 The Year in Review

The year just closed was one in which growth in industrial countries exceeded most expectations.

A year ago, it had been widely expected that the large imbalances in world trade would bring about a slowdown. These fears were reinforced for a time by the share-market crash in October 1987.

In the event, growth was strong throughout the year.

Policy settings in most countries eased after October but were tightened during the second half of the year.

Australia was no exception to the general scene.

It had been expected that, because of the continuing process of restoring better balance to our external accounts, there would be only modest growth in the economy, particularly in view of the sombre world outlook. However, in line with overseas experience, Australia's GDP growth was well above that forecast at the beginning of the year. Employment continued to grow and unemployment fell. Inflation slowed, though not to the extent projected a year earlier.

The underlying strength of demand was not fully recognised in the early months and, in any event, the stock-market crash intervened.

In the second half of the year, it became clear that the effects of the share-market fall were largely confined to the financial sector and that the momentum of growth was almost unimpaired. There were several reasons for this:

• World growth and world trade grew much more strongly than was expected. This led to a marked acceleration in commodity prices and stimulated demand for our goods and services. Increases in commodity prices restored much of the fall in our terms of trade that had occurred over the previous three years and added further buoyancy to the economy.
• Spurred by lower interest rates and tax changes, housing demand was already growing strongly before the share-market crash and prices were on the increase. The crash gave housing a further boost. Some investors turned directly to property; others redirected their funds to banks. Savings banks experienced large deposit inflows and, with their investment opportunities largely restricted to property-based loans, the supply of funds available to meet heavy borrower demand rose sharply.
• Finally, confidence that appropriate macro-policy adjustments were being made grew throughout the year. The Commonwealth Budget, which promised to be in balance for the first time in many years, actually recorded a substantial surplus. Wages were restrained and real unit labour costs fell.

For most of the year financial markets were optimistic, tending to push interest rates down and the exchange rate up.

Against this background, monetary policy faced some dilemmas.

In the early months of the year, fiscal tightening and wage moderation presented an opportunity to lift some of the burden from monetary policy. Some scope was seen for interest rate falls without damaging the overall firm setting of policies. To the extent that the exchange rate was lower because of this, there was less erosion of the competitiveness of Australian industry. Of course, policies which slowed the rise in the exchange rate made the purchase of Australian assets, including shares and real estate, cheaper for foreigners.

The share-price fall brought the Australian dollar under heavy selling pressure. The immediate requirement was to maintain order in both the domestic money market and the foreign exchange market. The Bank moderated the fall in the exchange rate by running down external reserves. Tightening monetary policy would have been inappropriate in these unusual circumstances. Indeed, the first need was to ensure adequate liquidity in the system. The Bank indicated publicly that it recognised that need.

After the financial markets were stabilised, there was a short period of uncertainty and nervousness. As this gave way to renewed confidence, activity rose and there was increased demand for the Australian dollar.

Two considerations differentiated this situation from that earlier in the year. One was the sounder under-pinning of the rising exchange rate provided by higher commodity prices. The second was the emergence of stronger demand; this showed up in a rapidly rising volume of imports, a booming housing market, a tight labour market and wage increases in areas where bottlenecks were being felt.

Thus, whilst the Bank bought foreign exchange in some volume over the June quarter, in order to test the pressures in the foreign exchange market, this could not be allowed to produce significantly easier monetary conditions. To the contrary, monetary policy was tightened over the quarter and interest rates rose.

Volatility in the exchange market was high at times. While uncomfortable, it largely reflected re-alignments among the major economies and our own adjustment to changing conditions, in particular rising commodity prices.

On occasions, the volatility was accentuated by the operations of overseas-based investors attracted to “high yielding” (i.e. high interest) economies. As well as Australia, these included, at times, the United Kingdom and Canada.

In most countries, pragmatism is playing an increasing part in the making of monetary policy. In Australia, policy continues to be based on continuous assessment of a wide range of current and potential influences on monetary conditions.

Australia's external imbalance and the high level of external debt were major issues for general economic policy throughout 1987/88. It was of some concern, therefore, that strong domestic demand boosted imports over the year. Also, in the second half of the year, earnings and prices appeared to be growing uncomfortably quickly, threatening the downward course of inflation and the improving trend in the balance of payments.

The tightening of monetary policy in the second half of the year was in response to those developments.

At the close of the year, the setting of overall economic policy in Australia seemed generally appropriate to the economic problems facing Australia at home and abroad.

This could not be more than a tentative judgment. One important consideration is the future course of the world economy, international trade and international financial conditions. These are uncertain, though the outlook seems more hopeful than it did a year ago.

Other aspects are more within our own control.

While the rise in commodity prices is very welcome from Australia's viewpoint, it cannot be taken for granted that the levels of mid 1988 will continue for long. The higher prices should be regarded as a windfall which provides the opportunity to reduce markedly the balance of payments deficit. It would be tragic if they were absorbed in an overly rapid increase in domestic demand, with the pressures that would unleash, or if we were deflected from the long-term task of adjusting the structure of the economy.

There was some progress during the year in the long task of restructuring Australian industry. Equipment destined to improve our net export performance was an important component of import growth; manufacturing exports recorded another substantial increase.

However, it is disappointing in that context that Australia's high economic growth in the year just closed largely reflected strong domestic demand with no further gains in volume terms in net exports.

International competitiveness is vital. For this, further reductions in the rate of price increases, to levels more consistent with those of our competitors and trading partners, are essential. Whilst the link between prices and wages is well recognised, greater productivity offers opportunities for both real wage increases and lower costs.

The crash in world share markets in October 1987 put financial systems and their members to a searching test. With a few relatively minor exceptions, the test was met. Nevertheless, some stresses were observed. These have called attention to the need for strong and reliable domestic and international settlement procedures and for better surveillance of securities and financial markets generally.

It was appropriate therefore that the world-wide trend for monetary authorities to improve their oversight of prudential standards within the financial system moved further forward during the year.

Plans to introduce a “risk-ratio” approach to the adequacy of banks' capital and for prudential standards among countries to converge are now well advanced. A “risk-ratio” system is expected to be introduced in Australia before the end of 1988. Here, as elsewhere, it is necessary to reconcile distinctive features of the domestic banking system with the objective of broadly uniform international practice.

Early in 1988, the Bank began the issue of a new style of $10 note to commemorate Australia's Bicentenary. Teething problems delayed high-volume issues of the note. The note is printed on plastic instead of paper and incorporates an optically variable device on a clear background as an additional deterrent to counterfeiting. In other respects, the note looks and feels like a conventional paper note. It incorporates new technology which will have wide application in security and other high-quality printing.

The Bank's net operating earnings in 1987/88 were less than half those of the previous year. In particular, gains on sales of foreign currency were sharply reduced. The appreciation of the Australian dollar required some substantial writing down of the value, in Australian dollar terms, of the Bank's holdings of foreign currencies. Such write-downs were charged against relevant reserves and provisions without directly affecting operating earnings for the year. However, a sizeable proportion of 1987/88 earnings was retained by the Bank to replenish provisions. That reflected in lower net profits.

Deregulation of the financial system, rapid changes in technology and pressure for greater efficiency are leading the Bank and many other central banks to review the range and effectiveness of their activities. Obviously the shift to market-based methods of carrying out monetary policy and greater involvement with the stability and efficiency of the financial system call for new skills. Contraction in the need for resources in some other areas, however, has been inevitable. Substantial further changes in the nature of the Bank's operations are likely over the next few years.