Reserve Bank of Australia Annual Report – 2007 Governor's Foreword

The structure of this year's Annual Report differs from that in recent years. The Report first sets out the Reserve Bank's functions and objectives, and then outlines its governance, accountability and communication arrangements, before describing activities during the year. The costs of those activities are then explained, followed by a detailed treatment of earnings and distribution. Statutory material and the formal financial statements appear at the end of the document.

There were some significant changes in personnel during 2006/07. At Board level, after 10 years as Governor, Ian Macfarlane retired from the Reserve Bank in September 2006. As a result of my own appointment, a new Deputy Governor was required and I am delighted that the Treasurer selected Ric Battellino for that role. Graham Kraehe joined the Board from February 2007 and at its July 2007 meeting the Board farewelled Hugh Morgan, who has been a forceful advocate of sound money for many years. Several key senior management changes flowed from Ric Battellino's appointment. The Bank's senior ranks continue to be filled with exceptionally capable and experienced people.

The Reserve Bank's staff has increased somewhat over the past two years, after a long period in which it had declined or been fairly stable. This growth reflects additional activities that the Bank needs to undertake but also a rise in the resilience required from our systems. A case in point is the new dedicated business resumption site in north-western Sydney. It carried construction and IT costs of $39 million and will have an ongoing operational cost, including additional staff, of about $4 million per year from now on. But not to have such capacity is no longer acceptable. The project was delivered on time and on budget. The new facility has been operational from mid July.

A major upgrade to the RITS system, which is Australia's main high-value payments system, was rolled out to customers during the year, at substantial cost to the Reserve Bank. Handling about $170 billion in transactions on the average day, this critical piece of infrastructure is provided to the Australian financial community at a high level of reliability, at a total annual cost of just $11 million.

Efforts to improve the quality of notes in the hands of the public continued, with the introduction of a new program of incentives for note sorting by banks and armoured car companies. This carries some financial cost to the Reserve Bank, but the payoff will be better quality, cleaner notes in the community as unfit notes are more effectively removed from circulation.

The Reserve Bank's economic policy work continued as normal. Monetary policy was tightened somewhat in the first half of the financial year and again in August 2007, as the Board acted to keep inflation close to the target. The Board's reasoning for its decisions, as well as the Bank's assessment of the economic situation and prospects, are given in statements announcing policy changes and in the detailed material in the Statement on Monetary Policy published each quarter, so they are not repeated here. Financial stability continues to be a key focus, with the Bank publishing its regular Financial Stability Review twice yearly and working with APRA, ASIC and the Treasury as the Council of Financial Regulators, which met four times during the year. The activities of the Payments System Board are reported in its own annual report.

A highlight in the area of international relations was the co-hosting of the G-20 meeting of finance ministers and central bank governors in Melbourne in November 2006, followed by the Bank for International Settlements bi-monthly meetings held in Sydney, attended by governors from 45 central banks. These were the largest meetings of their kind ever held in Australia and were very successful.

The Reserve Bank's balance sheet expanded further, to around $132 billion at the end of June, a rise of 25 per cent from the previous year and an increase of 120 per cent over five years. This was in large part a result of the accumulation of Government deposits resulting from budget surpluses and the accompanying need for the Bank to hold counterpart assets with an appropriate risk profile. It had no impact on monetary policy or financial conditions. Now that the Future Fund is in operation, the balance sheet is likely to diminish in size over the next year or two.

The Bank's financial results for 2006/07 were affected by the rise in the exchange rate of the Australian dollar. As previous annual reports of the Bank have explained in some detail, and as this report again outlines, central banks which hold their nations' foreign currency reserves on their balance sheet are exposed to considerable currency risk. When the Australian dollar exchange rate appreciates, the accounts record a fall in the value of foreign assets. In 2006/07, the rising Australian dollar meant that the Bank experienced a substantial unrealised valuation loss on its financial assets, which exceeded the flow of income from its assets during the year. Therefore, the Bank recorded a loss in 2006/07, as measured by Australian equivalents to International Financial Reporting Standards.

This is not the first such loss – the Reserve Bank last experienced one on an AIFRS basis in 1993/94 – and it is unlikely to be the last. The reason is that there is very little scope for a central bank to manage foreign currency risk without compromising its policy obligations. Foreign assets cannot be hedged back to Australian dollars because that would defeat the purpose of holding them. This risk has to be accepted as part and parcel of being a central bank. In some years very large valuation gains will be observed. But on some other occasions, the Bank can expect to record a valuation loss.

A strong capital position is needed in order to absorb sustained valuation losses should they occur. The Reserve Bank's capital position, at a little over 10 per cent of assets at risk, is strong and has not been impaired by the outcome in 2006/07 because the unrealised valuation losses were mostly offset against unrealised gains from earlier years, which were held in reserve. The remainder has been charged against other sources of income, leaving capital unaffected.

Earnings available for distribution are determined by the provisions of the Reserve Bank Act 1959, which have proven over the years to be a very sound basis for determining an appropriate flow of dividends while maintaining the soundness of the Bank's balance sheet. The Act provides for the flow of net interest earnings plus any realised valuation gains to be available as a dividend. Un realised gains are not distributed but are retained either until they are offset by future unrealised losses or until they become realised. If unrealised losses exceed previous unrealised gains, the difference reduces earnings available for distribution pari passu, which is the situation this year. As a result, the dividend available to the Government from the 2006/07 result will be slightly smaller than last year's. Details are spelled out in the chapter on Earnings and Distribution.

The Reserve Bank's activities in its various areas of responsibility are set out in the chapters that follow. The staff's contribution to the Bank's work was, as usual, of the highest professional calibre and the Board joins me in thanking them for their efforts.

Glenn Stevens
Chairman, Reserve Bank Board
16 August 2007