Statement on Monetary Policy – February 2007 International and Foreign Exchange Markets

International financial markets

Global financial markets were relatively buoyant over the past year, reflecting the strong performance of the global economy. Five features have characterised global market developments over the year:

• Moderate monetary tightening by virtually all central banks. By the end of the year, the majority of central banks had official interest rates at or near normal levels. Japanese interest rates, however, remain close to zero, and this is continuing to provide an ongoing source of cheap money for global markets.
• A search for yield. This has kept bond yields low and credit spreads tight. Demand for investments funded out of Japan (the carry trade) was one factor contributing to this. Unprecedented increases in the official reserves of Asian and oil-producing countries most likely was another.
• Strong share markets. The strong state of the world economy and company profits accounted for most of this, but leveraged merger and acquisition (M&A) activity may also have contributed.
• Low market volatility. Even a run of political events in some emerging markets, which in earlier times would have caused a great deal of instability, passed with little impact.
• Widespread expansion in debt financing. This no doubt was related to the low cost of debt relative to the expected return on assets. Most developed economies experienced strong growth in credit and a marked increase in leveraged buyout activity last year.

Official interest rates

All the major central banks increased policy rates in 2006 (Table 2, Graph 15). In the English-speaking countries, rates are either at neutral levels, or even somewhat on the restrictive side. In the case of the US, the Fed has kept interest rates steady at 5¼ per cent since June as it waits to see the impact of the seventeen policy tightenings over the previous couple of years. For much of the second half of 2006 markets priced in the possibility that the Fed would be easing in 2007 in order to offset the consequences of the housing downturn. The most recent expectation, however, is that rates will not change for at least the next six months.

European countries still have interest rates a little lower than what is commonly regarded as normal. The ECB, for instance, has interest rates at 3½ per cent. As such, with European economies remaining strong, some further policy tightening is expected there over the next few months.

In Japan, rates remain very low. The Bank of Japan (BoJ) has only just begun its monetary tightening, lifting interest rates to 0.25 per cent in July after five years of following a zero interest rate policy. Amid mixed signals on the strength of the domestic economy and inflation, the BoJ has left rates unchanged at this low level since then. Markets currently expect rates to be raised by another 25 basis points some time in the first half of 2007.

Thus far in 2007, only one developed country has changed official interest rates: the Bank of England tightened by 25 basis points in January, lifting rates to 5¼ per cent, in response to a rise in inflation to 3 per cent, the upper end of the range set for the Bank of England.

Among the emerging markets, the most notable policy moves have been in China. The People's Bank of China (PBoC) tightened monetary conditions several times in 2006 to try to curtail the growth in money and credit. The PBoC has used a number of policy instruments. Benchmark interest rates that banks can pay and charge have been increased, as have the required reserves ratios for banks. These measures have produced some modest slowing in monetary and credit growth but asset prices have continued to rise rapidly.

Elsewhere in Asia, most countries have gradually raised rates from historically low levels earlier in the decade, but the overall level of interest rates remains relatively low. Recently Indonesia and Thailand have reduced policy rates after tightening earlier in 2006. Bank Indonesia has reduced its policy rate by 350 basis points since June 2006, to 9¼ per cent, as inflation pressures there have eased. The Bank of Thailand cut rates by 25 basis points to 4¾ per cent in January 2007. Elsewhere in emerging-market economies, policy rates were generally increased over 2006, with the notable exception being Brazil, where rates have been cut by 675 basis points in this easing cycle, reflecting a sizeable decline in inflation there.

Bond yields

Yields on the major economies' long-term government debt traded in a historically narrow range in 2006 (Graph 16). Most countries experienced a modest net rise in yields over the year, mostly in the first half when the market was most concerned about inflation (Graph 17). Overall, the level of bond yields remains relatively low, with yield curves negatively sloped in the English-speaking economies and most of Asia.

In the US, yields on government bonds rose noticeably over the first half of 2006, in line with the Fed's removal of monetary accommodation and growing concerns about inflation. By the second half of the year, however, the market's focus had shifted to the downturn in the US housing market and yields fell again. In recent months, these concerns too have faded and yields have risen again, though not to the levels of mid year.

At 4¾ per cent, US 10-year bond yields are about 50 points below the fed funds rate (Graph 18). This degree of inversion would normally signal expectations of monetary easing but, as noted earlier, such expectations no longer exist in the US. Rather, it appears that longer-term yields have been held down by strong demand for such securities.

