RDP 8812: International Interest Rate Linkages and Monetary Policy: The Case of Australia 2. Structural Background

Over the past decade or so, the Australian financial system has changed from being heavily regulated to being largely deregulated. In some cases, developments took place in a series of minor steps, but in others there were major events which clearly distinguished one period from another. The major changes were:

• the floating of the Australian dollar in December 1983. In the period before the float, the Australian dollar was set every day by the Reserve Bank under a crawling peg arrangement. While the exchange rate changed frequently, there was no market in foreign exchange and the system was more similar to the textbook fixed exchange rate regime than to a floating exchange rate regime. At the same time as the exchange rate was floated, exchange controls were abolished, which increased the scope for inward movement of capital, and opened up for the first time the opportunity for Australian investors to diversify into foreign fixed-interest assets;
• the introduction of the tender system for sales of government debt. This was done for short-term securities (Treasury notes) in 1979 and for longer-term government bonds in the middle of 1982. Prior to the introduction of the tender system for selling government bonds, yields had been set by the authorities under a tap arrangement. Thus, prior to the introduction of the tender, yields moved in a stepwise fashion, as the authorities adjusted them from time to time to changes in investor demand. Since the tender, yields in the secondary market have moved continuously and so the day-to-day variability has obviously been greater than under the administered system. The tender also facilitated the development of a deep secondary market in government bonds, with turnover having expanded twentyfold since 1982;
• over the past decade or so, there have also been a number of moves to deregulate financial intermediaries' interest rates. This has been a gradual process, starting in the late 1960s. By 1980, all ceilings on bank deposits had been abolished, but there were a couple of remaining ceilings on bank lending rates. To all intents and purposes, these have now been abolished. The maturity restriction which prevented banks from paying interest on short-term (including overnight) borrowing was lifted in 1984;
• 16 foreign banks were allowed entry into the Australian market as full trading banks in 1985. Prior to that, the only foreign banks which could operate in Australia as trading banks were a couple that had been established in the last century. Other foreign banks had entered the Australian market through merchant banking subsidiaries.

Many changes have resulted from this widespread deregulation, of which several are important for the present paper. Two that are clearly visible from the graphs shown later in the paper are that long-term government bond rates only became fully market determined after mid 1982, and the exchange rate after the end of 1983.

There has also been a major change in the way the Reserve Bank conducts its monetary policy. Prior to the introduction of the tender system and the float, the setting of rates on long-term government paper was an important aspect of monetary policy. After deregulation, monetary policy has essentially been implemented through daily open market operations. The cost and availability of cash has been the operating objective. In periods when the Bank has wished to tighten, its domestic market operations have led to a rise in overnight rates in the professional money market. This has quickly translated to a rise in all short-term security yields.