German yields also rose in 2006 and are just over 4 per cent, up from a post-war low of 3 per cent in late 2005. The net rise over the year was more than that in the US. Japanese government bond yields increased slightly in 2006, fluctuating within a narrow range between 1½ and 2 per cent.

Spreads on corporate and emerging-market bonds remained low after declining sharply over recent years (Graph 19). Emerging-market debt was sold over May and June 2006, as risk aversion temporarily increased, but spreads on such debt soon returned to earlier lows. They have remained there since. There was little movement in emerging-market spreads in response to events, such as the coup in Thailand and increased concerns about nationalisation of major industries in parts of Latin America, which in the past have resulted in a large widening. Thai spreads rose modestly following the coup and the introduction of capital controls, but have since declined again.

Heightened speculation of a significant slowdown in the US economy in the second half of 2006 saw spreads on low-rated corporate debt in the US rise somewhat in anticipation that an economic slowdown would cause an increase in corporate defaults. However, these spreads too have since narrowed following the publication of data indicating only a modest slowing in US growth.

Equities

Global equity markets were strong in 2006 (Table 3). There was only a brief interruption to their rise mid year when there was a general increase in risk aversion in all global markets. Share markets ended 2006 with a weighted average increase of 14 per cent, the fourth consecutive year of strong gains. The rise was supported by continued robust global growth, strong earnings and an environment of low volatility. The share of profit in national income in many countries is close to historical highs. The relatively cheap cost of debt and low gearing ratios of a number of companies, particularly in the US and euro area, resulted in a large amount of takeover activity in 2006, further boosting equity prices. Global M&A activity has returned to levels last seen during the 1990s share market bubble (Graph 20). A number of equity markets approached, and in some cases exceeded, their peaks reached in 2000, including the Dow Jones in the US and the Canadian and Hong Kong equity market indices. Despite the rally in equity markets, global price-to-earnings (P/E) ratios, measured on historical earnings, remain around long-run averages (Graph 21).

The one notable exception to the strength in global share markets was in Japan, where equities rose only marginally in 2006, albeit after having outperformed other markets in 2005.

Equity markets in emerging economies have benefited from a general climate of low market volatility, improved economic conditions, and high commodity prices. They have risen strongly since 2003, the rise interrupted only briefly by a sharp fall in May and June as risk aversion by investors increased for a short time. In emerging Asia, the Indian and Indonesian equity markets have led the rally, growing by more than 300 per cent since the start of 2003. The primary exception has been in Thailand, where in early January the equity market fell to its lowest level since August 2004 following the introduction of capital controls late in 2006.

In recent months the rapid rise of share prices in China has been causing concern for the authorities. Local currency share prices on the Shanghai exchange have risen 50 per cent in the past three months and 135 per cent over the past year.

Shares in Latin America have increased by nearly 300 per cent since their 2003 trough, with equity markets in the smaller Latin American economies recording the strongest growth. Despite Venezuelan equities recording large falls on several days last month following the announcement of plans to nationalise companies in a number of key industries, Venezuelan equities remain 120 per cent higher than their levels at the start of 2006, and over 450 per cent higher than at the start of 2003.

Exchange rates

Volatility in the major exchange rates has continued to remain at low levels over the past year (Graph 22). The main trend has been for the US dollar to depreciate against most major currencies, with the exception of the yen (Table 4). The US dollar fell most sharply against the euro and other European currencies. This in part reflected the differing economic and policy cycles in the two regions, summed up by the fact that US monetary policy has been held steady since June while European interest rates have continued to rise. Overall, the US TWI fell by 5 per cent last year, to a level which is about 25 per cent below the 2002 peak (Graph 23).

The US dollar was affected at various times during the year by talk that holders of official reserve assets were diversifying away from US dollars. A number of countries either announced diversification plans or were rumoured to be considering such moves. At the aggregate level, however, there is little evidence of a shift away from US dollars in global reserves holdings; the proportion of US dollars in official reserves remains around two-thirds.

The Japanese yen was the only major currency that did not rise against the US dollar. Despite the Bank of Japan's decision to end the zero interest rate policy in July, the level of interest rates in Japan remains very low. This appears to have encouraged increased ‘carry trade’ activity, where funds are borrowed at low interest rates in Japan and converted to other currencies for investment at higher rates elsewhere. In addition, there have been large capital outflows from Japan due to Japanese investors diversifying their financial portfolios. On a real trade-weighted basis, the Japanese exchange rate has depreciated to its lowest level in around two decades, and is 45 per cent below its peak in the mid 1990s (Graph 24).

The pace of appreciation in the Chinese renminbi against the US dollar accelerated somewhat during 2006, though the total appreciation over the year was only 3 per cent. The PBoC undertook over $US200 billion of intervention last year to stem what would have otherwise been a larger rise in the exchange rate. With the US dollar depreciating by more than 3 per cent against many other currencies, the renminbi depreciated in trade-weighted terms. Pricing in the non-deliverable forward market indicates that the markets expect the renminbi to appreciate by a further 51/2 per cent against the US dollar this year.

Emerging Asian currencies continued to appreciate against the US dollar during 2006, although they remain significantly below their levels at the time of the financial crisis of 1997/98 (Graph 25). As in the case of China, the pace of appreciation in Asian currencies was tempered by large-scale foreign exchange intervention. East Asian central banks resumed their build-up of reserves after scaling back activity in the previous year (Graph 26).

Reflecting concerns about the appreciation of the baht, which at that point had risen by 14 per cent against the US dollar since the beginning of 2006, the Bank of Thailand in December announced controls on short-term capital inflows. The controls primarily involved penalties on non-trade related capital flows that were reversed in less than 12 months. Foreign direct and portfolio equity investment were exempt from this measure. This resulted in a short-lived depreciation in the baht, but the largest effect appeared to be on the Thai stock market (see above). In January, the Thai authorities reduced controls on capital outflow by residents to try to further alleviate the upward pressure on the baht. Similar measures to encourage capital outflows were also introduced in Korea where residents obtained a tax holiday for three years on foreign portfolio investment.

Australian dollar

The Australian dollar appreciated by about 4 per cent on a trade-weighted basis in 2006 (Table 5). The rise was more pronounced against the US dollar and even more so against the yen. The Australian dollar's exchange rate against the yen in January 2007 reached its highest level since the onset of the Asian crisis in mid 1997 (Graph 27). The release of the December quarter CPI, which resulted in a downward adjustment to interest rate expectations, saw the Australian dollar fall from its peaks of early January. The currency is currently trading at US773/4 cents and 64 on a trade-weighted basis, around the levels at the time of the previous Statement.

Over the past year, the demand for the currency has been supported by the rising terms of trade, reflecting continued strength in commodity prices, particularly base metals, iron ore and gold. In addition, in recent months the Australian dollar has been boosted by an increased appetite for carry trades. Australian dollar investments, along with the New Zealand dollar and British pound, have been an important destination of much of these flows, particularly from Japan. As investors have become more convinced that the Bank of Japan will not raise interest rates significantly in the foreseeable future, they have increased their appetite for carry trades. Moreover, as noted above, there appears to be a structural shift by Japanese household investors to increase their holdings of higher yielding offshore assets. By international standards Japanese investors have traditionally held very conservative financial portfolios skewed towards domestic assets, but this now seems to be changing.

The attractiveness of yields in Australia has been reflected in the large net inflows into bank and money market instruments which have accounted for the largest share of total capital inflow in Australia (Graph 28). A sizeable component of these inflows also reflected Australian banks sourcing funds in offshore markets, taking advantage of strong demand for such investments in these markets. There has been a trend of modest net outflow of equity capital in recent years, with large investments offshore both directly by Australian companies and through portfolio flows of Australian funds managers. These have more than offset inflows of equity capital from abroad, even though these too have been substantial. Australian superannuation funds continue to allocate about one-quarter of their funds under management to overseas equities.

Notwithstanding the appreciation over the year, the trading range for the trade-weighted index of the Australian dollar in 2006 remained narrow by historical standards (Graph 29). The range was only slightly wider than that recorded in 2005 which was the lowest in the floating exchange rate period. While volatility of the currency has picked up in recent months, it still remains below its post-float average (Graph 30).

Measures of investor sentiment towards the Australian dollar appear positive with speculators continuing to hold net long positions in Australian dollar futures on the Chicago Mercantile Exchange.

Since 2002, the Reserve Bank has been buying foreign exchange reserves to replenish sales that it had made during intervention operations to support the Australian dollar between 1997 and 2001. After significant purchases were made in both 2003 and 2004, net purchases were scaled back over both 2005 and 2006, given reserves had reached relatively comfortable levels and the exchange rate had settled into a steadier range. Over 2006, net purchases of foreign exchange totalled around $360 million. The Bank stepped up its purchases somewhat in January 2007 when the exchange rate of the Australian dollar rose to around its highest level since 2004. Net reserves are currently around $31½ billion.